Item 1. Business

General

Internet America is an Internet service provider (“ISP”) that provides a wide array of Internet services tailored to meet the needs of individual and business subscribers. As of June 30, 2004, we served approximately 58,000 active subscribers. Internet America was incorporated in Texas in 1995 and currently has operations in Texas. Our new growth strategy is to expand Internet America’s customer base by acquiring dialup ISPs in markets surrounding our major market cities. Additionally we intend to gain new customers and improve retention of existing customers through improved marketing, increased broadband service availability and the introduction of new value-added services.

Elements of our growth strategy include:

Development of Value-Added Revenue Streams. We continue to develop value-added revenue streams such as dedicated broadband connectivity, news access and Web hosting. In addition, we continue to evaluate other value-added service opportunities such as Internet telephony. We believe that a user dense, regional customer base provides an excellent platform for the introduction of new value-added services, taking advantage of existing brand awareness and economies of scale.

Cost-Effective Development of Network Infrastructure. We deploy network infrastructure in a disciplined manner to achieve substantial economies of scope and scale. We have been consolidating our Texas operations and have realized substantial efficiencies from this consolidation. With our “Virtual POP” architecture, we can provide local access services quickly and efficiently without investing in additional physical infrastructure. See “— Infrastructure,” below.

Creative Use of Advertising to Maintain the Internet America Brand. We have used primarily outdoor billboard, radio and print media advertising. We are currently developing marketing using these media and new ones in more rural markets.

See Item 6, Selected Consolidated Financial Data contained in Part II to this report on Form 10-K for comparative information regarding, among other things, revenue, net income (loss) and total assets.

Services

We offer Internet services tailored to meet the needs of both individual and business subscribers. Our primary service offerings are broadband and dial-up Internet access, as well as related value-added services. For our business subscribers, we offer dedicated high speed Internet access, Web hosting, co-location and other business related services. Our services are offered in several different packages to provide subscribers a broad range of choices to satisfy their Internet needs. The majority of our consumer subscribers have month-to-month subscriptions and the majority of our business customers are under service contracts for a term. We bill most consumer subscribers through automatic charges to their credit cards or bank accounts, and we bill most of our business customers by monthly invoices. We offer discounts on almost all of our services for subscribers who prepay for a longer term.

High Speed Connectivity; DSL Services. We offer broadband connectivity for business and consumers, including 64k/128k Integrated Service Digital Network (ISDN) access, 1.5M Asymmetrical Digital Subscriber Lines (ADSL), fractional to full T-1, DS-3 level connectivity and wireless connectivity. Our DSL products provide high-speed Internet access over existing telephone lines, and may allow subscribers to simultaneously use a single telephone line for voice service and for access to the Internet. DSL provides an “always on” connection thereby removing wait times associated with dialing into a network. The DSL products offer our residential and business subscribers a cost-effective way to substantially increase the speed at which they access the Internet.

Dial-Up Internet Access. Our most popular dial-up Internet access package includes basic Internet access and related

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Internet applications such as World Wide Web browsing, e-mail, file transfer protocol (FTP), and USENET news access. Available value-added services include multiple e-mail mailboxes, national roaming services, personalized e-mail addresses, personal Web sites and enhanced USENET news access.

USENET. Our Airnews.net product provides access to Internet America’s newsgroup services for subscribers of other Internet services and on a wholesale basis to other businesses or ISPs.

Web Services. We offer Web hosting through our Airweb.net service for businesses and other organizations that wish to create their own World Wide Web sites without maintaining their own Web servers and high-speed Internet connections. Web hosting subscribers are responsible for building their own Web sites and then uploading the pages to an Internet America server. This Web hosting service features state-of-the-art servers for high speed and reliability, a high quality connection to the Internet, specialized customer support and advanced services features, such as secure transactions and site usage reports.

Customer Care

Our goal of 100% customer satisfaction begins with providing superior systems and network performance. We focus on scalability, reliability and speed in the technical design and maintenance of our systems. In addition to the provision of superior systems and network performance, we emphasize high quality customer care and technical support. We strive to retain our subscribers by prompt response to customer problems via telephone, email and newsgroups.

Individuals accessing the Internet have many different operating system, hardware and network configurations, coupled with varying levels of computer sophistication. Consequently, our customer care department must be able to efficiently and effectively address:

We had approximately 49 customer care employees at June 30, 2004. Customer care is available to subscribers 24-hours-a-day, 7-days-a-week. The customer care department is organized in tiers designed to respond to varying types of support needs. In addition to diagnosing and resolving subscribers’ technical problems, our customer care department answers questions about account status and billing information, provisions new product requests and provides configuration information.

We maintain a comprehensive description of our customer care services on our Web site, as well as troubleshooting tips and configuration information. Additionally, we offer our subscribers free educational classes, which are held monthly in our Dallas office. Subscribers can also obtain recorded system and network status reports at any time and review extensive system and network performance on the World Wide Web.

Marketing

Our marketing strategy is to differentiate our offerings along three major axes: 1. Service Availability; 2. Product differentiation, and; 3. Unique, creative advertising and execution.

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To date in 2004, Internet America has successfully deployed several new products and services to enhance our portfolio and to increase customer loyalty.

Fax-2-Email – This provides our customers the ability to receive faxes directly in their email inbox. We offer two versions of the service, one with a limit of 50 received faxes and another with unlimited usage. The product has been well received in the marketplace as we have added over 650 customers in just the first 9 months of service.

Family Safe – In keeping with our view of providing our customers a safe Internet experience, we launched a new product called Family Safe which offers customers a specialized software package to customize restrictions of access to certain websites and also to track the viewing habits of others who might abuse the use of the Internet

@Backup – In 2004 Internet America partnered with @Backup to develop a new online storage solution for our customers. The product was released in early summer and has seen many customers utilize the new online storage solution to better manage their need to safely backup their data. Our @Backup solution is simple, cost effective and allows a customer to set-it-and-forget-it.

WAP Mail – In 2004 we released a tool to allow our customers to receive their email messages using any web enabled browser that is currently available via most cellular telephones. By using this browser, customers are able to check their email messages and also respond or send new messages, all from their cellular phone. This service is free to all Internet America customers.

Air Fetch – Also in 2004, we developed and implemented a new service called Air Fetch to enable our customers to check their non-Internet America email accounts from a local Internet America website, to provide better management of all of a customer’s email accounts. An example would be if a customer had abc@ev1.net and abc@airmail.net , by signing up with the Air fetch service from Internet America, a customer could check all of their email accounts in one place using Air Fetch. Because of the nature of these products, there can be no assurance that all of these products will generate significant revenue for the Company in the future.

We are developing several exciting new products for our portfolio that will further enhance the customer value delivered for Internet America subscribers.

Future anticipated products include the following:

Voice over Internet Protocol (VOIP) – A new service in the marketplace that is quickly gaining acceptance with the likes of AT&T, Time Warner Cable, and several other communications companies. Internet America plans to launch a VOIP offering in the very near future. Our standalone VOIP product will be a competitive phone offering and will provide us the ability to create new bundles of services for our customers.

FAX America – Capitalizing on the successful roll out in early 2004 of Fax delivery directly to a customer’s inbox, later this year we will roll out a new FAX SEND and RECEIVE product that will be branded with the FAX America name. FAX America will allow us to enhance the current RECEIVE only service by adding SEND capabilities. Our product will not only be versatile in its functionality but also be very price competitive allowing us to aggressively market FAX America to our customers.

Family Mail America – Playing upon the idea that we are a net-enabled Internet service provider and furthering the idea that our products are customizable to the market, we are rolling out a new personalized email service called Family Mail America. This product will allow a customer to have their own EMAIL domain i.e. thejonesfamily.com and assign as many names as they wish to the email to personalize their Internet mail experience.

Expanded DSL coverage – With the increase in broadband adoption in the marketplace and with Internet America continuing to expand our product set to better serve the high-speed broadband marketplace, we will continue to look for new ways to expand our DSL offering and to further our footprint in the market. We are looking at new partnerships that will facilitate this need and allow us to better serve the markets we operate in.

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Broadband over Powerline (BPL ) – Internet America is exploring a new technology on the horizon called Broadband over Powerline to help provide expanded broadband coverage to customers. BPL is a technology that allows a customer to easily plug in a modem into their electrical outlet and receive high-speed Internet. While still in the development phase, Internet America is beginning to work on testing such a service and hopes to create a total product solution in the next 3 – 6 months that will allow us expand our broadband options.

Wi-Fi – Internet America is moving into the Wireless Internet Access marketplace in rural markets and testing new Wireless solutions that should provide wireless internet connectivity at very competitive prices in high density markets. Our desire is to find a new way to offer the 802.11 and other wireless technologies in selected markets. Our first launch of a high density market is slated for late 2004.

Our advertising strategy relies on the utilization of several different mediums for customer acquisition activity, including but not limited to, Radio, Outdoor, Paid Search on Search Engine portals such as Yahoo and Google, paid on-line banner advertising on technology focused websites, print communications, and others. The number and type of mediums rotates on a regular basis and we anticipate that will continue to be the case as work to improve the efficiencies in our advertising communications strategy.

Infrastructure

Our network provides subscribers with local dial-up and broadband (DSL) access in all major metropolitan areas of Texas, as well as dial-up access in many tier 2 and tier 3 cities. Our systems and network infrastructure are designed to provide reliability and speed. Reliability is achieved through redundancy in mission critical systems that minimize the number of single points of failure. Speed is achieved through clustered systems, diverse network architecture, multi-peered Internet backbone connections and aggressive load balancing.

Physical and Virtual POPs. Subscribers dial a local phone number and connect to one of our points of presence (POPs), consisting of inbound telephone lines, modems and related computer equipment. The POPs are either facilities owned by Internet America or “Virtual POPs” owned by telecommunication companies. Virtual POP architecture allows us to provide local access services without deploying additional physical infrastructure. The Virtual POP architecture enables subscribers to dial a local phone number and connect to a modem owned and housed by a telecommunications provider. The subscriber’s data call is then routed across leased lines to our internal network. Unlike simply leasing network capacity from a third-party provider, the Virtual POP architecture allows us to maintain substantial control over quality of service and capacity. The benefits of this architecture include substantially reduced capital expenditures and reduced exposure to technological obsolescence. In addition, when entering new markets, the Virtual POP architecture allows us to more precisely match capacity needs to actual sales in that market.

Internal Network Infrastructure. Subscribers enter our network from either the physical POP or Virtual POP. Our primary internal network is designed to maximize sustained high-speed traffic and provide both resiliency to failure and redundancy. Our facilities are powered by a computer controlled uninterruptible power supply that provides battery backup, surge protection and power conditioning. Automatic onsite diesel generators provide power for prolonged power outages.

We also maintain a Network Operations Control Center (“NOCC”) in Dallas, which is staffed 24 hours a day. The NOCC is responsible for monitoring the status of all networking facilities, components, applications and equipment deployed throughout our infrastructure. The NOCC is responsible for operational communications among internal departments and is also responsible for communication with external service providers. Sophisticated historical and statistical analysis software used in the NOCC provides data about the quality of service most subscribers are experiencing, as well as information to help control costs by purchasing additional bandwidth and services only when needed.

We maintain our applications on a variety of systems from a number of vendors. The major applications, such as e-mail and newsgroup access services, utilize a network of servers which are connected directly to our network backbone through high-availability network routers. We deploy PC style hardware in clusters for distributing the load of other applications and providing fault-tolerance against application failure. These distributed applications are housed on low cost, easily obtainable components with minimal interdependency.

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Management Information Systems. Our MIS department uses a near real-time customer database, billing and flow-through fulfillment system (“CMS”) to handle all customer contact and billing information for the services we provide. CMS maintains access controls for the authentication servers and various applications. The system also creates customer invoices and automatically processes credit card charges and automatic check handling. During the year ended June 30, 2004, our MIS department successfully migrated our PDQ subsidiary and our NeoSoft subsidiary database management systems to CMS. We are also enhancing CMS to automate many additional functions and provide improved financial, marketing and management reporting.

Technology and Development

Although we do not focus a material amount of resources on creating new technologies, we continuously evaluate new technologies and applications for possible introduction or incorporation into our services. High-speed connectivity is essential to the commercially viable deployment of new, value-added services such as Internet telephony, particularly VoIP, video and audio programming distribution and other high-bandwidth, low-latency applications. We believe that we are well positioned to efficiently market and deploy our broadband products and other new, value-added services due to the high density of our subscriber base.

Proprietary Rights

General. We believe that our success is more dependent upon technical, marketing and customer service expertise than upon our proprietary rights. However, our success and ability to compete are dependent in part upon proprietary rights. We primarily rely on copyright and trademark laws. “Internet America,” the Internet America logo, “1-800-Be-A-Geek,” “PDQ.Net,” “ExpressLane DSL,” “Airmail.net,” “Airnews.net,” “Airscreen.net” and “Airweb.net” are registered service marks of Internet America or its subsidiaries.

There can be no assurance that the steps we take will be adequate to prevent the misappropriation of our technology or that our competitors will not independently develop technologies and services that are substantially equivalent or superior to ours.

Competition

The Internet services market is extremely competitive. There are no substantial barriers to entry, and we expect that competition will continue to intensify. We believe that the primary competitive factors determining success in this market include pricing, access speed, a reputation for reliability and service, effective customer support, and access to capital. Our current and prospective competitors include many large companies that have substantially greater market presence and financial, technical, marketing and other resources than we have. Increased competition for users of Internet services may result in lower subscriber growth rates or continued subscriber loss. Competitors may charge less than we do, causing us to reduce or preventing us from raising our fees. As a result, our business and revenues may suffer. We currently compete or expect to compete with the following types of Internet access providers:

The market for broadband services is extremely competitive. The markets we serve have been flooded with DSL, cable and wireless offers from our competitors, some of which have greater resources than we have and are able to offer their products at lower prices than we offer. We have to rely on local loop providers with which we compete to provide DSL services to our customers. These providers have been exerting pressure on independent ISPs, including raising prices and changing billing relationships, all of which puts us at a competitive disadvantage. Many local loop providers have consolidated or failed, causing fewer choices for us to offer to our customers. Furthermore, other methods of broadband delivery which we do not currently offer, such as cable or wireless transmission, may be more successful than DSL.

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We expect to continue to experience competition from numerous telecommunications providers, including the traditional telecommunications carriers, local exchange carriers and traditional long-distance companies, many of which have greater coverage and market presence, as well as substantial financial, technical and marketing resources. These telecommunications providers may have the ability to bundle Internet access with basic voice services, which may make it difficult for us to compete effectively. We also face competition from companies that provide connections to consumers’ homes, including national and regional telecommunications providers, cable companies, electric utility companies and terrestrial and satellite wireless communications companies. For example, cable television operators offer Internet access through their cable facilities at significantly faster rates than existing analog modem speeds. These companies include Internet access in the basic bundle of services, or offer such access for a nominal additional charge, and could prevent us from delivering Internet access through wire and cable connections owned by these competitors.

Our competition is likely to continue increasing, especially as diversified telecommunications and media companies begin providing Internet services, ISPs consolidate into larger more competitive companies and new competitors enter the Internet services market. The ability of these competitors or others to enter into business combinations, strategic alliances or joint ventures or to bundle services and products with Internet access could put us at a significant competitive disadvantage.

Government Regulation

We are not currently subject to direct regulation by the Federal Communications Commission or any other agency, other than regulations applicable to businesses and public companies generally. The FCC classifies Internet access providers as “information service providers” rather than regulated “telecommunications providers” under the 1996 Telecommunications Act. As such, we are not subject to regulations that apply to telephone companies and similar carriers. However, we provide Internet access through transmissions over public telephone lines, which transmissions are governed by regulations and policies of the FCC establishing charges, terms and conditions. Changes in the FCC’s policies relating to the classification of telecommunications services and information services could have a material adverse effect on our business. If we became classified as a provider of telecommunications services, regulations could affect the charges we pay to connect to the local telephone network, could impede our ability to compete for broadband customers and could cause us to have to increase prices for our services.

For example, Internet access providers currently are not required to pay carrier access charges. If Internet communications become regulated by the FCC in the same manner as traditional telecommunications services, access fees similar to those paid by long distance telephone carriers could be imposed on Internet access providers. Access fees could increase the cost of the Internet to users, most of whom currently enjoy unlimited, flat-fee usage. This in turn could slow the growth of the Internet and cause an adverse effect on our business. The FCC also does not currently require ISPs to contribute to the Universal Service Fund (although most telecommunications providers charge these fees to their customers, including us). Telecommunications carriers are actively seeking reconsideration or reversal of the FCC decisions regarding universal service as well as carrier access fees. In addition, a reclassification of Internet services as telecommunications services would jeopardize Internet access providers’ current right to nondiscriminatory access to the telephone lines owned by incumbent local telephone companies for use for broadband services. We cannot predict the outcome of FCC proceedings or other federal legislation, but if adopted, these and other regulatory actions could have a material adverse effect on our business, financial condition and results of operation. Finally, any change in the FCC’s policy of not regulating Internet access providers may cause states to regulate aspects of our business as telecommunications services.

The FCC also does not currently regulate the use of cable infrastructure for Internet access as a telecommunications service or cable service. This classification will likely protect cable modem service providers from regulation, including regulations requiring open access to cable infrastructure. Although some cable operators are voluntarily providing access to competing service providers, the FCC’s classifications decrease our potential to provide Internet access services via the cable television infrastructure.

Due to the increasing popularity and use of the Internet, it is possible that additional laws, regulations, or legal precedent may be adopted with respect to the Internet, covering issues such as content, privacy, pricing, unsolicited email, encryption standards, consumer protection, electronic commerce, taxation, copyright infringement and other intellectual property issues. We cannot predict the impact, if any, that any future legal or regulatory changes or developments may have on our business, financial condition and results of operations. Changes in the legal or regulatory environment relating to the Internet access industry, including changes that directly or indirectly affect telecommunication costs or increase the likelihood or scope of competition from regional telephone companies, cable operators or others, could have a material adverse effect on our business, financial condition and results of operations.

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Employees

As of June 30, 2004, we employed approximately 87 people, almost all of whom are full-time employees. None of our current employees are represented by a labor organization, and we consider employee relations to be good.

William E. Ladin, Jr. Mr. Ladin became CEO and Chairman of the Board of Directors in September 2003 after serving as Vice Chairman of the Board since January 2000. He joined us in connection with our acquisition of PDQ.Net, a Houston-based Internet service provider that Mr. Ladin formed in 1997. Mr. Ladin served as chief executive officer of PDQ.Net until its acquisition by Internet America. Ladin was instrumental in growing PDQ.Net into Houston’s largest independent Internet service provider, known for providing quality connectivity at an affordable price. Prior to forming PDQ.Net, Ladin was a successful entrepreneur having been involved with founding and/or operating a number of publicly held companies, including The ForeFront Group, a Houston based Internet company; ComputerCraft, a chain of micro-computer retail stores that grew to 65 stores during his management; Mobil Communications Corporation, known as MobilCom, a national paging company that was sold to Bell South in 1988; Lifemark, a hospital company that merged with AMI in 1984; and First of Texas Incorporated, a Houston based investment banking firm.

David E. Allard joined us in April 2003 as Executive Vice President - Strategic Implementation. Mr. Allard previously was employed by Primedia Workplace Learning, where as Chief Operating Officer, he created and managed new products and strategies to increase revenue and profitability. As Executive Vice President and Chief Financial Officer of E-Train from 1997 to 2000, Mr. Allard administered major business combinations and developed a business turnaround plan to create significant savings. From 1992 to 1996, Mr. Allard was Senior Vice President – Business Development of Westcott Communications, Inc., where he managed product lines and business combinations. Mr. Allard is a certified public accountant and a former partner of Farmer and Allard, P.C.