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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 11, 2005, there were issued and outstanding 207,040,934 shares of our Class A common stock.

1

2

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

3

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

 (Unaudited)

See accompanying notes to condensed consolidated financial statements.

4

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 (Unaudited)

See accompanying notes to condensed consolidated financial statements.

5

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Unaudited)

Supplemental schedule of noncash investing and financing activities

For the Three Months Ended March 31, 2005:

Issued 10,054,561 shares of Class A common stock in conversion of 900 shares of Series I Convertible Preferred Stock.

Issued 1,384,275 shares of Class A common stock as payment of $250,000 of dividends on Series H Preferred Stock.

Issued 655,162 shares of Class A common stock as payment of $124,000 interest on long-term debt.

Accrued $47,000 of dividends on Series I Preferred Stock.

Accrued $250,000 of dividends on Series H Preferred Stock

For the Three Months Ended March 31, 2004:

Issued 3,730,196 shares of Class A common stock for $1,314,000 in subscriptions receivable.

Issued 1,463,753 shares of Class A common stock in full satisfaction of $292,000 of liabilities.

The Company purchased all of the capital stock of LTEL Holdings Corporation for $12,800,000.  In conjunction with the acquisition, the Company acquired $22,259,000 of assets and assumed $9,459,000 of liabilities of LTEL Holdings Corporation by the issuance of 7,036,801 shares of Class A common stock valued at $4,176,000, the issuance of 2,000 shares of 5% Series H nonvoting, nonconvertible preferred stock valued at $4,000,000 and the issuance of a 5% $10,000,000 promissory note valued at $4,624,000.

See accompanying notes to condensed consolidated financial statements.

6

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation - The accompanying unaudited condensed consolidated financial statements of Fonix Corporation and subsidiaries (collectively, the “Company” or “Fonix”) have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”).  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the following disclosures are adequate to make the information presented not misleading.  The Company suggests that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s 2004 Annual Report on F orm 10-K.

These condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary to present fairly the financial position and results of operations of the Company for the periods presented.  The Company’s business strategy is not without risk, and readers of these condensed consolidated financial statements should carefully consider the risks set forth under the heading “Certain Significant Risk Factors” in the Company’s 2004 Annual Report on Form 10-K.

Operating results for the three months ended March 31, 2005, are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.  

Nature of Operations – Fonix Corporation and its subsidiaries are engaged in providing integrated telecommunications services through Fonix Telecom, Inc., and value-added speech-enabling technologies through The Fonix Speech Group.  Through Fonix Telecom, Inc., the Company operates LecStar Telecom, Inc., a regional provider of telecommunications services in the Southeastern United States, and LecStar DataNet, Inc., a provider of Internet services.  (LecStar Telecom, Inc., and LecStar DataNet are collectively referred to in this report as “LecStar.”)  

The Company offers its speech-enabling technologies including automated speech recognition (“ASR”) and text-to-speech (“TTS”) through The Fonix Speech Group.  The Company offers ASR and TTS technologies to markets for wireless and mobile devices, computer telephony, server solutions and personal software for consumer applications. The Company has received various patents for certain elements of its core technologies and has filed applications for other patents covering various aspects of its technologies. The Company seeks to develop relationships and strategic alliances with third-party developers and vendors in telecommunications, computers, electronic devices and related industries, including producers of application software, operating systems, computers and microprocessor chips.  Revenues relating to the speech-enabling technologies are generated through licensing agreements, maintenance contracts and services.

LecStar’s telecommunication services include wireline voice, data, long distance and Internet services to business and residential customers.  LecStar Telecom, Inc., is certified by the Federal Communications Commission in nine states—Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South Carolina and Tennessee—as a competitive local exchange carrier (“CLEC”) to provide regulated local, long distance and international telecommunications services.  LecStar DataNet, Inc., provides non-regulated telecommunication services including Internet access.

Business Condition - For the three months ended March 31, 2005 and 2004, the Company generated revenues of $4,223,000 and $1,925,000, respectively, incurred net losses of $4,080,000 and $2,342,000, respectively and had negative cash flows from operating activities of $2,559,000 and $5,478,000, respectively.  As of March 31, 2005, the Company had an accumulated deficit of $231,002,000, negative working capital of $13,120,000, accrued liabilities of $6,877,000, accounts payable of $5,383,000 and accrued employee wages and other compensation of $1,311,000.  The Company expects to continue to incur significant losses and negative cash flows from operating activities through at least December 31, 2005, primarily due to significant expenditure requirements associated with continued marketing and development of its speech-enabling technologies and further developing its telecommunications services business.

7

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

The Company’s cash resources, limited to collections from customers, draws on the Sixth Equity Line and loans, have not been sufficient to cover operating expenses.  As a result, payments to employees and vendors have been delayed.  The Company has not been declared in default under the terms of any material agreements.

These factors, as well as the risk factors set out in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004, raise substantial doubt about the Company’s ability to continue as a going concern.  The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty.  Management plans to fund future operations of the Company through revenues generated from its telecommunications operations, from cash flows from future license and royalty arrangements and with proceeds from additional issuance of debt and equity securities.  There can be no assurance that management’s plans will be successful.

Net Loss Per Common Share - Basic and diluted net loss per common share are calculated by dividing net loss attributable to common stockholders by the weighted average number of shares of common stock outstanding during the period.  As of March 31, 2005 and 2004, there were outstanding common stock equivalents to purchase 47,349,772 and 28,542,535 shares of common stock, respectively, that were not included in the computation of diluted net loss per common share as their effect would have been anti-dilutive, thereby decreasing the net loss per common share.

The following table is a reconciliation of the net loss numerator of basic and diluted net loss per common share for the three months ended March 31, 2005 and 2004:

Imputed Interest Expense - Interest is imputed on long-term debt obligations where management has determined that the contractual interest rates are below the market rate for instruments with similar risk characteristics.

Comprehensive Loss - Other comprehensive loss as presented in the accompanying condensed consolidated financial statements consists of cumulative foreign currency translation adjustments.  

Intangible Assets - Customer base, contracts and agreements and brand names are amortized over their estimated useful lives unless they are deemed to have indefinite useful lives.  For intangible assets subject to amortization, an impairment charge is recognized if the carrying amount is not recoverable and the carrying amount exceeds the fair value of the intangible asset.  Intangible assets deemed to have indefinite useful lives, primarily the LecStar brand name, are not amortized, are tested for impairment on a quarterly basis and impairment is recognized if the carrying amount is not recoverable or exceeds its fair value.  

Revenue Recognition - The Company recognizes revenue when pervasive evidence of an arrangement exists; services have been rendered or products have been delivered; the price to the buyer is fixed and determinable; and collectibility is reasonably assured.  Revenues are recognized by the Company based on the various types of transactions generating the revenue.  For software sales, the Company recognizes revenues in accordance with the provisions of Statement of Position No. 97-2, “Software Revenue Recognition,” and related interpretations.  The Company generates revenues from licensing the rights to its software products to end users and from royalties.  For telecommunications services, revenue is recognized in the period that the service is provided.  

For The Fonix Speech Group, revenue of all types is recognized when acceptance of functionality, rights of return, and price protection are confirmed or can be reasonably estimated, as appropriate.  Revenue for hardware units delivered is recognized when delivery is verified and collection assured.   

8

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

Revenue for products distributed through wholesale and retail channels and through resellers is recognized upon verification of final sell-through to end users, after consideration of rights of return and price protection.  Typically, the right of return on such products has expired when the end user purchases the product from the retail outlet.  Once the end user opens the package, it is not returnable unless the medium is defective.

When arrangements to license software products do not require significant production, modification or customization of software, revenue from licenses and royalties are recognized when persuasive evidence of a licensing arrangement exists, delivery of the software has occurred, the fee is fixed or determinable, and collectibility is probable.   Post-contract obligations, if any, generally consist of one year of support including such services as customer calls, bug fixes, and upgrades.  Related revenue is recognized over the period covered by the agreement.  Revenues from maintenance and support contracts are also recognized over the term of the related contracts.

Revenues applicable to multiple-element fee arrangements are bifurcated among the elements such as license agreements and support and upgrade obligations using vendor-specific objective evidence of fair value. Such evidence consists primarily of pricing of multiple elements as if sold as separate products or arrangements.  These elements vary based upon factors such as the type of license, volume of units licensed, and other related factors.  

For Fonix Telecom, Inc., the Company’s telecommunications revenue is comprised of two main components: (1) fees paid by business and residential subscribers of voice and data services and (2) carrier access fees.  Subscriber revenues include monthly recurring charges, usage charges and non-recurring charges.  Monthly recurring charges are flat monthly fees for local phone and data services.  Usage charges, which primarily include long distance fees, are generally billed on a per-minute or per-call basis.  Non-recurring charges are generally one-time charges for installation or changes to the subscriber’s service.  Carrier access fees are paid to the Company by other telecommunications carriers as compensation for originating and terminating the carriers’ long distance traffic.   

Deferred revenue as of March 31, 2005, and December 31, 2004, consisted of the following:

Cost of Revenues - Cost of revenues from telecommunications services consists mainly of billings from the incumbent local exchange carriers (“ILECs”) for access to the ILEC’s network.  With respect to The Fonix Speech Group, cost of revenues from license, royalties, and maintenance consists of costs to distribute the product, installation and support personnel compensation, amortization and impairment of capitalized speech software costs, licensed technology, and other related costs.  Cost of service revenues consists of personnel compensation and other related costs.

Software Technology Development and Production Costs - All costs incurred to establish the technological feasibility of speech software technology to be sold, leased, or otherwise marketed are charged to product development and research expense.  Technological feasibility is established when a product design and a working model of the software product have been completed and confirmed by testing.  Costs to produce or purchase software technology incurred subsequent to establishing technological feasibility are capitalized.  Capitalization of software costs ceases when the product is available for general release to customers.  Costs to perform consulting or development services are charged to cost of revenues in the period in which the corresponding revenues are recognized.  The cost of maintenance and customer support is charged to expense when related revenue is recognized or when these costs are incurred, whichever o ccurs first.

9

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

Stock-based Compensation Plans - The Company accounts for its stock-based compensation issued to non-employees using the fair value method in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation.” Under SFAS No. 123, stock-based compensation is determined as either the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable.  The measurement date for these issuances is the earlier of the date at which a commitment for performance by the recipient to earn the equity instruments is reached or the date at which the recipient’s performance is complete.

At March 31, 2005, the Company had stock-based employee compensation plans.  The Company accounts for the plans under the recognition method and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and the related Interpretations. Under APB Opinion No. 25, compensation related to stock options, if any, is recorded if an option’s exercise price on the measurement date is below the fair value of the Company’s common stock, and amortized to expense over the vesting period.  Compensation expense for stock awards or purchases, if any, is recognized if the award or purchase price on the measurement date is below the fair value of the Company’s common stock, and is recognized on the date of award or purchase.  The effect on net loss and net loss per common share if the Company had applied the fair value recognition provisions of SFAS No. 123 to employee stock-based compensation is as follo ws:

2.  ACQUISITIONS

LecStar Acquisition - On February 24, 2004, Fonix acquired all of the capital stock of LTEL Holdings Corporation ("LTEL") and its wholly owned subsidiaries, LecStar Telecom, Inc., and LecStar DataNet, Inc. (collectively "LecStar").  The results of LecStar's operations are included in the consolidated financial statements from February 24, 2004.  LecStar is a regional provider of communications services, including wireline voice, data, long distance and Internet services, to business and residential customers in the Southeastern United States.  LecStar Telecom, Inc., is certified by the Federal Communications Commission in nine states as a competitive local exchange carrier (“CLEC”) to provide regulated local, long distance and international telecommunications services.  LecStar DataNet, Inc., provides non-regulated telecommunications services such as Internet access.

The following pro forma information is presented to reflect the operations of the Company and LTEL on a combined basis as if the acquisition of LTEL had been completed as of the beginning of the three-month period ended March 31, 2004:

Empire One Telecommunications, Inc Acquisition - On November 19, 2004, the Company signed a Merger Agreement (the “Agreement”) that set forth the principal terms on which Fonix would acquire Empire One Telecommunications, Inc., (“EOT”), a Brooklyn, New York-based CLEC. EOT is a regional provider of communications services, including wireline voice, data, long distance and Internet services, to business and residential customers in 16 states and the District of Columbia.  The closing of the EOT transaction (as anticipated by the Agreement) is subject to several conditions including, among others, the completion of necessary regulatory approvals.  

There can be no assurance that Fonix will complete this acquisition.

10

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

3.  GOODWILL AND INTANGIBLE ASSETS

Goodwill - Goodwill relates solely to our speech-enabling business segment of The Fonix Speech Group.  The carrying value of goodwill is assessed for impairment quarterly.  These assessments resulted in no impairment and the carrying value of goodwill remained unchanged at $2,631,000 for the three months ended March 31, 2005.  

Intangible Assets - The components of other intangible assets at March 31, 2005, which all relate to Fonix Telecom, Inc., were as follows:

Customer base amortization was $1,300,000 during the three months ended March 31, 2005, and amortization related to contracts and agreements was $285,000 for the same period.  All amortization expense is charged to selling, general and administrative expense.  At June 30, 2004, the Company recognized an impairment loss on the contracts and agreements intangible asset acquired in connection with the LecStar acquisition of $738,000 based on estimated future cash flows.  No further impairment was required at March 31, 2005.

Estimated aggregate amortization expense for the nine months ending December 31, 2004, and each of the succeeding three full years is as follows:

4.  NOTES PAYABLE

During the first quarter of 2003, the Company entered into a promissory note with an unrelated third party converting accounts payable for outstanding lease payments of $114,000 to a note payable.  This note accrued interest at 10% annually and was paid in full during the quarter ended March 31, 2004.

In connection with the acquisition of the capital stock of LTEL in 2004, the Company issued a 5%, $10,000,000, secured, six-year note payable to McCormack Avenue, Ltd.  Under the terms of the note payable, quarterly interest- only payments were required through January 15, 2005, with quarterly principal and interest payments of $319,000 beginning April 2005 and continuing through January 2010.  Interest on the promissory note is payable in cash or, at the Company’s option, in shares of the Company’s Class A common stock.  The note is secured by the capital stock and all of the assets of LTEL and its subsidiaries.  The note was valued at $4,624,000 based on an imputed interest rate of 25 percent per annum.  The note has a mandatory prepayment clause wherein the Company is required to make prepayments in any given month where the Company receives net proceeds in excess of $900,000 from the Fifth Equity Line (or replacements t hereof with the Equity Line Investor).  The required prepayment is calculated by multiplying the net proceeds received over $900,000 by 33%.  From December 2004 through March 31, 2005, the Company had made mandatory prepayments on the note of $415,000.

11

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

The discount on the note is based on an imputed interest rate of 25%.  The unpaid principal amount of the note at March 31, 2005 was $9,585,000.  The carrying amount of the note was $5,008,000 at March 31, 2005, was net of unamortized discount of $4,577,000.  The Company elected to make the April 15, 2005, principal and interest payment under the note in stock.  

On February 28, 2003, LecStar established an asset securitization facility which provided LecStar with $750,000.  Assets securitized under this facility consist of executory future cash flows from LecStar customers in the states of Georgia, Tennessee, Florida, and Louisiana.  LecStar has pledged its interest in the special purpose securitization facility, LecStar Telecom Ventures LLC, and customer accounts receivable to the lender.  The Company has recorded the $750,000 as a note payable in its consolidated financial statements.  The note bears an interest rate of 6.5% and is due on February 27, 2007, with 24 equal monthly installments beginning on March 6, 2005.  

The following schedule summarizes the Company’s current debt obligations and respective balances at March 31, 2005, and December 31, 2004:

12

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

5.  RELATED-PARTY NOTES PAYABLE

In connection with the acquisition of certain entities in 1998, the Company issued unsecured demand notes payable to former stockholders of the acquired entities in the aggregate amount of $1,710,000.  Of the notes payable, $78,000 remained unpaid as of March 31, 2005.  During 2000, the holders of these notes made demand for payment and the Company commenced negotiating with the holders of these notes to reduce the outstanding balance.  No additional demands have been made and no payments have been made by the Company to the holders of these notes.

13

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

During 2002, two executive officers of the Company (the “Lenders”) sold shares of the Company’s Class A common stock owned by them and advanced the resulting proceeds amounting to $333,000 to the Company under the terms of a revolving line of credit and related promissory note.  The funds were advanced for use in Company operations.  The advances bear interest at 12 percent per annum, which interest is payable on a semi-annual basis.  The entire principal, along with unpaid accrued interest and any other unpaid charges or related fees, were originally due and payable on June 10, 2003.  The Company and the Lenders agreed to postpone the maturity date on several occasions.  The note is presently due June 30, 2005.  After December 11, 2002, all or part of the outstanding balance and unpaid interest became convertible at the option of the Lenders into shares of Class A common stock of the Company.  The conversion price was the average closing bid price of the shares at the time of the advances.  To the extent the market price of the Company’s shares is below the conversion price at the time of conversion, the Lenders are entitled to receive additional shares equal to the gross dollar value received from the original sale of the shares.  A beneficial conversion option of $15,000 was recorded as interest expense in connection with this transaction.  The Lenders may also receive additional compensation as determined appropriate by the Board of Directors.

In October 2002, the Lenders pledged 30,866 shares of the Company's Class A common stock to the Equity Line Investor in connection with an advance of $183,000 to the Company under the Third Equity Line.  The Equity Line Investor subsequently sold the pledged shares and applied $82,000 of the proceeds as a reduction of the advance.  The value of the pledged shares of $82,000 was treated as an additional advance from the Lenders under the revolving line of credit.

During the fourth quarter of 2003, the Company made a principal payment of $26,000 against the outstanding balance of the promissory note.  At September 30, 2004 the Company entered into an agreement with the holders of the promissory note to increase the balance of the note payable by $300,000 in exchange for a release of the $1,443,000 of accrued liabilities related to prior indemnity agreements between the company and the note holders.  The Company classified the release of $1,443,000 as a capital contribution during the fourth quarter of 2004.  

The Company made principal payments against the note of $253,000 during the year ended December 31, 2004.  The remaining balance due at March 31, 2005 was $435,000.

The unpaid balance of $435,000 is secured by a second priority security interest in the Company’s intellectual property rights.  As of March 31, 2005, the Lenders had not converted any of the outstanding balance or interest into common stock.

6.  SERIES D CONVERTIBLE DEBENTURES

On October 11, 2002, the Company issued $1,500,000 of Series D 12% Convertible Debentures (the “Debentures”), due April 9, 2003, and 194,444 shares of Class A common stock to The Breckenridge Fund, LLC (“Breckenridge”), an unaffiliated third party, for $1,500,000 before offering costs of $118,000.  The outstanding principal amount of the Debentures was convertible at any time at the option of the holder into shares of the Company’s common stock at a conversion price equal to the average of the two lowest closing bid prices of the Company’s Class A common stock for the twenty trading days immediately preceding the conversion date, multiplied by 90%.

In connection with the issuance of the Debentures, the Company issued, as collateral to secure its performance under the Debenture, 2,083,333 shares of Class A common stock (the "Collateral Shares"), which were placed into an escrow pursuant to an escrow agreement.  Under the escrow agreement, the Collateral Shares were not released to Breckenridge unless the Company was delinquent with respect to payments under the Debenture.

The Debentures were originally due April 9, 2003.  However, the Company and Breckenridge agreed in January 2003 to modify the terms of the Debentures requiring principal and interest payments from January through May 2003 totaling $1,540,000.  Additionally, the Company agreed to release 237,584 of the Collateral Shares to Breckenridge as consideration (the “Released Shares”) for revising the terms of the purchase agreement.  The additional shares were accounted for as an additional discount to the Debentures of $285,000.

As part of the Debenture agreement, the Company was required to pay Breckenridge a placement fee in the amount of $350,000 payable in stock at the conclusion of the Debenture.  The Company satisfied the obligation through the issuance of 2,000,000 shares of the Company’s Class A common stock valued at $358,000, or $0.179 per share and 377,717 shares of the Company’s Class A common stock valued at $59,000, or $0.157 per share.  The Company recorded the expense as interest expense during December 2003.

14

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

In March 2004, the Company discovered that during 2003 an aggregate of 2,277,778 shares of Class A common stock (the “Unauthorized Shares”) were improperly transferred to the Debenture holder as a result of (i) the unauthorized release from escrow of the Collateral Shares (net of the Released Shares), and (ii) the transfer to the Debenture holder of a duplicate certificate for 194,445 shares where the original certificate was not returned to the transfer agent for cancellation.  The Unauthorized Shares were, therefore, in excess of the shares the Debenture holder was entitled to receive.  No consideration was paid to or received by the Company for the Unauthorized Shares during 2003; therefore, the Company did not recognize the Unauthorized Shares as being validly issued during 2003 nor subsequently.  Accordingly, the Company does not deem the Unauthorized Shares to be validly outstanding and the transfer of the Unauthorized Shares t o the Debenture holder has not been recognized in the accompanying consolidated financial statements.

Upon discovering in March 2004 that the Unauthorized Shares had been improperly transferred to the Debenture holder, the Company attempted to settle the matter with the Debenture holder but was unable to reach a settlement.  Accordingly, on May 3, 2004, the Company filed a lawsuit against the Debenture holder, alleging the improper transfer to and subsequent sale of the Unauthorized Shares by the Debenture holder.  The lawsuit was subsequently dismissed without prejudice and refilled on October 12, 2004.  The complaint seeks (i) a declaratory judgment that the Company may set off the fair value of the Unauthorized Shares against the value the Company owes to the Debenture holder in connection with the Series I Preferred Stock transaction (see Note 7), (ii) judgment against the Debenture holder for the fair value of the Unauthorized Shares, and (iii) punitive damages from the Debenture holder for improper conversion of the Unauthorized Shares.< /P>

7.  PREFERRED STOCK

The Company’s certificate of incorporation allows for the issuance of preferred stock in such series and having such terms and conditions as the Company’s board of directors may designate.

Series A Convertible Preferred Stock - At March 31, 2005, there were 166,667 shares of Series A convertible preferred stock outstanding.  Holders of the Series A convertible preferred stock have the same voting rights as common stockholders, have the right to elect one person to the board of directors and are entitled to receive a one time preferential dividend of $2.905 per share of Series A convertible preferred stock prior to the payment of any dividend on any class or series of stock.  At the option of the holders, each share of Series A convertible preferred stock is convertible into one share of Class A common stock and in the event that the common stock price has equaled or exceeded $10 per share for a 15 day period, the shares of Series A convertible preferred stock will automatically be converted into Class A common stock.  In the event of liquidation, the holders are entitled to a liquidating distribution of $36.33 per share and a conversion of Series A convertible preferred stock at an amount equal to .0375 shares of common stock for each share of Series A convertible preferred stock.

Series H Preferred Stock - The Company issued 2,000 shares of 5% Series H nonvoting, nonconvertible preferred stock with a stated value of $10,000 per share on February 24, 2004.  The Series H Preferred Stock is carried at $4,000,000 or $2.00 per share.

Dividends on the stated value of the outstanding Series H Preferred Stock are payable at the rate of 5% per annum as and when declared by the Board of Directors.  The annual dividend requirement is $1,000,000.  If dividends are declared on Fonix's common stock, as a condition of that dividend, Fonix is required to pay 3% of the aggregate amount of such dividend to the holders of the Series H Preferred Stock.  Dividends on the Series H Preferred Stock are payable in cash or, at the option of Fonix, in shares of Class A common stock.  

In the event of a voluntary or involuntary liquidation, dissolution or winding up of Fonix, the funds available for distribution, after payment to creditors and then to the holders of Fonix's Series A preferred stock of their liquidation payment, but before any liquidation payments to holders of junior preferred stock or common stock, would be payable to the holders of the Series H Preferred Stock (and any other subsequently created class of preferred stock having equal liquidation rights with the Series H Preferred Stock) in an amount equal to the stated value of the then outstanding Series H Preferred Stock plus any unpaid accumulated dividends thereon.  The closing of any transaction or series of transactions involving the sale of all or substantially all of the assets of Fonix, LTEL or a merger, reorganization or other transaction in which holders of a majority of the outstanding voting control of Fonix do not continue to own a majority of the outst anding voting shares of the surviving corporation would be deemed to be a liquidation entitling the holders of the Series H Preferred Stock, at their option, to the payments described above.

15

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

Fonix has the option, but not the obligation, exercisable at any time, to redeem all or any portion of the outstanding Series H Preferred Stock.  The redemption price is equal to any unpaid accumulated dividends on the redeemed shares plus a percentage of the $10,000 per share stated value of the redeemed shares, based on the date the redemption occurs in relation to the original issuance date as follows: before the second anniversary - 102%; thereafter but before the third anniversary - 104%; thereafter but before the fourth anniversary - 106% and thereafter - 108%.  If shares of Series H Preferred Stock are redeemed, additional Series H Preferred Stock dividends will be recognized on the date of redemption in an amount equal to the difference between the amount paid to redeem the shares and their original fair value at the date of issuance of $2,000 per share.  

Under the terms of the Series H Preferred Stock, the consent of the holders of 66% of the outstanding Series H Preferred Stock is required in order to:

$

issue securities with any rights senior to or on parity with the Series H Preferred Stock;

$

sell substantially all of Fonix's assets, grant any exclusive rights or license to Fonix's products or intangible assets (except in the ordinary course of business), or merge with or consolidate into any other entity in a transaction or series of related transactions, except during periods after the stated value of the outstanding Series H Preferred Stock is less than $5,000,000;

$

redeem any outstanding equity securities, except for previously issued options, warrants, or preferred stock, except during periods after the stated value of the outstanding Series H Preferred Stock outstanding is less than $5,000,000; or

$     make any changes in the rights, preferences, or privileges of the Series H Preferred Stock or amend the certificate of incorporation or bylaws.

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

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

Following negotiations with Breckenridge, on January 29, 2004, the Company issued to Breckenridge 3,250 shares of 8% Series I Convertible Preferred Stock (the "Series I Preferred Stock"), for an aggregate purchase price of $3,250,000, including the Private Placement Funds which the Company had already received.  The Company received the proceeds from the issuance of the Series I Preferred Stock in January 2004.  The Series I Preferred Stock was issued under a purchase agreement (the "Purchase Agreement") dated as of December 31, 2003.  The Series I Preferred Stock has a stated value of $1,000 per share.

In connection with the offering of the Series I Preferred Stock, the Company also issued to Breckenridge warrants to purchase up to 965,839 shares of the Company’s Class A common stock at $0.50 per share, exercisable through December 31, 2008, and issued 2,414,596 shares of Class A common stock.

In connection with the issuance of the Series I Preferred Stock, the Company agreed to register the resale by Breckenridge of the Class A common shares issued and the Class A common shares issuable upon conversion of the Series I Preferred Stock, issuable as payment of dividends accrued on the Series I Preferred Stock and issuable upon exercise of the warrants.

Dividends on the Series I Preferred Stock are payable at the annual rate of 8% of the stated value of the shares of Series I Preferred Stock outstanding.  The dividends are payable in cash or shares of our Class A common stock, at the Company’s option.  Aggregate annual dividend requirements for the Series I Preferred Stock are $260,000.  As of March 31, 2005, the Company had accrued dividends of $304,000 on its Series I Preferred Stock.

16

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

In the event of a voluntary or involuntary liquidation, dissolution or winding up of Fonix, the funds available for distribution, after payment to creditors and then to the holders of Fonix's Series A preferred stock of their liquidation payment, but before any liquidation payments to holders of junior preferred stock or common stock, would be payable to the holders of the Series I Preferred Stock in an amount equal to the stated value of the then outstanding Series I Preferred Stock plus any unpaid accumulated dividends thereon.

The Series I Preferred Stock is convertible into shares of our Class A common stock at the lower of (i) $0.75 per share or (ii) 87.5% of the average of the two lowest closing bid prices over the twenty trading days prior to the conversion date.

Under the terms of the purchase agreement, the Company agreed to establish an escrow account (the “Escrow Account”), into which it deposits funds which can be used for the Company’s optional redemption of the Preferred Stock, or which may be used by Breckenridge to require the Company to redeem the Preferred Stock if the Company has defaulted under the purchase agreement.  The Company is required to deposit into the Escrow Account 25% of any amount it receives in excess of $1,000,000, calculated per put, under the terms of the Fifth Equity Line of Credit, or other similar equity line of financing arrangement.   As of March 31, 2005, the Company had deposited $395,000 into the escrow account in full compliance with the requirement.  The escrow deposit is reflected as a long-term asset in the accompanying financial statements.

In the event that there remains in the Escrow Account amounts following either (i) the conversion of all of the outstanding shares of Preferred Stock, together with any accrued and unpaid dividends thereon, or (ii) redemption of all of the outstanding shares of Preferred Stock, together with any accrued and unpaid dividends thereon, those remaining amounts shall be released from the Escrow Account to the Company.

The Company has granted Breckenridge a first lien position on the Company’s intellectual property assets as security under the Purchase Agreement. Breckenridge has agreed to release such lien upon the registration of the Company’s Class A common stock becoming effective, which has occurred, and the Company depositing $2,000,000 in the Escrow Account.

Redemption of the Preferred Stock, whether at our option or that of Breckenridge, requires the Company to pay, as a redemption price, the stated value of the outstanding shares of Preferred Stock to be redeemed, together with any accrued but unissued dividends thereon, multiplied (i) 120% for any redemption occurring between the 151st day and the second anniversary of the closing date of the issuance or (ii) 130% for any payment of the redemption price occurring on or after the second anniversary of the closing date of the issuance.

The Company allocated the proceeds from the issuance of the Series I Preferred Stock, warrants, additional shares and fee shares as follows: $262,000 was allocated to the warrants, $730,000 was allocated to the common shares, $429,000 to the Series I Preferred Stock, and $1,830,000 to a beneficial conversion option.  The amounts allocated to the warrants, common shares and the beneficial conversion option resulted in a discount on the Series I Preferred Stock that was fully amortized at the date of issuance, resulting in the recognition of a dividend on the Series I Preferred Stock of $2,821,000 on January 29, 2004.  The Series I Preferred Stock was recorded as an item of stockholders’ deficit with $2,821,000 recognized as a dividend distribution related to the beneficial conversion and $429,000 as the value of the Series I Preferred Stock.

As of March 31, 2005, the Company has issued 18,490,433 shares of the Company’s Class A common stock in response to conversion requests during 2004 and 2005 for 1,900 shares of Series I Preferred Stock.  As of March 31, 2005, there were 1,350 shares of Series I Preferred Stock outstanding.  Subsequent to March 31, 2005 and through May 11, 2005, the Company issued an additional 3,763,343 shares of Class A common stock in conversion of 78.207 shares of Series I Preferred Stock.

The Company and Breckenridge are engaged in litigation in New York Superior Court concerning the Company’s assertion that it should be allowed to offset certain claims against Breckenridge against the balance due under the Series I Preferred Stock, as more fully described in Note 10 below.

17

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

8.  EQUITY LINES OF CREDIT

Fifth Equity Line of Credit - The Company entered, as of July 1, 2003, into a fifth private equity line agreement (the “Fifth Equity Line Agreement”) with the Equity Line Investor.  Under the Fifth Equity Line Agreement, the Company had the right to draw up to $20,000,000 against an equity line of credit (“the Fifth Equity Line”) from the Equity Line Investor.  The Company was entitled under the Fifth Equity Line Agreement to draw certain funds and to put to the Equity Line Investor shares of the Company’s Class A common stock in lieu of repayment of the draw.  The number of shares to be issued is determined by dividing the amount of the draw by 90% of the average of the two lowest closing bid prices of the Company’s Class A common stock over the ten trading days after the put notice is tendered.  The Equity Line Investor is required under the Fifth Equity Line Agreement to tender the funds requ ested by the Company within two trading days after the ten-trading-day period used to determine the market price.  

For the three months ended March 31, 2005, the Company issued 5,480,405 shares of Class A common stock to the Equity Line Investor in full satisfaction of an outstanding put of $668,000.

Sixth Equity Line of Credit – On November 15, 2004, the Company entered into a sixth private equity line agreement (the “Sixth Equity Line Agreement”) with the Equity Line Investor.  Under the Sixth Equity Line Agreement, the Company has the right to draw up to $20,000,000 against an equity line of credit (“the Sixth Equity Line”) from the Equity Line Investor.  The Company is entitled under the Sixth Equity Line Agreement to draw certain funds and to put to the Equity Line Investor shares of the Company’s Class A common stock in lieu of repayment of the draw.  The number of shares to be issued is determined by dividing the amount of the draw by 90% of the average of the two lowest closing bid prices of the Company’s Class A common stock over the ten trading days after the put notice is tendered.  The Equity Line Investor is required under the Sixth Equity Line Agreement to tender the funds requested by the Company within two trading days after the ten-trading-day period used to determine the market price.

In connection with the Sixth Equity Line Agreement, the Company granted registration rights to the Equity Line Investor and filed a registration statement on Form S-2, which covered the resales of the shares to be issued under the Sixth Equity Line.  The Company is obligated to maintain the effectiveness of the registration statement.

The Company entered into an agreement with the Equity Line Investor to terminate all previous equity lines, and cease further draws or issuances of shares in connection with all previous equity lines.  As such, as of the date of this report, the only active equity line of credit was the Sixth Equity Line.

For the three months ended March 31, 2005, the Company received $2,050,000 in funds and a subscription receivable of $6,000 drawn under the Sixth Equity Line, less commissions and fees of $60,000 and issued 28,320,751 shares of Class A common stock to the Equity Line Investor.

9.  COMMON STOCK, STOCK OPTIONS AND WARRANTS

Class A Common Stock – During the three months ended March 31, 2005, 33,801,156 shares of Class A common stock were issued in connection with draws on the equity line (see Note 8), 10,054,561 shares were issued in conversion of 900 shares of Series I Preferred Stock, 1,384,275 shares were issued as payment of $250,000 of Series H Preferred dividends and 655,162 shares were issued as payment of $124,000 of interest on long-term debt.

Stock Options – On January 19, 2005 the Company entered into an option exchange program with its employees, wherein the Company gave eligible Fonix employees the opportunity to exchange outstanding stock options for the same number of new options to be issued at least six months and one day from the expiration of the offer.  As a result of the option exchange program, the Company cancelled 414,450 options to purchase shares of the Company’s Class A common stock effective February 22, 2005.  The Company issued a promise to grant options on August 23, 2005, to employees who elected to tender their options.  As of March 31, 2005, the Company had a total of 992,950 options to purchase Class A common stock outstanding.  .During the three months ended March 31, 2005, the Company granted options to employees to purchase 708,100 shares of Class A common stock, none of which were to employees participating in the option exc hange program.  The options have an exercise price of $0.12 per share, which was the quoted fair market value of the stock on the dates of grant.  The options granted vest over the three years following issuance.  Options expire within ten years from the date of grant if not exercised.  Using the Black-Scholes pricing model, the weighted average fair value of the employee options was $0.11 per share.  

18

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

Warrants – As of March 31, 2005, the Company had warrants to purchase a total of 1,005,389 shares of Class A common stock outstanding that expire through 2010.

10.  LITIGATION, COMMITMENTS AND CONTINGENCIES

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

The Company did not have sufficient cash to pay the first installment payment due May 1, 2003.  The Company reached an agreement with the Department of Labor to extend the commencement date for installment payments to August 1, 2003 and since that time has made the required payments due under the modified agreement.  On March 31, 2004, the balance due under this obligation was approximately $914,000.

Grenfell Litigation - Two of the Company’s subsidiaries, LecStar Telecom, Inc., and LecStar DataNet, Inc., (the “Subsidiaries”) are among the defendants who have been sued in the Superior Court of Fulton County, State of Georgia, by James D. Grenfell, the former CFO of LecStar.  The suit was filed in December 2003. The plaintiff in that case alleges that he has an unpaid judgment in the amount of $1,015,000 plus interest against the former parent entities of the Subsidiaries and that the transfer of such stock and business in December 2002 was in violation of the Georgia Fraudulent Transfer statute. The plaintiff sought a preliminary injunction prior to our acquisition of the capital stock of LTEL in February 2004.  The Georgia state trial court denied the plaintiff’s motion for injunctive relief. The Plaintiff did not appeal.  Several of the defendants in the action, including the Subsidiaries, have filed a m otion to dismiss the action.  As of March 28, 2005, the trial court had not ruled on that motion.  LecStar Telecom, Inc. has also intervened in the underlying action relating to the judgment and has appealed the Court’s order granting the judgment against the Subsidiaries’ former parents. That appeal is pending before the Georgia Court of Appeals. To the extent that we or our subsidiaries are or should become proper parties to this action, and if the appeal and the motion to dismiss are denied, the Company will defend vigorously against these claims.  

First Empire Complaint – One of the Company’s subsidiaries, LTEL Holding Corporation, is among the defendants who have been sued in the Superior Court of Fulton County, State of Georgia, by First Empire Corporation and Allen B. Thomas, directly and derivatively in his capacity as shareholder of LecStar Corporation.  The lawsuit was filed in July 2004.  The plaintiffs in that case allege that certain of the defendants employed fraudulent and deceptive means to acquire the assets of LecStar Corporation, which included the capital stock of the Subsidiaries, LecStar Telecom, Inc. and LecStar Datanet, Inc.  The plaintiffs further allege that those defendants subsequently transferred the stock of the subsidiaries to LTEL Holding Ltd., which we acquired through our subsidiary LTEL Acquisition Corporation in February 2004.  The plaintiffs argue that they are entitled to recover the value that we paid for LTEL Holding Corpo ration under multiple legal theories including breaches of fiduciary duty, negligence, gross negligence, conversion, fraud and violation of the Georgia Securities Act.  Three of the employees of the Subsidiaries have also been named as defendants in the litigation.  

The Company has filed an answer in the litigation and are in the process of seeking to have a default judgment which the plaintiffs obtained against the Company set aside.  The plaintiffs claim that they are entitled to the default judgment because the Company did not timely answer the complaint.  However, the complaint was not properly delivered to the Company in a timely fashion, which the Company believes is an adequate basis to have the default judgment entered against the Company set aside.  

The Company has not been involved in discovery in this litigation because the litigation is in the early stages.  Nonetheless, the Company believes that the claims of the plaintiffs are without merit and management intends to vigorously defend against the claims of the plaintiffs.  

19

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

The principal Series H preferred stockholder has placed 300 shares of Series H Preferred Stock in escrow for a period of 12 months from the date of acquisition as protection with respect to breaches of representations and warranties of the LTEL selling stockholders, including any liability or payment that may arise from the above mentioned legal action.  As a result of the filing of the First Empire Litigation, we have asserted a claim for breach of certain representations and warranties.  To our knowledge, the Escrow Shares have not been released.

Breckenridge Lawsuit - On May 3, 2004, the Company filed a lawsuit against The Breckenridge Fund, LLC (“Breckenridge”), alleging the improper transfer to and subsequent sale of shares of our common stock by Breckenridge.  That lawsuit was subsequently dismissed without prejudice and refilled in the Third Judicial District Court of Salt Lake County, Utah, on October 13, 2004 (the “Breckenridge Lawsuit”).  The complaint seeks (i) a declaratory judgment that we may set off the fair value of the Unauthorized Shares against the value we owe to Breckenridge in connection with the Series I Preferred Stock transaction, (ii) judgment against Breckenridge for the fair value of the Unauthorized Shares, and (iii) punitive damages from Breckenridge for improper conversion of the Unauthorized Shares.  We also sought and obtained a temporary restraining order against Breckenridge, prohibiting them from selling any of our com mon stock, or alternatively requiring Breckenridge to deposit the proceeds of any such sales into an interest bearing account.  Breckenridge removed the case to the United States District Court for the District of Utah, which: (1) found that the state court’s temporary restraining order had expired; and (2) declined to enter its own injunction.   On March 18, 2005, the federal court dismissed the Breckenridge Lawsuit without prejudice, finding that a forum selection clause required the claims to be litigated in New York.  The Company intends to litigate those claims in New York.

First Series I Complaint – On November 10, 2004, Breckenridge tendered to Fonix a conversion notice, converting 16 shares of Series I Preferred Stock into 123,971 shares of common stock.  In light of the temporary restraining order that had been issued by the state court in the Breckenridge Lawsuit, Fonix instructed its transfer agent to include on the share certificate a legend referencing the restraining order and the Breckenridge Lawsuit.   Subsequently, Breckenridge filed a complaint against us (Supreme Court of the State of New York, County of Nassau, Index No. 015822/04) in connection with the Series I Preferred Stock (the “First Series I Complaint”).  In the First Series I Complaint, Breckenridge alleges that it was improper for us to include any legends on the shares issued in connection with conversions of the Series I Preferred Stock other than those agreed to by Breckenridge in the Series I Preferre d Stock purchase agreement (the “Series I Agreement”).  Breckenridge also seeks liquidated damages for our failure to issue shares free of the allegedly inappropriate legend.  The Complaint seeks $4,000,000 in compensatory damages and $10,000,000 in punitive damages.  The Company has filed a motion to dismiss and intends to vigorously defend itself.

Subsequent to filing the complaint, Breckenridge moved for a temporary restraining order to prevent the Company from issuing shares with any legend other than those agreed upon by Breckenridge in the Series I Agreement.  On November 18, 2004, at a hearing on Breckenridge’s motion, the court entered an order stating that we may not place any legend on shares issued to Breckenridge upon conversion of the Series I Preferred Stock other than those permitted under the Series I Agreement.

The Security Agreement Complaint – On November 23, 2004, Breckenridge filed a complaint against the Company (Supreme Court of the State of New York, County of Nassau, Index No. 015185/04) alleging: (1) Fonix executed a Security Agreement and a Registration Rights Agreement in connection with the Series I Agreement pursuant to which it granted to Breckenridge a security interest in certain collateral, including Fonix’s intellectual property (the “Collateral”); (2) Fonix breached the Registration Rights Agreement and the Security Agreement; and (3) Breckenridge is entitled to damages totaling $585,000 and possession of the Collateral.  The Company has filed a motion to dismiss and intends to vigorously defend itself.

Second Series I Complaint – On March 10, 2005, Breckenridge filed a complaint against the Company (Supreme Court of the State of New York, County of Nassau, Index No. 3457/05) in connection with the Series I Preferred Stock (the “Second Series I Complaint”).  In the Second Series I Complaint, Breckenridge alleges that Fonix improperly failed to honor a conversion notice it tendered to us on February 25, 2005, converting 500 shares of Series I Preferred Stock into 6,180,469 shares of common stock.  Breckenridge sought a temporary restraining order and preliminary injunction requiring Fonix to honor that conversion notice, and all subsequently tendered conversion notices.  On March 14, 2005, the Court entered a temporary restraining order directing us to honor the February 25, 2005, conversion notice, and directed Breckenridge to deposit all proceeds from the sale of the converted shares to be deposited in an interes t-bearing escrow account.  Breckenridge subsequently agreed that it would deposit the proceeds of all converted shares into the interest-bearing escrow account pending the outcome of this litigation.  The Company has filed a counterclaim against Breckenridge and intends to vigorously defend itself against the claims of Breckenridge.

20

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

11. BUSINESS SEGMENTS

Information related to Fonix’s reportable operating business segments is shown below.  Fonix’s reportable segments are reported in a manner consistent with the way management evaluates the businesses.  The Company identifies its reportable business segments based on differences in products and services.  The accounting policies of the business segments are the same as those described in the summary of significant accounting policies.  The products and services of each business segment are further described in Note 1.  The Company has identified the following business segments:

LecStar Telecom - Telecommunications services include wireline voice, data, long distance and Internet services to business and residential customers.

Speech - The Company’s speech-enabling technologies include automated speech recognition and text-to-speech for wireless and mobile devices, computer telephony and server solutions, and personal software for consumer applications.

Fonix Telecom – Telecommunications services including Voice over Internet Protocol (“VOiP”) and Broadband over Power Line (“BPL”) and other services including satellite television and security services to business and residential customers

The following presents certain segment information as of and for the three months ended March 31, 2005:

Revenues and assets outside the United States of America were not material.  During the three months ended March 31, 2005 and 2004, the Company had no customers that exceeded 10% of total revenues.  

12.  SUBSEQUENT EVENTS

Subsequent to March 31, 2005 and through May 11, 2005 the Company received $693,000 in funds drawn under the Sixth Equity Line and issued 26,182,267 additional shares of Class A common stock to the Equity Line Investor.

Subsequent to March 31, 2005 and through May 11, 2005, the Company issued 3,763,343 shares of its Class A common stock in conversion of 78.207 shares of Series I Preferred Stock

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ITEM 2.

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

This report on Form 10-Q contains, in addition to historical information, forward-looking statements that involve substantial risks and uncertainties.  All forward-looking statements contained herein are deemed by Fonix to be covered by and to qualify for the safe harbor protection provided by Section 21E of the Private Securities Litigation Reform Act of 1995.  Actual results could differ materially from the results anticipated by Fonix and discussed in the forward-looking statements.  When used in this report, words such as “believes,” “expects,” “intends,” “plans,” “anticipates,” “estimates,” and similar expressions are intended to identify forward-looking statements, although there may be certain forward-looking statements not accompanied by such expressions.  Factors that could cause or contribute to such differences are discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

To date, we have earned only limited revenue from operations and intend to continue to rely primarily on financing through the sale of our equity and debt securities to satisfy future capital requirements.

Overview

We are engaged in providing integrated telecommunications services through Fonix Telecom, Inc., and LecStar Telecom, Inc., and value-added speech technologies through The Fonix Speech Group.  We operate Fonix Telecom, Inc., and LecStar Telecom, Inc., a regional provider of telecommunications services in the Southeastern United States and LecStar DataNet, Inc., a provider of Internet services.  (LecStar Telecom, Inc. and LecStar DataNet are collectively referred to in this report as “LecStar.”)  

We offer our speech-enabling technologies including automated speech recognition (“ASR”) and text-to-speech (“TTS”) through The Fonix Speech Group.  We offer our ASR and TTS technologies to markets for wireless and mobile devices, computer telephony, server solutions and personal software for consumer applications. We have received various patents for certain elements of our core technologies and have filed applications for other patents covering various aspects of our technologies. We seek to develop relationships and strategic alliances with third-party developers and vendors in telecommunications, computers, electronic devices and related industries, including producers of application software, operating systems, computers and microprocessor chips.  Revenues are generated through providing telecommunication services, licensing of speech-enabling technologies, maintenance contracts and services.

Fonix Telecom’s non-regulated telecommunication services include VoIP, BPL and wireless broadband access.  These services are initially available in the southeastern United States and we anticipate that they eventually will be available throughout the United States.

LecStar’s telecommunication services include wireline voice, data, long distance and Internet services to business and residential customers.  LecStar Telecom, Inc., is certified by the Federal Communications Commission in nine states—Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South Carolina and Tennessee—as a competitive local exchange carrier (“CLEC”) to provide regulated local, long distance and international telecommunications services.  LecStar DataNet, Inc., provides non-regulated telecommunication services including Internet access.

For the three months ended March 31, 2005 and 2004, we generated revenues of $4,223,000 and $1,925,000, respectively; incurred net losses of $4,080,000 and $2,342,000, respectively; and had negative cash flows from operating activities of $2,559,000 and $5,478,000, respectively.  As of March 31, 2005, we had an accumulated deficit of $231,002,000, negative working capital of $13,121,000, accrued liabilities of $6,877,000, accounts payable of $5,383,000 and accrued employee wages and other compensation of $1,311,000.  We expect to continue to incur significant losses and negative cash flows from operating activities through at least December 31, 2005, primarily due to expenditure requirements associated with continued marketing and development of our speech-enabling technologies and further developing our telecommunications services business.

Our cash resources, limited to collections from customers, draws on the Sixth Equity Lines and loans, have not been sufficient to cover operating expenses.  We have not been declared in default under the terms of any material agreements.

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Significant Accounting Policies

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States.  The preparation of these financial statements 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 sales and expenses during the reporting period.  Significant accounting policies and areas where substantial judgments are made by management include:

Accounting estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures 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.

 Valuation of long-lived assets - The carrying values of our long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that they may not be recoverable. When such an event occurred, we would project undiscounted cash flows to be generated from the use of the asset and its eventual disposition over the remaining life of the asset.  If projections were to indicate that the carrying value of the long-lived asset would not be recovered, the carrying value of the long-lived asset, other than software technology, would be reduced by the estimated excess of the carrying value over the projected discounted cash flows.

Intangible assets – Customer base, contracts and agreements and brand names are amortized over their estimated useful lives unless they are deemed to have indefinite useful lives.  For intangible assets subject to amortization, an impairment charge is recognized if the carrying amount is not recoverable and the carrying amount exceeds the fair value of the intangible asset.  Intangible assets deemed to have indefinite useful lives, primarily the LecStar brand name are not amortized, are tested for impairment on a quarterly basis and impairment is recognized if the carrying amount is not recoverable or exceeds its fair value.  During the year ended December 31, 2004, we recorded an impairment loss on the intangible asset related to the contracts and agreements acquired in connection with the LecStar acquisition (see Note 2 of the Condensed Consolidated Financial Statements) of $738,000 based on estimated fut ure cash flows.

Goodwill - Goodwill represents the excess of the cost over the fair value of net assets of acquired businesses. Goodwill is not amortized, but is tested for impairment quarterly or when a triggering event occurs.  If a triggering event occurs, the undiscounted net cash flows of the asset or entity to which the goodwill relates are evaluated.  Impairment is indicated if undiscounted cash flows are less than the carrying value of the assets.  The amount of the impairment is measured using a discounted-cash-flow model considering future revenues, operating costs, a risk-adjusted discount rate and other factors.  

Revenue recognition – We recognize revenue when pervasive evidence of an arrangement exists, services have been rendered or products have been delivered, the price to the buyer is fixed and determinable and collectibility is reasonable assured.  Revenues are recognized by us based on the various types of transactions generating the revenue.  For software sales, we recognize revenues in accordance with the provisions of Statement of Position No. 97-2, “Software Revenue Recognition” and related interpretations.  We generate revenues from licensing the rights to our software products to end users and from royalties.  For telecommunications services, revenue is recognized in the period that the service is provided.  

For The Fonix Speech Group, revenue of all types is recognized when acceptance of functionality, rights of return, and price protection are confirmed or can be reasonably estimated, as appropriate.  Revenue for hardware units delivered is recognized when delivery is verified and collection assured.   

Revenue for products distributed through wholesale and retail channels and through resellers is recognized upon verification of final sell-through to end users, after consideration of rights of return and price protection.  Typically, the right of return on such products has expired when the end user purchases the product from the retail outlet.  Once the end user opens the package, it is not returnable unless the medium is defective.

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When arrangements to license software products do not require significant production, modification or customization of software, revenue from licenses and royalties are recognized when persuasive evidence of a licensing arrangement exists, delivery of the software has occurred, the fee is fixed or determinable, and collectibility is probable.   Post-contract obligations, if any, generally consist of one year of support including such services as customer calls, bug fixes, and upgrades.  Related revenue is recognized over the period covered by the agreement.  Revenues from maintenance and support contracts are also recognized over the term of the related contracts.

Revenues applicable to multiple-element fee arrangements are bifurcated among the elements such as license agreements and support and upgrade obligations using vendor-specific objective evidence of fair value. Such evidence consists primarily of pricing of multiple elements as if sold as separate products or arrangements.  These elements vary based upon factors such as the type of license, volume of units licensed, and other related factors.  

For Fonix Telecom, Inc., our telecommunications revenue is comprised of two main components: (1) fees paid by business and residential subscribers of voice and data services and (2) carrier access fees.  Subscriber revenues include monthly recurring charges, usage charges and non-recurring charges.  Monthly recurring charges are flat monthly fees for local phone and data services.  Usage charges, which primarily include long distance fees, are generally billed on a per-minute or per-call basis.  Non-recurring charges are generally one-time charges for installation or changes to the subscriber’s service.  Carrier access fees are paid to us by other telecommunications carriers as compensation for originating and terminating the carriers’ long distance traffic.   

Deferred revenue as of March 31, 2005, and December 31, 2004, consisted of the following:

Cost of revenues - Cost of revenues from telecommunications services consists mainly of billings from the incumbent local exchange carriers (“ ILECs”) for access to the ILECs network.  With respect to The Fonix Speech Group, cost of revenues from license, royalties, and maintenance consists of costs to distribute the product, installation and support personnel compensation, amortization and impairment of capitalized speech software costs, licensed technology, and other related costs.  Cost of service revenues consists of personnel compensation and other related costs.

Software Technology Development and Production Costs - All costs incurred to establish the technological feasibility of speech software technology to be sold, leased, or otherwise marketed are charged to product development and research expense. Technological feasibility is established when a product design and a working model of the software product have been completed and confirmed by testing.  Costs to produce or purchase software technology incurred subsequent to establishing technological feasibility are capitalized.  Capitalization of software costs ceases when the product is available for general release to customers.  Costs to perform consulting or development services are charged to cost of revenues in the period in which the corresponding revenues are recognized.  Costs of maintenance and customer support are charged to expense when related revenue is recognized or when these costs are incu rred, whichever occurs first.

Capitalized software technology costs were amortized on a product-by-product basis.  Amortization was  recognized from the date the product was available for general release to customers as the greater of (a) the ratio that current gross revenue for a product bears to total current and anticipated future gross revenues for that product or (b) the straight-line method over the remaining estimated economic life of the products.  Amortization was charged to cost of revenues.

We assessed unamortized capitalized software costs for possible write down on a quarterly basis based on net realizable value of each related product. Net realizable value was determined based on the estimated future gross revenues from a product reduced by the estimated future cost of completing and disposing of the product, including the cost of performing maintenance and customer support. The amount by which the unamortized capitalized costs of a software product exceeded the net realizable value of that asset was written off.

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Stock-based Compensation Plans –We account for our stock-based compensation issued to non-employees using the fair value method in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation.” Under SFAS No. 123, stock-based compensation is determined as either the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable.  The measurement date for these issuances is the earlier of the date at which a commitment for performance by the recipient to earn the equity instruments is reached or the date at which the recipient’s performance is complete.

At March 31, 2005, we had stock-based employee compensation plans.  We account for the plans under the recognition method and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and the related Interpretations. Under APB Opinion No. 25, compensation related to stock options, if any, is recorded if an option’s exercise price on the measurement date is below the fair value of our common stock, and amortized to expense over the vesting period.  Compensation expense for stock awards or purchases, if any, is recognized if the award or purchase price on the measurement date is below the fair value of our common stock, and is recognized on the date of award or purchase.  

Imputed Interest Expense - Interest is imputed on long-term debt obligations and notes receivable where management has determined that the contractual interest rates are below the market rate for instruments with similar risk characteristics.

Foreign Currency Translation - The functional currency of our Korean subsidiary is the South Korean won.  Consequently, assets and liabilities of the Korean operations are translated into United States dollars using current exchange rates at the end of the year.  All revenue is invoiced in South Korean won and revenues and expenses are translated into United States dollars using weighted-average exchange rates for the year.

Comprehensive Income - Other comprehensive income presented in the accompanying consolidated financial statements consists of cumulative foreign currency translation adjustments.  

Recently Enacted Accounting Standards - In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123 (revised 2004), Share-Based Payment. SFAS No. 123(R) requires that the compensation cost relating to share-based payment transactions be recognized in financial statements.  The cost will be measured based on the fair value of the instruments issued. SFAS No. 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. SFAS No. 123(R) replaces SFAS No. 123 and supersedes APB Opinion No. 25. As originally issued in 1995, SFAS No. 123 established as preferable the fair-value-based method of accounting for share-based payment transactions with employees.  However, that Statement permitted entities the option of continuing to apply the guidance in Opinion 25, as long as the footnotes to financial statements disclosed what net income would have been had the preferable fair-value-based method been used. We will be required to apply SFAS No. 123(R) as of the first interim reporting period that begins after June 15, 2005, and we plan to adopt it using the modified-prospective method, effective July 1, 2005.  We are currently evaluating the impact SFAS No. 123(R) will have on us and, based on our preliminarily analysis, we expect that the adoption will not have a material impact on our financial statements.

In December 2004, the FASB issued SFAS Statement No. 153, “Exchanges of Non-monetary Assets—an amendment of APB Opinion No. 29.” This Statement amends APB Opinion 29 to eliminate the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The statement will be effective in January 2006. We do not expect that the adoption of SFAS No. 153 will have a material impact on our consolidated financial statements.

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Results of Operations

Three months ended March 31, 2005, compared with three months ended March 31, 2004

During the three months ended March 31, 2005, we recorded revenues of $4,223,000, an increase of $2,298,000 from $1,925,000 in 2004.  The increase was primarily due to the acquisition of LecStar, accounting for $2,436,000 of the increase, increased non-recurring engineering (“NRE”) revenues of $125,000, increase retail revenues of $12,000, partially offset by decreased licenses revenues of $226,000, and decreased DECtalk royalties of $49,000.

Cost of revenues was $2,187,000, an increase of $1,395,000 from $792,000 for the three months ended March 31, 2005.  The increase was primarily due to the acquisition of LecStar, contributing $2,180,000 to the increase.  These costs represent expenses associated with providing LecStar’s services through the leasing of network components from BellSouth and long distance services purchased from inter-exchange carriers.  

Selling, general and administrative expenses were $3,415,000 for the three months ended March 31, 2005, a increase of $1,084,000 from $2,331,000 in 2004 The increase is primarily due to the acquisition of LecStar, which contributed $1,477,000 to the increase, and increased investor relations expenses of $45,000, increased occupancy related expenses of $14,000 partially offset by decreased salary and wage expenses of $186,000, decreased legal and accounting fees of $174,000, decreased travel expenses of $33,000 decrease other operating expenses of $24,000 decreased consulting expenses of $16,000 decreased taxes, licenses and permits of $12,000,  and decreased depreciation expenses of $7,000.

We incurred research and product development expenses of $520,000 for the three months ended March 31, 2005, a decrease of $279,000 from $799,000 in 2004.  The decrease is primarily due to an overall decrease in salaries and wage-related expenses of $214,000, decreased other operating expenses of $39,000, decreased travel expenses of $9,000, decreased consulting expenses of $22,000, due to a decrease in the utilization of external consultants, and decreased depreciation of $9,000 due to the overall decrease in fixed assets, partially offset by increased occupancy of $14,000.

Net interest and other expense was $595,000 for the three months ended March 31, 2005, a decrease of $843,000 from $248,000 for 2004.  The overall decrease is due to the gain on forgiveness of liabilities of $481,000, partially offset by increased interest expense of $319,000, the gain on the sale of long-term investments of $134,000 and increased interest income of $13,000.

Three months ended March 31, 2004, compared with three months ended March 31, 2003

During the three months ended March 31, 2004, we recorded revenues of $1,925,000, an increase of $1,335,000 over the same period in the previous year.  The increase was primarily due to the acquisition of LecStar accounting for $1,447,000, partially offset by decreased NRE revenues of $87,000 and a decrease in DECtalk royalties of $25,000.

Cost of revenues was $792,000 for the three months ended March 31, 2004, an increase of $712 000 from $80,000 over the same period in the previous year.  The increase is primarily due to the acquisition of LecStar contributing $775,000 to the increase.  These costs represent expenses associated with providing LecStar’s services through the leasing of network components from Bellsouth and long distance services purchased from inter-exchange carriers.  This increase was partially offset by decreased expenses related to NRE projects due to the overall decrease in NRE contracts during the quarter.

Selling, general and administrative expenses were $2,924,000 for the three months ended March 31, 2004, representing an increase of $647,000 over the same period in the previous year.  The increase is due to increased depreciation expense and increased amortization expense related to intangible assets acquired in the LecStar acquisition of $601,000, increased legal and accounting fees of $219,000 also primarily related to the LecStar acquisition, and increased travel related expenses of $25,000, partially offset by decreased salary and wage related costs of $146,000, decreased taxes and license fees of $65,000, decreased investor relations related expenses of $51,000, decreased occupancy related costs of $21,000 and decreased promotion and advertising expenses of $21,000.

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We incurred research and product development expenses of $799,000 for the three months ended March 31, 2004, a decrease of $876,000 over the same period in the previous year.  The decrease is primarily due to an overall decrease in salaries and wage related expenses of $770,000, decreased occupancy related costs of $51,000, decreased consulting expenses of $43,000 due to a decrease in the utilization of external consultants and decreased depreciation of $30,000 due to the overall decrease in fixed assets.

Net interest and other expense was $233,000 for the three months ended March 31, 2004, a decrease of $509,000 from the same period in the previous year.  The overall decrease is due to the retirement of the Series D Debentures during the fourth quarter of 2003, partially offset by increased interest expense related to debt acquired in connection with the LecStar acquisition.

Liquidity and Capital Resources

We must raise additional funds to be able to satisfy our cash requirements during the next 12 months. Product development, corporate operations, and marketing expenses will continue to require additional capital.  Because we presently have only limited revenue from operations, we intend to continue to rely primarily on financing through the sale of our equity and debt securities to satisfy future capital requirements until such time as we are able to enter into additional third-party licensing, collaboration, or co-marketing arrangements such that we will be able to finance ongoing operations from license, royalty, and sales revenue. There can be no assurance that we will be able to enter into such agreements. Furthermore, the issuance of equity or debt securities which are or may become convertible into equity securities of Fonix in connection with such financing could result in substantial additional dilution to the stockholders Foni x.

As of March 31, 2005, our cash resources were limited to collections from customers, draws on the Sixth Equity Line, proceeds from the issuance of preferred stock and loan proceeds, and were only sufficient to cover current operating expenses and payments of current liabilities.  We have entered into certain term payment plans with current and former employees and vendors.  As a result of cash flow deficiencies, payments to former employees and vendors not on a payment  plan have been delayed.  At March 31, 2005, we had accrued liabilities of $6,877,000, accrued wages and other compensation payable to current and former employees amounted to approximately $1,311,000 and vendor accounts payable amounted to approximately $5,383,000.  We have not been declared in default under the terms of any material agreements.

Several former employees filed suits against Fonix to collect past due wages or filed complaints with the State of Utah Labor Commission asserting past due wage claims.  We have settled several of these suits and are negotiating to settle the remaining suits on terms similar to those offered to current employees who are also owed past due wages.

We had $4,223,000 in revenue and a loss of $4,080,000 for the three months ended March 31, 2005. Net cash used in operating activities of $2,559,000 for the three months ended March 31, 2005, resulted principally from the net loss incurred of $4,080,000 decreased accrued payroll of $455,000, decreased prepaid expenses and other current assets of $155,000, the gain recognized in connection with the sale of long-term assets of $134,000, decreased other assets of $48,000 and decreased deferred revenues of $42,000, partially offset by amortization of intangible assets of $1,586,000, collection of LecStar accounts receivables of $218,000, increased accounts payable and accrued liabilities of $183,000 and depreciation expense of $37,000.  Net cash provided by investing activities of $92,000 is due to the sale of long-term investments of $237,000, partially offset by purchases of property and equipment of $145,000.  Net cash provided by financing activities of $2,614,000 consisted of the receipt of $2,652,000 in cash related to the sale of shares of Class A common stock, partially offset by principal payments on notes payable of $60,000.

We had negative working capital of $13,121,000 at March 31, 2005, compared to negative working capital of $13,580,000 at December 31, 2003.  Current assets increased by $214,000 to $2,344,000 from December 31, 2004, to March 31, 2005.  Current liabilities decreased by $235,000 to $15,464,000 during the same period.  The change in working capital from December 31, 2004, to March 31, 2005, reflects, in part, the increases resulting from collection of receivable balances and the overall decrease in the accrued payroll balance due to scheduled payments made during the period.  Total assets were $17,557,000 at March 31, 2005, compared to $19,000,000 at December 31, 2004.

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Notes Payable - Related Parties

During 2002, two of our executive officers (the “Lenders”) sold shares of our Class A common stock owned by them and advanced the resulting proceeds amounting to $333,000 to us under the terms of a revolving line of credit and related promissory note.  The funds were advanced for use in our operations.  The advances bear interest at 10 percent per annum, which interest is payable on a semi-annual basis.  The entire principal, along with unpaid accrued interest and any other unpaid charges or related fees, were originally due and payable on June 10, 2003.  Fonix and the Lenders agreed to postpone the maturity date on several occasions.  The note is presently due June 30, 2005.  All or part of the outstanding balance and unpaid interest may be converted at the option of the Lenders into shares of Class A common stock of Fonix at any time.  The conversion price was the average closing bid price of t he shares at the time of the advances.  To the extent the market price of our shares is below the conversion price at the time of conversion, the Lenders are entitled to receive additional shares equal to the gross dollar value received from the original sale of the shares.  A beneficial conversion option of $15,000 was recorded as interest expense in connection with this transaction.  The Lenders may also receive additional compensation as determined appropriate by the Board of Directors.

In October 2002, the Lenders pledged 30,866 shares of the Company's Class A common stock to the Equity Line Investor in connection with an advance of $183,000 to us under the Third Equity Line (see Note 12 to Consolidated Financial Statements).  The Equity Line Investor subsequently sold the pledged shares and applied $82,000 of the proceeds as a reduction of the advance.  The value of the pledged shares of $82,000 was treated as an additional advance from the Lenders.

During the fourth quarter of 2003, we made a principal payment of $26,000 against the outstanding balance of the promissory note.  During 2004, we entered into an agreement with the holders of the promissory note to increase the balance of the note payable by $300,000 in exchange for a release of the $1,443,000 of accrued liabilities related to prior indemnity agreements between us and the note holders.  We classified the release of $1,143,000 as a capital contribution in the Consolidated Financial Statements during the fourth quarter of 2004.  We made principal payments against the note of $253,000 during the year ended December 31, 2004.  The remaining balance due at March 31, 2005 was $435,000.

The aggregate advances of $435,000 are secured by our intellectual property rights.  As of March 31, 2005, the Lenders had not converted any of the outstanding balance or interest into common stock.

Notes Payable

In connection with the acquisition of the capital stock of LTEL in 2004, we issued a 5%, $10,000,000, secured, six-year note payable to McCormack Avenue, Ltd.  Under the terms of the note payable, quarterly interest-only payments were required through January 15, 2005, with quarterly principal and interest payments beginning April 2005 and continuing through January 2010.  Interest on the promissory note is payable in cash or, at our option, in shares of our Class A common stock.  The note is secured by the capital stock and all of the assets of LTEL and its subsidiaries.  The note was valued at $4,624,000 based on an imputed interest rate of 25 percent per annum.  The note has a mandatory prepayment clause wherein we are required to make prepayments in any given month where we receive net proceeds in excess of $900,000 from the Fifth Equity Line (or replacements thereof with the Equity Line Investor).  The req uired prepayment is calculated by multiplying the net proceeds received over $900,000 by 33%.  Through March 31, 2005, we made mandatory prepayments on the note of $415,000.

The discount on the note is based on an imputed interest rate of 25%.  The carrying amount of the note was $5,008,000 at March 31, 2005, net of unamortized discount of $4,577,000.  

We had unsecured demand notes payable to former stockholders of an acquired entity in the aggregate amount of $78,000 outstanding as of March 31, 2005.

On February 28, 2003, LecStar established an asset securitization facility which provided LecStar with $750,000.  Assets securitized under this facility consist of executory future cash flows from LecStar customers in the states of Georgia, Tennessee, Florida, and Louisiana.  LecStar has pledged its interest in the special purpose securitization facility, LecStar Telecom Ventures LLC, and customer accounts receivable to the lender.  We have recorded the $750,000 as a note payable in our consolidated financial statements.  The note bears an interest rate of 6.5% and is due on February 27, 2007, with 24 equal monthly installments beginning on March 6, 2005.  

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Series D Debentures

On October 11, 2002, the Company issued $1,500,000 of Series D 12% Convertible Debentures (the “Debentures”), due April 9, 2003, and 194,444 shares of Class A common stock to Breckenridge Fund, LLC (“Breckenridge”), an unaffiliated third party, for $1,500,000 before offering costs of $118,000.  The outstanding principal amount of the Debentures was convertible at any time at the option of the holder into shares of our common stock at a conversion price equal to the average of the two lowest closing bid prices of our Class A common stock for the twenty trading days immediately preceding the conversion date, multiplied by 90%.

In connection with the issuance of the Debentures, we issued, as collateral to secure its performance under the Debenture, 2,083,333 shares of Class A common stock (the “Collateral Shares”), which were placed into an escrow pursuant to an escrow agreement.  Under the escrow agreement, the Collateral Shares would not be released to Breckenridge unless we were delinquent with respect to payments under the Debenture.

The Debentures were originally due April 9, 2003.  However, Fonix and Breckenridge agreed in January 2003 to modify the terms of the Debentures requiring the following principal payments plus accrued interest: $400,000 in January 2003; $350,000 in February 2003; $250,000 in March 2003; $250,000 in April 2003; and $250,000 in May 2003.  Additionally, we agreed to release 237,584 of the Collateral Shares to Breckenridge as consideration (the “Released Shares”) for revising the terms of the purchase agreement.  The additional shares were accounted for as an additional discount of $285,000.

As part of the Debenture agreement, we were required to pay Breckenridge a placement fee in the amount of $350,000 payable in stock at the conclusion of the Debenture.  We satisfied the obligation through the issuance of 2,000,000 shares of our Class A common stock valued at $358,000, or $0.179 per share and 377,717 shares of our Class A common stock valued at $59,000, or $0.157 per share.  We recorded the expense as interest expense in the accompanying financial statements.

In March 2004, we discovered that during 2003 an aggregate of 2,277,778 shares of Class A common stock (the “Unauthorized Shares”) were improperly transferred to the Debenture holder as a result of (i) the unauthorized release from escrow of the Collateral Shares (net of the Released Shares), and (ii) the transfer to the Debenture holder of a duplicate certificate for 194,445 shares where the original certificate was not returned to the transfer agent for cancellation.  The Unauthorized Shares were, therefore, in excess of the shares the Debenture holder was entitled to receive.  No consideration was paid to or received by us for the Unauthorized Shares during 2003; therefore, we did not recognize the Unauthorized Shares as being validly issued during 2003 nor subsequently.  Accordingly, we do not deem the Unauthorized Shares to be validly outstanding and the transfer of the Unauthorized Shares to the Debenture hold er has not been recognized in the accompanying consolidated financial statements.

Upon discovering in March 2004 that the Unauthorized Shares had been improperly transferred to the Debenture holder, we attempted to settle the matter with the Debenture holder but was unable to reach a settlement.  Accordingly, on May 3, 2004, we filed a lawsuit against the Debenture holder, alleging the improper transfer to and subsequent sale of the Unauthorized Shares by the Debenture holder.  The lawsuit was subsequently dismissed without prejudice and refilled on October 12, 2004.  The complaint seeks (i) a declaratory judgment that we may set off the fair value of the Unauthorized Shares against the value we owe to the Debenture holder in connection with the Series I Preferred Stock transaction (see Note 7 to Condensed Consolidated Financial Statements), (ii) judgment against the Debenture holder for the fair value of the Unauthorized Shares, and (iii) punitive damages from the Debenture holder for improper conversion of the Unauthorized Shares.

 Fifth Equity Line of Credit

We entered, as of July 1, 2003, into a Private Equity Line Agreement (the “Fifth Equity Line Agreement”) with an investor (the “Equity Line Investor”).  Under the Fifth Equity Line Agreement, we had the right to draw up to $20,000,000 against an equity line of credit (“the Fifth Equity Line”) from the Equity Line Investor.  We were entitled under the Fifth Equity Line Agreement to draw certain funds and to put to the Equity Line Investor shares of our Class A common stock in lieu of repayment of the draw.  The number of shares to be issued was determined by dividing the amount of the draw by 90% of the average of the two lowest closing bid prices of our Class A common stock over the ten trading days after the put notice was tendered.  The Equity Line Investor is required under the Fifth Equity Line Agreement to tender the funds requested by us within two trading days after the ten-tra ding-day period used to determine the market price.  

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In connection with the Fifth Equity Line Agreement, we granted registration rights to the Equity Line Investor and filed a registration statement on Form S-2, which covered the resales of the shares to be issued under the Fifth Equity Line.

For the three months ended March 31, 2005, we issued 5,480,405 shares of Class A common stock to the Equity Line Investor in full satisfaction of an outstanding put of $668,000.

Sixth Equity Line of Credit

We entered, as of November 15, 2004, into a sixth private equity line agreement (the "Sixth Equity Line Agreement") with the Equity Line Investor, on terms substantially similar to those of the Fifth Equity Line.  Under the Fifth Equity Line Agreement, we have the right to draw up to $20,000,000 against an equity line of credit ("the Sixth Equity Line") from the Equity Line Investor.  We are entitled under the Sixth Equity Line Agreement to draw certain funds and to put to the Equity Line Investor shares of our Class A common stock in lieu of repayment of the draw.  The number of shares to be issued is determined by dividing the amount of the draw by 90% of the average of the two lowest closing bid prices of our Class A common stock over the ten trading days after the put notice is tendered.  The Equity Line Investor is required under the Sixth Equity Line Agreement to tende r the funds requested by us within two trading days after the ten-trading-day period used to determine the market price.

In connection with the Sixth Equity Line Agreement, we granted registration rights to the Equity Line Investor and filed a registration statement on Form S-2, which covered the resales of the shares to be issued under the Sixth Equity Line.  That registration statement was declared effective on January 5, 2005.

We entered into an agreement with the Equity Line Investor to terminate all previous equity lines, and cease further draws or issuances of shares in connection with all previous equity lines.  As such, as of the date of this report, the only active equity line of credit was the Sixth Equity Line.

For the three months ended March 31, 2005, we received $2,050,000 in funds and a subscription receivable of $6,000 drawn under the Sixth Equity Line, less commissions and fees of $59,000 and issued 28,320,751 shares of Class A common stock to the Equity Line Investor.  Subsequent to March 31, 2005 and through May 10, 2005, the Company received $693,000 in funds drawn under the Sixth Equity Line and issued 26,182,267 additional shares of Class A common stock to the Equity Line Investor.

Series I Convertible Preferred Stock

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

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

Following negotiations with Breckenridge, on January 29, 2004, we issued to Breckenridge 3,250 shares of 8% Series I Convertible Preferred Stock (the "Series I Preferred Stock"), for an aggregate purchase price of $3,250,000, including the Private Placement Funds which the Company had already received.  We received the proceeds from the issuance of Series I Preferred Stock in January 2004.  The Series I Preferred Stock was issued under a purchase agreement (the "Purchase Agreement") dated as of December 31, 2003.  The Series I Preferred Stock has a stated value of $1,000 per share.

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In connection with the offering of the Series I Preferred Stock, we also issued to Breckenridge warrants to purchase up to 965,839 shares of the Company’s Class A common stock at $0.50 per share through December 31, 2008, and issued 2,414,596 shares of our Class A common stock.

In connection with the issuance of the Series I Preferred Stock, we agreed to register the resale by Breckenridge of the Class A common shares issued and the Class A common shares issuable upon conversion of the Series I Preferred Stock, issuable as payment of dividends accrued on the Series I Preferred Stock and issuable upon exercise of the warrants.

Dividends on the Series I Preferred Stock are payable at the annual rate of 8% of the stated value of the shares of Series I Preferred Stock outstanding.  The dividends are payable in cash or shares of our Class A common stock, at the Company’s option.  Aggregate annual dividend requirements for the Series I Preferred Stock are $260,000.

In the event of a voluntary or involuntary liquidation, dissolution or winding up of Fonix, the funds available for distribution, after payment to creditors and then to the holders of Fonix's Series A preferred stock of their liquidation payment, but before any liquidation payments to holders of junior preferred stock or common stock, would be payable to the holders of the Series I Preferred Stock in an amount equal to the stated value of the then outstanding Series I Preferred Stock plus any unpaid accumulated dividends thereon.

The Series I Preferred Stock is convertible into shares of our Class A common stock at the lower of (i) $0.75 per share or (ii) 87.5% of the average of the two lowest closing bid prices over the twenty trading days prior to the conversion date.

In connection with the sale of the Series I Preferred Stock, we agreed to establish an escrow account (the "Escrow Account"), into which it deposits funds which can be used for our optional redemption of the Series I Preferred Stock, or which may be used by Breckenridge to require us to redeem the Series I Preferred Stock if we have defaulted under the Purchase Agreement.  We are required to deposit into the Escrow Account 25% of any amount we receive in excess of $1,000,000, calculated per put, under the terms of the Fifth Equity Line of Credit, or other similar equity line of financing arrangement.  As of March 31, 2005, we had deposited $395,000 into the Escrow Account.

In the event that there remains in the Escrow Account amounts following either (i) the conversion of all of the outstanding shares of Series I Preferred Stock, together with any accrued and unpaid dividends thereon, or (ii) redemption of all of the outstanding shares of Series I Preferred Stock, together with any accrued and unpaid dividends thereon, those remaining amounts shall be released from the Escrow Account to us.

We granted Breckenridge a first lien position on our intellectual property assets as security under the Purchase Agreement.  Breckenridge has agreed to release such lien upon the registration of our Class A common stock, as outlined above, becoming effective and our depositing $2,000,000 in the Escrow Account.

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

As of March 31, 2005, we had issued 18,490,433 shares of our Company’s Class A common stock in response to conversion requests for 1,900 shares of Series I Preferred Stock.  As of March 31, 2005, there were 1,350 shares of Series I Preferred Stock outstanding.  Subsequent to March 31, 2005 and through May 11, 2005, we issued 3,763,343 shares of our Class A common stock in conversion of 78.207 shares of Series I Preferred Stock.

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We are engaged in litigation with Breckenridge in New York Superior Court concerning our assertion that we should be allowed to offset certain claims against Breckenridge against the balance due under the Series I Preferred Stock (see Note 10 to Condensed Consolidated Financial Statements.)

Stock Options and Warrants  

 During the three months ended March 31, 2005, we granted options to employees to purchase 708,100 shares of Class A common stock.  The options have an exercise price of $0.12 per share, which was the quoted fair market value of the stock on the dates of grant.  The options granted vest over the three years following issuance.  Options expire within ten years from the date of grant if not exercised.  Using the Black-Scholes pricing model, the weighted average fair value of the employee options was $0.11 per share.  

On January 19, 2005 we entered into an option exchange program with our employees, wherein we gave eligible Fonix employees the opportunity to exchange outstanding stock options for the same number of new options to be issued at least six months and one day from the expiration of the offer.  As a result of the option exchange program, we cancelled 414,450 options to purchase shares of our Class A common stock effective February 22, 2005.  We issued a promise to grant options on August 23, 2005 to employees who elected to tender their options.  As of March 31, 2005, we had a total of 992,950 options to purchase Class A common stock outstanding.

As of March 31, 2005, we had warrants to purchase a total of 1,005,389 shares of Class A common stock outstanding that expire through 2010.

Other

We presently have no plans to purchase new research and development or office facilities.

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Outlook

Corporate Mission Statement, Strategic Goals, Financial Objectives and Growth Strategy

Mission Statement:  “Provide integrated communication products and services through innovative technologies.”

Strategic Goals:

§

Deliver innovated technologies such as Voice over Internet Protocol (“VoIP”), Broadband over Power Line (“BPL”) and switched telecommunication services with efficient and profitable revenue.

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Capitalize on LecStar’s built-in and growing customer base.

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Implement a CLEC roll-up and consolidation strategy using the LecStar platform and infrastructure.

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Integrate our speech technologies with LecStar’s product offerings to expand customer base and improve operating margins.

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Provide competitive speech solutions for mobile/wireless devices, games, telephony systems and assistive markets based on text-to-speech technologies (“TTS”) and automated speech recognition technologies (“ASR” and together with our TTS, the “Core Technologies”).

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Couple our award-winning Core Technology with the leading names in wireless devices, entertainment game platforms and telephony solutions.

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Focus on clearly measured, value-added speech-based market solutions.

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Expand awareness of our products and services by enhancing our public profile on a targeted basis.

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Enhance our competitiveness by increasing value-added solutions, portability and ease of use.

Financial Goals:

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Increase revenue and positive EBITDA based on the combination of LecStar’s revenue and our speech technology revenue.

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Deliver predictable revenue and earnings.

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Provide return on shareholder equity.

Growth Strategy:

We anticipate that we will deliver VoIP services on our own soft switch and expand our partner relationship with Duke Energy facilitating BPL.  We expect to employ a consolidation-driven growth strategy in the telecom industry using LecStar as the platform.  We also anticipate that strategic acquisitions of synergistic companies will deliver a stable revenue stream and expanded customer base.  We expect to transition our telecommunication customers and acquired customers to our VoIP and/or BPL solution.  Integration of support functions and overhead will create operational and financial efficiencies.  We further expect that the implementation of our Core Technologies by acquired synergistic companies will

§

enhance operating margins;

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improve customer service;

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minimize customer churn; and

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increase customer loyalty.

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Most speech recognition products offered by other companies are based on technologies that are largely in the public domain and represent nothing particularly “new” or creative.  Many of the Fonix speech products and Core Technologies are based on proprietary technology that is protected by patents.  Management believes our speech-enabled products provide a superior competitive alternative compared to other technologies available in the marketplace.  In addition, we believe our unique market focus for our speech-enabled Products will be a substantial differentiator.  To accomplish this objective, we intend to proceed as follows:

Substantially Increase Marketing and Sales Activities.  We intend to expand our sales through partners, OEMs, VARs, direct sales, and existing sales channels, both domestically and internationally, who will focus on the wireless and mobile device markets, telephony and server phone solutions and assistive and language learning devices.  To address global opportunities, we will continue to develop and expand our sales and marketing teams in Asia, Europe, and the United States.  

Expand Strategic Relationships.  We have a number of strategic collaboration and marketing arrangements with developers and VARs.  We intend to expand such relationships and add additional similar relationships, specifically in the wireless and mobile device markets, assistive and language learning devices and end-to-end solutions.  Further, when we are able to identify “first mover” speech-enabling applications in which we can integrate our products and Core Technologies, we intend to investigate investment opportunities so we can obtain preferred or priority collaboration rights.

Continue to Develop Standard Speech Solutions Based on the Core Technologies.  We plan to continue to invest resources in the development and acquisition of standard speech solutions and enhancements to the Core Technologies of speech-enabling technologies, developer tools, and development frameworks to maintain our competitive advantages.

As we proceed to implement our strategy and to reach our objectives, we anticipate further development of complementary technologies, added product and applications development expertise, access to market channels and additional opportunities for strategic alliances in other industry segments.  The strategy adopted by us has significant risks, and shareholders and others interested in Fonix and our Class A common stock should carefully consider the risks set forth under the heading “Certain Significant Risk Factors” in Item 1, Part I, of our Annual Report on Form 10-K for the year ended December 31, 2004.

As noted above, as of March 31, 2005, we had an accumulated deficit of $231,002,000, negative working capital of $13,121,000, accrued liabilities of $6,877,000, accounts payable $5,383,000, and accrued employee wages and other compensation of $1,311,000.  Sales of products and telecommunications services and revenue from licenses based on our technologies have not been sufficient to finance ongoing operations, although we have limited capital available under an equity line of credit.  These matters raise substantial doubt about our ability to continue as a going concern.  Our continued existence is dependent upon several factors, including our success in (1) increasing telecommunications services, license, royalty and services revenues, (2) raising sufficient additional funding, and (3) minimizing operating costs.  Until sufficient revenues are generated from operating activities, we expected to continue to fund our oper ations through the sale of our equity securities, primarily in connection with the Sixth Equity Line.  We are currently pursuing additional sources of liquidity in the form of traditional commercial credit, asset based lending, or additional sales of our equity securities to finance our ongoing operations.  Additionally, we are pursuing other types of commercial and private financing, which could involve sales of our assets or sales of one or more operating divisions.  Our sales and financial condition have been adversely affected by our reduced credit availability and lack of access to alternate financing because of our significant ongoing losses and increasing liabilities and payables.  Over the past year, we have reduced our workforce in our speech business unit by approximately 50%.  This reduction may adversely affect our ability to fill existing orders.  As we have noted in our annual report and other public filings, if additional financing is not obtained in the near futu re, we will be required to more significantly curtail our operations or seek protection under bankruptcy laws.

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Information Concerning Forward-Looking Statements

Certain of the statements contained in this report (other than the historical financial data and other statements of historical fact), including, without limitation, statements as to management’s expectations and beliefs, are forward-looking statements.  Forward-looking statements are made based upon managements’ good faith expectations and beliefs concerning future developments and their potential effect upon Fonix.  There can be no assurance that future developments will be in accordance with such expectations or that the effect of future developments on Fonix will be those anticipated by management.  Forward-looking statements can be identified by the use of words such as “believe,” “expect,” “plans,” “strategy,” “prospects,” “estimate,” “project,” “anticipate,” “intends” and other words of similar meaning in connection with a discussion of future operating or financial performance.  Many important factors could cause actual results to differ materially from management’s expectations, including:

•

unpredictable difficulties or delays in the development of new products and technologies;

•

changes in U.S. or international economic conditions, such as inflation, interest rate fluctuations, foreign exchange rate fluctuations or recessions in Fonix’s markets;

•

pricing changes to our suppliers or products or those of our competitors, and other competitive pressures on pricing and sales;

•

increased difficulties in obtaining the supplies necessary to avoid disruptions of operations at pricing levels which will not have an unduly adverse effect on results of operations;

•

labor relations;

•

integration of acquired businesses, especially integration of LecStar;

•

difficulties in obtaining or retaining the management and other human resource competencies that we need to achieve our business objectives;

•

the impact on Fonix or a subsidiary from the loss of a customer or a few customers;

•

risks generally relating to our international operations, including governmental, regulatory or political changes;

•

changes in laws or different interpretations of laws that may affect our expected effective tax rate for 2005;

•

transactions or other events affecting the need for, timing and extent of our capital expenditures; and

•

the extent to which we reduce outstanding debt.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency Exposure

To date, all of our revenues have been denominated in United States dollars and received primarily from customers in the United States.  Our exposure to foreign currency exchange rate changes has been insignificant.  We expect, however, that future product license and services revenue may also be derived from international markets and may be denominated in the currency of the applicable market.  As a result, operating results may become subject to significant fluctuations based upon changes in the exchange rate of certain currencies in relation to the U.S. dollar.  Furthermore, to the extent that we engage in international sales denominated in U.S. dollars, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in international markets.  Although we will continue to monitor our exposure to currency fluctuations, we cannot assure that exchange rate fluctuations will not adve rsely affect financial results in the future.

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Regulatory Uncertainty

In December 2004, the FCC issued final rules that effectively eliminated the requirement that incumbent local exchange companies provide us wholesale services using the unbundled network element platform (UNE-P) and established a 12-month transition plan for implementation. Beginning on March 11, 2005, we are no longer able to use the unbundled network element platform to provide service to new customers and 12 months after that date the limitation will extend to all customers. During this 12-month period, the wholesale rates that we are charged will increase by $1 per line per month. At the end of the 12-month period, we will need to service customers that are not on our own networking platform through a resale or other wholesale agreement, both of which will have significantly higher costs than servicing customers through the unbundled network platform. Finally, the company’s Interconnection Agreement, the primary wholesale contract between the compan y and its wholesale provider BellSouth Telecommunications expires on June 11, 2005 and the companies have not reached agreement on terms and conditions for the renewal of that agreement.  If a mutually acceptable agreement cannot be reached, the company may seek arbitration to determine the rates, terms and conditions for the wholesale services purchased from BellSouth. As a result of (a) significant changes to the FCC rules that previously required the incumbent local exchange companies to provide on a wholesale basis the unbundled network elements to us at cost based rates; (b) price increases established by various state public utility commissions and (c) the renegotiation of our Interconnection Agreement, the rates that we are to be charged to provide our services is expected to increase significantly in the remainder of 2005 and, are likely to continue to increase over time.

These cost increases have and will continue to lead us to increase our product pricing, which we believe inhibits our ability to add new customers and to retain existing customers. Therefore we have reduced our efforts to increase subscriber growth in markets other than those areas where we currently have or plan to deploy network facilities (Atlanta, GA and Charlotte, NC), which will require the company to target its sales and marketing expenditures around those future investments. In addition to the increases discussed above as a result of these regulatory actions, we plan to further increase our product pricing for our customers located in those areas where we do not currently have or plan to deploy network facilities. These cost increases will increase our revenue for such customers; however, it will likely adversely affect our ability to retain such customers on our service.  

Potential Impacts

LecStar seeks to structure and price its products in order to maintain gross margin as a percentage of revenue at certain targeted levels. While the control of the structure and pricing of our products assists us in mitigating risks of regulatory uncertainty that can lead to increases in network and line costs, the telecommunications industry is highly competitive and there can be no assurances that we will be able to effectively pass along any increases in wholesale network access rates in the form of higher priced products.  There are several regulatory uncertainties that could cause our network and line costs as a percentage of revenue to increase in the future, including, without limitation:

·

Determinations by the FCC, courts, or state commission(s) that make unbundled local switching and/or combinations of unbundled network elements effectively unavailable to us in some or all of our geographic service areas, requiring us to provide services in these areas through other means, including total service resale agreements with incumbent local telephone companies, purchase of special access services or network elements purchased from the Regional Bell Operating Companies at "just and reasonable" rates under Section 271 of the Telecommunications Act of 1996, in any case at significantly increased costs, or to provide services over our own switching facilities, if we are able to deploy them. The U.S. Court of Appeals for the District of Columbia, on March 2, 2004, issued an order that reversed the FCC’s Triennial Review Order in part and remanded to the FCC with instruction s to revise the Order in material ways that have the potential to make unbundled switching, other unbundled network elements and/or combinations of unbundled network elements effectively unavailable to us in some or all of our geographic service areas.

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·

Adverse changes to the current pricing methodology mandated by the FCC for use in establishing the prices charged to us by incumbent local telephone companies for the use of their unbundled network elements. The FCC’s 2003 Triennial Review Order, which was reversed in part and remanded to the FCC with instructions to revise the Order in material ways, clarified several aspects of these pricing principles related to depreciation, fill factors (i.e. network utilization) and cost of capital, which could enable incumbent local telephone companies to increase the prices for unbundled network elements. In addition, the FCC released a Notice of Proposed Rulemaking on December 15, 2003, which initiated a proceeding to consider making additional changes to its unbundled network element pricing methodology, including reforms that would base prices more on the actual network costs incurred by incumbe nt local telephone companies than on the hypothetical network costs that would be incurred when the most efficient technology is used. These changes could result in material increases in prices charged to us for unbundled network elements.

·

 Determinations by state commissions to increase prices for unbundled network elements in ongoing state cost dockets.

As a result of such current uncertainty in the regulatory environment, any or all of a variety of variables such as the pending Federal and related state regulatory and court decisions, on-going proceedings in these jurisdictions and commercial negotiations underway, could potentially result in retroactively applied liabilities and/or future increases in monthly recurring costs of services.

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Item 4.  Evaluation of Disclosure Controls and Procedures

Evaluation of Disclosure Controls and Procedures.  Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 (Exchange Act) Rules 13a-15(e) or 15d-15(e)) as of the end of the period covered by this quarterly report, have concluded that our disclosure controls and procedures are effective based on their evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15.

Changes in Internal Control Over Financial Reporting. There were no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Section 404 Assessment. Section 404 of the Sarbanes-Oxley Act of 2002 requires management’s annual review and evaluation of our internal controls, and an attestation of the effectiveness of these controls by our independent registered public accounting firm beginning with our Form 10-K for the fiscal year ending on December 31, 2006.  We are dedicating significant resources, including management time and effort, and incurring substantial costs in connection with our ongoing Section 404 assessment. We are currently documenting and testing our internal controls and considering whether any improvements are necessary for maintaining an effective control environment at our company. The evaluation of our internal controls is being conducted under the direction of our senior management. In addition, our management is regularly discussing the results of our testing and any proposed improvements to our control environment with our A udit Committee. We will continue to work to improve our controls and procedures, and to educate and train our employees on our existing controls and procedures in connection with our efforts to maintain an effective controls infrastructure at our Company.

Limitations on Effectiveness of Controls. A system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the system will meet its objectives. The design of a control system is based, in part, upon the benefits of the control system relative to its costs. Control systems can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. In addition, over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. In addition, the design of any control system is based in part upon assumptions about the likelihood of future events.

PART II - OTHER INFORMATION

Item 1.  Legal Proceedings

Grenfell Litigation - Two of our subsidiaries, LecStar Telecom, Inc., and LecStar DataNet, Inc., (the “Subsidiaries”) are among the defendants who have been sued in the Superior Court of Fulton County, State of

 Georgia, by James D. Grenfell, the former CFO of LecStar.  The suit was filed in December 2003. The plaintiff in that case alleges that he has an unpaid judgment in the amount of $1,015,000 plus interest against the former parent entities of the Subsidiaries and that the transfer of such stock and business in December 2002 was in violation of the Georgia Fraudulent Transfer statute. The plaintiff sought a preliminary injunction prior to our acquisition of the capital stock of LTEL in February 2004.  The Georgia state trial court denied the plaintiff’s motion for injunctive relief. The Plaintiff did not appeal.  Several of the defendants in the action, including the Subsidiaries, have filed a motion to dismiss the action.  As of March 28, 2005, the trial court had not ruled on that motion.  LecStar Telecom, Inc. has also intervened in the underlying action relating to the judgment and has appealed the Cour t’s order granting the judgment against the Subsidiaries’ former parents. That appeal is pending before the Georgia Court of Appeals. To the extent that we or our subsidiaries are or should become proper parties to this action, and if the appeal and the motion to dismiss are denied, we will defend vigorously against these claims.  

First Empire Complaint – One of our subsidiaries, LTEL Holding Corporation, is among the defendants who have been sued in the Superior Court of Fulton County, State of Georgia, by First Empire Corporation and Allen B. Thomas, directly and derivatively in his capacity as shareholder of LecStar Corporation.  The lawsuit was filed in July 2004.  The plaintiffs in that case allege that certain of the defendants employed fraudulent and deceptive means to acquire the assets of LecStar Corporation, which included the capital stock of the Subsidiaries, LecStar Telecom, Inc.  and LecStar Datanet, Inc.  The plaintiffs further allege that those defendants subsequently transferred the stock of the subsidiaries to LTEL Holding Ltd., which we acquired through our subsidiary LTEL Acquisition Corporation in February 2004.  The plaintiffs argue that they are entitled to recover the value that we paid for LTEL Hold ing Corporation under multiple legal theories including breaches of fiduciary duty, negligence, gross negligence, conversion, fraud and violation of the Georgia Securities Act.  Three of the employees of the Subsidiaries have also been named as defendants in the litigation.  

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We have filed an answer in the litigation and are in the process of seeking to have a default judgment which the plaintiffs obtained against us set aside.  The plaintiffs claim that they are entitled to the default judgment because we did not timely answer the complaint.  However, the complaint was not properly delivered to us in a timely fashion, which we believe is an adequate basis to have the default judgment entered against us set aside.  

We have not been involved in discovery in this litigation because the litigation is in the early stages.  Nonetheless, we believe that the claims of the plaintiffs are without merit and management intends to vigorously defend against the claims of the plaintiffs.  

The principal Series H preferred stockholder has placed 300 shares of Series H Preferred Stock in escrow for a period of 12 months from the date of acquisition as protection with respect to breaches of representations and warranties of the LTEL selling stockholders, including any liability or payment that may arise from the above mentioned legal action.  As a result of the filing of the First Empire Litigation, we have asserted a claim for breach of certain representations and warranties.  To our knowledge, the Escrow Shares have not been released.

Breckenridge Lawsuit - On May 3, 2004, we filed a lawsuit against The Breckenridge Fund, LLC (“Breckenridge”), alleging the improper transfer to and subsequent sale of shares of our common stock by Breckenridge.  That lawsuit was subsequently dismissed without prejudice and refilled in the Third Judicial District Court of Salt Lake County, Utah, on October 13, 2004 (the “Breckenridge Lawsuit”).  The complaint seeks (i) a declaratory judgment that we may set off the fair value of the Unauthorized Shares against the value we owe to Breckenridge in connection with the Series I Preferred Stock transaction, (ii) judgment against Breckenridge for the fair value of the Unauthorized Shares, and (iii) punitive damages from Breckenridge for improper conversion of the Unauthorized Shares.  We also sought and obtained a temporary restraining order against Breckenridge, prohibiting them from selling any o f our common stock, or alternatively requiring Breckenridge to deposit the proceeds of any such sales into an interest bearing account.  Breckenridge removed the case to the United States District Court for the District of Utah, which: (1) found that the state court’s temporary restraining order had expired; and (2) declined to enter its own injunction.   On March 18, 2005, the federal court dismissed the Breckenridge Lawsuit without prejudice, finding that a forum selection clause required the claims to be litigated in New York.  We intend to litigate those claims in New York.

First Series I Complaint – On November 10, 2004, Breckenridge tendered to us a conversion notice, converting 16 shares of Series I Preferred Stock into 123,971 shares of common stock.  In light of the temporary restraining order that had been issued by the state court in the Breckenridge Lawsuit, Fonix instructed its transfer agent to include on the share certificate a legend referencing the restraining order and the Breckenridge Lawsuit.   Subsequently, Breckenridge filed a complaint against us (Supreme Court of the State of New York, County of Nassau, Index No. 015822/04) in connection with the Series I Preferred Stock (the “First Series I Complaint”).  In the First Series I Complaint, Breckenridge alleges that it was improper for us to include any legends on the shares issued in connection with conversions of the Series I Preferred Stock other than those agreed to by Breckenridge in the Se ries I Preferred Stock purchase agreement (the “Series I Agreement”).  Breckenridge also seeks liquidated damages for our failure to issue shares free of the allegedly inappropriate legend.  We seek $4,000,000 in compensatory damages and $10,000,000 in punitive damages.  We have filed a motion to dismiss and intend to vigorously defend against this complaint.

Subsequent to filing the complaint, Breckenridge moved for a temporary restraining order to prevent us from issuing shares with any legend other than those agreed upon by Breckenridge in the Series I Agreement.  On November 18, 2004, at a hearing on Breckenridge’s motion, the court entered an order stating that we may not place any legend on shares issued to Breckenridge upon conversion of the Series I Preferred Stock other than those permitted under the Series I Agreement.

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The Security Agreement Complaint – On November 23, 2004, Breckenridge filed a complaint against us (Supreme Court of the State of New York, County of Nassau, Index No. 015185/04) alleging: (1) Fonix executed a Security Agreement and a Registration Rights Agreement in connection with the Series I Agreement pursuant to which it granted to Breckenridge a security interest in certain collateral, including Fonix’s intellectual property (the “Collateral”); (2) Fonix breached the Registration Rights Agreement and the Security Agreement; and (3) Breckenridge is entitled to damages totaling $585,000 and possession of the Collateral.  We have a motion to dismiss and intend to vigorously defend against this complaint.

Second Series I Complaint – On March 10, 2005, Breckenridge filed a complaint against us (Supreme Court of the State of New York, County of Nassau, Index No. 3457/05) in connection with the Series I Preferred Stock (the “Second Series I Complaint”).  In the Second Series I Complaint, Breckenridge alleges that Fonix improperly failed to honor a conversion notice it tendered to us on February 25, 2005, converting 500 shares of Series I Preferred Stock into 6,180,469 shares of common stock.  Breckenridge sought a temporary restraining order and preliminary injunction requiring Fonix to honor that conversion notice, and all subsequently tendered conversion notices.  On March 14, 2005, the Court entered a temporary restraining order directing us to honor the February 25, 2005, conversion notice, and directed Breckenridge to deposit all proceeds from the sale of the converted shares to be deposited in a n interest-bearing escrow account.  Breckenridge subsequently agreed that it would deposit the proceeds of all converted shares into the interest-bearing escrow account pending the outcome of the litigation.  We have filed a counterclaim against Breckenridge and intend to vigorously defend against the claims of Breckenridge.

We are involved in other claims and actions arising in the ordinary course of business.  In the opinion of management, after consultation with legal counsel, the ultimate disposition of these other matters will not materially affect our consolidated financial position, liquidity, or results of operations.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

During the quarter ended March 31, 2005, we issued 5,480,405 shares of our common stock under the Fifth Equity Line and 28,320,751 shares of our common stock under the Sixth Equity Line to the Equity Line Investor.  We issued 10,054,561 shares of our common stock in connection with conversions of our Series I Preferred stock to Breckenridge.  Subsequent to March 31, 2005 and through the date of this report, we issued 26,182,267 shares of our common stock under the Sixth Equity Line and 3,763,343 shares of our common stock in conversion of 78.207 shares of Series I Preferred Stock.  The shares of common stock were issued without registration under the 1933 Act in reliance on Section 4(2) of the 1933 Act and the rules and regulations promulgated thereunder.  The resales of the shares were subsequently registered under registration statements on Form S-2.  The proceeds from the Fifth and Sixth Equity Line transactions were used for work ing capital.

Item 6.  Exhibits

a.

Exhibits: The following Exhibits are filed with this Form 10-Q pursuant to Item 601(a) of Regulation S-K:

Exhibit No.

Description of Exhibit

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SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Fonix Corporation

Date: May 13, 2005

/s/ Roger D. Dudley                       

Roger D. Dudley, Executive Vice President,

Chief Financial Officer

(Principal financial officer)

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