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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, 2005
 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: 000-25271 COVAD COMMUNICATIONS GROUP, INC. (Exact name of registrant as specified in its charter)
 Delaware(State or other jurisdiction
of incorporation or organization)
    
    77-0461529(I.R.S. Employer
Identification Number)110 Rio Robles
San Jose, California(Address of principal executive offices)
    
    95134(Zip Code)
 (408) 952-6400(Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. 
Yes þ No o Indicate by check mark whether the registrant is an accelerated filer (as described by Rule
12b-2 of the Exchange Act). Yes þ No o APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and reports required to
be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the
distribution of securities under a plan confirmed by a court. Yes þ No o As of April 22, 2005 there were 263,940,130 shares outstanding of the Registrants Common
Stock and no shares outstanding of the Registrants Class B Common Stock.




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COVAD COMMUNICATIONS GROUP, INC.
For the Quarterly Period Ended March 31, 2005 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
    
    
    21ITEM 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    47ITEM 4.
    
    Controls and Procedures
    
    
    48PART II. OTHER INFORMATIONITEM 1.
    
    Legal Proceedings
    
    
    49ITEM 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    50ITEM 3.
    
    Defaults Upon Senior Securities
    
    
    50ITEM 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    51ITEM 5.
    
    Other Information
    
    
    51ITEM 6.
    
    Exhibits
    
    
    51SIGNATURES
    
    
    52EXHIBIT 10.53EXHIBIT 10.54EXHIBIT 10.55EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  1




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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)
 March 31,
    
    
    December 31,2005
    
    
    2004(Unaudited)
    
    
    (Note 1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    109,448
    
    
    $
    117,506Short-term investments in debt securities
    
    
    23,570
    
    
    
    33,490Restricted cash and cash equivalents
    
    
    2,533
    
    
    
    2,533Short-term investments in equity securities
    
    
    27,671
    
    
    
    Accounts receivable, net
    
    
    27,862
    
    
    
    30,041Unbilled revenues
    
    
    4,402
    
    
    
    3,825Other receivables
    
    
    1,028
    
    
    
    1,204Inventories
    
    
    4,828
    
    
    
    4,629Prepaid expenses and other current assets
    
    
    4,732
    
    
    
    2,553Total current assets
    
    
    206,074
    
    
    
    195,781Property and equipment, net
    
    
    71,444
    
    
    
    78,707Collocation fees and other intangible assets, net
    
    
    29,452
    
    
    
    34,561Goodwill
    
    
    36,626
    
    
    
    36,626Deferred costs of service activation
    
    
    29,128
    
    
    
    30,152Deferred customer incentives, net
    
    
    2,246
    
    
    
    2,683Deferred debt issuance costs, net
    
    
    3,979
    
    
    
    4,231Other long-term assets
    
    
    2,464
    
    
    
    2,484Total assets
    
    $
    381,413
    
    
    $
    385,225LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)Current liabilities:Accounts payable
    
    $
    17,055
    
    
    $
    20,755Accrued compensation
    
    
    18,576
    
    
    
    15,619Accrued collocation and network service fees
    
    
    20,815
    
    
    
    24,160Accrued transaction-based taxes
    
    
    31,868
    
    
    
    33,730Accrued interest
    
    
    156
    
    
    
    1,121Accrued market development funds and customer incentives
    
    
    2,743
    
    
    
    3,182Collateralized customer deposit
    
    
    8,027
    
    
    
    7,906Unearned revenues
    
    
    4,537
    
    
    
    4,420Other accrued liabilities
    
    
    6,048
    
    
    
    5,824Total current liabilities
    
    
    109,825
    
    
    
    116,717Long-term debt
    
    
    125,000
    
    
    
    125,000Collateralized customer deposit
    
    
    42,237
    
    
    
    44,444Deferred gain resulting from deconsolidation of subsidiary
    
    
    
    
    
    
    53,963Unearned revenues
    
    
    49,728
    
    
    
    51,518Other long-term liabilities
    
    
    2,108
    
    
    
    2,218Total liabilities
    
    
    328,898
    
    
    
    393,860Commitments and contingencies (Note 6)Stockholders equity (deficit):Preferred stock, $0.001 par value; 5,000 shares
authorized; no shares issued and outstanding at March 31,
2005 and December 31, 2004
    
    
    
    
    
    
    Common Stock, $0.001 par value; 590,000 shares
authorized; 263,936 shares issued and outstanding at
March 31, 2005 (263,681 shares issued and outstanding at
December 31, 2004)
    
    
    264
    
    
    
    264Common Stock  Class B, $0.001 par value; 10,000 shares
authorized; no shares issued and outstanding at March 31,
2005 and December 31, 2004
    
    
    
    
    
    
    Additional paid-in capital
    
    
    1,693,608
    
    
    
    1,695,424Deferred stock-based compensation
    
    
    (219
    )
    
    
    (939
    )Accumulated other comprehensive income (loss)
    
    
    26,887
    
    
    
    (985
    )Accumulated deficit
    
    
    (1,668,025
    )
    
    
    (1,702,399
    )Total stockholders equity (deficit)
    
    
    52,515
    
    
    
    (8,635
    )Total liabilities and stockholders equity (deficit)
    
    $
    381,413
    
    
    $
    385,225
 See accompanying notes. 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 endedMarch 31,2005
    
    
    2004Revenues, net
    
    $
    107,718
    
    
    $
    108,477Operating expenses:Cost of sales (exclusive of depreciation and amortization)
    
    
    72,749
    
    
    
    68,294Selling, general and administrative
    
    
    42,374
    
    
    
    33,302Depreciation and amortization of property and equipment
    
    
    13,785
    
    
    
    14,495Amortization of collocation fees and other intangible assets
    
    
    5,364
    
    
    
    4,751Provision for restructuring expenses
    
    
    
    
    
    
    547Total operating expenses
    
    
    134,272
    
    
    
    121,389Loss from operations
    
    
    (26,554
    )
    
    
    (12,912
    )Other income (expense):Interest income
    
    
    899
    
    
    
    351Gain on sale of equity securities
    
    
    7,246
    
    
    
    Gain on deconsolidation of subsidiary
    
    
    53,963
    
    
    
    Interest expense
    
    
    (1,238
    )
    
    
    (1,141
    )Miscellaneous income, net
    
    
    58
    
    
    
    171Other income (expense), net
    
    
    60,928
    
    
    
    (619
    )Net income (loss)
    
    $
    34,374
    
    
    $
    (13,531
    )Earnings (loss) per common share:Basic
    
    $
    0.13
    
    
    $
    (0.06
    )Diluted
    
    $
    0.11
    
    
    $
    (0.06
    )Weighted-average number of common shares outstanding:Basic
    
    
    263,690
    
    
    
    233,257Diluted
    
    
    310,755
    
    
    
    233,257
 See accompanying notes. 3




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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 31,2005
    
    
    2004Operating Activities:Net income (loss)
    
    $
    34,374
    
    
    $
    (13,531
    )Adjustments to reconcile net income (loss) to net cash provided by (used
in) operating activities:Provision for bad debts (bad debt recoveries), net
    
    
    137
    
    
    
    (25
    )Depreciation and amortization
    
    
    19,149
    
    
    
    19,246Loss on disposition of property and equipment
    
    
    23
    
    
    
    1Amortization of deferred stock-based compensation, net
    
    
    (1,331
    )
    
    
    796Amortization of deferred customer incentives
    
    
    437
    
    
    
    437Other non-cash charges
    
    
    252
    
    
    
    (12
    )Accretion of interest on investments, net
    
    
    (159
    )
    
    
    (101
    )Gain on sale of equity securities
    
    
    (7,246
    )
    
    
    Gain on deconsolidation of subsidiary
    
    
    (53,963
    )
    
    
    Net changes in operating assets and liabilities:Accounts receivable
    
    
    2,042
    
    
    
    (2,865
    )Unbilled revenues
    
    
    (577
    )
    
    
    303Inventories
    
    
    (199
    )
    
    
    806Prepaid expenses and other assets
    
    
    (1,899
    )
    
    
    (2,166
    )Deferred costs of service activation
    
    
    1,024
    
    
    
    517Accounts payable
    
    
    (3,700
    )
    
    
    (1,916
    )Collateralized customer deposit
    
    
    (2,086
    )
    
    
    (1,968
    )Other current liabilities
    
    
    (3,529
    )
    
    
    (2,203
    )Unearned revenues
    
    
    (1,705
    )
    
    
    (2,307
    )Net cash used in operating activities
    
    
    (18,956
    )
    
    
    (4,988
    )Investing Activities:Restricted cash and cash equivalents
    
    
    
    
    
    
    (50
    )Purchase of short-term investments in debt securities
    
    
    (16,013
    )
    
    
    (49,563
    )Maturities of short-term investments in debt securities
    
    
    26,100
    
    
    
    41,030Proceeds from the sale of equity securities
    
    
    7,439
    
    
    
    Purchase of property and equipment
    
    
    (6,500
    )
    
    
    (11,502
    )Proceeds from sale of property and equipment
    
    
    7
    
    
    
    21Payment of collocation fees and purchase of other intangible assets
    
    
    (255
    )
    
    
    (2,892
    )Decrease in other long-term assets
    
    
    21
    
    
    
    201Net cash provided by (used in) investing activities
    
    
    10,799
    
    
    
    (22,755
    )Financing Activities:Proceeds from the issuance of senior unsecured convertible debentures, net
    
    
    
    
    
    
    120,151Principal payment of long-term debt
    
    
    
    
    
    
    (50,000
    )Principal payments under capital lease obligations
    
    
    (135
    )
    
    
    Proceeds from the issuance of common stock
    
    
    234
    
    
    
    1,264Net cash provided by financing activities
    
    
    99
    
    
    
    71,415Net increase (decrease) in cash and cash equivalents
    
    
    (8,058
    )
    
    
    43,672Cash and cash equivalents at beginning of period
    
    
    117,506
    
    
    
    65,376Cash and cash equivalents at end of period
    
    $
    109,448
    
    
    $
    109,048Supplemental Disclosures of Cash Flow Information:Cash paid during the period for interest
    
    $
    1,913
    
    
    $
    6,569Supplemental Schedule of Non-Cash Investing and Financing Activities:Equipment purchased through capital leases
    
    $
    156
    
    
    $
    Common stock issued in settlement of claims related to bankruptcy
    
    $
    
    
    
    $
    6,951
 See accompanying notes. 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 The condensed consolidated financial statements include the accounts of Covad Communications
Group, Inc. and its wholly-owned subsidiaries (the Company, or Covad) except for the accounts
of BlueStar Communications Group, Inc. and its wholly-owned subsidiaries, which have been excluded
from the Companys condensed consolidated financial statements, effective June 25, 2001. All
significant intercompany accounts and transactions have been eliminated in consolidation. The accompanying unaudited condensed consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States for interim financial
information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do
not include some of the information and footnotes required by accounting principles generally
accepted in the United States for complete financial statements. In the opinion of management, all
adjustments (consisting of normal recurring adjustments) considered necessary for a fair statement
of the condensed consolidated financial statements have been included. 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. Based on the Companys 2005 business plan, the Company believes it will be able to continue as
a going concern through March 31, 2006 using only its unrestricted cash, cash equivalents and
short-term investment in debt securities balances in existence as of March 31, 2005. Adverse
business, legal, regulatory or legislative developments, such as the inability to continue
accessing certain network elements from the regional Bell operating companies (RBOCs), may
require the Company to raise additional financing, raise its prices or substantially decrease its
cost structure. The Company also recognizes that it may not be able to raise additional capital. If
the Company is unable to acquire additional capital on favorable terms if needed, or is required to
raise it on terms that are less satisfactory than it desires, its financial condition will be
adversely affected. The consolidated balance sheet as of December 31, 2004 has been derived from the audited
condensed consolidated financial statements at that date but does not include some of the
information and footnotes required by accounting principles generally accepted in the United States
for complete financial statements. All information included in this report should be read in conjunction with the Companys
audited consolidated financial statements and notes thereto included in the Companys Annual Report
on Form 10-K for the year ended December 31, 2004. Use of 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 at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual results may differ materially
from these estimates. The Companys critical accounting estimates include (i) revenue recognition
and the establishment of accounts receivable allowances, (ii) inventory valuation, (iii) useful
life assignments and impairment evaluations associated with property and equipment, collocation
fees and other intangible assets, (iv) restructuring liabilities, (v) anticipated outcomes of legal
proceedings and other disputes, (vi) transaction-based and employment-related tax liabilities,
(vii) liabilities for market development funds and customer incentives and (viii) valuation
allowances associated with deferred tax assets. During the three months ended March 31, 2005 the Company reduced its estimates of certain
liabilities for transaction-based taxes and property taxes as a result of various settlements and
related statute of limitations. These changes in accounting estimate decreased the Companys cost
of sales by $2,386 and its selling, general and administrative expenses by $117, and increased net
income by $2,503, or $0.01 per share. 5




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Earnings (Loss) Per Share Basic earnings (loss) per share is computed using the weighted-average number of common shares
outstanding during the period, less the weighted-average number of common shares outstanding
subject to repurchase. Diluted earnings (loss) per share is computed in the same manner as basic earnings (loss) per
share, except that the weighted-average number of common shares outstanding computed for basic
earnings (loss) per share is increased by the weighted-average number of common shares resulting
from the (i) exercise of dilutive stock options and warrants using the treasury stock method, and
(ii) conversion of dilutive convertible debt instruments. In applying the treasury stock method for
dilutive stock-based compensation arrangements, the assumed proceeds are computed as the sum of (i)
the amount, if any, the employee must pay upon exercise, (ii) the amounts of compensation cost
attributed to future services and not yet recognized, and (iii) the amount of tax benefits (both
deferred and current), if any, that would be credited to additional paid-in capital assuming
exercise of the options. In addition, in computing the dilutive effect of convertible securities,
net income (loss) is adjusted to add back (i) any convertible preferred dividends, and (ii) the
after-tax amount of interest recognized in the period associated with any convertible debt. The following table presents the calculation of net income (loss) used in the computations of
basic and diluted earnings (loss) per share presented in the accompanying condensed consolidated
statements of operations: Three months ended March 31,2005
    
    
    2004Basic:Net income (loss) as reported
    
    $
    34,374
    
    
    $
    (13,531
    )Diluted:Add back interest on 3% convertible debentures
    
    
    1,190
    
    
    
    Net income (loss) adjusted for assumed
conversions
    
    $
    35,564
    
    
    $
    (13,531
    )
 The following table presents the calculation of weighted-average number of common shares
outstanding used in the computations of basic and diluted earnings (loss) per share presented in
the accompanying condensed consolidated statements of operations: Three months ended March 31,2005
    
    
    2004Basic:Weighted-average number of common shares outstanding
    
    
    263,881
    
    
    
    233,257Less weighted-average number of common shares
outstanding subject to
repurchase
    
    
    191
    
    
    
    Weighted-average number of common shares
outstanding used in the computations of basic
earnings (loss) per share
    
    
    263,690
    
    
    
    233,257Diluted:Dilutive stock options and warrants
    
    
    7,494
    
    
    
    Assumed conversion of convertible
debentures
    
    
    39,380
    
    
    
    Common shares subject to
repurchase
    
    
    191
    
    
    
    Weighted-average number of common shares
outstanding used in the computations of diluted
earnings (loss) per share
    
    
    310,755
    
    
    
    233,257
 The company excludes equity instruments from the calculation of diluted weighted-average
number of common shares outstanding if the effect of including such instruments is anti-dilutive to
earnings (loss) per share. Accordingly, certain employee stock options and certain warrants have
been excluded from the calculation of diluted weighted average shares. The total number of
outstanding options, options under employee stock purchase plan, and warrants that were excluded
from the computation of diluted earnings per share for the three months ended March 31, 2005 were
23,539, 5,126 and 5,573, respectively. For the three months ended March 31, 2004, weighted-average number of common shares
outstanding used in the computations of diluted loss per share is the same as basic because the
impact of (i) common shares subject to 6




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repurchase, (ii) the assumed exercise of outstanding stock options and warrants, and (iii) the
assumed conversion of the Companys convertible debentures would be anti-dilutive. Total
outstanding options, options under employee stock purchase plan, and warrants to purchase common
stock at March 31, 2004 were 24,715, 10,314 and 6,512 shares, respectively. Stock-Based Compensation The Company accounts for stock-based awards to (i) employees (including non-employee
directors) using the intrinsic value method and (ii) non-employees using the fair value method.
Under the intrinsic value method, when the exercise price of the Companys employee stock options
equals or exceeds the market price of the underlying stock on the date of grant, no compensation
expense is recognized. The following table illustrates the pro forma effect on net income (loss), weighted-average
number of common shares outstanding, and earnings (loss) per share had the Company applied the fair
value method to account for stock-based awards to employees: Three months ended March 31,2005
    
    
    2004Basic:Net income (loss), as reported
    
    $
    34,374
    
    
    $
    (13,531
    )Stock-based employee compensation expense
(reversal) included in the determination of net
income (loss), as reported
    
    
    (1,331
    )
    
    
    796Stock-based employee compensation expense that
would have been included in the determination of
net income (loss) if the fair value method had
been applied to all awards
    
    
    (4,190
    )
    
    
    (6,184
    )Net income (loss), pro forma
    
    
    28,853
    
    
    
    (18,919
    )Diluted:Add back interest on 3% convertible debentures
    
    
    1,190
    
    
    
    Net income (loss) adjusted for assumed conversions
    
    $
    30,043
    
    
    $
    (18,919
    )Basic:Weighted-average number of common shares
outstanding used in the computations of basic
earnings (loss) per share
    
    
    263,690
    
    
    
    233,257Diluted:Dilutive stock options and warrants
    
    
    3,985
    
    
    
    Assumed conversion of convertible debentures
    
    
    39,380
    
    
    
    Common shares subject to repurchase
    
    
    191
    
    
    
    Weighted-average number of common shares
outstanding used in the computations of diluted
earnings (loss) per share
    
    
    307,246
    
    
    
    233,257Earnings (loss) per common share, pro forma:Basic
    
    $
    0.11
    
    
    $
    (0.08
    )Diluted
    
    $
    0.10
    
    
    $
    (0.08
    )Earnings (loss) per common share, as reported:Basic
    
    $
    0.13
    
    
    $
    (0.06
    )Diluted
    
    $
    0.11
    
    
    $
    (0.06
    )
 Comprehensive Income (Loss) Significant components of the Companys comprehensive income (loss) are as follows: Cumulative
    
    
    Three months ended March 31,amounts
    
    
    2005
    
    
    2004Net income (loss)
    
    $
    (1,668,025
    )
    
    $
    34,374
    
    
    $
    (13,531
    )Unrealized gains (losses) on
available-for-sale securities
    
    
    27,657
    
    
    
    27,680
    
    
    
    (4
    )Foreign currency translation adjustment
    
    
    (770
    )
    
    
    192
    
    
    
    Comprehensive income (loss)
    
    $
    (1,641,138
    )
    
    $
    62,246
    
    
    $
    (13,535
    )
 7




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Inventories Inventories, consisting primarily of customer premises equipment, are stated at the lower of
cost, determined using the first-in, first-out method, or market. Shipping and handling costs
incurred in conjunction with the sale of inventory are included as an element of cost of sales. Collateralized Customer Deposit The Company entered into a 10-year resale agreement with SBC Communications (SBC) in
December 2001 under which SBC, its affiliates or special agents will resell the Companys DSL
services. Under the arrangement with SBC, the Company recognizes revenue consistent with its
revenue recognition policy, which is described in Note 2, Revenue Recognition, to its condensed
consolidated financial statements. As part of the resale agreement, SBC made a $75,000
noninterest-bearing prepayment, which is collateralized by substantially all of the Companys
domestic assets. As the Company provides certain products and services to SBC, the resultant
billings are recognized as revenue in accordance with the Companys revenue recognition policy and
are offset by the prepayment to the extent of SBCs right to do so under the resale agreement. The
total balance of the prepayment as of March 31, 2005 was $50,264. The Company categorizes a portion
of the prepayment liability as a current liability, based upon the amount of expected billings over
the next twelve months, with the remainder classified as long-term. The amount of billings expected
over the next twelve months is an estimate based on the current quantity of products and services
for which SBC is being billed, and the actual amount sold during this period may be greater or
lesser than this estimated amount. SBC recently announced that it has reached an agreement to
acquire AT&T Corp. (AT&T), another one of the Companys wholesale customers.
On May 5, 2005, the Company announced that it reached an agreement
with SBC and AT&T setting forth terms under which
the Company will provide broadband access to AT&T and SBC
following their merger. The Agreement will also allow both SBC and
AT&T to use the remainder of the prepayment. The agreement is
contingent upon completion of the SBC and AT&T merger.
SBC has indicated
that the acquisition is not expected to be completed until the first half of 2006. The
completion of this acquisition and our related agreement with SBC
and AT&T will likely result in accelerated
utilization of the prepayment. The Company will continue to monitor
these events to determine whether a change in these classifications is appropriate. Recent Accounting Pronouncements In March 2005, the Financial Accounting Standards Board (FASB), issued Interpretation
(FIN) No. 47, Accounting for Conditional Asset Retirement Obligations  an interpretation of
FASB Statement of Financial Accounting Standards (SFAS), No. 143, Accounting for Asset
Retirement Obligations. FIN 47 clarifies that the term conditional asset retirement obligationas
used in SFAS 143,refers to a legal obligation to perform an asset retirement activity in which the
timing and (or) method of settlement are conditional on a future event that may or may not be
within the control of the entity. The obligation to perform the asset retirement activity is
unconditional even though uncertainty exists about the timing and (or) method of settlement. Thus,
the timing and (or) method of settlement may be conditional on a future event. Accordingly, an
entity is required to recognize a liability for the fair value of a conditional asset retirement
obligation if the fair value of the liability can be reasonably estimated. The fair value of a
liability for the conditional asset retirement obligation should be recognized when incurred,
generally upon acquisition, construction, or development and (or) through the normal operation of
the asset. Uncertainty about the timing and (or) method of settlement of a conditional asset
retirement obligation should be factored into the measurement of the liability when sufficient
information exists. SFAS 143 acknowledges that in some cases, sufficient information may not be
available to reasonably estimate the fair value of an asset retirement obligation. FIN 47 also
clarifies when an entity would have sufficient information to reasonably estimate the fair value of
an asset retirement obligation. The Company is required to adopt FIN 47 by no later than December
31, 2005. The Company is currently evaluating the effect that the adoption of FIN 47 will have on
its condensed consolidated statement of operations and financial condition for the year ending
December 31, 2005. In December 2004, the FASB, issued SFAS No. 123 (revised 2004), Share-Based Payment, or SFAS
123R, that addresses the accounting for share-based payment transactions in which an enterprise
receives employee services in exchange for either equity instruments of the enterprise or
liabilities that are based on the fair value of the enterprises equity instruments or that may be
settled by the issuance of such equity instruments. The statement eliminates the ability to account
for share-based compensation transactions using the intrinsic value method as prescribed by
Accounting Principles Board, or APB, Opinion No. 25, Accounting for Stock Issued to Employees,
and generally requires that such transactions be accounted for using a fair-value-based method and
recognized as expenses in the Companys condensed consolidated statement of operations. The
statement requires companies to assess the most appropriate model to calculate the value of the
options. The Company currently uses the Black- 8




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Scholes option pricing model
to value options and is currently assessing which model it may
use in the future under the statement and may deem an alternative model to be the most appropriate.
The use of a different model to value options may result in a different fair value than the use of
the Black-Scholes option pricing model. In addition, there are a number of other requirements under
the new standard that will result in differing accounting treatment than currently required. These
differences include, but are not limited to, the accounting for the tax benefit on employee stock
options and for stock issued under the Company employee stock purchase plan. In addition to the
appropriate fair value model to be used for valuing share-based payments, the Company will also be
required to determine the transition method to be used at date of adoption. The allowed transition
methods include prospective and retroactive adoption options. Under the retroactive options, prior
periods may be restated either as of the beginning of the year of adoption or for all periods
presented. The prospective method requires that compensation expense be recorded for all unvested
stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123R. On April 14, 2005 the Securities and Exchange Commission, or SEC, announced the adoption of a
new rule that amends the compliance dates for SFAS 123R. Under SFAS 123R, the Company would have
been required to implement the standard as of the beginning of the first interim or annual period
that begins after June 15, 2005. The SECs new rule allows the Company to implement SFAS 123R at
the beginning of its next fiscal year. Consequently, the effective date of the new standard for the
Companys condensed consolidated financial statements is its first quarter in 2006. The SECs new
rule does not change the accounting required by SFAS 123R; it changes only the dates for compliance
with the standard. Upon adoption, this statement will have a significant impact on the Companys condensed
consolidated financial statements as it will be required to expense the fair value of its stock
option grants and stock purchases under its employee stock purchase plan rather than disclose the
impact on its condensed consolidated net income within its footnotes as is its current practice
(see Note 1 of the notes of the condensed consolidated financial statements contained herein). The
amounts disclosed within the Companys footnotes are not necessarily indicative of the amounts that
will be expensed upon the adoption of SFAS 123R. Compensation expense calculated under SFAS 123R
may differ materially from amounts currently disclosed within the Companys footnotes based on
changes in the fair value of its common stock, changes in the number of options granted or the
terms of such options, the treatment of tax benefits and changes in interest rates or other
factors. In addition, upon adoption of SFAS 123R the Company may choose to use a different
valuation model, or continue to use its current model, but with different assumptions, to value the
compensation expense associated with employee stock options. In December 2004, the FASB issued SFAS No. 153 Exchanges of Non-monetary Assets. SFAS
eliminates the exception from fair value measurement for non-monetary exchanges of similar
productive assets in paragraph 21 (b) of APB opinion 29, Accounting for Non-monetary
Transactions, and replaces it with an exception for exchanges that do not have commercial
substance. SFAS 153 specifies that 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. SFAS 153
is effective for fiscal periods beginning after June 15, 2005. The Company is currently evaluating
the effect that the adoption of SFAS 153 will have on its condensed consolidated statement of
operations and financial condition for fiscal periods beginning after June 15, 2005. In November 2004, the FASB issued SFAS No. 151 Inventory Costs  an amendment of Accounting
Research Bulletin No. 43, Chapter 4. SFAS 151 amends the guidance in ARB No. 43, Chapter 4,
Inventory Pricing,, to clarify the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material, or spoilage. Paragraph 5 of ARB 43, previously stated
that under some circumstances, items such as idle facility expense, excessive spoilage, double
freight, and re-handling costs may be so abnormal as to require treatment as current period
charges. SFAS 151 requires that such items be recognized as current period charges regardless of
whether they meet the criterion of so abnormal. In addition, SFAS 151 requires that allocation of
fixed production overheads to the costs of conversion be based on the normal capacity of the
production facilities. SFAS 151 is effective for fiscal periods beginning after June 15, 2005. The
Company is currently evaluating the effect that the adoption of SFAS 151 will have on its condensed
consolidated statement of operations and financial condition for fiscal periods beginning after
June 15, 2005. In March 2004, the FASB approved Emerging Issue Task Force, or EITF, Issue 03-6,
Participating Securities and the Two-Class Method under SFAS 128. EITF Issue 03-6 supersedes the
guidance in Topic No. D-95, Effect 9




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of Participating Convertible Securities on the Computation of Basic Earnings per Share, and
requires the use of the two-class method of participating securities. The two-class method is an
earnings allocation formula that determines earnings per share for each class of common stock and
participating security according to dividends declared (or accumulated) and participation rights in
undistributed earnings. In addition, EITF Issue 03-6 addresses other forms of participating
securities, including options, warrants, forwards and other contracts to issue an entitys common
stock, with the exception of stock-based compensation subject to the provisions of Opinion 25 and
SFAS 123. EITF Issue 03-6 is effective for reporting periods beginning after March 31, 2004 and
should be applied by restating previously reported earnings per share. The adoption of EITF Issue
03-6 did not have a significant effect on the Companys condensed consolidated financial statements
for the three months ended March 31, 2005. 2. Revenue Recognition Revenues from recurring service are recognized when (i) persuasive evidence of an arrangement
between the Company and the customer exists, (ii) service has been provided to the customer, (iii)
the price to the customer is fixed or determinable and (iv) collectibility of the sales prices is
reasonably assured. If a customer is (i) experiencing financial difficulties and, (ii) is not
current in making payments for the Companys services or, (iii) is essentially current in making
payments but, subsequent to the end of the reporting period, the financial condition of such
customer deteriorates significantly or such customer files for bankruptcy protection, then, based
on this information, the Company may determine that the collectibility of revenues from this
customer is not reasonably assured or its ability to retain some or all of the payments received
from a customer that has filed for bankruptcy protection is not reasonably assured. Accordingly,
the Company classifies this group of customers as financially distressed for revenue recognition
purposes. Revenues from financially distressed customers are recognized when cash for the services
to those customers is collected, assuming all other criteria for revenue recognition have been met,
but only after the collection of all previous outstanding accounts receivable balances. Payments
received from financially distressed customers during a defined period prior to their filing of
petitions for bankruptcy protection are recorded in the condensed consolidated balance sheets
caption Unearned revenues if the Companys ability to retain these payments is not reasonably
assured. Revenues earned for which the customer has not been billed are recorded as Unbilled revenues
in the Companys condensed consolidated balance sheets. Amounts billed in advance of providing
service are deferred and recorded in the Companys condensed consolidated balance sheets caption
Unearned revenues. Included in revenues are Federal Universal Service Fund (FUSF) charges
billed to customers aggregating $1,619 and $1,405 for the three months ended March 31, 2005 and
2004, respectively. Shipping and handling charges billed to customers are included in the Companys
net revenues. The Company recognizes up-front fees associated with service activation over the expected term
of the customer relationships, which ranges from 24 to 48 months, using the straight-line method.
The Company treats the incremental direct costs of service activation (which consist principally of
customer premises equipment, service activation fees paid to other telecommunications companies and
sales commissions) as deferred charges in amounts that are no greater than the up-front fees that
are deferred. These deferred incremental direct costs are amortized to expense using the
straight-line method over 24 to 48 months. The Company has billing disputes with some of its customers. These disputes arise in the
ordinary course of business in the telecommunications industry and their impact on the Companys
accounts receivable and revenues can be reasonably estimated based on historical experience. In
addition, certain revenues are subject to refund if the end-user terminates service within 30 days
of service activation. Accordingly, the Company maintains allowances, through charges to revenues,
based on the Companys estimates of (i) the ultimate resolution of the disputes and (ii) future
service cancellations. The allowance for service credits and bad debts is calculated generally as a
percentage, based on historical trends, of balances that meet certain criteria plus specific
reserves for known disputes. As stated above, revenues from financially distressed customers are
recognized when cash for the services to those customers is collected but only after the collection
of all previous outstanding accounts receivable balances. Upon determining that a customer is
financially distressed, the Company establishes an allowance, through a charge to bad debt expense,
based on the outstanding balance of such customer. 10




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Accounts receivable consisted of the following: March 31, 2005
    
    
    December 31, 2004Gross accounts receivable
    
    $
    29,894
    
    
    $
    31,607Allowance for service credits
    
    
    (1,800
    )
    
    
    (1,405
    )Allowance for bad debts
    
    
    (232
    )
    
    
    (161
    )Accounts receivable, net
    
    $
    27,862
    
    
    $
    30,041
 Significant Customers The Company had approximately 400 wholesale customers as of March 31, 2005. For the three
months ended March 31, 2005 and 2004, the Companys 30 largest wholesale customers collectively
comprised 92.5% and 93.5%, respectively, of the Companys total wholesale gross revenues, and 65.5%
and 68.2%, respectively, of the Companys total gross revenues. As of March 31, 2005 and December
31, 2004, receivables from these customers collectively comprised 65.4% and 65.1%, respectively, of
the Companys gross accounts receivable balance. Two of the Companys wholesale customers, EarthLink, Inc. and AT&T, accounted for 15.9% and
13.9%, and 18.4% and 12.6%, of the Companys total net revenues for the three months ended March
31, 2005 and 2004, respectively. Accounts receivable from these customers totaled 19.5% and 17.9%,
and 17.9% and 20.9% of the Companys gross accounts receivables as of March 31, 2005 and December
31, 2004, respectively. No other individual customer accounted for more than 10% of the Companys
total net revenues for the three months ended March 31, 2005 and December 31, 2004. On January 31, 2005, AT&T announced that it had agreed to be acquired by SBC, one of the
largest RBOCs. This acquisition is subject to regulatory, antitrust and other forms of review.
Based upon the statements of the parties, subject to the outcome of this review, the transaction is
expected to close in the first half of 2006. At this time, the Company cannot reliably predict the
effects of this transaction on its revenues derived from AT&T
and SBC or the timing of any such effects. Wholesaler Financial Difficulties During the three months ended March 31, 2005 and 2004, the Company issued billings to its
financially distressed customers aggregating $851 and $902, respectively, that were not recognized
as revenues or accounts receivable in the accompanying condensed consolidated financial statements
at the time of such billings. However, in accordance with the revenue recognition policy described
above, the Company recognized revenues from certain of these customers when cash was collected
aggregating $725 and $662 during the three months ended March 31, 2005 and 2004, respectively.
Revenues from customers that filed for bankruptcy accounted for approximately 0.3% and 0.4% of the
Companys total net revenues for the three months ended March 31, 2005 and 2004, respectively. The
Company had contractual receivables from its financially distressed customers totaling $1,398 and
$1,317 as of March 31, 2005 and December 31, 2004, respectively, which are not reflected in the
accompanying condensed consolidated balance sheets as of such dates. Although MCI Inc. (MCI)
filed for bankruptcy protection on July 21, 2002, the Company continued to recognize revenues from
MCI on an accrual basis during 2004 and 2005 (MCI emerged from bankruptcy in April 2004) based on
its specific facts and circumstances in relation to the revenue recognition criteria described
above. Consequently, the amounts in this paragraph related to financially distressed customers
exclude amounts pertaining to MCI. The Company has identified certain of its customers who were essentially current in their
payments for the Companys services prior to March 31, 2005, or have subsequently paid all or
significant portions of the respective amounts that the Company recorded as accounts receivable as
of March 31, 2005, that the Company believes may be at risk of becoming financially distressed.
Revenues from these customers accounted for approximately 7.5% and 9.8% of the Companys total net
revenues for the three months ended March 31, 2005 and 2004, respectively. As of March 31, 2005,
receivables from these customers comprised 9.5% of the Companys gross accounts receivable balance.
If these customers are unable to demonstrate their ability to pay for the Companys services in a
timely manner in periods ending subsequent to March 31, 2005, revenues from such customers will
only be recognized when cash is collected, as described above. 11




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3. Customer Warrants On January 1, 2003, in conjunction with an amendment to an agreement with AT&T, the Company
granted AT&T three warrants to purchase shares of the Companys common stock as follows: 1,000
shares for $0.94 per share; 1,000 shares for $3.00 per share; and 1,000 shares for $5.00 per share.
Such warrants were immediately exercisable, fully vested and nonforfeitable at the date of grant.
Accordingly, the measurement date for these warrants was the date of grant. The aggregate fair
value of such warrants of $2,640 was recorded as a deferred customer incentive during the year
ended December 31, 2003 and is being recognized as a reduction of revenues on a straight-line basis
over the three-year term of the agreement because the Company believes that future revenues from
AT&T will exceed the fair value of the warrants described above. The aggregate fair value was
determined using the Black-Scholes option valuation model with the following facts and assumptions:
closing price of the Companys common stock on December 31, 2002 of $0.94 per share; expected life
of seven years (which is also the contractual life of the warrants); dividend yield of zero;
volatility of 1.52; and a risk-free interest rate of 3.36%. None of these warrants were exercised
during the three months ended March 31, 2005 or 2004, or had expired as of March 31, 2005. As of
March 31, 2005 and December 31, 2004 the carrying amount of the warrants was $412 and $660,
respectively. On September 4, 2002, in conjunction with the execution of a five-year agreement with America
Online, Inc. (AOL), a wholesale customer, the Company granted AOL three warrants to purchase
1,500 shares of the Companys common stock for $1.06 per share, 1,000 shares of the Companys
common stock for $3.00 per share and 1,000 shares of the Companys common stock for $5.00 per
share. Such warrants were immediately exercisable, fully vested and nonforfeitable at the date of
grant. Accordingly, the measurement date for these warrants was the date of grant. The aggregate
fair value of such warrants of $3,790, which was determined using the Black-Scholes option
valuation model with the following facts and assumptions: closing price of the Companys common
stock on September 4, 2002 of $1.14 per share; expected life of seven years (which is also the
contractual life of the warrants); dividend yield of zero; volatility of 1.56; and a risk-free
interest rate of 3.63%, was recorded as a deferred customer incentive during the year ended
December 31, 2002 and is being recognized as a reduction of revenues on a straight-line basis over
the five-year term of the agreement because the Company believes that future revenues from AOL will
exceed the fair value of the warrants described above. None of these warrants were exercised during
the three months ended March 31, 2005 or 2004, or had expired as of March 31, 2005. As of March 31,
2005 and December 31, 2004 the carrying amount of the warrants was $1,834 and $2,023, respectively. Other warrants for the purchase of 14 shares of the Companys common stock were outstanding as
of March 31, 2005. Such warrants are exercisable at a purchase price ranging from $0.01 to $2.13
per share and are fully vested as of March 31, 2005. Unless exercised, all such warrants will
expire during periods ending between October 2007 and March 2008. The Company recorded amortization on the above described warrants in the amount of $437 for
the three months periods ended March 31, 2005 and 2004, respectively. 4. Restructuring Reduction in Force The Company reduced its workforce by approximately 41 employees, which represented
approximately 3.7% of the Companys workforce during the three months ended March 31, 2004. The
reductions covered employees in the areas of sales and marketing, operations and corporate
functions. In connection with the reductions in force, the Company recorded a charge to operations
for the three months ended March 31, 2004 of $547, relating to employee severance benefits, $446 of
which were paid during the three months ended March 31, 2004 and $101 were paid in April 2004. The
expenses associated with these reductions in force were $186 related to the Companys Wholesale
segment, and $123 related to the Companys Direct segment. The remaining $238 in expenses
associated with these reductions in force were related to the Companys Corporate Operations for
the three months ended March 31, 2004. The Company did not record restructuring activities during
the three months ended March 31, 2005. 12




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Other Restructuring Activities On September 22, 2000, the Company acquired BlueStar Communications Group, Inc. and its
subsidiaries (collectively BlueStar), in a transaction accounted for as a purchase. BlueStar, a
wholly owned subsidiary of the Company, provided broadband communications and Internet services to
small and medium sized businesses. Continued losses at BlueStar, caused the Companys board of
directors to decide, on June 22, 2001, to cease the Companys funding of BlueStars operations. On June 25, 2001, BlueStar made an irrevocable assignment for the benefit of creditors (ABC)
of all its assets to an independent trustee (the Assignee) in the State of Tennessee. An ABC
under Tennessee law is a non-judicial alternative to a plan of liquidation under Chapter 7 of the
Bankruptcy Code. As a result of the ABC, BlueStars former assets were no longer controlled by
BlueStar or the Company and could not be used by either BlueStars or the Companys boards of
directors to satisfy the liabilities of BlueStar and the liquidation of BlueStars assets and the
settlement of its liabilities was under the sole control of the Assignee. Consequently, the Company
deconsolidated BlueStar effective June 25, 2001, which resulted in the recognition of a deferred
gain in the amount of $55,200 in the Companys consolidated balance sheet as of December 31, 2001.
This deferred gain represented the difference between the carrying values of BlueStars assets
(aggregating $7,900) and liabilities (aggregating $63,100) as of June 25, 2001. During 2003 and
2002, the deferred gain was reduced by $9 and $1,228, respectively, because certain BlueStar assets
were inadvertently not deconsolidated on June 25, 2001. As of December 31, 2004, the amount of this
deferred gain was $53,963. On February 4, 2005, the Seventh Circuit Court for Davidson County, Tennessee ordered the
Assignee in the ABC to make a final distribution of funds of the estates to holders of allowed
claims. Such final distribution has been made. As a result of the completion of the ABC, the
Company recognized a deferred gain of $53,963 during the three months ended March 31, 2005. 5. Long-Term Debt On March 10, 2004, the Company completed a private placement of $125,000 in aggregate
principal amount of 3% Convertible Senior Debentures (Debentures) due 2024, which are convertible
into shares of the Companys common stock at a conversion price of approximately $3.1742 per share,
subject to certain adjustments. The Debentures mature on March 15, 2024. The Company may redeem
some or all of the Debentures for cash at any time on or after March 20, 2009. Holders of the
Debentures have the option to require the Company to purchase the Debentures in cash, in whole or
in part, on March 15, 2009, 2014 and 2019. The holders of the Debentures will also have the ability
to require the Company to purchase the Debentures in the event that the Company undergoes a change
in control. In each case, the redemption or purchase price would be at 100% of their principal
amount, plus accrued and unpaid interest thereon. Net proceeds from the Debentures were
approximately $119,961 after commission and other transaction costs. The Company incurred
approximately $5,039 in transaction costs in conjunction with the placement of the Debentures. The
transaction costs, or debt issuance costs, are being amortized to operations over sixty months, the
period through to the first date that holders have the option to require the Company to purchase
the Debentures. On March 11, 2004, the Company used a portion of the net proceeds of the offering to repay its
11% note payable to SBC. The payment amounted to $56,569, including $50,000 of principal and $6,569
of accrued interest. As of March 31, 2005, the
Company had a $3,000 revolving line of credit note with a bank that was
available through May 1, 2005. The Company renewed the $3,000
revolving line of credit note on May 1, 2005. The outstanding
principal balance of the new note bears interest at a rate per annum
equal to the prime rate. Interest accrued of the note is payable on
the last day of the month commencing May 31, 2005. The outstanding
principal balance of the note is due in full on May 1, 2006. 6. Commitments and Contingencies Litigation On December 13, 2001, the United States Bankruptcy Court for the District of Delaware (the
Bankruptcy Court) entered an order confirming the Companys pre-negotiated First Amended Plan of
Reorganization as modified on November 26, 2001 (the Plan). On December 20, 2001 (the Effective
Date), the Plan was consummated and the Company emerged from bankruptcy. Under the Plan, the
Company settled several claims against it. As of March 31, 2005 and 2004, there were approximately
$39 and $1,355, respectively, in unresolved claims related to the Companys Chapter 11 bankruptcy
proceedings. As of March 31, 2005 and 2004, the Company had recorded $39 and $392, respectively,
for these unresolved claims in its condensed consolidated balance sheets. 13




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However, it is reasonably possible that the Companys unresolved Chapter 11 bankruptcy claims
could ultimately be settled for amounts that differ from the amounts recorded in the Companys
condensed consolidated balance sheets. In April 1999, the Company filed a lawsuit against Bell Atlantic (now Verizon) and its
affiliates in the United States District Court for the District of Columbia. The Company is
pursuing antitrust and other claims in this lawsuit arising out of Verizons conduct as a supplier
of network facilities, including central office space, transmission facilities and telephone lines.
In December 2000, the Company also filed a lawsuit against BellSouth Telecommunications and its
subsidiaries in the United States District Court for the Northern District of Georgia. The Company
is pursuing claims in this lawsuit that are similar to its claims against Verizon. Both courts
dismissed some of the Companys claims based on the ruling of the Seventh Circuit in Goldwasser v.
Ameritech. The court in the Verizon case also dismissed the Companys remaining claims on other
grounds. The Company voluntarily dismissed its remaining claims in the BellSouth case so it could
pursue certain issues on appeal. The Company appealed these decisions to the United States Court of
Appeals for the Eleventh Circuit and the United States Court of Appeals for the District of
Columbia. On August 2, 2002, the Eleventh Circuit Court of Appeals reversed the lower courts
decision in the BellSouth case and remanded the case for further proceedings. BellSouth appealed
this decision to the United States Supreme Court. On January 20, 2004, the United States Supreme
Court reversed a decision entitled Verizon Communications v. Law Offices of Curtis Trinko, which
rejected the Goldwasser decision. The Supreme Court also vacated the Eleventh Circuits decision in
the Companys case against BellSouth and remanded the case to the Eleventh Circuit for review in
light of the Trinko decision. On June 25, 2004, the Eleventh Circuit reversed portions of the lower
courts decision in the BellSouth case and remanded that case to the District Court for further
proceedings. On November 24, 2004, the Company requested that the United States Supreme Court
review certain portions of the Eleventh Circuits decision unrelated to the Companys antitrust
claims. The Supreme Court denied the Companys request. The Court of Appeals for the District of
Columbia also recently reversed in part and affirmed in part the District Courts decision and
remanded the Companys case against Verizon to the District Court for further proceedings. The
Company cannot predict the outcome of these proceedings at this time. On June 11, 2001, Verizon filed a lawsuit against the Company in the United States District
Court for the Northern District of California. Verizon is a supplier of telephone lines that the
Company uses to provide services to its customers. In its amended complaint, Verizon claims that
the Company falsified trouble ticket reports with respect to the telephone lines that the Company
ordered and seeks unspecified monetary damages (characterized as being in the millions) and
injunctive relief. On November 13, 2002, the District Court entered summary judgment in favor of
the Company and dismissed Verizons claims against the Company in their entirety. Verizon appealed
the dismissal of its lawsuit and in July 2004 the Ninth Circuit Court of Appeals partially reversed
the District Courts decision and indicated that Verizon could attempt to pursue a claim against
the Company for breach of contract. The matter has been sent back to the District Court for further
proceedings. The Company believes it has strong defenses to this lawsuit, but litigation is
inherently unpredictable and there is no guarantee it will prevail. Several stockholders have filed complaints in the United States District Court for the
Southern District of New York, on behalf of themselves and purported classes of stockholders,
against the Company and several former and current officers and directors in addition to some of
the underwriters who handled the Companys stock offerings. These lawsuits are so-called IPO
allocation cases, challenging practices allegedly used by certain underwriters of public equity
offerings during the late 1990s and 2000. On April 19, 2002, the plaintiffs amended their complaint
and removed the Company as a defendant. Certain directors and officers are still named in the
complaint. The plaintiffs claim that the Company and others failed to disclose the arrangements
that some of these underwriters purportedly made with certain investors. The plaintiffs and the
issuer defendants have reached a tentative agreement to settle the matter, and the Company believes
the tentative settlement will not have a material adverse effect on its consolidated financial
position or results of operations. That settlement, however, has not been finalized. If the
settlement is not finalized, the Company believes it has strong defenses to these lawsuits and
intends to contest them vigorously. However, litigation is inherently unpredictable and there is no
guarantee that the Company will prevail. In June 2002, Dhruv Khanna was relieved of his duties as the Companys General Counsel and
Secretary. Shortly thereafter, Mr. Khanna alleged that, over a period of years, certain current and
former directors and officers had breached their fiduciary duties to the Company by engaging in or
approving actions that constituted waste and self-dealing, that certain current and former
directors and officers had provided false representations to the Companys auditors and that he had
been relieved of his duties in retaliation for his being a purported whistleblower and because of
racial or national origin discrimination. He threatened to file a shareholder derivative action
against 14




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##### Table of Contents



those current and former directors and officers, as well as a wrongful termination lawsuit.
Mr. Khanna was placed on paid leave while his allegations were being investigated. The Companys Board of Directors appointed a special investigative committee, which initially
consisted of Dale Crandall and Hellene Runtagh, to investigate the allegations made by Mr. Khanna.
Richard Jalkut was appointed to this committee shortly after he joined the Companys Board of
Directors. This committee retained an independent law firm to assist in its investigation. Based on
this investigation, the committee concluded that Mr. Khannas allegations were without merit and
that it would not be in the best interests of the Company to commence litigation based on these
allegations. The committee considered, among other things, that many of Mr. Khannas allegations
were not accurate, that certain allegations challenged business decisions lawfully made by
management or the Board, that the transactions challenged by Mr. Khanna in which any director had
an interest were approved by a majority of disinterested directors in accordance with Delaware law,
that the challenged director and officer representations to the auditors were true and accurate,
and that Mr. Khanna was not relieved of his duties as a result of retaliation for alleged
whistleblowing or racial or national origin discrimination. Mr. Khanna has disputed the committees
work and the outcome of its investigation. After the committees findings had been presented and analyzed, the Company concluded in
January 2003 that it would not be appropriate to continue Mr. Khanna on paid leave status, and
determined that there was no suitable role for him at the Company. Accordingly, he was terminated
as an employee of the Company. Based on the events mentioned above, in September 2003, Mr. Khanna filed a purported class
action and a derivative lawsuit against the Companys current and former directors in the Court of
Chancery of the State of Delaware in and for New Castle County. On August 3, 2004, Mr. Khanna
amended his Complaint and two additional purported shareholders joined the lawsuit. In this action
the plaintiffs seek recovery on behalf of the Company from the individual defendants for their
purported breach of fiduciary duty. The plaintiffs also seek to invalidate the Companys election
of directors in 2002, 2003 and 2004 because they claim that the Companys proxy statements were
misleading. The Company is unable to predict the outcome of this lawsuit. The Company is also a party to a variety of other pending or threatened legal proceedings as
either plaintiff or defendant, or is engaged in business disputes that arise in the ordinary course
of business. Failure to resolve these various legal disputes and controversies without excessive
delay and cost and in a manner that is favorable to the Company could significantly harm its
business. The Company does not believe the ultimate outcome of these matters will have a material
impact on its condensed consolidated financial position and results of operations. However,
litigation is inherently unpredictable and there is no guarantee the Company will prevail or
otherwise not be adversely affected. The Company is subject to state public utility commission, FCC and other regulatory and court
decisions as they relate to the interpretation and implementation of the 1996 Telecommunications
Act. In addition, the Company is engaged in a variety of legal negotiations, arbitrations and
regulatory and court proceedings with multiple telephone companies. These negotiations,
arbitrations and proceedings concern the telephone companies denial of central office space, the
cost and delivery of transmission facilities and telephone lines and central office spaces, and
other operational issues. Other than the payment of legal fees and expenses, which are not
quantifiable but are expected to be material, the Company does not believe that these matters will
result in material liability to it and the potential gains are not quantifiable at this time. An
unfavorable result in any of these negotiations, arbitrations and proceedings, however, could have
a material adverse effect on the Companys condensed consolidated financial position and results of
operations if it is denied or charged higher rates for transmission lines or central office spaces. Purchasers of the Companys common stock and purchasers of the convertible senior notes the
Company issued in September 2000 filed complaints on behalf of themselves and alleged classes of
stockholders and holders of convertible notes against the Company and certain present and former
officers of the Company in the United States District Court for the Northern District of California
(the District Court) alleging violations of federal securities laws on behalf of persons who
purchased or otherwise acquired the Companys securities, including common stock and notes, during
the period from April 19, 2000 to May 24, 2001. In 2001, the Company and the officer and director
defendants agreed to settle the litigation. The settlement provided for the distribution to the
plaintiffs of $16,500 in cash to be funded by the Companys insurance carriers and 6,496 shares of
the Companys common stock. Consequently, the Company recorded a liability of approximately $18,578
in its condensed consolidated 15




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balance sheet as of December 31, 2001 through a charge to litigation-related expenses for the
year then ended in connection with this anticipated settlement. As a result of changes in the fair
market value of the Companys common stock, the Company decreased this liability to $6,950 as of
December 31, 2002 through credits to litigation-related expenses in the amount of $11,628 for the
year ended December 31, 2002. The settlement was subject to the approval of the District Court and,
on December 18, 2002, the District Court issued its final judgment and dismissal order. One class
member subsequently filed an appeal pertaining to the final judgment, but this appeal only related
to the allocation of the settlement proceeds between the plaintiffs and their attorneys. On
February 18, 2004, the Ninth Circuit affirmed the District Courts final judgment. Consequently, on
such date the Company considered the 6,496 shares validly issued and outstanding. The distribution
of the shares was completed in April of 2004. Other Contingencies As of March 31, 2005, the Company had disputes with a number of telecommunications companies
concerning the balances owed to such carriers for collocation fees and certain network services.
The Company believes that such disputes will be resolved without a material adverse effect on its
condensed consolidated financial position and results of operations. However, it is reasonably
possible that the Companys estimates of its collocation fee and network service obligations, as
reflected in the accompanying condensed consolidated balance sheets, could change in the near term,
and the effects could be material to the Companys condensed consolidated financial position and
results of operations. The Company performs ongoing analysis of the applicability of certain transaction-based taxes
to (i) sales of its products and services and (ii) purchases of telecommunications circuits from
various carriers. This analysis includes discussions with authorities of significant jurisdictions
in which the Company does business to determine the extent of its transaction-based tax
liabilities. It is the Companys opinion that this analysis will be concluded without a material
adverse effect on its condensed consolidated financial position and results of operations. However,
it is reasonably possible that the Companys estimates of its transaction-based tax liabilities, as
reflected in the accompanying condensed consolidated balance sheets, could change in the near term,
and the effects could be material to the Companys condensed consolidated financial position and
results of operations. The Company is analyzing the applicability of employment-related taxes for certain stock-based
compensation provided to employees in prior periods. Due to the probable applicability of these
taxes, the Company recorded an estimated liability through a charge to operations in the amount of
$5,931 during the year ended December 31, 2003. During the year ended December 31, 2004, the
Company determined that it does not owe a portion of this tax, approximately $3,079, and
consequently, released the amount as a benefit to the statement of operations. It is the Companys
opinion that such analysis will be concluded without a material adverse effect on its condensed
consolidated financial position and results of operations. However, it is reasonably possible that
the Companys estimates of these tax liabilities, as reflected in the accompanying condensed
consolidated balance sheets as of March 31, 2005, could change in the near term, and the effects
could be material to the Companys condensed consolidated financial position and results of
operations. Indemnification Agreements From time to time, the Company enters into certain types of contracts that contingently
require it to indemnify various parties against claims from third parties. These contracts
primarily relate to: (i) certain real estate leases, under which the Company may be required to
indemnify property owners for environmental and other liabilities, and other claims arising from
the Companys use of the applicable premises, (ii) certain agreements with the Companys officers,
directors and employees, under which the Company may be required to indemnify such persons for
liabilities arising out of their employment relationship, (iii) contracts under which the Company
may be required to indemnify customers against third-party claims that a Company product infringes
a patent, copyright or other intellectual property right and (iv) procurement or license agreements
under which the Company may be required to indemnify licensors or vendors for certain claims that
may be brought against them arising from the Companys acts or omissions with respect to the
supplied products or technology. Generally, a maximum obligation under these contracts is not explicitly stated. Because the
obligated amounts associated with these types of agreements are not explicitly stated, the overall
maximum amount of the obligation cannot be reasonably estimated. Historically, the Company has not
been required to make significant payments 16




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under these obligations, and no liabilities have, therefore, been recorded for these
obligations in the Companys condensed consolidated balance sheets. Commitments Effective March 31, 2005, the
Company entered into an agreement to extend the terms of its office
lease in Herndon, Virginia. The extension is for a period of five
years which commences on August 1, 2005. The extension of the
lease increases the Companys lease commitments by approximately
$5,029. In 2005, the Company entered into an agreement with Sylantro Systems Corporation to obtain
discounted pricing on ComSuite Module licenses. For 2005, the Company has a minimum remaining aggregate
purchase commitment of $1,800 as of March 31, 2005. In 2002, the Company entered into a three-year, non-exclusive agreement with MCI, for the
right to provide certain network services to the Company. The Company has a monthly minimum usage
requirement which began in June 2002. The agreement expires in May 2005 and has a remaining
purchase obligation of $1,340 as of March 31, 2005. In addition, in 2002, the Company entered into
a four-year, non-exclusive agreement with AT&T for the right to provide long distance services to
the Company. The Company has an annual minimum usage requirement which began in April 2002. The
agreement expires in March 2006 and has a minimum remaining aggregate usage commitment of
approximately $1,125 as of March 31, 2005. 7. Business Segments The Company sells to businesses and consumers indirectly through Internet service providers,
or ISPs, telecommunications carriers and other resellers. The Company also sells its services
directly to business and consumer end-users through its field sales force, telephone sales,
referral agents and its website. The Company presently operates two business segments, Wholesale
and Direct, which are described below in more detail. The Companys business segments are strategic business units that are managed based upon
differences in customers, services and marketing channels, even though the assets and cash flows
from these operations are not independent of each other. The Companys wholesale segment, or
Wholesale, is a provider of high-speed connectivity services to ISPs and enterprise and
telecommunications carrier customers. The Companys direct segment, or Direct, is a provider of
voice over Internet protocol, or VoIP, high-speed connectivity, Internet access and other services
to individuals, small and medium-sized businesses, corporations and other organizations. All other
business operations and activities of the Company are reported as Corporate Operations. These
operations and activities are primarily comprised of general corporate functions to support the
Companys revenue producing segments as well as costs and expenses for headquarters facilities and
equipment, certain branding and corporate promotions, depreciation and amortization, network
capacity and other non-recurring or unusual items not directly attributable or allocated to the
segments, gains and losses on the Companys investments, and income and expenses from the Companys
treasury and financing activities. The Company evaluates performance and allocates resources to the segments based on income or
loss from operations, excluding certain operating expenses, such as depreciation and amortization,
and other income and expense items. The Company does not segregate its assets or its cash flows
between its two segments because these resources are not managed separately by segment. The Company
similarly manages its capital expenditures and cash needs as one entity. Therefore, the Company
does not allocate such operating expenses and other income and expense items to its business
segments because it believes that these expenses and other income items are not directly managed or
controlled by its business segments. Segment information, including a reconciliation to the respective balances in the Companys
condensed consolidated financial statements, as of and for the three months ended March 31, 2005
and 2004 are as follows: 17




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Total
    
    
    Corporate
    
    
    ConsolidatedAs of and for the three months ended March 31, 2005:
    
    Wholesale
    
    
    Direct
    
    
    Segments
    
    
    Operations
    
    
    TotalRevenues, net
    
    $
    76,261
    
    
    $
    31,457
    
    
    $
    107,718
    
    
    $
    
    
    
    $
    107,718Cost of sales (exclusive of depreciation and
amortization)
    
    
    47,421
    
    
    
    16,117
    
    
    
    63,538
    
    
    
    9,211
    
    
    
    72,749Selling, general and administrative
    
    
    2,215
    
    
    
    15,394
    
    
    
    17,609
    
    
    
    24,765
    
    
    
    42,374Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,149
    
    
    
    19,149Income (loss) from operations
    
    
    26,625
    
    
    
    (54
    )
    
    
    26,571
    
    
    
    (53,125
    )
    
    
    (26,554
    )Other income, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    60,928
    
    
    
    60,928Net income (loss)
    
    $
    26,625
    
    
    $
    (54
    )
    
    $
    26,571
    
    
    $
    7,803
    
    
    $
    34,374Total assets
    
    $
    45,631
    
    
    $
    18,444
    
    
    $
    64,075
    
    
    $
    317,338
    
    
    $
    381,413
 Total
    
    
    Corporate
    
    
    ConsolidatedAs of and for the three months ended March 31, 2004:
    
    Wholesale
    
    
    Direct
    
    
    Segments
    
    
    Operations
    
    
    TotalRevenues net
    
    $
    79,097
    
    
    $
    29,380
    
    
    $
    108,477
    
    
    $
    
    
    
    $
    108,477Cost of sales (exclusive of depreciation and
amortization)
    
    
    46,792
    
    
    
    11,402
    
    
    
    58,194
    
    
    
    10,100
    
    
    
    68,294Selling, general and administrative
    
    
    2,680
    
    
    
    5,163
    
    
    
    7,843
    
    
    
    25,459
    
    
    
    33,302Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,246
    
    
    
    19,246Provision for restructuring expenses
    
    
    186
    
    
    
    123
    
    
    
    309
    
    
    
    238
    
    
    
    547Income (loss) from operations
    
    
    29,439
    
    
    
    12,692
    
    
    
    42,131
    
    
    
    (55,043
    )
    
    
    (12,912
    )Other expense, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    619
    
    
    
    619Net income (loss)
    
    $
    29,439
    
    
    $
    12,692
    
    
    $
    42,131
    
    
    $
    (55,662
    )
    
    $
    (13,531
    )Total assets
    
    $
    62,593
    
    
    $
    8,612
    
    
    $
    71,205
    
    
    $
    318,612
    
    
    $
    389,817
 8. Acquisition of GoBeam, Inc. On June 8, 2004, the Company completed its acquisition of all of the outstanding shares of
privately-held GoBeam, a Delaware corporation based in Pleasanton, California, that provides VoIP
solutions to small and medium-sized businesses. The Company acquired GoBeam to accelerate its plan
to enter the VoIP market. As a result of the acquisition, the Company has added a VoIP offering to
its current portfolio of products and services. In addition, the Company also plans to realize
certain costs synergies and strategic value from combining the two enterprises. These factors
contributed to a purchase price that was in excess of the fair value of GoBeams net tangible and
intangible assets acquired and, as a result, the Company recorded goodwill in connection with this
transaction. The acquisition was effectuated by merging a wholly-owned subsidiary of the Company
with and into GoBeam, with GoBeam surviving the merger as a wholly-owned subsidiary of the Company.
The merger is intended to qualify as a tax-free reorganization. As a result of the merger, the Company issued 18,724 shares of its common stock. Additionally,
the Company has reserved 266 shares to cover shares issuable upon exercise of assumed GoBeam stock
options and 3 shares to cover assumed warrants. Of the shares issued in conjunction with the
merger, 2,216 shares have been placed in an escrow account until August 2005 to cover GoBeams
indemnification obligations under the merger agreement. The Company accounted for the acquisition of GoBeam using the purchase method of accounting.
Accordingly, the Companys condensed consolidated financial statements include the results of
operations of GoBeam for periods ending after the date of acquisition. The Company valued the
common share options and warrants issued, for accounting purposes, based on an average market price
of $2.08 per share, which is based on the average closing price for a range of two trading days
before and after the measurement date of the transaction, June 4, 2004. The outstanding GoBeam
stock options were converted into options to purchase approximately 266 shares of the Companys
common stock. In addition, the outstanding GoBeam warrants were converted into warrants to purchase
3 shares of the Companys common stock. The value of the options and warrants was determined using
the Black-Scholes option pricing model with inputs of 1.284 for volatility, four-year expected life
and a risk-free interest rate of 3.27%. The values of the options and assumed warrants, as well as
direct acquisition costs, were included as elements of the total purchase cost. The total purchase cost of the GoBeam acquisition has been allocated to the assets and
liabilities of GoBeam based upon estimates of their fair values. The following tables set forth the
total purchase cost and the allocation thereof: 18




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Total purchase cost:Value of common shares issued
    
    $
    38,910Value of assumed GoBeam options and warrants
    
    
    45439,364Acquisition costs
    
    
    473Total purchase cost
    
    $
    39,837Purchase price allocation:Tangible net liabilities acquired
    
    $
    (4,479
    )Intangible assets acquired:Customer relationships
    
    
    6,600Internal use software
    
    
    1,090Goodwill
    
    
    36,626Total purchase consideration
    
    $
    39,837
 The tangible assets of GoBeam acquired by the Company aggregating $1,723 consisted principally
of cash, accounts receivable and property and equipment. The liabilities of GoBeam assumed by the
Company aggregating $6,202 consisted principally of accounts payable and accrued expenses. The customer relationships were valued using an income approach, which projects the associated
revenues, expenses and cash flows attributable to the customer base. These cash flows are then
discounted to their present value. Through March 31, 2005, this intangible asset was being
amortized on a straight-line basis over a period of forty-eight months which represents the
expected life of the customer relationships. The internal use software was valued using the replacement cost approach. This approach
estimates value based upon estimated cost to recreate the software with equivalent functionality.
Through March 31, 2005, this intangible asset was being amortized on a straight-line basis over a
period of sixty months. Goodwill was determined based on the residual difference between the purchase cost and the
values assigned to identified tangible and intangible assets and liabilities, and is not deductible
for tax purposes. The Company will test for impairment of these assets on at least an annual basis. The following unaudited pro forma financial information presents the condensed consolidated
results of operations of the Company as if the acquisition of GoBeam had occurred at the beginning
of the period presented. For the three months ended March 31, 2004, net loss included GoBeam merger
expenses of $376. This financial information does not purport to be indicative of the results of
the operations that would have occurred had the acquisition been made at the beginning of the
periods presented, or the results that may occur in the future: Three months endedMarch 31, 2004Revenue
    
    $
    110,077Net loss
    
    $
    (15,717
    )Basic and diluted net loss per share
    
    $
    (0.06
    )
 Upon closing of the acquisition of GoBeam, the Company effectively granted 337 shares of
restricted common stock to certain employees of GoBeam. The restricted common stock was valued on
the date of issuance at $1.96 and vested over a period of two years. Accordingly the Company
recorded deferred stock-based compensation of $660 during the second quarter of 2004. During the
three months ended September 30, 2004, as a result of the resignation of one of the Companys
executives, the Company reversed $289 of such deferred stock-based compensation and cancelled 148
shares of the restricted common stock. The remaining net deferred stock-based compensation balance
of $371 at December 31, 2004 is being amortized on an accelerated basis over the vesting period
consistent with the method described in FIN 28. For the three months ended March 31, 2005, the
Company recognized $78 of stock-based compensation related to such amount. The remaining $112 will
be amortized over the next fourteen months. As part of the acquisition of GoBeam, the Company sold 834 shares for $1,781, or $2.13 per
share, to pay for GoBeams merger expenses. 19




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9. Related Party Transactions A member of the Companys Board of Directors, Richard Jalkut, is the President and CEO of
TelePacific Communications (TelePacific), one of the Companys resellers. The Company recognized
revenues from TelePacific of $78 and $105 during the three months ended March 31, 2005 and 2004,
respectively. Accounts receivables from TelePacific were $25 as of March 31, 2005 and $29 as of
December 31, 2004, respectively. L. Dale Crandall, another of the Companys directors, is a
director of BEA Systems (BEA), one of the Companys vendors. The Company paid $33 and $472 to BEA
during the three months ended March 31, 2005 and 2004, respectively. Charles Hoffman, the Companys
CEO, is a director of Chordiant Software (Chordiant), one of the Companys vendors. The Company
paid $50 to Chordiant during the three months ended March 31, 2005. No amount was paid to this
vendor during the three months ended March 31, 2004. Gary Hoffman, a sibling of the Companys Chief
Executive Officer, is employed by the Company. During the three months ended March 31, 2005, Gary
Hoffman received compensation in the form of salary and commissions in the amount of $29, as well
as an option grant to purchase 2 of the Companys common stock at an exercise price of $1.54. 10. 2003 Employee Stock Purchase Plan In June 2003, the Company adopted the 2003 Employee Stock Purchase Plan. Under this plan,
eligible employees may purchase common stock at 85% of: (i) the fair market value of the Companys
common stock on the first day of the applicable twenty-four month offering period, or (ii) the fair
market value on the last day of the applicable six-month purchase period. The offering period that
commenced in July 2003 and ends in June 2005 is subject to variable accounting. Accordingly the
Company recorded net cumulative deferred stock-based compensation of $13,586 and $20,264 as of
March 31, 2005 and 2004, respectively. During the three months ended March 31, 2005 and 2004, the
Company amortized (reversed) $(1,413) and $781 to operations, respectively. The remaining net
deferred stock compensation balance of $102 as of March 31, 2005, which will fluctuate with changes
in the Companys stock price, is being amortized to operations over the remainder of the life of
the offering period that is subject to variable accounting. 11. Sale of Investments In August 2000, the Company made an equity investment in 10 shares of ACCA Networks Co., Ltd.,
 or ACCA, a privately- held Japanese telecommunications company. In March 2005, ACCA completed a
public offering of its shares in Japan. The Company recorded a net realized gain of $7,246 for the
three months ended March 31, 2005 as a result of the sale of 2 shares of ACCA. In connection with
ACCAs public offering, the Company entered into a customary lock-up agreement with ACCAs
underwriters. Pursuant to that agreement the Company cannot sell 5 of its ACCA shares before
August 2005. The Companys investment in ACCA is classified as available-for-sale, as a result of ACCAs
initial public offering, and stated at its fair market value, which is determined based on quoted
market prices and foreign exchange rates. Unrealized gain and losses on available-for-sale
securities are included as a separate component of the Companys stockholders equity. As of March
31, 2005, the Company recorded an unrealized gain of its shares of ACCA in the amount of $27,671
which is included in the balance of accumulated other comprehensive income (loss). 12. Income Taxes Although the Company recorded net income for the three months ended March 31, 2005, it
projects that on an annualized basis it will record a net loss for the year ending December 31,
2005. The Company made no provision for income taxes in any period presented in the accompanying
condensed consolidated financial statements because it incurred net losses for the periods
presented, or expects to incur net losses for the current year . 13. Subsequent Events During April, 2005, the Company sold an additional 3 shares of ACCA. The sale resulted in a
net realized gain of $9,420. 20




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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 onForm 10-Qand 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, 2004 included in our Annual Report on Form
10-K filed with the Securities and Exchange Commission on March 14,, 2005. 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 onForm 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 We provide voice and data communications products and services to consumers and businesses. We
provide these services throughout the United States in approximately 235 major metropolitan areas,
which includes over 900 cities. Our telecommunications network allows us to offer services to more
than 57 million homes and businesses. Our products and services include high-speed, or broadband,
data communications, Internet access connectivity, voice over Internet Protocol telephony, or VoIP,
and a variety of related services. We primarily use digital subscriber line, or DSL, and DS-1, also
referred to as T-1, technologies to deliver our services. In order to provide our services we
purchase network elements, such as telecommunication lines and central office facilities, from the
traditional local telephone companies, which are often referred to as the incumbent local telephone
companies, or ILECs, and other carriers, and then combine these network elements with our own
nationwide network facilities. We purchase the majority of these network elements from Verizon
Communications, Inc., or Verizon, BellSouth Telecommunications, Inc., or BellSouth, SBC
Communications, Inc., or SBC, and Qwest Corporation, or Qwest, which are also known as the regional
Bell operating companies, or RBOCs. As of March 31, 2005, we had approximately 547,400 broadband
access end-users and 690 VoIP business customers with a combined total of approximately 23,400 VoIP
stations. We operate two business segments, Wholesale and Direct. Wholesale is a provider of high-speed
data connectivity services to Internet service providers, or ISPs, and telecommunications carrier
customers. As of March 31, 2005, Wholesale had approximately 465,900 DSL and T-1 lines in service,
up from 444,600 lines at the end of March 31, 2004. Our Direct segment sells VoIP, high-speed data connectivity and related value-added services
through multiple channels including telesales, field sales, affinity partner programs, and our
website. Direct focuses on the small business market and also sells to enterprise customers that
purchase our services for distribution across their enterprise. Direct ended March 31, 2005 with
approximately 81,500 DSL and T-1 lines in service, up from 71,200 lines at the end of March 31,
2004. Since our inception, we have generated significant net and operating losses and negative
operating cash flow. Our cash reserves are limited and our business plan is based on assumptions
that we believe are reasonable, but some of which are out of our control. If actual events differ
from our assumptions, we may need to raise additional capital on terms that are less favorable than
we desire. Our Opportunities and Challenges Our business is in transition due to changes in telecommunications technologies, the
competitive environment, federal and state telecommunications regulations and our resellers
changing strategies. Sales of our stand-alone DSL services have slowed, and we continue to
experience a high level of churn among our existing end-users due to 21




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competitive pricing pressures and other factors. As a result, we have increased our focus on
direct sales of bundled voice, VoIP and data communications services to small and medium-sized
businesses. This transition presents a substantial business opportunity for us. While we believe we
are favorably positioned to take advantage of this opportunity, our ability to grow our sales of
these services is inherently difficult to predict. Given the facts above and the highly competitive, dynamic and heavily regulated nature of our
business environment, we face a complex array of factors that create challenges and opportunities
for us. Key matters upon which we are focused at this time include the following: Efficient use of cash Since we exited our voluntary bankruptcy proceedings at the end of
2001, we have been able to decrease the amount of cash used in our operations, and concluded the
three months ended March 31, 2005 with working capital of approximately $96,000. We continue to
manage expenses closely. Our ability to attain cash flow sufficiency will largely depend on the
rate at which we can grow our revenues while controlling the expenditures necessary to generate and
support increases in revenue. Manage through a transition in the delivery of broadband Internet access services to consumers
 The delivery of stand-alone high-speed Internet connectivity services by our ISP customers is
facing intense competition from the RBOCs and cable providers like Comcast, Time Warner and Cox
Communications, who are aggressively pricing their consumer broadband services, often as part of a
bundled service offering. We believe these market conditions have placed additional pricing
pressure on us and our resellers, reduced the number of orders for our services, and have caused a
higher level of churn among our end-users. During the first half of 2004, these conditions caused
reductions of approximately 2,600 in our total number of DSL end-users. However, we experienced
increases in net additions of approximately 18,800 DSL end-users in the second half of 2004 and
14,200 DSL end-users for the three months ended March 31, 2005. A portion of our current orders are generated by line-splitting arrangements with voice
providers that bundle our data services with their voice services. The viability of these
line-splitting arrangements is dependent on the ability of these voice providers to enter into
agreements with the RBOCs that provide them with continued access to UNE-P or similar voice resale
platforms. We are also exploring other methods of selling bundled voice and data services directly
to end-users and to our resellers using line-powered voice and wireless broadband technologies, but
we may be unsuccessful in deploying feasible or profitable alternatives. Our operational results in
2005 and beyond will be dependent on the extent to which we can continue sales of our services
under bundling arrangements. Obtain acceptable line-sharing terms from the ILECs We currently support our consumer and
small office/home office focused resellers through line-sharing. We currently generate 17.3% of our
revenues from the sale of our line-shared services. While the revenues we generate from
line-sharing with the RBOCs may decline in future periods, we think this market will continue to be
important to us. The RBOCs are the incumbent local telephone companies in almost all of the
metropolitan areas where we offer our services. Therefore our ability to generate significant
revenue from the sale of our line-shared DSL services will depend on whether we are able to reach
long-term agreements with the RBOCs, like our agreements with
Verizon, SBC and Qwest, or obtain favorable
regulatory rulings that will allow us to share telephone lines for new customers on reasonable
terms. Expand and diversify our sources of revenue We are taking steps to improve our prospects for
revenue growth. First, we have expanded our network by adding central office locations, which will
allow us to offer our services to more end-users. Second, we will continue our efforts to diversify
our revenue sources by adding new services such as VoIP, line-powered voice and wireless
broadband, as well as by adding new resellers. New market opportunities We believe that VoIP services have the potential to be a
significant contributor to our future revenues. However, we are in the early stages of offering
this capability, and our success in providing this new service will depend on our ability to offer
a service that is competitive with voice services provided by other telecommunications service
providers and to continue to improve this service. 22




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Recent Developments On
May 5, 2005, we announced that we reached an agreement with SBC
and AT&T setting forth terms under which we will
provide broadband access to AT&T and SBC following their merger.
The agreement is contingent upon completion of the SBC and AT&T
merger. We also signed a separate commercial agreement with SBC that
allows us to purchase line-sharing over copper and remote-terminal
facilities in SBCs territory for a four-year period. On
March 11, 2005, the most recent changes in the Federal
Communications Commission, or FCC, rules regarding the obligations of ILECs to share their networks with competitive
telecommunications companies like us went into effect. These rules limited, and in some cases
eliminated, our access to:  
    Transport services between the telephone companies central offices at regulated rates
where certain criteria are met;
    High-capacity unbundled DS-1 and DS-3 loops at regulated rates in locations where
certain criteria are met; and
    Dark fiber loops at regulated rates We expect these changes will increase our cost to purchase network elements from the ILECs,
but at this time we cannot reliably quantify the aggregate amount of these increases. In addition, as of March 11, 2005, competitive telecommunications carriers, including our
resellers, are no longer permitted to order voice services from the ILECs under an arrangement
known as the Unbundled Network Element Platform, or UNE-P, for new customers at regulated rates,
and, after a twelve month transition period, will no longer be able to provide service to existing
customers using UNE-P. The existence of UNE-P had allowed us to bundle our data services with the
voice services of competitive telecommunications providers through line-splitting arrangements. We
currently provide services to 9.4% of our end-users, or 2.0% of our revenues, utilizing
line-splitting technology. We will only be able to continue bundling services in this manner with
competitive telecommunications providers that reach agreements with the ILECs to allow them
continued access to UNE-P or similar resold services. If these competitive telecommunications
providers cannot reach agreements with the ILECs for continued access to UNE-P, we expect that our
ability to continue to provide bundled services with these providers will cease, however, at this
time we cannot reliably quantify such impact. We are also exploring alternative methods of
delivering residential voice services with which we and our resellers can package our data
services. For example, we plan to conduct trials of a line-powered voice access service that would enable our
resellers to offer local and long distance voice services to their customers in competition with
the local telephone companies. We are also conducting trials of a wireless broadband service. The FCCs recent decisions have created a number of uncertainties, challenges and potential
opportunities for us. The final effect of these developments will be subject to further proceedings
at the FCC and the reactions of the various participants in the telecommunications industry, and
many of these components are, or likely will be, the subject of continuing litigation that could
influence the decisions ultimate impact. As such, it is very difficult for us to predict with a
high degree of certainty the final effects of the FCCs decisions. As a result of these events, we
are exploring alternative methods of selling bundled voice and data services directly to end-users
and through our resellers. However, we may be unsuccessful in identifying feasible or profitable
alternatives. Critical Accounting Policies and Estimates Our discussion and analysis of financial condition and results of operations is based upon our
condensed consolidated financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States for interim financial information, the
instructions to Form 10-Q and Article 10 of Regulation S-X. The preparation of our condensed
consolidated financial statements requires us to make estimates that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosures of contingent assets and
liabilities. We base our accounting estimates on historical experience and other factors that we
believe to be reasonable under the circumstances. However, actual results may vary from these
estimates under different assumptions or conditions. We have discussed the development and
selection of critical accounting policies and estimates with our audit committee. The following is
a summary of our critical accounting policies and estimates we make in preparing our condensed
consolidated financial statements:  
    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 23




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price is reasonably assured. We recognize up-front fees associated with service activation
over the expected term of the customer relationship, which is presently estimated to be
twenty-four to forty-eight months using the straight-line method. Similarly, we treat the
incremental direct costs of service activation, which consist principally of customer premises
equipment, service activation fees paid to other telecommunications companies and sales
commissions, as deferred charges in amounts no greater than the up-front fees that are
deferred, and such incremental direct costs are amortized to expense using the straight-line
method over a range of twenty-four to forty-eight months.
    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. 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 determine our reporting units, for
purposes of testing for impairment, by determining (i) how we manage our operations, (ii)
if a component of an operating unit constitutes a business for which discrete financial
information is available and our management regularly reviews such financial information,
and (iii) how the acquired entity is integrated with our operations. Based on these
criteria, we determined that our Wholesale and Direct segments are our reporting units. On
June 8, 2004, we completed the acquisition of all of the outstanding shares of
privately-held GoBeam, Inc., as described in Note 8 to our condensed consolidated financial
statements, Acquisition of GoBeam, Inc. We integrated and manage the GoBeam business
within our Direct segment. Accordingly, the recorded goodwill from the acquisition of
GoBeam was allocated to the Direct segment for purposes of testing for impairment.
    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. However, it is
reasonably possible that the liabilities reflected in our condensed 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 condensed
consolidated financial position and results of operations. 24




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
    We continue to analyze the applicability of certain transaction-based taxes to sales of
our products and services and purchases of telecommunications circuits from various
carriers. This analysis includes discussions with authorities of jurisdictions in which we
do business and various transaction-based tax experts to determine the extent of our
transaction-based tax liabilities. We believe that these discussions will be concluded
without a material adverse effect on our condensed consolidated financial position and
results of operations. 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 condensed consolidated financial position and
results of operations.
    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 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.
    We account for stock-based awards to employees using the intrinsic value method, and
non-employees using the fair value method. Under the intrinsic value method, when the
exercise price of our employee stock options equals or exceeds the market price of the
underlying stock on the date of grant, we do not record compensation expense in our
condensed consolidated statements of operations. We use the intrinsic value method in
accounting for employee stock options because the alternative fair value accounting
requires us to use option valuation models that were not developed for use in valuing
employee stock options. Rather, such option valuation models were developed for use in
estimating the fair value of traded options that have no vesting restrictions and are fully
transferable. Because our employee stock options have characteristics significantly
different from those of traded options and because changes in the subjective input
assumptions can materially affect the fair value estimates of these valuation models, we
believe such existing models do not necessarily provide a reliable single measure of the
fair value of our employee stock options. Recent Accounting Pronouncements In March 2005, the Financial Accounting Standards Board (FASB), issued Interpretation
(FIN) No. 47, Accounting for Conditional Asset Retirement Obligations  an interpretation of
FASB Statement of Financial Accounting Standards (SFAS), No. 143, Accounting for Asset
Retirement Obligations. FIN 47 clarifies that the term conditional asset retirement obligationas
used in SFAS 143,refers to a legal obligation to perform an asset retirement activity in which the
timing and (or) method of settlement are conditional on a future event that may or may not be
within the control of the entity. The obligation to perform the asset retirement activity is
unconditional even though uncertainty exists about the timing and (or) method of settlement. Thus,
the timing and (or) method of settlement may be conditional on a future event. Accordingly, an
entity is required to recognize a liability for the fair value of a conditional asset retirement
obligation if the fair value of the liability can be reasonably estimated. The fair value of a
liability for the conditional asset retirement obligation should be recognized when incurred,
generally upon acquisition, construction, or development and (or) through the normal operation of
the asset. Uncertainty about the timing and (or) method of settlement of a conditional asset
retirement obligation should be factored into the measurement of the liability when sufficient
information exists. SFAS 143 acknowledges that in some cases, sufficient information may not be
available to reasonably estimate the fair value of an asset retirement obligation. FIN 47 also
clarifies when an entity would have sufficient information to reasonably estimate the fair value of
an asset retirement obligation. We are required to adopt FIN 47 by no later than December 31, 2005.
We are currently 25




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evaluating the effect that the adoption of FIN 47 will have on our condensed consolidated
statement of operations and financial condition for the year ending December 31, 2005. In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, or SFAS
123R, that addresses the accounting for share-based payment transactions in which an enterprise
receives employee services in exchange for either equity instruments of the enterprise or
liabilities that are based on the fair value of the enterprises equity instruments or that may be
settled by the issuance of such equity instruments. The statement eliminates the ability to account
for share-based compensation transactions using the intrinsic value method as prescribed by
Accounting Principles Board, or APB, Opinion No. 25, Accounting for Stock Issued to Employees,
and generally requires that such transactions be accounted for using a fair-value-based method and
recognized as expenses in our condensed consolidated statements of operations. The statement
requires companies to assess the most appropriate model to calculate the value of the options. We
currently use the Black-Scholes option pricing model to value options and are currently assessing
which model we may use in the future under the statement and may deem an alternative model to be
the most appropriate. The use of a different model to value options may result in a different fair
value than the use of the Black-Scholes option pricing model. In addition, there are a number of
other requirements under the new standard that will result in differing accounting treatment than
currently required. These differences include, but are not limited to, the accounting for the tax
benefit on employee stock options and for stock issued under our employee stock purchase plan. In
addition to the appropriate fair value model to be used for valuing share-based payments, we will
also be required to determine the transition method to be used at date of adoption. The allowed
transition methods include prospective and retroactive adoption options. Under the retroactive
options, prior periods may be restated either as of the beginning of the year of adoption or for
all periods presented. The prospective method requires that compensation expense be recorded for
all unvested stock options and restricted stock at the beginning of the first quarter of adoption
of SFAS 123R. On April 14, 2005 the Securities and Exchange Commission, or SEC, announced the adoption of a
new rule that amends the compliance dates for SFAS 123R. Under SFAS 123R, we would have been
required to implement the standard as of the beginning of the first interim or annual period that
begins after June 15, 2005. The SECs new rule allows us to implement SFAS 123R at the beginning of
our next fiscal year. Consequently, the effective date of the new standard for our condensed
consolidated financial statements is our first quarter in 2006. The SECs new rule does not change
the accounting required by SFAS 123R; it changes only the dates for compliance with the standard. Upon adoption, this statement will have a significant impact on our condensed consolidated
financial statements as we will be required to expense the fair value of our stock option grants
and stock purchases under our employee stock purchase plan rather than disclose the impact on our
condensed consolidated net income within our footnotes as is our current practice (see Note 1 of
the notes of the condensed consolidated financial statements contained herein). The amounts
disclosed within our footnotes are not necessarily indicative of the amounts that will be expensed
upon the adoption of SFAS 123R. Compensation expense calculated under SFAS 123R may differ
materially from amounts currently disclosed within our footnotes based on changes in the fair value
of our common stock, changes in the number of options granted or the terms of such options, the
treatment of tax benefits and changes in interest rates or other factors. In addition, upon
adoption of SFAS 123R we may choose to use a different valuation model, or continue to use our
current model, but with different assumptions, to value the compensation expense associated with
employee stock options. In December 2004, the FASB issued SFAS No. 153 Exchanges of Non-monetary Assets. SFAS 153
eliminates the exception from fair value measurement for non-monetary exchanges of similar
productive assets in paragraph 21 (b) of APB opinion 29, Accounting for Non-monetary
Transactions, and replaces it with an exception for exchanges that do not have commercial
substance. SFAS 153 specifies that 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. SFAS 153
is effective for fiscal periods beginning after June 15, 2005. We are currently evaluating the
effect that the adoption of SFAS 153 will have on our condensed consolidated statement of
operations and financial condition for fiscal periods beginning after June 15, 2005. In November 2004, the FASB issued SFAS No. 151 Inventory Costs  an amendment of Accounting
Research Bulletin No. 43, Chapter 4. SFAS 151 amends the guidance in ARB No. 43, Chapter 4,
Inventory Pricing,, to clarify the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material, or spoilage. Paragraph 5 of ARB 43, previously stated
that under some circumstances, items such as idle facility 26




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expense, excessive spoilage, double freight, and re-handling costs may be so abnormal as to
require treatment as current period charges. SFAS 151 requires that such items be recognized as
current period charges regardless of whether they meet the criterion of so abnormal. In addition,
SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based
on the normal capacity of the production facilities. SFAS 151 is effective for fiscal periods
beginning after June 15, 2005. We are currently evaluating the effect that the adoption of SFAS 151
will have on our condensed consolidated statement of operations and financial condition for fiscal
periods beginning after June 15, 2005. In March 2004, the FASB approved Emerging Issue Task Force, or EITF, Issue 03-6,
Participating Securities and the Two-Class Method under SFAS 128. EITF Issue 03-6 supersedes the
guidance in Topic No. D-95, Effect of Participating Convertible Securities on the Computation of
Basic Earnings per Share, and requires the use of the two-class method of participating
securities. The two-class method is an earnings allocation formula that determines earnings per
share for each class of common stock and participating security according to dividends declared (or
accumulated) and participation rights in undistributed earnings. In addition, EITF Issue 03-6
addresses other forms of participating securities, including options, warrants, forwards and other
contracts to issue an entitys common stock, with the exception of stock-based compensation subject
to the provisions of Opinion 25 and SFAS 123. EITF Issue 03-6 is effective for reporting periods
beginning after March 31, 2004 and should be applied by restating previously reported earnings per
share. The adoption of EITF Issue 03-6 did not have a significant effect on our consolidated
financial statements for the three months ended March 31, 2005. Results of Operations For The Three Months Ended March 31, 2005 and 2004 Business Segment Information We manage our business segments based upon differences in customers, services and marketing
channels, even though the assets and cash flows from these operations were not independent of each
other. Our wholesale segment, or Wholesale, is a provider of high-speed connectivity services to
ISPs, and enterprise and telecommunications carrier customers. Our direct segment, or Direct, is a
provider of voice and data communication services, which include VoIP, high-speed Internet access
and other related services, to individuals, small and medium-sized businesses, and other
organizations. We report all other operations and activities as Corporate Operations. These
operations and activities were primarily comprised of general corporate functions to support our
revenue producing segments and included costs and expenses for headquarters facilities and
equipment, depreciation and amortization, network capacity and non-recurring or unusual items not
directly attributable or allocated to the segments, gains and losses on our investments, and income
and expenses from our treasury and financing activities. We do not allocate such operating expenses
and other income and expense items to our business segments because we believe these expenses and
other income items are not directly managed or controlled by our business segments. We measure our business segments profitability as income from operations, excluding certain
operating expenses such as depreciation and amortization, and other income and expenses items. We
record business segments net revenues based upon the differences in customers and related
marketing channels. Wholesale net revenues are primarily driven by products and services sold to
large resellers, whereas Direct net revenues are primarily driven by products and services sold
directly to end-users. Our business segments operating expenses are primarily comprised of network
costs and labor and related non-labor expenses to provision services and to provide support to our
customers. Our business segments network costs consist of end-user circuits, aggregation circuits,
central office space, Internet transit charges, customer premises equipment and equipment
maintenance. Operating expenses also consist of labor and related non-labor expenses for customer
care, dispatch, and repair and installation activities. We allocate network costs to our business segments based on their consumption of circuit or
equipment capacity. We allocate end-user circuit costs to a segment based on the products and
services sold by such segment. Aggregation circuits are allocated based on actual capacity usage
determined by the total number of customers in a segment utilizing those circuits. Customer
premises equipment, or CPE, cost is directly assigned to a business segment based on installations
performed by such segment and the cost of each specific CPE. We allocate labor costs from our
operations to our business segments based on resource consumption formulas, which are primarily
based on installations, percentage of total lines in service and trouble tickets by segment. We
allocate employee compensation for our sales forces directly to the business segments based on the
customers they sell to and serve. 27




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We allocate advertising and promotions to the business segments primarily based on
expenditures incurred to stimulate demand for target customer within those segments. Revenues, net The primary component of our net revenues is earned monthly broadband subscription billings
for DSL services. We also earn revenues from monthly subscription and usage billings related to our
VoIP services, monthly billings for T-1 circuits, monthly billings for high-capacity circuits sold
to our wholesale customers and to a lesser degree from dial-up services sold to end-users. Because
we do not recognize revenue from billings to financially distressed customers until we receive
payment and until our ability to keep the payment is reasonably assured, our reported revenues for
the three months ended March 31, 2005 and 2004 have been impacted by whether we receive, and the
timing of receipt of, payments from these customers. Our revenues also include billings for
installation fees and equipment sales, which are recognized as revenue over the expected life of
the relationship with the end-user, and Federal Universal Service Fund, or FUSF, charges billed to
our customers. We record customer incentives and rebates that we offer to attract and retain
customers as reductions to gross revenues. We regularly have billing disputes with our customers.
These disputes arise in the ordinary course of business in the telecommunications industry, and we
believe their impact on our accounts receivable and revenues can be reasonably estimated based on
historical experience. In addition, certain revenues are subject to refund if an end-user
terminates service within thirty days of the 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. Our net revenues of $107,718 for the three months ended March 31, 2005 decreased by $759, or
0.7%, when compared to our net revenues of $108,477 for the three months ended March 31, 2004. This
decrease was attributable to a $8,765 decrease in broadband net revenues primarily as a result of
lower selling prices, and a $1,058 decrease in dial-up revenue, as a result of the continuing
decrease in the demand for this service. These decreases were partially offset by a $6,769 increase
in broadband net revenues as a result of adding end-users to our network, and $2,350 of net
revenues as a result of the addition of our VoIP services, which began in June 2004. We expect to
continue to add VoIP stations to our network and also expect to continue to add broadband
end-users, subject to the effect on our wholesale customers of uncertainty caused by regulatory
events as discussed in Overview  Recent Developments above. This uncertainty may cause these
resellers to stop marketing certain of our services or otherwise change their strategies. It is
possible that these conditions will cause our revenue to decline in future periods. We also expect
to continue to experience competitive pricing pressures for our current services and equipment
products. As a result, we expect customer rebates and incentives to continue to be an element of
our sales and marketing programs in order to respond to competitive market conditions. Segment Revenues and Significant Customers Our segment net revenues were as follows: Three months ended March 31,2005
    
    
    2004Wholesale
    
    $
    76,261
    
    
    $
    79,097Percent of total net revenues
    
    
    70.8
    %
    
    
    72.9
    %Direct
    
    $
    31,457
    
    
    $
    29,380Percent of total net revenues
    
    
    29.2
    %
    
    
    27.1
    %
 Our wholesale net revenues for the three months ended March 31, 2005 decreased by $2,836, or
3.6%, when compared to the three months ended March 31, 2004. This decrease was primarily
attributable to a $5,364 decrease in broadband net revenues primarily as a result of lower selling
prices, partially offset by a $2,322 increase in broadband net revenues as a result of adding
end-users to our network. Our direct net revenues for the three months ended March 31, 2005
increased by $2,077, or 7.1%, when compared to March 31, 2004. This increase was primarily
attributable to a $4,096 increase in broadband net revenues as a result of adding end-users to our
network, and $2,431 of net revenues as a result of the addition of our VoIP services, which began
in June 2004. These decreases were partially offset by a $3,401 decrease in broadband net revenues
primarily as a result of lower selling prices, and a $1,058 decrease in dial-up revenue as a result
of the continuing decrease in demand for this service. 28




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We had approximately 400 wholesale customers as of March 31, 2005 compared to approximately
320 as of March 31, 2004. The increase in 2005 from 2004 resulted primarily from the addition of
smaller resellers. For the three months ended March 31, 2005 and 2004, our 30 largest wholesale
customers comprised 65.5% and 68.2% of our total gross revenues, respectively. As of March 31, 2005
and December 31, 2004, receivables from these customers collectively comprised 65.4% and 65.1%,
respectively, of our gross accounts receivable balance. Two of our wholesale customers, EarthLink, Inc. and AT&T Corp., accounted for 15.9% and 13.9%,
and 18.4% and 12.6%, of our total net revenues for the three months ended March 31, 2005 and 2004,
respectively. Amounts owed to us from these customers totaled 19.5% and 17.9%, and 17.9% and 20.9%
of our gross accounts receivables as of March 31, 2005 and December 31, 2004, respectively. On
January 31, 2005, AT&T announced that it had agreed to be acquired by SBC, one of the largest
RBOCs. This acquisition is subject to regulatory, antitrust and other forms of review. Based upon
the statements of the parties, subject to the outcome of this review, the transaction is expected
to close in the first half of 2006. At this time, we cannot reliably predict the effects of this
transaction on our revenues derived from AT&T, or the timing of any such effects. We had approximately 81,500 direct end users as of March 31, 2005 compared to approximately
71,200 as of March 31, 2004. As of March 31, 2005, we had 690 VoIP business customers with
approximately 23,400 stations. Wholesaler Financial Difficulties We have identified certain of our customers who were essentially current in their payments for
our services prior to March 31, 2005, or have subsequently paid all or significant portions of the
respective amounts that we recorded as accounts receivable as of March 31, 2005, that we believe
may be at risk of becoming financially distressed. Revenues from these customers accounted for
approximately 7.5% and 9.9% of our total net revenues for the three months ended March 31, 2005 and
2004, respectively. As of March 31, 2005, amounts owed to us from these customers comprised 9.5% of
our gross accounts receivable balance. If these customers are unable to demonstrate their ability
to pay for our services in a timely manner in periods ending subsequent to March 31, 2005, revenues
from such customers will only be recognized when cash is collected, as described above. Operating Expenses Operating expenses include cost of sales, selling, general and administrative expenses,
depreciation and amortization expenses and provision for restructuring expenses. Our total operating expenses were as follows: Three months ended March 31,2005
    
    
    2004Amount
    
    $
    134,272
    
    
    $
    121,389Percent of net revenues
    
    
    124.7
    %
    
    
    111.9
    %
 Cost of sales (exclusive of depreciation and amortization) Cost of sales consists primarily of the costs of provisioning and maintaining
telecommunications circuits and central office space, equipment sold to our customers, labor and
related expenses and other non-labor items to operate and maintain our network and related system
infrastructure. Our cost of sales was as follows: Three months ended March 31,2005
    
    
    2004Amount
    
    $
    72,749
    
    
    $
    68,294Percent of net revenue
    
    
    67.5
    %
    
    
    63.0
    %
 Our cost of sales for the three months ended March 31, 2005 increased by $4,455, or 6.5%, when
compared to our cost of sales for the three months ended March 31, 2004. This increase was
primarily attributable to increases in 29




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network costs of $3,545, cost of equipment and installation of $984, and labor and other
related operating expenses of $3,971 as a result of the addition of broadband and VoIP subscribers
to our network, partially offset by a decrease in incentive and stock-based compensation expenses
of $1,440 that primarily resulted from a reduction in the variable accounting for our 2003 employee
stock purchase plan, or 2003 ESPP. The reduction in variable accounting was the result of a
decrease in our stock price. In addition, during the three months ended March 31, 2005, we changed
our estimates of certain liabilities for transaction-based taxes and property taxes as a result of
various settlements. These changes in accounting estimate decreased our cost of sales and our net
loss by $2,386, or $0.01 per share. We expect cost of sales to increase in future periods as we add subscribers and services to
our network. However, expect cost of sales to decrease as a percentage of our net revenues if we
are successful in increasing our revenues, which would allow us to leverage some of our fixed
costs. In light of the increased cost of sales, we plan to continue to execute cost-saving programs
and improve the efficiency of the delivery of our services. As discussed above in Overview
Recent Developments and Part II, Item 1 Legal Proceedings, there is uncertainty concerning our
ability to continue to purchase certain network elements at regulated prices from the ILECs as a
result of the FCCs recent decisions. As a result of those legal and regulatory proceedings, it is
possible that the ILECs could substantially increase the cost or reduce the availability of these
network elements, which would substantially increase our overall network cost structure and might
cause us to discontinue services that become unprofitable. Our cost of sales was allocated as follows: Three months ended March 31,2005
    
    
    2004Wholesale Segment
    
    $
    47,421
    
    
    $
    46,792Direct Segment
    
    
    16,117
    
    
    
    11,402Corporate Operations
    
    
    9,211
    
    
    
    10,100Total
    
    $
    72,749
    
    
    $
    68,294
 Our cost of sales for the Wholesale segment for the three months ended March 31, 2005
increased by $629, or 1.3%, when compared to our cost of sales for the Wholesale segment for the
three months ended March 31, 2004. This increase was attributable to an increase in network costs
and cost of equipment of $1,579 as a result of the growth in our network customer base, partially
offset by a decrease in incentives and stock-based compensation expenses of $950 primarily as a
result of our 2003 ESPP. Our cost of sales for the Direct segment for the three months ended March
31, 2005 increased by $4,715, or 41.4%, when compared to our cost of sales for the Direct segment
for the three months ended March 31, 2004. This increase was attributable to an increase in network
costs of $2,865, an increase in cost of equipment of $615, and an increase in labor and other
operating expense of $1,235 as a result of the addition of broadband and VoIP subscribers to our
network. Our cost of sales for Corporate Operations for the three months ended March 31, 2005
decreased by $889, or 8.8%, when compared to our cost of sales for Corporate Operations for the
three months ended March 31, 2004. This decrease was attributable to a decrease in network costs of
$532 due to continued network cost management and a decrease in stock-based compensation expenses
of $321 related to our 2003 ESPP, offset by an increase in labor and other operating expenses of
$2,364. In addition, during the three months ended March 31, 2005, we changed our estimates of
certain liabilities for transaction-based taxes and property taxes as a result of various
settlements and related statute of limitations. These changes in accounting estimate decreased our
cost of sales and our net loss by $2,386, or $0.01 per share. Selling, General and Administrative Expenses Selling, general and administrative expenses consist primarily of salaries and related
expenses, other non-labor items, and our promotional and advertising expenses. 30




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Our selling, general and administrative expenses were as follows: Three months ended March 31,2005
    
    
    2004Amount
    
    $
    42,374
    
    
    $
    33,302Percent of net revenue
    
    
    39.3
    %
    
    
    30.7
    %
 Our selling, general and administrative expenses for the three months ended March 31, 2005,
increased by $9,072, or 27.2%, when compared to our selling, general and administrative expenses
for the three months ended March 31, 2004. This increase was primarily attributable to increases in
marketing expenses of $4,144, and labor and other related operating expenses of $7,116 primarily as
a result of the addition of our VoIP services, which began in June 2004, partially offset by a
decrease in incentive and stock-based compensation expenses of $2,223 primarily as a result of our
2003 ESPP, which is subject to variable accounting. In addition, during the three months ended
March 31, 2005, we changed our estimates of certain liabilities for property taxes as a result of
various settlements. This change in accounting estimate decreased our selling, general and
administrative expenses and our net loss by $117, or $0.00 per share. We expect to increase our selling, general and administrative expenses primarily as a result
of sales compensation and increased marketing efforts associated with efforts to promote growth in
sales of our VoIP services. Our selling, general and administrative expenses were allocated as follows: Three months ended March 31,2005
    
    
    2004Wholesale Segment
    
    $
    2,215
    
    
    $
    2,680Direct Segment
    
    
    15,394
    
    
    
    5,163Corporate Operations
    
    
    24,765
    
    
    
    25,459Total
    
    $
    42,374
    
    
    $
    33,302
 Our selling, general and administrative expenses for the Wholesale segment for the three
months ended March 31, 2005 decreased by $465 or 17.4 %, when compared to our selling, general and
administrative expenses for the Wholesale segment for the three months ended March 31, 2004. This
decrease was primarily attributable to a decrease in salaries, incentive and stock-based
compensation expenses of $833 primarily as a result of our 2003 ESPP, offset by an increase in
marketing expenses of $368. Our selling, general and administrative expenses for the Direct segment
for the three months ended March 31, 2005 increased by $10,231, or 198.2%, when compared to our
selling, general and administrative expenses for the Direct segment for the three months ended
March 31, 2004. This increase was attributable to an increase in marketing expenses of $5,280, and
labor and other related operating expenses of $4,951 as a result of the addition of our VoIP
services. Our selling, general and administrative expenses for Corporate Operations for the three
months ended March 31, 2005 decreased by $694, or 2.7 %, when compared to our selling, general and
administrative expenses for Corporate Operations for the three months ended March 31, 2004. This
decrease was primarily attributable to a decrease in salaries, incentive and stock-based
compensation expenses of $1,016 primarily as a result of our 2003 ESPP, a decreased in advertising
expense of $1,504, offset by increase in other related operating expenses of $1,943. In addition,
during the three months ended March 31, 2005, we changed our estimates of certain liabilities for
property taxes as a result of various settlements. This change in accounting estimate decreased our
selling, general and administrative expenses and our net loss by $117, or $0.00 per share. Depreciation and Amortization Our depreciation and amortization of property and equipment, or depreciation, was $13,785 and
$14,495 for the three months ended March 31, 2005 and 2004, respectively. Our depreciation for the
three months ended March 31, 2005 decreased by $710 when compared to our depreciation for the three
months ended March 31, 2004 primarily as a result of certain historical assets becoming fully
depreciated. We expect depreciation to increase in future periods as we add more broadband and VoIP
end-users to our network and purchase additional equipment so that we can 31




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offer new services. This increase in depreciation will be partially offset as historical
assets continue to become fully depreciated. Our amortization of intangible assets, or amortization, was $5,364 and $4,751 for the three
months ended March 31, 2005 and 2004, respectively. Our amortization for the three months ended
March 31, 2005 increased primarily as a result of the resumption of our network build and
augmentation during 2004, which increased collocation fee expenditures and related amortization
expenses. In addition, amortization for the three months ended March 31, 2005 increased as a result
of the acquisition of certain customer lists during 2004. We expect amortization of intangible
assets to continue to increase as we augment our network. As explained above, we do not allocate depreciation and amortization expense to our business
segments. Provision for Restructuring Expenses During the three months ended March 31, 2004, we reduced our workforce by approximately 41
employees, or 3.7% of our workforce. The reductions covered employees in the areas of sales and
marketing, operations and corporate functions. In connection with our reductions during the three
months ended March 31, 2004, we recorded restructuring expenses, consisting primarily of employee
severance benefits, of $186, $123, and $238 in our Wholesale segment, our Direct segment and our
Corporate Operations, respectively. We did not record restructuring expenses during the three
months ended March 31, 2005. We continue to evaluate whether additional restructuring is necessary,
and we may incur additional charges to operations related to any further restructuring activities
in future periods. Other Income (Expense) Net Interest Expense Our net interest expense was $339 and $790 for the three months ended March 31, 2005 and 2004,
respectively. Net interest expense for the three months ended March 31, 2005 consisted principally
of interest on our 3% convertible senior debentures, less interest income earned on our cash, cash
equivalents and short-term investments in debt securities balances. Net interest expense during the
three months ended March 31, 2004 consisted principally of interest expense on our 11% long-term
note payable to SBC Communications Inc., which we repaid in March of 2004, less interest income
earned on our cash, cash equivalents and short-term investments in debt securities balances. We
expect future net interest expense to be limited to interest on our 3% convertible senior
debentures partially offset by interest earned on our cash balances. We may, however, seek
additional debt financing in the future if it is available on terms that we believe are favorable.
If we seek additional debt financing, our interest expense would increase. Investment Gains In August 2000, we made an equity investment in 10 shares of ACCA Networks Co., Ltd. , or
ACCA, a privately-held, Japanese telecommunications company. In March 2005, ACCA completed a public
offering of its shares in Japan. We recorded a net realized gain of $7,246 for the three months
ended March 31, 2005 as a result of the sale of 2 shares of ACCA . We did not recognize similar
gains for the three months ended March 31, 2004. Gain on Deconsolidation of Subsidiary We recognized a gain of $53,963 for the three months ended March 31, 2005 as a result of the
deconsolidation of one of our subsidiaries. Refer to Note 4, under Other Restructuring
Activities, to our condensed consolidated financial statements for additional information on such
gain. We did not recognize similar gains for the three months ended March 31, 2004. Income Taxes Although we recorded net income for the three months ended March 31, 2005, we project that on
an annualized basis we will record a net loss for the year ending December 31, 2005. We made no
provision for income taxes in 32




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any period presented in the accompanying condensed consolidated financial statements because
we incurred net losses for the periods presented, or expect to incur net losses for the current
year . Related Party Transactions A member of our Board of Directors, Richard Jalkut, is the President and CEO of TelePacific
Communications (TelePacific), one of our resellers. We recognized revenues from TelePacific of
$78 and $105 during the three months ended March 31, 2005 and 2004, respectively. Accounts
receivables from TelePacific were $25 as of March 31, 2005 and $29 as of December 31, 2004. L. Dale
Crandall, one of our directors, is also a director of BEA Systems (BEA), one of our vendors. We
paid $33 and $472 to BEA during the three months ended March 31, 2005 and 2004, respectively.
Charles Hoffman, our CEO, is a director of Chordiant Software (Chordiant), one of our vendors. We
paid $50 to Chordiant during the three months ended March 31, 2005. No amount was paid to this
vendor during the three months ended March 31, 2004. Gary Hoffman, a sibling of our Chief Executive
Officer, is employed by us. During the three months ended March 31, 2005, Gary Hoffman received
compensation in the form of salary and commissions in the amount of $29, as well as an option grant
to purchase 2 of our common stock at an exercise price of $1.54. We
believe these transactions were negotiated on an arms-length basis
with terms we believe
are comparable to transactions that would likely be negotiated with unrelated parties. Liquidity and Capital Resources Over the last five years we have invested substantial capital for the procurement, design and
construction of our central office collocation facilities, the design, creation, implementation and
maintenance of our internally used software, the purchase of telecommunications equipment and the
design, development and maintenance of our networks. We expect that in future periods our
expenditures related to the purchase of infrastructure equipment necessary for the expansion of our
networks and the development of new regions will be relatively lower than in recent periods while
incremental, or success-based, expenditures related to the addition of subscribers in existing
regions, and expenditures related to the offering of new services, will increase based on the
number of new subscribers and types of new services that we add to our network. Our cash and cash equivalents balance for the three months ended March 31, 2005 decreased by
$8,058. The change in cash and cash equivalents was as follows: Three months ended March 31,2005
    
    
    2004Net cash provided by (used in):Operating activities
    
    $
    (18,956
    )
    
    $
    (4,988
    )Investing activities
    
    
    10,799
    
    
    
    (22,755
    )Financing activities
    
    
    99
    
    
    
    71,415Total
    
    $
    (8,058
    )
    
    $
    43,672
 Operating Activities Net cash used in our operating activities for the three months ended March 31, 2005 increased
by $13,968 when compared to net cash used in our operating activities for the three months ended
March 31, 2004. This increase was attributable to an increase in our net loss, adjusted for
non-cash and non-operating items, of $15,138, offset by the net change in our operating assets and
liabilities of $1,170, primarily as a result a $4,907 decrease in our account receivables due to
the timing of receipts from our customers, offset by a $3,110 decrease in our accounts payable and
other liabilities primarily due to the timing of payments to our vendors. During the three months
ended March 31, 2005 we paid one of our vendor $5,600 as a result of a purchase commitment contract
for network services. Such purchase commitment contract began in 2002 and expired in December 2004.
We expect net cash usage to continue in our operating activities during 2005, primarily as a result
of our product, sales and marketing activities to promote our broadband and VoIP services. 33




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Investing Activities Our investing activities consist primarily of purchases, maturities and sale of short-term
investments in debt securities, capital expenditures for property and equipment and expenditures to
acquire collocation facilities. Net cash provided by our investing activities for the three months
ended March 31, 2005 increased by $33,554 when compared to our net cash used in our investing
activities for the three months ended March 31, 2004. This increase was primarily attributable to
$18,620 from the net cash effect of purchase, sale and maturity activities on our short-term
investments in debt securities, a $7,639 decrease in capital expenditures for property and
equipment and collocation fees and $7,439 related to the proceeds from the sale of a portion of our
equity holdings in ACCA. In April 2005, we sold another portion of our ACCA holdings and received
proceeds of $9,709. In connection with ACCAs public offering, we entered into a customary lock-up
agreement with ACCAs underwriters. Pursuant to that agreement we cannot sell 5 of our ACCA shares
before August 2005. Upon the expiration of the lock-up agreement, we plan to sale of our remaining
shares of ACCA later this year. Financing Activities Our financing activities consist primarily of proceeds and repayments of long-term debt and
proceeds from the issuance of our common stock under our employee stock-based compensation plans.
Net cash provided by our financing activities for the three months ended March 31, 2005 decreased
by $71,316 when compared to our net cash provided by our financing activities for the three months
ended March 31, 2004. This decrease was primarily attributable to $120,151 of net proceeds from the
issuance of our senior unsecured convertible bonds which occurred during the three months ended
March 31, 2004, and a $1,030 decrease in proceeds from the issuance of our common stock, offset by
the $50,000 principal repayment of our note to SBC, which we repaid during the three months ended
March 31, 2004. We expect that in 2005 our cash from financing activities will be primarily related
to proceeds from the issuance of common stock under our employee stock-based compensation plans. Liquidity Our total cash, cash equivalents and short-term investments in debt securities balance as of
March 31, 2005 decreased by $17,978 from our total cash balance as of December 31, 2004. As of
March 31, 2005, we had a total cash, cash equivalents and short-term investments in debt securities
balance of $135,551. This balance was comprised of $109,448 in unrestricted cash and cash
equivalents, $23,570 in unrestricted short-term investments in debt securities and $2,533 in
restricted cash and cash equivalents. We expect to continue to use our cash resources primarily to
increase sales and marketing activities and improve our operational capabilities. The amount of
this additional usage of cash to expand the offering of our VoIP services will depend on our
ability to control incremental selling, general and administrative expenses, the amount of capital
expenditures that is required to grow our subscriber base, development and maintenance of our
operating support systems and software, and our ability to generate demand for VoIP services. In
addition, we may wish to selectively pursue possible acquisitions of, or investments in,
businesses, technologies or products complementary to ours in order to expand our geographic
presence, broaden our product and service offerings and achieve operating efficiencies. We may not
have sufficient liquidity, or we may be unable to obtain additional financing on favorable terms or
at all, in order to finance such an acquisition or investment. Based on our 2005 business plan, we believe we will be able to continue as a going concern
through March 31, 2006 using only our unrestricted cash, cash equivalents and short-term investment
in debt securities balances in existence as of March 31, 2005. Adverse business, legal, regulatory
or legislative developments, such as the inability to continue accessing certain network elements
from the RBOCs, may require us to raise additional financing, raise our prices or substantially
decrease our cost structure. We also recognize that we may not be able to raise additional capital.
If we are unable to acquire additional capital on favorable terms if needed, or are required to
raise it on terms that are less satisfactory than we desire, our financial condition will be
adversely affected. Our cash requirements for 2005 and beyond for developing, deploying and enhancing our network
and operating our business will depend on a number of factors including:  
    further development of our VoIP capabilities, including systems and software to expand
and improve our VoIP services; 34




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
    our continuing ability to reach agreements with the ILECs to access line-shared
telephone lines, remote terminals, interoffice transport, high-capacity circuits and other
facilities, 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;
    unanticipated opportunities;
    network development schedules and associated costs; and
    number of regions entered and the timing of entry and services offered Contractual Cash Obligations Our contractual debt, lease and purchase obligations as of March 31, 2005 for the next five
years, and thereafter, were as follows: 2005
    
    
    2006-2007
    
    
    2008-2009
    
    
    Thereafter
    
    
    TotalNote payable to debentures
    
    $
    
    
    
    $
    
    
    
    $
    125,000
    
    
    $
    
    
    
    $
    125,000Interest on note payable
    
    
    2,813
    
    
    
    7,500
    
    
    
    4,531
    
    
    
    
    
    
    
    14,844Capital leases
    
    
    686
    
    
    
    56
    
    
    
    13
    
    
    
    
    
    
    
    755Office leases
    
    
    3,578
    
    
    
    7,981
    
    
    
    4,975
    
    
    
    616
    
    
    
    17,150Other operating leases
    
    
    286
    
    
    
    601
    
    
    
    283
    
    
    
    
    
    
    
    1,170Purchase obligations
    
    
    3,984
    
    
    
    281
    
    
    
    
    
    
    
    
    
    
    
    4,265$
    11,347
    
    
    $
    16,419
    
    
    $
    134,802
    
    
    $
    616
    
    
    $
    163,184
 We lease certain vehicles, equipment and office facilities under various non-cancelable
operating leases that expire at various dates through 2009. Our office leases generally require us
to pay operating costs, including property taxes, insurance and maintenance, and contain scheduled
rent increases and certain other rent escalation clauses. Rent expense is reflected in our
condensed consolidated financial statements on a straight-line basis over the terms of the
respective leases. Effective
March 31, 2005, we entered into an agreement to extend the terms
of our office lease in Herndon,
Virginia. The extension is for a period of five years which commences
on August 1, 2005. In 2005, we entered into an agreement with Sylantro Systems Corporation to obtain discounted
pricing on ComSuite Module licenses. For 2005 we have a minimum remaining aggregate purchase commitment of $1,800
as of March 31, 2005. In 2002, we entered into a three-year, non-exclusive agreement with MCI, for the right to
provide certain network services to us. We have a monthly minimum usage requirement which began in
June 2002. The agreement expires in May 2005 and has a remaining purchase obligation of $1,340 as
of March 31, 2005. In addition, in 2002, we entered into a four-year, non-exclusive agreement with
AT&T for the right to provide long distance services to us. We have an annual minimum usage
requirement which began in April 2002. The agreement expires in March 2006 and has a minimum
remaining aggregate usage commitment of approximately $1,125 as of March 31, 2005. As part of our ongoing business, we do not participate in transactions that generate
relationships with unconsolidated entities of financial partnerships, such as entities often
referred to as structured finance or special purpose entities, or SPEs, which would have been
established for the purpose of facilitating off-balance sheet arrangements or other contractually
narrow or limited purpose. As of March 31, 2005, we were not involved in any SPE transactions. 35




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Risk Factors 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. Our services are subject to federal, state and local government regulations. In particular,
the company and its resellers are dependent on certain provisions of the 1996 Telecommunications
Act to procure certain facilities and services from the ILECs that are necessary to provide
services. As a result, our business is highly dependent on rules and rulings from the FCC,
legislative actions at both the state and federal level, and rulings from state public utility
commissions. For instance, over the last two years the FCC has made substantial changes to the regulatory
environment in which we operate. The FCCs August 21, 2003 Triennial Review order and its
announcement of further changes on December 15, 2004, limited, and in some cases eliminated our
access to some of the network elements that we use to operate our business. Where we no longer have
regulated access to network elements, our costs are likely to increase as a result of these orders
and we may be unable to profitably offer some of our services. We may be unable to adapt to the
changed regulatory environment, in its current form, or to future changes, whether resulting from
these orders or from subsequent action by the courts, the FCC or other regulatory authorities. In addition, as a result of the FCCs December 15, 2004 order and subsequent rules that were
issued on February 4, 2005, our resellers will no longer be permitted to order voice services for
new customers utilizing regulated UNE-P services provided by the traditional phone companies, and,
after a twelve month transition period, will no longer be able to provide service to pre-existing
customers using UNE-P. The existence of UNE-P allowed our resellers to offer bundles that combine
our data services with their residential voice services. Some of our larger resellers, including
MCI and AT&T, have already indicated that they will scale back or eliminate their residential voice
services as a result of these decisions. Other resellers may also decide not to sell residential
voice services, or may use alternative means of providing residential voice service that allow them
to offer their own data services, as opposed to reselling our services. 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. ILECs provide the telephone lines that connect each end-user to our equipment located in their
central offices. The 1996 Telecommunications Act generally requires that charges for these
unbundled network elements be cost-based and nondiscriminatory. Nonetheless, the nonrecurring and
recurring monthly charges for lines (telephone wires) that we require vary greatly. These rates are
subject to negotiations between us and the ILECs and to the approval of the state PUCs.
Consequently, we are subject to the risk that the non-recurring and recurring charges for lines and
other unbundled network elements will increase based on higher rates proposed by the ILECs and
approved by state PUCs from time to time, which would increase our operating expenses and reduce
our ability to provide competitive products. The impact of judicial and regulatory decisions on the prices we pay to the ILECs for
collocation and unbundled network elements is highly uncertain. There is a risk that any new prices
set by the regulators could be materially higher than current prices. As a result of the FCCs
recent decisions, it is likely that we will pay higher prices for line-shared lines, high-capacity
lines and data transport between many of the ILECs central offices. If we are required to pay
higher prices to the ILECs for collocation and network components as a result of the FCCs recent
decisions and other judicial and regulatory decisions, it could materially increase our operating
expenses and reduce our ability to provide competitive products. Our business will be adversely affected if our interconnection agreements are not renewed or if
they are modified on unfavorable terms. We are required to enter into interconnection agreements covering each of the metropolitan
areas we serve with the appropriate ILECs in order to provide service in those regions. Many of our
existing interconnection agreements have a maximum term of three years. Therefore, we will have to
renegotiate these agreements with the ILECs when 36




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they expire. A number of these agreements have expired and we are currently in the process of
renegotiating them. We may not succeed in extending or renegotiating these interconnection
agreements on favorable terms or at all. As the FCC modifies, changes and implements rules related to unbundling and collocation, we
generally have to renegotiate our interconnection agreements to implement those new or modified
rules. For example, we are involved in a number of renegotiations of interconnection agreements to
reflect the FCCs recent decisions. We may be unable to renegotiate these agreements in a timely
manner, or we may be forced to arbitrate and litigate with the RBOCs in order to obtain agreement
terms that fully comply with FCC rules. Additionally, disputes have arisen and will continue to arise in the future as a result of
differences in interpretations of the interconnection agreements. These disputes have delayed the
deployment of network capabilities and services, and resolution of the litigated matters will
require ongoing expenditures and management time. In addition, the interconnection agreements are
subject to state PUCs, FCC and judicial oversight. These government authorities may modify the
terms of the interconnection agreements in a way that reduces our access to, or increases the cost
of, the network components that we purchase from the ILECs. 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 majority of our revenue comes from Internet service providers, telecommunications carriers
and other customers who resell our Internet access services to their business and consumer
end-users. Our agreements with our resellers are generally non-exclusive, and many of our customers
also resell services offered by our competitors. Our agreements with our resellers generally do not
contain purchase commitments. A limited number of resellers account for a significant portion of
our revenues. Our top 30 resellers accounted for approximately 65.5% of our net revenue for the
three months ended March 31, 2005. We expect that our reseller customers will continue to account
for a significant portion of our revenue and new end user additions. If we were to lose one or more of our key resellers or if one or more of our key resellers
stopped providing us with orders or removed end-users from our network, our revenue and line-growth
could be materially adversely affected. Consolidations, mergers and acquisitions involving our key
resellers have occurred in the past and may occur in the future. These consolidations, mergers and
acquisitions may cause key resellers to stop providing us with orders or to remove end-users from
our network. On January 31, 2005, one of our major resellers, AT&T Corp., announced that it had
agreed to be acquired by SBC, one of the largest RBOCs. This acquisition is subject to regulatory,
antitrust and other forms of review. Based upon the statements of the parties, subject to the
outcome of these reviews, the transaction is expected to close in the first half of 2006. For the
three months ended March 31, 2005, AT&T accounted for 13.9% of our revenue. SBC is both one of our
competitors and a reseller of our services. At this time, we cannot predict the effects of this
transaction on our revenues derived from AT&T or SBC, or the timing of any such effects. Based on our agreements with several competitive telephone companies, we have the ability to
offer our services over a telephone line that is being used by a voice provider other than the
ILECs. All of these competitive telephone companies currently use UNE-P. As a result of the FCCs
December 15, 2004 order and subsequent rules that were issued on February 4, 2005, our resellers
will no longer be permitted to order voice services for new customers utilizing regulated UNE-P
services provided by the traditional phone companies, and, after a twelve month transition period,
will no longer be able to provide service to pre-existing customers using UNE-P. Some of our larger
resellers, including MCI and AT&T, have already indicated that they will scale back or eliminate
their residential voice services as a result of the FCCs decisions. Other resellers may also
decide not to sell residential voice services, or may use alternative means of providing
residential voice service that allow them to offer their own data services, as opposed to reselling
our services. It is therefore unclear whether our resellers will increase the number of end-users
that purchase these services. 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. We face significant competition in the markets for business and consumer Internet access,
network access and voice services and we expect this competition to intensify. In addition, the
RBOCs dominate the current market and 37




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have a monopoly on telephone lines. We pose a competitive risk to the RBOCs and, as both our
competitors and our suppliers, they have the ability and the motivation to disadvantage our
business. We also face competition from cable modem service providers, competitive
telecommunications companies, traditional and new national long distance carriers, Internet service
providers, on-line service providers and wireless and satellite service providers. Many of these
competitors have longer operating histories, greater name recognition, better strategic
relationships and significantly greater financial, technical or marketing resources than we do. As
a result, these competitors may be able to:  
    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 high-speed digital services The intense competition from our competitors, including the RBOCs, the cable modem service
providers and the competitive telecommunications companies could harm our business. The RBOCs represent the dominant competition in all of our target service areas, and we expect
this competition to intensify. These competitors have established brand names and reputations for
quality service, possess sufficient capital to deploy DSL equipment rapidly, have their own
telephone lines and can bundle digital data services with their existing voice, wireless and other
services to achieve economies of scale in serving customers. They can also offer service to
end-users from certain central offices and using fiber and fiber-fed loops that are not available
to us. Certain RBOCs are aggressively pricing their DSL services as low as $19.95 per month when
ordered as part of a bundle, which has slowed sales of stand-alone DSL services by our reseller
partners and increased the rate of churn among our existing users. If we are unable to enter into
and maintain agreements with the RBOCs that provide us with access to line-sharing at reasonable
rates, we will be unable to price our consumer services at a price that is competitive with the
RBOCs. Cable modem service providers, such as Cox Communications, Comcast, and Time Warner, and their
respective cable company customers, have deployed high-speed Internet access services over coaxial
cable networks. These networks provide similar, and in some cases, higher-speed data services than
we provide. In addition, cable providers are beginning to bundle VoIP telephony and other services,
such as video-on-demand, with their Internet access offerings. As a result, competition with the
cable modem service providers may have a significant negative effect on our ability to secure
customers and may create downward pressure on the prices we can charge for our services. Failure to complete development, testing and introduction of new services, including VoIP services,
could affect our ability to compete in the industry. We continuously develop, test and introduce new services that are delivered over our network.
These new services are intended to allow us to address new segments of the communications
marketplace and to compete for additional customers. In some cases, the introduction of new
services requires the successful development of new technology. To the extent that upgrades of
existing technology are required for the introduction of new services, the success of these
upgrades may depend on the conclusion of contract negotiations with vendors and vendors meeting
their obligations in a timely manner. In addition, new service offerings may not be widely accepted
by customers. If we are not able to successfully complete the development and introduction of new
services, including VoIP services, line powered voice, and wireless services in a timely manner,
our business could be materially adversely affected. We may need to raise additional capital under difficult financial market conditions. We believe our current cash, cash equivalents, and short-term investments in debt securities
should be sufficient to meet our anticipated cash needs for working capital and capital
expenditures until we become cash flow positive. We have a business plan that we believe will take
us to the point where our operations will yield a positive cash flow without raising additional
capital. This business plan is based upon several assumptions, including growth of our 38




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subscriber base with a reasonable per subscriber profit margin and improvements in
productivity. If actual events differ from these assumptions, we may be required to alter our
business plan to reflect these changes. We will continue to monitor events to determine if such
adjustments to our business plan are appropriate. We are currently facing a variety of challenges that may affect the assumptions contained in
our business plan, including, among others:  
    changes in government regulations and legal actions challenging government regulations;
    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;
    any adverse resolution of lawsuits against us; and
    additional risk factors mentioned throughout this section We entered into a 10-year resale agreement with SBC in December 2001 under which SBC, its
affiliates or special agents will resell the Companys DSL services. As part of the resale
agreement, SBC made a $75,000 non-interest-bearing prepayment, which is collateralized by
substantially all of our domestic assets. As of March 31, 2005, the outstanding balance of the
SBCs prepayment was approximately $50,264. This collateralization of the outstanding balance of
SBCs prepayment, in addition to the existence of $125,000 in 3% convertible notes, may limit our
ability to raise additional capital through sales of our debt or equity securities. Adverse business, regulatory or legislative developments may require us to raise additional
financing, raise our prices or substantially decrease our cost structure. We also recognize that we
may not be able to raise additional capital under the current capital market conditions. If we are
unable to acquire additional capital or are required to raise it on terms that are less
satisfactory than we desire, our financial condition will be adversely affected. In order to become cash flow positive and to achieve profitability, we must add end-users and sell
additional services to our existing end-users while minimizing the cost to expand our network
infrastructure. We must increase the volume of Internet, data and voice transmission on our network in order
to realize the anticipated cash flow, operating efficiencies and cost benefits of our network. If
we do not add new customers and maintain our relationships with current customers, we may not be
able to substantially increase traffic on our network, which would adversely affect our
profitability. To accomplish this strategy, we must, among other things:  
    acquire new end-users;
    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 and improve our VoIP services;
    upgrade our network to improve reliability and remain competitive;
    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 growth has placed, and will continue to place, significant demands on our management and
operations. We expect to implement system upgrades, new software releases and other enhancements
which could cause disruption and dislocation in our business. If we are successful in implementing
our marketing strategy, we may have difficulty responding to demand for our services and technical
support in a timely manner and in accordance with our customers expectations. We expect these
demands to require the addition of new management personnel and the increased outsourcing of Covad
functions to third parties. We may be unable to do this successfully, in which case we could
experience an adverse effect on our financial performance. 39




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If we do not reduce our end-user disconnection rate our revenue and end-user growth will decline. We experience high disconnection or churn rates. Our high end-user churn rate continues to
impair the growth we need to cover the cost of maintaining our network. These disconnections occur
as a result of several factors, including end-users who:  
    move to a new location;
    disconnect because of better offers in the market; and
    disconnect because they do not like our service or the service provided by our resellers While we are working to address problems with the end-user experience, many of these factors
are beyond our control. As a result, we may see additional increases in our churn rates even if we
improve the customer experience. In addition, promotions and rebates that we offer to our resellers
and end-users are based on an assumption that a given end-user will maintain our service for a
period of time. If our disconnection rate increases for more recently added end-users, we may not
recoup the money we spend on these promotions and rebates. We may experience decreasing margins on the sale of our services, which may impair our ability to
achieve profitability or positive cash flow. Prices for our services have steadily decreased since we first began operations. We expect we
will experience an overall price decrease for our services due to competition, volume-based pricing
and other factors. We currently charge higher prices for some of our services than some of our
competitors do for similar services. As a result, we cannot assure you that our customers will
select our services over those of our competitors. In addition, prices for digital communications
services in general have fallen historically, and we expect this trend to continue. As a result of
these factors, we cannot predict whether demand for our services will exist at prices that enable
us to achieve profitability or positive cash flow. If our internal control over financial reporting do not comply with the requirements of the
Sarbanes-Oxley Act, our business, reputation and stock price could be adversely affected. Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our
internal control over financial reporting as of the end of each year beginning in fiscal 2004, and
to include a management report assessing the effectiveness of our internal control over financial
reporting in all annual reports beginning with our 2004 Form 10-K. Section 404 also requires our
independent registered public accounting firm to attest to, and report on, managements assessment
of our internal control over financial reporting. Although our management has determined, and our independent registered public accounting firm
has attested, that our internal control over financial reporting was effective as of December 31,
2004, we cannot assure you that we or our independent registered public accounting firm will not
identify a material weakness in our internal controls in the future. A material weakness in our
internal controls over financial reporting would require us and our independent registered public
accounting firm to evaluate our internal control over financial reporting as ineffective. If our
internal control over financial reporting are not considered adequate, we may experience a loss of
public confidence, which could have an adverse effect on our business and our stock price. Some of our resellers are facing financial difficulties, which makes it more difficult to predict
our revenues. Some of our reseller customers may experience financial difficulties, including bankruptcy. If
a customer cannot provide us with reasonable assurance of payment, then we only recognize revenue
when we collect cash for our services, assuming all other criteria for revenue recognition have
been met, and only after we have collected all previous accounts receivable balances. Although we
will continue to try to obtain payments from these customers, it is likely that one or more of
these customers will not pay us for our services. With respect to resellers that are in bankruptcy
proceedings, we similarly may not be able to collect sums owed to us by these customers and we also
may be required to refund pre-petition amounts paid to us during the 90 days prior to the
bankruptcy filing. 40




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The development of our direct business poses operational challenges and may cause our resellers to
place fewer orders with us or may cause us to lose resellers. Sales of services directly to end-user customers represent a significant and growing part of
our business. As we expand our direct business, we will face new operational challenges. These
challenges include, but are not limited
to, our ability to:  
    recruit, hire and train additional direct sales teams;
    create effective automated systems to provision, manage and bill for VoIP services;
    manage expanding and increasingly diverse distribution channels;
    effectively manage additional vendors; and
    enhance our network and access products to provide business-class VoIP services In addition, some of our existing resellers may perceive us as a potential or actual
competitor. As a result, these resellers may reduce the volume or the rate of growth of the sales
of our services, or may cease to resell our services entirely. The communications industry is undergoing rapid technological changes and new technologies may be
superior to the technology we use. The communications industry is subject to rapid and significant technological changes,
including continuing developments in DSL and VoIP technology and alternative technologies for
providing broadband and telephony communications, such as cable modem, satellite and wireless
technology. As a consequence, our success may depend on:  
    third parties, including some of our competitors and potential competitors, to
develop and provide 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 The investments required to address technological changes are difficult to predict and may
exceed our available resources. If we fail to adapt successfully to technological changes or fail
to obtain access to important technologies, our business will be adversely affected. A system failure could delay or interrupt service to our customers, which could reduce demand for
our services. Our operations depend upon our ability to support our highly complex network infrastructure
and avoid damage from fires, earthquakes, terrorist attacks, floods, power losses, excessive
sustained or peak user demand, telecommunications failures, network software flaws, transmission
cable cuts and similar events. The occurrence of a natural disaster or other unanticipated problem
at our network operations center or any of our regional data centers could cause interruptions in
our services. Additionally, failure of an ILEC or other service provider to provide communications
capacity as a result of a natural disaster, operational disruption, labor dispute or any other
reason could cause interruptions in our services. We have previously had difficulties obtaining
service from the ILECs due to their labor disputes. Any damage or failure that interrupts our
operations could harm our business. A breach of network security could delay or interrupt service to our customers, which could reduce
demand for our services. Our network may be vulnerable to unauthorized access, computer viruses, worms and Trojan
horses and other disruptions. Internet service providers, telecommunications carriers and corporate
networks have in the past experienced, and may in the future experience, interruptions in service
as a result of accidental or intentional actions of Internet users, current and former employees
and others. Unauthorized access could also potentially jeopardize the security of confidential
information stored in our computer systems, our end-users and our resellers end-users. This might
result in liability to us and also might deter potential customers from purchasing or selling our
services. While we attempt to implement and develop additional security measures we have not
implemented all of the security measures commercially available, and we may not implement such
measures in a timely manner or at all. 41




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Moreover, these measures, if and when implemented, may be circumvented, and eliminating
computer viruses and alleviating other security problems may require interruptions, delays or
cessation of service to our customers and our resellers customers, which could harm our business. 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 the performance of our executive officers and key employees. In particular, our
senior management has significant experience in the telecommunications industry and the loss of any
of them could negatively affect our ability to execute our business strategy. Additionally, we do
not have key person life insurance policies on any of our employees. Our future success also depends on our continuing ability to identify, hire, train and retain
other highly qualified technical, operations, sales, marketing, finance, legal, human resource, and
managerial personnel as we add end-users to our network. Competition for qualified personnel is
intense. The significant drop in our stock price has greatly reduced or eliminated the value of
stock options held by many of our employees, making it more difficult to retain employees in a
competitive market. In addition, in the event that our employees unionize, we could incur higher
ongoing labor costs and disruptions in our operations in the event of a strike or other work
stoppage. 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. We rely on outside parties to manufacture our network equipment and provide certain network
services. These services, software and equipment include:  
    DSLAMs;
    customer premises equipment, 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 We have in the past experienced supply problems with certain vendors. These vendors may not be
able to meet our needs in a satisfactory and timely manner in the future, which may cause us to
lose revenue. In addition, we may not be able to obtain additional vendors when needed. Our reliance on third-party vendors involves additional risks, including:  
    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 software vendors will stop supporting software that we use; and
    reduced control over delivery schedules, quality assurance, production yields and costs Any of these events could have a material adverse impact on our business and operating results. 42




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We use third party vendors offshore for tasks that were previously done by our employees. In 2003 we began using offshore vendors to assist us with software development and certain
customer support functions. Since we have historically used employees for most of our software
development, we have limited experience in managing offshore software development projects. Because
we are using a third-party vendor to manage the day to day operations, we do not have as much
control over the hiring and oversight of the vendors employees. In addition, the differences in
time zones, languages and culture may make it difficult to integrate the vendors software
development teams with our internal resources. As a result, this arrangement may impair our ability
to modify and improve our software and to develop new software in a timely manner. In addition, we
have provided these vendors with access to our intellectual property. While we have taken certain
contractual and procedural steps to protect our intellectual property, if any of the vendors or
their employees improperly uses our intellectual property, it may be more difficult for us to
assert our intellectual property rights because we may not be able to use United States courts to
enforce our rights. In outsourcing certain customer support functions to offshore vendors, we face similar
integration problems as we do with our software outsourcing arrangements. In addition, these
vendors may have difficulties communicating with our customers and resolving non-standard customer
issues. We also may experience difficulties as we integrate the vendors systems with our own. Some of these offshore locations have experienced civil unrest and terrorism and have been
involved in conflicts with neighboring countries. If some of these locations become engaged in
armed hostilities, particularly if these hostilities are protracted or involved the threat of or
use of weapons of mass destruction, our vendors operations could be adversely affected. While we
have attempted to contractually protect ourselves against calamities, if our vendors operations
are adversely affected, our customer service and software development efforts could be negatively
impacted. 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. We intend to consider acquisitions of businesses and technologies in the future on an
opportunistic basis. Acquisitions of businesses and technologies involve numerous risks, including
the diversion of management attention, difficulties in assimilating the acquired operations, loss
of key employees from the acquired company, and difficulties in transitioning key customer
relationships. In addition, these acquisitions may result in dilutive issuances of equity
securities, the incurrence of additional debt and large one-time expenditures. Any such acquisition
may not provide the benefits originally anticipated, and there may be difficulty in integrating the
service offerings and networks gained through acquisitions and strategic investments with our own.
In a strategic investment where we acquire a minority interest in a company, we may lack control
over the operations and strategy of the business, and we cannot guarantee that such lack of control
will not interfere with the integration of services and distribution channels of the business with
our own. Although we attempt to minimize the risk of unexpected liabilities and contingencies
associated with acquired businesses through planning, investigation and negotiation, unexpected
liabilities nevertheless may accompany such strategic investments and acquisitions. In addition, the purchase price of an acquired business may exceed the current fair value of
the net tangible assets of the acquired business. As a result, we would be required to record
material amounts of goodwill and other intangible assets, which could result in significant
impairment charges and amortization expense in future periods. These charges, in addition to the
results of operations of such acquired businesses, could have a material adverse effect on our
business, financial condition and results of operations. We cannot forecast the number, timing or
size of future acquisitions, or the effect that any such acquisitions might have on our operating
or financial results. Under generally accepted accounting principles, we are required to review our intangible
assets for impairment whenever events or changes in circumstances indicate that the carrying value
of these assets may not be recoverable. In addition, we are required to review our goodwill and
indefinite-lived intangible assets on an annual basis. If presently unforeseen events or changes in
circumstances arise which indicate that the carrying value of our goodwill or other intangible
assets may not be recoverable, we will be required to perform impairment reviews of these assets,
which have carrying values of approximately $36,626 as of March 31, 2005. An impairment review
could result in a write-down of all or a portion of these assets to their fair values. We will
perform an annual impairment review during the fourth quarter of each fiscal year or more
frequently if we believe indicators of impairment exist. In light 43




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of the large carrying value associated with our goodwill and intangible assets, any write-down
of these assets may result in a significant charge to our statement of operations in the period any
impairment is determined and could cause our stock price to decline. We must pay federal, state and local taxes and other surcharges on our service, the applicability
and levels of which are uncertain. Telecommunications providers pay a variety of surcharges and fees on their gross revenues from
interstate and intrastate services. Interstate surcharges include FUSF and Common Carrier
Regulatory Fees. In addition, state regulators impose similar surcharges and fees on intrastate
services and the applicability of these surcharges and fees to our services is uncertain in many
cases. The division of our services between interstate and intrastate services, and between
services that are subject to surcharges and fees and those that are not, is a matter of
interpretation and may in the future be contested by the FCC or state authorities. The FCC is
currently considering the nature of Internet service provider-bound traffic and new interpretations
or changes in the characterization of jurisdictions or service categories could cause our payment
obligations, pursuant to the relevant surcharges, to increase or result in liabilities. In
addition, periodic revisions by state and federal regulators of the applicable surcharges may
increase the surcharges and fees we currently pay. In addition, we may be required to pay certain
state taxes, including sales taxes, depending on the jurisdictional treatment of the services we
offer. The amount of those taxes could be significant, depending on the extent to which the various
states choose to tax our services. The federal government and many states apply transaction-based taxes to the sales of our
products and services and to our purchases of telecommunications services from various carriers. We
are in discussions with federal and state tax authorities regarding the extent of our
transaction-based tax liabilities. It is reasonably possible that our estimates of our
transaction-based tax liabilities could materially change in the near term. We may or may not be
able to recover some of those taxes from our customers. We are a party to litigation and adverse results of such litigation matters could negatively impact
our financial condition and results of operations. We are a defendant in some of the litigation matters described in Part II, Item 1. Legal
Proceedings. While we are vigorously defending these lawsuits, the total outcome of these
litigation matters is inherently unpredictable, and there is no guarantee we will prevail. Adverse
results in any of these actions could negatively impact our financial condition and results of
operations and, in some circumstances result in a material adverse effect on us. In addition,
defending such actions could result in substantial costs and diversion of resources that could
adversely affect our financial condition, results of operations and cash flows. Our intellectual property protection may be inadequate to protect our proprietary rights. We regard certain aspects of our products, services and technology as proprietary. We attempt
to protect them with patents, copyrights, trademarks, trade secret laws, restrictions on disclosure
and other methods. These methods may not be sufficient to protect our technology. We also generally
enter into confidentiality or license agreements with our employees and consultants, and generally
control access to and distribution of our documentation and other proprietary information. Despite
these precautions, it may be possible for a third party to copy or otherwise obtain and use our
products, services or technology without authorization, or to develop similar technology
independently. Currently, we have been issued sixteen patents and we have a number of additional patent
applications pending. We intend to prepare additional applications and to seek patent protection
for our systems and services. These patents may not be issued to us. If issued, they may not
protect our intellectual property from competition. Competitors could design around or seek to
invalidate these patents. Effective patent, copyright, trademark and trade secret protection may be unavailable or
limited in certain foreign countries. The global nature of the Internet makes it virtually
impossible to control the ultimate destination of our proprietary information. The steps that we
have taken may not prevent misappropriation or infringement of our technology. Litigation may be
necessary in the future to enforce our intellectual property rights, to protect our trade secrets
or to determine the validity and scope of the proprietary rights of others. Such litigation could
result in substantial costs and diversion of resources and could harm our business. 44




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The price of our common stock may continue to fluctuate significantly. The market price for our common stock has been, and is likely to continue to be, highly
volatile, which may result in losses to investors. We believe that a number of factors contribute
to this fluctuation and may cause our stock price to decline in the future. While it is not
possible to foresee all of the events that could adversely affect the price of our common stock or
cause such price to remain volatile, a few of the factors include:  
    state and federal regulatory and legislative actions;
    general economic conditions and the condition of the telecommunications industry;
    our ability to maintain existing customers and add new customers and recognize
revenue from distressed customers;
    our ability to reach profitability and cash flow positive 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 In addition, we were delisted from the NASDAQ National Market on July 20, 2001 and our common
stock currently trades on NASDAQs Over-the-Counter Bulletin Board. This contributes to our
volatility and may affect the liquidity of our common stock. The stock market has periodically experienced significant price and volume fluctuations that
have particularly affected the market prices of common stock of technology companies. These changes
have often been unrelated to the operating performance of particular companies. These broad market
fluctuations may also negatively affect the market price of our common stock. Substantial leverage and debt service obligations may adversely affect our cash flow. (Refer to
Part I, Item 2  Management Discussion and Analysis of Financial Condition and Results of
Operations  Liquidity and Capital Resources for additional information) We may be unable to generate cash sufficient to pay the principal of, interest on and other
amounts due in respect of our indebtedness when due. We may also add equipment loans and lease
lines to finance capital expenditures and may obtain additional long-term debt, working capital
lines of credit and lease lines some of which may be on less than optimal terms. Our substantial leverage could have significant negative consequences, including:  
    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 45




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Forward-Looking Statements We include certain estimates, projections, and other forward-looking statements in our
reports, in presentations to analysts and others, and in other publicly available material. Future
performance cannot be ensured. Actual results may differ materially from those in forward-looking
statements. The statements contained in this Report on Form 10-Q that are not historical facts are
forward-looking statements (as such term is defined in Section 27A of the Securities Act and
Section 21E of the Exchange Act), which can be identified by the use of forward-looking terminology
such as estimates, projects, anticipates, expects, intends, believes, or the negative
thereof or other variations thereon or comparable terminology, or by discussions of strategy that
involve risks and uncertainties. Examples of such forward-looking statements include but are not
limited to:  
    impact of the FCCs recent decisions and related litigation, and our ability to obtain
ILEC network elements and facilities at reasonable rates;
    continuing deployment of local voice services by providers other than the ILECs and our
ability to bundle our data services with the voice services of these alternative 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;
    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;
    estimates and expectations of future operating results, the adequacy of our cash
reserves, and the number of anticipated installed lines;
    plans to increase sales of value-added services, like VoIP;
    anticipated capital expenditures;
    plans to enter into business arrangements with broadband-related service providers;
    regulatory changes;
    feasibility of alternative access solutions, like wireless;
    effects of litigation currently pending; and
    other statements contained in this Report on Form 10-Q regarding matters that are not historical facts These statements are only estimates or predictions and cannot be relied upon. We can give you
no assurance that future results will be achieved. Actual events or results may differ materially
as a result of risks facing us or actual results differing from the assumptions underlying such
statements. Such risks and assumptions that could cause actual results to vary materially from the
future results indicated, expressed or implied in such forward-looking statements include our
ability to:  
    adapt our business plan in response to further developments resulting from the FCCs
recent decisions and related litigation; 46




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
    collect receivables from customers;
    retain and recruit employees;
    successfully market our services to customers and generate customer demand for our services;
    successfully defend our company against litigation;
    successfully manage our operating costs and overhead while continuing to provide good customer service;
    successfully continue to increase the number of business-grade lines and VoIP stations;
    achieve favorable pricing for our services;
    respond to increasing competition;
    manage growth of our operations, particularly the expansion of our Direct business;
    maintain suitable interconnection agreements with the ILECs in the areas where we
provide service, all in a timely manner, at reasonable costs and on satisfactory terms that
provide us with access to ILECs network elements and facilities that we use to provide our
services; and
    retain end-users that are served by customers facing financial difficulties All written and oral forward-looking statements made in connection with this Report on Form
10-Q which are attributable to us or persons acting on our behalf are expressly qualified in their
entirety by the Risk Factors and other cautionary statements included in this document and in our
Annual Report on Form 10-K for the year ended December 31, 2004. We disclaim any obligation to
update information contained in any forward-looking statement. 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk (All dollar amounts are presented in thousands) Our exposure to financial market risk, including changes in interest and marketable equity
security prices, relates primarily to our investment portfolio and outstanding debt obligations. We
typically do not attempt to reduce or eliminate our market exposure on our investment securities
because the majority of our investments are in fixed-rate, short-term debt securities. We do not
have any derivative instruments. The fair value of our investment portfolio or related income would
not be significantly impacted by either a 100 basis point increase or decrease in interest rates
due mainly to the fixed-rate nature of our investment portfolio in debt securities. In addition,
all of our outstanding indebtedness as of March 31, 2005 is fixed-rate debt. As March 31, 2005, we
have a carrying value of $27,671 on our financial statements related to our investment in ACCA. We
have certain financial risks on this investment. These risks relate primarily to the changes in the
price of the securities and fluctuations in the price of the Japanese Yen. The table below presents the carrying value and related weighted-average interest rates for
our cash and cash equivalents, short-term investments in debt securities and restricted cash and
cash equivalents as of March 31, 2005: Carrying value
    
    
    Interest rateCash and cash equivalents
    
    $
    109,448
    
    
    
    2.70
    %Short-term investments in debt securities
    
    
    23,570
    
    
    
    2.33
    %Restricted cash and cash equivalents
    
    
    2,533
    
    
    
    1.71
    %$
    135,551
    
    
    
    2.62
    %
 47




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Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures.The Securities and Exchange Commission
defines the term disclosure controls and procedures to mean a companys controls and other
procedures that are designed to ensure that information required to be disclosed in the reports
that it files or submits under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported, within the time periods specified in the Commissions rules and forms. Our
chief executive officer and chief financial officer have concluded, based on the evaluation of the
effectiveness of the disclosure controls and procedures by our management, with the participation
of our chief executive officer and chief financial officer, as of the end of the period covered by
this report, that our disclosure controls and procedures were effective for this purpose. Changes in Internal Controls.During the fiscal quarter covered by this report, we did not
make any change in our internal control over financial reporting that materially affected or is
reasonably likely to materially affect our internal control over financial reporting. 48




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PART II. OTHER INFORMATION 
 Item 1. Legal Proceedings In April 1999, we filed a lawsuit against Bell Atlantic, now Verizon, and its affiliates in
the United States District Court for the District of Columbia. We are pursuing antitrust and other
claims in this lawsuit arising out of Verizons conduct as a supplier of network facilities,
including central office space, transmission facilities and telephone lines. In December 2000, we
also filed a lawsuit against BellSouth Telecommunications and its subsidiaries in the United States
District Court for the Northern District of Georgia. We are pursuing claims in this lawsuit that
are similar to our claims against Verizon. Both courts dismissed some of our claims based on the
ruling of the United States Court of Appeals of the Seventh Circuit in Goldwasser v. Ameritech. The
court in the Verizon case also dismissed our remaining claims on other grounds. We voluntarily
dismissed our remaining claims in the BellSouth case so we could pursue certain issues on appeal.
We appealed the BellSouth and Verizon decisions to the United States Court of Appeals for the
Eleventh Circuit and the United States Court of Appeals for the District of Columbia, respectively.
On August 2, 2002, the Eleventh Circuit Court of Appeals reversed the lower courts decision in the
BellSouth case and remanded the case for further proceedings. BellSouth appealed this decision to
the United States Supreme Court. On January 20, 2004, the United States Supreme Court reversed a
decision entitled Verizon Communications v. Law Offices of Curtis Trinko, which rejected the
Goldwasser decision. The Supreme Court also vacated the Eleventh Circuits decision in our case
against BellSouth and remanded the case to the Eleventh Circuit for review in light of the Trinko
decision. On June 25, 2004, the Eleventh Circuit reversed portions of the lower courts decision in
the BellSouth case and remanded the case for further proceedings. On November 24, 2004, we
requested that the United States Supreme Court review certain portions of the Eleventh Circuits
decision unrelated to our antitrust claims. The Supreme Court denied our request. The Court of
Appeals for the District of Columbia also recently reversed in part and affirmed in part the
District Courts decision in our case against Verizon and remanded the case to the United States
District Court for further proceedings. We cannot predict the outcome of these proceedings at this
time. On June 11, 2001, Verizon Communications filed a lawsuit against us in the United States
District Court for the Northern District of California. Verizon is a supplier of telephone lines
that we use to provide services to our customers. In its amended complaint, Verizon claims that we
falsified trouble ticket reports with respect to the telephone lines that we ordered and seeks
unspecified monetary damages, characterized as being in the millions, and injunctive relief. On
November 13, 2002, the District Court entered summary judgment in favor of us and dismissed
Verizons claims against us in their entirety. Verizon appealed the dismissal of its lawsuit. In
July 2004 the Ninth Circuit Court of Appeals partially reversed the District Courts decision and
indicated that Verizon could attempt to pursue a claim against us for breach of contract. The
matter has been sent back to the District Court for further proceedings. We believe we have strong
defenses to this lawsuit, but litigation is inherently unpredictable and there is no guarantee we
will prevail. Several stockholders filed complaints in the United States District Court for the Southern
District of New York, on behalf of themselves and purported classes of stockholders, against us and
several former and current officers and directors in addition to some of the underwriters in our
stock offerings. These lawsuits are so-called IPO allocation cases, challenging practices allegedly
used by certain underwriters of public equity offerings during the late 1990s and 2000. On April
19, 2002 the plaintiffs amended their complaint and removed us as a defendant. Certain directors
and officers are still named in the complaint. The plaintiffs claim that we failed to disclose the
arrangements that some of these underwriters purportedly made with certain investors. The
plaintiffs and the issuer defendants have reached a tentative agreement to settle the matter, and
we believe the tentative settlement will not have a material adverse effect on our condensed
consolidated financial position or results of operations. That settlement, however, has not been
finalized. If the settlement is not finalized, we believe we have strong defenses to these lawsuits
and we intend to contest them vigorously. However, litigation is inherently unpredictable and there
is no guarantee we will prevail. In June 2002, Dhruv Khanna was relieved of his duties as our General Counsel and Secretary.
Shortly thereafter, Mr. Khanna alleged that, over a period of years, certain current and former
directors and officers had breached their fiduciary duties to Covad by engaging in or approving
actions that constituted waste and self-dealing, that certain 49




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##### Table of Contents



current and former directors and officers had provided false representations to our auditors
and that he had been relieved of his duties in retaliation for his being a purported whistleblower
and because of racial or national origin discrimination. He threatened to file a shareholder
derivative action against those current and former directors and officers, as well as a wrongful
termination lawsuit. Mr. Khanna was placed on paid leave while his allegations were being
investigated. Our Board of Directors appointed a special investigative committee, which initially consisted
of Dale Crandall and Hellene Runtagh, to investigate the allegations made by Mr. Khanna. Richard
Jalkut was appointed to this committee shortly after he joined our Board of Directors. This
committee retained an independent law firm to assist in its investigation. Based on this
investigation, the committee concluded that Mr. Khannas allegations were without merit and that it
would not be in the best interests of Covad to commence litigation based on these allegations. The
committee considered, among other things, that many of Mr. Khannas allegations were not accurate,
that certain allegations challenged business decisions lawfully made by management or the Board,
that the transactions challenged by Mr. Khanna in which any director had an interest were approved
by a majority of disinterested directors in accordance with Delaware law, that the challenged
director and officer representations to the auditors were true and accurate, and that Mr. Khanna
was not relieved of his duties as a result of retaliation for alleged whistleblowing or racial or
national origin discrimination. Mr. Khanna has disputed the committees work and the outcome of its
investigation. After the committees findings had been presented and analyzed, we concluded in January 2003
that it would not be appropriate to continue Mr. Khanna on paid leave status, and determined that
there was no suitable role for him at Covad. Accordingly, he was terminated as an employee of
Covad. Based on the events mentioned above, in September 2003, Mr. Khanna filed a purported class
action and a derivative action against our current and former directors in the Court of Chancery of
the State of Delaware in and for New Castle County. On August 3, 2004, Mr. Khanna amended his
Complaint and two additional purported shareholders joined the lawsuit. In this action the
plaintiffs seek recovery on behalf of the company from the individual defendants for their
purported breach of fiduciary duty. The plaintiffs also seek to invalidate our election of
directors in 2002, 2003 and 2004 because they claim that our proxy statements were misleading. We
are unable to predict the outcome of this lawsuit. We are also a party to a variety of pending or threatened legal proceedings as either
plaintiff or defendant, or are engaged in business disputes that arise in the ordinary course of
business. Failure to resolve these various legal disputes and controversies without excessive delay
and cost and in a manner that is favorable to us could significantly harm our business. We do not
believe the ultimate outcome of these matters will have a material impact on our condensed
consolidated financial position and results of operations. However, litigation is inherently
unpredictable and there is no guarantee we will prevail or otherwise not be adversely affected. We are subject to state PUCs, FCC and other regulatory and court decisions as they relate to
the interpretation and implementation of the 1996 Telecommunications Act. In addition, we are
engaged in a variety of legal negotiations, arbitrations and regulatory and court proceedings with
multiple ILECs. These negotiations, arbitrations and proceedings concern the ILECs denial of
central office space, the cost and delivery of transmission facilities and telephone lines and
central office spaces, billing issues and other operational issues. Other than the payment of legal
fees and expenses, which are not quantifiable but are expected to be material, we do not believe
that these matters will result in material liability to us and the potential gains are not
quantifiable at this time. An unfavorable result in any of these negotiations, arbitrations and
proceedings, however, could have a material adverse effect on our condensed consolidated financial
position and results of operations if we are denied or charged higher rates for transmission lines
or central office spaces. 
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds None. 
 Item 3. Defaults Upon Senior Securities None. 50




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Item 4. Submission of Matters to a Vote of Security Holders None. 
 Item 5. Other Information None. 
 Item 6. Exhibits Incorporated by ReferenceExhibit
    
    
    
    
    
    
    
    
    
    ExhibitNumber
    
    Exhibit Description
    
    Form
    
    File No.
    
    Date of First Filing
    
    Number
    
    Filed Herewith10.53
    
    
    Letter Agreement between Covad
Communications and John Trewin
dated February 28, 2005
    
    
    
    
    
    
    
    
    
    X10.54
    
    
    Change in Control Agreement
between Covad Communications
Group, Inc. and John Trewin
    
    
    
    
    
    
    
    
    
    X10.55
    
    
    Indemnification Agreement
between Covad Communications
Group, Inc. and John Trewin
    
    
    
    
    
    
    
    
    
    X31.1
    
    
    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. 51




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##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized. COVAD COMMUNICATIONS GROUP, INC.By:
    
    /s/ CHARLES E. HOFFMANCharles E. HoffmanPresident, Chief ExecutiveOfficer and DirectorDate: May 6, 2005
    
    
    
    By:
    
    /s/ JOHN E. TREWINJohn E. TrewinSenior Vice President andDate: May 6, 2005
    
    
    
    
    
    Chief Financial Officer
 52




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Incorporated by ReferenceExhibit
    
    
    
    
    
    
    
    
    
    ExhibitNumber
    
    Exhibit Description
    
    Form
    
    File No.
    
    Date of First Filing
    
    Number
    
    Filed Herewith10.53
    
    
    Letter Agreement between Covad Communications
and John Trewin dated February 28, 2005
    
    
    
    
    
    
    
    
    
    X10.54
    
    
    Change in Control Agreement between Covad
Communications Group, Inc. and John Trewin
    
    
    
    
    
    
    
    
    
    X10.55
    
    
    Indemnification Agreement between Covad
Communications Group, Inc. and John Trewin
    
    
    
    
    
    
    
    
    
    X31.1
    
    
    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