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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark one)

[X]

Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended December 31, 2003, 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 No. 0-23862

Fonix Corporation

(Exact name of registrant as specified in its charter)

9350 South 150 East, Suite 700

Sandy, Utah 84070

(Address of principal executive offices with zip code)

(801) 553-6600

(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Class A Common Stock ($0.0001 par value per share)

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[ ].

The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2003 is approximately $4,029,000, calculated using a closing price of $0.205 per share on June 30, 2003.  For purposes of this calculation, the registrant has included only the number of shares directly held by its officers and directors as of June 30, 2003 (and not counting shares beneficially owned on that date), in determining the shares held by non-affiliates.  

As of April 13, 2004, there were issued and outstanding 87,544,231 shares of our Class A common stock.

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [  ]

Fonix Corporation

2003 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

Part I

Page

Item  1.

Business

3

Item  2.

Properties

38

Item  3.

Legal Proceedings

39

Item  4.

Submission of Matters to a Vote of Security Holders

39

Part II

Item  5.

Market for Registrant's Common Equity and Related Stockholder Matters

41

Item  6.

Selected Financial Data

45

Item  7.

Management's Discussion and Analysis of Financial Condition and

Results of Operations

46

Item  8.

Financial Statements and Supplementary Data

63

Item  9.

Changes in and Disagreements with Accountants on Accounting and

Financial Disclosure

63

Item 9a.

Controls and Procedures

64

Part III

Item 10.

Directors and Executive Officers of the Registrant

65

Item 11.

Executive Compensation

67

Item 12.

Security Ownership of Certain Beneficial Owners and Management

69

Item 13.

Certain Relationships and Related Transactions

72

Item 14.

Principal Accountant Fees and Services

72

Part IV

Item 15.

Exhibits, Financial Statement Schedules and Reports on Form 8-K

74

Page 2

PART I

ITEM 1.

 BUSINESS

THIS ANNUAL REPORT ON FORM 10-K CONTAINS, IN ADDITION TO HISTORICAL INFORMATION, FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES.  OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE RESULTS ANTICIPATED BY FONIX AND DISCUSSED IN THE FORWARD-LOOKING STATEMENTS.  FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES ARE DISCUSSED BELOW IN THE SECTION ENTITLED “FORWARD-LOOKING STATEMENTS” AND ELSEWHERE IN THIS ANNUAL REPORT.  THE FOLLOWING DISCUSSION SHOULD BE READ TOGETHER WITH OUR’S FINANCIAL STATEMENTS AND RELATED NOTES THERETO INCLUDED ELSEWHERE IN THIS DOCUMENT.

General

Fonix Corporation, a Delaware corporation (“we” or “Fonix”), is an industry leader in delivering conversational speech solutions to consumer systems and devices for everyday use.  Manufacturers and developers incorporate Fonix’s award-winning technology to provide their customers with an easy, convenient and reliable user experience.  Fonix currently offers voice technology for mobile/wireless devices, computer telephony systems, the assistive market and automobiles.  Fonix recently acquired LecStar Telecom Inc., a rapidly growing Atlanta-based regional provider of integrated communications services to businesses and consumers.  LecStar, a competitive local exchange carrier (“CLEC”), offers a full array of wireline voice, data, long distance and Internet services to business and residential customers throughout BellSouth’s Southeastern United States operating territory.  LecSt ar’s solid customer base offers a unique direct marketing and distribution channel for Fonix’s speech technologies and solutions.

We were incorporated under the laws of the State of Delaware on September 12, 1985.  Currently, we operate as two business units: Fonix Speech Group and Fonix Telecom Group.

Fonix Speech Group:

We deliver speech interface solutions and applications (“Products”) that empower people to interact conversationally with information systems and computing devices. Our Products are based on our speech-enabling technologies, which include text-to-speech (“TTS”) and neural network-based automated speech recognition (“ASR”).  ASR and TTS technologies are sometimes collectively referred to in this report as our “Core Technologies.”  We believe our intuitive speech-enabling Products enhance user productivity and efficiency in a broad range of markets including mobile and wireless devices; embedded speech solutions for automotive applications; entertainment game consoles; computer telephony and server applications; assistive and language learning applications for everyday use with computers and electronic devices; and client-to-server distributive speech processing and connectivity.

 Prior to 2002, we focused on research and development (“R&D”) and prototype development projects for customized applications.  The R&D and prototype development utilized the Core Technologies and development and marketing of multiple operating systems and hardware platforms. The transition from R&D and prototype development to standard speech Products began in 2002. We expect to leverage our standard speech Products across multiple platforms, Products and markets.

Fonix serves markets that are adopting speech-enabled solutions and applications. As memory requirements, noise robustness, recognition accuracy and efficiency of speech solutions become increasingly critical, Fonix expects its highly competitive solutions to meet customer demand for simple, convenient user interfaces

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 We currently market speech Products that utilize our Core Technologies to industry-leading software developers, consumer electronics manufacturers, original device manufacturers, micro-processor manufacturers, third-party product developers, operating system developers, network developers, and wireless operators, as well as directly to consumers.  With the acquisition of LecStar, we expect that our distribution channel to consumers will increase.  We currently focus our marketing efforts toward embedded systems for automotive applications and wireless and mobile electronic devices, server-based solutions for telephony voice-activated applications, and enterprise distributive speech solutions. We pursue revenue opportunities through generation of royalty fees, product and technology licenses, product sales, non-recurring engineering fees, and support agreements.

Our speech interfaces are value-added solutions for computing and communications devices.  Manufacturers of consumer electronics products, software developers, wireless operators, telephony distributors, system integrators and value added re-sellers (VARs) can simplify the use and increase the functionality of their products and services by integrating Fonix speech solutions, resulting in broader market opportunities and significant competitive advantage. Fonix solutions support multiple hardware and software platforms, are environment and speaker independent, optimize cost and power efficiencies, provide easy integration within a relatively small memory requirement for embedded applications, and enhance scalability for high channel capacity for computer telephony and server-based systems.

Speech Group Market Focus

We deliver speech solutions in the following markets:

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Mobile / Wireless

We provide speech interface solutions for mobile phones, Smartphones, PDAs, web pads and wireless communication devices. The award-winning Fonix VoiceDial™ is a totally interactive, hands-free software application that enables users to place calls and navigate device menus and applications simply by speaking. Fonix VoiceCentral™ is a hands-free software application for Pocket PC that allows users to access Personal Information Management (PIM) tools simply by speaking.

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Automotive

Fonix AutoSuite™ solutions work as a natural voice interface inside an automobile for controlling and managing complex system functions. Navigation, climate control, multi-media, Internet and mobile phone access are just some of the hands-free, safety-minded voice-activated solutions for vehicles.

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Computer Telephony and Server

Fonix ConnectMe™ is an innovative solution for computer telephony integration and server systems. ConnectMe is a voice-automated telephone operator that provides an efficient, professional means of routing incoming, outgoing and internal calls. Fonix also offers a voice interface solution  for 511 system integrators.  511 is the designated three-digit phone number for national travel information within the United States of America.

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Assistive and Consumer Speech

Our solutions make everyday life a lot easier for people who are blind or have visual, vocal or mobility impairments, and for non-English speakers who are learning the language. Fonix DECtalk®, the best-known and most respected name in the assistive markets, transforms ordinary text into highly intelligible speech. We have taken our intuitive Core Technologies and applied them to everyday speech solutions for game consoles, PCs and other consumer devices such as cordless phones, electronic dictionaries, MP3s and toys.

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Distributed Speech

Distributed or client device-to-server solutions combine the convenience of mobile devices with the power of network servers. Distributed speech technology enables the mobile device user in the field to still have access to a server network via user-friendly speech input/output.

Fonix Mobile / Wireless Solutions

We provide intuitive speech interfaces for mobile and wireless devices such as PDAs, Smartphones, other mobile phones, web pads, wireless communication devices and other consumer electronics.

Our speech solutions for mobile / wireless devices include:

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Fonix VoiceDial

Fonix VoiceDial^TM is a totally interactive, hands-free software application for Windows Mobile Pocket PC and Smartphone and Symbian devices that enables users to access mobile phone contacts simply by speaking. With VoiceDial, there is no need to scroll through menus or push buttons; users just speak the name of the contact. VoiceDial is speaker independent, so  no voice training is involved, including both contact names and digit dialing. The speech recognition is highly accurate, even in noisy environments like cars or airports. VoiceDial offers several prompting voices; users choose which voices to download to their device. All TTS voices are highly intelligible and will handle an unlimited vocabulary, even with difficult contact names.  It is available in multiple languages — English, French, German and Spanish. Current phones supported by Fonix VoiceDial include Nokia 6600, Nokia N-Gage, Nokia 3660/3620/3650/ 3600 and the Nokia 7650.

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Fonix VoiceCentral

Fonix VoiceCentral™ is a totally interactive, hands-free software application for Windows Mobile Pocket PC and Smartphone devices that enables users to access Personal Information Management (PIM) tools simply by speaking. VoiceCentral incorporates the award-winning Fonix VoiceDial software, while adding several other significant capabilities. VoiceCentral allows users to manage email (listen to email, then choose to delete, reply with a .wav file or save), access calendar and tasks, launch or close any application simply by speaking, dial names directly from the contact list (users do not have to navigate multiple menu trees; they just say the name of the person they want to call), and dial a number directly using a continuous string of numbers.

Fonix Mobile / Wireless Market Opportunities

Our partners and original equipment manufacturers (OEMs) and original device manufacturers (ODMs) provide significant potential to reach users in many market areas. We have already seen significant market response to VoiceDial and expect to deliver in the following channels:

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OEMs & ODMs: Our first VoiceDial contract delivered the solution on the Hewlett Packard (HP) Journada ® 928 WDA. We also have partnerships with Microsoft, Intel, TI, Hitachi, O2 and HTC and are aggressively pursuing additional OEM opportunities with Nokia, Sony-Ericsson, Accelent, NeoMagic, Siemens, Palm and Samsung.

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Mobile Operators: We market VoiceDial and VoiceCentral through mobile operators such as AT&T Wireless, T-Mobile, Orange, Vodafone and Verizon. VoiceDial can be delivered in several methods including loading software directly on the device or over-the-air activation.

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Innovative Retail Opportunities: The market for speech applications sold over the Internet is beginning to mature. Handango, PocketGear, PocketPC Passion and others allow us to distribute VoiceDial in high traffic Internet locations without the distribution costs of working with retail stores. We also provide VoiceDial and VoiceCentral on our website.  

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Bundled Solutions: Other complementary solutions are also channels for distribution of our products. Companies like Travroute have integrated our solutions into their applications. We foresee partners shipping the full VoiceDial and VoiceCentral functionality as a complement to their applications and devices.

We have several competitors offering a variety of speech technologies and products.  Companies like ART, Voice Signal and Neuvoice all deliver speaker-dependent and speaker-independent solutions. Other speech companies like IBM, Nuance and Scansoft may introduce competitive products.  

Fonix Automotive Solutions

We provide speech applications for fully integrated multimedia automotive solutions.  These applications can be quickly deployed and adopted by the automotive electronics marketplace and are based on our proprietary Core Technologies. These solutions are ideal for automotive environments, because they are highly noise robust, require no user training, are available in many language options, require minimal computing resources and are available in a wide variety of automotive-qualified hardware configurations.

Today’s automakers require a solution platform that can provide a wide range of speech interface functionality. Fonix integrated speech solutions are developed to accommodate highly flexible, open-ended computing platforms that are able to serve a number of telematics applications. These applications provide the auto manufacturer as well as the driver the highest degree of flexibility and convenience.

The Fonix AutoSuite™ includes the following components:

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Hands-free Phone Kit – Voice-enabled access to mobile phone contacts; users dial any contact with just their voice, no need to scroll through phone menus.

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Stand-alone Navigation – Avoid dangerous manual entry; users access the car’s navigation system by simply speaking or spelling destinations.

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Radio-based Multimedia – Voice access of standard radio functions.

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Mid-range Stand-alone Multimedia – The radio-based voice interface with navigation and total multimedia added.

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High-end Multimedia – Fully integrated hands-free phone, navigation systems, automotive command and control, and multimedia control.

Fonix AutoSuite Market Opportunities

We continue to seek partnerships and joint-marketing relationships with the leading silicon, operating systems and Tier 1 mobile suppliers to create compelling solutions for automotive OEMs. We continually work with our partners’ sales and marketing organizations to create and deploy speech interface solutions required by the automotive industry. Current Fonix automotive partners include Motorola, Hitachi, Yazaki North America, Volkswagen North America, Mitsubishi, Intel, Analog Devices, QNX, Sun Microsystems and WindRiver. Fonix has also had discussions directly with multiple Tier 1 suppliers such as Lear Automotive Systems, JCI and other OEMs to drive large-volume recurring revenue business.

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Major competitors include IBM (Via Voice, Pervasive Computing), and Scansoft.  As our AutoSuite solutions are proven, we seek to enter into supplier relationships to create long-term, recurring revenue situations.

Fonix Computer Telephony and Server Solutions

We provide telephony and server-based solutions for automated phone directory and database information systems. We believe that traditional operator systems and other means of accessing information are becoming antiquated. Significant employee and personal time is lost trying to access information through keypad directories or because calls are blocked after hours.  Also, information stored or transferred through servers, PBX or databases may not easily be accessed through non-integrated platforms. Voice-automated systems are capable of integrating these markets and meeting customer expectations of competitive costs, easy installation with minimal change to their existing infrastructure and a simple user interface.

Fonix speech solutions for telephony and server systems include:

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Fonix ConnectMe™

Fonix ConnectMe is a unique voice-automated telephone operator that provides an efficient, professional means of routing incoming, outgoing and internal calls. Customers and employees dial one number, speak the name of a person or a department and are quickly connected to the person or department they want to reach. Whether during peak business hours or late at night, ConnectMe’s 24-hour high-tech customer service capabilities ensure that all calls reach their intended destinations. By deploying ConnectMe, businesses increase employee efficiency and decrease the amount of time receptionists and office managers spend answering phones. ConnectMe handles all incoming calls simultaneously, so callers are never put on hold. It eliminates the annoyance of remembering and dialing extension numbers or looking up extensions in a phone directory. Employees can create, maintain and access their own phone lists, and can customize the delivery of calls. For example, while at lunch, employees can route calls to their cell phones or pre-define ConnectMe for weekends and holidays by creating a weekday schedule.  To our knowledge, no other company in this niche has emerged with a competitive product with our unique features, functionality and price.

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511 Traffic Information System

In July 2000, the Federal Communications Commission (FCC) assigned “511” as the number for nationwide access to traveler information. 511 was designated as a free service and when fully implemented will cover the majority of roads in the U.S., helping travelers avoid congested routes and safety hazards. By dialing 5-1-1, callers can access information about route-specific weather and road conditions. Fonix and partner Meridian Environmental Technology, Inc. provide a 511 system in North Dakota.  Current markets in development include Nebraska, Montana and South Dakota, with other states scheduled to deploy the system in the near future.  Competition in the 511 market includes TellMe and IBM’s WebSphere.

Fonix Computer Telephony and Server Market Opportunities

We are well positioned to be a primary competitor in telephony products with ConnectMe. The value-add for customers using ConnectMe include the system’s appeal to customer satisfaction, immediate ROI, user convenience, easy installation and maintenance, and its ability to bring a professional “voice” to companies’ telephone operator systems.  Our market strategy is to sell ConnectMe through VARs and distributors, as well as to customers of LecStar.  Potential competitors in the telephony/server market nclude Phonetic Systems, Locus Dialog and Avaya.

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Fonix Assistive and Consumer Speech Solutions

We provide a variety of speech solutions for the assistive community, language learning, games and toys, and consumer electronic devices.

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The Assistive Market

Fonix solutions make everyday life a lot easier for people who are blind or have visual, vocal or mobility impairments. Fonix DECtalk is the industry’s premier text-to-speech engine, offering nine highly intelligible voices and six languages. Many users rely on Fonix DECtalk to read their email, the daily news or other documents, or to function as their voice to the outside world. In addition, we have expanded our solutions for the assistive market to incorporate the full line of Fonix TTS offerings, including high-quality concatenated TTS and high-recognition-rate ASR. These offerings meet assistive users’ needs whether someone has a learning disability requiring a more natural voice or a disabled user who requires voice-activated input methods. Current OEM partners in the assistive market include Dynavox, GW Micro, Prentke-Romich, Kurzweil Education Systems and Toby Churchill.

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Language Learning

Fonix speech solutions are particularly useful for non-English speakers who are learning the language. In the speech-enabled language learning market, we have capitalized on DECtalk’s small memory footprint and high intelligibility and Fonix ASR’s high-recognition-rate capabilities. Speech-enabled language learning is an emerging market, especially in Asia. Several OEMs, including Eintech and TopGrade, are selling handheld electronic dictionaries that allow individuals to speak a word in their native language (like Korean) and have the text read back to them in English. Our other partners in the Asian market include E-Star Laboratories, NEC Custom Technica, Kodensha, Dream C&C and Dico. Educational electronic dictionary devices are growing in popularity in China and are expected to exceed a market volume of over 500,000 units per quarter. These channels expand our ability to serve millions of individuals while generating reve nue on already existing technologies that can be diverse in their final application. Our goal is to become the primary supplier of speech solutions for OEMs providing language learning devices and systems.  

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PDA, PC and Electronic Devices

Fonix speech solutions apply the intuitive use of voice to tasks that users perform everyday. Many of these solutions are appropriate for multiple markets — assistive, mobile and wireless, and business and home users. Fonix Core Technologies enable users to interact naturally with electronic devices. With Fonix speech solutions, users may listen to documents of any length, have email read aloud, access programs and launch applications by speaking. We also offer solutions for cordless phones, toys, home audio, and MP3 Players.

Fonix speech solutions for PDAs and PCs include:

Fonix VoiceAlert™ gives users the ability to have scheduled meetings read aloud from a PDA telling details like who they will meet with and where, all without looking at the screen.

Fonix VoiceDirector™ allows PC users to launch desktop shortcuts or commonly used files and applications with the command of the user’s voice.

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Fonix iSpeak™ reads email, digital books, documents and websites in a natural, human-sounding voice.

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Game Consoles

Fonix voice command software is available for cross-platform game developers who wish to employ speech interfaces in games. In March 2004, we made Fonix VoiceIn™ commercially available to game developers that produce games on multiple game platforms.  Fonix voice command technology has been available in the Microsoft Xbox® developer’s kit (XDK) since February 2003, and now creators of cross-platform games can use the same voice command software for PlayStation®2 and PC games. Game developers worldwide can now build games that utilize a common API across PlayStation®2, Xbox® and PC platforms. Fonix VoiceIn software is optimized for game development where memory and processing power are at a premium.

Electronic Arts, the world’s largest game developer, has also licensed the Fonix voice platform for its game developers worldwide. EA signed a multiple year license agreement with Fonix for PlayStation®2 entertainment consoles and has an option to license Fonix speech solutions for additional game platforms.

Fonix VoiceIn voice command software is available to game developers in multiple languages, including English and UK English, German, French, Spanish, and Japanese. Additional languages, specifically Italian and Korean, will be available mid-2004.

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C

Platforms, Ports, Processors

We support multiple microprocessors ("Chips") and operating systems ("OS").  The following chart identifies some of the Chips and OS platforms we support:

Fonix Assistive and Consumer Speech Market Opportunities

Revenue potential in the assistive and consumer speech markets is significant as world markets evolve. In the assistive market, more governments are recognizing the benefits of providing accessibility to their disabled citizens. We expect significant market expansion as governments enact new regulations supporting and funding the use of speech-based solutions.

Also, with the acceptance of the Internet and an increasingly global economy, more people are endeavoring to learn foreign languages.  We believe that language learning tools, including translators and electronic dictionaries, will be a profitable market.

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In the games market, Fonix VoiceIn is a compelling feature for today’s gamers.  Gamers seek enhancements that add excitement, interaction and realism.  Fonix VoiceIn allows developers to take voice command and control to a new level. Fonix speech technology gives players new access to games features, command and control functions, and menu navigation.  We expect this exciting new interface to expand market demand for games.

Our primary competitors in the above described markets  include ScanSoft, IBM, NextUp Technologies, Voice Signal and Premier Assistive Technology.

Fonix Distributed Speech Solutions

Distributed or client device-to-server  speech solutions are connected and/or wireless systems where an embedded device (usually a mobile device such as a cell phone or PDA) works with a network element such as a database or application server. Distributed speech technology enables the mobile device user in the field to  access a server network via user-friendly speech input/output. The solution is particularly useful for mobile workforces including sales reps, field service personnel, delivery services and field survey crews. Distributed solutions are essential when customers need the power and connectivity of an application server and direct interaction with a mobile device. This arrangement enables users to issue voice commands and get spoken feedback on information such as medical records, blueprints, customer/account contact information, and maps, or to perform financial transactions. Other examples of services this architec ture can support include voice dialing, email reading, GPS navigation, calendar management, package delivery tracking, warehouse or filed inventory management and SMS text messaging.

Fonix Distributed Speech Market Opportunities

Fonix’s primary distributed speech marketing approach is to partner with data-base software platforms like Oracle that can incorporate our embedded speech technology with server functionality.  Partners may be network equipment or software vendors, telecommunications carriers and mobile equipment manufacturers. These partners will contribute technology on the network side for a better product solution that will in turn help us access a wider customer base.

Currently, our most active partner is Oracle®. In October 2003, we joined the Oracle PartnerNetwork as a member partner and are teaming with Oracle to deliver joint distributed speech solutions. Oracle offers a network application server, and we are working cooperatively to build a software interface between Oracle’s server and our handheld software.

Our competitors are primarily other embedded speech software vendors like IBM, ART and ScanSoft.  Our partners also have competitors, for example Oracle competes with Microsoft.  However, we are not precluded from working with our partners’ competitors.

Fonix Telecom Group:

On February 24, 2004, we completed our acquisition of all of the capital stock of LTEL Holdings Corporation (“LTEL”) and its wholly-owned subsidiaries, LecStar Telecom, Inc. and LecStar DataNet, Inc. (collectively “LecStar”).  LecStar, an Atlanta-based CLEC, offers wire-line voice, data, long distance, and Internet services to business and residential customers throughout BellSouth’s Southeastern United States operating territory.  The acquisition of LecStar significantly accelerates Fonix’s growth strategy by providing a recurring revenue stream, built-in customer base and new marketing channels.

LecStar serves small-to-medium sized businesses and residential customers with a balanced focus on high-density metropolitan areas and under-served smaller communities.  Services are offered at moderate discounts of BellSouth prices and delivered through the cost-effective use of LecStar’s own network facilities, Unbundled Network Elements (“UNEs”) leased from BellSouth and/or resold services acquired through wholesale

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agreements with other carriers.  LecStar’s provisioning systems are electronically bonded with BellSouth enabling the efficient ordering of services in real-time.  We believe that unlike many traditional CLECs which failed by putting short-term growth ahead of long-term fundamentals - attempting to grow more quickly than the market could sustain, adding new network assets to new geographical markets too soon, and/or relying on unsustainable revenues such as reciprocal compensation - LecStar took a unique and cost-effective approach to building its business. As a result, LecStar has low customer churn, a growing customer base and a deep, experienced management team.

In accordance with Statement on Financial Accounting Standards No. 141, Business Combinations, the aggregate purchase price for financial reporting purposes was $13,550,000 and consisted of the issuance of 7,036,802 shares of Class A common stock valued at $4,926,000 or $0.70 per share, 2,000 shares of 5% Series H non-voting, non-convertible preferred stock with a stated value of $10,000 per share valued at $4,000,000, and a 5% $10,000,000 secured, six-year promissory note valued at $4,624,000.  The value of the shares of Class A common stock was determined based on the average market price of the Fonix common stock over the three-day period before and after the terms of the acquisition were agreed to and announced.  The values of the Series H preferred stock and the promissory note were determined based on the estimated risk-adjusted cost of capital  to Fonix at the date of the acquisition.  The fair value of th e Series H preferred stock was based on an imputed yield rate of 25% per annum and the discount on the promissory note of $5,376,000 was based on an imputed interest rate of 25% per annum.

LecStar Distribution Strategy

LecStar has entered into interconnection agreements with major incumbent carriers through the Southeast United States allowing LecStar to efficiently collocate network facilities with these carriers, lease UNEs, resell their services and utilize the carriers’ provisioning, installation, and maintenance services at favorable costs.  Interconnection and resale agreements have been entered with BellSouth, Qwest, US Lec, and Global Crossings for access to other network and wholesale access services so LecStar may market a full suite of communications solutions on par with other major carriers.

LecStar Utility Partnerships

LecStar has implemented a marketing and distribution channel strategy that it believes to be one of the most cost efficient in the industry.  LecStar has entered into strategic partnerships with local electric utilities in several parts of the Southeastern United States region to market co-branded voice and data services to residential and business customers, including Cobb Energy Management Corporation, EnergyUnited, Memphis Light, Gas and Water, and Allied Utilities.  In addition, LecStar has developed marketing partnerships with interconnect companies and value-added agents that market more complex telecommunication services to medium and large businesses.

Competition and Industry Position

LecStar operates in a highly competitive market with a large number of competitors.  Several of our key competitors have significantly greater financial resources, well-established brand names and reputations, larger customer bases and diverse strategic plans and technologies.  Often, telecommunication services companies will compete for consumers based on price.  The dominant providers conduct extensive advertising campaigns to capture market share.   Competitors with greater financial resources may also be able to provide more attractive incentive packages to agents to encourage them to carry products that compete with our services.  In addition, competitors with greater resources than ours may be better situated to negotiate more favorable contracts with agents and have the capital to rapidly deploy or leverage existing communications equipment and broadband networks.

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In the provision of local access services, long distance services and data and integrated services, we face competition from incumbent local exchange carriers, competitive local exchange carriers, integrated communications providers and inter-exchange carriers who may have a more substantial marketing presence or possess their own network facilities and may offer services similar to ours at more favorable prices.  In addition, we face competition from Internet service providers and others who offer domestic and long distance service over the Internet at greatly reduced prices.

Both our competitors and we rely substantially on independent agents to market and sell our services to their respective customer bases.  Competitors may offer agents greater commissions, better terms or other incentives that hinder our use of these agents.  In addition, agents may enter into exclusive arrangements with competitors, which could hinder our ability to attract and retain agents.

We believe that various legislative initiatives including the Telecommunications Act have removed many of the remaining regulatory barriers to local exchange competition. Nevertheless, legislators and regulators are likely to provide incumbent local exchange carriers with increased pricing flexibility as competition increases.  If incumbent local exchange carriers are permitted to lower their rates substantially or engage in excessive volume or term discount pricing practices for their customers, the net income or cash flow of integrated communications providers and competitive local exchange carriers such as ours, could be materially adversely affected. Furthermore, several large long distance providers have entered local exchange services markets.  We cannot predict the number of competitors that will emerge as a result of currently existing or potential federal and state regulatory or legislative actions. Competition from the regional Bell operating companies with respect to inter-exchange services could have a materially adverse effect on our business.

Existing competitors are likely to continue to expand their service offerings to appeal to agents and consumers and new competitors are likely to enter the telecommunications market and attempt to market services similar to ours which will result in greater competition.  If our existing competitors or new competitors devote significant additional resources to the provision of international or national long distance telecommunications services to our customer base, such actions could have a material adverse effect on our business, financial condition and results of operations, and we can make no assurance that we will be able to compete successfully against such existing or new competitors.

In addition to traditional wireline competitors, we also face strong competition from competing telecommunication technologies.  There exist other technologies that provide greater bandwidth than our methods of transmission and may be used instead of our services.  Existing alternative technologies include:

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Digital Subscriber Line Technology - Digital subscriber line technology was developed to produce higher data transfer rates over the existing copper-based telephone network. The data transfer rates for digital subscriber lines are reported to range between 144,000 bits of data per second and six million bits of data per second.

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Cable Modems - Cable modems can allow users to send and receive data using cable television distribution systems. According to industry sources, cable modem users typically experience download speeds of 1.5 million bits of data per second.

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Wireless Technologies - Wireless technologies, such as satellite and microwave communications systems, can provide high-speed data communications.  Not only are wireless technologies commercially deployed, there are significant tests underway to increase the bandwidth and availability of wireless technologies.

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Integrated Services Digital Networks -  Integrated services digital networks have been offered by the incumbent local telephone companies over the existing copper-based telephone network for some time.  These services offer data transfer speeds of 128,000 bits of data per second. The development of new technologies or the significant penetration of alternative technologies into our target market may reduce the demand for our services and harm our business.

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Voice of Internet Protocol -  Voice of Internet Protocol usually permits broadband users to place and receive local and long distance calls using the Internet.  When compared to traditional wireline services, VOIP is usually less expensive.

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Power Line Carrier - Providing telecommunication service using electrical  utilities’ infrastructure has been successfully deployed in Europe for a number of years; however, in the United States this technology has experienced limited commercial deployment to date.  Several entities are researching this technology and have announced plans to launch testing its commercial viability.

Fonix’s Internet address is www.fonix.com and LecStar’s Internet address is www.lecstar.com.  

Employees

As of April 13, 2004, Fonix employed 63 people.  Of this total, 31 were employed in product development and delivery, 9 were employed in sales and marketing, and 23 were employed in strategic development, administration and support.

As of April 13, 2004, LecStar employed 91 people.  Of this total, 42 were employed in customer services, 12 were employed in sales and marketing and 37 were employed in operations support and administration.

RECENT DEVELOPMENTS

2002 Employee Compensation Plan

On February 6, 2003, the Fonix Board of Directors adopted the 2002 Employee Compensation Plan (the "2002 Plan").  Shares of Class A common stock issued under the 2002 Plan will be in partial payment of wages and salaries earned by employees during the plan period, which runs from December 1, 2002, through May 31, 2003.  The plan period may be extended by the Board of Directors.  Each current employee has agreed to the terms of the 2002 Plan.

The maximum aggregate number of shares that may be issued under the 2002 Plan is 3,750,000 shares.  The 2002 Plan will be administered by the Board of Directors or a committee of the Board.  Shares under the 2002 Plan may be issued only to employees of Fonix.

Employees subject to the 2002 Plan will be required to provide us with a notice of election to participate in the 2002 Plan and to indicate the amount of compensation to be deferred during the plan period.  The deferred compensation of employees electing to participate in the 2002 Plan may be paid, at the option of the employee, in shares of our Class A common stock, in cash, or in a combination of the two.  The payment of deferred compensation was to commence on June 30, 2003; however, as of June 30, 2003, our shareholders had not approved the 2002 Plan and no employee was notified of the ratio of cash and Class A common stock to be issued under the 2002 Plan.

We are considering whether the 2002 Plan, should be amended, abandoned or implemented as adopted by our Board of directors in February 2003.  No shares or options to purchase shares will be issued under the 2002 Plan until it has been approved by our shareholders.

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U.S. Department of Labor Settlement Agreement

On March 5, 2003, we entered into a settlement agreement with the U.S. Department of Labor relating to back wages owed to former and current employees during 2002.  Under the agreement we will pay an aggregate of $4,755,000 to certain former and current employees in twenty-four installment payments.  The first installment payment was due May 1, 2003.  The remaining payments are due on the first day of each subsequent month, until paid in full.  If any of the installment payments are more than fifteen days late, the entire balance may become due and payable.  

We did not have sufficient cash to pay the first installment payment due May 1, 2003.  We reached an agreement with the Department of Labor to extend the commencement date for installment payments to August 1, 2003.  We have paid all sums due under the modified agreement.  

Series I Convertible Preferred Stock

On October 24, 2003, we entered into a private placement of shares of its Class A common stock with The Breckenridge Fund, LLC, a New York limited liability company ("Breckenridge").  Under the terms of the private placement, we agreed to sell 1,043,478 shares of our Class A common stock for $240,000 (the "Private Placement Funds").

Subsequent to our receiving the Private Placement Funds, but before any shares were issued in connection with the private placement, we agreed with Breckenridge to rescind the private placement of the shares and to restructure the transaction.  We retained the Private Placement Funds as an advance in connection with the restructured transaction.  We paid no interest or other charges to Breckenridge for use of the Private Placement Funds.

Following negotiations with Breckenridge, we agreed to sell to Breckenridge 3,250 shares of Series I 8% Convertible Preferred Stock (the "Series I Preferred Stock"), for an aggregate purchase price of $3,250,000, net of the Private Placement Funds which the Company had already received.  The Series I Preferred Stock was sold under a purchase agreement (the "Purchase Agreement") dated as of December 31, 2003.

In connection with the offering of the Series I Preferred Stock, we also issued to Breckenridge (i) warrants (the "Warrants") to purchase up to 965,839 additional shares of our Class A common stock; (ii) 1,931,677 shares of our Class A common stock (the "Additional Shares"); and (iii) 482,919 shares of our Class A common stock (the "Fee Shares").

In connection with the purchase and sale of the Series I Preferred Stock, we agreed to register the resale by Breckenridge of shares issued upon conversion of the Series I Preferred Stock, issued as payment of dividends accrued on the Series I Preferred Stock, and issuable upon conversion of the Warrants, as well as the Additional Shares and the Fee shares.

The Series I Preferred Stock entitles Breckenridge to receive dividends in an amount equal to 8% of the then-outstanding shares of Series I Preferred Stock.  The dividends are payable in cash or shares of our Class A common stock, at the Company’s option.

The Series I Preferred Stock is convertible into shares of our Class A common stock as follows:

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The conversion of the first $250,000 of the Series I Preferred Stock shall be as follows: (I) for conversion occurring prior to the date on which the SEC declares a registration statement effective (the "Effective Registration Date") and through the tenth business day following the Effective Registration Date, the conversion price shall be the lower of $0.23 per share or 87.5% of the average of the two (2) lowest closing bid prices over the twenty trading days prior to the conversion date; and (ii) for conversion occurring on or after the eleventh business day following the Effective Registration Date, the conversion price shall be $0.23 per share.

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The remaining $3,000,000 of the Series I Preferred Stock may be converted into common stock of the Company at the option of the holder by using a conversion price which shall be the lower of (1) $0.75 per share or (2) 87.5% of the average of the two (2) lowest closing bid prices for the twenty-day trading period prior to the conversion date.

The following hypothetical information is provided to demonstrate the conversion of shares of Series I Preferred Stock with a stated value of $500,000 into shares of Class A common stock:

Hypothetical closing bid prices (twenty trading days following the date of the conversion notice):

Trading day 1

$0.49

Trading day 11

$0.52

Trading day 2

$0.49

Trading day 12

$0.57

Trading day 3

$0.51

Trading day 13

$0.66

Trading day 4

$0.48

Trading day 14

$0.72

Trading day 5

$0.47

Trading day 15

$0.72

Trading day 6

$0.53

Trading day 16

$0.79

Trading day 7

$0.55

Trading day 17

$0.73

Trading day 8

$0.56

Trading day 18

$0.68

Trading day 9

$0.53

Trading day 19

$0.68

Trading day 10

$0.57

Trading day 20

$0.67

Conversion rate: (87.5% of average of two lowest closing bid prices)

Trading day 4

$0.48

Trading day 5

$0.47

Average

$0.475

87.5% of average

$0.4156

Conversion calculation: $500,000/ $0.4156 = 1,203,008 shares issuable upon conversion.

Under the terms of the purchase agreement, we agreed to establish an escrow account (the "Escrow Account"), into which it deposits funds which can be used for our optional redemption of the Series I Preferred Stock, or which may be used by Breckenridge to require us to redeem the Series I Preferred Stock if we have defaulted under the purchase agreement.  The conditions of deposit into the Escrow Account are as follows:

(i)

If, prior to August 31, 2004, there has not been a declared default under the purchase agreement, we will deposit into the Escrow Account twenty-five percent (25%) of any amount it receives in excess of $1,000,000, calculated per put, under the terms of the Fifth Equity Line of Credit (the "Fifth Equity Line") between Fonix and Queen, LLC, dated as of July 1, 2003, or other similar equity line of financing arrangement.

(ii)

If, prior to August 31, 2004, there has been a declared default under the preferred stock purchase agreement, we will deposit into the Escrow Account thirty-three percent (33%) of any amount we receive in excess of $1,000,000, calculated per put, under the terms of the Fifth Equity Line or other similar equity line of financing arrangement.

(iii)

If as of August 31, 2004, we had not closed or had abandoned its attempt to acquire the capital stock of LTEL, whether or not there has been a declared default under the preferred stock purchase agreement, we will deposit into the Escrow Account fifty percent (50%) of any amount the Company receives in excess of $1,000,000, calculated per put, under the terms of the Fifth Equity Line or other similar equity line of financing arrangement.

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(iv)

If we have at any time deposited into the Escrow Account an aggregate amount sufficient to redeem all of the then-outstanding shares of Series I Preferred Stock, together with any accrued and unpaid dividends our obligation to deposit the sums into the Escrow Account shall be suspended until such time, if any, that the balance of the Escrow Account is not sufficient to effectuate such redemption.

Because we closed the acquisition of the capital stock of LTEL as of February 24, 2004, condition (iii) above will not apply.

In the event that we default under our obligations under the purchase agreement, and such default has not been cured within 60 days, Breckenridge shall have the right, exercisable at its option, to demand that we redeem all or any portion of the then-outstanding shares of the Series I Preferred Stock at any time after the balance in the Escrow Account equals or exceeds the amount necessary for us to redeem all or any portion of the Series I Preferred Stock.  

Redemption of the Series I Preferred Stock, whether at our option or that of Breckenridge, requires us to pay, as a redemption price, the stated value of the outstanding shares of Series I Preferred Stock to be redeemed, together with any accrued but unissued dividends thereon, multiplied by (I) one hundred ten percent (110%) for any redemption occurring within ninety (90) days after the closing date of the purchase of the Series I Preferred Stock; (ii) one hundred fifteen percent (115%) for any redemption occurring between the 91st day but before the one hundred fiftieth (150th) day after the closing date of the purchase; (iii) one hundred twenty percent (120%) for any redemption occurring between the 151st day and the second anniversary of the closing date of the purchase; and (iv) one hundred thirty percent (130%) for any payment of the redemption price occurring on or after the second anniversary of the closing date o f the purchase.

Use of the proceeds of the sale of the Series I Preferred Stock is limited to working capital and to paying deeply-discounted liabilities.

We have allocated the proceeds from the issuance of the Series I Preferred Stock, warrants, additional shares and fee shares as follows: i) $261,000 was allocated to the warrants, ii) $730,000 was allocated to the additional and fee shares, iii) $429,000 to the Series I Preferred Stock, and iv) $1,830,000 to a beneficial conversion option.  The amounts allocated to the warrants, additional and fee shares and the beneficial conversion option will result in a discount on the Series I Preferred Stock that will be fully amortized at the date of issuance, resulting in the recognition of a dividend on the Series I Preferred Stock of $2,821,000 on January 29, 2004.  The Series I Preferred Stock will be recorded as an item of stockholders’ deficit for the face amount of $3,250,000.

Series D Debenture

During the process of reconciling our shareholder records relating to our issued and outstanding shares of common stock with the records of our transfer agent in connection with the preparation of this report, it came to our attention that shares of our Class A common stock may have been inadvertently transferred to the Debenture holder in excess of the shares the Debenture holder was entitled to receive.  We believe this inadvertent transfer may have occurred as a result of an unauthorized release by the escrow agent of shares that were being held in escrow.  We did not have any knowledge of such release until after the inadvertently released shares had been publicly resold by the Debenture holder.  Although two registration statements had been filed to register the resales of shares by the Debenture holder in connection with the Series D Debentures and were effective at the time of the sales, as a result of the inadvertent duplicate transfer of some shares covered by the registration statements, the number of shares actually resold by the Debenture holder may have exceeded the number of shares allotted to the Debenture holder in the effective registration statements.  In light of what appears to be an inadvertent transfer of shares in excess of what the Debenture holder was entitled to receive, the Debenture holder has agreed to equitably compensate us, either by way of offset or by payment to us.

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CERTAIN SIGNIFICANT RISK FACTORS

The short- and long-term success of Fonix is subject to certain risks, many of which are substantial in nature and outside the control of Fonix. You should consider carefully the following risk factors, in addition to other information contained herein.  All forward-looking statements contained herein are deemed by Fonix to be covered by and to qualify for the safe harbor protection provided by Section 21E of the Private Securities Litigation Reform Act of 1995.   When used in this Report, words such as “believes,” “expects,” “intends,” “plans,” “anticipates,” “estimates,” and similar expressions are intended to identify forward-looking statements, although there may be certain forward-looking statements not accompanied by such expressions.  You should understand that several factors govern whether any forward-looking statement contained herein will or ca n be achieved.  Any one of those factors could cause actual results to differ materially from those projected herein. These forward-looking statements include plans and objectives of management for future operations, including the strategies, plans and objectives relating to the products and the future economic performance of Fonix and its subsidiaries discussed above.  In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of any such statement should not be regarded as a representation by Fonix or any other person that the objectives or plans of Fonix will be achieved.

Risk Factors Associated with All of our Operations

Our substantial and continuing losses since inception, coupled with significant ongoing operating expenses, raise doubt about our ability to continue as a going concern.

Since inception, we have sustained substantial losses.  Such losses continue due to ongoing operating expenses and a lack of revenues sufficient to offset operating expenses.  We had negative working capital of $13,188,000 at December 31, 2003. We have raised capital to fund ongoing operations by private sales of our securities, some of which sales have been highly dilutive and involve considerable expense.  In our present circumstances, there is substantial doubt about our ability to continue as a going concern absent significant sales of our existing products, substantial revenues from new licensing or co-development contracts, or continuing large sales of our securities.

We incurred net losses of $13,543,000, $19,898,000 and $31,062,000 for the years ended December 31, 2003, 2002 and 2001.  As of December 31, 2003, we had an accumulated deficit of $207,550,000, and owed trade payables of $2,650,000, of which $2,019,000 were more than 60 days past due.

We expect to spend significant amounts to enhance our products and technologies, expand domestic and international sales and operations and fund further Product development.  As a result, we will need to generate significant additional revenue to achieve profitability.  Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis.  If we do not achieve and maintain profitability, the market price for our common stock may further decline, perhaps substantially, and we may have to curtail or cease our operations.

The "going concern" paragraph in the reports of our independent certified public accountants for the years ended December 31, 2003, 2002 and 2001 raises doubts about our ability to continue as a going concern.

The independent certified public accountants' reports for our financial statements for the years ended December 31, 2003, 2002, and 2001 include an explanatory paragraph regarding substantial doubt about our ability to continue as a going concern.  This may have an adverse effect on our ability to obtain financing for operations and to further develop and market products.

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