You should read the following discussion together with our Condensed Consolidated Financial Statements and the related notes and other financial information included elsewhere in this periodic report. The discussion in this periodic report contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. The cautionary statements made in this report should be read as applying to all related forward-looking statements wherever they appear in this report. Our actual results could differ materially from those discussed here. In this report, Cbeyond, Inc. and its subsidiary are referred to as "we", the "Company" or "Cbeyond".

Overview

We provide managed IP-based communications services to small businesses in select large metropolitan areas across the United States. We provide these services through bundled packages of local and long distance voice services, broadband Internet access and mobile voice and data, together with additional applications and services, for an affordable fixed monthly fee under fixed-length contracts.

We sell three integrated packages of services, primarily delineated by the number of local voice lines, long distance minutes and T-1 connections provided to the customer. Each of our BeyondVoice packages includes local and long distance voice services, broadband Internet access and mobile voice and data plus additional value-added applications, such as email, voicemail, web hosting, secure backup and file sharing, fax-to-email, virtual private network, and other communications and IT services. Customers may also choose to add extra features or lines for an additional fee. During the quarter ended June 30, 2008 we began offering secure desktop services and expanded our hosted Microsoft Exchange services to customers in all of our current markets.

Our voice services (other than our mobile voice services) are delivered using Voice over Internet Protocol, or VoIP, technology, and all of such services are delivered over our secure all-IP network, which we believe affords greater service flexibility and significantly lower network costs than traditional service providers using circuit-switch technologies. We offer our mobile voice and data services via our mobile virtual network operator relationship with a nationwide wireless network provider.

We sell our services primarily through a direct sales force in each market, supplemented by sales agents. These agents often have other business relationships with the customer and, in many cases, perform equipment installations for us at our customers' sites. A significant portion of our new customers are generated by referrals from existing customers and partners. We offer financial incentives to our customers and other sources for referrals which are charged to selling expenses.

We compete primarily against ILECs' and, to a lesser extent, against competitive local exchange carriers, both of which are local telephone companies. Local telephone companies do not generally have the same focus on our target market and principally concentrate on medium or large enterprises or residential customers. In addition, cable television providers have begun serving the small and medium business market with telephone service, in addition to high speed Internet access and video. To date, we have not experienced significant competition from cable television providers and do not believe that they intend to offer the breadth of services and applications that our customers purchase from us. We compete primarily based on our high-value bundled services that bring many of the same managed services to our customers that have historically been available only to large businesses, as well as based on our customer care, network reliability and operational efficiencies.

We formed Cbeyond and began the development of our network and business processes following our first significant funding in early 2000. We launched our first market early in 2001 and have since expanded operations into eleven additional markets. We revised our market expansion plan, which is to open two new markets per year during 2008 and 2009 and between two and three markets per year thereafter, depending on economic conditions. This plan is a reduction of previous plans to open three new markets per year. However, we do not expect this decision to significantly affect our ability to expand operations and establish operations in the largest 25 U.S. markets. We have chosen a revised market expansion plan that is more reflective of current economic conditions, including a delay until the first quarter of 2009 of the new market opening originally planned for the fourth quarter of 2008. The following comprises the service launch date for our current markets and the anticipated launch date of our future announced markets:

            Current Markets                        Service Launch Date
            Atlanta                                  2 nd Quarter 2001
            Dallas                                   4 th Quarter 2001
            Denver                                   1 st Quarter 2002
            Houston                                  1 st Quarter 2004
            Chicago                                  1 st Quarter 2005
            Los Angeles                              1 st Quarter 2006
            San Diego                                1 st Quarter 2007
            Detroit                                  3 rd Quarter 2007
            San Francisco Bay area                   4 th Quarter 2007
            Miami                                    1 st Quarter 2008
            Minneapolis                              2 nd Quarter 2008

            Announced Markets              Planned Service Launch Date
            Greater Washington D.C. area             1 st Quarter 2009

We focus on adjusted EBITDA as a principal indicator of the operating performance of our business. EBITDA represents net income (loss) before interest, income taxes, depreciation and amortization. We define adjusted EBITDA as net income (loss) before interest, income taxes, depreciation and amortization expenses, excluding, when applicable, non-cash share-based compensation, public offering expenses, gains related to our troubled debt restructuring and our early payoff of the restructured debt, gain or loss on disposal of property and equipment and other non-operating income or expense. In our presentation of segment financial results, adjusted EBITDA for a geographic segment does not include corporate overhead expense and other centralized operating costs. We believe that adjusted EBITDA trends are a valuable indicator of our operating segments' relative performance and of whether our operating segments are able to produce operating cash flow to fund working capital needs, to service debt obligations and to fund capital expenditures.

We believe our business approach requires significantly less capital to launch operations compared to traditional communications companies using legacy technologies. Based on our historical experience, over time, a substantial majority of our market-specific capital expenditures, such as integrated access devices installed at our customers' locations, are success-based, incurred primarily as our customer base grows. We believe the success-based nature of our capital expenditures mitigates the risk of unprofitable expansion. We have a relatively low fixed-cost component in our budgeted capital expenditures associated with each new market we enter, particularly in comparison to service providers employing time-division multiplexing, which is a technique for transmitting multiple channels of separate data, voice and/or video signals simultaneously over a single communication medium, or circuit-switch technology, which is a switch that establishes a dedicated circuit for the entire duration of a call.

The nature of the primary components of our operating results - revenues, cost of revenue and selling, general and administrative expenses - are described below:

Revenue

The majority of our customers subscribe to our BeyondVoice I package, which serves customers with 4-15 local voice lines, or generally 30 or fewer employees. We also sell subscriptions of BeyondVoice II to customers with 16-24 local voice lines, or generally 31-100 employees. Our BeyondVoice III package is typically offered to customers with 101-249 employees. Each BeyondVoice I customer receives all our services over a dedicated broadband T-1 connection providing a maximum symmetric bandwidth of 1.5 Mbps (megabits per second). BeyondVoice II customers receive their services over two dedicated T-1 connections offering a maximum symmetric bandwidth of 3.0 Mbps. BeyondVoice III customers receive their services over three dedicated T-1 connections offering a maximum symmetric bandwidth of 4.5 Mbps. We believe that our customers highly value the level of symmetric bandwidth offered with our services. As of September 30, 2008, approximately 83.9% of our customer base had BeyondVoice I, 14.9% had BeyondVoice II, and 1.2% had BeyondVoice III.

In the quarter ended September 30, 2008, we recorded a change in estimate for promotional obligations resulting in $0.4 million of revenue related to certain customer promotional liabilities recorded in prior periods. Prior to the third quarter, these promotional obligations were recorded at their maximum amount as a reduction in revenue when earned by the customer due to the lack of sufficient historical experience required under U.S. generally accepted accounting principles (GAAP) to estimate the amount that would ultimately be earned and claimed by customers. We recognize the benefit of changes to these estimated promotional obligations on customer promotions when such amounts are reasonably estimable.

Average monthly revenue per customer location (ARPU) is impacted by a variety of factors, including the distribution of customer installations during a period, the adoption by customers of applications for which incremental fees are paid, the trend toward customers signing three-year contracts at lower package prices as compared to shorter term contracts, the amount of long distance call volumes that generate overage charges above the basic amount of minutes included in customers' packages as well as additional terminating access charges and customer usage and purchase patterns. We expect ARPU to be relatively stable or moderately increasing in future periods due to increased adoption of our value-added applications, such as our mobile related service offerings. Customer revenues represented approximately 98.1% and 98.0% of total revenues for the three and nine months ended September 30, 2008, respectively, as compared to 97.8% for both of the comparable periods in 2007. Access charges paid to us by other communications companies to terminate calls to our customers represented the majority of the remainder of total revenues.

Customer revenues are generated under contracts that typically run for three-year terms. Therefore, customer churn rates have an impact on projected future revenue streams. We historically maintained monthly churn rates of approximately 1.0%. Beginning with the third quarter of 2007, however, we have experienced elevated churn rates that we believe are attributable primarily to the inability of certain of our customers to meet their payment obligations as a result of deteriorating economic conditions. We experienced average monthly churn rates of 1.1% in the third quarter of 2007, 1.4% in the fourth quarter of 2007, and 1.3% in the first, second, and third quarters of 2008. We cannot predict the future duration or magnitude of the currently deteriorated economic conditions, but we expect our churn rate to continue to be elevated above our historical average monthly rate of 1.0% as long as the current economic environment persists. In response to deteriorating economic conditions, we have taken steps which we believe will mitigate the risk of heightened churn and bad debt levels on a longer term basis. These steps include a tightening of credit and collection policies and practices for customers with a higher risk profile. As a result of these steps, we have seen bad debt expense decline as a percentage of revenue and have also experienced improvements in the age of outstanding receivables from customers during 2008 as compared to the fourth quarter of 2007.

Cost of Revenue

Our cost of revenue represents costs directly related to the operation of our network, including payments to the local telephone companies and other communications carriers such as long distance providers and our mobile provider, for access, interconnection and transport fees for voice and Internet traffic, customer circuit installation expenses paid to the local telephone companies, fees paid to third-party providers of certain applications such as web hosting services, collocation rents and other facility costs, telecommunications-related taxes and fees, and the cost of mobile handsets. The primary component of cost of revenue is the access fees paid to local telephone companies for the T-1 circuits we lease on a monthly basis to provide connectivity to our customers. These access circuits link our customers to our network equipment located in a collocation facility, which we lease from local telephone companies. The access fees for these circuits vary by state and are the primary reason for differences in cost of revenue across our markets.

As a result of the TRRO, we are required to lease circuits under special access, or retail, rates in locations that are deemed to offer competitive facilities as outlined in the FCC's regulations and interpreted by the state regulatory agencies. For additional discussion, see "Results of Operations-Revenue and Cost of Revenue."

Where permitted by regulation, we lease our access circuits on a wholesale basis as UNE loops or extended enhanced links as provided for under the FCC's Telecommunications Elemental Long Run Incremental Cost rate structure. Where UNE pricing is not available, we pay special access or negotiated rates, which may be significantly higher than UNE pricing. We employ loops when the customer's T-1 circuit is located where it can be connected to a local telephone company's central office where we have a collocation, and we use extended enhanced links when we do not have a central office collocation available to serve a customer's T-1 circuit. Historically, approximately half of our circuits are provisioned using loops and half using extended enhanced links, although the impact of the TRRO has reduced our usage of the T-1 transport portion of extended enhanced links and resulted in the conversion and consolidation of a majority of the previously installed T-1 transports to high capacity DS-3 transport. Our monthly expenses are significantly less when using loops rather than extended enhanced links, but loops require us to incur the capital expenditures of central office collocation equipment. We install central office collocation equipment in those central offices having the densest concentration of small businesses. We usually launch operations in a new market with several collocations and add additional collocation facilities over time as we confirm the most advantageous locations in which to deploy the equipment. We believe our discipline of leasing these T-1 access circuits on a wholesale basis rather than on the basis of special access rates from the local telephone companies is an important component of our operating cost structure.

Another significant component of our cost of revenue is the cost associated with our mobile offering. These costs, which represent our fastest growing cost of revenue, include monthly base charges or usage based charges, depending on the type of mobile product in service, and the cost of mobile equipment sold to our customers to facilitate their use of our service. The cost of mobile equipment typically exceeds the selling price of such devices due to the long-term profitability of the service over the life of the customer contract. Primarily as a result of the loss on the sale of mobile equipment recorded in full at the time of the sale, increased volumes of mobile sales decrease our gross margin percentages, although the growth of this service offering is expected to result in greater gross profits over time.

We routinely receive telecommunication cost recoveries from various local telephone companies to adjust for prior errors in billing, including the effect of price decreases retroactively applied upon the adoption of new rates as mandated by regulatory bodies. These service credits are often the result of negotiated resolutions of bill disputes that we conduct with our vendors. We also receive payments from the local telephone companies in the form of performance penalties that are assessed by state regulatory commissions based on the local telephone companies' performance in the delivery of circuits and other services that we use in our network. Because of the many factors, as noted above, that impact the amount and timing of telecommunication cost recoveries, estimating the ultimate outcome of these situations is uncertain. Accordingly, we recognize telecommunication cost recoveries as offsets to cost of revenue when the ultimate resolution and amount are known. These items do not follow any predictable trends and often result in variances when comparing the amounts received over multiple periods.

Selling, General and Administrative Expenses

Our selling, general and administrative expenses consist of salaries and related costs for employees and other expenses related to sales and marketing, engineering, information technology, billing, regulatory, administrative, collections and legal and accounting functions. In addition, share-based compensation expense is included in selling, general and administrative expense. Our selling, general and administrative expenses include both fixed and variable costs. Fixed selling expenses include salaries and office rents. Variable selling costs include commissions and marketing collateral. Fixed general and administrative costs include the cost of staffing certain corporate overhead functions such as IT, marketing, administrative, billing and engineering, and associated costs, such as office rent, legal and accounting fees, property taxes and recruiting costs. Variable general and administrative costs include the cost of provisioning and customer activation staff, which grows with the level of installation of new customers, and the cost of customer care and technical support staff, which grows with the level of total customers on our network. As we expand into new markets, certain fixed costs are likely to increase; however, these increases are intermittent and not proportional with the growth of customers.

Reclassifications

Reclassifications have been made to the three and nine months ended September 30, 2007 Revenue and Cost of Revenue table within Item 2 herein to aggregate backbilling expiration credits from Other cost of revenue to Telecommunications cost recoveries as well as to disaggregate Mobile cost from Other cost of revenue. Such reclassifications were made to conform to the current presentation for the three and nine months ended September 30, 2008.

Results of Operations

Revenue and Cost of Revenue (Dollar amounts in thousands)



                                                   For the Three Months Ended
                                         September 30, 2008          September 30, 2007          Change from Previous
                                                       % of                        % of
                                        Dollars       Revenue       Dollars       Revenue        Dollars        Percent
Revenue:
Customer revenue                       $   88,500        98.1 %    $   70,835        97.8 %    $    17,665         24.9 %
Terminating access revenue                  1,743         1.9 %         1,581         2.2 %            162         10.2 %

Total revenue                              90,243                      72,416                       17,827         24.6 %

Cost of revenue (exclusive of
depreciation and amortization):
Circuit access fees                        11,640        12.9 %         9,514        13.1 %          2,126         22.3 %
Other cost of revenue                      11,639        12.9 %         9,610        13.3 %          2,029         21.1 %
Mobile cost                                 7,222         8.0 %         4,143         5.7 %          3,079         74.3 %
Telecommunications cost recoveries         (3,478 )      (3.9 )%       (1,479 )      (2.0 )%        (1,999 )      135.2 %

Total cost of revenue                      27,023        29.9 %        21,788        30.1 %          5,235         24.0 %


Gross margin (exclusive of
depreciation and amortization):        $   63,220        70.1 %    $   50,628        69.9 %    $    12,592         24.9 %


Customer data:
Customer locations at period end           40,569                      33,287                        7,282         21.9 %

Average revenue per customer
location                               $      760                  $      749                  $        11          1.5 %

                                                  For the Nine Months Ended
                                        September 30, 2008          September 30, 2007          Change from Previous
                                                      % of                        % of
                                       Dollars       Revenue       Dollars       Revenue        Dollars        Percent
Revenue:
Customer revenue                      $  250,688        98.0 %    $  198,640        97.8 %    $    52,048         26.2 %
Terminating access revenue                 5,140         2.0 %         4,517         2.2 %            623         13.8 %

Total revenue                            255,828                     203,157                       52,671         25.9 %

Cost of revenue (exclusive of
depreciation and amortization):
Circuit access fees                       33,149        13.0 %        26,929        13.3 %          6,220         23.1 %
Other cost of revenue                     32,710        12.8 %        28,110        13.8 %          4,600         16.4 %
Mobile cost                               19,371         7.6 %         9,156         4.5 %         10,215        111.6 %
Telecommunications cost recoveries        (5,967 )      (2.3 )%       (3,465 )      (1.7 )%        (2,502 )       72.2 %

Total cost of revenue                     79,263        31.0 %        60,730        29.9 %         18,533         30.5 %


Gross margin (exclusive of
depreciation and amortization):       $  176,565        69.0 %    $  142,427        70.1 %    $    34,138         24.0 %


Customer data:
Customer locations at period end          40,569                      33,287                        7,282         21.9 %

Average revenue per customer
location                              $      752                  $      745                  $         7          0.9 %

Revenue. Total revenue increased for the three and nine months ended September 30, 2008 compared to the three and nine months ended September 30, 2007 relatively proportional to the increase in the average number of customers year over year. ARPU was $760 and $752 for the three and nine months ended September 30, 2008, as compared to $749 and $745 for the three and nine months ended September 30, 2007. This increase in ARPU from the three months ended September 30, 2007 to the three months ended September 30, 2008 resulted primarily from an increase in the average applications used per customer to 6.8 in the period ended September 30, 2008 from 6.1 in the period ended September 30, 2007, and as discussed above, the recognition of reductions to promotional obligations of $0.4 million in the three and nine months ended September 30, 2008 related to certain customer promotional liabilities recorded in prior periods. The ARPU for the three and nine months ended September 30, 2008 includes $4 and $1, respectively, related to the afforementioned customer promotional liabilities. We anticipate ARPU to continue to be relatively stable or moderately increasing in future periods based on the expectation that our customers will continue to increase the average number of applications they use.

Revenues from access charges paid to us by other communications companies to terminate calls to our customers increased for the three and nine months comparison periods due to our customer growth. These terminating access charges have historically grown at a slower rate than our customer base due to reductions in access rates on interstate calls as mandated by the FCC. These rate reductions are expected to continue in the future, so we expect access charge revenues will continue to grow at a rate slower than our customer growth.

The following comprises the segment contributions to the increase in revenue in the three and nine months ended September 30, 2008 as compared to the three and nine months ended September 30, 2007:

(Dollar amounts in thousands)

                                          For the Three Months Ended
                                 September 30, 2008        September 30, 2007         Change from Previous Period
                                               % of                      % of
                                  Dollars     Revenue       Dollars     Revenue        Dollars           Percent
Atlanta                         $    20,641      22.9 %   $    18,555      25.6 %   $        2,086             11.2 %
Dallas                               17,733      19.7 %        15,652      21.6 %            2,081             13.3 %
Denver                               17,999      19.9 %        16,453      22.7 %            1,546              9.4 %
Houston                              11,963      13.3 %        10,147      14.0 %            1,816             17.9 %
Chicago                               9,410      10.4 %         7,143       9.9 %            2,267             31.7 %
Los Angeles                           6,250       6.9 %         3,522       4.9 %            2,728             77.5 %
San Diego                             3,030       3.4 %           818       1.1 %            2,212            270.4 %
Detroit                               1,567       1.7 %           126       0.2 %            1,441               nm
San Francisco Bay Area                1,045       1.2 %            -         -               1,045               nm
Miami                                   407       0.5 %            -         -                 407               nm
Minneapolis                             198       0.2 %            -         -                 198               nm

Total Revenue                   $    90,243               $    72,416               $       17,827


                                           For the Nine Months Ended
                                 September 30, 2008        September 30, 2007         Change from Previous Period
                                               % of                      % of
                                  Dollars     Revenue       Dollars     Revenue        Dollars           Percent
. . .