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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, 2004, 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, 2004 is approximately $23,213,000, calculated using a closing price of $0.265 per share on June 30, 2004.  For purposes of this calculation, the registrant has included only the number of shares directly held by its officers and directors as of (and not counting shares beneficially owned on that date), in determining the shares held by non-affiliates.  

As of March 28, 2005, there were issued and outstanding 173,040,324 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. [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).  Yes [  ]  No [X].

Fonix Corporation

2004 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

Part I

Page

Item  1.

Business

3

Item  2.

Properties

30

Item  3.

Legal Proceedings

31

Item  4.

Submission of Matters to a Vote of Security Holders

32

Part II

Item  5.

Market for Registrant's Common Equity and Related Stockholder Matters

34

Item  6.

Selected Financial Data

38

Item  7.

Management's Discussion and Analysis of Financial Condition and

Results of Operations

39

Item  8.

Financial Statements and Supplementary Data

58

Item  9.

Changes in and Disagreements with Accountants on Accounting and

Financial Disclosure

58

Item 9a.

Controls and Procedures

58

Part III

Item 10.

Directors and Executive Officers of the Registrant

59

Item 11.

Executive Compensation

61

Item 12.

Security Ownership of Certain Beneficial Owners and Management

64

Item 13.

Certain Relationships and Related Transactions

65

Item 14.

Principal Accountant Fees and Services

66

Part IV

Item 15.

Exhibits and Financial Statement Schedules

68

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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.

About Fonix

Based in Salt Lake City, Utah, Fonix Corporation is a communications and technology company that provides integrated telecommunications services through Fonix Telecom, Inc., and LecStar Telecom, Inc., and value-added speech technologies through the Fonix Speech Group. The combination of interactive speech technology and integrated telecommunications services allows Fonix to provide customers with comprehensive, cost-effective solutions to enhance and expand their communications needs.

Fonix is currently emerging from a transitional phase of its development.  Through December 31, 2003, Fonix was solely reliant on the revenue earned from its proprietary speech technologies, development tools and applications.  With its acquisition of LecStar Telecom in February 2004, the Company’s primary revenue source shifted to telecommunications services.  In the near term, the Company expects to continue its development of a diversified revenue base and expects that the telecommunication activities will become major sources of long-term revenue and earnings.  

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

History and Development of the Company

The Company was incorporated in Delaware in 1985, and pursuant to a merger transaction in 1994, the Company’s name was changed to Fonix Corporation. Fonix delivers, through the Fonix Speech Group, speech interface development tools, solutions and applications (the “Products”) that empower people to interact conversationally with information systems and computing devices. The Products are based on the Company’s speech-enabling technologies, which include text-to-speech (“TTS”) and neural network-based automatic speech recognition (“ASR”).  ASR and TTS technologies are sometimes collectively referred to in this report as “Core Technologies.”  The Company believes its intuitive speech Products enhance user productivity and efficiency in a broad range of markets including mobile and wireless devices; entertainment game consoles; computer telephony and server applications; and assistive and language lear ning applications for everyday use with computers and electronic devices.

Prior to 2002, the Company focused on research and development (“R&D”) and prototype development projects for customized applications.  The R&D and prototype development used 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.

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

On February 24, 2004, the Company completed its 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 competitive local exchange carrier (“CLEC”), offers wire line voice, data, long distance, and Internet services to business and residential customers throughout BellSouth’s

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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.

On November 22, 2004, Fonix signed a definitive agreement to acquire Empire One Telecommunications, Inc. (“Empire”). Empire is a privately held CLEC based in Brooklyn, NY.  Fonix anticipates that Empire will provide facility-based local and long distance phone service, Internet service to business and residential customers and Voice Over Internet Protocol (“VoIP”) services initially in the Northeastern United States.  Fonix is in the process of obtaining regulatory approvals for the acquisition of Empire. Fonix management anticipates that, subject to the completion of the regulatory approval process described above, and Empire’s shareholder approval, the acquisition will close as soon thereafter as circumstances permit.

TELECOMMUNICATIONS

 Fonix Telecom, Inc.

On January 13, 2005, Fonix announced the official formation of Fonix Telecom, Inc., a wholly owned subsidiary. Fonix Telecom will begin offering new telecommunications products and services including VoIP as well as next-generation technologies such as Broadband Over Power Lines (“BPL”) through specialized sales and product groups.

On October 4, 2004 Fonix launched VoIP services for small-to medium-sized business customers in the Southeastern United States through LecStar Telecom. VoIP service provides customers with an economical alternative to private branch exchange (PBX) or central office exchange (Centrex) services with the flexibility and durability of Internet Protocol (IP).

The Fonix IP Phone Service, known as Fonix Fone^sm, offers VoIP to business customers.  It is a feature-rich service package that provides all Class 5 switching features including E911 (911 service with enhanced abilities to locate mobile customers), conference calling, unified messaging, “find me – follow me” (virtual call forwarding) and a user portal. The service works over the customer’s existing broadband connection and provides proven quality of service and interoperability with all common VoIP protocols. Fonix IP Phone Service is a cost-effective solution, combining all the features and functionalities of a virtual private network at a lower price than traditional voice service platforms.

On August 17, 2004 LecStar field-tested with Duke Power delivery of BPL and VoIP via power lines. On December 20, 2004, the trial was expanded from 10,000 to 15,000 homes in Duke Power’s service area in North and South Carolina from the original 500-home trial. The trial’s specific locations will be determined in the first quarter of 2005.

LecStar’s BPL service allows users to turn any electrical outlet in their home into a gateway to the Internet, simply by plugging in their computer and BPL modem. LecStar expects the service will be available for businesses and consumers by mid-2005 in select markets.

LecStar Telecom, Inc.

LecStar Telecom, a wholly owned subsidiary of Fonix, provides a full array of wireline voice, data, long distance and Internet telephone services utilizing traditional lines. 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 off BellSouth prices and are delivered through the cost-effective use of LecStar Telecom’s network facilities, Unbundled Network Elements (“UNEs”) leased from BellSouth and/or resold via services acquired through wholesale agreements with other carriers. LecStar Telecom’s provisioning systems are electronically bonded with BellSouth enabling the efficient ordering of services in real-time.

LecStar Telecom believes the traditional CLEC model is unsustainable and has failed by putting short-term growth ahead of long-term fundamentals. Traditional CLECs have attempted to grow more quickly than the market could sustain by adding new network assets to new geographical markets too soon, and/or relying on unsustainable revenues such as reciprocal compensation. Instead, LecStar Telecom is taking a unique and cost-effective approach to building its business. As a result, LecStar Telecom has low customer churn and a growing customer base, complemented by an experienced management team.

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LecStar Distribution Strategy

LecStar Telecom has entered into interconnection agreements with major incumbent carriers throughout the Southeastern United States, allowing the company 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 the company may market a full suite of communications solutions on par with other major carriers.

LecStar Utility Partnerships

LecStar Telecom 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 to market co-branded voice and data services to residential and business customers.  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.  Several of its 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 independent sales agents to encourage them to offer products that compete with LecStar services.  In addition, competitors with greater resources than LecStar may be better situated to negotiate more favorable contracts with independent sales agents and have the capital to rapidly deploy or leverage existing communications equipment and broadband networks.

In the provision of local access services, long distance services and data and integrated services, LecStar faces competition from incumbent local exchange carriers (“ILECs”) such as BellSouth and Verizon, other CLECs, such as US LEC, ITC Deltacom, TalkAmerica, Z-Tel and other 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 the Company at more favorable prices.  

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

LecStar believes that various legislative initiatives, including the Telecommunications Act if 1996, have removed many of the remaining regulatory barriers to local exchange competition. Nevertheless, legislators and regulators are likely to provide ILECs with increased pricing flexibility as competition increases.  If ILECs 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 CLECs such as LecStar could be materially adversely affected. Furthermore, several large, long distance providers have entered local exchange services markets.  LecStar 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 the Company’s 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 LecStar’s, which will result in greater competition.  If LecStar’s existing competitors or new competitors devote significant additional resources to the provision of international or national long distance telecommunications services to their customer base, such actions could have a material adverse effect on its business, financial condition and results of operations, and LecStar can make no assurance that it will be able to compete successfully against such existing or new competitors.

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In addition to traditional wireline competitors, LecStar also faces strong competition from competing telecommunication technologies.  Other technology exists that provides greater bandwidth than LecStar’s methods of transmission which may be used instead of LecStar’s services.  The development of new technologies, or the significant penetration of alternative technologies into LecStar’s target market, may reduce the demand for its services and harm its business.  Existing alternative technologies include:

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Digital Subscriber Line (DSL) Technology - DSL 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 (ISDN) - ISDN has 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.

 VALUE-ADDED SPEECH TECHNOLOGIES

The Fonix Speech Group

The Fonix Speech Group, an operating division of Fonix Corporation, provides speech technology development tools and solutions for mobile/wireless devices; interactive videogames, toys and appliances; computer telephony systems; and the assistive market.

The 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 development tools and solutions, resulting in broader market opportunities and significant competitive advantage. Fonix speech development tools and 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

The Fonix Speech Group delivers speech solutions in the following markets:

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Mobile / Wireless

Fonix speech provides 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, navigate through the device software, and access song and movie lists simply by speaking.

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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.

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Assistive and Consumer Speech

Fonix speech 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 market, transforms ordinary text into highly intelligible speech. Fonix VoiceIn™ is the Company’s proprietary neural network-based automatic speech recognition. The Fonix Speech  Group has taken its intuitive Core Technologies and applied them to everyday speech solutions for PCs and other consumer devices such as cordless phones, electronic dictionaries, MP3s and toys.

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Game Consoles

Fonix VoiceIn Game Edition is the company’s award-winning software solution for voice command and control in Xbox, PlayStation®2, PC and Mac videogames. Fonix VoiceIn is the industry’s most memory-efficient voice interface. Game developers worldwide can now build games that utilize a common API across Xbox, PlayStation®2, PC and Mac platforms. Fonix VoiceIn is optimized for game development where memory and processing power are at a premium.

Fonix Mobile/Wireless Solutions:

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Fonix VoiceDial

Fonix VoiceDial^TM is a totally interactive, hands-free software application for Windows Mobile Pocket PC, Smartphone and Symbian devices that enables users to access mobile phone contacts simply by speaking. 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 PIM tools, navigate through the device software, and access song and movie lists 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

Fonix Speech’s partners, original equipment manufacturers (“OEMs”) and original device manufacturers (“ODMs”) provide significant potential to reach users in many market areas. The Fonix Speech Group has already seen significant market response to VoiceDial and expects to deliver in the following channels:

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OEMs & ODMs: The first VoiceDial contract delivered the solution on the Hewlett Packard (HP) Journada ® 928 WDA. To date VoiceDial has shipped with these additional devices: Hitachi G1000, i-mate PDA2k, T-Mobile MDA III, and the O2 XDA IIs.  Fonix also has partnerships with Microsoft, Intel, Texas Instruments, Hitachi, O2 and HTC and is aggressively pursuing additional OEM opportunities with Nokia, Motorola, Sony-Ericsson, Siemens, Palm and Samsung.

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Mobile Operators: Fonix markets 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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Bundled Solutions: Other complementary solutions are also channels for distribution for the Products. Companies like ALK have integrated the Company’s solutions into their applications. The Company foresees partners shipping the full VoiceDial and VoiceCentral functionality as a complement to their applications and devices.

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The Fonix Speech Group has several competitors offering a variety of speech technologies and products.  Companies like ScanSoft, Voice Signal and Neuvoice all deliver speaker-dependent and speaker-independent solutions. Other speech companies like IBM and Nuance may introduce competitive products.  

Fonix Computer Telephony and Server Solutions

The Fonix Speech Group provides telephony and server-based solutions for automated phone directory and database information systems.  Fonix believes 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.  ConnectMe handles all incoming calls simultaneously, so callers are never put on hold.  Employees can create, maintain and access their own phone lists, and can customize the delivery of calls.  To the Company’s knowledge, no other company in this niche has emerged with a competitive product with ConnectMe’s 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.  Additional 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

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

Fonix Assistive and Consumer Speech Solutions

The Fonix Speech Group provides a variety of speech solutions for markets including the assistive community, language learning, games and toys, and consumer electronic devices.

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The Assistive Market

Fonix speech solutions make everyday life easier for people who are blind, have visual, vocal or mobility impairments or have learning disabilities.  Fonix DECtalk is the assistive industry’s

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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, Fonix has expanded its solutions for the assistive market to incorporate the full line of Fonix TTS offerings, including high-quality concatenated TTS and high-recognition-rate ASR, which is marketed as Fonix VoiceIn. 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, Fonix has capitalized on DECTalk’s small memory footprint and high intelligibility and Fonix VoiceIn’s high-recognition-rate capabilities. Speech-enabled language learning is an emerging market, especially in Asia. Several OEMs, including Casio, Eintech and TopGrade, are selling handheld electronic dictionaries that allow individuals to speak a word in their native language (like Chinese) and have the word read back to them in English. Other Fonix Speech 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 more than 500,000 units per quarter.  The Company’s goal is to become the primary suppl ier of speech solutions for OEMs providing language learning devices and systems.  The Fonix Speech Group has partnered with Epson to provide an integrated chip with the Company’s speech technology to various language learning OEM’s.

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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.  The Products enable users to listen to documents of any length, have email read aloud, access programs and launch applications by speaking.  Fonix also offers solutions for cordless phones, toys, home audio and MP3 Players.

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Game Consoles

The Company’s voice command software is available for cross-platform game developers who wish to employ speech interfaces in videogames. In March 2004, Fonix Speech 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 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 utilized a common application program interface across PlayStation®2, Xbox® and PC platforms.  As of March 28, 2005, Fonix VoiceIn is included on nine videogame titles.  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. Electronic Arts 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, Japanese and Italian.

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Platforms, Ports, Processors

Fonix Speech supports multiple microprocessors ("Chips") and operating systems ("OS").  The following chart identifies some of the Chip and OS platforms Fonix Speech supports:

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Fonix Assistive and Consumer Speech Market Opportunities

Revenue potential in the assistive, language learning and game consoles markets is significant as world markets evolve. In the assistive market, more governments are recognizing the benefits of providing accessibility to their disabled citizens. Fonix expects 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.  Fonix believes that language-learning tools, including translators and electronic dictionaries, will be a profitable market.

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.  The Products give players new access to games features, command and control functions, and menu navigation.  Fonix expects this exciting new interface to expand market demand for games.

The Company’s primary competitors in these markets include ScanSoft, IBM, NextUp Technologies, Voice Signal and Premier Assistive Technology.

The Company’s competitors are primarily other embedded speech software vendors like IBM and ScanSoft.  The Company’s partners also have competitors.  For example, Oracle competes with Microsoft.  However, Fonix is not precluded from working with its partners’ competitors.

RECENT DEVELOPMENTS

On February 21, 2005, the Company entered into an option exchange program with its employees, wherein eligible Fonix employees received the opportunity to exchange outstanding stock options for the same number of new options to be issued at least six months and one day from the expiration of the offer.  As a result of the option exchange program, 414,450 options to purchase shares of our Class A common stock were cancelled effective February 22, 2005.  The Company issued a promise to grant options on August 23, 2005, to employees who elected to tender the 414,450 current outstanding options.

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 can be achieved. &nbs p;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 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 products and telecommunication services, substantial revenues from new licensing or

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co-development contracts, or continuing large sales of our securities.

We incurred net losses of $15,148,000, $13,543,000 and $19,898,000 for the years ended December 31, 2004, 2003 and 2002.  As of December 31, 2004, we had an accumulated deficit of $226,625,000, current liabilities of $6,815,000 and owed trade payables of $5,225,000.

We expect to spend significant amounts to expand our telecommunications services, enhance our Products and technologies 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 registered public accounting firm for the years ended December 31, 2004, 2003 and 2002 raises doubts about our ability to continue as a going concern.

The independent registered public accounting firm’s' reports for our financial statements for the years ended December 31, 2004, 2003 and 2002 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.

LecStar's current operations may not provide sufficient cash flow to sustain operations, and we may be required to divert proceeds from our Sixth Equity Line towards offsetting cash flow shortfalls at LecStar for an indefinite time period.  If we do not receive additional capital when and in the amounts needed in the near future, our ability to continue as a going concern is in substantial doubt.

We anticipate incurring substantial sales and marketing, product development and research and general operating expenses in the future that will require substantial amounts of additional capital on an ongoing basis.  We will most likely have to obtain such capital from sales of our equity, convertible equity and/or debt securities.  Obtaining future financing may be costly and will likely be dilutive to existing stockholders.  We previously established five equity lines of credit with an unaffiliated third party (the “Equity Line Investor”) upon which we drew to pay operating expenses.  We have entered into a Sixth Equity Line agreement wherein we have registered the sale of up to 75,000,000 shares of Class A common stock and are currently drawing funds against the Sixth Equity Line.

LecStar’s operations did not generate sufficient operating revenue to pay all operating expenses in 2004 and required us to fund some of its operations and liabilities through our otherwise available financing sources, including the Fifth Equity Line.  Although management anticipates that LecStar will become self-sufficient during 2005, there can be no assurance that will occur during 2005 or at all, or that if LecStar becomes self-sufficient whether it will be able to maintain such level of operations.  If we are required to provide significant operating capital to LecStar for extended periods, our business and financial condition could be adversely and materially affected.  Accordingly, if we are not able to obtain adequate financing under the existing or additional equity line agreements or from other financing sources when and in the amounts needed, and on terms that are acceptable, our operations, financial conditio n and prospects could be materially and adversely affected, and we could be forced to curtail our operations or sell part or all of our assets, including our Core Technologies, LTEL or LecStar, or seek protection under bankruptcy laws.

Continuing debt obligations could impair our ability to continue as a going concern.

As of December 31, 2004, we had debt obligations of $6,085,000, remaining unpaid compensation payable to current and former employees was approximately $1,756,000 and vendor accounts payable was approximately $5,225,000.  At present, our revenues from existing licensing arrangements, Product sales and telecommunication services are not sufficient to offset our ongoing operating expenses or to pay in full our current debt obligations.  

In connection with the acquisition of the capital stock of LTEL, we issued a 5% $10,000,000 secured, six-year note payable to McCormack Avenue, Ltd.  Under the terms of the note payable, quarterly interest only payments were required through January 15, 2005 with quarterly principal and interest payments beginning April 2005 through the final payment due January 2010.

There is substantial risk, therefore, that the existence and extent of the debt obligations described above

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could adversely affect our business, operations and financial condition, and we may be forced to curtail our operations, sell part or all of our assets, including the Core Technologies, LTEL or LecStar, or seek protection under bankruptcy laws.  Additionally, there is substantial risk that the current or former employees or our vendors could bring lawsuits to collect the unpaid amounts.  In the event of lawsuits of this type, if we are unable to negotiate settlements or satisfy our obligations, we could be forced into bankruptcy.

There can be no guarantee that the proceeds available to us under the Sixth Equity Line will be sufficient for us to achieve profitable operations or to pay our current liabilities, which could have a material adverse impact on our ability to continue operations.

There is no assurance that the funds which are available to us under the Sixth Equity Line will be sufficient to allow us to continue our marketing and sales efforts to the point we achieve profitable operations.  Additionally, the payment of our current outstanding liabilities may require significant portions of the funds available to us under the Sixth Equity Line, and the amounts remaining may not be sufficient for us to use as working capital in our operations, which could have a material adverse effect on our ability to continue our operations.

Holders of Fonix Class A common stock are subject to the risk of additional and substantial dilution to their interests as a result of the issuances of Class A common stock in connection with the Sixth Equity Line.

The following table describes the number of shares of Class A common stock that would be issuable, assuming that the full remaining amount available under the Sixth Equity Line as of March 28, 2005, namely $17,500,000, had been put to the Equity Line Investor (irrespective of the availability of registered shares), and further assuming that the applicable conversion price at the time of such put were the following amounts:

Given the formulas for calculating the shares to be issued in connection with puts under the Sixth Equity Line, there effectively is no limitation on the number of shares of Class A common stock which may be issued in connection with a put under the Sixth Equity Line, except for the number of shares registered under the prospectus and the registration statement covering the resale of shares issued in connection with the Sixth Equity Line.  As such, shareholders are subject to the risk of substantial dilution to their interests as a result of our issuance of shares under the Sixth Equity Line.

Holders of Fonix Class A common stock are subject to the risk of additional and substantial dilution to their interests as a result of the issuances of Class A common stock in connection with conversions of shares of the Series I Preferred Stock.

Through March 28, 2005, the Breckenridge Fund, LLC (“Breckenridge”) had converted 1,900 shares of our Series I Preferred Stock, in connection with which we issued 18,490,433 shares of our common stock.  The following table describes the number of shares of Class A common stock that would be issuable, assuming that Breckenridge converted the full number of shares of the Series I Preferred Stock (not including any shares issuable as payment of dividends accrued) as of March 28, 2005, and further assuming that the applicable conversion prices at the time of such conversion were the following amounts:

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Our issuances of shares in connection with the conversions of the Series I Preferred Stock and in connection with the Sixth Equity Line likely will result in overall dilution to market value and relative voting power of previously issued common stock, which could result in substantial dilution to the value of shares held by shareholders.

Historically, the issuance of Class A common stock to the Equity Line Investor under the first five equity lines resulted in substantial dilution to the equity interests of all holders of Class A common stock, except the Equity Line Investor.  The issuance of Class A common stock in connection with conversions of the Series I Preferred Stock and with draws under the Sixth Equity Line may result in substantial dilution to the equity interests of holders of Fonix Class A common stock other than Breckenridge and the Equity Line Investor.  Specifically, the issuance of a significant amount of additional Class A common stock will result in a decrease of the relative voting control of the Class A common stock issued and outstanding prior to the issuance of Class A common stock in connection with conversions of the Series I Preferred Stock or with the Sixth Equity Line.  Furthermore, public resales of Class A common stock by Brecken ridge or by the Equity Line Investor following the issuance of Class A common stock in connection with conversions of the Series I Preferred Stock or with puts under the Sixth Equity Line likely will depress the prevailing market price of the Class A common stock.  Even prior to the time of actual conversions, exercises, and public resales, the market “overhang” resulting from the mere existence of our obligation to honor such conversions or exercises could depress the market price of our Class A common stock.

Existing shareholders likely will experience increased dilution with decreases in market value of Class A common stock in relation to our issuances of shares upon conversion of the Series I Preferred Stock or in connection with puts made under the Sixth Equity Line, which could have a material adverse impact on the value of their shares.

The formulas for determining the number of shares of Class A common stock to be issued upon conversion of the shares of Series I Preferred Stock or in connection with puts made under the Sixth Equity Line are based, in part, on the market price of the Class A common stock and includes a discount from the market price equal to 87.5% of the average of the two lowest closing bid prices of the Class A common stock for the Series I Preferred Stock, and a discount from the market price equal to 90% of the average of the two lowest closing bid prices of the Class A common stock for puts under the Sixth Equity Line, over a specified trading period.  As a result, the lower the market price of our Class A common stock at and around the time Breckenridge converts shares of the Series I Preferred Stock or we put shares under the Sixth Equity Line, the more shares of Class A common stock Breckenridge or the Equity Line Investor, as applicable, woul d receive.  Any increase in the number of shares of Class A common stock issued upon puts of shares as a result of decreases in the prevailing market price would compound the risks of dilution described in the preceding paragraph.

There is an increased potential for short sales of the Class A common stock due to the sales of shares put to the Equity Line Investor in connection with the Sixth Equity Line, which could materially affect the market price of the stock.

Downward pressure on the market price of the Class A common stock that likely will result from sales of the Class A common stock by the Equity Line Investor issued in connection with a put under the Sixth Equity Line could encourage short sales of Class A common stock by the Equity Line Investor.  Significant amounts of such

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short selling could place further downward pressure on the market price of our Class A common stock.

Certain restrictions on the extent of puts may have little, if any, effect on the adverse impact of our issuance of shares under the Sixth Equity Line, and as such, the Equity Line Investor may sell a large number of shares, resulting in substantial dilution to the value of shares held by existing shareholders.

We are prohibited from putting shares to the Equity Line Investor under the Sixth Equity Line if such put would result in that investor holding more than 4.999% of the then-outstanding shares of Class A common stock.  These restrictions, however, do not prevent the Equity Line Investor from selling shares of Class A common stock received in connection with a put, and then receiving additional shares of Class A common stock in connection with a subsequent put.  In this way, the Equity Line Investor could sell more than 4.999% of the outstanding Class A common stock in a relatively short time frame while never holding more than 4.999% at one time.

Certain restrictions on the number of shares of Series I Preferred Stock Breckenridge may convert at any time may have little, if any, effect on the adverse impact of our issuance of shares upon conversion of the Series I Preferred Stock, and as such, Breckenridge may sell a large number of shares, resulting in substantial dilution to the value of shares held by existing shareholders.

Breckenridge is prohibited by the Series I Preferred Stock purchase agreement from converting shares of Series I Preferred Stock to the extent that the number of shares we issue upon conversion would result in Breckenridge’s holding more than 4.999% of the then-outstanding shares of Class A common stock.  These restrictions, however, do not prevent Breckenridge from converting certain shares of Series I Preferred Stock, selling the shares received in connection with the conversion, and then converting additional shares of Series I Preferred Stock in a subsequent conversion.  In this way, Breckenridge could sell more than 4.999% of the outstanding Class A common stock in a relatively short time frame while never holding more than 4.999% at one time.

We have registered under registration statements the resale of shares approximately equal to the number of shares currently issued and outstanding, which may result in substantial dilution to current shareholders if the selling shareholders under the other registration statements sell all of the shares under those registration statements.

We have filed, in connection with the Sixth Equity Line, the LTEL acquisition and the sale of the Series I Preferred Stock, registration statements which register, in the aggregate, the resale by the Equity Line Investor, the LTEL shareholders and Breckenridge of up to approximately 142,536,801  shares of our Class A common stock.  As of March 28, 2005 we had 173,040,324 shares of our Class A common stock issued and outstanding.  Accordingly, the sale by the Equity Line Investor, the LTEL shareholders and Breckenridge of all of the shares registered under the outstanding registration statements will result in substantial dilution to current holders of our Class A common stock.

Because the conversion price for the shares of Series I Preferred Stock is based on the market price of our Class A common stock, if the market price declines we may be unable to satisfy the conversion requests of Breckenridge without registering additional shares, which would impose additional costs in connection with the Series I Preferred Stock.

If the market price of the Class A common stock continues to decline, the number of shares of Class A common stock issuable in connection with conversions of the Series I Preferred Stock will increase.  Accordingly, we may run out of shares registered under the prospectus and the related registration statement to issue to Breckenridge in connection with conversions of the Series I Preferred Stock.  In such an event, we would be required to, and would, file additional registration statements to cover the resale of additional shares issuable upon conversion of the Series I Preferred Stock.  The filing of the additional registration statement would impose additional costs in connection with the Series I Preferred Stock.

We have no dividend history and have no intention to pay dividends in the foreseeable future.

We have never paid dividends on or in connection with any class of our common stock and do not intend to pay any dividends to common stockholders for the foreseeable future.

Competition from other industry participants and rapid technological change could impede our ability to

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achieve profitable operations.  Additionally, our current and potential competitors, some of whom have greater resources and experience than we do, may develop products and technologies that may cause a decline in demand for, and the prices of, our Products and our telecommunications services.

The speech-enabled technologies market sector and telecommunications industry are characterized by rapid technological change.  Competition in the speech-enabled technologies market is based largely on marketing ability and resources, distribution channels, technology and product superiority and product service and support.  A number of companies have developed, or are expected to develop, products that compete with our Products and Core Technologies. Competitors in the speech technology software market include IBM, SpeechWorks International, Nuance, and ScanSoft. We expect additional competition from other companies, including Microsoft. Furthermore, our competitors may combine with each other, and other companies may enter our markets by acquiring or entering into strategic relationships with our competitors. Current and potential competitors have established, or may establish, cooperative relationships among themselves or with third parties to increase the abilities of their speech and language technology products to address the needs of our prospective customers.

Similarly, the market for telecommunications services is highly competitive. We compete, and expect to continue to compete, with current and potential market entrants, including: long-distance carriers; ILECs; other CLECs; competitive access providers (“CAPs”); cable television companies; electric utilities; microwave carriers; wireless telephone system operators; and private networks built by large end-users.   In addition, the possibility of combinations and strategic alliances in the telecommunications industry could give rise to significant new competitors.  We also expect in