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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549


FORM 10-Q

|  |  |                                                         
|- |  | --------------------------------------------------------
|x |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE 
|  |  | SECURITIES EXCHANGE ACT OF 1934                         
|  |  | For the quarterly period ended September 30, 2003       
|  |  |                                                         
|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 Drive
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
x     No o

Indicate by check mark whether the registrant is an accelerated filer (as
described by Rule 12b-2 of the Exchange Act).
Yes x  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
x     No o

As of October 16, 2003 there were 227,259,122 shares outstanding of the
Registrants Common Stock, including Class B Common Stock.



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TABLE OF CONTENTS



|                              |                                                                                               |                                                      |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ---------------------------------------------------- |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION
|                              | Item 1. Condensed Consolidated Financial Statements                                          
|                              |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS               
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS     
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                              |                                                                                               | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|                              | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                              | Item 3. Market Risk                                                                          
|                              | Item 4. Controls and Procedures                                                              
|PART II. OTHER INFORMATION   
|                              | Item 1. Legal Proceedings (all dollar amounts are presented in thousands)                    
|                              | Item 2. Changes in Securities and Use of Proceeds                                            
|                              | Item 3. Defaults upon Senior Securities                                                      
|                              | Item 4. Submission of Matters to a Vote of Security Holders                                  
|                              | Item 5. Other Information                                                                    
|                              | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURES                   
|EXHIBIT 10.40                
|EXHIBIT 31.1                 
|EXHIBIT 31.2                 
|EXHIBIT 32.1                 
|EXHIBIT 32.2                 



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##### Table of Contents



TABLE OF CONTENTS

COVAD COMMUNICATIONS GROUP, INC.

FORM 10-Q

TABLE OF CONTENTS

|           |                                                                                                                        |  |     
|---------- | ---------------------------------------------------------------------------------------------------------------------- |  | ----
|           |                                                                                                                        |  | Page
|           |                                                                                                                        |  |     
|PART I.    | FINANCIAL INFORMATION                                                                                                  |  |     
|ITEM 1.    | CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)                                                                |  | 1   
|           | CONDENSED CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER
30, 2003 AND DECEMBER 31, 2002                                   |  | 1   
|           | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE
THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2003
AND 2002 |  | 2   
|           | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE
NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002                  |  | 3   
|           | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                                                   |  | 4   
|ITEM 2.    | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS                                  |  | 17  
|ITEM 3.    | MARKET RISK                                                                                                            |  | 32  
|ITEM 4.    | CONTROLS AND PROCEDURES                                                                                                |  | 32  
|PART II.   | OTHER INFORMATION                                                                                                      |  |     
|ITEM 1.    | LEGAL PROCEEDINGS                                                                                                      |  | 34  
|ITEM 2.    | CHANGES IN SECURITIES AND USE OF PROCEEDS                                                                              |  | 36  
|ITEM 3.    | DEFAULTS UPON SENIOR SECURITIES                                                                                        |  | 36  
|ITEM 4.    | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                    |  | 36  
|ITEM 5.    | OTHER INFORMATION                                                                                                      |  | 36  
|ITEM 6.    | EXHIBITS AND REPORTS ON FORM 8-K                                                                                       |  | 37  
|SIGNATURES |                                                                                                                        |  | 37  





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PART I. FINANCIAL INFORMATION




Item 1.Condensed Consolidated Financial Statements (Unaudited)

COVAD COMMUNICATIONS GROUP, INC.




CONDENSED CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except share and per share amounts)

|                                                           |                                                                                                                                                                                                 |   |               |            |              |   |         |            |  
|---------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | - | ------------- | ---------- | ------------ | - | ------- | ---------- | -
|                                                           |                                                                                                                                                                                                 |   | September 30, |            | December 31,
|                                                           |                                                                                                                                                                                                 |   | 2003          |            | 2002        
|                                                           |                                                                                                                                                                                                 |   |               |            |             
|                                                           |                                                                                                                                                                                                 |   | (Unaudited)   |            | (Note 1)    
|ASSETS                                                     |                                                                                                                                                                                                 |   |               |            |              |   |         |           
|Current assets:                                            |                                                                                                                                                                                                 |   |               |            |              |   |         |           
|                                                           | Cash and cash equivalents                                                                                                                                                                       |   | $             | 68,115     |              |   | $       | 96,491     |  
|                                                           | Short-term investments                                                                                                                                                                          |   |               | 66,680     |              |   |         | 108,076    |  
|                                                           | Restricted cash and investments                                                                                                                                                                 |   |               | 400        |              |   |         | 501        |  
|                                                           | Accounts receivable, net of allowances of $4,727 at September 30, 2003 ($5,388 at December 31, 2002)                                                                                            |   |               | 27,770     |              |   |         | 21,746     |  
|                                                           | Unbilled revenues                                                                                                                                                                               |   |               | 5,802      |              |   |         | 3,921      |  
|                                                           | Other receivables                                                                                                                                                                               |   |               | 738        |              |   |         | 1,385      |  
|                                                           | Inventories                                                                                                                                                                                     |   |               | 7,229      |              |   |         | 5,096      |  
|                                                           | Prepaid expenses and other current assets                                                                                                                                                       |   |               | 2,839      |              |   |         | 5,524      |  
|                                                           |                                                                                                                                                                                                 |   |               |            |              |   |         |            |  
|Total current assets                                       |                                                                                                                                                                                                 |   | 179,573       |            |              |   | 242,740 |           
|Property and equipment, net                                |                                                                                                                                                                                                 |   | 95,857        |            |              |   | 108,737 |           
|Collocation fees and other intangible assets, net          |                                                                                                                                                                                                 |   | 41,509        |            |              |   | 43,284  |           
|Investments in unconsolidated affiliates                   |                                                                                                                                                                                                 |   |              |            |              |   | 1,026   |           
|Deferred costs of service activation                       |                                                                                                                                                                                                 |   | 31,848        |            |              |   | 40,286  |           
|Deferred customer incentives                               |                                                                                                                                                                                                 |   | 4,869         |            |              |   | 3,540   |           
|Other long-term assets                                     |                                                                                                                                                                                                 |   | 2,527         |            |              |   | 2,548   |           
|                                                           |                                                                                                                                                                                                 |   |               |            |              |   |         |            |  
|Total assets                                               |                                                                                                                                                                                                 | $ | 356,183       |            |              | $ | 442,161 |           
|                                                           |                                                                                                                                                                                                 |   |               |            |              |   |         |            |  
|LIABILITIES AND STOCKHOLDERS EQUITY                       |                                                                                                                                                                                                 |   |               |            |              |   |         |           
|Current liabilities:                                       |                                                                                                                                                                                                 |   |               |            |              |   |         |           
|                                                           | Accounts payable                                                                                                                                                                                |   | $             | 12,524     |              |   | $       | 10,915     |  
|                                                           | Accrued compensation and employment-related taxes                                                                                                                                               |   |               | 20,663     |              |   |         | 12,774     |  
|                                                           | Current portion of capital lease obligations                                                                                                                                                    |   |               | 31         |              |   |         | 165        |  
|                                                           | Accrued collocation and network service fees                                                                                                                                                    |   |               | 14,521     |              |   |         | 16,537     |  
|                                                           | Accrued transaction-based taxes                                                                                                                                                                 |   |               | 39,600     |              |   |         | 45,426     |  
|                                                           | Accrued interest                                                                                                                                                                                |   |               | 9,808      |              |   |         | 5,683      |  
|                                                           | Accrued market development funds and customer incentives                                                                                                                                        |   |               | 12,363     |              |   |         | 6,422      |  
|                                                           | Unresolved claims related to bankruptcy proceedings                                                                                                                                             |   |               | 7,532      |              |   |         | 7,381      |  
|                                                           | Other accrued liabilities                                                                                                                                                                       |   |               | 5,309      |              |   |         | 8,581      |  
|                                                           |                                                                                                                                                                                                 |   |               |            |              |   |         |            |  
|Total current liabilities                                  |                                                                                                                                                                                                 |   | 122,351       |            |              |   | 113,884 |           
|Long-term debt                                             |                                                                                                                                                                                                 |   | 50,000        |            |              |   | 50,000  |           
|Collateralized customer deposit                            |                                                                                                                                                                                                 |   | 62,204        |            |              |   | 68,191  |           
|Deferred gain resulting from deconsolidation of subsidiary |                                                                                                                                                                                                 |   | 53,963        |            |              |   | 53,972  |           
|Unearned revenues                                          |                                                                                                                                                                                                 |   | 63,488        |            |              |   | 73,815  |           
|                                                           |                                                                                                                                                                                                 |   |               |            |              |   |         |            |  
|Total liabilities                                          |                                                                                                                                                                                                 |   | 352,006       |            |              |   | 359,862 |           
|Commitments and contingencies                              |                                                                                                                                                                                                 |   |               |            |              |   |         |           
|Stockholders equity:                                      |                                                                                                                                                                                                 |   |               |            |              |   |         |           
|                                                           | Preferred stock, $0.001 par value; 5,000,000 shares authorized; no shares issued and outstanding
at September 30, 2003 and December 31, 2002                                                    |   |               |           |              |   |         |           |  
|                                                           | Common Stock, $0.001 par value; 590,000,000 shares authorized; 227,093,970 shares issued and
outstanding at September 30, 2003 (223,182,511 shares issued and outstanding at December 31, 2002) |   |               | 227        |              |   |         | 223        |  
|                                                           | Common Stock - Class B, $0.001 par value; 10,000,000 shares authorized; no shares issued and
outstanding at September 30, 2003 and December 31, 2002                                            |   |               |           |              |   |         |           |  
|                                                           | Additional paid-in capital                                                                                                                                                                      |   |               | 1,621,451  |              |   |         | 1,612,319  |  
|                                                           | Deferred stock-based compensation                                                                                                                                                               |   |               | (72        | )            |   |         | (160       | )
|                                                           | Accumulated other comprehensive loss                                                                                                                                                            |   |               | (941       | )            |   |         | (747       | )
|                                                           | Accumulated deficit                                                                                                                                                                             |   |               | (1,616,488 | )            |   |         | (1,529,336 | )
|                                                           |                                                                                                                                                                                                 |   |               |            |              |   |         |            |  
|Total stockholders equity                                 |                                                                                                                                                                                                 |   | 4,177         |            |              |   | 82,299  |           
|                                                           |                                                                                                                                                                                                 |   |               |            |              |   |         |            |  
|Total liabilities and stockholders equity                 |                                                                                                                                                                                                 | $ | 356,183       |            |              | $ | 442,161 |           
|                                                           |                                                                                                                                                                                                 |   |               |            |              |   |         |            |  

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.




CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except share and per share amounts)
(Unaudited)

|                                                                                                |                                                                      |                          |             |                                  |         |                                 |             |        |         |      |             |         |         |   |             |         |         | 
|----------------------------------------------------------------------------------------------- | -------------------------------------------------------------------- | ------------------------ | ----------- | -------------------------------- | ------- | ------------------------------- | ----------- | ------ | ------- | ---- | ----------- | ------- | ------- | - | ----------- | ------- | ------- | 
|                                                                                                |                                                                      |                          |             | Three Months Ended September 30, |         | Nine Months Ended September 30,
|                                                                                                |                                                                      |                          |             |                                  |         |                                
|                                                                                                |                                                                      |                          |             | 2003                             |         | 2002                            |             | 2003   |         | 2002
|                                                                                                |                                                                      |                          |             |                                  |         |                                 |             |        |         |     
|Revenues, net                                                                                   |                                                                      | $                        | 100,507     |                                  |         | $                               | 96,206      |        |         | $    | 283,812     |         |         | $ | 295,605     |        
|Operating expenses:                                                                             |                                                                      |                          |             |                                  |         |                                 |             |        |         |      |             |         |         |   |             |        
|                                                                                                | Network and product costs                                            |                          |             | 74,052                           |         |                                 |             | 69,546 |         |      |             | 211,803 |         |   |             | 236,002 |        
|                                                                                                | Sales, marketing, general and administrative                         |                          |             | 32,510                           |         |                                 |             | 41,173 |         |      |             | 102,189 |         |   |             | 112,210 |        
|                                                                                                | Provision for bad debts (bad debt recoveries), net                   |                          |             | (8                               | )       |                                 |             | (1,731 | )       |      |             | 26      |         |   |             | 312     |        
|                                                                                                | Depreciation and amortization of property and
equipment              |                          |             | 13,054                           |         |                                 |             | 33,498 |         |      |             | 41,399  |         |   |             | 92,882  |        
|                                                                                                | Amortization of collocation fees and other
intangible assets         |                          |             | 4,775                            |         |                                 |             | 3,700  |         |      |             | 12,795  |         |   |             | 10,990  |        
|                                                                                                | Litigation-related expenses                                          |                          |             |                                 |         |                                 |             | 1,884  |         |      |             |        |         |   |             | (9,029  | )      
|                                                                                                |                                                                      |                          |             |                                  |         |                                 |             |        |         |      |             |         |         |   |             |        
|                                                                                                |                                                                      | Total operating expenses |             |                                  | 124,383 |                                 |             |        | 148,070 |      |             |         | 368,212 |   |             |         | 443,367 | 
|                                                                                                |                                                                      |                          |             |                                  |         |                                 |             |        |         |      |             |         |         |   |             |        
|Loss from operations                                                                            |                                                                      |                          | (23,876     | )                                |         |                                 | (51,864     | )      |         |      | (84,400     | )       |         |   | (147,762    | )      
|Other income (expense):                                                                         |                                                                      |                          |             |                                  |         |                                 |             |        |         |      |             |         |         |   |             |        
|                                                                                                | Interest income                                                      |                          |             | 448                              |         |                                 |             | 1,559  |         |      |             | 1,737   |         |   |             | 4,072   |        
|                                                                                                | Realized loss on short-term investments                              |                          |             |                                 |         |                                 |             |       |         |      |             |        |         |   |             | (17     | )      
|                                                                                                | Provision for impairment of investments in
unconsolidated affiliates |                          |             | (538                             | )       |                                 |             |       |         |      |             | (747    | )       |   |             |        |        
|                                                                                                | Equity in losses of unconsolidated affiliates                        |                          |             | (83                              | )       |                                 |             | (101   | )       |      |             | (279    | )       |   |             | (704    | )      
|                                                                                                | Loss on disposal of investments in unconsolidated
affiliates         |                          |             |                                 |         |                                 |             |       |         |      |             |        |         |   |             | (636    | )      
|                                                                                                | Interest expense                                                     |                          |             | (1,376                           | )       |                                 |             | (1,375 | )       |      |             | (4,148  | )       |   |             | (4,125  | )      
|                                                                                                | Miscellaneous income (expense), net                                  |                          |             | 282                              |         |                                 |             | 74     |         |      |             | 685     |         |   |             | (167    | )      
|                                                                                                |                                                                      |                          |             |                                  |         |                                 |             |        |         |      |             |         |         |   |             |        
|                                                                                                | Other income (expense), net                                          |                          |             | (1,267                           | )       |                                 |             | 157    |         |      |             | (2,752  | )       |   |             | (1,577  | )      
|                                                                                                |                                                                      |                          |             |                                  |         |                                 |             |        |         |      |             |         |         |   |             |        
|Net loss                                                                                        |                                                                      | $                        | (25,143     | )                                |         | $                               | (51,707     | )      |         | $    | (87,152     | )       |         | $ | (149,339    | )      
|                                                                                                |                                                                      |                          |             |                                  |         |                                 |             |        |         |      |             |         |         |   |             |        
|Basic and diluted net loss per share                                                            |                                                                      | $                        | (0.11       | )                                |         | $                               | (0.23       | )      |         | $    | (0.39       | )       |         | $ | (0.68       | )      
|                                                                                                |                                                                      |                          |             |                                  |         |                                 |             |        |         |      |             |         |         |   |             |        
|Weighted-average number of common shares used in
computing basic and diluted net loss per share |                                                                      |                          | 224,872,907 |                                  |         |                                 | 220,432,609 |        |         |      | 224,019,089 |         |         |   | 218,901,267 |        
|                                                                                                |                                                                      |                          |             |                                  |         |                                 |             |        |         |      |             |         |         |   |             |        

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.




CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
(Unaudited)

|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |          |         |         |         |  
|-------------------------------------------------- | --------------------------------------------------------------------------- | -------------------------------------------------------------------- | --------------------------------------------------- | --------------------------------------------------- | ------ | ------------------------------- | ------- | -------- | ------- | ------- | ------- | -
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        | Nine Months Ended September 30,
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                                
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        | 2003                            |         | 2002    
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |         
|Operating Activities:                              |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |         
|                                                   | Net loss                                                                    |                                                                      | $                                                   | (87,152                                             | )      |                                 | $       | (149,339 | )      
|                                                   | Adjustments to reconcile net loss to net cash used in operating activities: |                                                                      |                                                     |                                                     |        |                                 |         |          |        
|                                                   |                                                                             | Provision for bad debts (bad debt recoveries), net                   |                                                     |                                                     | 26     |                                 |         |          | 312     |        
|                                                   |                                                                             | Depreciation and amortization                                        |                                                     |                                                     | 54,194 |                                 |         |          | 103,872 |        
|                                                   |                                                                             | Loss on disposition of property and equipment                        |                                                     |                                                     | 221    |                                 |         |          | 332     |        
|                                                   |                                                                             | Non-cash litigation-related expenses                                 |                                                     |                                                     |       |                                 |         |          | (9,029  | )      
|                                                   |                                                                             | Employee stock-based compensation                                    |                                                     |                                                     | 1,325  |                                 |         |          | 473     |        
|                                                   |                                                                             | Other stock-based compensation                                       |                                                     |                                                     | 86     |                                 |         |          | 36      |        
|                                                   |                                                                             | Other non-cash charges                                               |                                                     |                                                     | 1,311  |                                 |         |          |        |        
|                                                   |                                                                             | Amortization (accretion) of interest on investments, net             |                                                     |                                                     | (956   | )                               |         |          | (92     | )      
|                                                   |                                                                             | Realized loss on short-term investments                              |                                                     |                                                     |       |                                 |         |          | 17      |        
|                                                   |                                                                             | Equity in losses of unconsolidated affiliates                        |                                                     |                                                     | 279    |                                 |         |          | 704     |        
|                                                   |                                                                             | Provision for impairment of investments in unconsolidated affiliates |                                                     |                                                     | 747    |                                 |         |          |        |        
|                                                   |                                                                             | Loss on disposal of investments in unconsolidated affiliates         |                                                     |                                                     |       |                                 |         |          | 636     |        
|                                                   |                                                                             | Net changes in operating assets and liabilities:                     |                                                     |                                                     |        |                                 |         |          |         |        
|                                                   |                                                                             |                                                                      | Restricted cash                                     |                                                     |        | 101                             |         |          |         | 8,703   |        
|                                                   |                                                                             |                                                                      | Accounts receivable                                 |                                                     |        | (6,050                          | )       |          |         | (9,459  | )      
|                                                   |                                                                             |                                                                      | Unbilled revenues                                   |                                                     |        | (1,881                          | )       |          |         | 1,030   |        
|                                                   |                                                                             |                                                                      | Inventories                                         |                                                     |        | (2,133                          | )       |          |         | 2,181   |        
|                                                   |                                                                             |                                                                      | Prepaid expenses and other current assets           |                                                     |        | 3,332                           |         |          |         | (3,191  | )      
|                                                   |                                                                             |                                                                      | Deferred costs of service activation                |                                                     |        | 8,438                           |         |          |         | 13,327  |        
|                                                   |                                                                             |                                                                      | Accounts payable                                    |                                                     |        | 1,609                           |         |          |         | (2,540  | )      
|                                                   |                                                                             |                                                                      | Unresolved claims related to bankruptcy proceedings |                                                     |        | 151                             |         |          |         | (2,913  | )      
|                                                   |                                                                             |                                                                      | Collateralized customer deposit                     |                                                     |        | (5,987                          | )       |          |         | (4,920  | )      
|                                                   |                                                                             |                                                                      | Other current liabilities                           |                                                     |        | 6,842                           |         |          |         | 8,417   |        
|                                                   |                                                                             |                                                                      | Unearned revenues                                   |                                                     |        | (10,327                         | )       |          |         | (19,109 | )      
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |          |        
|                                                   |                                                                             |                                                                      |                                                     | Net cash used in operating activities               |        |                                 | (35,824 | )        |         |         | (60,552 | )
|Investing Activities:                              |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |         
|                                                   | Purchases of short-term investments                                         |                                                                      |                                                     | (113,486                                            | )      |                                 |         | (213,681 | )      
|                                                   | Maturities of short-term investments                                        |                                                                      |                                                     | 155,644                                             |        |                                 |         | 70,988   |        
|                                                   | Sales of short-term investments                                             |                                                                      |                                                     |                                                    |        |                                 |         | 40,000   |        
|                                                   | Purchases of property and equipment                                         |                                                                      |                                                     | (30,401                                             | )      |                                 |         | (12,323  | )      
|                                                   | Proceeds from sales of property and equipment                               |                                                                      |                                                     | 60                                                  |        |                                 |         | 13,451   |        
|                                                   | Recovery of internal use software costs                                     |                                                                      |                                                     | 1,592                                               |        |                                 |         | 458      |        
|                                                   | Payment of collocation fees and purchase of other intangible assets         |                                                                      |                                                     | (11,020                                             | )      |                                 |         | (1,963   | )      
|                                                   | Proceeds from sales of investments in unconsolidated affiliates             |                                                                      |                                                     |                                                    |        |                                 |         | 3,360    |        
|                                                   | Decrease of other long-term assets                                          |                                                                      |                                                     | 21                                                  |        |                                 |         |         |        
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |          |        
|                                                   |                                                                             |                                                                      |                                                     | Net cash provided by (used in) investing activities |        |                                 | 2,410   |          |         |         | (99,710 | )
|Financing Activities:                              |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |         
|                                                   | Principal payments under capital lease obligations                          |                                                                      |                                                     | (134                                                | )      |                                 |         | (11      | )      
|                                                   | Proceeds from common stock issuance                                         |                                                                      |                                                     | 5,172                                               |        |                                 |         | 1,583    |        
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |          |        
|                                                   |                                                                             |                                                                      |                                                     | Net cash provided by (used in) financing activities |        |                                 | 5,038   |          |         |         | 1,572   |  
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |          |        
|                                                   | Net decrease in cash and cash equivalents                                   |                                                                      |                                                     | (28,376                                             | )      |                                 |         | (158,690 | )      
|                                                   | Cash and cash equivalents at beginning of period                            |                                                                      |                                                     | 96,491                                              |        |                                 |         | 207,810  |        
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |          |        
|                                                   | Cash and cash equivalents at end of period                                  |                                                                      | $                                                   | 68,115                                              |        |                                 | $       | 49,120   |        
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |          |        
|Supplemental Disclosures of Cash Flow Information: |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |         
|                                                   | Cash paid during the period for interest                                    |                                                                      | $                                                   | 9                                                   |        |                                 | $       |         |        
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                                 |         |         

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.




NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2003 and 2002
(All dollar 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. (Covad) and its wholly-owned subsidiaries
(collectively, the Company). All significant intercompany accounts and
transactions have been eliminated in consolidation.

The 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 all 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 presentation of the condensed consolidated financial statements have
been included. Operating results for the three and nine months ended September
30, 2003 are not necessarily indicative of the results that may be expected for
the year ending December 31, 2003.

The Companys 2003 business plan includes certain discretionary spending
that is based on several assumptions, including growth of the Companys
subscriber base with a reasonable per subscriber profit margin and improvements
in productivity. If necessary, the Company will curtail this discretionary
spending so that it can continue as a going concern at least through December
31, 2003 using only the Companys unrestricted cash, cash equivalent and
short-term investment balances in existence as of December 31, 2002.
Additionally, on August 21, 2003, the Federal Communications Commission (FCC)
issued its order in the Triennial Review of its rules for network unbundling
obligations of Incumbent Local Exchange Carriers (ILECs) (Note 8). Among
other things, the FCC announced that it will phase out its rule requiring
line-sharing over a three-year period. The ultimate impact of the Triennial
Review order on the Companys business, which relies on line-sharing to serve
consumer end-users, will depend on the Companys ability to negotiate
prices with the ILECs that allow the Company to maintain acceptable profit
levels. Management does not believe the FCCs revised unbundling rules will
have a material adverse effect on the Companys ability to continue as a going
concern at least through December 31, 2003.

The condensed consolidated balance sheet as of December 31, 2002 has been
derived from the audited consolidated financial statements at that date but
does not include all 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, 2002.

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) reorganization and restructuring liabilities,
(v) anticipated outcomes of legal proceedings and other disputes, (vi)
transaction-based tax liabilities, (vii) employment-related tax liabilities,
(viii) liabilities for market development funds and customer incentives and
(ix) valuation allowances associated with deferred tax assets.

During the three and nine months ended September 30, 2003, the Company
changed its estimates of certain accrued liabilities for cooperative
advertising and customer incentives based on historical data
regarding the amount of cooperative advertising that will not be utilized and
sales incentives that will not be claimed by customers. These changes in
accounting estimate increased the Companys revenues by $927 and $1,662 for the
three and nine months ended September 30, 2003, respectively, and decreased the

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Companys net loss by $927 ($0.00 per share) and $2,376 ($0.01 per share)
for the three and nine months ended September 30, 2003, 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 loss and net loss per
share for the three and nine months ended September 30, 2003 and 2002 had the
Company applied the fair value method to account for stock-based awards to
employees:

|                                                                                                                                                                 |             |   |                    |       |                   |   |         |       |      |   |         |       |   |   |          |       |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------- | - | ------------------ | ----- | ----------------- | - | ------- | ----- | ---- | - | ------- | ----- | - | - | -------- | ----- | -
|                                                                                                                                                                 |             |   | Three Months Ended |       | Nine Months Ended
|                                                                                                                                                                 |             |   | September 30,      |       | September 30,    
|                                                                                                                                                                 |             |   |                    |       |                  
|                                                                                                                                                                 |             |   | 2003               |       | 2002              |   | 2003    |       | 2002
|                                                                                                                                                                 |             |   |                    |       |                   |   |         |       |     
|Net loss, as reported                                                                                                                                            |             | $ | (25,143            | )     |                   | $ | (51,707 | )     |      | $ | (87,152 | )     |   | $ | (149,339 | )    
|Stock-based employee compensation expense included in the
determination of net loss, as reported                                                                 |             |   | 23                 |       |                   |   | 52      |       |      |   | 1,325   |       |   |   | 473      |      
|Stock-based employee compensation expense that would have
been included in the determination of net loss if the fair value
method had been applied to all awards |             |   | (3,591             | )     |                   |   | (8,167  | )     |      |   | (9,033  | )     |   |   | (21,478  | )    
|                                                                                                                                                                 |             |   |                    |       |                   |   |         |       |      |   |         |       |   |   |          |      
|Pro forma net loss                                                                                                                                               |             | $ | (28,711            | )     |                   | $ | (59,822 | )     |      | $ | (94,860 | )     |   | $ | (170,344 | )    
|                                                                                                                                                                 |             |   |                    |       |                   |   |         |       |      |   |         |       |   |   |          |      
|Basic and diluted net loss per common share:                                                                                                                     |             |   |                    |       |                   |   |         |       |      |   |         |       |   |   |          |      
|                                                                                                                                                                 | As reported |   | $                  | (0.11 | )                 |   | $       | (0.23 | )    |   | $       | (0.39 | ) |   | $        | (0.68 | )
|                                                                                                                                                                 |             |   |                    |       |                   |   |         |       |      |   |         |       |   |   |          |      
|                                                                                                                                                                 | Pro forma   |   | $                  | (0.13 | )                 |   | $       | (0.27 | )    |   | $       | (0.42 | ) |   | $        | (0.78 | )
|                                                                                                                                                                 |             |   |                    |       |                   |   |         |       |      |   |         |       |   |   |          |      

During the three months ended June 30, 2003, a matter was identified
related to prior financial reporting periods that necessitated the recording of
additional expense. This matter related to the modification of stock options
granted to certain employees in prior years. These modifications occurred upon
the separation of such employees from the Company, principally during 2000.
Accordingly, for the three months ended June 30, 2003, the Company recorded
additional stock-based compensation expense in the amount of $1,237 ($0.01 per
share). This amount is reflected in the Companys sales, marketing, general and
administrative expenses for the nine months ended September 30, 2003. The
Company does not believe this amount is material to the periods in which it
should have been recorded, nor does it expect that this expense will be
material to its consolidated operating results for the year ending December 31,
2003. However, if this adjustment is ultimately deemed to be material to the
Companys consolidated operating results for the year ending December 31, 2003,
the Company will need to restate prior financial reporting periods, including
the current period. As noted above, this adjustment is principally related to
2000, the impact of which would have been to increase sales, marketing, general
and administrative expenses and net loss by $1,237 ($0.01 per share) for such
year. As previously reported in the Companys 2002 Annual Report on Form 10-K,
certain other adjustments were recorded during 2002 that related to prior
periods. Of such amounts, $1,139 pertained to 2000, the effect of which would
have been to decrease the Companys 2000 net loss by $0.01 per share. The
aggregate effect of the adjustments recorded during the year ended December 31,
2002 and the nine months ended September 30, 2003 to the previously reported
results of operations for the year ended December 31, 2000 would be to increase
net loss by $98, or $0.00 per share, for such year if these adjustments had
been recorded in 2000.

Basic and Diluted Net Loss Per Share

Basic net loss per share is computed using the weighted-average number of
shares of the Companys common stock outstanding during the period, less the
weighted-average number of outstanding common shares subject to repurchase.

Diluted per share amounts are determined in the same manner as basic per
share amounts, except that the number of weighted-average common shares used in
the computations includes dilutive common shares subject to repurchase and is
increased assuming the (i) exercise of dilutive stock options and warrants
using the treasury stock method and (ii) conversion of dilutive convertible
debt instruments. However, diluted net loss per share is the same as basic net
loss per share in the periods presented in the accompanying condensed
consolidated statements of operations because the impact of (i) common shares
subject to repurchase and (ii) the assumed exercise of outstanding stock
options and warrants is not dilutive.

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The following table presents the calculation of weighted-average common
shares used in the computations of basic and diluted net loss per share
presented in the accompanying condensed consolidated statements of operations:

|                                                                                                |  |                                  |             |                                 |  |      |             |      |  |  |             |  |  |  |             | 
|----------------------------------------------------------------------------------------------- |  | -------------------------------- | ----------- | ------------------------------- |  | ---- | ----------- | ---- |  |  | ----------- |  |  |  | ----------- | 
|                                                                                                |  | Three Months Ended September 30, |             | Nine Months Ended September 30,
|                                                                                                |  |                                  |             |                                
|                                                                                                |  | 2003                             |             | 2002                            |  | 2003 |             | 2002
|                                                                                                |  |                                  |             |                                 |  |      |             |     
|Weighted-average number of shares of
common stock outstanding                                   |  |                                  | 224,872,907 |                                 |  |      | 220,433,234 |      |  |  | 224,019,089 |  |  |  | 218,910,100 | 
|Less weighted-average number of shares
of common stock subject to repurchase                    |  |                                  |            |                                 |  |      | 625         |      |  |  |            |  |  |  | 8,833       | 
|                                                                                                |  |                                  |             |                                 |  |      |             |      |  |  |             |  |  |  |             | 
|Weighted-average number of common
shares used in computing basic and
diluted net loss per share |  |                                  | 224,872,907 |                                 |  |      | 220,432,609 |      |  |  | 224,019,089 |  |  |  | 218,901,267 | 
|                                                                                                |  |                                  |             |                                 |  |      |             |      |  |  |             |  |  |  |             | 

Comprehensive Loss

Significant components of the Companys comprehensive loss are as follows:

|                                                           |  |            |            |      |  |                    |         |                   |  |      |         |   |  |   |         |   |  |   |          |  
|---------------------------------------------------------- |  | ---------- | ---------- | ---- |  | ------------------ | ------- | ----------------- |  | ---- | ------- | - |  | - | ------- | - |  | - | -------- | -
|                                                           |  |            |            |      |  | Three Months Ended |         | Nine Months Ended
|                                                           |  |            |            |      |  | September 30,      |         | September 30,    
|                                                           |  | Cumulative |            |      |  |                   
|                                                           |  | Amounts    |            | 2003 |  | 2002               |         | 2003              |  | 2002
|                                                           |  |            |            |      |  |                    |         |                   |  |     
|Net loss                                                   |  | $          | (1,616,488 | )    |  | $                  | (25,143 | )                 |  | $    | (51,707 | ) |  | $ | (87,152 | ) |  | $ | (149,339 | )
|Unrealized gains (losses) on available-for-sale
securities |  |            | 21         |      |  |                    | (66     | )                 |  |      | 78      |   |  |   | (194    | ) |  |   | 265      |  
|Foreign currency translation adjustment                    |  |            | (962       | )    |  |                    |        |                   |  |      |        |   |  |   |        |   |  |   | 1,342    |  
|                                                           |  |            |            |      |  |                    |         |                   |  |      |         |   |  |   |         |   |  |   |          |  
|Comprehensive loss                                         |  | $          | (1,617,429 | )    |  | $                  | (25,209 | )                 |  | $    | (51,629 | ) |  | $ | (87,346 | ) |  | $ | (147,732 | )
|                                                           |  |            |            |      |  |                    |         |                   |  |      |         |   |  |   |         |   |  |   |          |  

Recent Accounting Pronouncements

On May 15, 2003, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 150, Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and
Equity. SFAS No. 150 establishes standards for classifying and measuring as
liabilities certain financial instruments that embody obligations of the issuer
and have characteristics of both liabilities and equity, such as mandatorily
redeemable equity instruments. SFAS No. 150 must be applied immediately to
instruments entered into or modified after May 31, 2003 and to all other
instruments that exist as of the beginning of the first interim financial
reporting period beginning after June 15, 2003, except for mandatorily
redeemable instruments of non-public companies, to which the provisions of SFAS
No. 150 must be applied in fiscal periods beginning after December 15, 2003.
The application of SFAS No. 150 to pre-existing instruments should be
recognized as the cumulative effect of a change in accounting principle. The
adoption of SFAS No. 150 had no effect on the Companys consolidated financial
position as of September 30, 2003 or the results of its operations for the
three and nine months ended September 30, 2003.

In January 2003, the FASB issued Interpretation (FIN) No. 46,
Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulleting No. 51, Consolidated Financial Statements. FIN 46 applies
to any business enterprise that has a controlling interest, contractual
relationship or other business relationship with a variable interest entity
(VIE) and establishes guidance for the consolidation of VIEs that function to
support the activities of the primary beneficiary. FIN 46 was effective
immediately for enterprises with VIEs created after January 31, 2003, and will
be effective December 31, 2003 for enterprises with VIEs created before
February 1, 2003. The Company believes it has no investments in, or contractual
or other business relationships with, VIEs. Therefore, the adoption of FIN 46
had no effect on the Companys consolidated financial position as of September
30, 2003 or the results of its operations for the three and nine months ended
September 30, 2003.

In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation - Transition and Disclosure. SFAS No. 148 amends SFAS
No. 123, Accounting for Stock-Based Compensation, to provide alternative
methods of transition for an entity that voluntarily changes to the fair value
method of accounting for stock-based employee compensation. In addition, SFAS
No. 148 amends the disclosure provisions of SFAS No. 123 to require prominent
disclosure of the effects of an entitys accounting policy with respect to
stock-based employee compensation on reported operating results, including per
share amounts, in annual and interim financial statements. The disclosure
provisions of SFAS No. 148 were effective immediately upon issuance in 2002. As
of September 30, 2003, the Company has no immediate plans to adopt the fair
value method of accounting for stock-based employee compensation.

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In November 2002, the FASBs Emerging Issues Task Force (EITF) reached a
final consensus on Issue No. 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables, which is effective for revenue arrangements entered
into in fiscal periods beginning after June 15, 2003. Under EITF Issue No.
00-21, revenue arrangements with multiple deliverables are required to be
divided into separate units of accounting under certain circumstances. The
Company prospectively adopted EITF Issue No. 00-21 on July 1, 2003, and such
adoption did not have a material effect on its condensed consolidated financial
statements for the three and nine months ended September 30, 2003.

In November 2002, the FASB issued FIN No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others. FIN No. 45 requires certain guarantees to be recorded
at fair value, which is different from current practice, which is generally to
record a liability only when a loss is probable and reasonably estimable. FIN
No. 45 also requires a guarantor to make significant new disclosures, even when
the likelihood of making any payments under the guarantee is remote. The
disclosure provisions of FIN No. 45 were effective immediately in 2002. The
Company adopted the recognition and measurement provisions of FIN No. 45 on a
prospective basis with respect to guarantees issued or modified after December
31, 2002. The adoption of the recognition and measurement provisions of FIN No.
45 had no effect on the Companys condensed consolidated financial statements
as of and for the three and nine months ended September 30, 2003.

On January 1, 2003, the Company adopted SFAS No. 146, Accounting for
Costs Associated with an Exit or Disposal Activity. SFAS No. 146 revised the
accounting for exit and disposal activities under EITF Issue No. 94-3,
Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (Including Certain Costs Incurred in a
Restructuring), by extending the period in which expenses related to
restructuring activities are reported. A commitment to a plan to exit an
activity or dispose of long-lived assets is no longer sufficient to record a
one-time charge for most restructuring activities. Instead, companies record
exit or disposal costs when they are incurred and can be measured at fair
value. In addition, the resultant liabilities are subsequently adjusted for
changes in estimated cash flows. SFAS No. 146 is effective prospectively for
exit or disposal activities initiated after December 31, 2002. Companies may
not restate previously issued financial statements for the effect of the
provisions of SFAS No. 146, and liabilities that a company previously recorded
under EITF Issue No. 94-3 are grandfathered. The adoption of SFAS No. 146 had
no effect on the Companys condensed consolidated financial statements as of
and for the three and nine months ended September 30, 2003.

On January 1, 2003, the Company adopted SFAS No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections. SFAS No. 145 rescinds SFAS No. 4, Reporting Gains and Losses
from Extinguishment of Debt, which required all gains and losses from
extinguishment of debt to be aggregated and, if material, classified as an
extraordinary item, net of related income tax effect. SFAS No. 145 requires
that gains or losses from extinguishment of debt be classified as extraordinary
items only if they meet the criteria of APB Opinion No. 30. The adoption of
SFAS No. 145 had no effect on the Companys condensed consolidated financial
statements as of and for the three and nine months ended September 30, 2003.

On January 1, 2003, the Company adopted SFAS No. 143, Accounting for
Asset Retirement Obligations. SFAS No. 143 requires that the fair value of a
liability for an asset retirement obligation be recognized in the period in
which it is incurred if a reasonable estimate of fair value can be made. The
associated asset retirement costs are capitalized as part of the carrying
amount of the long-lived asset. The adoption of SFAS No. 143 had no effect on
the Companys condensed consolidated financial statements as of and for the
three and nine months ended September 30, 2003.

Reclassifications

Certain balances in the Companys 2002 condensed consolidated financial
statements, including certain operating expenses, have been reclassified to
conform to the presentation in 2003.

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 price is reasonably
assured. Revenues earned for which the customer has not been billed are
recorded as Unbilled revenues in the condensed consolidated balance sheets.
Amounts billed in advance of providing service are deferred and recorded as an
element of the condensed consolidated balance sheet caption Unearned
revenues. Included in revenues are Federal Universal Service Fund (FUSF)
charges billed to customers aggregating $1,422 and $3,681 for the three and
nine months ended September 30, 2003, respectively, and $1,861 and $7,757 for
the three and nine months ended September 30, 2002, respectively.

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The Company regularly has billing disputes with 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 thirty
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.
These charges to revenues were $459 and $2,079 during the three and nine months
ended September 30, 2003, respectively, and $540 and $2,130 during the three
and nine months ended September 30, 2002, respectively.

Significant Customers

As of September 30, 2003, the Company had approximately 270 wholesale
customers. For the three and nine months ended September 30, 2003, the
Companys 30 largest customers collectively comprised 95.9% and 95.2%,
respectively, of the Companys total wholesale revenues and 72.5% and 74.1%,
respectively, of the Companys total revenues. As of September 30, 2003,
receivables from these customers collectively comprised 75.5% of the Companys
gross accounts receivable balance. For the three and nine months ended
September 30, 2002, these customers collectively comprised 93.6% and 93.4%,
respectively, of the Companys total wholesale revenues and 80.5% and 80.3%,
respectively, of the Companys total revenues. As of September 30, 2002,
receivables from these customers collectively comprised 81.9% of the Companys
gross accounts receivable balance.

For the three months ended September 30, 2003, Earthlink, Inc. and AT&T
Corp. (AT&T), two of the Companys wholesale customers, accounted for 22.4%
and 10.9%, respectively, of the Companys total net revenues. For the nine
months ended September 30, 2003, these customers accounted for 22.3% and 11.3%,
respectively, of the Companys total net revenues. As of September 30, 2003,
receivables from these customers comprised 23.9% and 11.7% of the Companys
gross accounts receivable balance. No other individual customer accounted for
more than 10% of the Companys total net revenues during the three and nine
months ended September 30, 2003.

For the three months ended September 30, 2002, Earthlink, Inc. and AT&T,
accounted for 20.7% and 10.0%, respectively, of the Companys total revenues.
For the nine months ended September 30, 2002, these wholesale customers
individually accounted for 20.5% and 9.2%, respectively, of the Companys total
revenues. As of September 30, 2002, receivables from these wholesale customers
comprised 39.3% and 8.2% of the Companys gross accounts receivable balance.

Wholesaler Financial Difficulties

Some of the Companys wholesale customers are experiencing financial
difficulties. During the three and nine months ended September 30, 2003 and
2002, certain of these customers either (i) were not current in their payments
for the Companys services or (ii) were essentially current in their payments
but had filed for bankruptcy protection. Based on this information, the Company
determined that (i) the collectibility of revenues from these customers was not
reasonably assured or (ii) its ability to retain some or all of the payments
received from some of the customers that are in bankruptcy proceedings was not
reasonably assured. Accordingly, the Company classified this group of customers
as financially distressed for revenue recognition purposes. Revenues from
financially distressed customers are recognized when the Company collects cash
for services rendered, 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 a petition for bankruptcy
protection are recorded in the condensed consolidated balance sheet caption
Unearned revenues if the Companys ability to retain these payments is not
reasonably assured.

Some of the Companys wholesale customers are currently in bankruptcy
proceedings. Revenues from these customers accounted for approximately 0.9% and
1.7% of the Companys total net revenues for the three and nine months ended
September 30, 2003, respectively, and 18.9% and 19.6% of the Companys total
revenues for the three and nine months ended September 30, 2002, respectively.
Although WorldCom, Inc. (WorldCom) filed for bankruptcy protection on July
21, 2002, the Company continued to recognize revenues from WorldCom on an
accrual basis during 2002 and 2003 based on its specific facts and
circumstances and the revenue recognition criteria described above.
Consequently, the disclosures in the following paragraph regarding financially
distressed customers exclude amounts pertaining to WorldCom because the Company
does not currently classify it as a financially distressed customer for revenue
recognition purposes. The Company attempts to migrate end-users from some of
its financially distressed customers to the extent it is legally and
operationally feasible.

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The Company issued billings to its financially distressed customers
aggregating $702 and $4,142 during the three and nine months ended September
30, 2003, respectively, which were not recognized as revenues or accounts
receivable when billed in the Companys consolidated financial statements, as
compared to the corresponding amounts of $7,447 and $39,779 for the three and
nine months ended 2002, respectively. However, the Company recognized revenues
from certain of these customers when cash was collected (as described above)
aggregating $100 and $3,353 during the three and nine months ended September
30, 2003, respectively, and $12,077 and $43,446 during the three and nine
months ended September 30, 2002, respectively, some of which relates to
services provided in prior periods. Revenues for the three and nine months
ended September 30, 2003 also include payments totaling $793 and $827, respectively,
from bankrupt customers that the Company received prior to January 1, 2003 and
recorded as unearned revenue in its consolidated balance sheet as of
December 31, 2002 because the Companys ability to retain these payments was
not reasonably assured as of that date. However, as a result of subsequent
developments in the bankruptcy proceedings of such customers, the Company
recognized these payments as revenues during the three and nine months ended
September 30, 2003. Similar revenues from bankrupt customers were $1,120 and
$4,427, respectively, during the three and nine months ended September 30,
2002. The Company had contractual receivables from its financially distressed
customers totaling $945 as of September 30, 2003 that are not reflected in the
accompanying condensed consolidated balance sheet.

The Company has obtained information indicating that some of its wholesale
customers, including WorldCom, who (i) were essentially current in their
payments for the Companys services prior to September 30, 2003, or (ii) have
subsequently paid all or significant portions of the respective amounts
recorded as accounts receivable as of September 30, 2003, may be at risk of
becoming financially distressed. Revenues from these customers accounted for
approximately 18.8% and 22.5% of the Companys total net revenues for the three
and nine months ended September 30, 2003, respectively. As of September 30,
2003, receivables from these customers comprised 25.8% 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 September 30, 2003, revenues from these customers will be
recognized when cash is collected (as described above).

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: 1,000,000 shares for $0.94 per share;
1,000,000 shares for $3.00 per share; and 1,000,000 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 first quarter of 2003 and is being
recognized as a reduction of revenues on a straight-line basis over the
three-year term of the agreement because management believes that future
revenues from AT&T will exceed the fair value of the warrants described above.
This value was determined using the Black-Scholes option valuation model and
the following 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%.

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 1,500,000 shares of the Companys common
stock for $1.06 per share, 1,000,000 shares of the Companys common stock for
$3.00 per share and 1,000,000 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
and the following 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 and is being recognized as a reduction of revenues on a
straight-line basis over the five-year term of the agreement because management
believes that future revenues from AOL will exceed the fair value of the
warrants described above. However, because the agreement contains no minimum
purchase commitment and is cancelable under certain circumstances by AOL, the
Company will continue to monitor the recoverability of the deferred customer
incentive balance.

4. Asset Purchases

Qwest

On June 5, 2003, the Company purchased a customer list from Qwest
Communications Corporation and Qwest Interprise America, Inc. (collectively,
Qwest) pertaining to approximately 23,000 out-of-region digital subscriber
line (DSL) subscribers (substantially

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all of whom were not, indirectly, end-user customers of the Company as of
June 5, 2003 under the then-existing wholesale DSL services agreement with
Qwest). In exchange for the customer list, the Company paid $3,750 in cash and
released Qwest from its obligations under the wholesale DSL services agreement.
In addition, the Company will pay Qwest an additional amount of up to $1,250 if
certain levels of these customers successfully migrate to the Companys network
within a defined period. The Company did not assume any liabilities or
obligations of Qwest or hire any of Qwests employees. In addition, the Company
does not believe the customer list acquired from Qwest constitutes a
self-sustaining, integrated set of activities and assets that would constitute
a business. Approximately 12,800 of these customers have been
successfully migrated to the Companys network. In
addition, over 1,400 orders have been processed and are pending migration. The
solicitation and migration of these customers to the Companys network is
expected to be complete by October 2003.

The Company recorded the $3,750 cash payment to Qwest for the customer
list as an intangible asset, and such intangible asset is being amortized on a
straight-line basis to operations over a twenty-four month period, which is the
Companys estimate of the aggregate expected term of its customer relationship.

InternetConnect

On January 3, 2002, the Company purchased substantially all of the assets
of InternetConnect, a related party, in an auction supervised by the United
States Bankruptcy Court for the Central District of California. The purchase
price for these assets was $5,470 in cash, $235 of which had been deposited
with InternetConnects agent prior to December 31, 2001. (Under the terms of
the asset purchase agreement, the Company may be required to pay additional
cash of up to $1,880, depending upon the outcome of a previous post-petition
bankruptcy claim filed against InternetConnect by the Company, which is still
pending before the court.) The Company did not assume any liabilities or
obligations of InternetConnect or hire any of InternetConnects employees. In
addition, the Company does not believe the assets acquired from InternetConnect
constitute a self-sustaining, integrated set of activities and assets that
would constitute a business.

The tangible assets of InternetConnect purchased by the Company consisted
of accounts receivable, refundable deposits and property and equipment. The
Company also purchased the right, but not the obligation, to assume
InternetConnects customer contracts. However, the Company did not exercise
this right. Instead, the Company solicited the approximate 9,250 DSL, T-1,
virtual private network (VPN) and dial-up customers of InternetConnect
(substantially all of whom were, indirectly, end-user customers of the Company
as of January 3, 2002 under the existing wholesale DSL services agreement with
InternetConnect), and approximately 6,200 of such customers executed new
contracts with the Company and its resellers subsequent to January 3, 2002.

The Company has allocated the aforementioned purchase price based on the
estimated fair values of the elements of this transaction as of January 3,
2002, as follows:

|                           |  |   |       | 
|-------------------------- |  | - | ----- | 
|Accounts receivable        |  | $ | 1,386 | 
|Refundable deposits        |  |   | 349   | 
|Property and equipment     |  |   | 61    | 
|Customer acquisition costs |  |   | 3,674 | 
|                           |  |   |       | 
|                           |  | $ | 5,470 | 
|                           |  |   |       | 

The customer acquisition costs of $3,674 were charged to network and
product costs for the three months ended March 31, 2002 based on the Companys
accounting policy for costs of this nature that are not accompanied by up-front
fees.

5. Property Sale

During the three months ended December 31, 2001, the Company tentatively
decided to sell land, a building and certain improvements located in Manassas,
Virginia. This property was part of the Companys Corporate Operations. In
March 2002, the Company entered into a non-binding letter of intent with a
third party to sell such property for $14,000, which was subject to approval by
the Companys board of directors. In April 2002, the Company received the
necessary approval from its board of directors to proceed with the sale of this
property (at which time the Company suspended depreciation of the building and
related improvements when such assets had an aggregate carrying value of
$13,201). In June 2002, the Company completed the sale of this property and
recognized a gain of $133, which represents the net proceeds of $13,334 less
the aggregate carrying value of the property as described above.

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6. Reductions in Force

During the nine months ended September 30, 2003, the Company reduced its
workforce by approximately 113 employees, which represented approximately 10.2%
of the Companys workforce. The reductions covered employees in the areas of
sales and marketing, operations and corporate functions. None of these
reductions occurred during the three months ended September 30, 2003.

In connection with the reductions in force, the Company recorded a charge
to operations for the nine months ended September 30, 2003 of $1,235 relating
to employee severance benefits. For the nine months ended September 30, 2003,
$242 of these expenses were charged to network and product costs and the
remaining $993 were charged to sales, marketing, general and administrative
expenses. The Company paid $147 and $1,235 in severance benefits during the
three and nine months ended September 30, 2003, respectively. The expenses
associated with these reductions in force were $103 related to the Companys
Strategic Partnerships business segment and $349 related to its Broadband
Solutions business segment. The remaining $783 in expenses associated with
these reductions in force were related to the Companys Corporate Operations.

7. Pro forma Stock-Based Compensation Information

Pro forma information regarding the results of operations and net loss per
share (Note 1) is determined as if the Company had accounted for its employee
stock options using the fair value method. Under this method, the fair value of
each option granted is estimated on the date of grant using the Black-Scholes
option valuation model.

The Company uses the intrinsic value method in accounting for its employee
stock options because, as discussed below, the alternative fair value
accounting requires the use of option valuation models that were not developed
for use in valuing employee stock options. 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.

Option valuation models such as Black-Scholes were developed for use in
estimating the fair value of traded options that have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions, including the expected life of the
option. In managements opinion, the existing models do not necessarily provide
a reliable single measure of the fair value of the Companys employee stock
options because the Companys 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.

For the three and nine months ended September 30, 2003 and 2002, the fair
value of the Companys stock-based awards to employees was estimated using the
following weighted-average assumptions:

|                                  |  |                             |       |                              |  |      |       |      |  |  |       |   |  |  |       |  
|--------------------------------- |  | --------------------------- | ----- | ---------------------------- |  | ---- | ----- | ---- |  |  | ----- | - |  |  | ----- | -
|                                  |  | Three and Nine Months Ended |       | Three and Nine Months Ended 
|                                  |  | September 30,               |       | September 30,               
|                                  |  |                             |       |                             
|                                  |  | Stock Options               |       | Employee Stock Purchase Plan
|                                  |  |                             |       |                             
|                                  |  | 2003                        |       | 2002                         |  | 2003 |       | 2002
|                                  |  |                             |       |                              |  |      |       |     
|Expected life of options in years |  |                             | 4.0   |                              |  |      | 4.0   |      |  |  | 0.5   |   |  |  | 0.5   |  
|Volatility                        |  |                             | 133.2 | %                            |  |      | 137.7 | %    |  |  | 133.2 | % |  |  | 137.7 | %
|Risk-free interest rate           |  |                             | 2.98  | %                            |  |      | 2.94  | %    |  |  | 1.03  | % |  |  | 1.64  | %
|Expected dividend yield           |  |                             | 0.0   | %                            |  |      | 0.0   | %    |  |  | 0.0   | % |  |  | 0.0   | %

8. Contingencies

Litigation

On December 13, 2001, the Unites 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. These claims include:



| |  |  | The class action lawsuits filed in the United States District Court
for the Northern District of California. This settlement is described in
more detail below.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------

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| |  |  | The lawsuits filed in the Superior Court of the State of California
for the County of Santa Clara by six purchasers of the convertible notes
that the Company issued in September 2000.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Disputed claims made by former shareholders of Laser Link.net., Inc.                                                                                                                   
|
| |  |  | Disputed claims made by GE Capital and its subsidiary, Heller Financial Group.                                                                                                         

As of September 30, 2003, there were approximately $8,494 in unresolved
claims related to the Companys Chapter 11 bankruptcy proceedings. As of
September 30, 2003, the Company had recorded $7,532 for these unresolved claims
in its condensed consolidated balance sheet. 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 sheet.

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). The complaints were consolidated and the lead plaintiff
filed its amended consolidated complaint. The amended consolidated complaint
alleges 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. The
relief sought includes monetary damages and equitable relief. In 2001, the
Company and the officer and director defendants entered into a Memorandum of
Understanding (MOU) with counsel for the lead plaintiffs in this litigation
that tentatively resolves the litigation. The MOU sets forth the terms upon
which the Company, the officer and director defendants and the plaintiffs agree
to settle the litigation. Pursuant to the MOU, the plaintiffs agreed to support
and vote in favor of the Plan if it provided for the distribution of $16,500 in
cash to be funded by the Companys insurance carriers and 6,495,844 shares of
the Companys common stock. The plaintiffs voted in favor of the plan.
Consequently, the Company recorded a liability of approximately $18,578 in its
condensed consolidated 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 $9,549 as of
September 30, 2002 through charges (credits) to litigation-related expenses of
$1,884 and $(9,029) for the three and nine months ended September 30, 2002,
respectively. The settlement provided for in the MOU 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 has filed an
appeal pertaining to the final judgment, but this appeal only relates to the
allocation of the settlement proceeds between the plaintiffs and their
attorneys.

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 United States
Court of Appeals for 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 is seeking an appeal of this decision before the United
States Supreme Court. In addition, the United States Supreme Court has agreed
to review a decision from the United States Court of Appeals for the Second
Circuit entitled Verizon Communications v. Law Offices of Curtis Trinko, which
rejected the Goldwasser decision. The Eleventh Circuit relied in part on the
Trinko decision when it reversed the lower courts dismissal of the Companys
claims against BellSouth. The Court of Appeals for the District of Columbia has
indicated that it will not act on the Companys appeal in the Verizon case
until the Supreme Court decides the Trinko case. The Company cannot predict the
outcome of these matters.

On June 11, 2001, Verizon Communications 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 phone
lines the Company ordered and seeks unspecified monetary damages (characterized
as being in the millions) and injunctive relief. The current complaint
asserts causes of action for negligent and intentional misrepresentation and
violations of Californias unfair competition statute. On November 13, 2002,
the District Court entered summary judgment in favor of the Company and
dismissed Verizons

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claims against the Company in their entirety. Verizon has appealed the
dismissal of its lawsuit. 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 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
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 had 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.

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 of directors, 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 Companys 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 action against the Companys current
and former directors in the Court of Chancery of the State of Delaware in and
for New Castle County. In this action Mr. Khanna seeks recovery on behalf of

the Company from the individual defendants for their purported breach of
fiduciary duty. Mr. Khanna also seeks to invalidate the Companys election of
directors in 2002 and 2003 because he claims that the Companys proxy
statements were misleading. While the Company believes Mr. Khannas contentions
referred to above are without merit, and the Company and its directors will
vigorously defend against them, it 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 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, the interpretation of
competitive telecommunications company interconnection agreements in general,
and the Companys interconnection agreements in particular. In some cases the
Company may be bound by or may otherwise be significantly impacted by the
results of ongoing proceedings of these bodies or the

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legal outcomes of other contested interconnection agreements that are
similar to the Companys agreements. The results of any of these proceedings
could harm the Companys business.

Other Contingencies

On August 21, 2003, the FCC issued its order in the Triennial Review. This
order is a significant development for the Company for the following reasons:



| |  |  | The FCC is phasing out its rule requiring line-sharing over a
three-year period. Line-sharing currently allows the Company to
provision services using asymmetric DSL (ADSL) technology over the
same telephone line that the local telephone company is using to provide
voice services. The phase-out period will be handled in the following
manner:
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|

| |  |  | The Companys 235,800 line-shared customers as of October 2, 2003
will be grandfathered indefinitely at current rates, terms and
conditions. These line-shared customers provided approximately
$28,052, or 27.9%, of the Companys revenues for the three months
ended September 30, 2003, and $75,555, or 26.6%, of its revenues for
the nine months ended September 30, 2003.                                                                                                                      
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The Company can only acquire new line-shared customers at
regulated rates until October 2, 2004. For customers acquired during
this first year, the FCC-mandated maximum price for the high-frequency
portion of the phone line will be 25% of the cost of a separate phone
line during the first year, 50% during the second year and 75% during
the third year. After the third year, the Company will be required to
transition these customers to new arrangements.                               
|
| |  |  | Beginning on October 3, 2004, the Company cannot acquire new
line-shared customers unless it reaches agreements with the local
telephone companies that provide it with continued access to
line-sharing. In the event that it does not reach agreements with the
local telephone companies, the Company will be required to purchase a
separate telephone line in order to provide services to an end-user.
The cost of a separate phone line is significantly higher than the
cost of a shared line.
|

| |  |  | The local telephone companies are not required to allow the
Company to access the packet-switching functions of fiber-fed telephone
lines to provision DSL services. This means that, unless the Company
reaches agreements with the local telephone companies, it will be unable
to provide its most commonly-used services to end-users served by
fiber-fed lines. This is significant for the Company because it
preserves a substantial limit on the addressable market for its
services, thereby limiting its growth. In addition, the local telephone
companies are increasing their deployment of fiber-fed remote terminal
architectures.                                                                                                                         
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The local telephone companies can petition the various state utility
commissions for authority to stop providing data transport between the
phone companies central offices as an unbundled network element on
routes that have sufficient competitive alternatives to telephone
company data transport services. The Company currently purchases this
interoffice transport from the traditional phone companies in order to
carry traffic over its network. It is unclear whether any state
commissions will grant these requests, or whether such requests will be
granted on routes that impact the Company. The removal of any of these
transport links from the list of available network elements could
increase the price the Company pays for such connectivity.
|
| |  |  | Companies that compete with the local telephone companies continue to
have access to the local telephone companies networks in order to
provide their services under an arrangement known as the Unbundled
Network Element platform (UNE-P), so long as the state public
utilities commissions deem it appropriate. Under this arrangement these
competitive telecommunications companies purchase phone lines in order
to provide voice and data services. The continued existence of the UNE-P
allows the Company to bundle its data services with the voice services
of these companies pursuant to line-splitting arrangements. The Company
recently announced expansions of its relationships with AT&T and MCI to
include these bundled services.                

It is difficult for the Company to predict the full impact of the FCCs
decision on its business. In addition, there is some uncertainty regarding the
Triennial Review order because a number of legal challenges to the Triennial
Review order are pending in the courts and before the FCC. However, if the
Company is unable to obtain from the traditional telephone companies reasonable
line-sharing rates substantially below the cost of a separate telephone line,
it may stop selling stand-alone consumer grade services to new customers, which
would slow the growth of its revenue and require it to significantly change its
business plan.

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In its Triennial Review order, the FCC concluded that October 2, 2003
shall be deemed the trigger date for change of law provisions in the
Companys interconnection agreements with the various traditional phone
companies. As such, on or after October 2, 2003 the traditional telephone
companies may inform the Company that they want to change the line-sharing
terms and conditions of their agreements with the Company, which commences a
nine-month negotiation process that may result in arbitration before the state
utility commissions. Three of the traditional telephone companies have already
notified the Company that they intend to immediately commence a renegotiation
of the Companys interconnection agreements with them. These agreements contain
the prices and other terms for the telephone lines that the Company purchases
from this traditional telephone company. It is possible that other traditional
telephone companies will provide the Company with similar notices and will
attempt to renegotiate these interconnection agreements to eliminate
line-shared services or significantly increase the price the Company pays for
these services.

The Company has 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 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 consolidated
financial position and results of operations.

In addition, the Company is engaged in a variety of negotiations,
arbitrations and regulatory and court proceedings with multiple telephone
companies. These negotiations, arbitrations and proceedings concern the
telephone companies denial of physical central office space to the Company in
certain central offices, the cost and delivery of transmission facilities and
telephone lines and central office space, billing issues and other operational
issues. An unfavorable outcome in any of these negotiations, arbitrations and
proceedings could have a material adverse effect on the Companys consolidated
financial position and results of operations if it is denied access to, or
charged higher rates for transmission lines or central office spaces.

The Company is analyzing 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 and various transaction-based tax experts to determine the extent
of the Companys respective transaction-based tax liabilities. It is the
Companys opinion that such analysis will be concluded without a material
adverse effect on its 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 consolidated financial position and
results of operations. During the three and nine months ended September 30,
2003, the Company changed its estimates of certain accrued liabilities for
transaction-based and property taxes based on settlement agreements reached
with various states and local jurisdictions where the Company does business.
These changes in accounting estimate reduced the Companys net loss by $2,494
($0.01 per share) and $5,000 ($0.02 per share) for the three and nine months
ended September 30, 2003, respectively.

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 $5,938 during the
three months ended March 31, 2003. It is the Companys opinion that such
analysis will be concluded without a material adverse effect on its
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 sheet as of
September 30, 2003, could change in the near term, and the effects could be
material to the Companys consolidated financial position and results of
operations.

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##### Table of Contents



9. Business Segments

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. Covad Strategic Partnerships (CSP) focuses on delivering
services to enterprise, corporate, small business, small office/home office
(SoHo) and consumer customers primarily through wholesale relationships with
large Internet service providers (ISPs), telecommunications carriers and
other large resellers. Covad Broadband Solutions (CBS) focuses on small
business and SoHo markets by selling services directly to end-users as well as
through independent authorized sales agents, small ISPs and resellers. All
other business operations and activities of the Company are aggregated and
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, 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 the performance of, and allocates resources to, the
segments based on segment net income or loss, which excludes certain operating
expenses, including depreciation and amortization in its entirety,
and all other income and expense items,
all of which are allocated to Corporate Operations. 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 controlled by the 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 and nine months ended September 30, 2003 and 2002, are as follows (the
Companys 2002 segment information has been restated to conform to the
Companys organizational structure in 2003):

|                                                      |  |     |        |     |  |          |        |            |  |              |         |           |  |              |         |              |  |   |   |  |  |   |         |  
|----------------------------------------------------- |  | --- | ------ | --- |  | -------- | ------ | ---------- |  | ------------ | ------- | --------- |  | ------------ | ------- | ------------ |  | - | - |  |  | - | ------- | -
|As of and for the Three Months Ended                  |  |     |        |     |  |          |        |            |  | Total        |         | Corporate |  | Intercompany |         | Consolidated
|September 30, 2003:                                   |  | CSP |        | CBS |  | Segments |        | Operations |  | Eliminations |         | Total    
|                                                      |  |     |        |     |  |          |        |            |  |              |         |          
|Domestic revenues from external customers, net        |  | $   | 61,372 |     |  | $        | 39,135 |            |  | $            | 100,507 |           |  | $            |        |              |  | $ |  |  |  | $ | 100,507 |  
|Network and product costs                             |  | $   | 46,048 |     |  | $        | 23,032 |            |  | $            | 69,080  |           |  | $            | 4,972   |              |  | $ |  |  |  | $ | 74,052  |  
|Sales, marketing, general and administrative expenses |  | $   | 2,820  |     |  | $        | 6,710  |            |  | $            | 9,530   |           |  | $            | 22,980  |              |  | $ |  |  |  | $ | 32,510  |  
|Depreciation and amortization                         |  | $   |       |     |  | $        |       |            |  | $            |        |           |  | $            | 17,829  |              |  | $ |  |  |  | $ | 17,829  |  
|Other expenses, net                                   |  | $   |       |     |  | $        |       |            |  | $            |        |           |  | $            | (1,259  | )            |  | $ |  |  |  | $ | (1,259  | )
|Net income (loss)                                     |  | $   | 12,504 |     |  | $        | 9,393  |            |  | $            | 21,897  |           |  | $            | (47,040 | )            |  | $ |  |  |  | $ | (25,143 | )
|Total assets                                          |  | $   | 47,843 |     |  | $        | 22,446 |            |  | $            | 70,289  |           |  | $            | 285,894 |              |  | $ |  |  |  | $ | 356,183 |  

|                                                      |  |     |        |     |  |          |        |            |  |              |        |           |  |              |         |              |  |   |   |  |  |   |         |  
|----------------------------------------------------- |  | --- | ------ | --- |  | -------- | ------ | ---------- |  | ------------ | ------ | --------- |  | ------------ | ------- | ------------ |  | - | - |  |  | - | ------- | -
|As of and for the Three Months Ended                  |  |     |        |     |  |          |        |            |  | Total        |        | Corporate |  | Intercompany |         | Consolidated
|September 30, 2002:                                   |  | CSP |        | CBS |  | Segments |        | Operations |  | Eliminations |        | Total    
|                                                      |  |     |        |     |  |          |        |            |  |              |        |          
|Domestic revenues from external customers, net        |  | $   | 59,519 |     |  | $        | 36,687 |            |  | $            | 96,206 |           |  | $            |        |              |  | $ |  |  |  | $ | 96,206  |  
|Network and product costs                             |  | $   | 40,917 |     |  | $        | 15,335 |            |  | $            | 56,252 |           |  | $            | 13,294  |              |  | $ |  |  |  | $ | 69,546  |  
|Sales, marketing, general and administrative expenses |  | $   | 2,505  |     |  | $        | 15,189 |            |  | $            | 17,694 |           |  | $            | 23,479  |              |  | $ |  |  |  | $ | 41,173  |  
|Depreciation and amortization                         |  | $   |       |     |  | $        |       |            |  | $            |       |           |  | $            | 37,198  |              |  | $ |  |  |  | $ | 37,198  |  
|Other income, net                                     |  | $   |       |     |  | $        |       |            |  | $            |       |           |  | $            |        |              |  | $ |  |  |  | $ |        |  
|Net income (loss)                                     |  | $   | 16,097 |     |  | $        | 6,163  |            |  | $            | 22,260 |           |  | $            | (73,967 | )            |  | $ |  |  |  | $ | (51,707 | )
|Total assets                                          |  | $   | 66,813 |     |  | $        | 17,878 |            |  | $            | 84,691 |           |  | $            | 418,120 |              |  | $ |  |  |  | $ | 502,811 |  

|                                                      |  |     |         |     |  |          |         |            |  |              |         |           |  |              |          |              |  |   |   |  |  |   |         |  
|----------------------------------------------------- |  | --- | ------- | --- |  | -------- | ------- | ---------- |  | ------------ | ------- | --------- |  | ------------ | -------- | ------------ |  | - | - |  |  | - | ------- | -
|For the Nine Months Ended                             |  |     |         |     |  |          |         |            |  | Total        |         | Corporate |  | Intercompany |          | Consolidated
|September 30, 2003:                                   |  | CSP |         | CBS |  | Segments |         | Operations |  | Eliminations |         | Total    
|                                                      |  |     |         |     |  |          |         |            |  |              |         |          
|Domestic revenues from external customers, net        |  | $   | 174,769 |     |  | $        | 109,043 |            |  | $            | 283,812 |           |  | $            |         |              |  | $ |  |  |  | $ | 283,812 |  
|Network and product costs                             |  | $   | 129,973 |     |  | $        | 58,454  |            |  | $            | 188,427 |           |  | $            | 23,376   |              |  | $ |  |  |  | $ | 211,803 |  
|Sales, marketing, general and administrative expenses |  | $   | 8,301   |     |  | $        | 22,764  |            |  | $            | 31,065  |           |  | $            | 71,124   |              |  | $ |  |  |  | $ | 102,189 |  
|Depreciation and amortization                         |  | $   |        |     |  | $        |        |            |  | $            |        |           |  | $            | 54,194   |              |  | $ |  |  |  | $ | 54,194  |  
|Other expenses, net                                   |  | $   |        |     |  | $        |        |            |  | $            |        |           |  | $            | (2,778   | )            |  | $ |  |  |  | $ | (2,778  | )
|Net income (loss)                                     |  | $   | 36,495  |     |  | $        | 27,825  |            |  | $            | 64,320  |           |  | $            | (151,472 | )            |  | $ |  |  |  | $ | (87,152 | )

|                                                      |  |     |         |     |  |          |         |            |  |              |         |           |  |              |          |              |  |   |   |  |  |   |          |  
|----------------------------------------------------- |  | --- | ------- | --- |  | -------- | ------- | ---------- |  | ------------ | ------- | --------- |  | ------------ | -------- | ------------ |  | - | - |  |  | - | -------- | -
|For the Nine Months Ended                             |  |     |         |     |  |          |         |            |  | Total        |         | Corporate |  | Intercompany |          | Consolidated
|September 30, 2002:                                   |  | CSP |         | CBS |  | Segments |         | Operations |  | Eliminations |         | Total    
|                                                      |  |     |         |     |  |          |         |            |  |              |         |          
|Domestic revenues from external customers, net        |  | $   | 178,487 |     |  | $        | 117,118 |            |  | $            | 295,605 |           |  | $            |         |              |  | $ |  |  |  | $ | 295,605  |  
|Network and product costs                             |  | $   | 133,965 |     |  | $        | 51,872  |            |  | $            | 185,837 |           |  | $            | 50,165   |              |  | $ |  |  |  | $ | 236,002  |  
|Sales, marketing, general and administrative expenses |  | $   | 7,884   |     |  | $        | 30,720  |            |  | $            | 38,604  |           |  | $            | 73,606   |              |  | $ |  |  |  | $ | 112,210  |  
|Depreciation and amortization                         |  | $   |        |     |  | $        |        |            |  | $            |        |           |  | $            | 103,872  |              |  | $ |  |  |  | $ | 103,872  |  
|Other income, net                                     |  | $   |        |     |  | $        |        |            |  | $            |        |           |  | $            | 7,140    |              |  | $ |  |  |  | $ | 7,140    |  
|Net income (loss)                                     |  | $   | 36,638  |     |  | $        | 34,526  |            |  | $            | 71,164  |           |  | $            | (220,503 | )            |  | $ |  |  |  | $ | (149,339 | )

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Item 2.Managements Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of
operations should be read in conjunction with the unaudited condensed
consolidated financial statements and the related notes thereto included
elsewhere in this Report on Form 10-Q and the audited consolidated financial
statements and notes thereto and managements discussion and analysis of
financial condition and results of operations for the year ended December 31,
2002 included in our Annual Report on Form 10-K filed with the Securities and
Exchange Commission on March 20, 2003. This discussion contains forward-looking
statements, the accuracy of which is subject to risks and uncertainties. Our
actual results could differ materially from those expressed in forward-looking
statements for many reasons including, but not limited to, those discussed
herein and in the Risk Factors section of our Annual Report on Form 10-K,
which is contained in Part I, Item 1, Business  Risk Factors, of that
report. We disclaim any obligation to update information contained in any
forward-looking statement. See  Forward Looking Statements.

(All dollar amounts are presented in thousands, except per share amounts)

Overview

We are a leading provider of high-speed Internet connectivity and related
communications services, which we sell to businesses and consumers indirectly
through Internet service providers (ISP), telecommunications carriers and
other resellers. We also sell our services directly to business and consumer
end-users through our field sales force, telephone sales, referral agents and
our Web site. Our services include a range of high-speed, or broadband,
Internet access connectivity and related services using digital subscriber line
(DSL), T-1, Virtual Private Network (VPN) and firewall technologies.

We have a relatively short operating history. We introduced our services
commercially in the San Francisco Bay Area in December 1997. As of September
30, 2003, we believe we have one of the largest nationally deployed DSL
networks based on approximately 1,800 operational central offices that pass
more than 40 million homes and businesses in the United States. As of September
30, 2003, we had approximately 491,000 high-speed Internet access lines in
service using DSL and T-1 technology. We also provide dial-up Internet access
service to over 43,200 customers through our direct sales channel. We are also
developing a variety of services that are enhanced or enabled by our high-speed
network.

Since our inception, we have generated significant net and operating
losses and we continue to experience negative operating cash flow. As of
September 30, 2003, we had an accumulated deficit of $1,616,488. We expect
operating losses and negative cash flow to continue at least into 2004.
Although we currently have a plan in place that we believe will ultimately
allow us to achieve positive cash flows from our operating activities without
raising additional capital, our cash reserves are limited and our plan is based
on assumptions, which 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, which may
have a material adverse effect on our financial condition and could cause
significant dilution to our stockholders.

Recent Developments

On August 21, 2003, the Federal Communications Commission (FCC) issued
its order in the Triennial Review. This order is a significant development for
us for the following reasons:



| |  |  | The FCC is phasing out its rule requiring line-sharing over a
three-year period. Line-sharing currently allows us to provision
services using asymmetric DSL (ADSL) technology over the same
telephone line that the local telephone company is using to provide
voice services. The phase-out period will be handled in the following
manner:
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|

| |  |  | Our 235,800 line-shared customers as of October 2, 2003 will be
grandfathered indefinitely at current rates, terms and conditions.
These line-shared customers provided approximately $28,052, or 27.9%,
of our revenues for the three months ended September 30, 2003, and
$75,555, or 26.6%, of our revenues for the nine months ended September
30, 2003.                                                                                         
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | We can only acquire new line-shared customers at regulated rates
until October 2, 2004. For customers acquired during this first year,
the FCC-mandated maximum price for the high-frequency portion of the
phone line will be 25% of the cost of a separate phone line during the
first year, 50% during the second year and 75% during the third year.
After the third year, we will be required to transition these
customers to new arrangements.

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| |  |  | Beginning on October 3, 2004, we cannot acquire new line-shared
customers unless we reach agreements with the local telephone
companies that provide us with continued access to line-sharing. In
the event that we do not reach agreements with the local telephone
companies, we will be required to purchase a separate telephone line
in order to provide services to an end-user. The cost of a separate
phone line is significantly higher than the cost of a shared line.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|

| |  |  | The local telephone companies are not required to allow us to access
the packet-switching functions of fiber-fed telephone lines to provision
DSL services. This means that, unless we reach agreements with the local
telephone companies, we will continue to be unable to provide our most
commonly-used services to end-users served by fiber-fed lines. This is
significant for our business because it preserves a substantial limit on
the addressable market for our services, thereby limiting our growth. In
addition, the local telephone companies are increasing their deployment
of fiber-fed remote terminal architectures.                                                                                                   
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The local telephone companies can petition the various state utility
commissions for authority to stop providing data transport between the
phone companies central offices as an unbundled network element on
routes that have sufficient competitive alternatives to telephone
company data transport services. We currently purchase this interoffice
transport from the traditional phone companies in order to carry traffic
over our network. It is unclear whether any state commissions will
grant these requests, or whether such requests will be granted on routes
that impact us. The removal of any of these transport links from the
list of available network elements could increase the price we pay for
such connectivity.
|
| |  |  | Companies that compete with the local telephone companies continue to
have access to the local telephone companies networks in order to
provide their services under an arrangement known as the Unbundled
Network Element platform (UNE-P), so long as the state public
utilities commissions deem it appropriate. Under this arrangement these
competitive telecommunications companies purchase phone lines in order
to provide voice and data services. The continued existence of the UNE-P
allows us to bundle our data services with the voice services of these
companies pursuant to line-splitting arrangements. We recently announced
expansions of our relationships with AT&T and MCI to include these
bundled services.     

It is difficult for us to predict the full impact of the FCCs decision on
our business. In addition, there is some uncertainty regarding the Triennial
Review order because a number of legal challenges to the Triennial Review order
are pending in the courts and before the FCC. However, if we are unable to
obtain from the traditional telephone companies reasonable line-sharing rates
substantially below the cost of a separate telephone line, we may stop selling
stand-alone consumer grade services to new customers, which would slow the
growth of our revenue and require us to significantly change our business plan.

In its Triennial Review order, the FCC concluded that October 2, 2003
shall be deemed the trigger date for change of law provisions in our
interconnection agreements with the various traditional phone companies. As
such, on or after October 2, 2003, the traditional telephone companies may
inform us that they want to change the line-sharing terms and conditions of
their agreements with us, which commences a nine-month negotiation process that
may result in arbitration before the state utility commissions. Three of the
traditional telephone companies have already notified us that they intend to
immediately commence a renegotiation of our interconnection agreements with
them. These agreements contain the prices and other terms for the telephone
lines that we purchase from this traditional telephone company. It is possible
that other traditional telephone companies will provide us with similar notices
and will attempt to renegotiate our interconnection agreements to eliminate
line-shared services or significantly increase the price we pay for these
services.

Related Party Transactions

Our former vice-chairman and former interim chief executive officer, Frank
Marshall, who was also a member of our board of directors from October 1997 to
December 2002, was a minority stockholder and former member of the board of
directors of one of our former ISP customers, InternetConnect, which filed for
bankruptcy protection in 2001. On January 3, 2002, we purchased substantially
all of the assets of InternetConnect in an auction supervised by the United
States Bankruptcy Court for the Central District of California for $5,470 in
cash, and we may be required to pay additional cash of up to $1,880 for the
assets of InternetConnect, depending upon the outcome of a previous
post-petition bankruptcy claim filed by us against InternetConnect. That claim
is still unresolved. We did not assume any liabilities or obligations of
InternetConnect or hire any of InternetConnects employees.

A member of our Board of Directors, Richard Jalkut, is the President and
CEO of TelePacific, one of our resellers. We recognized revenues from
TelePacific of $169 and $561 for the three and nine months ended September 30,
2003, respectively, and $301 and $1,070 for the three and nine months ended
September 30, 2002, respectively.

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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 are believed to be
reasonable under the circumstances. However, actual results may vary from these
estimates under different assumptions or conditions.

In the course of preparing our financial statements for the year ended
December 31, 2000, internal control weaknesses were discovered, some of which
continued into 2001 and 2002. The improvements we have made over the last
several quarters to our internal systems, policies and procedures have
significantly improved controls. During our 2002 year-end financial statement
close process, we identified some additional control weaknesses, which are
discussed in Part IV, Item 14, Controls and Procedures in our 2002 Annual
Report on Form 10-K.

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 recognize revenues when (i) persuasive evidence of an arrangement
between the customer and us 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 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 24 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 24 months.                                                                                                                                                                                                                                                                                                                                    
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | We have concentrations of credit risk with several customers and some
of our customers are not current in their payments for our services.
Accordingly, we recognize revenues from some of these customers in the
period in which cash is collected, but only after the collection of all
previous outstanding accounts receivable balances. 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 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, determined using the
first-in, first-out method, or market. In assessing the ultimate
recoverability of inventories, we are required to make estimates
regarding future customer demand.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| |  |  | Property and equipment and intangible assets are recorded at cost,
subject to adjustments for impairment. Property and equipment and
intangible assets are depreciated or amortized 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 consummated a plan of reorganization under Chapter 11 of the
United States Bankruptcy Code on December 20, 2001. As of September 30,
2003, we had certain unresolved claims relating to our Chapter 11
bankruptcy proceedings that remain in dispute. Therefore, it is
reasonably possible that such disputed bankruptcy claims could
ultimately be settled for amounts that differ from the aggregate
liability for such claims reflected in our condensed consolidated
balance sheet as of September 30, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|
| |  |  | 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                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

19



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| |   |  | matters, as well as potential ranges of probable losses for certain of
these matters. The determination of the liabilities that are required to be
recognized, if any, for loss contingencies is made after careful 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 consolidated financial position
and results of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | We are currently analyzing the applicability of certain
transaction-based taxes to (i) sales of our products and services and
(ii) 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 consolidated financial position and results of
operations. In addition, we are currently analyzing the probable
applicability of employment-related taxes for certain stock-based
compensation provided to employees in prior periods. We believe that the
analysis of the probable applicability of these taxes will be concluded
without a material adverse effect to our consolidated financial position
and results of operations. However, it is reasonably possible that our
estimates of our transaction-based and employment-related tax
liabilities could change in the near term, the effects of which could be
material to our consolidated financial position and results of
operations.                                 
|
| |  |  | We make market development funds (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 (i) the customers provide us with
third-party evidence of such co-branded advertising and (ii) we can
reasonably estimate the fair value of our portion of the advertising,
such amounts are charged to advertising expense as incurred. MDF
activities that do not qualify for expense treatment are recorded as
reductions of revenues as incurred. Other amounts payable to customers
relating to rebates and customer incentives are recorded as reductions
of revenues based on our estimate of the amount of these rebates and
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 (including non-employees directors)
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 statement 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

On May 15, 2003, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 150, Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and
Equity. SFAS No. 150 establishes standards for classifying and measuring as
liabilities certain financial instruments that embody obligations of the issuer
and have characteristics of both liabilities and equity, such as mandatorily
redeemable equity instruments. SFAS No. 150 must be applied immediately to
instruments entered into or modified after May 31, 2003 and to all other
instruments that exist as of the beginning of the first interim financial
reporting period beginning after June 15, 2003, except for mandatorily
redeemable instruments of non-public companies, to which the provisions of SFAS
No. 150 must be applied in fiscal periods beginning after December 15, 2003.
The application of SFAS No. 150 to pre-existing instruments should be
recognized as the cumulative effect of a change in accounting principle. The
adoption of SFAS No. 150 had no effect on our consolidated financial position
as of September 30, 2003 or the results of our operations for the three and
nine months ended September 30, 2003.

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In January 2003, the FASB issued Interpretation (FIN) No. 46,
Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulleting No. 51, Consolidated Financial Statements. FIN 46 applies
to any business enterprise that has a controlling interest, contractual
relationship or other business relationship with a variable interest entity
(VIE) and establishes guidance for the consolidation of VIEs that function to
support the activities of the primary beneficiary. FIN 46 was effective
immediately for enterprises with VIEs created after January 31, 2003, and it
will be effective December 31, 2003 for enterprises with VIEs created before
February 1, 2003. We believe we have no investments in, or contractual or other
business relationships with VIEs. Therefore, the adoption of FIN 46 had no
effect on our consolidated financial position as of September 30, 2003 or the
results of our operations for the three and nine months ended September 30,
2003.

In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure. SFAS No. 148 amends SFAS
No. 123, Accounting for Stock-Based Compensation, to provide alternative
methods of transition for an entity that voluntarily changes to the fair value
method of accounting for stock-based employee compensation. In addition, SFAS
No. 148 amends the disclosure provisions of SFAS No. 123 to require prominent
disclosure of the effects of an entitys accounting policy with respect to
stock-based employee compensation on reported results of operations, including
per share amounts, in annual and interim financial statements. The disclosure
provisions of SFAS No. 148 were effective immediately upon issuance in 2002. As
of September 30, 2003, we have no immediate plans to adopt the fair value
method of accounting for stock-based employee compensation.

In November 2002, the FASBs Emerging Issues Task Force (EITF) reached a
final consensus on Issue No. 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables, which is effective for revenue arrangements entered
into in fiscal periods beginning after June 15, 2003. Under EITF Issue
No.00-21, revenue arrangements with multiple deliverables are required to be
divided into separate units of accounting under certain circumstances. We will
prospectively adopt EITF Issue No. 00-21 on July 1, 2003, and we do not believe
the adoption of EITF Issue No. 00-21 will have a material effect on our
condensed consolidated financial statements.

In November 2002, the FASB issued FIN No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others. FIN No. 45 requires certain guarantees to be recorded
at fair value, which is different from current practice, which is generally to
record a liability only when a loss is probable and reasonably estimable. FIN
No. 45 also requires a guarantor to make significant new disclosures, even when
the likelihood of making any payments under the guarantee is remote. The
disclosure provisions of FIN No. 45 were effective immediately upon issuance in
2002. We adopted the recognition and measurement provisions of FIN No. 45 on a
prospective basis with respect to guarantees issued or modified after December
31, 2002. The adoption of the recognition and measurement provisions of FIN No.
45 had no effect on our condensed consolidated financial statements as of and
for the three and nine months ended September 30, 2003. However, some of our
contracts with our customers have provisions that would require us to indemnify
them in the event that our services infringe upon a third partys intellectual
property rights.

On January 1, 2003, we adopted SFAS No. 146, Accounting for Costs
Associated with an Exit or Disposal Activity. SFAS No. 146 revises the
accounting for exit and disposal activities under EITF Issue No. 94-3,
Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (Including Certain Costs Incurred in a
Restructuring), by extending the period in which expenses related to
restructuring activities are reported. A commitment to a plan to exit an
activity or dispose of long-lived assets is no longer sufficient to record a
one-time charge for most restructuring activities. Instead, companies record
exit or disposal costs when they are incurred and can be measured at fair
value. In addition, the resultant liabilities are subsequently adjusted for
changes in estimated cash flows. SFAS No. 146 was effective prospectively for
exit or disposal activities initiated after December 31, 2002. Companies may
not restate previously issued financial statements for the effect of the
provisions of SFAS No. 146, and liabilities that a company previously recorded
under EITF Issue No. 94-3 are grandfathered. The adoption of SFAS No. 146 had
no effect on our condensed consolidated financial statements as of and for the
three and nine months ended September 30, 2003.

On January 1, 2003, we adopted SFAS No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of SFAS No. 13, and Technical
Corrections. SFAS No. 145 rescinds SFAS No. 4, Reporting Gains and Losses
from Extinguishment of Debt, which required all gains and losses from
extinguishment of debt to be aggregated and, if material, classified as an
extraordinary item, net of related income tax effect. SFAS No. 145, which is
effective in periods beginning after May 15, 2002, requires that gains or
losses from extinguishment of debt be classified as extraordinary items only if
they meet the criteria of APB Opinion No. 30. The adoption of SFAS No. 145 had
no effect on our condensed consolidated financial statements as of and for the
three and nine months ended September 30, 2003.

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On January 1, 2003, we adopted SFAS No. 143, Accounting for Asset
Retirement Obligations. SFAS No. 143 requires that the fair value of a
liability for an asset retirement obligation be recognized in the period in
which it is incurred if a reasonable estimate of fair value can be made. The
associated asset retirement costs are capitalized as part of the carrying
amount of the long-lived asset. The adoption of SFAS No. 143 had no effect on
our condensed consolidated financial statements as of and for the three and
nine months ended September 30, 2003.

Results of Operations

Business Segment Information

During the three and nine months ended September 30, 2003 and 2002, we
managed 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. Covad Strategic Partnerships (CSP)
focused on delivering services to enterprise, corporate, small business, small
office/home office (SoHo) and consumer customers primarily through wholesale
relationships with large ISPs, telecommunications carriers and other large
resellers. Covad Broadband Solutions (CBS) focused on small business and SoHo
markets by selling services directly to end-users as well as through
independent authorized sales agents, small ISPs and other resellers. We
aggregated and reported all other business 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 by our business segments.

Our 2002 segment information has been restated to conform to our
organizational structure in 2003.

Reclassifications

Certain balances in our 2002 condensed consolidated financial statements,
including certain operating expenses, have been reclassified to conform to the
presentation in 2003.

Three and Nine Months Ended September 30, 2003 and 2002

Revenues, Net

We recorded net revenues of $100,507 for the three months ended September
30, 2003, an increase of $4,301, or 4.5%, over net revenues of $96,206 for the
three months ended September 30, 2002. We recorded net revenues of $283,812 for
the nine months ended September 30, 2003, a decrease of $11,793, or 4.0% over
net revenues of $295,605 for the nine months ended September 30, 2002. Included
in net revenues are Federal Universal Service Fund (FUSF) charges billed to
our customers aggregating $1,422 and $3,681 for the three and nine months ended
September 30, 2003, respectively, and $1,252 and $7,147 for the three and nine
months ended September 30, 2002, respectively. The increase in FUSF of $170 and
the decrease of $3,466 for the three and nine months ended September 30 2003,
respectively, is primarily driven by the change in the applicability of FUSF to
some of our wholesale customers.

The increase in net revenues for the three months ended September 30, 2003
is primarily attributable to an increase of approximately 38,000 end-users, the
impact of which is partially offset by an increase of $2,690 in customer incentives and
rebates, which we recorded as reductions of revenues. The decrease in net
revenues for the nine months ended September 30, 2003 is primarily attributable
to an increase of $11,813 in customer incentives and rebates, and a
decrease of $3,466 in FUSF
charges billed to our customers, the impact of which is partially offset by an
increase of approximately 116,000 end-users. In addition, during the three and
nine months ended September 30, 2003, we changed our estimates of certain
accrued liabilities for cooperative advertising and customer incentives based
on historical and spending data regarding the amount of cooperative advertising
that will not be utilized and sales incentives that will not be claimed by
customers. These changes in accounting estimate increased our revenues by $927
and $1,662 for the three and nine months ended September 30, 2003,
respectively. Furthermore, as a result of the developments in the bankruptcy
proceedings of certain of our wholesalers, as discussed further below, we
recognized revenues of $3,307 during the three months ended March 31, 2002 for
services provided prior to January 1, 2002. Similar revenues from bankrupt
customers were $793 and $827, respectively, during the three and nine months
ended September 30, 2003.

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We expect our subscriber base to continue to grow as we execute on our
current sales and marketing programs, and as we introduce new sales and
marketing programs and create new services for our customers. However, our
revenue growth may continue to be impaired by lower selling prices in response
to the competitive landscape, increases in subscriber disconnects, and
increases in customer incentives and rebates, which reduce our revenues. For
example, recent price reductions by some of the traditional telephone companies
have caused us to offer lower prices to some of our customers. In addition, if
we are unable to obtain from the traditional telephone companies reasonable
line-sharing rates substantially below the cost of a separate telephone line,
we may stop selling stand-alone consumer grade services to new customers. If we
stop selling stand-alone consumer grade services, our revenue growth would be
adversely affected since approximately 27.9% and 26.6% of our revenue during the
three and nine months ended September 30, 2003, respectively, was from sales of
consumer-grade services utilizing line-shared technology.

One new technology that we expect to contribute to revenue growth is
line-splitting, which allows us to offer our services over a telephone line
that is being used by a voice provider other than the traditional telephone
company. Based on our agreements with AT&T, MCI and other competitive
telephone companies, we recently began offering our consumer-grade services
over line-splitting technology. However, we are experiencing operational
challenges as we work with the traditional telephone companies to deploy this
new technology. It is also unclear how quickly our resellers will increase the
number of end users that purchase these services.

We regularly have billing disputes with our customers. These disputes
arise in the ordinary course of business in the telecommunications industry and
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 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. These charges to revenues amounted
to $459
and $2,079 during the three and nine months ended September 30, 2003,
respectively, and $540 and $2,130 during the three and nine months ended
September 30, 2002, respectively.

Segment Revenues and Significant Customers

We recorded net revenues of $61,372 and $39,135 from our CSP and CBS
business segments, respectively, for the three months ended September 30, 2003,
an increase of $1,853, or 3.1%, and $2,448, or 6.7%, over net revenues of
$59,519 and $36,687, respectively, for the three months ended September 30,
2002. We recorded net revenues of $174,769 and $109,043 from our CSP and CBS
business segments, respectively, for the nine months ended September 30, 2003,
a decrease of $3,718, or 2.1%, and $8,075, or 6.9%, over net revenues of
$178,487 and $117,118, respectively, for the nine months ended September 30,
2002. As described above, the decrease in net revenues for the nine months
ended September 30, 2003 is primarily attributable to an increase in customer
incentives and rebates, which we recorded as reductions of revenues, and a
decrease in FUSF charges billed to our customers, partially offset by an
increase in the number of end-users. Net revenues from our CSP business segment
represented 61.0% and 61.6% of our total net revenues for the three and nine
months ended September 30, 2003, respectively, and 61.9% and 60.4% of our total
net revenues for the three and nine months ended September 30, 2002,
respectively. Net revenues from our CBS business segment represented 39.0% and
38.4% of our total net revenues for the three and nine months ended September
30, 2003, respectively, and 38.1% and 39.6% of our total net revenues for the
three and nine months ended September 30, 2002, respectively.

We had approximately 270 wholesale customers as of September 30, 2003, as
compared to approximately 140 as of September 30, 2002. The increase in the
number of wholesale customers resulted primarily from the addition of smaller
resellers to our CBS segment. Our 30 largest customers (11 from CSP and 19 from
CBS) collectively comprised 72.5% and 74.1% of our total net revenues for the
three and nine months ended September 30, 2003, respectively, and (11 from CSP
and 19 from CBS) 80.5% and 80.3% of our total net revenues for the three and
nine months ended September 30, 2002, respectively. As of September 30, 2003
and 2002, receivables from these 30 customers collectively comprised 75.5% and
81.9%, respectively, of our gross accounts receivable balance.

For the three months ended September 30, 2003, EarthLink, Inc. and AT&T,
two wholesale customers in our CSP business segment, accounted for 22.4% and
10.9% of our total net revenues. For the nine months ended September 30, 2003,
these customers accounted for 22.3% and 11.3% of our total net revenues. As of
September 30, 2003, receivables from these customers comprised 23.9% and 11.7%
of our gross accounts receivable balance. No other individual customer
accounted for more than 10% of our total net revenues during the three months
ended September 30, 2003.

For the three months ended September 30, 2002, Earthlink, Inc. and AT&T,
two wholesale customers in our CSP business segment, accounted for 20.7% and
10.0% of our total revenues. For the nine months ended September 30, 2002,
these wholesale customers accounted for 20.5% and 9.2% of our total revenues.
As of September 30, 2002, receivables from these wholesale

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customers comprised 39.3% and 8.2% of our gross accounts receivable
balance.

Wholesaler Financial Difficulties

Some of our wholesale customers are experiencing financial difficulties.
During the three and nine months ended September 30, 2003 and 2002, some of
these customers either (i) were not current in their payments for our services
or (ii) were essentially current in their payments but had filed for bankruptcy
protection. Based on this information, we determined that (i) the
collectibility of revenues from these customers was not reasonably assured or
(ii) our ability to retain some or all of the payments received from some of
these customers that are in bankruptcy proceedings was not reasonably assured.
Accordingly, we classified this group of customers as financially distressed
for revenue recognition purposes. Revenues from financially distressed
customers that have not filed for bankruptcy protection are recognized when we
collect cash for those services, assuming all other criteria for revenue
recognition have been met, but only after the collection of all previous
outstanding accounts receivable balances. If we are not reasonably assured of
our ability to retain payments received from financially distressed customers
during a defined period prior to their filing of a petition for bankruptcy
protection, then these payments are included in the condensed consolidated
balance sheet caption Unearned revenues until the preference period has
expired.

We have customers that are currently in bankruptcy proceedings. Revenues
from these customers accounted for approximately 0.9% and 1.7% of our total net
revenues for the three and nine months ended September 30, 2003, respectively,
and 18.9% and 19.6% of our total net revenues for the three and nine months
ended September 30, 2002, respectively. Most of these customers are classified
as financially distressed for revenue recognition purposes. Although WorldCom
filed for bankruptcy protection on July 21, 2002, we continued to recognize
revenues from WorldCom on an accrual basis during 2002 and 2003 based on its
specific facts and circumstances and the revenue recognition criteria described
in Note 2 to our condensed consolidated financial statements. Consequently, the
disclosures in the following paragraph regarding financially distressed
customers exclude amounts pertaining to WorldCom because we have not presently
classified it as a financially distressed customer for revenue recognition
purposes. We attempt to migrate end-users from some financially distressed
customers to the extent it is legally and operationally feasible.

We issued billings to our financially distressed customers aggregating
$702 and $4,142 during the three and nine months ended September 30, 2003,
respectively, which were not recognized as revenues or accounts
receivable when billed in
our consolidated financial statements, as compared to the
corresponding amounts of $7,447 and $39,779 for the three and nine months ended
September 30, 2002, respectively. However, we recognized revenues from certain
of these customers when we collected $100 and $3,353 in cash during the three
and nine months ended September 30, 2003, respectively, and $12,077 and $43,446
during the three and nine months ended September 30, 2002, respectively. A
portion of this revenue relates to services provided in prior
periods. Revenues
for the three and nine months ended September 30, 2003 also include
payments totaling $793 and $827, respectively, from certain bankrupt customers
that we received prior to January 1, 2003 and recorded as unearned revenues in
our consolidated balance sheet as of December 31, 2002 because our ability to
retain these payments was not reasonably assured as of that date. However, as a
result of subsequent developments in the bankruptcy proceedings of such
customers, we recognized
these payments as revenues during the three and nine months ended September 30, 2003.
Similar revenues from bankrupt customers were $1,120 and $4,427, respectively,
during the three and nine months ended September 30, 2002. We had contractual
receivables from our financially distressed customers totaling $945 as of
September 30, 2003 that are not reflected in our condensed consolidated
financial statements. We have made progress in reducing the number of
financially distressed customers in recent periods. As discussed in the
following paragraph, however, it is reasonably possible that additional customers
may become financially distressed.

We have obtained information indicating that some of our customers,
including WorldCom, who were essentially current in their payments for our
services on September 30, 2003 may be at risk of becoming financially
distressed. Revenues from these customers accounted for approximately 18.8% and
22.5% of our total net revenues for the three and nine months ended September
30, 2003, respectively, and 25.6% and 25.1% of our total net revenues for the
three and nine months ended September 30, 2002, respectively. As of September
30, 2003, receivables from these customers comprised 25.8% 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 September 30, 2003, revenue from such customers will be recognized when cash
is collected, as described above.

Network and Product Costs

We recorded network and product costs of $74,052 for the three months
ended September 30, 2003, an increase of $4,506, or 6.4% from the network and
product costs of $69,546 for the three months ended September 30, 2002. We
recorded network and product costs of $211,803 for the nine months ended
September 30, 2003, a decrease of $24,199, or 10.2%, from network and product
costs of

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$236,002 for the nine months ended September 30, 2002. For the three
months ended September 30, 2003 and 2002, network and product costs were
comprised of $46,048 and $40,917, respectively, from our CSP business segment,
$23,032 and $15,335, respectively, from our CBS business segment and $4,972 and
$13,294, respectively, from our Corporate Operations. For the nine months ended
September 30, 2003 and 2002, network and product costs were comprised of
$129,973 and $133,965, respectively, from our CSP business segment, $58,454 and
$51,872, respectively, from our CBS business segment and, $23,376 and $50,165,
respectively, from our Corporate Operations.

The increase in network and product costs during the three months ended
September 30, 2003 is largely attributable to $5,220 of migration expenses associated
with the Qwest customer list acquisition. The growth in subscribers
on our network led to higher network and product costs. The increase in network
and product costs during the three months ended September 30, 2003 was
partially offset by a change in estimate of certain accrued liabilities for
transaction-based taxes based on settlements agreements reached with various
states and local jurisdictions where we do business. This change in accounting
estimate decreased our network and product cost by $2,494 and decreased our net
loss by $2,494, or $0.01 per share for the three months ended September 30,
2003.

The decrease in network and product costs during the nine months ended
September 30, 2003 is primarily attributable to continued efforts to lower
network costs by more efficiently managing our network capacity and a reduction
in our operations and engineering workforces. These reductions in network and
product costs were partially offset by the additional network and product costs
associated with the addition of subscribers to our network. In addition, during
the nine months ended September 30, 2003, we changed our estimates of certain
liabilities for transaction-based taxes and property taxes based on settlements
reached with various states and local jurisdictions on our transaction-based
taxes and additional compilation of data on the valuation of our taxable
property and equipment. These changes in accounting estimate decreased our
network and product costs by $5,000 during the nine months ended September 30,
2003, and decreased our net loss by $5,000, or $0.02 per share, for the nine
months ended September 30, 2003. Network and product costs for the nine months
ended September 30, 2003 include charges of $5,200 of migration expenses from
the Qwest customer line acquisition and $2,137 for the probable applicability
of employment-related taxes related to certain stock-based compensation
provided to employees in prior periods. Network and product costs for the nine
months ended September 30, 2002 include acquisition costs of $3,674 associated
with certain of InternetConnects former customers, as described above. We
expect network and product costs to increase in future periods as we add
subscribers and services like line-splitting to our network.

As
discussed in the Overview - Recent Developments section of this
document, there is uncertainty concerning our ability to purchase line-shared
services from the traditional telephone companies as a result of the FCCs
decision in its Triennial Review of the Telecommunications Act of 1996. As a
result, it is possible that the traditional telephone companies could increase
the cost or reduce the availability of line-shared services, which would
substantially increase our overall network cost structure and might cause us to
discontinue our stand-alone consumer grade services for new customers.

Sales, Marketing, General and Administrative Expenses

We recorded sales, marketing, general and administrative expenses of
$32,510 for the three months ended September 30, 2003, a decrease of $8,663, or
21.0%, over sales, marketing, general and administrative expenses of $41,173
recorded for the three months ended September 30, 2002. We recorded sales,
marketing, general and administrative expenses of $102,189 for the nine months
ended September 30, 2003, a decrease of $10,021, or 8.9%, over sales, marketing,
general and administrative expenses of $112,210 recorded for the nine months
ended September 30, 2002. Sales, marketing, general and administrative expenses
consist primarily of salaries and related expenses and our promotional and
advertising expenses. For the three months ended September 30, 2003 and 2002,
sales, marketing, general and administrative expenses were comprised of $2,820
and $2,505, respectively, from our CSP business segment, $6,710 and $15,189,
respectively, from our CBS business segment and $22,980 and $23,479,
respectively, from our Corporate Operations. For the nine months ended
September 30, 2003 and 2002, sales, marketing, general and administrative
expenses were comprised of $8,301 and $7,884 from our CSP business segment,
respectively, $22,764 and $30,720 from our CBS business segment, respectively,
and $71,124 and $73,606 from our Corporate Operations, respectively.

The decrease in sales, marketing, general and administrative expenses for
the three months and nine months ended September 30, 2003 is primarily
attributable to a reduction in our workforce and lower advertising and
marketing expenses. The decrease in sales, marketing, general and
administrative expenses was offset by additional expenses of $1,400
attributable to migration expenses associated with the Qwest customer list
acquisition. For the nine months ended September 30, 2003, the decrease in
sales, marketing, general and administrative expenses was partially offset by
charges of $1,237 for additional stock-based compensation and $3,800 for the
potential applicability of employment-related taxes related to certain
stock-based compensation provided to employees in prior periods. We expect
sales, marketing, general and administrative expense levels to increase in the
near future as we continue our marketing efforts. However, if the traditional
telephone companies increase the cost or reduce the availability of line-shared
services

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as a result of the FCCs decision in the Triennial Review, our sales,
marketing, general and administrative expense levels may be curtailed as an
element of a new business structure.

Total Operating Expenses

Total operating expenses, which include network and product costs, sales,
marketing, general and administrative expenses, provision for bad debts or bad
debt recoveries, depreciation and amortization expenses, and litigation-related
expenses were $124,383 and $368,212, respectively, for the three and nine
months ended September 30, 2003, a decrease of $23,687, or 15.9%, and $75,155,
or 16.9%, over operating expenses of $148,070 and $443,367, respectively, for
the three and nine months ended September 30, 2002. Operating expenses for the
three months ended September 30, 2003 and 2002 were comprised of $48,868 and
$43,422, respectively, from our CSP business segment, $29,742 and $30,524,
respectively, from our CBS business segment and $45,773 and $74,124,
respectively, from our corporate operations. For the nine months ended
September 30, 2003 and 2002, operating expenses were comprised of $138,274 and
$141,849, respectively, from our CSP business segment, $81,218 and $82,592,
respectively, from our CBS business segment and $148,720 and $218,926,
respectively, from our corporate operations.

Provision for Bad Debts (Bad Debt Recoveries), Net

We recorded net bad debt expenses (recoveries) of $(8) and $(1,731) for
the three months ended September 30, 2003 and 2002, respectively. Bad debt
expenses (recoveries) were (0.0)% and (1.8)% of net revenues for the three
months ended September 30, 2003 and 2002, respectively. We recorded net bad
debt expenses (recoveries) of $26 and $312 for the nine months ended September
30, 2003 and 2002, respectively. Bad debt expenses (recoveries) were 0.0% and
0.0% of net revenues for the nine months ended September 30, 2003 and 2002,
respectively. The increase from 2002 to 2003, for the three months ended
September 30, resulted from a bad debt recovery of $2,491 recognized during the
three months ended September 30, 2002 as a result of developments in the
bankruptcy proceedings of one of our customers.

Depreciation and Amortization

We recorded depreciation and amortization expense for property and
equipment in the amount of $13,054 for the three months ended September 30,
2003, a decrease of $20,444, or 61.0%, from depreciation and amortization
expense for property and equipment of $33,498 for the three months ended
September 30, 2002. We recorded depreciation and amortization expense for
property and equipment in the amount of $41,399 for the nine months ended
September 30, 2003, a decrease of $51,483, or 55.4% from depreciation and
amortization expense for property and equipment of $92,882 for the nine months
ended September 30, 2002. The decrease from 2002 to 2003 was due principally to
asset retirements and certain assets becoming fully depreciated during 2002 and
2003. Although our capital expenditures will be less in the near future than
historical amounts, we expect depreciation and amortization to increase in the
future because we anticipate that our depreciation and amortization on new
capital expenditures will offset the declining depreciation on our current
property and equipment base. At
this time we are not planning any significant expansion of our network so we
expect that near term capital expenditures will be mostly limited to adding
capacity to our network to support new users.

Amortization of intangible assets was $4,775 for the three months ended
September 30, 2003, representing an increase of $1,075, or 29.0%, over the
amortization of intangible assets of $3,700 for the three months ended
September 30, 2002. Amortization of intangible assets was $12,795 for the nine
months ended September 30, 2003, representing an increase of $1,805, or 16.4%,
over the amortization of intangible assets of $10,990 for the nine months ended
September 30, 2002. The increase from 2002 to 2003 resulted from network
expansion and augmentation of our network during the latter portion of 2002 and
the nine months ended September 30, 2003, which increased collocation fee
expenditures and related amortization expenses. We did not incur significant
capital expenditures for property and equipment in connection with this
expansion.

As explained above, we do not allocate depreciation and amortization
expense to our business segments.

Reductions in Force

During the nine months ended September 30, 2003, we reduced our workforce
by approximately 113 employees, which represented approximately 10.3% of our
workforce, respectively. The reductions covered employees in the areas of sales
and marketing, operations and corporate functions. None of these reductions
occurred during the three months ended September 30, 2003.

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In connection with the reductions in force, we recorded a charge to
operations for the nine months ended September 30, 2003 of $1,235 relating to
employee severance benefits. For the nine months ended September 30, 2003, $242
of these expenses were charged to network and product costs and the remaining
$993 were charged to sales, marketing, general and administrative expenses. We
paid $147 and $1,235 in severance benefits during the three and nine months ended September 30, 2003.
The expenses associated with these reductions in force were $103 related to our
Covad Strategic Partnerships business segment and $349 related to our Covad
Broadband Solutions business segment. The remaining expenses of $783 associated
with these reductions in force were related to our Corporate Operations.

Litigation-related Expenses

We recorded charges (credits) to litigation-related expenses of $1,884 and
$(9,029) for the three and nine months ended September 30, 2002. The charges
(credits) represent the non-cash adjustments for the change in value of the
6,495,844 shares of common stock that will ultimately be distributed pursuant
to the Memorandum of Understanding (MOU) described in Note 8 to our condensed
consolidated financial statements and in Part II, Item 1, Legal Proceedings.
We did not recognize similar charges (credits) for the three and nine months
ended September 30, 2003.

Net Interest Income (Expense)

Net interest income (expense) was $(928) and $(2,411) for the three and
nine months ended September 30, 2003, respectively, and $184 and $(53) for the
three and nine months ended September 30, 2002, respectively. Net interest
income (expense) in 2003 and 2002 consisted principally of interest expense on
our 11% long-term note payable to SBC Communications Inc. (SBC), less
interest income earned on our cash, cash equivalent and short-term investment
balances. We expect future net interest expense to be limited to accrued
interest on our note payable to SBC offset by interest earned on cash, cash
equivalent and short-term investment 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 Losses

We recorded losses and write-downs on investments for the three months
ended September 30, 2003 in the amount of $621. This included an impairment
write-down of an equity investment of $538 and our equity in the losses of
unconsolidated affiliates of $83. We recorded losses and write-downs on
investments for the nine months ended September 30, 2003 in the amount of
$1,026. This included an impairment write-down of an equity investment of $747
and our equity in the losses of unconsolidated affiliates of $279.

We recorded net losses on investments for the three months ended September
30, 2002 in the amount of $101 as a result of our equity in the losses of
unconsolidated affiliates. For the nine months ended September 30, 2002, we
recorded losses and write-downs on investments for the nine months ended
September 30, 2002 in the amount of $1,357. This included a net realized loss
on the sale of certain investments in unconsolidated affiliates of $636, our
equity in the losses of unconsolidated affiliates of $704 and a net realized
loss on short-term investments of $17.

Income Taxes

Because we incurred operating losses during all periods presented, we made
no provision for income taxes in any period presented in the accompanying
condensed consolidated financial statements.

Liquidity and Capital Resources

Our operations have required substantial capital investment for the
procurement, design and construction of our central office collocation
facilities, the design, creation, implementation and maintenance of our
systems, the purchase of telecommunications equipment and the design,
development and maintenance of our networks. Capital expenditures were $18,824
and $41,421 for the three and nine months ended September 30, 2003,
respectively. We expect that in future periods our capital expenditures related
to the purchase of infrastructure equipment necessary for the development and
expansion of our networks and the development of new regions will be lower than
the historical amounts. However, if we continue to add end-users to our network
then the capital expenditures related to the addition of these end users in our
existing regions will increase proportionately in relation to the number of new
end users.

From our inception through September 30, 2003, we financed our operations
primarily through private placements of $220,600 of equity securities,
$1,282,000 in net proceeds raised from the issuance of notes (including our
agreement with SBC for a $50,000 note

27



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payable), a $75,000 collateralized deposit and $719,000 in net proceeds
raised from public equity offerings. As of September 30, 2003, we had an
accumulated deficit of $1,616,488 and unrestricted cash, cash equivalents and
short-term investments of $134,795. In addition, we had stockholders equity as
of September 30, 2003 of $4,177.

Net cash used in our operating activities was $35,824 for the nine months
ended September 30, 2003. The net cash used in our operating activities during
this period was primarily due to the net loss of $87,152, partially offset by
depreciation and amortization charges of $54,194 and net usage of cash from
changes in our current assets and liabilities.

Net cash provided by our investing activities was $2,410 for the nine
months ended September 30, 2003. The net cash provided by our investing
activities during this period was primarily due to maturities of short-term
investments of $155,644, offset by purchases of short-term investments of
$113,486 and capital expenditures of $41,421.

Net cash provided by our financing activities was $5,038 for the nine
months ended September 30, 2003. The net cash provided by our financing
activities during this period was due to proceeds from the issuance of common
stock of $5,172, offset by principal payments under capital lease obligations
of $134.

As of September 30, 2003, we had $68,115 in unrestricted cash and cash
equivalents, and $66,680 in unrestricted short-term investments. We expect to
experience negative cash flow from operating and investing activities at least
into 2004 due to the cost of maintaining our network, continued development of
new services and the addition of new end-users. Our future cash requirements
for developing, deploying and enhancing our network and operating our business,
as well as our revenues, will depend on a number of factors including:



| |  |  | the effect of the FCCs Triennial Review order, our continuing
ability to access line-shared telephone wires and our ability to obtain
access to the traditional telephone companies remote terminals, all at
reasonable prices;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the rate at which wholesalers and end-users purchase and pay for our services and the pricing of such services;                                                                                                                  
|
| |  |  | the financial condition of our customers;                                                                                                                                                                                        
|
| |  |  | the level of marketing required to acquire and retain customers and to attain a competitive position in the marketplace;                                                                                                         
|
| |  |  | the rate at which we invest in engineering, development and
intellectual property with respect to existing and future technology;                                                                                                
|
| |  |  | the 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                                                                                                                                                                          
|
| |  |  | the number of regions entered, the timing of entry and services offered.                                                                                                                                                         

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.

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Our contractual debt and lease obligations as of December 31, 2002 for the
next five years, and thereafter, were as follows:

|                       |  |      |       |           |  |           |        |            |  |       |       |  |  |   |     |  |  |   |        | 
|---------------------- |  | ---- | ----- | --------- |  | --------- | ------ | ---------- |  | ----- | ----- |  |  | - | --- |  |  | - | ------ | 
|                       |  | 2003 |       | 2004-2005 |  | 2006-2007 |        | Thereafter |  | Total
|                       |  |      |       |           |  |           |        |            |  |      
|Note payable to SBC    |  | $    |      |           |  | $         | 50,000 |            |  | $     |      |  |  | $ |    |  |  | $ | 50,000 | 
|Capital leases         |  |      | 165   |           |  |           |       |            |  |       |      |  |  |   |    |  |  |   | 165    | 
|Office leases          |  |      | 5,424 |           |  |           | 6,112  |            |  |       | 2,450 |  |  |   | 720 |  |  |   | 14,706 | 
|Other operating leases |  |      | 1,451 |           |  |           | 209    |            |  |       | 4     |  |  |   |    |  |  |   | 1,664  | 
|                       |  |      |       |           |  |           |        |            |  |       |       |  |  |   |     |  |  |   |        | 
|                       |  | $    | 7,040 |           |  | $         | 56,321 |            |  | $     | 2,454 |  |  | $ | 720 |  |  | $ | 66,535 | 
|                       |  |      |       |           |  |           |        |            |  |       |       |  |  |   |     |  |  |   |        | 

We lease certain vehicles, equipment and office facilities under various
noncancelable operating leases that expire at various dates through 2009. The
facility leases generally require us to pay operating costs, including property
taxes, insurance and maintenance, and contain scheduled rent increases and
other rent escalation clauses. Rent expense is reflected in our consolidated
financial statements on a straight-line basis over the terms of the respective
leases. We are also obligated under a capital equipment lease, which expires in
2003.

Our 2003 business plan includes discretionary spending that is based on
several assumptions, including growth of our subscriber base with a reasonable
per subscriber profit margin and improvements in productivity. If necessary, we
will curtail this discretionary spending so that we can continue as a going
concern at least through December 31, 2003 using only our unrestricted cash,
cash equivalent and short-term investment balances in existence as of December
31, 2002. On August 21, 2003, the FCC issued its order in the Triennial Review
of its rules for network unbundling obligations of Incumbent Local Exchange
Carriers. Among other things, that order will phase-out the FCC rule requiring
line-sharing over a three-year period. The ultimate impact of the Triennial
Review order on our business, which relies on line-sharing to serve our
consumer end-users, will depend on our ability to negotiate fair and reasonable
prices substantially lower than the whole loop cost that will ultimately be
permitted under the FCCs rules. We do not believe the FCCs revised unbundling
rules will have a material adverse effect on our ability to continue as a going
concern at least through December 31, 2003, but our operating results and
financial condition may be adversely affected over time if the new rules result
in substantially higher prices for access to the ILECs telephone lines.

We have in the past described our expectation of attaining cash flow
sufficiency from our operating activities in mid-2004. Subsequent to our
announcement of these expectations the FCC announced the results of its
Triennial Review and on August 21, 2003, issued its order. The order may impact
our cash flow from operations and the manner in which we progress towards cash
flow sufficiency. In particular, our ability to continue to sell stand-alone
consumer-grade services to new customers will likely depend on our ability to
negotiate with the telephone companies fair and reasonable prices for
line-shared services that are substantially lower than the cost of a separate
line. If we cannot reach reasonable terms with the telephone companies, we may
be unable to sell stand-alone consumer-grade services to new customers. In that
event, we would be required to, and we believe we can, adjust our business plan
so that we can still reach cash flow sufficiency in mid-2004. However, in this
event, our growth could be impaired because of our reduced access to the
consumer market.

Nonetheless, adverse business, legal, regulatory or legislative
developments, such as the inability to continue line-sharing, 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, especially under the current capital market conditions. If we are
unable to acquire additional capital on favorable terms when needed, or are
required to raise it on terms that are less satisfactory than we desire, our
financial condition will be adversely affected.

Risk Factors

The following is a summary list of some of the risk factors relating to
our Company. For additional detail regarding these and other risk factors,
please refer to Part I, Item 1, Business - Risk Factors found in our 2002
Annual Report on Form 10-K, which was filed with the SEC on March 20, 2003.



| |  |  | 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. For example,
the FCC only recently issued its order in the Triennial Review, and we
may be adversely affected by the manner in which the FCC implements that
decision. In addition, portions of the Triennial Review order are the
subject of legal challenges by us, the traditional telephone companies
and other competitive telephone companies.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Charges for unbundled network elements are generally outside of our
control because they are proposed by the traditional telephone companies
and are subject to costly regulatory approval processes.                                                                                                                                                                                                                                                                                                                                                 

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| |  |  | Our business will suffer if our interconnection agreements are not
renewed or if they are modified on unfavorable terms.                                                                                                                                                                                                                                                                                                                                                                                  
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The traditional telephone companies are not required to provide us
with access to packet-switching sections of the ILECs fiber-fed
telephone network, which limits the addressable market for our services.
We have no guaranties that we will obtain access to these fiber-fed
lines at economically reasonable terms and, unless we have such access,
additional deployment of fiber-fed lines by the ILECs will continue to
reduce our addressable market.                                            
|
| |  |  | Based on our agreements with AT&T, MCI and other competitive
telephone companies, we recently began offering the ability to offer our
services over a telephone line that is being used by a voice provider
other than the traditional telephone company. However, we are
experiencing operational challenges as we work with the traditional
telephone companies to deploy this service. It is also unclear how
quickly our resellers will increase the number of end-users that
purchase these services.
|
| |  |  | We may need to raise additional capital under difficult financial
market conditions in order to maintain our operations.                                                                                                                                                                                                                                                                                                                                                                                  
|
| |  |  | In order to become cash flow positive and to achieve profitability,
we must add end-users to our network while minimizing the cost to expand
our network infrastructure.                                                                                                                                                                                                                                                                                                                                  
|
| |  |  | Our end-user disconnection rate increased significantly during the
third quarter. If we do not reduce this rate it will continue to impair
our revenue and end-user growth.                                                                                                                                                                                                                                                                                                                               
|
| |  |  | Our competitors have recently introduced lower prices for their
competing services. These reduced prices are likely to reduce the
margins on the sale of our services, which may impair our ability to
achieve profitability or positive cash flow.                                                                                                                                                                                                                                                       
|
| |  |  | Our internal controls need to be improved.                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|
| |  |  | We depend on a limited number of customers for the preponderance of
our revenues, and we are highly dependent on sales through our
resellers.                                                                                                                                                                                                                                                                                                                                                             
|
| |  |  | Some of our wholesalers are facing financial difficulties, which
makes it more difficult to predict our revenues.                                                                                                                                                                                                                                                                                                                                                                                         
|
| |  |  | Our direct sales to end-users poses operational challenges and the
perceived threat may cause our resellers to place fewer orders with us
or may cause us to lose resellers.                                                                                                                                                                                                                                                                                                                              
|
| |  |  | The markets in which we operate are highly competitive, and we may
not be able to compete effectively, especially against established
industry competitors with significantly greater financial resources.                                                                                                                                                                                                                                                                                                
|
| |  |  | The broadband communications industry is undergoing rapid
technological changes, and new technologies may be superior to the
technology we use.                                                                                                                                                                                                                                                                                                                                                           
|
| |  |  | A system failure could delay or interrupt service to our customers,
which could reduce demand for our services.                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  |  | Our network security still needs to be improved and a breach of
network security could delay or interrupt service to our customers,
which could reduce demand for our services.                                                                                                                                                                                                                                                                                                                           
|
| |  |  | If we are not able to electronically interface with the traditional
phone companies to order services, our costs will increase.                                                                                                                                                                                                                                                                                                                                                                           
|
| |  |  | Our success depends on our retention of certain key personnel, our
ability to hire additional key personnel and the maintenance of good
labor relations.                                                                                                                                                                                                                                                                                                                                                  
|
| |  |  | We depend on a limited number of third parties for equipment supply, service and installation.                                                                                                                                                                                                                                                                                                                                                                                                            
|
| |  |  | Our business is difficult to evaluate because we have a limited operating history.                                                                                                                                                                                                                                                                                                                                                                                                                        
|
| |  |  | 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.                                                                                                                                                                                                                                                                                                                            

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| |  |  | The unpredictability of our revenues, along with other factors, may
cause the price of our common stock to fluctuate and could cause it to
decline.                                                                                                                                                 
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Future sales or issuances of our common stock may depress our stock
price.                                                                                                                                                                                                                          
|
| |  |  | Anti-takeover effects of certain charter and bylaw provisions,
Delaware law, our indebtedness, our Stockholder Protection Rights Plan
and our change in control severance arrangements could prevent a change
in our control, which could inhibit your ability to receive a premium
for your shares.
|
| |  |  | We must comply with federal, state and local tax and other surcharges
on our service, the levels of which are uncertain.                                                                                                                                                                            
|
| |  |  | We are a party to litigation and adverse results of such litigation
matters could negatively impact our financial condition and results of
operations.                                                                                                                                              
|
| |  |  | Our intellectual property protection may be inadequate to protect our
proprietary rights.                                                                                                                                                                                                           

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:



| |  |  | the impact of the FCCs decision in the Triennial Review and our
ability to obtain access to line-sharing at rates that allow us to sell
consumer-grade services to new customers;                                                                   
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | expectations regarding the continuing deployment of local voice
services by providers other than the traditional telephone companies and
our ability to bundle our data services with the voice services of these
alternative providers;             
|
| |  |  | expectations regarding our ability to become cash-flow positive;                                                                                                                                                                                     
|
| |  |  | expectations regarding the extent to which customers purchase our services;                                                                                                                                                                          
|
| |  |  | expectations regarding our relationships with our strategic partners and other potential third parties;                                                                                                                                              
|
| |  |  | expectations as to pricing for our services in the future;                                                                                                                                                                                           
|
| |  |  | expectations regarding our margins on our service offerings;                                                                                                                                                                                         
|
| |  |  | the possibility 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, including
expectations regarding when we anticipate operating on a cash flow
positive basis, the adequacy of our cash reserves, our monthly cash burn
rate and the number of installed lines;
|
| |  |  | plans to develop and commercialize value-added services;                                                                                                                                                                                             
|
| |  |  | our anticipated capital expenditures;                                                                                                                                                                                                                
|
| |  |  | plans to enter into business arrangements with broadband-related service providers;                                                                                                                                                                  

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| |  |  | the effect of regulatory changes;                                                                      
| | - |  | -------------------------------------------------------------------------------------------------------
|
| |  |  | the effect 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 Triennial Review order;                                                                                                                                                                            
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | collect receivables from customers;                                                                                                                                                                                                                                                     
|
| |  |  | retain end-users that are served by customers facing financial difficulties;                                                                                                                                                                                                            
|
| |  |  | generate customer demand for our services;                                                                                                                                                                                                                                              
|
| |  |  | successfully defend our company against litigation;                                                                                                                                                                                                                                     
|
| |  |  | successfully reduce our operating costs and overhead while continuing to provide good customer service;                                                                                                                                                                                 
|
| |  |  | successfully continue to increase the number of business-grade lines we sell;                                                                                                                                                                                                           
|
| |  |  | achieve favorable pricing for our services;                                                                                                                                                                                                                                             
|
| |  |  | respond to increasing competition;                                                                                                                                                                                                                                                      
|
| |  |  | manage growth of our operations; and                                                                                                                                                                                                                                                    
|
| |  |  | access regions and negotiate suitable interconnection agreements with
the traditional telephone companies 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 line-sharing and remote terminals.

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, 2002. We disclaim any obligation
to update information contained in any forward-looking statement.




Item 3.Market Risk

Quantitative and Qualitative Disclosures about Market Risk

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 a
substantial majority of our investments are in fixed-rate, short-term
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, short-term nature of the substantial majority of our investment
portfolio. In addition, all of our outstanding indebtedness as of September 30,
2003 is fixed-rate debt.




Item 4.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

32



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Commissions rules and forms. Our chief executive officer and our chief
financial officer, based on their evaluation of the effectiveness of our
disclosure controls and procedures as of the end of the period covered by
this report, have concluded that our disclosure controls and procedures were
effective for this purpose.

During the period covered by this report, there have been no changes in
the Companys internal control over financial reporting that have materially
affected or are reasonably likely to materially affect the Companys internal
control over financial reporting.

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PART II. OTHER INFORMATION




Item 1.Legal
Proceedings (all dollar amounts are presented in thousands)

On December 13, 2001, the United States Bankruptcy Court for the District
of Delaware (the Bankruptcy Court) entered an order confirming our
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 we emerged from bankruptcy. Under our Plan, we settled
several claims against us. These claims include:



| |  |  | The class action lawsuits filed in the United States District Court
for the Northern District of California. This settlement is described in
more detail below.               
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The lawsuits filed in the Superior Court of the State of California
for the County of Santa Clara by six purchasers of the convertible notes
that we issued in September 2000.
|
| |  |  | Disputed claims made by former shareholders of Laser Link.net.                                                                                                                
|
| |  |  | Disputed claims made by GE Capital and its subsidiary, Heller Financial Group.                                                                                                

As of September 30, 2003, there were approximately $8,494 in unresolved
claims related to our Chapter 11 bankruptcy proceedings. As of September 30,
2003, we have recorded $7,532 for these unresolved claims in our condensed
consolidated balance sheet. However, it is reasonably possible that our
unresolved Chapter 11 bankruptcy claims could ultimately be settled for amounts
that differ from the amounts recorded in our condensed consolidated balance
sheet.

Purchasers of our common stock and purchasers of the convertible notes we
issued in September 2000 have filed complaints on behalf of themselves and
alleged classes of stockholders and holders of convertible notes against us and
certain of our present and former officers and directors. These complaints were
filed in the United States District Court for the Northern District of
California (District Court) in the fourth quarter of 2000. The complaints
were consolidated and the lead plaintiff has filed its amended consolidated
complaint. The amended consolidated complaint alleges violations of federal
securities laws on behalf of persons who purchased or otherwise acquired our
securities, including common stock and notes, during the period from April 19,
2000 to May 24, 2001. The relief sought includes monetary damages and equitable
relief. We and the officer and director defendants entered into a Memorandum of
Understanding (MOU) with counsel for the lead plaintiffs in this litigation
that tentatively resolves the litigation. The MOU sets forth the terms upon
which we, the officer and director defendants and the plaintiffs agree to
settle the litigation. Pursuant to the MOU, the plaintiffs agreed to support
and vote in favor of our bankruptcy plan if it provided for the distribution of
$16,500 in cash to be funded by our insurance carriers and 6,495,844 shares of
our common stock. The plaintiffs voted in favor of the Plan. The settlement
provided for in the MOU 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 has filed an appeal pertaining to the final
judgment, but this appeal only relates to the allocation of the settlement
proceeds between the plaintiffs and their attorneys.

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 have 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. Both
BellSouth and Covad are seeking an appeal of this decision in the United States
Supreme Court. In addition, the United States Supreme Court has agreed to
review a decision from the United States Court of Appeals for the Second
Circuit entitled Verizon Communications v. Law Offices of Curtis Trinko, which
rejected the Goldwasser decision. The Eleventh Circuit relied in part on the
Trinko decision when it reversed the lower courts dismissal of our claims
against BellSouth. The Court of Appeals for the District of Columbia has
indicated that it will not act on our appeal in our case against Verizon until
the Supreme Court issues a decision in the Trinko case. We cannot predict the
outcome of these matters.

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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 phone lines that we ordered and seeks
unspecified monetary damages (characterized as being in the millions) and
injunctive relief. The current complaint asserts causes of action for negligent
and intentional misrepresentation and violations of Californias unfair
competition statute. 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 has appealed the dismissal of its lawsuit. 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 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 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 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 Mr. Crandall and Ms. Runtagh, to investigate the
allegations made by Mr. Khanna. Mr. 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 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, 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 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 action against our current and former
directors in the Court of Chancery of the State of Delaware in and for New
Castle County. In this action Mr. Khanna seeks recovery on behalf of the
company from the individual defendants for their purported breach of fiduciary
duty. Mr. Khanna also seeks to invalidate our election of directors in 2002
and 2003 because he claims that our proxy statements were misleading. While we
believe the contentions of Mr. Khanna referred to above are without merit, and
the company and its directors will vigorously defend themselves, 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 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.

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We are 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, the interpretation of
competitive telecommunications company interconnection agreements in general,
and our interconnection agreements in particular. In some cases we may be bound
by or may otherwise be significantly impacted by the results of ongoing
proceedings of these bodies or the legal outcomes of other contested
interconnection agreements that are similar to our agreements. The results of
any of these proceedings could harm our business.

In addition, we are 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, 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 consolidated financial position and results of
operations if we are denied or charged higher rates for transmission lines or
central office spaces.




Item 2.Changes in Securities and Use of Proceeds

On July 3, 2003, we issued 10,000 shares of our common stock to an
industry organization in exchange for their services. These shares were issued
in a private placement under Section 4(2) of the Securities Exchange Act of
1933.




Item 3.Defaults upon Senior Securities

None.




Item 4.Submission of Matters to a Vote of Security Holders

On August 14, 2003, we held our Annual Meeting of Stockholders. Set forth
below is a summary of each matter voted upon at the meeting and the number of
votes cast for, against or withheld, as well as the number of abstentions and
broker non-votes.

|                                                                                                                                                                                                                             |                   |  |             |             |         |  |            |   |          |  |           |   |  |  |   |            |  |  |             |   | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------- |  | ----------- | ----------- | ------- |  | ---------- | - | -------- |  | --------- | - |  |  | - | ---------- |  |  | ----------- | - | 
|                                                                                                                                                                                                                             |                   |  | Votes       |             | Votes   |  | Votes      |   | Votes    |  | Broker   
|                                                                                                                                                                                                                             |                   |  | For         |             | Against |  | Abstained  |   | Withheld |  | Non-Votes
|                                                                                                                                                                                                                             |                   |  |             |             |         |  |            |   |          |  |          
|1. Election of
Class I directors
to serve on our
Board of Directors
for a term to
expire at the third
succeeding annual
meeting (expected
to be the 2006
annual meeting) and
until their
successor are
elected and
qualified |                   |  |             |             |         |  |            |   |          |  |           |   |  |  |   |            |  |  |             |  
|                                                                                                                                                                                                                             | Larry Irving      |  |             | 202,585,421 |         |  |            |  |          |  |           |  |  |  |   | 8,938,496  |  |  |             |  | 
|                                                                                                                                                                                                                             | Richard A.
Jalkut |  |             | 202,767,064 |         |  |            |  |          |  |           |  |  |  |   | 8,756,853  |  |  |             |  | 
|                                                                                                                                                                                                                             | Daniel C.
Lynch   |  |             | 200,885,736 |         |  |            |  |          |  |           |  |  |  |   | 10,638,181 |  |  |             |  | 
|2. Proposal to
approve Covads
2003 Employee Stock
Purchase
Plan                                                                                                                                                             |                   |  | 40,073,488  |             |         |  | 17,584,646 |   |          |  | 480,984   |   |  |  |  |            |  |  | 153,384,799 |  
|3. Proposal to
ratify Ernst &
Young LLP as
independent
auditors of the
Company for 2003
fiscal
year                                                                                                                          |                   |  | 201,427,136 |             |         |  | 9,726,513  |   |          |  | 370,268   |   |  |  |  |            |  |  |            |  




Item 5.Other Information

None.

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Item 6.Exhibits and Reports on Form 8-K

a.     Exhibits:

|        |  |                                                                                                                        
|------- |  | -----------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                        
|Number  |  | Description                                                                                                            
|        |  |                                                                                                                        
|10.40   |  | General Release of All Claims executed by Anjali Joshi                                                                 
|        |  |                                                                                                                        
|31.1    |  | Certification Pursuant to Rule 13a-14(a).                                                                              
|        |  |                                                                                                                        
|31.2    |  | Certification Pursuant to Rule 13a-14(a).                                                                              
|        |  |                                                                                                                        
|32.1*   |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
|        |  |                                                                                                                        
|32.2*   |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

* These certifications accompany the Registrants Quarterly Report on Form 10-Q
and are not deemed filed with the SEC

b.     Reports on Form 8-K

On July 17, 2003, we furnished a current report on Form 8-K, pursuant to
Item 12 thereof, attaching a copy of a press release dated July 16, 2003*.

On July 31, 2003, we furnished a current report on Form 8-K, pursuant to
Item 12 thereof, attaching a copy of a press release dated July 31, 2003*.

*     These reports shall not by this reference be, or be deemed to have been,
filed with the Securities and Exchange Commission under the Securities Act of
1933, the Securities Exchange Act of 1934, or otherwise.




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. HOFFMAN      
|                       |  |  |                                  |     |  |                             
|                       |  |  |                                  |     |  | Charles E. Hoffman          
|                       |  |  |                                  |     |  | President, Chief Executive  
|                       |  |  |                                  |     |  | Officer and Director        
|                       |  |  |                                  |     |  |                             
|Date: October 24, 2003 |  |  |                                  |     |  |                             
|                       |  |  |                                  |     |  |                             
|                       |  |  |                                  | By: |  | /s/ MARK A. RICHMAN         
|                       |  |  |                                  |     |  |                             
|                       |  |  |                                  |     |  | Mark A. Richman             
|                       |  |  |                                  |     |  | Executive Vice President and
|                       |  |  |                                  |     |  | Chief Financial Officer     
|                       |  |  |                                  |     |  |                             
|Date: October 24, 2003 |  |  |                                  |     |  |                             

37



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|        |  |                                                                                                                        
|------- |  | -----------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                        
|Number  |  | Description                                                                                                            
|        |  |                                                                                                                        
|10.40   |  | General Release of All Claims executed by Anjali Joshi                                                                 
|        |  |                                                                                                                        
|31.1    |  | Certification Pursuant to Rule 13a-14(a).                                                                              
|        |  |                                                                                                                        
|31.2    |  | Certification Pursuant to Rule 13a-14(a).                                                                              
|        |  |                                                                                                                        
|32.1*   |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
|        |  |                                                                                                                        
|32.2*   |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.



---

|* |  | These certifications accompany the Registrants Quarterly Report on Form
10-Q and are not deemed filed with the SEC.
|- |  | --------------------------------------------------------------------------------------------------------------------