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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES

EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

COMMISSION FILE NUMBER: 000-32647

KNOLOGY, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (706) 645-8553

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

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

As of October 31, 2004, Knology, Inc. had 21,515,206 shares of common stock and 2,170,127 shares of non-voting common stock outstanding.

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KNOLOGY, INC.

QUARTER ENDED SEPTEMBER 30, 2004

INDEX

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ITEM 1. FINANCIAL STATEMENTS

KNOLOGY, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)

See notes to condensed consolidated financial statements.

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KNOLOGY, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)

See notes to condensed consolidated financial statements.

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KNOLOGY, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(DOLLARS IN THOUSANDS)

See notes to condensed consolidated financial statements.

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KNOLOGY, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)

1. ORGANIZATION AND NATURE OF BUSINESS

Knology, Inc. (including its predecessors, “Knology” or the “Company”) is a publicly traded company incorporated under the laws of the State of Delaware in September 1998.

Knology and its subsidiaries own and operate an advanced interactive broadband network and provide residential and business customers broadband communications services, including analog and digital cable television, local and long-distance telephone, high-speed Internet access, and broadband carrier services to various markets in the southeastern United States.

Our telephone operations group, consisting of Interstate Telephone Company, Globe Telecommunications, Inc., ITC Globe, Inc., and Valley Telephone Co., LLC (our “Telephone Operations Group”) is wholly owned and provides a full line of local telephone and related services and broadband services. Certain of the Telephone Operations Group subsidiaries are subject to regulation by state public service commissions of applicable states for intrastate telecommunications services. For applicable interstate matters related to telephone service, certain Telephone Operations Group subsidiaries are subject to regulation by the Federal Communications Commission.

2. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments considered necessary for the fair presentation of the financial statements have been included, and the financial statements present fairly the financial position and results of operations for the interim periods presented. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto, together with management’s discussion and analysis of financial condition and results of operations contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the year ending December 31, 2004, or any other period.

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

RECENT ACCOUNTING PRONOUNCEMENTS

In December 2003, the FASB issued a revision to FASB Interpretation No. 46 (“FIN 46-R”), “Consolidation of Variable Interest Entities.” FIN 46 is an Interpretation of Accounting Research Bulletin 51, “Consolidated Financial Statements” and addresses consolidation by business enterprises of variable interest entities (“VIEs”) that possess certain characteristics. The revision clarifies the definition in the original release that potentially could have classified any business as a VIE. The revision also delays the effective date of the Interpretation from the first reporting period following December 15, 2003 to the first reporting period ending after March 15, 2004. The revision was effective for the Company in the first quarter of fiscal 2004. The Company has not identified any VIEs and, accordingly, the application of this Interpretation did not have an effect on the Company’s results of operations or financial position.

At the March 2004 Emerging Issues Task Force (“EITF”) meeting, the Task Force reached a consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. Issue 03-1 defines the terms other–than-temporary and other-than-temporary impairment and establishes a three-step impairment model applicable to debt and equity securities that are within the scope of SFAS 115. At the November 2003 EITF meeting, the Task Force reached a consensus effective for fiscal years ending after December 15, 2003 on quantitative disclosures. Except for disclosure requirements already in place, the Issue 03-1 consensus will be effective prospectively for all relevant current and future investments in reporting periods beginning after

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June 15, 2004. The Company adopted EITF Issue No. 03-1 disclosure requirements for the fiscal year ended December 31, 2003 and does not expect the adoption of future requirements of EITF Issue No. 03-1 to have material impact on the Company’s results of operations or financial position.

4. CASH

As of September 30, 2004, the Company had $8,428 of cash that was restricted in use. Of this amount, $3,132 was held at the Telephone Operations Group and restricted for use by these entities. Also, the Company has pledged $5,295 of cash as collateral for amounts potentially payable under certain franchise, insurance, lease agreements and surety bond agreements.

5. INVESTMENTS

Due to certain changes in Grande Communications, Inc.’s business during the third quarter of 2003, including the loss of a significant wholesale contract, the company evaluated the carrying amount of its investment in Grande. Based on the evaluation, the company recorded a loss of $12,406 on its investment in Grande during the third quarter of 2003. This loss is deemed to be other than temporary and has been charged to earnings.

6. GOODWILL AND INTANGIBLE ASSETS

The Company performs a goodwill impairment test in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” annually on January 1. There was no impairment identified as a result of the January 1, 2004 impairment test.

Intangible assets as of December 31, 2003 and September 30, 2004, respectively, were as follows:

Amortization expense related to intangible assets was $302 and $251 for the nine months ended September 30, 2003 and 2004, respectively.

7. LONG-TERM DEBT

Long-term debt at December 31, 2003 and September 30, 2004 consists of the following:

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On September 10, 2004, we completed certain amendments to our credit facilities with Wachovia Bank, National Association and CoBank, ACB. The amended credit facilities defer approximately $24,500 of principal payments until 2007 which were previously scheduled during 2004, 2005 and 2006, and modified certain financial covenants. In addition, the amendments allowed our Telephone Operations Group to make a $7,700 dividend payment to us, as well as future dividend payments equal to the net income of the Telephone Operations Group. These dividends decrease the amount of the company’s restricted cash.

As of September 30, 2004, the Company was in compliance with all of its debt covenants.

8. EQUITY INTERESTS

On January 13, 2004, pursuant to the exercise of the underwriters’ over-allotment option, the Company issued approximately 900,000 shares at a per share price to the public of $9.00, with net proceeds of approximately $7,300.

These consolidated financial statements have been revised to give effect to the reverse stock split on November 28, 2003, which was a one-for-ten stock split of our common and non-voting common stock. As a result of the stock split, each of the outstanding shares of common stock was reclassified as one-tenth (1/10) of a share of common stock and each of the outstanding shares of non-voting common stock was reclassified as one-tenth (1/10) of a share of non-voting common stock.

On May 7, 2004, pursuant to a proposal ratified by a shareholder vote, all outstanding options to purchase common stock granted prior to December 18, 2003 under the 2002 Long-Term Incentive Plan with an exercise price of $18.70 per share were cancelled and replaced with new options with an exercise price of $6.87 per share.

9. LOSS PER SHARE

The Company computes loss per share in accordance with SFAS No. 128, Earnings per Share. Basic loss per share is computed by dividing income from continuing operations by the weighed-average number of common shares outstanding for the period. Diluted loss per share is computed in the same manner, but also includes the dilutive effect of common stock equivalents and other financial instruments that are convertible or exercisable for the Company’s common stock. For the three months ended September 30, 2003 and 2004, the Company had 17,797,634 and 2,924,203 shares related to preferred stock, stock options and warrants outstanding that were not included in the computation of diluted loss per share because such effects would have been antidilutive for the respective periods.

10. COMMITMENTS AND CONTINGENCIES

LEGAL PROCEEDINGS

In September 2000, the City of Louisville, Kentucky granted Knology of Louisville, Inc., a subsidiary of Knology, Inc., a cable television franchise. On November 2, 2000, Insight filed a complaint against the City of Louisville in Kentucky Circuit Court in Jefferson County, Kentucky claiming that the Company’s franchise was more favorable than Insight’s franchise. Insight’s complaint suspended the Company’s franchise until there is a final, nonappealable order in Insight’s Kentucky Circuit Court case. In April 2001 the City of Louisville moved for summary judgment in Kentucky Circuit Court against Insight. In March 2002, the Kentucky Circuit Court ruled that Insight’s complaint had no merit and the Kentucky Circuit Court granted the City of Louisville’s motion to dismiss Insight’s complaint. Insight appealed the Kentucky Circuit Court order dismissing their complaint and in June 2003 the Kentucky Court of Appeals upheld the Kentucky Circuit Court ruling. Insight sought discretionary review of the Kentucky Court of Appeals ruling from the Kentucky Supreme Court which request was denied

On November 8, 2000, the Company filed an action in the U.S. District Court for the Western District of Kentucky against Insight seeking monetary damages, declaratory and injunctive relief from Insight and the City arising out of Insight’s complaint and the suspension of the Company’s franchise. In March 2001, the U.S. District Court issued an order granting the Company’s motion for preliminary injunctive relief and denying Insight’s motion to dismiss. In June 2003, the U.S. District Court ruled on the parties’ cross motions for summary judgment, resolving certain claims and setting others down for trial. The U.S. District Court granted the Company’s motion for summary judgment based on causation on certain claims. In August 2003, the U.S. District Court granted Insight’s motion for an immediate interlocutory appeal on certain issues, which was accepted in October 2003 by the U.S. Court of Appeals for the Sixth Circuit. The matter has been fully briefed and oral arguments have been held. At this time it is impossible to determine with certainty the ultimate outcome of the litigation.

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On November 21, 2001, the Company filed a complaint against Georgia Power Company requesting FCC adjudication of a dispute regarding amounts Georgia Power charged the Company in connection with the construction of its network in Augusta, Georgia. The Company requested the FCC to review these charges to determine whether they were “reasonable” in accordance with FCC pole attachment regulations. The company requested reimbursement from Georgia Power of approximately $2,500. Georgia Power responded to the FCC complaint by asserting the Company owed Georgia Power approximately $900 for additional construction-related charges. In May 2003, Georgia Power filed a complaint against Knology Broadband, the Company’s subsidiary, in the Superior Court of Troup County, State of Georgia, re-asserting claims for construction related charges. Georgia Power’s claim duplicates its claim pending before the FCC. The Company responded to Georgia Power’s complaint in state court by re-asserting its claims that are currently pending before the FCC. The Company also sought to remove the state court action to federal court and moved to dismiss the lawsuit or to stay the action to allow the FCC time to issue its decision. Georgia Power has moved to remand the case to state court. On November 20, 2003, the FCC issued an order determining that certain pole attachment fees charged by Georgia Power were improper. The Commission ordered Georgia Power to refund $52 and to recalculate certain charges that it had billed the Company. Georgia Power refunded the $52. On August 11, 2004 the Company filed a motion seeking enforcement of the other provisions of the Commission’s Order. At this time, it is impossible to determine with certainty the ultimate outcome of the motion or the litigation.

The Company is subject to other litigation in the normal course of its business. However, in the Company’s opinion, there is no legal proceeding pending against it which would have a material adverse effect on its financial position, results of operations or liquidity. The Company is also a party to regulatory proceedings affecting the segments of the communications industry generally in which it engages in business.

11. BUSINESS HELD FOR SALE

On May 24, 2004 the Company announced that it had entered into a definitive asset purchase agreement to sell its cable system located in Cerritos, California for $14,800 in cash, subject to customary closing adjustments. The Company acquired the Cerritos cable system in December 2003 from Verizon Media Ventures Inc. in conjunction with its acquisition of Verizon Media’s Pinellas County, Florida operations. The sale of the Cerritos system is expected to close during the first quarter of 2005, subject to the satisfaction of closing conditions, including receipt of regulatory approvals with respect to the municipal franchise in Cerritos, California.

Following the guidance of SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” effective April 30, 2004, the Cerritos cable system was deemed to be a long-lived asset to be disposed of based on management’s commitment, plan, and actions taken to sell the property. Therefore, no depreciation expense related to the Cerritos assets will be recorded subsequent to April 30, 2004. The assets and liabilities related to the Cerritos system are separately stated on the Company’s balance sheet. The table below summarizes the major classes of assets and liabilities classified as held for sale.

The net income associated with the Cerritos cable system since April 30, 2004 is presented separately in the statement of operations as income from discontinued operations. The Cerritos cable system generated approximately $1,442 of revenue for the period that the assets have been classified as held for sale.

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12. SEGMENT INFORMATION

The Company follows SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” which established revised standards for the reporting of financial and descriptive information about operating segments in financial statements.

The Company owns and operates advanced interactive broadband networks and provides residential and business customers broadband communications services, including analog and digital cable television, local and long distance telephone, and high-speed Internet access, which the Company refers to as video, voice, and data services. We also provide other services including broadband carrier services, which includes local transport services such as local Internet transport, special access, local private line, and local loop services.

While management of the Company monitors the revenue generated from each of the various broadband services, operations are managed and financial performance is evaluated based upon the delivery of multiple services to customers over a single network. As a result of multiple services being provided over a single network, many expenses and assets are shared related to providing the various broadband services to customers. Management believes that any allocation of the shared expenses or assets to the broadband services would be subjective and impractical.

Revenues by broadband communications service are as follows:

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

THE MANAGEMENT’S DISCUSSION AND ANALYSIS AND OTHER PORTIONS OF THIS QUARTERLY REPORT INCLUDE “FORWARD-LOOKING” STATEMENTS WITHIN THE MEANING OF THE FEDERAL SECURITIES LAWS, INCLUDING THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995, THAT ARE SUBJECT TO FUTURE EVENTS, RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED. IMPORTANT FACTORS THAT EITHER INDIVIDUALLY OR IN THE AGGREGATE COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED INCLUDE, WITHOUT LIMITATION, (1) THAT WE WILL NOT RETAIN OR GROW OUR CUSTOMER BASE, (2) THAT OUR SUPPLIERS AND CUSTOMERS MAY REFUSE TO CONTINUE DOING BUSINESS WITH US, (3) THAT WE WILL FAIL TO BE COMPETITIVE WITH EXISTING AND NEW COMPETITORS, (4) THAT WE WILL NOT ADEQUATELY RESPOND TO TECHNOLOGICAL DEVELOPMENTS IMPACTING OUR INDUSTRY AND MARKETS, (5) THAT NEEDED FINANCING WILL NOT BE AVAILABLE, (6) THAT A SIGNIFICANT CHANGE IN THE GROWTH RATE OF THE OVERALL U.S. ECONOMY WILL OCCUR SUCH THAT CONSUMER AND CORPORATE SPENDING ARE MATERIALLY IMPACTED, (7) THAT WE WILL NOT BE ABLE TO COMPLETE FUTURE ACQUISITIONS, THAT WE MAY HAVE DIFFICULTIES INTEGRATING ACQUIRED BUSINESSES, OR THAT THE COST OF SUCH INTEGRATION WILL BE GREATER THAN WE EXPECT, (8) THAT WE MAY NOT COMPLETE THE SALE OF THE CERRITOS CABLE SYSTEM OR WE MAY NOT COMPLETE THE SALE IN A TIMELY MANNER, OR IN THE EVENT WE DO NOT RECEIVE NECESSARY REGULATORY OR OTHER APPROVALS OR FAIL TO SATISFY THE CONDITIONS TO CLOSING, THE TRANSACTION WILL TERMINATE, AND (9) THAT SOME OTHER UNFORESEEN DIFFICULTIES OCCUR, AS WELL AS THOSE RISKS SET FORTH IN OUR ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2003, WHICH ARE INCORPORATED HEREIN BY REFERENCE. THIS LIST IS INTENDED TO IDENTIFY ONLY CERTAIN OF THE PRINCIPAL FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE DESCRIBED IN THE FORWARD-LOOKING STATEMENTS INCLUDED HEREIN.

The following is a discussion of our consolidated financial condition and results of operations for the three and nine months ended September 30, 2004, and certain factors that are expected to affect our prospective financial condition. The following discussion and analysis should be read in conjunction with the financial statements and related notes included elsewhere in this Form 10-Q.

Introduction

We are a fully integrated provider of video, voice, data and advanced communications services to residential and business customers in nine markets in the southeastern United States. We provide a full suite of video, voice and data services in Huntsville and Montgomery, Alabama; Panama City and Pinellas County, Florida; Augusta, Columbus and West Point, Georgia; Charleston, South Carolina; and Knoxville, Tennessee. We also provide video services in Cerritos, California, but, as discussed below, we have entered into an agreement to sell those assets to Orange Broadband, Inc. Our primary business is the delivery of bundled communication services over our own network. In addition to our bundled package offerings, we sell these services on an unbundled basis.

We have built our business through:

To date, we have experienced operating losses as a result of the expansion of our service territories and the construction of our network. We expect to continue to focus on increasing our customer base and expanding our broadband operations. Our ability to generate profits and positive cash flow from operations will depend in large part on our ability to increase revenues to offset the costs of construction, expansion and operation of our network.

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Recent Transactions

On December 23, 2003, we completed a public offering of our common stock. Including the shares issued on January 13, 2004, pursuant to the exercise of the underwriters’ over-allotment option, we issued 6.9 million shares at a per share price to the public of $9.00, and our net proceeds were approximately $56.3 million.

In December 2003, we also completed the acquisition of certain assets from Verizon Media, including the cable television systems and franchise rights in Pinellas County, Florida and Cerritos, California. We paid Verizon Media an aggregate of approximately $17.0 million in cash, which was funded with the net proceeds of our common stock offering. In connection with the completion of the Verizon Media acquisition, we also issued to a prior prospective purchaser and certain of its employees warrants to purchase one million shares of our common stock with an exercise price of $9.00 per share in exchange for the release of the prospective purchaser’s exclusivity rights with Verizon Media.

On May 24, 2004, we announced that we entered into a definitive asset purchase agreement to sell our cable system located in Cerritos, California to Orange Broadband, Inc. for $14.8 million in cash, subject to customary closing adjustments. We expect the sale of the Cerritos system to close during the first quarter of 2005, subject to the satisfaction of closing conditions, including receipt of regulatory approvals with respect to the municipal franchise in Cerritos, California.

On September 10, 2004, we completed certain amendments to our credit facilities with Wachovia Bank, National Association and CoBank, ACB. The amended credit facilities defer approximately $24.5 million of principal payments until 2007 which were previously scheduled during 2004, 2005 and 2006, and modified certain financial covenants. In addition, the amendments allowed our Telephone Operations Group to make a $7.7 million dividend payment to us, as well as future dividend payments equal to the net income of the Telephone Operations Group.

Homes Passed and Connections

We report homes passed as the number of residential and business units, such as single residence homes, apartments and condominium units, passed by our broadband network and listed in our database. Marketable homes passed are homes passed other than those we believe are covered by exclusive arrangements with other providers of competing services. Because we deliver multiple services to our customers, we report the total number of connections for video, voice and data rather than the total number of customers. We count each video, voice or data service as a separate connection. For example, a single customer who purchases cable television, local telephone and Internet access services would count as three connections. We do not record the purchase of digital video services by an analog video customer as an additional connection. As we continue to sell bundled services, we expect more of our video customers to purchase voice, data and other enhanced services in addition to video services. Accordingly, we expect that our number of voice and data connections will grow faster than our video connections and will represent a higher percentage of our total connections in the future.

As of September 30, 2004, 100% of our video and data connections and over 95% of our voice connections were provided over our own network. The following table sets forth the number of marketable homes passed and connections as of September 30, 2003 and 2004.

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Revenues

We group our revenues into the following categories:

We experienced a net loss of connections during the first and second quarters of 2004. The lost connections were primarily a result of clean-up activities in the newly acquired Pinellas County market, including the elimination of non-paying customers from prior periods, customer database reconciliations and customers with expired promotions. We added voice services to our current video and data offerings in the Pinellas County market during the third quarter of 2004, and achieved net connection additions in this market. We expect to continue with positive net additions, on a consolidated basis, during the fourth quarter of 2004.

We expect the growth of new video connections to decrease as the video segment matures in our current markets. While the number of new video connections may decrease, management feels that opportunity to increase revenue and margins is available with the introduction of new products and new technology. New voice and data connections are expected to increase with sales and marketing efforts directed at selling new customers a bundle of services, penetrating untapped market segments and offering new services to existing and new customers.

Our operating expenses include cost of services, selling, operations and administrative expenses, depreciation and amortization, expenses associated with capital market activities, non-cash stock option compensation and litigation fees.

Cost of services include:

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and nine months ended September 30, 2004 compared to the 46.2% and 46.2% for the three and nine months ended September 30, 2003. We pay a monthly fee for programming services, generally based on the average number of subscribers to the program, although some fees are adjusted based on the total number of subscribers to the system and/or the system penetration percentage. Since programming cost is partially based on numbers of subscribers, it will increase as we add more subscribers. It will also increase as costs per channel increase over time and as programmers increase their rates.

Relative to our current product mix, we expect voice and data revenue will become larger percentages of our overall revenue, and potentially will provide higher margins. Based on the anticipated changes in our revenue mix, we expect that our consolidated cost of service as a percentage of our consolidated revenue will decrease.

Selling, operations and administrative expenses include:

Depreciation and amortization expenses include depreciation of our interactive broadband networks and equipment and amortization of intangible assets related to customer acquisitions.

As our sales and marketing efforts continue and our networks expand, we expect to add customer connections resulting in increased revenue. We also expect our operating expenses, including depreciation and amortization, to increase as we expand our networks and business.

We have experienced operating losses as a result of the expansion of our advanced broadband communications networks and services into new and existing markets. We expect to continue to focus on increasing our customer base and expanding our broadband operations. Accordingly, we expect that our operating expenses and capital expenditures will continue to increase as we extend our interactive broadband networks in existing and new markets in accordance with our business plan.

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RESULTS OF OPERATIONS

THREE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2004

The following table sets forth financial data as a percentage of operating revenues for the three months ended September 30, 2003 and 2004.

Revenues. Operating revenues increased 19.1% from $43.7 million for the three months ended September 30, 2003, to $52.1 million for the three months ended September 30, 2004. Operating revenues from video services increased 31.8% from $18.0 million for the three months ended September 30, 2003, to $23.7 million for the same period in 2004. Operating revenues from voice services increased 2.2% from $17.7 million for the three months ended September 30, 2003, to $18.1 million for the same period in 2004. Operating revenues from data and other services increased 27.6% from $8.1 million for the three months ended September 30, 2003, to $10.3 million for the same period in 2004.

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The increased revenues from video, voice and data and other services are due primarily to an increase in the number of connections, from 319,031 as of September 30, 2003, to 389,374 as of September 30, 2004. The significant increase in the number of connections accounted for substantially all of the increased revenue for the three months ended September 30, 2004. The additional connections resulted primarily from:

Cost of services. Cost of services increased 27.3% from $11.9 million for the three months ended September 30, 2003, to $15.1 million for the three months ended September 30, 2004. Cost of services for video services increased 45.27% from $8.3 million for the three months ended September 30, 2003, to $12.0 million for the same period in 2004. Cost of services for voice services decreased 15.1% from $3.0 million for the three months ended September 30, 2003, to $2.6 million for the same period in 2004. Cost of services for data and other services decreased 10.9% from $519,000 for the three months ended September 30, 2003, to $463,000 for the same period in 2004. The decrease in voice and data cost of services is primarily due to efficiency gains in our network architecture. We expect our cost of services to increase as we add more connections. Programming costs, which are one of our largest single expense items, have been increasing over the last several years on an aggregate basis due to an increase in subscribers, as a result of internal growth and the Verizon Media acquisition noted above, and on a per subscriber basis due to an increase in costs per program channel. We expect this trend to continue. We may not be able to pass these higher costs on to customers because of competitive forces, which would adversely affect our cash flow and gross profit.

Gross profit. Gross profit increased 16.0% from $31.9 million for the three months ended September 30, 2003, to $37.0 million for the three months ended September 30, 2004. Gross profit for video services increased 20.3% from $9.7 million for the three months ended September 30, 2003, to $11.6 million for the same period in 2004. Gross profit for voice services increased 5.8% from $14.7 million for the three months ended September 30, 2003, to $15.5 million for the same period in 2004. Gross profit for data and other services increased 30.2% from $7.5 million for the three months ended September 30, 2003, to $9.8 million for the same period in 2004. The increase in gross profit is primarily a result of the fluctuations as described above in revenues and cost of services.

Operating expenses. Our operating expenses, excluding depreciation and amortization, expenses associated with capital market activities, non-cash stock option compensation and litigation fees, increased 30.8% from $35.0 million for the three months ended September 30, 2003, to $45.8 million for the three months ended September 30, 2004. The increase in our operating expenses is consistent with the growth in revenues and is a result of the expansion of our operations and an increase in the number of employees associated with such expansion and growth in our markets. During the three months ended September 30, 2004, we incurred certain incremental expenses associated with the unusual storm activity. We estimate these incremental expenses to be between $500,000 and $1.0 million. Selling, operations and administrative expenses will continue to increase as we expand into new markets and our existing markets mature.

Our depreciation and amortization decreased from $19.6 million for the three months ended September 30, 2003, to $18.4 million for the three months ended September 30, 2004. The decrease in depreciation and amortization resulted from a combination of lower spending for additions in property, plant, equipment and intangible assets in 2004 and a portion of our long-lived assets becoming fully depreciated. We expect depreciation and amortization expense to increase as we make capital expenditures to extend our existing networks and build additional networks.

We have adopted SFAS No. 123 and SFAS No. 148 and recorded a non-cash stock option compensation expense of $478,000 for the three months ended September 30, 2003 and $568,000 for the three months ended September 30, 2004.

Other income and expense, including interest income and interest expense. Our total other expenses decreased from $19.6 million for the three months ended September 30, 2003, to $7.4 million for the three months ended September 30, 2004. Interest income was $72,000 for the three months ended September 30, 2003, compared to $193,000 for the same period in 2004. The increase in interest income primarily reflects a higher average cash balance for the three months ended September 30, 2004. Interest expense increased from $7.3 million for the three months ended September 30, 2003, to $7.7 million for the three months ended September 30, 2004. The interest expense represents the interest incurred on our 12% senior notes due 2009 and our two existing credit facilities. In the third quarter of 2003, we determined that changes in business conditions at Grande Communications were other than temporary, and recorded a loss on investment of $12.4 million for the quarter ended September 30, 2003.

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In the third quarter of 2004, we adjusted the carrying value of the outstanding warrants to purchase our common stock to market value based on the published market per share value of our common stock. The published market per share value of our common stock on September 30, 2004 was $4.15 resulting in an $85,000 gain on the adjustment of warrants to market value. Other income, net decreased to $19,000 for the three months ended September 30, 2004.

Income tax benefit. We recorded no income tax benefit or provision for the three months ended September 30, 2003 and 2004, respectively.

Net income from discontinued operations. Effective April 30, 2004, following the guidance of SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” we deemed the Cerritos cable system to be a long-lived asset to be disposed of based on our plan, and actions taken to sell the property.

Net loss. We incurred a net loss of $31.3 million and $20.0 million for the three months ended September 30, 2003 and 2004, respectively. We expect net losses to continue as our business matures.

NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2004

The following table sets forth financial data as a percentage of operating revenues for the nine months ended September 30, 2003 and 2004.

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Revenues. Operating revenues increased 24.6% from $127.3 million for the nine months ended September 30, 2003, to $158.6 million for the nine months ended September 30, 2004. Operating revenues from video services increased 38.2% from $53.1 million for the nine months ended September 30, 2003, to $73.4 million for the same period in 2004. Operating revenues from voice services increased 5.6% from $51.6 million for the nine months ended September 30, 2003, to $54.5 million for the same period in 2004. Operating revenues from data and other services increased 36.0% from $22.6 million for the nine months ended September 30, 2003, to $30.7 million for the same period in 2004.

Cost of services. Cost of services increased 32.6% from $34.7 million for the nine months ended September 30, 2003, to $46.0 million for the nine months ended September 30, 2004. Cost of services for video services increased 48.9% from $24.5 million for the nine months ended September 30, 2003, to $36.5 million for the same period in 2004. Cost of services for voice services decreased 7.9% from $8.8 million for the nine months ended September 30, 2003, to $8.1 million for the same period in 2004. Cost of services for data and other services increased 0.6% from $1,360,000 for the nine months ended September 30, 2003, to $1,367,000 for the same period in 2004.

Gross profit. Gross profit increased 21.6% from $92.6 million for the nine months ended September 30, 2003, to $112.6 million for the nine months ended September 30, 2004. Gross profit for video services increased 29.0% from $28.6 million for the nine months ended September 30, 2003, to $36.9 million for the same period in 2004. Gross profit for voice services increased 8.4% from $42.8 million for the nine months ended September 30, 2003, to $46.4 million for the same period in 2004. Gross profit for data and other services increased 38.3% from $21.2 million for the nine months ended September 30, 2003, to $29.3 million for the same period in 2004.

Operating expenses. Our operating expenses, excluding depreciation and amortization, expenses associated with capital market activities, non-cash stock option compensation and litigation fees, increased 29.6% from $103.6 million for the nine months ended September 30, 2003, to $134.2 for the nine months ended September 30, 2004.

Our depreciation and amortization decreased from $58.9 million for the nine months ended September 30, 2003, to $55.9 million for the nine months ended September 30, 2004.

We have adopted SFAS No. 123 and SFAS No. 148 and recorded a non-cash stock option compensation expense of $1.4 million for the nine months ended September 30, 2003 and $2.8 million for the nine months ended September 30, 2004. The increase in the non-cash stock option compensation expense was due to a re-pricing of certain stock options during the second quarter of 2004.

Other income and expense, including interest income and interest expense. Our total other expenses decreased from $33.6 million for the nine months ended September 30, 2003, to $22.0 million for the nine months ended September 30, 2004. Interest income was $281,000 for the nine months ended September 30, 2003, compared to $532,000 for the same period in 2004. Interest expense increased from $21.6 million for the nine months ended September 30, 2003, to $23.2 million for the nine months ended September 30, 2004.

In the first, second and third quarters of 2004, we adjusted the carrying value of the outstanding warrants to purchase our common stock to market value based on the published market per share value of our common stock. The published market per share value of our common stock on March 31, 2004 was $6.89, on June 30, 2004 was $4.97, and on September 30, 2004 was $4.15, resulting in a $504,000 gain on the adjustment of warrants to market value for the nine months ended September 30, 2004. Other income, net increased from $108,000 for the nine months ended September 30, 2003 to $159,000 for the nine months ended September 30, 2004. In the third quarter of 2003, we determined that changes in business conditions at Grande Communications were other than temporary, and recorded a loss on investment of $12.4 million for the nine months ended September 30, 2003.

Income tax benefit. We recorded no income tax benefit or provision for the nine months ended September 30, 2003 and a tax benefit of $24,000 for the nine months ended September 30, 2004.

Net income from discontinued operations. Effective April 30, 2004, following the guidance of SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” we deemed the Cerritos cable system to be a long-lived asset to be disposed of based on our plan, and actions taken to sell the property.

Net loss. We incurred a net loss of $71.2 million and $57.1 million for the nine months ended September 30, 2003 and 2004, respectively. We expect net losses to continue as our business matures.

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Liquidity and Capital Resources

As of September 30, 2004, we had net working capital of $19.6 million, compared to net working capital of $42.9 million as of December 31, 2003. The decrease in working capital resulted primarily from the following:

The decreases in working capital were partially offset by a decrease of $5.2 million in current portion of notes payable.

On May 24, 2004 we entered into a definitive asset purchase agreement to sell our cable system located in Cerritos, California to Orange Broadband, Inc. for $14.8 million in cash, subject to customary closing adjustments. We expect the sale of the Cerritos system to close during the first quarter of 2005, subject to the satisfaction of closing conditions, including receipt of regulatory approvals with respect to the municipal franchise in Cerritos, California.

On September 10, 2004, we completed certain amendments to our credit facilities with Wachovia Bank, National Association and CoBank, ACB. The amended credit facilities defer approximately $24.5 million of principal payments until 2007 which were previously scheduled during 2004, 2005 and 2006, and modified certain financial covenants. In addition, the amendments allowed our Telephone Operations Group to make a $7.7 million dividend payment to us, as well as future dividend payments equal to the net income of the Telephone Operations Group. These dividends decrease the amount of our restricted cash.

In November 2004, we will begin paying the interest, semiannually at 12%, on our senior notes due 2009. Approximately $14.2 million will be due to be paid on November 30, 2004.

We believe we can satisfy all of our anticipated funding requirements, including capital expenditures, through 2004 using a combination of internally generated cash flow from operations and cash currently on hand.

Net cash provided by operations totaled $18.9 million and $31.7 million for the nine months ended September 30, 2003 and 2004, respectively. The net cash flow activity related to operations consists primarily of changes in operating assets and liabilities and adjustments to net income for non-cash transactions including:

Net cash used for investing activities was $26.8 million and $45.9 million for the nine months ended September 30, 2003 and 2004, respectively. Our investing activities for the nine months ended September 30, 2003 primarily consisted of $26.6 million of capital expenditures and $329,000 of expenditures for intangible assets. Our investing activities for the nine months ended September 30, 2004 primarily consisted of $45.7 million of capital expenditures and $363,000 of expenditures for intangible assets. Of the $45.7 million in capital expenditures for the nine months ended September 30, 2004, $19.4 million related to the newly acquired Pinellas County market.

Financing activities used cash of $2.5 million for the nine months ended September 30, 2003, and provided cash of $4.2 million for the nine months ended September 30, 2004. Financing activities for the nine months ended September 30, 2003 primarily consisted of $2.5 million of principal payments on debt. Financing activities for the nine months ended September 30, 2004 consisted of $7.3 million of net proceeds from the exercise of the underwriters’ over-allotment option of 900,000 shares, partially offset by $2.7 million of principal payments on debt.

As of September 30, 2004, we were in compliance with all of our debt covenants.

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Capital Expenditures

We have invested approximately $45.7 million in capital expenditures during 2004 through September 30, and we expect to spend approximately $15.0 million in the fourth quarter of 2004. Of the capital expenditures through September 30, 2004, $25.3 million relates to network construction and the remainder relates to the purchase of customer premise equipment, such as cable set-top boxes and cable modems, network equipment, including switching and transport equipment, and billing and information systems. We believe we have sufficient cash on hand and cash from internally generated cash flow to cover our planned operating expenses and capital expenditures during the remainder of 2004. If we decide to expand our broadband network into new markets, we would require additional funding to operate and for the capital expenditures necessary to finance the construction and purchase of customer premise equipment.

We have received franchises to build a network in Louisville, Kentucky and Nashville, Tennessee, although our franchise in Louisville is currently being contested by the incumbent cable provider in that city. The indenture governing our 12% senior notes due 2009 includes a covenant limiting our ability to fund expansion into new markets, including Louisville and Nashville, from operating cash flows or new borrowings.

We do not intend to expand into Nashville, Louisville or other markets until the required funding is available. We estimate the cost of constructing our network and funding initial customer premise equipment in new markets to be approximately $750 to $1,000 per home passed. The actual costs of each new market may vary significantly from this range and will depend on the number of miles of network to be constructed, the geographic and demographic characteristics of the city, population density, costs associated with the cable franchise in each city, the number of customers in each city, the mix of services purchased, the cost of customer premise equipment we pay for or finance, utility requirements and other factors.

Contractual Obligations

The following table sets forth, as of September 30, 2004, our long-term debt, capital lease and operating lease obligations for 2004, the following five years and thereafter. The long-term debt obligations are our cash debt service obligations, including both principal and interest. The capital lease obligations are our future rental payments under one lease with a 10-year term. Operating lease obligations are the future minimum rental payments required under the operating leases that have initial or remaining noncancelable lease terms in excess of one year as of September 30, 2004.

In addition to the contractual obligations described above, we have entered into contracts with various entities to provide programming to be aired on our network. We pay a monthly fee for the programming services, generally based on the number of average video subscribers to the program, although some fees are adjusted based on the total number of video subscribers to the system and/or the system penetration percentage.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require us to make estimates and assumptions. We believe that the following may involve a higher degree of judgment and complexity.

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Revenue recognition. We generate recurring or multi-period operating revenues, as well as nonrecurring revenues. We recognize revenue in accordance with SEC Staff Accounting Bulletin, or SAB, No. 104, “Revenue Recognition,” which requires that the following four basic criteria must be satisfied before revenues can be recognized:

We base our determination of the third and fourth criteria above on our judgment regarding the fixed nature of the fee we have charged for the services rendered and products delivered, and the prospect that those fees will be collected. If changes in conditions should cause us to determine that these criteria likely will not be met for certain future transactions, revenue recognized for any reporting period could be materially affected.

We generate recurring revenues for our broadband offerings of video, voice and data and other services. Revenue generated from these services primarily consists of a fixed monthly fee for access to cable programming, local phone services and enhanced services and access to the Internet. Additional fees are charged for services including pay-per-view movies, events such as boxing matches and concerts, long distance service and cable modem rental. Revenues are recognized as services are provided and advance billings or cash payments received in advance of services performed are recorded as deferred revenue.

Allowance for doubtful accounts. We use estimates to determine our allowance for bad debts. These estimates are based on historical collection experience, current trends, credit policy and a percentage of our customer accounts receivable. In determining these percentages, we look at historical write-offs of our receivables, but our history is limited.

Plant and equipment. The costs associated with the construction of our broadband transmission and distribution facilities and new service installations are capitalized. Capitalized costs include all direct labor and materials, as well as some indirect costs. We perform periodic evaluations of any estimates associated with indirect costs and changes to the estimates, which are significant, are included prospectively in the period in which the evaluations are completed.

Valuation of long-lived and intangible assets and goodwill. We assess the impairment of identifiable long-lived assets and related goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable in accordance with Statement of Financial Accounting Standards, or SFAS No. 121, and beginning January 1, 2002 SFAS No. 144. Factors we consider important and that could trigger an impairment review include the following:

In July 2001, the FASB issued SFAS No. 144, “Impairment or Disposal of Long-Lived Assets,” which is effective for fiscal years beginning after December 15, 2001. The provisions of this statement provide a single accounting model for impairment of long-lived assets. We recorded no asset impairment during the nine months ended September 30, 2003 and 2004, respectively, in accordance with SFAS No. 144.

We adopted SFAS No. 142 on January 1, 2002 and have performed a goodwill impairment test in accordance with SFAS No. 142. As a result of the impairment test in January 2003 and 2004, no impairments were identified.

The foregoing list in not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for us to judge the application. There are also areas in which our judgment in selecting any available alternative would not produce a materially different result. See our consolidated financial statements and related notes thereto contained in our Annual Report on Form 10-K, which contains accounting policies and other disclosures required by accounting principles generally accepted in the United States.

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Recent Accounting Pronouncements