##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, DC 20549
 FORM 10-Q
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2007
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the transition period from  to  .
 Commission file number: 001-32588
 COVAD COMMUNICATIONS GROUP, INC.
  Delaware
    
    77-0461529(State or other jurisdiction
    
    (I.R.S. Employerof incorporation or organization)
    
    Identification Number)110 Rio RoblesSan Jose, California(Address of principal executive
    
    95134offices)
    
    (Zip Code)
 (408) 952-6400  (Registrants telephone number, including area code)
 þ o
  o þ o
 o þ
 APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS:
 o o




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##### 



COVAD COMMUNICATIONS GROUP, INC.
 For the Quarterly Period Ended March 31, 2007
 TABLE OF CONTENTS
 PagePART I. FINANCIAL INFORMATIONITEM 1. Financial Statements
    
    
    2Condensed Consolidated Balance Sheets
    
    
    2Condensed Consolidated Statements of Operations
    
    
    3Condensed Consolidated Statements of Cash Flows
    
    
    4Notes to Condensed Consolidated Financial Statements
    
    
    5ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    22ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    38ITEM 4. Controls and Procedures
    
    
    38PART II. OTHER INFORMATIONITEM 1. Legal ProceedingsITEM 1A. Risk Factors
    
    
    39ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    40ITEM 3. Defaults Upon Senior Securities
    
    
    53ITEM 4. Submission of Matters to a Vote of Security Holders
    
    
    53ITEM 5. Other Information
    
    
    53ITEM 6. Exhibits
    
    
    53SIGNATURES
    
    
    54EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  1




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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 ITEM 1. Financial Statements
 COVAD COMMUNICATIONS GROUP, INC.
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (All dollar and share amounts are presented in thousands, except par value)
 (Unaudited)
 March 31,
    
    
    December 31,2007
    
    
    2006(Note 1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    34,979
    
    
    $
    46,279Short-term investments in debt securities
    
    
    19,983
    
    
    
    15,793Restricted cash and cash equivalents
    
    
    17,176
    
    
    
    19,578Accounts receivable, net
    
    
    31,145
    
    
    
    31,151Unbilled revenues
    
    
    3,620
    
    
    
    2,567Inventories
    
    
    3,519
    
    
    
    3,602Prepaid expenses and other current assets
    
    
    5,092
    
    
    
    4,979Total current assets
    
    
    115,514
    
    
    
    123,949Property and equipment, net
    
    
    82,722
    
    
    
    87,586Collocation fees and other intangible assets, net
    
    
    20,711
    
    
    
    22,768Goodwill
    
    
    50,002
    
    
    
    50,002Deferred costs of service activation
    
    
    24,938
    
    
    
    24,268Deferred debt issuance costs, net
    
    
    3,363
    
    
    
    3,823Other long-term assets
    
    
    2,342
    
    
    
    912Total assets
    
    $
    299,592
    
    
    $
    313,308LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)Current liabilities:Accounts payable
    
    $
    32,609
    
    
    $
    34,189Accrued compensation
    
    
    12,116
    
    
    
    14,539Accrued collocation and network service fees
    
    
    16,959
    
    
    
    15,594Accrued transaction-based taxes
    
    
    7,754
    
    
    
    7,754Collateralized and other customer deposits
    
    
    5,263
    
    
    
    5,585Unearned revenues
    
    
    6,185
    
    
    
    6,528Loan payable to bank
    
    
    6,100
    
    
    
    6,100Other accrued liabilities
    
    
    10,182
    
    
    
    11,381Total current liabilities
    
    
    97,168
    
    
    
    101,670Long-term debt
    
    
    169,774
    
    
    
    167,240Unearned revenues
    
    
    39,409
    
    
    
    39,506Other long-term liabilities
    
    
    4,924
    
    
    
    2,538Total liabilities
    
    
    311,275
    
    
    
    310,954Commitments and contingencies (Notes 5 and 6)Stockholders equity (deficit):Preferred stock, $0.001 par value; 5,000 shares
authorized; no shares issued and outstanding at March
31, 2007 and December 31, 2006
    
    
    
    
    
    
    Common stock, $0.001 par value; 590,000 shares
authorized; 296,944 shares issued and outstanding at
March 31, 2007 (296,877 shares issued and outstanding
at December 31, 2006)
    
    
    297
    
    
    
    297Common stock  Class B, $0.001 par value; 10,000
shares authorized; no shares issued and outstanding at
March 31, 2007 and December 31, 2006
    
    
    
    
    
    
    Additional paid-in capital
    
    
    1,734,602
    
    
    
    1,734,124Accumulated other comprehensive income
    
    
    4
    
    
    
    3Accumulated deficit
    
    
    (1,746,586
    )
    
    
    (1,732,070
    )Total stockholders equity (deficit)
    
    
    (11,683
    )
    
    
    2,354Total liabilities and stockholders equity (deficit)
    
    $
    299,592
    
    
    $
    313,308
  2




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COVAD COMMUNICATIONS GROUP, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (All dollar and share amounts are presented in thousands, except per share amounts)
 (Unaudited)
 Three months ended March 31,2007
    
    
    2006Revenues, net
    
    $
    120,150
    
    
    $
    117,751Operating expenses:Cost of sales (exclusive of depreciation and amortization)
    
    
    87,995
    
    
    
    79,937Selling, general and administrative
    
    
    31,334
    
    
    
    34,965Depreciation and amortization of property and equipment
    
    
    11,010
    
    
    
    8,648Amortization of collocation fees and other intangible assets
    
    
    2,349
    
    
    
    2,400Provision for restructuring and post-employment benefits
    
    
    
    
    
    
    763Total operating expenses
    
    
    132,688
    
    
    
    126,713Loss from operations
    
    
    (12,538
    )
    
    
    (8,962
    )Other income (expense):Interest income
    
    
    816
    
    
    
    977Interest expense
    
    
    (2,829
    )
    
    
    (1,322
    )Miscellaneous income, net
    
    
    35
    
    
    
    27Other expense, net
    
    
    (1,978
    )
    
    
    (318
    )Net loss
    
    $
    (14,516
    )
    
    $
    (9,280
    )Basic and diluted net loss per share
    
    $
    (0.05
    )
    
    $
    (0.03
    )Weighted-average number of common shares outstanding used in
computing basic and diluted per share amounts
    
    
    296,926
    
    
    
    276,488
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COVAD COMMUNICATIONS GROUP, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (All dollar amounts are presented in thousands)
 (Unaudited)
 Three months ended March 31,2007
    
    
    2006Operating Activities:Net loss
    
    $
    (14,516
    )
    
    $
    (9,280
    )Adjustments to reconcile net loss to net cash provided by (used in) operating
activities:Provision for bad debts, net
    
    
    215
    
    
    
    59Depreciation and amortization
    
    
    13,359
    
    
    
    11,048(Gain) loss on disposition of property and equipment
    
    
    8
    
    
    
    (2
    )Stock-based compensation expense
    
    
    431
    
    
    
    681Amortization of deferred customer incentives
    
    
    190
    
    
    
    189Amortization of deferred debt issuance costs
    
    
    460
    
    
    
    284Accretion of interest on investments, net
    
    
    (86
    )
    
    
    (86
    )Net changes in operating assets and liabilities, net of assets acquired and
liabilities assumed in acquisitions:Accounts receivable
    
    
    (209
    )
    
    
    (1,282
    )Unbilled revenues
    
    
    (1,053
    )
    
    
    (614
    )Inventories
    
    
    83
    
    
    
    1,124Prepaid expenses and other current assets
    
    
    (113
    )
    
    
    (1,725
    )Deferred costs of service activation
    
    
    (670
    )
    
    
    922Other long-term assets
    
    
    (1,627
    )
    
    
    Accounts payable
    
    
    1,496
    
    
    
    4,278Collateralized and other customer deposits
    
    
    (322
    )
    
    
    (6,176
    )Other liabilities
    
    
    3,008
    
    
    
    206Unearned revenues
    
    
    (440
    )
    
    
    (3,760
    )Net cash provided by (used in) operating activities
    
    
    214
    
    
    
    (4,134
    )Investing Activities:Restricted cash and cash equivalents, net
    
    
    2,402
    
    
    
    (49,807
    )Purchase of short-term investments in debt securities
    
    
    (11,553
    )
    
    
    (6,176
    )Maturities of short-term investments in debt securities
    
    
    7,450
    
    
    
    12,250Purchase of property and equipment
    
    
    (9,230
    )
    
    
    (3,423
    )Proceeds from sale of property and equipment
    
    
    
    
    
    
    2Payment of collocation fees and purchase of other intangible assets
    
    
    (292
    )
    
    
    (329
    )Payment in connection with business and asset acquisitions, net of cash acquired
    
    
    (177
    )
    
    
    (3,187
    )Other long-term assets
    
    
    7
    
    
    
    (136
    )Net cash used in investing activities
    
    
    (11,393
    )
    
    
    (50,806
    )Financing Activities:Proceeds from the issuance of senior secured note, net of issuance costs
    
    
    
    
    
    
    38,469Proceeds from utilization of credit facility
    
    
    6,100
    
    
    
    Principal payments on credit facility
    
    
    (6,100
    )
    
    
    Principal payment of long-term debt
    
    
    
    
    
    
    (17
    )Principal payments under capital lease obligations
    
    
    (168
    )
    
    
    (159
    )Proceeds from the issuance of common stock, net of issuance costs
    
    
    47
    
    
    
    11,112Net cash provided by (used in) financing activities
    
    
    (121
    )
    
    
    49,405Net decrease in cash and cash equivalents
    
    
    (11,300
    )
    
    
    (5,535
    )Cash and cash equivalents at beginning of period
    
    
    46,279
    
    
    
    84,291Cash and cash equivalents at end of period
    
    $
    34,979
    
    
    $
    78,756Supplemental Disclosures of Cash Flow Information:Cash paid during the period for interest
    
    $
    1,957
    
    
    $
    1,905Supplemental Schedule of Non-Cash Investing and Financing Activities:Interest obligation settled with the issuance of additional convertible
long-term notes
    
    $
    2,534
    
    
    $
    Equipment purchased through capital leases
    
    $
    1,201
    
    
    $
    Common stock issued for acquisition of business
    
    $
    
    
    
    $
    16,314Unpaid equipment purchases
    
    $
    4,298
    
    
    $
    3,097
  4




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COVAD COMMUNICATIONS GROUP, INC.
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (All dollar and share amounts are presented in thousands, except per share amounts)
 (Unaudited)
 1. Basis of Presentation and Summary of Significant Accounting Policies
   Long-Term Debt,
   Use of Estimates
  5




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Restricted Cash and Cash Equivalents
 Long-Term Debt.
 Inventories
  Goodwill
   Business Acquisition.
  6




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Collateralized and Other Customer Deposit s
  Revenue Recognition
 Post-Employment Benefits
  Net Loss Per Share
   7




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Three months ended March 31,2007
    
    
    2006Weighted-average shares of common stock outstanding
    
    
    296,926
    
    
    
    276,498Less weighted-average shares of common stock subject to
repurchase
    
    
    
    
    
    
    10Weighted-average common shares used in computing basic
and dilutive net loss per share amounts
    
    
    296,926
    
    
    
    276,488
   Three months ended March 31,2007
    
    2006Stock options
    
    
    25,746
    
    
    
    25,123Options under employee stock purchase plan
    
    
    1,005
    
    
    
    1,598Warrants
    
    
    6,514
    
    
    
    6,514Common shares issuable under the assumed
conversion of convertible debentures and
notes
    
    
    63,452
    
    
    
    60,885
 Comprehensive Loss
  Three months ended March 31,2007
    
    
    2006Net loss
    
    $
    (14,516
    )
    
    $
    (9,280
    )Unrealized gains on available-for-sale securities
    
    
    1
    
    
    
    7Comprehensive loss
    
    $
    (14,515
    )
    
    $
    (9,273
    )
 Recent Accounting Pronouncements
 Fair Value Measurements.
 How Taxes Collected from Customers and Remitted to Governmental Authorities should be presented in
the Income Statement.
 8




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Disclosure of Accounting Policies.
 Accounting for Uncertainty in Income
Taxes Accounting for Income Taxes.
 Risks and Uncertainties
  
    
    changes in government policy, regulation and enforcement or adverse judicial or
administrative interpretations and rulings or legislative action including, but not limited
to, changes that affect the continued availability of the unbundled network elements of the
local exchange carriers networks and the costs associated therewith;
    
    the Companys dependence on the availability and functionality of the networks of the
incumbent local exchange carriers;
    
    ability to generate cash flows or obtain adequate financing;
    
    increased price competition in local and long distance services, including bundled
services, and overall competition within the telecommunications industry; and
    
    adverse determinations in certain litigation matters.
  2. Revenue Recognition
  9




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March 31, 2007
    
    
    December 31, 2006Gross accounts receivable
    
    $
    34,363
    
    
    $
    34,123Allowance for service credits
    
    
    (2,796
    )
    
    
    (2,729
    )Allowance for bad debt
    
    
    (422
    )
    
    
    (243
    )Accounts receivable, net
    
    $
    31,145
    
    
    $
    31,151
 Significant Customers
   10




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Wholesaler Financial Difficulties
   3. Warrants
   11




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4. Restructuring and Post-Employment Benefits
 Reduction in Force
  5. Long-Term Debt
 12% Senior Secured Convertible Notes
    12




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3% Convertible Senior Debentures
  Line of Credit
   13




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Subsequent
Events
 6. Commitments and Contingencies
 Litigation
      14




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Other Contingencies
 .
   15




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Indemnification Agreements
   7. Stock-Based Compensation
     16




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Stock Options
    
    Employee Stock Purchase PlanThree months ended March 31,
    
    Three months ended March 31,2007
    
    2006
    
    2007
    
    2006Expected life of options in years
    
    
    3.5
    
    
    
    3.5
    
    
    
    0.5
    
    
    
    0.5Volatility
    
    
    68.80
    %
    
    
    86.80
    %
    
    
    52.30
    %
    
    
    77.30
    %Risk-free interest rate
    
    
    4.51
    %
    
    
    4.69
    %
    
    
    5.08
    %
    
    
    4.80
    %Expected dividend yield
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
  Number of Shares of
    
    
    Option Price per
    
    
    Weighted-AverageCommon Stock
    
    
    Share
    
    
    Exercise PriceBalance as of December 31, 2006
    
    
    23,082
    
    
    $
    0.350 - $149.79
    
    
    $
    4.31Granted
    
    
    3,341
    
    
    $
    1.190 -   $1.360
    
    
    $
    1.20Exercised
    
    
    (67
    )
    
    $
    0.560 -   $1.280
    
    
    $
    0.71Cancelled, expired and forfeited
    
    
    (610
    )
    
    $
    0.360 - $63.333
    
    
    $
    5.12Balance as of March 31, 2007
    
    
    25,746
    
    
    $
    0.350 - $149.79
    
    
    $
    3.90
 8. Business Segments
    17




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Total
    
    Corporate
    
    ConsolidatedAs of and for the three months ended March 31, 2007:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    TotalRevenues, net
    
    $
    76,751
    
    
    $
    43,399
    
    
    $
    120,150
    
    
    $
    
    
    
    $
    120,150Cost of sales (exclusive of depreciation and
amortization)
    
    
    47,600
    
    
    
    25,900
    
    
    
    73,500
    
    
    
    14,495
    
    
    
    87,995Selling, general and administrative
    
    
    2,062
    
    
    
    8,780
    
    
    
    10,842
    
    
    
    20,492
    
    
    
    31,334Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,359
    
    
    
    13,359Income (loss) from operations
    
    
    27,089
    
    
    
    8,719
    
    
    
    35,808
    
    
    
    (48,346
    )
    
    
    (12,538
    )Other expense, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,978
    )
    
    
    (1,978
    )Net income (loss)
    
    $
    27,089
    
    
    $
    8,719
    
    
    $
    35,808
    
    
    $
    (50,324
    )
    
    $
    (14,516
    )Total assets
    
    $
    37,303
    
    
    $
    22,400
    
    
    $
    59,703
    
    
    $
    239,889
    
    
    $
    299,592
 Total
    
    Corporate
    
    ConsolidatedAs of and for the three months ended March 31, 2006:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    TotalRevenues, net
    
    $
    81,084
    
    
    $
    36,667
    
    
    $
    117,751
    
    
    $
    
    
    
    $
    117,751Cost of sales (exclusive of
depreciation and amortization)
    
    
    46,234
    
    
    
    22,291
    
    
    
    68,525
    
    
    
    11,412
    
    
    
    79,937Selling, general and administrative
    
    
    2,229
    
    
    
    10,403
    
    
    
    12,632
    
    
    
    22,333
    
    
    
    34,965Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,048
    
    
    
    11,048Provision for restructuring and
post-employment benefits
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    763
    
    
    
    763Income (loss) from operations
    
    
    32,621
    
    
    
    3,973
    
    
    
    36,594
    
    
    
    (45,556
    )
    
    
    (8,962
    )Other expense, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (318
    )
    
    
    (318
    )Net income (loss)
    
    $
    32,621
    
    
    $
    3,973
    
    
    $
    36,594
    
    
    $
    (45,874
    )
    
    $
    (9,280
    )Total assets
    
    $
    38,700
    
    
    $
    20,578
    
    
    $
    59,278
    
    
    $
    300,636
    
    
    $
    359,914
 Total
    
    Corporate
    
    ConsolidatedAs of December 31, 2006:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    TotalTotal assets
    
    $
    35,795
    
    
    $
    22,191
    
    
    $
    57,986
    
    
    $
    255,322
    
    
    $
    313,308
 9. Business Acquisition
   18




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Total purchase cost:Cash
    
    $
    3,683Value of common shares issued
    
    
    16,31419,997Acquisition costs
    
    
    327Total purchase cost
    
    $
    20,324Purchase price allocation:Tangible assets acquired
    
    $
    4,918Liabilities assumed
    
    
    (5,662
    )Intangible assets acquired:Customer relationships
    
    
    7,630Non-compete covenant
    
    
    40Goodwill
    
    
    13,398Total purchase consideration
    
    $
    20,324
    19




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10. Related Party Transactions
     11. Income Taxes
  Accounting for Income Taxes.
  20




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12. Subsequent Events
   21




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ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 The following discussion of our financial condition and results of operations should be read
in conjunction with the unaudited condensed consolidated financial statements and the related notes
thereto included elsewhere in this Report on Form 10-Q and the audited consolidated financial
statements and notes thereto and managements discussion and analysis of financial condition and
results of operations for the year ended December 31, 2006 included in our Annual Report on Form
10-K filed with the Securities and Exchange Commission, or SEC, on February 28, 2007. This
discussion contains forward-looking statements, the accuracy of which is subject to risks and
uncertainties. Our actual results could differ materially from those expressed in forward-looking
statements for many reasons including, but not limited to, those discussed herein and in the Risk
Factors section of our Annual Report on Form 10-K , which is contained in Part I, Item 1, Business
- Risk Factors, of that report. We disclaim any obligation to update information contained in any
forward-looking statement. See Forward Looking Statements.
 (All dollar and share amounts are presented in thousands, except per share amounts)
 Overview
 Our Business
      22




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Our Opportunities and Challenges
  
    
    T-1 access;
    
    business asymmetric DSL, or ADSL;
    
    line-powered voice access service, or LPVA;
    
    VoIP; and
    
    Fixed wireless broadband access.
   Efficient use of cash
 Efficiently deliver broadband Internet access services
 Long-Term Debt
 Respond to Changes in Telecommunications Regulations 
 23




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Enter and maintain acceptable line-sharing terms with the RBOCs
 Expand and diversify our sources of revenue
 New market opportunities
  Critical Accounting Policies and Estimates
  
    
    We recognize revenues when persuasive evidence of our arrangement with the
customer exists, service has been provided to the customer, the price to the customer is fixed
or determinable and collectibility of the sales price is reasonably assured. We recognize
up-front fees associated with service activation, which includes set-up fees and revenue from
customer premises equipment, or CPE, using the straight-line method, over the expected term of
the customer relationship, which ranges from twenty-four to forty-eight months. We include
revenue from sales of CPE and the set-up fees for service activation as up-front fees because
neither is considered a separate unit of accounting. We treat the incremental direct costs of
service activation, which consist principally of CPE, service activation fees paid to other
telecommunications companies and sales commissions, as deferred charges in amounts no greater
than the aggregate up-front fees that are deferred. These deferred incremental direct costs
are amortized to operations using the straight-line method over a range of twenty-four to
forty-eight months.
 24




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
    
    We perform ongoing credit evaluations of our customers financial condition and
maintain an allowance for estimated credit losses. In addition, we have billing disputes with
some of our customers. These disputes arise in the ordinary course of business in the
telecommunications industry and we believe that their impact on our accounts receivable and
revenues can be reasonably estimated based on historical experience. In addition, certain
customer revenues are subject to refund if the end-user terminates service within thirty days
of service activation. Accordingly, we maintain allowances, through charges to revenues, based
on our estimate of the ultimate resolution of these disputes and future service cancellations,
and our reported revenue in any period could be different than what is reported if we employed
different assumptions in estimating the outcomes of these items.
 
    
    We state our inventories at the lower of cost or market, determined using the
first-in, first-out method. In assessing the ultimate recoverability of inventories, we are
required to make estimates regarding future customer demand.
 
    
    We record property and equipment and intangible assets at cost, subject to
adjustments for impairment. We depreciate or amortize property and equipment and intangible
assets using the straight-line method over their estimated useful lives. In assessing the
recoverability of our property and equipment and intangible assets, we must make assumptions
regarding estimated future cash flows and other factors to determine the fair value of the
respective assets. If these estimates and assumptions change in the future, we may be required
to record additional impairment charges relating to our property and equipment and intangible
assets.
 
    
    We record goodwill when the consideration paid for an acquisition exceeds the fair
value of net tangible and intangible assets acquired. We measure and test goodwill for
impairment on an annual basis or more frequently if we believe indicators of impairment
exists. The performance of the test involves a two-step process. The first step compares the
fair value of the reporting unit to its carrying amount, including goodwill. The fair value of
the reporting unit is determined by calculating the market capitalization of the reporting
unit as derived from quoted market prices or other generally accepted valuation methods if
quoted market prices are not available. A potential impairment exists if the fair value of the
reporting unit is lower than its carrying amount. The second step of the process is only
performed if a potential impairment exists, and it involves determining the difference between
the fair values of the reporting units net assets, other than goodwill, to the fair value of
the reporting unit. If the difference is less than the net book value of goodwill, impairment
exists and is recorded.
 
    
    We are a party to a variety of legal proceedings, as either plaintiff or
defendant, and are engaged in other disputes that arise in the ordinary course of business. We
are required to assess the likelihood of any adverse judgments or outcomes to these matters,
as well as potential ranges of probable losses for certain of these matters. The determination
of the liabilities to be recognized, if any, for loss contingencies is made after analysis of
each individual situation based on the facts and circumstances. We
also have billing disputes with
our telecommunication vendors that arise in the ordinary course of business. These disputes
are primarily driven by the timing of implementation and interpretation of complex rate
structures and the related agreements with these vendors in various states in which we
operate. Upon receiving an actual credit or a firm commitment to issue the credit by the
vendor, we record the recovery through an adjustment to cost of sales and the related
liability. Estimated recoveries are recorded if there is a legal basis, otherwise such amounts
are recorded when the actual credit or a firm commitment to issue a credit is received from
the vendor. However, it is reasonably possible that the liabilities reflected in our
consolidated balance sheets for loss contingencies and business disputes could change in the
near term due to new facts and circumstances, the effects of which could be material to our
consolidated financial position, results of operations or cash flows.
 
    
    We perform on-going research and analysis of the applicability of
transaction-based taxes to sales of our products and services and purchases of
telecommunications circuits from various carriers. This research and analysis may include
discussions with authorities of jurisdictions in which we do business and transaction-based
tax experts to determine the extent of our transaction-based tax liabilities. In addition, we
continue to analyze the probable applicability of employment-related taxes for certain
stock-based compensation provided to employees in prior periods. It is reasonably possible
that our estimates of our transaction-based and employment-related tax liabilities could
change in the near term, the effects of which could be material to our consolidated financial
position and results of operations.
 25




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
    
    We make market development funds, or MDF, available to certain customers for the
reimbursement of co-branded advertising expenses and other purposes. To the extent that MDF is
used by our customers for co-branded advertising, and the customers provide us with
third-party evidence of such co-branded advertising and we can reasonably estimate the fair
value of our portion of the advertising, such amounts are charged to advertising expense as
incurred. Other MDF activities are recorded as reductions of revenues as incurred. Amounts
payable to customers relating to rebates and customer incentives are recorded as reductions of
revenues based on our estimate of sales incentives that will ultimately be claimed by
customers.
 
    
    We record post-employment benefits which primarily consist of our severance plans.
These plans are primarily designed to provide severance benefits to our eligible employees
whose employment is terminated in connection with reductions in our workforce. We do not
accrue for this employee benefit, other than for individuals that have been notified of
termination, because we cannot reasonably determine the probability or the amount of such
payments.
 
    
    We account for income taxes using the liability method, under which deferred tax
assets and liabilities are determined based on differences between the financial reporting and
tax bases of our assets and liabilities. We record a valuation allowance on our deferred tax
assets to arrive at an amount that is more likely than not to be realized. In the future,
should we determine that we are able to realize all or part of our deferred tax assets, which
presently are fully reserved, an adjustment to our deferred tax assets would increase income
in the period in which the determination was made.
 
    
    Effective January 1, 2006, we adopted the provisions of Financial Accounting
Standards Board, or FASB, Statement of Financial Accounting Standards, or SFAS, No. 123
(revised 2004), Share-Based Payment, or SFAS 123R. Accordingly, we account for stock-based
awards exchanged for employee services based on the fair value of the award. We measure the
stock-based compensation cost at the grant-date and recognize such cost over the employee
requisite service period. We estimate the fair value of stock options using a Black-Scholes
valuation model, consistent with the provisions of SFAS 123R, SECs Staff Accounting Bulletin
No. 107, or SAB 107, including stock-based compensation (determined under a fair value method
as prescribed by SFAS 123). We determine the expected life of the options using historical
data for options exercised, cancelled after vesting and outstanding. We determine the
expected stock price volatility assumption using historical volatility of our common stock
over a period equal to the expected life of the option. These assumptions are consistent with
our estimates prior the adoption of SFAS 123R. We determine the forfeiture rate using
historical pre-vesting cancellation data for all options issued after 2001. Determining
assumptions, such as expected term, expected volatility and expected forfeiture rates,
requires significant judgment. Changes in those assumptions could materially impact reported
results in future periods.
 Recent Accounting Pronouncements
 Fair Value Measurements.
 How Taxes Collected from Customers and Remitted to Governmental Authorities should be
Presented in the Income Statement. Disclosure of
Accounting Policies.
 26




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##### Table of Contents



Accounting for Uncertainty in Income
Taxes Accounting for Income Taxes.
 Business Segment Information
    Results of Operations For The Three months Ended March 31, 2007 and 2006
 Revenues, net
  27




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Segment Revenues and Significant Customers
  Three months ended March 31,2007
    
    2006Wholesale
    
    $
    76,751
    
    
    $
    81,084Percent of net revenues
    
    
    63.9
    %
    
    
    68.9
    %Direct
    
    $
    43,399
    
    
    $
    36,667Percent of net revenues
    
    
    36.1
    %
    
    
    31.1
    %
  28




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Revenue
Recognition
  Wholesaler Financial Difficulties
  29




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##### Table of Contents



Operating Expenses
   Three months ended March 31,2007
    
    2006Amount
    
    $
    132,688
    
    
    $
    126,713Percent of net revenues
    
    
    110.4
    %
    
    
    107.6
    %
 Cost of Sales (exclusive of depreciation and amortization)
   Three months ended March 31,2007
    
    2006Amount
    
    $
    87,995
    
    
    $
    79,937Percent of net revenues
    
    
    73.2
    %
    
    
    67.9
    %
    Three months ended March 31,2007
    
    
    2006Wholesale Segment
    
    $
    47,600
    
    
    $
    46,234Direct Segment
    
    
    25,900
    
    
    
    22,291Corporate Operations
    
    
    14,495
    
    
    
    11,412Total
    
    $
    87,995
    
    
    $
    79,937
  30




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##### Table of Contents



Selling, General and Administrative Expenses
   Three months ended March 31,2007
    
    2006Amount
    
    $
    31,334
    
    
    $
    34,965Percent of net revenues
    
    
    26.1
    %
    
    
    29.7
    %
    Three months ended March 31,2007
    
    
    2006Wholesale Segment
    
    $
    2,062
    
    
    $
    2,229Direct Segment
    
    
    8,780
    
    
    
    10,403Corporate Operations
    
    
    20,492
    
    
    
    22,333Total
    
    $
    31,334
    
    
    $
    34,965
 31




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Stock-Based Compensation
  Depreciation and Amortization
    Provision for Restructuring and Post-Employment Benefits
  Other Expense
 Net Interest Expense
  32




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Income Taxes
  Accounting for Income Taxes.
   Related Party Transactions
    33




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Liquidity, Capital Resources and Contractual Cash Obligations
   Three months ended March 31,2007
    
    
    2006Net cash provided by (used in):Operating activities
    
    $
    214
    
    
    $
    (4,134
    )Investing activities
    
    
    (11,393
    )
    
    
    (50,806
    )Financing activities
    
    
    (121
    )
    
    
    49,405Total
    
    $
    (11,300
    )
    
    $
    (5,535
    )
 Operating Activities
   Investing Activities
  34




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Financing Activities
 Long-Term Debt,
  Liquidity
    35




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
    
    our continuing ability to obtain access to ILEC facilities, including
telephone lines, remote terminals, interoffice transport and high-capacity circuits, all
at reasonable prices;
    
    rates at which resellers and end-users purchase and pay for our services and
the pricing of such services;
    
    financial condition of our customers;
    
    levels of marketing required to acquire and retain customers and to attain a
competitive position in the marketplace;
    
    rates at which we invest in engineering, equipment, development and
intellectual property with respect to existing and future technology;
    
    operational costs that we incur to install, maintain and repair end-user
lines and our network as a whole;
    
    pending and any future litigation;
    
    existing and future technology, including any expansion of fixed wireless services;
    
    ability to generate cash flows or obtain adequate financing;
    
    unanticipated opportunities; and
    
    network development schedules and associated costs.
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Contractual Cash Obligations
  2007
    
    
    2008-2009
    
    
    2010-2011
    
    
    Thereafter
    
    
    Total3% convertible senior debentures
    
    $
    
    
    
    $
    125,000
    
    
    $
    
    
    
    $
    
    
    
    $
    125,00012% senior secured convertible note
    
    
    
    
    
    
    
    
    
    
    44,774
    
    
    
    
    
    
    
    44,774Bank loan
    
    
    6,100
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,100Interest on notes payable
    
    
    7,222
    
    
    
    15,277
    
    
    
    6,492
    
    
    
    
    
    
    
    28,991Capital leases
    
    
    794
    
    
    
    1,614
    
    
    
    185
    
    
    
    
    
    
    
    2,593Office leases
    
    
    3,775
    
    
    
    8,607
    
    
    
    2,837
    
    
    
    15
    
    
    
    15,234Other operating leases
    
    
    1,157
    
    
    
    1,795
    
    
    
    464
    
    
    
    31
    
    
    
    3,447Purchase obligations (network costs)
    
    
    4,022
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,022$
    23,070
    
    
    $
    152,293
    
    
    $
    54,752
    
    
    $
    46
    
    
    $
    230,161
   Forward-Looking Statements
  
    
    impact of federal, state and local telecommunications regulations, decisions
and related litigation, and our ability to obtain ILEC network elements and facilities
at reasonable rates;
    
    continuing deployment of LPVA and our ability to bundle our data services
with the voice services of EarthLink and other alternative voice providers;
    
    timing of our cash flows;
    
    extent to which customers purchase our services;
    
    relationships with our strategic partners and other potential third parties;
    
    pricing for our services in the future;
    
    plans regarding new financing arrangements;
    
    margins on our service offerings;
    
    possibilities that we will increase our revenues;
    
    plans to make strategic investments and acquisitions and the effect of such
investments and acquisitions;
 37




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##### Table of Contents




    
    estimates and expectations of future operating results, including
improvements in cash flow from operating activities, our selling, general and
administrative expenses, adequacy of our cash reserves, and the number of anticipated
installed lines;
    
    plans to increase sales of value-added services, like VoIP and fixed wireless;
    
    anticipated capital expenditures;
    
    plans to enter into business arrangements with broadband-related service providers;
    
    feasibility of alternative access solutions, like fixed wireless;
    
    effects of litigation currently pending; and
    
    other statements contained in this Report on Form 10-Q regarding matters that are not historical facts
   
 ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
 (All dollar amounts are presented in thousands)
   Carrying Value
    
    
    Interest RateCash and cash equivalents
    
    $
    34,979
    
    
    
    2.49
    %Short-term investments in debt securities
    
    
    19,983
    
    
    
    1.47
    %Restricted cash and cash equivalents
    
    
    17,176
    
    
    
    1.24
    %$
    72,138
 
 ITEM 4. Controls and Procedures
 Evaluation of Disclosure Controls and Procedures:
  Changes in Internal Controls.
  38




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PART II. OTHER INFORMATION
 
 ITEM 1. Legal Proceedings
      39




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##### Table of Contents



ITEM 1A. Risk Factors
 (All dollar amounts are presented in thousands, except monthly service subscription fees)
 Investing in and holding our common stock involve a degree of risk. Many factors, including
those described below and set forth elsewhere in this report and in other documents we file with
the Securities and Exchange Commission, or SEC, could cause actual results to differ materially
from the results contemplated by the forward-looking statements contained in this report. If any of
these risks materialize, our business, financial condition and results of operations could suffer.
These risks are not the only ones we face. Additional risks that we currently do not know about or
that we currently believe to be immaterial may also impair our business.
 Our services are subject to government regulation, and changes in current or future laws or
regulations and the methods of enforcing the law and regulations could adversely affect our
business.
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##### Table of Contents



Charges for network elements are generally outside of our control because they are proposed by the
ILECs and are subject to costly regulatory approval processes.
   Our business will be adversely affected if our interconnection agreements are not renewed or if
they are modified on unfavorable terms.
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We depend on a limited number of customers for the preponderance of our revenues, and we are
highly dependent on sales through our resellers.
   The markets in which we operate are highly competitive, and we may not be able to compete
effectively, especially against established industry competitors with significantly greater
financial resources.
  
    
    develop and adopt new or emerging technologies;
    
    respond to changes in customer requirements more quickly;
    
    devote greater resources to the development, promotion and sale of their products and services;
    
    form new alliances and rapidly acquire significant market share;
    
    undertake more extensive marketing campaigns;
    
    adopt more aggressive pricing policies; and
    
    devote substantially more resources to developing new services.
   42




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New competitors in the market for VoIP services and improvements in the quality of VoIP service
provided by competitors over the public Internet could increase competition for our VoIP services.
   Failure to complete development, upgrades, testing and introduction of new services, including
VoIP services, could affect our ability to compete in the industry.
  We may need to raise additional capital under difficult financial market conditions.
  43




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
    
    customer disconnection rates that reduce our revenues;
    
    significant price reductions by our competitors;
    
    higher levels of marketing expense required to acquire and retain end-users that purchase
our services from us and from our resellers;
    
    the need to upgrade our systems by investing in our existing and future technology and infrastructure;
    
    investment opportunities in complementary businesses, acquisitions or other opportunities;
    
    changes in government regulations and legal actions challenging government regulations; and
    
    additional risk factors mentioned throughout this section.
   In order to become profitable, we must add end-users and sell additional services to our existing
end-users while minimizing the cost to upgrade and expand our network infrastructure.
  
    
    acquire new end-users;
    
    efficiently deploy LPVA services under our agreement with EarthLink;
    
    enter into and maintain agreements with the RBOCs or obtain favorable regulatory rulings
that provide us with access to unbundled network elements on terms and conditions that allow
us to profitably sell our consumer services;
    
    enhance, improve and increase sales of our VoIP services;
    
    upgrade our network to improve reliability and remain competitive;
    
    efficiently expand fixed wireless broadband services;
 44




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##### Table of Contents




    
    expand our direct sales capability and infrastructure in a cost-effective manner; and
    
    continue to implement and improve our management information systems, including our
client ordering, provisioning, dispatch, trouble ticketing, customer billing, accounts
receivable, payable tracking, collection, fixed assets, transaction-based taxes and other
management information systems.
  Our end-user disconnection rate reduces our revenue and end-user growth.
  
    
    move to a new location;
    
    are moved off our network when one of our customers acquires, or is acquired by, a
competitor with network facilities;
    
    disconnect because of better offers in the market; or
    
    disconnect because they do not like our service or the service provided by our resellers.
  We may experience decreasing margins on the sale of our services, which may impair our ability to
achieve profitability or positive cash flow.
  If our internal controls over financial reporting do not comply with the requirements of the
Sarbanes-Oxley Act, our business, reputation and stock price could be adversely affected.
  45




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##### Table of Contents



Some of our resellers are facing financial difficulties, which makes it more difficult to predict
our revenues.
  The existence of our direct business poses challenges and may cause our resellers to place fewer
orders with us or may cause us to lose resellers.
  
    
    recruit, hire and train additional direct sales teams;
    
    reduce our cost of acquiring new customers;
    
    improve our VoIP provisioning, network management and monitoring and billing systems;
    
    manage expanding and increasingly diverse distribution channels;
    
    effectively manage additional vendors; and
    
    continue to enhance our network and improve our VoIP services.
  The communications industry is undergoing rapid technological changes and new technologies may be
superior to the technology we use.
  
    
    third parties, including some of our competitors and potential competitors, developing
and providing us with access to new communications and networking technology;
    
    our ability to anticipate or adapt to new technology on a timely basis; and
    
    our ability to adapt to new products and technologies that may be superior to, or may not
be compatible with, our products and technologies.
 46




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A system failure could delay or interrupt service to our customers, which could reduce demand for
our services.
   Our use of fixed broadband wireless technology presents several challenges.
   A breach of network security could delay or interrupt service to our customers, which could reduce
demand for our services.
  47




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##### Table of Contents



Our success depends on our retention of certain key personnel, our ability to hire additional key
personnel and the maintenance of good labor relations.
   We depend on a limited number of third parties for equipment supply, software utilities, service
and installation and if we are unable to obtain these items from these third parties we may not be
able to deliver our services as required.
  
    
    DSLAMs;
    
    CPE, including modems, routers, bridges and other devices;
    
    network routing and switching hardware;
    
    customer support;
    
    installation services;
    
    customized software design and maintenance;
    
    network management software;
    
    systems management software;
    
    database management software;
    
    collocation space;
    
    software used in our products;
    
    hosting, email and IP provisioning services;
    
    softswitches, used to provide VoIP services; and
    
    Internet connectivity and Internet protocol services.
 48




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##### Table of Contents




    
    the possibility that some of our vendors will leave the DSL equipment business or will
stop supporting equipment that we already have installed;
    
    the absence of guaranteed capacity;
    
    the possibility that vendors may become insolvent;
    
    the possibility that vendors will stop supporting software or equipment that we use or
will no longer offer supplemental or replacement parts; and
    
    reduced control over delivery schedules, quality assurance, production yields and costs.
  We use third-party vendors offshore for tasks that were previously done by our employees.
    We have made and may make acquisitions of complementary technologies or businesses in the future,
which may disrupt our business and be dilutive to our existing stockholders.
  49




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##### Table of Contents



We must pay federal, state and local taxes and other surcharges on our services, the applicability
and levels of which are uncertain.
   We are a party to litigation and adverse results of such litigation matters could negatively
impact our financial condition and results of operations.
 Legal
Proceedings.
 50




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##### Table of Contents



Our intellectual property protection may be inadequate to protect our proprietary rights.
    Third parties may claim we infringe their intellectual property rights.
  
    
    be time-consuming, costly and result in litigation;
    
    divert managements time and attention from developing our business;
    
    require us to pay monetary damages or enter into royalty and licensing agreements that we
would not normally find acceptable;
    
    require us to stop selling or to redesign certain of our products; or
    
    require us to satisfy indemnification obligations to our customers.
  The price of our common stock may continue to fluctuate significantly.
  
    
    state and federal regulatory and legislative actions;
    
    general economic conditions and the condition of the telecommunications industry;
 51




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##### Table of Contents




    
    our ability to maintain existing customers and add new customers and recognize revenue
from distressed customers;
    
    our ability to execute our operational plan and reach profitability and cash flow positive from operations;
    
    our ability to maintain sufficient liquidity to fund our operations;
    
    adverse litigation results;
    
    announcements of new products, services or pricing by our competitors or the emergence of
new competing technologies;
    
    our failure to meet the expectations of investors or of analysts;
    
    the adoption of new, or changes in existing, accounting rules, guidelines and practices,
which may materially impact our financial statements and may materially alter the
expectations of securities analysts or investors;
    
    the level of demand for broadband Internet access services and VoIP telephony services;
    
    departures of key personnel; and
    
    effective internal controls over financial reporting.
  Substantial leverage and debt service obligations may adversely affect our cash flow. (Refer to
Part I, Item 2  Managements Discussion and Analysis of Financial Condition and Results of
Operations  Liquidity and Capital Resources for additional information)
   
    
    increasing our vulnerability to general adverse economic and industry conditions;
    
    limiting our ability to obtain additional financing;
    
    requiring the dedication of a portion of our expected cash flow from operations to
service our indebtedness, thereby reducing the amount of our expected cash flow available
for other purposes, including capital expenditures;
    
    limiting our flexibility in planning for, or reacting to, changes in our business and the
industry in which we compete; and
    
    placing us at a possible competitive disadvantage relative to less leveraged competitors
and competitors that have better access to capital resources.
 52




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##### Table of Contents



ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
  
 ITEM 3. Defaults Upon Senior Securities
  
 ITEM 4. Submission of Matters to a Vote of Security Holders
  
 ITEM 5. Other Information
  
 ITEM 6. Exhibits
 Exhibit
    
    
    
    
    
    Incorporated by Reference
    
    ExhibitNumber
    
    Exhibit Description
    
    Form
    
    File No.
    
    Date of First Filing
    
    Number
    
    Filed Herewith10.1
    
    Covad Communications 2007 Executive Short Term Incentive Plan
    
    8-K
    
    001-32588
    
    1/9/07
    
    
    10.110.2
    
    Indemnification Agreement between Covad Communications
Group, Inc. and Justin Spencer
    
    8-K
    
    001-32588
    
    4/17/07
    
    
    10.110.3
    
    Amendment No. 2 to Loan and Security Agreement
    
    8-K
    
    001-32588
    
    4/26/07
    
    
    10.131.1
    
    Certification Pursuant to Rule 13a-14(a)
    
    
    
    
    
    
    
    
    
    
    
    X31.2
    
    Certification Pursuant to Rule 13a-14(a)
    
    
    
    
    
    
    
    
    
    
    
    X32.1*
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
    
    
    
    
    
    
    
    
    
    
    
    X32.2*
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
    
    
    
    
    
    
    
    
    
    
    
    X
 
 *
    
    These certifications accompany the Registrants Quarterly Report on Form 10-Q and are not
deemed filed with the SEC. 53




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##### Table of Contents



SIGNATURES
  COVAD COMMUNICATIONS GROUP, INC.By:
    
    /s/ CHARLES E. HOFFMANCharles E. HoffmanPresident, Chief Executive Officer and DirectorDate: May 7, 2007By:
    
    /s/ JUSTIN SPENCERJustin SpencerVice President and Acting Chief Financial OfficerDate: May 7, 2007
 54




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##### Table of Contents



Exhibit
    
    
    
    
    
    Incorporated by Reference
    
    ExhibitNumber
    
    Exhibit Description
    
    Form
    
    File No.
    
    Date of First Filing
    
    Number
    
    Filed Herewith10.1
    
    Covad Communications 2007 Executive Short Term Incentive Plan
    
    8-K
    
    001-32588
    
    1/9/07
    
    
    10.110.2
    
    Indemnification Agreement between Covad Communications
Group, Inc. and Justin Spencer
    
    8-K
    
    001-32588
    
    4/17/07
    
    
    10.110.3
    
    Amendment No. 2 to Loan and Security Agreement
    
    8-K
    
    001-32588
    
    4/26/07
    
    
    10.131.1
    
    Certification Pursuant to Rule 13a-14(a)
    
    
    
    
    
    
    
    
    
    
    
    X31.2
    
    Certification Pursuant to Rule 13a-14(a)
    
    
    
    
    
    
    
    
    
    
    
    X32.1*
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
    
    
    
    
    
    
    
    
    
    
    
    X32.2*
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
    
    
    
    
    
    
    
    
    
    
    
    X
 
 *
    
    These certifications accompany the Registrants Quarterly Report on Form 10-Q and are not
deemed filed with the SEC. 55