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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005

OR

FOR THE TRANSITION PERIOD FROM              TO             

COMMISSION FILE NUMBER 000-25147

INTERNET AMERICA, INC.

(Exact name of registrant as specified in its charter)

(214) 861-2500

(Registrant’s telephone number, including area code)

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 May 9, 2005, registrant had 10,597,035 shares of Common Stock at $.01 par value, outstanding.

PART I - FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

INTERNET AMERICA, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

2

INTERNET AMERICA, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

3

INTERNET AMERICA, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

4

INTERNET AMERICA, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to Article 10 of Regulation S-X of the Securities and Exchange Commission. The accompanying unaudited condensed consolidated financial statements reflect, in the opinion of management, all adjustments necessary to achieve a fair statement of the Company’s financial position and results of operations for the interim periods presented. All such adjustments are of a normal and recurring nature. These condensed financial statements should be read in conjunction with the financial statements and related footnotes for our fiscal year ended June 30, 2004 included in the Company’s Annual Report on Form 10-K (File No. 000-25147).

During the nine months ended March 31, 2005, the Company completed the acquisition of five internet service providers (“ISPs”). The combined aggregate purchase price was approximately $1,033,000, including approximately $109,000 in cash and common stock valued at approximately $55,000. The remaining consideration included the issuance of approximately $356,000 in debt and the assumption of approximately $513,000 in liabilities. The value of the 72,000 shares issued in connection with acquisitions was determined based on the average market price of the Company’s common shares over the 2-day period before and after the terms of the acquisitions were agreed to and announced.

Subscriber acquisition costs recorded in connection with the acquisitions totaled approximately $858,000. The fair values assigned to the assets acquired and liabilities assumed at the date of acquisition are based upon preliminary estimates. The Company is in the process of obtaining supplemental information related to certain intangible assets and equipment, accordingly, the allocation of the purchase price is subject to refinement.

All of the above acquisitions were accounted for as purchases and, accordingly, the operations of the acquired companies were included in the financial statements from their respective date of acquisition. Pro forma information for acquisitions is not presented as the impact is not material.

There are no adjustments required to be made to net income for the purpose of computing basic and diluted earnings per share (“EPS”) for the three and nine months ended March 31, 2005 and 2004. For the three months ended March 31, 2005 and 2004 diluted earnings per share is the same as basic earnings per share due to the net loss. For the nine months ended March 31, 2005 and 2004, options to purchase 129,750 and 20,000 shares of common stock were included in the computation of diluted EPS because the options were “in the money” as of March 31, 2005 and 2004, respectively, and it resulted in 48,951 and 12,609 common stock equivalents to be added to the weighted average shares for the nine months ended March 31, 2005 and 2004, respectively. During the nine months ended March 31, 2005 and 2004, options to purchase 361,145 and 465,037 shares of common stock were not included in the computation of diluted EPS because the options were not “in the money” as of March 31, 2005 and 2004, respectively.

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The carrying value of other assets at March 31, 2005 is as follows:

The weighted average amortization period for subscriber acquisition costs is 24 months for dial-up customers and 36 months for wireless customers. Amortization expense for the three and nine months ended March 31, 2005, was approximately $100,000 and $189,000, respectively. As of March 31, 2005, expected amortization expense for the fiscal years ended June 30, 2005, 2006, 2007 and 2008 is shown below:

The Company applies Accounting Principles Board Opinion (“APB”) No. 25 and related Interpretations in accounting for its employee stock option plans. The estimated fair value of each option grant was determined by reference to the quoted market price of the Company’s common shares at the date of grant over the amount an employee must pay to acquire the common shares of the Company. No compensation expense has been charged against operations for the nine months ended March 31, 2005 and 2004 related to stock option plans.

Had compensation cost for the Company’s stock options been determined based on the fair value at the grant dates for awards consistent with the method of Statement of Financial Accounting Standard (“SFAS’) No. 123, the Company’s net income (loss) and income (loss) per share for the three and nine months ended March 31, 2005 and 2004 would have been as indicated below:

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Options to purchase 19,608 shares of common stock were exercised during the three months ended March 31, 2005 and options to purchase 49,608 shares of common stock were exercised during the nine months ending March 31, 2005. During the three and nine months ended March 31, 2004, options to purchase 18,000 and 23,000 shares of common stock were exercised, respectively.

In March 2005 the Company completed a reduction-in-force terminating approximately 17% of its workforce. During the three and nine months ended March 31, 2005, the Company recorded and paid termination benefits in the form of severance costs of approximately $80,000 related to this reduction-in-force. The Company completed an additional reduction-in-force in April 2005. See Footnote 12 – Subsequent Events.

During the nine months ended March 31, 2005 and 2004, the Company generated net income. No provision for income taxes has been recorded as the Company has reduced the valuation allowance on its net operating losses generated in prior periods. As of March 31, 2005, the Company continues to maintain a full valuation allowance for its net deferred tax assets of approximately $11.4 million. Given its limited history of generating net income, the Company has concluded that it is not more likely than not that the net deferred tax assets will be realized.

Long-term debt consists of:

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The Company leases certain phone equipment, wireless equipment and switches under leases with bargain purchase options. The following is a schedule by fiscal years of the future minimum lease payments under these capital leases together with the present value of the net minimum lease payments as of March 31, 2005:

The Company entered into a consulting agreement for a one-year term beginning October 1, 2003 with the former Chairman and CEO of the Company, Jack T. Smith (“Mr. Smith”). The agreement, which terminated September 30, 2004, stated that a consulting fee was to be paid at a rate of $10,000 per month. During the nine months ended March 31, 2005, the Company paid a total of $30,000 in consulting fees to Mr. Smith. The Company also had an $82,000 note receivable due from Mr. Smith and accrued interest income due on the note of $5,349. Included in interest income for the nine months ended March 31, 2005, is approximately $1,300 related to Mr. Smith’s note receivable. In October 2004, the Company entered into a release agreement with Mr. Smith resulting in a cash payment to Mr. Smith of approximately $73,000 and the cancellation of the note receivable and related accrued interest, in connection with the purchase by the Company of 200,000 shares of common stock from Mr. Smith.

During the nine months ended March 31, 2005, the Company paid approximately $23,000 in marketing consulting fees and related expenses to Marc Ladin Consulting for services rendered through July 2004. Marc Ladin is the son of William E. Ladin, the CEO of the Company. Marc Ladin became Vice President-Marketing and Sales for the Company in August 2004 and resigned from the position in April 2005.

In April 2004, the Company settled a lawsuit it had filed against Gary Corona, a former non-employee board of director of the Company, and, as a result, entered into a non-interest bearing note payable with Mr. Corona due in eleven monthly installments of $12,500. Included in short-term note payable on the balance sheet as of March 31, 2005, is $12,500 related to the settlement with Mr. Corona.

In December 2004, the Financial Accounting Standards Board issued a revision to Statement No. 123 (revised 2004) (“SFAS 123R”), Share-Based Payment. SFAS 123R will, with certain exceptions, require entities that grant stock options and shares to employees to recognize the fair value of those options and shares as compensation cost over the service (vesting) period in their financial statements. The measurement of that cost will be based on the fair value of the equity or liability instruments issued. SFAS 123R is required to be adopted by the Company on July 1, 2005. As part of this adoption, the Company will begin expensing its options and has also elected to not restate prior period results. Since the Company will continue to issue stock options to employees as a form of incentive compensation and because the Company has outstanding stock options that will vest on or after July 1, 2005, the Company expects the adoption of this statement to have an impact on the financial statements, but the impact has not yet been determined.

8

In April 2005 the Company completed a reduction-in-force, terminating an additional 23 employees over and above the reduction-in-force carried out in March 2005. Termination benefits in the form of severance costs were approximately $53,000 related to this reduction-in-force.

On May 4, 2005, the Company received preliminary results from an on-going sales tax audit being conducted by the Texas State Comptroller’s office for the calendar years 2001 through 2003. Based on a review of the preliminary results with outside consultants the Company estimates a probable loss contingency in the range of approximately $100,000 to $250,000. Included on the balance sheet as of March 31, 2005, is a reserve of approximately $100,000 related to this loss contingency.

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ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Certain statements contained in this Form 10-Q constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements, identified by words such as “anticipate,” “believe,” “estimate,” “should,” “expect” and similar expressions include our expectations and objectives regarding our future financial position, operating results and business strategy. These statements reflect the current views of management with respect to future events and are subject to risks, uncertainties and other factors that may cause our actual results, performance or achievements, or industry results, to be materially different from those described in the forward-looking statements. We do not intend to update the forward-looking information to reflect actual results or changes in the factors affecting such forward-looking information. Our Annual Report on Form 10-K for the fiscal year ended June 30, 2004 and other publicly filed reports discuss some additional important factors that could cause our actual results to differ materially from those in any forward-looking statements.

Overview

Internet America is an Internet service provider (“ISP”) offering a wide array of Internet services tailored to meet the needs of individual and business subscribers. We provide a high quality Internet experience with fast, reliable service and responsive customer care. As of March 31, 2005, we served approximately 55,000 subscribers in the southwestern United States, primarily in Dallas and Houston, Texas. A subscriber represents an active, billed service. One customer account may represent multiple subscribers depending on the number of active and billed services for that customer.

As outlined in our Form 10-K for the fiscal year ended June 30, 2004, our growth strategy is to expand Internet America’s customer base by acquiring dial-up ISPs in markets surrounding our major market cities and then introduce or expand our broadband products in the acquired markets. The Company completed five acquisitions during the nine months ended March 31, 2005, including Interlink Computer Connection (“Hillsboro”), Texas Unwired (“TXUN”), MyLinux ISP (“My Linux), Wacool (“Wacool”) and Hilco (“Hilco”). These acquisitions added a total of approximately 5,400 subscribers to our customer base. The Company intends to continue to aggressively pursue additional acquisition opportunities. However, additional financing will be required to fund any future acquisitions.

Following the acquisition of Hilco in November 2004, the operations of TXUN, Wacool and Hilco were merged into Hillsboro. The Company consolidated all four operations into the Hillsboro Regional Division in order to eliminate duplicate costs. In addition, the Company began combined selling efforts and faster deployment of broadband services. While there remain significant potential improvements and challenges, to date we are pleased with the revenue growth from this division. In May 2005 the Company launched an additional non-metropolitan regional business division in Corsicana, Texas and intends to open two additional non-metropolitan divisions by the end of the current fiscal year ending June 30, 2005. Although there can be no assurance that it will be able to do so, the Company believes that it will be able to duplicate the successes achieved with the Hillsboro Regional Division in these new divisions.

The Company also continues to research new broadband products including broadband over power lines (“BPL”) and wireless broadband. The Company began a BPL pilot program in January, 2005, in a suburb of Dallas, Texas and introduced a VoIP (“Voice over Internet Protocol”) program for its customers in February, 2005. In addition to becoming a wireless internet service provider with the successful integration of Hillsboro and TXUN, in November 2004 the Company became a wireless equipment reseller. Becoming a reseller has allowed the Company to obtain better pricing as we build out our internal wireless network infrastructure, and also enabled us to capitalize on the expanding wireless network products market.

The Company continues to experience an attrition of dial-up service customers. The loss of these customers is primarily attributable to their moving to broadband connectivity with other service providers. While the Company does not currently have an adequate, competitive broadband solution for a majority of its customers in the major metropolitan areas, the loss of customers was mitigated by the addition of new customers through acquisitions and the increase in broadband customers in non-metropolitan markets. The Company believes that the initiatives it has undertaken in acquisitions, its development of new sources for broadband services, the introduction of new products like Fax to e-mail and VoIP, and its focus on marketing in non-metropolitan areas will positively impact its subscriber and revenue base in the near-term and mid-term future. The Company continues to explore creative ways to retain existing dialup customers.

10

The Company is actively pursuing development and acquisition opportunities in non-metropolitan markets where competition is less intense and the demand for internet connectivity may be underserved. In pursuing this strategy, the Company is narrowing its focus to products and developments that contribute directly to its implementation. Management is realigning both capital and human resources to focus on acquisitions, broadband connectivity, VoIP, and Fax to e-mail software. Additionally, management is evaluating other product offerings to ensure that we are maximizing profitability. In March 2005, as a result of this evaluation, the Company outsourced its Airnews product.

Management continues to evaluate overall profitability and, as a result, affected a reduction-in-force (“RIF”) in March and April 2005. The March 2005 RIF included 18 employees and resulted in approximately $80,000 of severance costs and the April 2005 RIF included 23 employees and resulted in approximately $53,000 in severance costs. The Company anticipates annual savings from the two RIFs of approximately $1.7 million. However, an increase in head count may be required upon the completion of certain acquisitions.

Individuals and businesses are increasingly adopting broadband access via DSL, cable and wireless and we believe, particularly with the emergence of low-cost, high-speed solutions, that broadband will continue to grow as the preferred method of connectivity. High-speed connectivity is essential to the commercially viable deployment of new, value-added services such as internet telephony, particularly VoIP, video and audio programming distribution and other high bandwidth applications. We believe this will significantly impact our ability, as well as that of other ISPs, to compete. We are, however, committed to becoming a leader in offering cost effective broadband solutions to individuals and businesses, and we will continue to pursue alternative methods of low-cost, high-speed connectivity.

Additionally, many of our DSL services include a local loop sold to us at wholesale prices by either SBC Communications, Inc. (“SBC”) or Verizon Communication, Inc. (“Verizon”). Pricing and availability of our DSL services are subject to the competitive pressures of those local exchange carriers, both of which also sell their own DSL services on a retail basis. Thus, pressures from SBC or Verizon may cause us to decrease the price of our DSL services, resulting in a decrease in revenue per subscriber, or may cause us to make fewer new sales of DSL services. However, our relationship with ALLTEL, which provides the DSL service to the subscribers acquired with My Linux, is structured differently and does not include our purchasing and reselling of the local loop.

Statement of Operations

Internet services revenue is derived from dial-up Internet access, including analog and ISDN access, DSL access, dedicated connectivity, wireless access, bulk dial-up access, Web hosting services, and value-added services, such as multiple e-mail boxes, personalized e-mail addresses and Fax 2 e-mail services. In addition to miscellaneous revenue, other revenue includes Neo server revenue, which was discontinued in November 2004, and wireless equipment reseller revenues.

A brief description of each element of our operating expenses follows:

Connectivity and operations expenses consist primarily of setup costs for new subscribers, telecommunication costs, merchant processing fees and wages of network operations and customer support personnel. Connectivity costs include (i) fees paid to telephone companies for subscribers’ dial-up connections to our network; (ii) fees paid to backbone providers for connections from our network to the Internet; and (iii) equipment and tower lease costs for our new wireless networks.

Sales and marketing expenses consist primarily of creative and production costs, costs of media placement, management salaries and call center wages. Advertising costs are expensed as incurred.

General and administrative expenses consist primarily of administrative salaries, professional services, rent and other general office and business expenses.

Bad debt expense (recoveries) consists primarily of customer accounts that have been deemed uncollectible and will potentially be written off in future periods, net of recoveries. Historically, the expense has been based on the aging of customer accounts whereby all customer accounts that are 90 days or older have been provided for as a bad debt expense.

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Depreciation expense is computed using the straight-line method over the estimated useful lives of the assets or the capital lease term, as appropriate. Data communications equipment, computers, data servers and office equipment are depreciated over three years. We depreciate furniture, fixtures and leasehold improvements over five years. Amortization expense consists of the amortization of subscriber acquisition costs.

Our business is not subject to any significant seasonal influences.

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Results of Operations

Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004

The following table sets forth certain unaudited financial data for the three months ended March 31, 2005 and 2004. Operating results for any period are not indicative of results for any future period. Dollar amounts are shown in thousands (except per share data and subscriber counts).

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Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004 (Continued)

Total revenue. Total revenue decreased by $45,000, or 1.6%, to $2,787,000 for the three months ended March 31, 2005, from $2,832,000 for the three months ended March 31, 2004. The Company’s subscriber count decreased by 10,000 or 15.4%, to 55,000 as of March 31, 2005 compared to 65,000 as of March 31, 2004. The net decrease in revenue is the direct result of the decrease in subscriber counts offset by increased revenue related primarily to dial-up and wireless access revenue from acquisitions and wireless equipment reseller revenue. Revenue from acquisitions and wireless equipment reseller revenue was approximately $426,000 and $216,000, respectively, for the three months ended March 31, 2005. The Company became a wireless access provider in September 2004 and in November 2004 became a wireless equipment reseller. The decrease in subscriber count is primarily attributed to the loss of dial-up customers.

Connectivity and operations. Connectivity and operations expense increased by $0.6 million, or 46.2%, to $1.9 million for the three months ended March 31, 2005 from $1.3 million for the three months ended March 31, 2004. Approximately $257,000 and $185,000 of the increase relates to connectivity costs for acquisitions and wireless equipment reseller cost of sales, respectively, incurred in the three months ended March 31, 2005. Approximately $324,000 of the net change relates to changes in sales tax expense. In the three months ended March 31, 2005 the Company recorded sales tax expense of $72,000 related to a reserve for an on-going sales tax audit for the calendar years 2001 to 2003 compared to a $252,000 reduction in expense in the three months ended March 31, 2004 for refunds of sales tax overpaid in 1999 and 2000.

Excluding the changes for acquisitions and wireless equipment reseller cost of sales in 2005 and sales tax, the net difference between the two periods is a decrease of approximately $186,000. This decrease relates primarily to the consolidation of internet and telephone connections and circuits to more closely align with demand, as well as the renegotiation of contracts with several of our major telecom vendors offset by severance costs of approximately $73,000 incurred in connection with the reduction-in-force carried out by the Company in March 2005. As a percentage of total revenue, connectivity and operations expense increased to 69.0% for the three months ended March 31, 2005, from 47.4% for the three months ended March 31, 2004 due lower margins on the wireless equipment reseller revenue as well as the decrease in revenues. Additionally, the refund of sales tax in 2004 contributed to the higher margin for that period.

Sales and marketing. Sales and marketing expense decreased by $133,000, or 42.4%, to $181,000 for the three months ended March 31, 2005, compared to $314,000 for the three months ended March 31, 2004. The decrease relates primarily to a larger advertising campaign in the three months ended March 31, 2004 compared to the same period in 2005 offset by increased marketing wages for the Vice President – Marketing and Sales hired in August 2004. Sales and marketing expense for the three months ended March 31, 2005 also includes severance costs, as a result of the reduction in force, of approximately $4,000.

General and administrative. General and administrative expense decreased by $0.5 million or 38.9%, to $751,000 for the three months ended March 31, 2005, from $1,229,000 for the three months ended March 31, 2004. The decrease is primarily a result of expenses incurred during the three months ended March 31, 2004 in connection with the settlement of a lawsuit with a former non-employee director, Mr. Gary Corona, including legal fees of approximately $312,000 and lawsuit settlement expense of approximately $213,000 for total costs of approximately $525,000. General and administrative expense for the three months ended March 31, 2005 also includes severance costs, as a result of the reduction in force, of approximately $3,000.

Provision for bad debt expense. Provision for bad debt expense decreased by $55,000, or 99.8%, to $87 for the three months ended March 31, 2005, from $55,000 for the three months ended March 31, 2004. The decrease is mainly related to an overall improvement in the Company’s aging of customer accounts that are at least 90 days old and improved billing and collection efforts. As of March 31, 2005, the Company continues to be fully reserved for all customer accounts that are at least 90 days old.

Depreciation and amortization. Depreciation and amortization increased by $117,000, or 174.6%, to $184,000 for the three months ended March 31, 2005, from $67,000 for the three months ended March 31, 2004. The increase relates to a $100,000 increase in amortization expense related to subscriber acquisition costs and a $17,000 increase in depreciation expense related to depreciating property and equipment acquired via the acquisitions.

14

Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004 (Continued)

Interest expense (income), net. For the three months ended March 31, 2005, the Company recorded approximately $12,000 in interest expense and approximately $6,000 in interest income. The interest expense recorded in the quarter ended March 31, 2005, relates to interest charges on newly issued and assumed debt related to acquisitions. Interest income represents interest earned on the Company’s money market accounts. For the three months ended March 31, 2004, the Company recorded no interest expense, but did record approximately $71,000 in interest income of which approximately $62,000 relates to interest earned on an overpayment of sales tax during 2000 with the remainder related to interest earned on the Company’s cash balances.

15

Nine Months Ended March 31, 2005 Compared to Nine Months Ended March 31, 2004

The following table sets forth certain unaudited financial data for the nine months ended March 31, 2005 and 2004. Operating results for any period are not indicative of results for any future period. Dollar amounts are shown in thousands (except per share data and subscriber counts).