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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 June 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                                 |  | 77-0461529            
|(State or other jurisdiction             |  | (I.R.S. Employer      
|of incorporation or organization)        |  | Identification Number)
|                                         |  |                       
|3420 Central Expressway                  |  |                       
|Santa Clara, California                  |  | 95051                 
|(Address of principal executive offices) |  | (Zip Code)            

(408) 616-6500(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 July 23, 2003 there were 223,922,388 shares outstanding of the
Registrants Common Stock, including Class B Common Stock.



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TABLE OF CONTENTS

COVAD COMMUNICATIONS GROUP, INC.

FORM 10-Q

TABLE OF CONTENTS

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                                                                    
|                              | 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 10.38                
|EXHIBIT 10.39                
|EXHIBIT 31.1                 
|EXHIBIT 31.2                 
|EXHIBIT 32.1                 
|EXHIBIT 32.2                 



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##### Table of Contents



|           |  |                                                                                                                  |    |      |    | 
|---------- |  | ---------------------------------------------------------------------------------------------------------------- | -- | ---- | -- | 
|           |  |                                                                                                                  |    | Page
|           |  |                                                                                                                  |    |     
|PART I.    |  | FINANCIAL INFORMATION                                                                                            |    |      |    | 
|ITEM 1.    |  | CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)                                                          |    |      | 1  | 
|           |  | CONDENSED CONSOLIDATED BALANCE SHEETS AS OF
JUNE 30, 2003 AND DECEMBER 31, 2002                                  |    |      | 1  | 
|           |  | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2003 AND 2002 |    |      | 2  | 
|           |  | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 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                            |    |      | 16 | 
|ITEM 3.    |  | MARKET RISK                                                                                                      |    |      | 32 | 
|ITEM 4.    |  | CONTROLS AND PROCEDURES                                                                                          |    |      | 32 | 
|PART II.   |  | OTHER INFORMATION                                                                                                |    |      |    | 
|ITEM 1.    |  | LEGAL PROCEEDINGS                                                                                                |    |      | 33 | 
|ITEM 2.    |  | CHANGES IN SECURITIES AND USE OF PROCEEDS                                                                        |    |      | 35 | 
|ITEM 3.    |  | DEFAULTS UPON SENIOR SECURITIES                                                                                  |    |      | 35 | 
|ITEM 4.    |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                              |    |      | 35 | 
|ITEM 5.    |  | OTHER INFORMATION                                                                                                |    |      | 35 | 
|ITEM 6.    |  | EXHIBITS AND REPORTS ON FORM 8-K                                                                                 |    |      | 35 | 
|SIGNATURES |  |                                                                                                                  | 36 |     





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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)

|                                                           |                                                                                                                                                                                            |   |             |            |              |   |         |            |  
|---------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | - | ----------- | ---------- | ------------ | - | ------- | ---------- | -
|                                                           |                                                                                                                                                                                            |   | June 30,    |            | December 31,
|                                                           |                                                                                                                                                                                            |   | 2003        |            | 2002        
|                                                           |                                                                                                                                                                                            |   |             |            |             
|                                                           |                                                                                                                                                                                            |   | (Unaudited) |            | (Note 1)    
|ASSETS                                                     |                                                                                                                                                                                            |   |             |            |              |   |         |           
|Current assets:                                            |                                                                                                                                                                                            |   |             |            |              |   |         |           
|                                                           | Cash and cash equivalents                                                                                                                                                                  |   | $           | 35,495     |              |   | $       | 96,491     |  
|                                                           | Short-term investments                                                                                                                                                                     |   |             | 118,704    |              |   |         | 108,076    |  
|                                                           | Restricted cash and investments                                                                                                                                                            |   |             | 400        |              |   |         | 501        |  
|                                                           | Accounts receivable, net of allowances of $4,682 at June 30, 2003 ($5,388 at December 31, 2002)                                                                                            |   |             | 25,105     |              |   |         | 21,746     |  
|                                                           | Unbilled revenues                                                                                                                                                                          |   |             | 6,228      |              |   |         | 3,921      |  
|                                                           | Other receivables                                                                                                                                                                          |   |             | 545        |              |   |         | 1,385      |  
|                                                           | Inventories                                                                                                                                                                                |   |             | 8,364      |              |   |         | 5,096      |  
|                                                           | Prepaid expenses and other current assets                                                                                                                                                  |   |             | 3,655      |              |   |         | 5,524      |  
|                                                           |                                                                                                                                                                                            |   |             |            |              |   |         |           
|Total current assets                                       |                                                                                                                                                                                            |   | 198,496     |            |              |   | 242,740 |           
|Property and equipment, net                                |                                                                                                                                                                                            |   | 95,024      |            |              |   | 108,737 |           
|Collocation fees and other intangible assets, net          |                                                                                                                                                                                            |   | 41,955      |            |              |   | 43,284  |           
|Investments in unconsolidated affiliates                   |                                                                                                                                                                                            |   | 621         |            |              |   | 1,026   |           
|Deferred costs of service activation                       |                                                                                                                                                                                            |   | 34,668      |            |              |   | 40,286  |           
|Deferred customer incentives                               |                                                                                                                                                                                            |   | 5,537       |            |              |   | 3,540   |           
|Other long-term assets                                     |                                                                                                                                                                                            |   | 2,494       |            |              |   | 2,548   |           
|                                                           |                                                                                                                                                                                            |   |             |            |              |   |         |           
|Total assets                                               |                                                                                                                                                                                            | $ | 378,795     |            |              | $ | 442,161 |           
|                                                           |                                                                                                                                                                                            |   |             |            |              |   |         |            |  
|LIABILITIES AND STOCKHOLDERS EQUITY                       |                                                                                                                                                                                            |   |             |            |              |   |         |           
|Current liabilities:                                       |                                                                                                                                                                                            |   |             |            |              |   |         |           
|                                                           | Accounts payable                                                                                                                                                                           |   | $           | 9,027      |              |   | $       | 10,915     |  
|                                                           | Accrued compensation and employment-related taxes                                                                                                                                          |   |             | 20,972     |              |   |         | 12,774     |  
|                                                           | Current portion of capital lease obligations                                                                                                                                               |   |             | 77         |              |   |         | 165        |  
|                                                           | Accrued collocation and network service fees                                                                                                                                               |   |             | 13,379     |              |   |         | 16,537     |  
|                                                           | Accrued transaction-based taxes                                                                                                                                                            |   |             | 41,533     |              |   |         | 45,426     |  
|                                                           | Accrued interest                                                                                                                                                                           |   |             | 8,433      |              |   |         | 5,683      |  
|                                                           | Accrued market development funds and customer incentives                                                                                                                                   |   |             | 11,961     |              |   |         | 6,422      |  
|                                                           | Unresolved claims related to bankruptcy proceedings                                                                                                                                        |   |             | 7,383      |              |   |         | 7,381      |  
|                                                           | Other accrued liabilities                                                                                                                                                                  |   |             | 5,229      |              |   |         | 8,581      |  
|                                                           |                                                                                                                                                                                            |   |             |            |              |   |         |           
|Total current liabilities                                  |                                                                                                                                                                                            |   | 117,994     |            |              |   | 113,884 |           
|Long-term debt                                             |                                                                                                                                                                                            |   | 50,000      |            |              |   | 50,000  |           
|Collateralized customer deposit                            |                                                                                                                                                                                            |   | 64,183      |            |              |   | 68,191  |           
|Deferred gain resulting from deconsolidation of subsidiary |                                                                                                                                                                                            |   | 53,963      |            |              |   | 53,972  |           
|Unearned revenues                                          |                                                                                                                                                                                            |   | 68,132      |            |              |   | 73,815  |           
|                                                           |                                                                                                                                                                                            |   |             |            |              |   |         |           
|Total liabilities                                          |                                                                                                                                                                                            |   | 354,272     |            |              |   | 359,862 |           
|Commitments and contingencies                              |                                                                                                                                                                                            |   |             |            |              |   |         |           
|Stockholders equity:                                      |                                                                                                                                                                                            |   |             |            |              |   |         |           
|                                                           | Preferred stock, $0.001 par value; 5,000,000 shares authorized; no shares issued and outstanding
at June 30, 2003 and December 31, 2002                                                    |   |             |           |              |   |         |           |  
|                                                           | Common Stock, $0.001 par value; 590,000,000 shares authorized; 223,854,260 shares issued and
outstanding at June 30, 2003 (223,182,511 shares issued and outstanding at December 31, 2002) |   |             | 224        |              |   |         | 223        |  
|                                                           | Common Stock - Class B, $0.001 par value; 10,000,000 shares authorized; no shares issued
and outstanding at June 30, 2003 and December 31, 2002                                            |   |             |           |              |   |         |           |  
|                                                           | Additional paid-in capital                                                                                                                                                                 |   |             | 1,616,614  |              |   |         | 1,612,319  |  
|                                                           | Deferred stock-based compensation                                                                                                                                                          |   |             | (95        | )            |   |         | (160       | )
|                                                           | Accumulated other comprehensive loss                                                                                                                                                       |   |             | (875       | )            |   |         | (747       | )
|                                                           | Accumulated deficit                                                                                                                                                                        |   |             | (1,591,345 | )            |   |         | (1,529,336 | )
|                                                           |                                                                                                                                                                                            |   |             |            |              |   |         |           
|Total stockholders equity                                 |                                                                                                                                                                                            |   | 24,523      |            |              |   | 82,299  |           
|                                                           |                                                                                                                                                                                            |   |             |            |              |   |         |           
|Total liabilities and stockholders equity                 |                                                                                                                                                                                            | $ | 378,795     |            |              | $ | 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 June 30, |         | Six Months Ended June 30,
|                                                                                                |                                                                      |                          |             |                             |         |                          
|                                                                                                |                                                                      |                          |             | 2003                        |         | 2002                      |             | 2003   |         | 2002
|                                                                                                |                                                                      |                          |             |                             |         |                           |             |        |         |     
|Revenues, net                                                                                   |                                                                      | $                        | 92,445      |                             |         | $                         | 97,733      |        |         | $    | 183,305     |         |         | $ | 199,399     |        
|Operating expenses:                                                                             |                                                                      |                          |             |                             |         |                           |             |        |         |      |             |         |         |   |             |        
|                                                                                                | Network and product costs                                            |                          |             | 68,727                      |         |                           |             | 76,262 |         |      |             | 137,751 |         |   |             | 166,456 |        
|                                                                                                | Sales, marketing, general and administrative                         |                          |             | 32,300                      |         |                           |             | 33,833 |         |      |             | 69,679  |         |   |             | 71,037  |        
|                                                                                                | Provision for bad debts (bad debt recoveries), net                   |                          |             | (164                        | )       |                           |             | 2,116  |         |      |             | 34      |         |   |             | 2,043   |        
|                                                                                                | Depreciation and amortization of property and equipment              |                          |             | 13,752                      |         |                           |             | 28,531 |         |      |             | 28,345  |         |   |             | 59,384  |        
|                                                                                                | Amortization of collocation fees and other intangible assets         |                          |             | 4,024                       |         |                           |             | 3,661  |         |      |             | 8,020   |         |   |             | 7,290   |        
|                                                                                                | Litigation-related expenses                                          |                          |             |                            |         |                           |             | (7,146 | )       |      |             |        |         |   |             | (10,913 | )      
|                                                                                                |                                                                      |                          |             |                             |         |                           |             |        |         |      |             |         |         |   |             |        
|                                                                                                |                                                                      | Total operating expenses |             |                             | 118,639 |                           |             |        | 137,257 |      |             |         | 243,829 |   |             |         | 295,297 | 
|                                                                                                |                                                                      |                          |             |                             |         |                           |             |        |         |      |             |         |         |   |             |        
|Loss from operations                                                                            |                                                                      |                          | (26,194     | )                           |         |                           | (39,524     | )      |         |      | (60,524     | )       |         |   | (95,898     | )      
|Other income (expense):                                                                         |                                                                      |                          |             |                             |         |                           |             |        |         |      |             |         |         |   |             |        
|                                                                                                | Interest income                                                      |                          |             | 573                         |         |                           |             | 1,044  |         |      |             | 1,289   |         |   |             | 2,513   |        
|                                                                                                | Realized loss on short-term investments                              |                          |             |                            |         |                           |             |       |         |      |             |        |         |   |             | (17     | )      
|                                                                                                | Provision for impairment of investments in unconsolidated
affiliates |                          |             | (97                         | )       |                           |             |       |         |      |             | (209    | )       |   |             |        |        
|                                                                                                | Equity in losses of unconsolidated affiliates                        |                          |             | (92                         | )       |                           |             | (212   | )       |      |             | (196    | )       |   |             | (603    | )      
|                                                                                                | Loss on disposal of investments in unconsolidated affiliates         |                          |             |                            |         |                           |             | (996   | )       |      |             |        |         |   |             | (636    | )      
|                                                                                                | Interest expense                                                     |                          |             | (1,393                      | )       |                           |             | (1,375 | )       |      |             | (2,772  | )       |   |             | (2,750  | )      
|                                                                                                | Miscellaneous income (expense), net                                  |                          |             | (84                         | )       |                           |             | 270    |         |      |             | 403     |         |   |             | (241    | )      
|                                                                                                |                                                                      |                          |             |                             |         |                           |             |        |         |      |             |         |         |   |             |        
|                                                                                                | Other (expense), net                                                 |                          |             | (1,093                      | )       |                           |             | (1,269 | )       |      |             | (1,485  | )       |   |             | (1,734  | )      
|                                                                                                |                                                                      |                          |             |                             |         |                           |             |        |         |      |             |         |         |   |             |        
|Net loss                                                                                        |                                                                      | $                        | (27,287     | )                           |         | $                         | (40,793     | )      |         | $    | (62,009     | )       |         | $ | (97,632     | )      
|                                                                                                |                                                                      |                          |             |                             |         |                           |             |        |         |      |             |         |         |   |             |        
|Basic and diluted net loss per share                                                            |                                                                      | $                        | (0.12       | )                           |         | $                         | (0.19       | )      |         | $    | (0.28       | )       |         | $ | (0.45       | )      
|                                                                                                |                                                                      |                          |             |                             |         |                           |             |        |         |      |             |         |         |   |             |        
|Weighted-average number of common shares used in computing
basic and diluted net loss per share |                                                                      |                          | 223,724,040 |                             |         |                           | 219,350,005 |        |         |      | 223,585,104 |         |         |   | 218,122,972 |        
|                                                                                                |                                                                      |                          |             |                             |         |                           |             |        |         |      |             |         |         |   |             |        

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.




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

|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |          |         |         |         |  
|-------------------------------------------------- | --------------------------------------------------------------------------- | -------------------------------------------------------------------- | --------------------------------------------------- | --------------------------------------------------- | ------ | ------------------------- | ------- | -------- | ------- | ------- | ------- | -
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        | Six Months Ended June 30,
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                          
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        | 2003                      |         | 2002    
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |         
|Operating Activities:                              |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |         
|                                                   | Net loss                                                                    |                                                                      | $                                                   | (62,009                                             | )      |                           | $       | (97,632  | )      
|                                                   | Adjustments to reconcile net loss to net cash used in operating activities: |                                                                      |                                                     |                                                     |        |                           |         |          |        
|                                                   |                                                                             | Provision for bad debts (bad debt recoveries), net                   |                                                     |                                                     | 34     |                           |         |          | 2,043   |        
|                                                   |                                                                             | Depreciation and amortization                                        |                                                     |                                                     | 36,365 |                           |         |          | 66,674  |        
|                                                   |                                                                             | Loss on disposition of property and equipment                        |                                                     |                                                     | 220    |                           |         |          | 314     |        
|                                                   |                                                                             | Non-cash litigation-related expenses                                 |                                                     |                                                     |       |                           |         |          | (10,913 | )      
|                                                   |                                                                             | Employee stock-based compensation                                    |                                                     |                                                     | 1,302  |                           |         |          | 175     |        
|                                                   |                                                                             | Other stock-based compensation                                       |                                                     |                                                     | 13     |                           |         |          | 269     |        
|                                                   |                                                                             | Other non-cash charges                                               |                                                     |                                                     | 643    |                           |         |          |        |        
|                                                   |                                                                             | Amortization (accretion) of interest on investments, net             |                                                     |                                                     | (731   | )                         |         |          | 14      |        
|                                                   |                                                                             | Realized loss on short-term investments                              |                                                     |                                                     |       |                           |         |          | 17      |        
|                                                   |                                                                             | Equity in losses of unconsolidated affiliates                        |                                                     |                                                     | 196    |                           |         |          | 603     |        
|                                                   |                                                                             | Provision for impairment of investments in unconsolidated affiliates |                                                     |                                                     | 209    |                           |         |          |        |        
|                                                   |                                                                             | Loss on disposal of investments in unconsolidated affiliates         |                                                     |                                                     |       |                           |         |          | 636     |        
|                                                   |                                                                             | Net changes in operating assets and liabilities:                     |                                                     |                                                     |        |                           |         |          |         |        
|                                                   |                                                                             |                                                                      | Restricted cash                                     |                                                     |        | 101                       |         |          |         | 2,603   |        
|                                                   |                                                                             |                                                                      | Accounts receivable                                 |                                                     |        | (3,393                    | )       |          |         | (9,985  | )      
|                                                   |                                                                             |                                                                      | Unbilled revenues                                   |                                                     |        | (2,307                    | )       |          |         | 572     |        
|                                                   |                                                                             |                                                                      | Inventories                                         |                                                     |        | (3,268                    | )       |          |         | 2,504   |        
|                                                   |                                                                             |                                                                      | Prepaid expenses and other current assets           |                                                     |        | 2,709                     |         |          |         | (117    | )      
|                                                   |                                                                             |                                                                      | Deferred costs of service activation                |                                                     |        | 5,618                     |         |          |         | 8,662   |        
|                                                   |                                                                             |                                                                      | Accounts payable                                    |                                                     |        | (1,887                    | )       |          |         | (6,680  | )      
|                                                   |                                                                             |                                                                      | Unresolved claims related to bankruptcy proceedings |                                                     |        | 2                         |         |          |         | (2,466  | )      
|                                                   |                                                                             |                                                                      | Collateralized customer deposit                     |                                                     |        | (4,008                    | )       |          |         | (3,150  | )      
|                                                   |                                                                             |                                                                      | Other current liabilities                           |                                                     |        | 6,082                     |         |          |         | 2,044   |        
|                                                   |                                                                             |                                                                      | Unearned revenues                                   |                                                     |        | (5,683                    | )       |          |         | (10,168 | )      
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |          |        
|                                                   |                                                                             |                                                                      |                                                     | Net cash used in operating activities               |        |                           | (29,792 | )        |         |         | (53,981 | )
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |          |        
|Investing Activities:                              |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |         
|                                                   | Purchases of short-term investments                                         |                                                                      |                                                     | (93,580                                             | )      |                           |         | (154,411 | )      
|                                                   | Maturities of short-term investments                                        |                                                                      |                                                     | 83,555                                              |        |                           |         | 19,988   |        
|                                                   | Sales of short-term investments                                             |                                                                      |                                                     |                                                    |        |                           |         | 40,000   |        
|                                                   | Purchases of property and equipment                                         |                                                                      |                                                     | (15,906                                             | )      |                           |         | (7,931   | )      
|                                                   | Proceeds from sales of property and equipment                               |                                                                      |                                                     | 60                                                  |        |                           |         | 13,451   |        
|                                                   | Recovery of internal use software costs                                     |                                                                      |                                                     | 986                                                 |        |                           |         | 164      |        
|                                                   | Payment of collocation fees and purchase of other intangible assets         |                                                                      |                                                     | (6,691                                              | )      |                           |         | (1,297   | )      
|                                                   | Proceeds from sales of investments in unconsolidated affiliates             |                                                                      |                                                     |                                                    |        |                           |         | 3,360    |        
|                                                   | Decrease of other long-term assets                                          |                                                                      |                                                     | 54                                                  |        |                           |         |         |        
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |          |        
|                                                   |                                                                             |                                                                      |                                                     | Net cash used in investing activities               |        |                           | (31,522 | )        |         |         | (86,676 | )
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |          |        
|financing Activities:                              |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |         
|                                                   | Principal payments under capital lease obligations                          |                                                                      |                                                     | (88                                                 | )      |                           |         | (11      | )      
|                                                   | Proceeds from common stock issuance                                         |                                                                      |                                                     | 406                                                 |        |                           |         | 1,400    |        
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |          |        
|                                                   |                                                                             |                                                                      |                                                     | Net cash provided by (used in) financing activities |        |                           | 318     |          |         |         | 1,389   |  
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |          |        
|                                                   | Net decrease in cash and cash equivalents                                   |                                                                      |                                                     | (60,996                                             | )      |                           |         | (139,268 | )      
|                                                   | Cash and cash equivalents at beginning of period                            |                                                                      |                                                     | 96,491                                              |        |                           |         | 207,810  |        
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |          |        
|                                                   | Cash and cash equivalents at end of period                                  |                                                                      | $                                                   | 35,495                                              |        |                           | $       | 68,542   |        
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |          |        
|Supplemental Disclosures of Cash Flow Information: |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |         
|                                                   | Cash paid during the period for interest                                    |                                                                      | $                                                   | 7                                                   |        |                           | $       |         |        
|                                                   |                                                                             |                                                                      |                                                     |                                                     |        |                           |         |          |        

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.




NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 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 six months ended June 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 February 20, 2003, the Federal Communications Commission
(FCC) announced the results of 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. While the FCC has not yet issued its
order pursuant to the Triennial Review, the ultimate impact of the FCCs
February 20, 2003 announcement on the Companys business, which relies on
line-sharing to serve certain 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 six months ended June 30, 2003, the Company changed its
estimates of certain accrued liabilities for customer incentives based on the
compilation of sufficient historical data with which to estimate sales
incentives that will not ultimately be claimed by customers. The change in
accounting estimate increased the Companys revenues by $735 and decreased the
Companys

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net loss by $1,449 ($0.01 per share) for the six months ended June 30,
2003. There were no similar changes during the three months ended
June 30, 2003.

Stock-Based Compensation

The Company accounts for stock-based awards to (i) employees 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 six months ended June 30, 2003 and 2002 had the Company
applied the fair value method to account for stock-based awards to employees:

|                                                                                                                                                                 |             |   |                    |       |                  |   |         |       |      |   |         |       |   |   |          |       |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------- | - | ------------------ | ----- | ---------------- | - | ------- | ----- | ---- | - | ------- | ----- | - | - | -------- | ----- | -
|                                                                                                                                                                 |             |   | Three Months Ended |       | Six Months Ended
|                                                                                                                                                                 |             |   | June 30,           |       | June 30,        
|                                                                                                                                                                 |             |   |                    |       |                 
|                                                                                                                                                                 |             |   | 2003               |       | 2002             |   | 2003    |       | 2002
|                                                                                                                                                                 |             |   |                    |       |                  |   |         |       |     
|Net loss, as reported                                                                                                                                            |             | $ | (27,287            | )     |                  | $ | (40,793 | )     |      | $ | (62,009 | )     |   | $ | (97,632  | )    
|Stock-based employee compensation expense
included in the determination of net loss,
as reported                                                                 |             |   | 1,266              |       |                  |   | 124     |       |      |   | 1,302   |       |   |   | 421      |      
|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 |             |   | (3,367             | )     |                  |   | (6,164  | )     |      |   | (5,480  | )     |   |   | (13,080  | )    
|                                                                                                                                                                 |             |   |                    |       |                  |   |         |       |      |   |         |       |   |   |          |      
|Pro forma net loss                                                                                                                                               |             | $ | (29,388            | )     |                  | $ | (46,833 | )     |      | $ | (66,187 | )     |   | $ | (110,291 | )    
|                                                                                                                                                                 |             |   |                    |       |                  |   |         |       |      |   |         |       |   |   |          |      
|Basic and diluted net loss per common share:                                                                                                                     |             |   |                    |       |                  |   |         |       |      |   |         |       |   |   |          |      
|                                                                                                                                                                 | As reported |   | $                  | (0.12 | )                |   | $       | (0.19 | )    |   | $       | (0.28 | ) |   | $        | (0.45 | )
|                                                                                                                                                                 |             |   |                    |       |                  |   |         |       |      |   |         |       |   |   |          |      
|                                                                                                                                                                 | Pro forma   |   | $                  | (0.13 | )                |   | $       | (0.21 | )    |   | $       | (0.30 | ) |   | $        | (0.51 | )
|                                                                                                                                                                 |             |   |                    |       |                  |   |         |       |      |   |         |       |   |   |          |      

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. Such matter was 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). Such amount is reflected in the Companys sales, marketing,
general and administrative expenses for the three and six months ended June 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. $1,139 of such amounts 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 three months ended June 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 June 30, |             | Six Months Ended June 30,
|                                                                                                |  |                             |             |                          
|                                                                                                |  | 2003                        |             | 2002                      |  | 2003 |             | 2002
|                                                                                                |  |                             |             |                           |  |      |             |     
|Weighted-average number of shares of common stock outstanding                                   |  |                             | 223,724,040 |                           |  |      | 219,355,630 |      |  |  | 223,585,104 |  |  |  | 218,135,910 | 
|Less weighted-average number of shares of common stock
subject to repurchase                    |  |                             |            |                           |  |      | 5,625       |      |  |  |            |  |  |  | 12,938      | 
|                                                                                                |  |                             |             |                           |  |      |             |      |  |  |             |  |  |  |             | 
|Weighted-average number of common shares used in computing
basic and diluted net loss per share |  |                             | 223,724,040 |                           |  |      | 219,350,005 |      |  |  | 223,585,104 |  |  |  | 218,122,972 | 
|                                                                                                |  |                             |             |                           |  |      |             |      |  |  |             |  |  |  |             | 

Comprehensive Loss

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

|                                                           |  |            |            |      |  |                    |         |                  |  |      |         |   |  |   |         |   |  |   |         |  
|---------------------------------------------------------- |  | ---------- | ---------- | ---- |  | ------------------ | ------- | ---------------- |  | ---- | ------- | - |  | - | ------- | - |  | - | ------- | -
|                                                           |  |            |            |      |  | Three Months Ended |         | Six Months Ended
|                                                           |  |            |            |      |  | June 30,           |         | June 30,        
|                                                           |  | Cumulative |            |      |  |                   
|                                                           |  | Amounts    |            | 2003 |  | 2002               |         | 2003             |  | 2002
|                                                           |  |            |            |      |  |                    |         |                  |  |     
|Net loss                                                   |  | $          | (1,591,345 | )    |  | $                  | (27,287 | )                |  | $    | (40,793 | ) |  | $ | (62,009 | ) |  | $ | (97,632 | )
|Unrealized gains (losses) on available-for-sale securities |  |            | 87         |      |  |                    | (38     | )                |  |      | 269     |   |  |   | (128    | ) |  |   | 187     |  
|Foreign currency translation adjustment                    |  |            | (962       | )    |  |                    |        |                  |  |      | 1,342   |   |  |   |        |   |  |   | 1,342   |  
|                                                           |  |            |            |      |  |                    |         |                  |  |      |         |   |  |   |         |   |  |   |         |  
|Comprehensive loss                                         |  | $          | (1,592,220 | )    |  | $                  | (27,325 | )                |  | $    | (39,182 | ) |  | $ | (62,137 | ) |  | $ | (96,103 | )
|                                                           |  |            |            |      |  |                    |         |                  |  |      |         |   |  |   |         |   |  |   |         |  

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (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 July 1, 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 June 30, 2003 or the results of its operations for the
three and six months ended June 30, 2003.

In December 2002, the FASB issued Statement of Financial Accounting
Standards (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 June 30, 2003, the
Company has 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. The
Company will prospectively adopt EITF Issue No. 00-21 on July 1, 2003, and it
does not believe the adoption of EITF Issue No. 00-21 will have a material
effect on its 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 in 2002. The Company adopted the recognition and measurement
provisions of FIN No. 45 on a prospective basis with respect to guarantees
issued or

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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 six months ended
June 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 six months ended June 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 six months ended June 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 six months ended June 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 prices 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 $1,282 and $2,258 for the three and six
months ended June 30, 2003, respectively, and $2,908 and $5,896 for the three
and six months ended June 30, 2002, respectively.

As of June 30, 2003, the Company had over 230 wholesale customers. For the
three and six months ended June 30, 2003, the Companys 30 largest customers
collectively comprised 97.4% and 95.7%, respectively, of the Companys total
wholesale revenues and 75.3% and 75.6%, respectively, of the Companys total
revenues. As of June 30, 2003, receivables from these customers collectively
comprised 77.8% of the Companys gross accounts receivable balance. For the
three and six months ended June 30, 2002, these customers collectively
comprised 92.8% and 93.2%, respectively, of the Companys total wholesale
revenues and 79.3% and 80.4%, respectively, of the Companys total revenues.
As of June 30, 2002, receivables from these customers collectively comprised
85.5% of the Companys gross accounts receivable balance.

For the three months ended June 30, 2003, Earthlink, Inc. and AT&T Corp.
(AT&T), two of the Companys wholesale customers, accounted for 23.2% and
11.6%, respectively, of the Companys total net revenues. For the six months
ended June 30, 2003, these customers accounted for 22.2% and 11.5%,
respectively, of the Companys total net revenues. As of June 30, 2003,
receivables from these customers comprised 25.5% and 12.3% of the Companys
gross accounts receivable balance. No other

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individual customer accounted for more than 10% of the Companys total net
revenues during the three and six months ended June 30, 2003.

For the three months ended June 30, 2002, Earthlink, Inc. and XO
Communications (XO), two of the Companys wholesale customers, accounted for
20.1% and 8.7%, respectively, of the Companys total net revenues. For the six
months ended June 30, 2002, these customers accounted for 20.3% and 9.7%,
respectively, of the Companys total net revenues. As of June 30, 2002,
receivables from Earthlink, Inc. comprised 29.9% of the Companys gross
accounts receivable balance. The Company began recognizing revenues from XO on
a cash basis (as described below) during the fourth quarter of 2001. Therefore,
the Companys contractual receivable from XO of $2,414 as of June 30, 2002 was
not recognized in the Companys condensed consolidated balance sheet as of such
date. However, the Company resumed the recognition of revenues from XO on an
accrual basis during the fourth quarter of 2002.

Some of the Companys wholesale customers are experiencing financial
difficulties. During the three and six months ended June 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,
subsequent to the end of the reporting period, the financial condition of such
customers deteriorated significantly and several of them have filed for
bankruptcy protection over the past three years. 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 certain of these customers that have filed for
bankruptcy protection 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 cash for services rendered is collected, assuming all other
criteria for revenue recognition have been met, but only after the collection
of all previous outstanding accounts receivable balances. Payments received
from financially distressed customers during a defined period prior to their
filing of petitions for bankruptcy protection are recorded in the condensed
consolidated balance 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 1.1% and
2.3% of the Companys total net revenues for the three and six months ended
June 30, 2003, respectively, and 20.1% and 20.0% of the Companys total
revenues for the three and six months ended June 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 in relation to the revenue recognition criteria described above.
Consequently, the disclosures in the following paragraph related to 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 continues to attempt to migrate end-users
from some of its financially distressed customers to the extent it is legally
and operationally feasible.

The Company issued billings to its financially distressed customers
aggregating $763 and $3,440 during the three and six months ended June 30,
2003, respectively, which were not recognized as revenues or accounts
receivable in the accompanying condensed consolidated financial statements, as
compared to the corresponding amounts of $13,557 and $32,332 for the three and
six months ended 2002, respectively. However, the Company ultimately recognized
revenues from certain of these customers when cash was collected (as described
above) aggregating $850 and $3,286 during the three and six months ended June
30, 2003, respectively, and $14,507 and $31,369 during the three and six months
ended June 30, 2002, respectively, some of which relates to services provided
in prior periods. In addition, revenues during the three and six months ended
June 30, 2002 include payments totaling $0 and $3,307, respectively, from
bankrupt customers that the Company received prior to January 1, 2002 and
recorded as unearned revenues in its condensed consolidated balance sheet as of
December 31, 2001 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 six months ended
June 30, 2002. The Company had contractual receivables from its financially
distressed customers totaling $5,857 as of June 30, 2003 that are not reflected
in the accompanying condensed consolidated balance sheet as of such date.

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 June 30, 2003, or (ii) have
subsequently paid all or significant portions of the respective amounts
recorded as accounts receivable as of June 30, 2003, may be at risk of becoming
financially distressed. Revenues from these customers accounted for
approximately 21.9% and 22.3% of the Companys total net revenues for the three
and six months ended June 30, 2003, respectively. As of June 30, 2003,
receivables from these customers comprised 33.8% 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 June 30, 2003, revenues from such customers will be recognized
when cash is collected (as described above).

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The Company has billing disputes with some of its customers. These
disputes arise in the ordinary course of business in the telecommunications
industry and their impact on the Companys accounts receivable and revenues can
be reasonably estimated based on historical experience. In addition, certain
revenues are subject to refund if the end-user terminates service within 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 amounted to $950 and $1,621 during the three and six
months ended June 30, 2003, respectively, and $261 and $1,521 during the three
and six months ended June 30, 2002, respectively.

3. Customer Warrants

On January 1, 2003, in conjunction with an amendment to an Agreement for
Broadband Internet Access Services 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%.

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 all of whom were not, indirectly,
end-user customers of the Company as of June 5, 2003 under the 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 existing 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. The Company is
currently soliciting the aforementioned 23,000 DSL customers of Qwest, and over
800 of such customers have been successfully migrated to the Companys network
subsequent to June 5, 2003. In addition, over 8,300 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 September 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 the 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

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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.

6. Reductions in Force

During the three and six months ended June 30, 2003, the Company reduced
its workforce by approximately 43 and 113 employees, respectively, which
represented approximately 3.3% and 8.7% of the Companys workforce,
respectively. The reductions covered employees in the areas of sales and
marketing, operations and corporate functions.

In connection with the reductions in force, the Company recorded charges
to operations for the three and six months ended June 30, 2003 of $604 and
$1,235, respectively, relating to employee severance benefits that met the
requirements for accrual. For the three and six months ended June 30, 2003, $95
and $242, respectively, of these expenses were charged to network and product
costs and the remaining $509 and $993, respectively, were charged to sales,
marketing, general and administrative expenses. During the three and six months
ended June 30, 2003, the Company paid severance benefits of approximately $519
and $1,088, respectively. The Company paid the remainder of the severance
benefits accrued as of June 30, 2003 in July 2003. The expenses associated with
the reductions in force for the three and six months ended June 30, 2003 were
$31 and $103, respectively, related to the Companys Covad Strategic
Partnerships business segment and $320 and $349, respectively, related to the
Companys Covad Broadband Solutions business segment. The remaining expenses
associated with these reductions in force during the three and six months ended
June 30, 2003 of $253 and $783, respectively, 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.

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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 six months ended June 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 Months Ended |       | Six Months Ended
|                                  |  | June 30,           |       | June 30,        
|                                  |  |                    |       |                 
|                                  |  | 2003               |       | 2002             |  | 2003 |       | 2002
|                                  |  |                    |       |                  |  |      |       |     
|Expected life of options in years |  |                    | 4     |                  |  |      | 4     |      |  |  | 4     |   |  |  | 4     |  
|Volatility                        |  |                    | 130.1 |                  |  |      | 140.7 |      |  |  | 130.1 |   |  |  | 140.7 |  
|Risk-free interest rate           |  |                    | 1.66  |                  |  |      | 3.37  |      |  |  | 1.66  |   |  |  | 3.37  |  
|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.                        
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | 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 June 30, 2003, there were approximately $8,346 in unresolved claims
related to the Companys Chapter 11 bankruptcy proceedings. As of June 30,
2003, the Company had recorded $7,383 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 $7,665 as of
June 30, 2002 through credits to litigation-related expenses of $7,146 and
$10,913 for

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the three and six months ended June 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 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 has 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

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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. While the Company believes Mr. Khannas contentions referred to above
are without merit, and will be vigorously defended if brought, it is unable to
predict the outcome of any potential 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 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 February 20, 2003, the FCC issued a press release announcing the
results of its Triennial Review. Based on the Companys understanding of such
press release, the FCCs Triennial Review is a significant development for the
Company for the following reasons:



| |  |  | The FCC announced that it 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 federal rules
requiring line-sharing will be phased out over a three-year period,
during which the Company will be required to transition its existing
line-sharing customers to new arrangements. New line-sharing
customers may be acquired at regulated rates only during the first
year of the transition. During each year of the transition, the
FCC-mandated maximum price for the high-frequency portion of the
phone line will increase incrementally towards the cost of a separate
phone line. This means that, unless the Company reaches agreements
with the local telephone companies that provide the Company with
continued access to line-sharing, it 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. As of June 30, 2003, the Company had
approximately 222,000 subscriber lines using line-sharing agreements.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The FCC also announced that the local telephone companies would
not be 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, the Company will be unable to provide its most
commonly-used services to end-users served by fiber-fed lines. This
is significant for the Companys business 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 Company currently has no lines in service using
packet-switching capabilities of fiber-fed telephone lines.                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  |  | The FCC announced that, if the state public utilities
commissions deem it appropriate, companies that compete with the
local telephone companies would 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). 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
provides the Company with the opportunity to potentially bundle its
data services with the voice services of these companies.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

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The FCC has not yet issued its order in the Triennial Review and it is
uncertain when that order will be released. Without that order, it is difficult
for the Company to evaluate the full impact of the FCCs decision on its
business. However, based on the FCCs announcement, it appears that at some
point the Company will be required to purchase a separate telephone line in
order to provide services to an end-user, unless it reaches agreements with the
local telephone companies that provide the Company with continued access to
line-sharing. The cost of a separate phone line is significantly higher than
the cost of a shared line. 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, which would slow the growth of its revenue and require
it to significantly change its business plan.

In addition, one of the traditional telephone companies has notified the
Company that it claims the decision in the Triennial Review is a change in
law that triggers a renegotiation of its interconnection agreements with the
Company. These agreements contain the prices and other terms for the telephone
lines the Company purchases from this traditional telephone company.

As of June 30, 2003, the Company had disputes with a number of
telecommunications companies concerning the balances owed to such carriers for
collocation fees and certain network services. The Company believes that such
disputes will be resolved without a material adverse effect on its 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.

As of June 30, 2003, the Company was 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 to determine the extent of its 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
six months ended June 30, 2003, the Company changed its estimates of certain
accrued liabilities for transaction-based and property taxes based on
settlement agreements reached with the tax authorities of certain jurisdictions
in which the Company does business. These changes in accounting estimate
reduced the Companys net loss by $2,506 ($0.01 per share) for the six months
ended June 30, 2003. There were no material changes in estimate
during the three months ended June 30, 2003.

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. 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 June 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.

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 and 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

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unusual items not directly attributable or allocated to the segments,
gains and losses on the Companys investments, and income and expenses from the
Companys treasury and financing activities.

The Company evaluates performance and allocates resources to the segments
based on income or loss from operations, excluding certain operating expenses,
including depreciation and amortization, and other income and expense items.
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 six months ended June 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
|June 30, 2003:                                        |  | CSP |        | CBS |  | Segments |        | Operations |  | Eliminations |        | Total    
|                                                      |  |     |        |     |  |          |        |            |  |              |        |          
|Domestic revenues from external customers, net        |  | $   | 56,948 |     |  | $        | 35,497 |            |  | $            | 92,445 |           |  | $            |        |              |  | $ |  |  |  | $ | 92,445  |  
|Network and product costs                             |  | $   | 41,632 |     |  | $        | 16,616 |            |  | $            | 58,248 |           |  | $            | 10,479  |              |  | $ |  |  |  | $ | 68,727  |  
|Sales, marketing, general and administrative expenses |  | $   | 2,466  |     |  | $        | 7,659  |            |  | $            | 10,125 |           |  | $            | 22,175  |              |  | $ |  |  |  | $ | 32,300  |  
|Depreciation and amortization                         |  | $   |       |     |  | $        |       |            |  | $            |       |           |  | $            | 17,776  |              |  | $ |  |  |  | $ | 17,776  |  
|Other expenses, net                                   |  | $   |       |     |  | $        |       |            |  | $            |       |           |  | $            | 929     |              |  | $ |  |  |  | $ | 929     |  
|Net income (loss)                                     |  | $   | 12,850 |     |  | $        | 11,222 |            |  | $            | 24,072 |           |  | $            | (51,359 | )            |  | $ |  |  |  | $ | (27,287 | )
|Total assets                                          |  | $   | 50,397 |     |  | $        | 21,141 |            |  | $            | 71,538 |           |  | $            | 307,257 |              |  | $ |  |  |  | $ | 378,795 |  

|                                                      |  |     |        |     |  |          |        |            |  |              |        |           |  |              |         |              |  |   |   |  |  |   |         |  
|----------------------------------------------------- |  | --- | ------ | --- |  | -------- | ------ | ---------- |  | ------------ | ------ | --------- |  | ------------ | ------- | ------------ |  | - | - |  |  | - | ------- | -
|As of and for the Three Months Ended                  |  |     |        |     |  |          |        |            |  | Total        |        | Corporate |  | Intercompany |         | Consolidated
|June 30, 2002:                                        |  | CSP |        | CBS |  | Segments |        | Operations |  | Eliminations |        | Total    
|                                                      |  |     |        |     |  |          |        |            |  |              |        |          
|Domestic revenues from external customers, net        |  | $   | 58,750 |     |  | $        | 38,983 |            |  | $            | 97,733 |           |  | $            |        |              |  | $ |  |  |  | $ | 97,733  |  
|Network and product costs                             |  | $   | 45,831 |     |  | $        | 16,994 |            |  | $            | 62,825 |           |  | $            | 13,437  |              |  | $ |  |  |  | $ | 76,262  |  
|Sales, marketing, general and administrative expenses |  | $   | 2,290  |     |  | $        | 8,246  |            |  | $            | 10,536 |           |  | $            | 23,297  |              |  | $ |  |  |  | $ | 33,833  |  
|Depreciation and amortization                         |  | $   |       |     |  | $        |       |            |  | $            |       |           |  | $            | 32,192  |              |  | $ |  |  |  | $ | 32,192  |  
|Other (income) expenses, net                          |  | $   |       |     |  | $        |       |            |  | $            |       |           |  | $            | (3,761  | )            |  | $ |  |  |  | $ | (3,761  | )
|Net income (loss)                                     |  | $   | 10,629 |     |  | $        | 13,743 |            |  | $            | 24,372 |           |  | $            | (65,165 | )            |  | $ |  |  |  | $ | (40,793 | )
|Total assets                                          |  | $   | 65,774 |     |  | $        | 19,104 |            |  | $            | 84,878 |           |  | $            | 464,426 |              |  | $ |  |  |  | $ | 549,304 |  

|                                                      |  |     |         |     |  |          |        |            |  |              |         |           |  |              |          |              |  |   |   |  |  |   |         |  
|----------------------------------------------------- |  | --- | ------- | --- |  | -------- | ------ | ---------- |  | ------------ | ------- | --------- |  | ------------ | -------- | ------------ |  | - | - |  |  | - | ------- | -
|For the Six Months Ended                              |  |     |         |     |  |          |        |            |  | Total        |         | Corporate |  | Intercompany |          | Consolidated
|June 30, 2003:                                        |  | CSP |         | CBS |  | Segments |        | Operations |  | Eliminations |         | Total    
|                                                      |  |     |         |     |  |          |        |            |  |              |         |          
|Domestic revenues from external customers, net        |  | $   | 113,397 |     |  | $        | 69,908 |            |  | $            | 183,305 |           |  | $            |         |              |  | $ |  |  |  | $ | 183,305 |  
|Network and product costs                             |  | $   | 81,581  |     |  | $        | 34,056 |            |  | $            | 115,637 |           |  | $            | 22,114   |              |  | $ |  |  |  | $ | 137,751 |  
|Sales, marketing, general and administrative expenses |  | $   | 5,368   |     |  | $        | 16,039 |            |  | $            | 21,407  |           |  | $            | 48,272   |              |  | $ |  |  |  | $ | 69,679  |  
|Depreciation and amortization                         |  | $   |        |     |  | $        |       |            |  | $            |        |           |  | $            | 36,365   |              |  | $ |  |  |  | $ | 36,365  |  
|Other expenses, net                                   |  | $   |        |     |  | $        |       |            |  | $            |        |           |  | $            | 1,519    |              |  | $ |  |  |  | $ | 1,519   |  
|Net income (loss)                                     |  | $   | 26,448  |     |  | $        | 19,813 |            |  | $            | 46,261  |           |  | $            | (108,270 | )            |  | $ |  |  |  | $ | (62,009 | )

|                                                      |  |     |         |     |  |          |        |            |  |              |         |           |  |              |          |              |  |   |   |  |  |   |         |  
|----------------------------------------------------- |  | --- | ------- | --- |  | -------- | ------ | ---------- |  | ------------ | ------- | --------- |  | ------------ | -------- | ------------ |  | - | - |  |  | - | ------- | -
|For the Six Months Ended                              |  |     |         |     |  |          |        |            |  | Total        |         | Corporate |  | Intercompany |          | Consolidated
|June 30, 2002:                                        |  | CSP |         | CBS |  | Segments |        | Operations |  | Eliminations |         | Total    
|                                                      |  |     |         |     |  |          |        |            |  |              |         |          
|Domestic revenues from external customers, net        |  | $   | 118,968 |     |  | $        | 80,431 |            |  | $            | 199,399 |           |  | $            |         |              |  | $ |  |  |  | $ | 199,399 |  
|Network and product costs                             |  | $   | 93,047  |     |  | $        | 36,537 |            |  | $            | 129,584 |           |  | $            | 36,872   |              |  | $ |  |  |  | $ | 166,456 |  
|Sales, marketing, general and administrative expenses |  | $   | 5,379   |     |  | $        | 15,532 |            |  | $            | 20,911  |           |  | $            | 50,126   |              |  | $ |  |  |  | $ | 71,037  |  
|Depreciation and amortization                         |  | $   |        |     |  | $        |       |            |  | $            |        |           |  | $            | 66,674   |              |  | $ |  |  |  | $ | 66,674  |  
|Other (income) expenses, net                          |  | $   |        |     |  | $        |       |            |  | $            |        |           |  | $            | (7,136   | )            |  | $ |  |  |  | $ | (7,136  | )
|Net income (loss)                                     |  | $   | 20,542  |     |  | $        | 28,362 |            |  | $            | 48,904  |           |  | $            | (146,536 | )            |  | $ |  |  |  | $ | (97,632 | )

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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 June 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 46
million homes and businesses in the United States. As of June 30, 2003, we had
approximately 453,000 high-speed Internet access lines in service using DSL and
T-1 technology (approximately 0.3% of these lines are associated with customers
for which we recognize revenue when cash for services rendered is received due
to their financial condition, primarily concentrated among two such customers).
We also provide dial-up Internet access service to over 42,300 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 June
30, 2003, we had an accumulated deficit of $1,591,345. 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. The inability to raise additional
capital could also result in a liquidation or sale of our company.

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 policies and procedures and systems
capabilities have significantly improved controls. However, 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.

Recent Developments

On June 5, 2003, we 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 all of whom were not, indirectly, end-user
customers of the Company as of June 5, 2003 under the existing wholesale DSL
services agreement with Qwest). In exchange for the customer list, we paid
$3,750 in cash and released Qwest from its obligations under the existing
wholesale DSL services agreement. In addition, we will pay Qwest an additional
amount of up to $1,250 if certain levels of these customers successfully
migrate to our network within a defined period. We did not assume any
liabilities or obligations of Qwest or hire any of Qwests employees. In
addition, we do not believe the customer list acquired from Qwest constitutes a
self-sustaining, integrated set of activities and assets that would constitute
a business. We are currently soliciting the aforementioned 23,000 DSL

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customers of Qwest, and over 800 of such customers have been successfully
migrated to our network subsequent to June 5, 2003. In addition, over 8,300
orders have been processed and are pending migration. The solicitation and
migration of these customers to our network is expected to be complete by
September 2003.

On February 20, 2003, the Federal Communications Commission (FCC) issued
a press release announcing the results of its Triennial Review. Based on our
understanding of such press release, the FCCs Triennial Review is a
significant development for us for the following reasons:



| |  |  | The FCC announced that it 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 federal rules requiring
line-sharing will be phased out over a three-year period, during
which we will be required to transition our existing line-sharing
customers to new arrangements. New line-sharing customers may be
acquired at regulated rates only during the first year of the
transition. During each year of the transition, the FCC-mandated
maximum price for the high-frequency portion of the phone line will
increase incrementally towards the cost of a separate phone line.
This means that, unless we reach agreements with the local telephone
companies that provide us with continued access to line-sharing, 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. As of June 30,
2003, we had approximately 222,000 subscriber lines using
line-sharing agreements.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The FCC also announced that the local telephone companies would
not be 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 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. We currently have no lines
in service using packet-switching capabilities of fiber-fed telephone
lines.                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  |  | The FCC announced that, if the state public utilities
commissions deem it appropriate, companies that compete with the
local telephone companies would 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). 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
provides us with the opportunity to potentially bundle our data
services with the voice services of these companies.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

The FCC has not yet issued its order in the Triennial Review and it is
uncertain when that order will be released. Without that order, it is difficult
for us to evaluate the full impact of the FCCs decision on our business.
However, based on the FCCs announcement, it appears that at some point we will
be required to purchase a separate telephone line in order to provide services
to an end-user, unless we reach agreements with the local telephone companies
that provide us with continued access to line-sharing. The cost of a separate
phone line is significantly higher than the cost of a shared line. 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, which would slow the
growth of our revenue and require us to significantly change our business plan.

In addition, one of the traditional telephone companies has notified us
that it claims the decision in the Triennial Review is a change in law that
triggers a renegotiation of our interconnection agreements with it. 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.

Wholesaler Financial Difficulties

Some of our wholesale customers are experiencing financial difficulties.
During the three and six months ended June 30, 2003 and 2002, certain of these
customers either (i) were not current in their payments for our services or
(ii) were essentially current in their payments but, subsequent to the end of
the reporting period, their financial condition deteriorated significantly.
Some of these customers 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 filed for bankruptcy
protection was not reasonably assured. Accordingly, we have classified this
group of customers as

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financially distressed for revenue recognition purposes. Revenues from
financially distressed customers are recognized when cash for services provided
is collected, assuming all other criteria for revenue recognition have been
met, but only after the collection of all previous outstanding accounts
receivable balances. Payments received from financially distressed customers
during a legally defined period prior to their filing of a petition for
bankruptcy protection are included in our condensed consolidated balance sheet
caption Unearned revenues if our ability to retain these payments is not
reasonably assured. Although WorldCom, Inc (WorldCom) filed for bankruptcy
protection during the year ended December 31, 2002, we have not classified it
as a financially distressed customer based on WorldComs specific facts and
circumstances and the revenue recognition criteria described in Note 2 to our
condensed consolidated financial statements. Therefore, we continued to
recognize revenues from WorldCom on an accrual basis during 2002 and 2003.

In order to limit our exposure to the financial difficulties of certain of
our wholesale customers, we have implemented certain policies and taken a
series of actions. We may stop taking new orders from these customers but
continue to install and maintain previously accepted orders. We may terminate
our contracts with those customers who are unresponsive to our collection
efforts. While our goal is to maintain consistent high quality service to
end-users, we may also decide to disconnect some end-users that are purchasing
our services from customers facing financial difficulties and, in some cases,
we may attempt to migrate these end-users to another wholesale customer or to
our own Covad Direct service.

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 $184 and $391 for the three and six months ended June 30, 2003,
respectively, and $347 and $769 for the three and six months ended June 30,
2002, respectively.

Results of Operations

Business Segment Information

During the three and six months ended June 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 and small ISPs and 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.

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Three and Six Months Ended June 30, 2003 and 2002

Revenues, Net

We recorded net revenues of $92,445 for the three months ended June 30,
2003, a decrease of $5,288, or 5.4%, over net revenues of $97,733 for the three
months ended June 30, 2002. We recorded net revenues of $183,305 for the six
months ended June 30, 2003, a decrease of $16,094, or 8.1% over net revenues of
$199,399 for the six months ended June 30, 2002. The decrease in net revenues
is primarily attributable to an increase in customer incentives and rebates,
which we recorded as reductions of revenues, and a decrease in Federal
Universal Service Fund (FUSF) charges billed to our customers, as further
described below, the impact of which was partially offset by an increase in the
number of end-users. In addition, 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. The amounts of these
payments from these bankrupt customers were not material during the three and
six months ended June 30, 2003. Although we expect our subscriber base to grow
as we introduce new services and continue to execute on our sales and marketing
programs, our revenue growth may continue to be impaired by lower selling
prices 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. If we stop selling stand-alone consumer grade services, our revenue
growth would be adversely affected since approximately 27.1% of our revenue
during the three months ended June 30, 2003 was from sales of consumer grade
services.

Included in net revenues are FUSF charges billed to our customers
aggregating $1,282 and $2,258 for the three and six months ended June 30, 2003,
respectively, and $2,908 and $5,896 for the three and six months ended June 30,
2002. The decrease in FUSF was primarily driven by the change in the
applicability of FUSF to some of our wholesale customers.

We recorded net revenues of $56,948 and $35,497 from our CSP and CBS
business segments, respectively, for the three months ended June 30, 2003, a
decrease of $1,802, or 3.1%, and $3,486, or 8.9%, over net revenues of $58,750
and $38,983, respectively, for the three months ended June 30, 2002. We
recorded net revenues of $113,397 and $69,908 from our CSP and CBS business
segments, respectively, for the six months ended June 30, 2003, a decrease of
$5,571, or 4.7%, and $10,523, or 13.1%, over net revenues of $118,968 and
$80,431, respectively, for the six months ended June 30, 2002. As described
above, the decrease in revenue 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 61.6% and 61.9% of total net revenues for the three and six months
ended June 30, 2003, respectively, and 60.1% and 59.7% of the total revenues
for the three and six months ended June 30, 2002, respectively. Net revenues
from our CBS business segment represented 38.4% and 38.1% of total net revenues
for the three and six months ended June 30, 2003, respectively, and 39.9% and
40.3% of the total revenues for the three and six months ended June 30, 2002,
respectively.

We had over 230 wholesale customers as of June 30, 2003, as compared to
approximately 130 as of June 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 75.3% and 75.6% of the Companys total net revenues for the three and
six months ended June 30, 2003, respectively, and (9 from CSP and 21 from CBS)
collectively comprised 79.3% and 80.4% of the Companys total net revenues for
the three and six months ended June 30, 2002, respectively. As of June 30, 2003
and 2002, receivables from these 30 customers collectively comprised 77.8% and
85.5%, respectively, of our gross accounts receivable balance.

For the three months ended June 30, 2003, EarthLink, Inc. and AT&T Corp.
(AT&T), two wholesale customers in our CSP business segment, accounted for
23.2% and 11.6% of our total net revenues. For the six months ended June 30,
2003, these customers accounted for 22.2% and 11.5% of our total net revenues.
As of June 30, 2003, receivables from these customers comprised 25.5% and 12.3%
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 June 30, 2003.

For the three months ended June 30, 2002, Earthlink, Inc. and XO
Communications (XO), two wholesale customers in our CSP business segment,
accounted for 20.1% and 8.7%, respectively, of our total net revenues. For the
six months ended June 30, 2002, these customers in our CSP business segment
accounted for 20.3% and 9.7%, respectively, of our total net revenues. As of
June 30, 2002, receivables from Earthlink, Inc. comprised 29.9% of our gross
accounts receivable balance. We began recognizing revenues from XO on a cash
basis (as described below) during the fourth quarter of 2001. Therefore, our
contractual receivable from XO of

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$2,414 as of June 30, 2002 was not recognized in our condensed
consolidated balance sheet as of such date. However, we resumed the recognition
of revenues from XO on an accrual basis during the fourth quarter of 2002.

Some of our wholesale customers are experiencing financial difficulties.
During the three and six months ended June 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, subsequent to the end of
the reporting period, the financial condition of such customers deteriorated
significantly. In addition, several of them have 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 have filed for bankruptcy protection 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 cash for those services is collected, 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 recorded in the
condensed consolidated balance sheet caption Unearned revenues until the
preference period has expired.

Some of our customers are currently in bankruptcy proceedings. Revenues
from these customers accounted for approximately 1.1% and 2.3% of our
total net revenues for the three and six months ended June 30, 2003,
respectively, and 20.1% and 20.0% of our total revenues for the three and six
months ended June 30, 2002, respectively. As described above, 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 continue to 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
$763 and $3,440 during the three and six months ended June 30, 2003,
respectively, which were not recognized as revenues or accounts receivable in
our condensed consolidated financial statements, as compared to the
corresponding amounts of $13,557 and $32,332 for the three and six months ended
June 30, 2002, respectively. However, we ultimately recognized revenues from
certain of these customers when cash was collected aggregating $850 and $3,286
during the three and six months ended June 30, 2003, respectively, and $14,507
and $31,369 during the three and six months ended June 30, 2002, respectively,
some of which relates to services provided in prior periods. Revenues
recognized during the three and six months ended June 30, 2002 include payments
totaling $0 and $3,307, respectively, from certain bankrupt customers that we
received prior to January 1, 2002 and recorded as unearned revenues in our
consolidated balance sheet as of December 31, 2001 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 determined that our ability to retain these payments was
reasonably assured prior to June 30, 2002. Consequently, we recognized these
payments as revenues during the six months ended June 30, 2002. We had
contractual receivables from our financially distressed customers totaling
$5,857 as of June 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, there is a high probability 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 prior to June 30, 2003, or have subsequently paid all or significant
portions of the respective amounts that we recorded as accounts receivable as
of June 30, 2003, may be at risk of becoming financially distressed. Revenues
from these customers accounted for approximately 21.9% and 22.3% of our total
net revenues for the three and six months ended June 30, 2003, respectively,
and 26.1% and 24.8% of our total net revenues for the three and six months
ended June 30, 2002, respectively. As of June 30, 2003, receivables from these
customers comprised 33.8% 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 June 30, 2003, revenue from such
customers will be recognized when cash is collected, as described above.

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 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

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these disputes and future service cancellations. These charges to revenues
amounted to $950 and $1,621 during the three and six months ended June 30,
2003, respectively, and $261 and $1,521 during the three and six months ended
June 30, 2002, respectively.

During the six months ended June 30, 2003, we changed our estimates of
certain accrued liabilities for customer incentives based on the compilation of
sufficient historical data with which to estimate sales incentives that will not ultimately be
claimed by customers. The change in accounting estimate increased our revenues
by $735 and decreased our net loss by $1,449 ($0.01 per share) for the six
months ended June 30, 2003. There were no similar changes during the three
months ended June 30, 2003.

Network and Product Costs

We recorded network and product costs of $68,727 for the three months
ended June 30, 2003, a decrease of $7,535, or 9.9% from the network and product
costs of $76,262 for the three months ended June 30, 2002. For the three months
ended June 30, 2003, network and product costs were 74.3% of revenues, an
improvement from the three months ended June 30, 2002, when network and product
costs were 78.0% of revenues. We recorded network and product costs of $137,751
for the six months ended June 30, 2003, a decrease of $28,705, or 17.2%, from
network and product costs of $166,456 for the six months ended June 30, 2002.
For the six months ended June 30, 2003, network and product costs were 75.1% of
revenues, an improvement from the six months ended June 30, 2002, when network
and product costs were 83.5% of revenues. For the three months ended June 30,
2003 and 2002, network and product costs were comprised of $41,632 and $45,831,
respectively, from our CSP business segment, $16,616 and $16,994, respectively,
from our CBS business segment and $10,479 and $13,437, respectively, from our
Corporate Operations. For the six months ended June 30, 2003 and 2002, network
and product costs were comprised of $81,581 and $93,047, respectively, from our
CSP business segment, $34,056 and $36,537, respectively, from our CBS business
segment and, $22,114 and $36,872, respectively, from our Corporate Operations.

The decrease in network and product costs during the three and six months
ended June 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. In addition, during the six
months ended June 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 reductions in our accounting estimate decreased our network
and product costs by $2,506 during the six months ended June 30, 2003, and
decreased our net loss by $2,506 ($0.01 per share) for the six months ended
June 30, 2003. Network and product costs for the six months ended June 30, 2003
include a charge of $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 six months ended June 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 if we are able to add subscribers
and services 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 and existing
customers.

Sales, Marketing, General and Administrative Expenses

We recorded sales, marketing, general and administrative expenses of
$32,300 for the three months ended June 30, 2003, a decrease of $1,533, or
4.5%, over sales, marketing, general and administrative expenses of $33,833
recorded for the three months ended June 30, 2002. We recorded sales,
marketing, general and administrative expenses of $69,679 for the six months
ended June 30, 2003, a decrease of $1,358, or 1.9%, over sales, marketing,
general and administrative expenses of $71,037 recorded for the six months
ended June 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 June 30, 2003 and 2002, sales,
marketing, general and administrative expenses were comprised of $2,466 and
$2,290, respectively, from our CSP business segment, $7,659 and $8,246,
respectively, from our CBS business segment and $22,175 and $23,297,
respectively, from our Corporate Operations. For the six months ended June 30,
2003 and 2002, sales, marketing, general and administrative expenses were
comprised of $5,368 and $5,379 from our CSP business segment, respectively,
$16,039 and $15,532 from our CBS business segment, respectively, and $48,272
and $50,126 from our Corporate Operations, respectively.

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The decrease in sales, marketing, general and administrative expenses for
the three months and six months ended June 30, 2003 is primarily attributable
to a reduction in our workforce and lower advertising and marketing expenses.
For the three months ended June 30, 2003, the decrease in sales, marketing,
general and administrative expenses was partially offset by a charge of $1,237
for additional stock-based compensation expense that relates to prior periods
(refer to Note 1 to the accompanying condensed consolidated financial statements). For the six months ended
June 30, 2003, the decrease in sales, marketing, general and administrative
expenses was partially offset by a charge of $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 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 $118,639 and $243,829, respectively, for the three and six months
ended June 30, 2003, a decrease of $18,618, or 13.6%, and $51,468, or 17.4%,
over operating expenses of $137,257 and $295,297, respectively, for the three
and six months ended June 30, 2002. Operating expenses for the three months
ended June 30, 2003 and 2002 were comprised of $44,098 and $48,121,
respectively, from our CSP business segment, $24,275 and $25,240, respectively,
from our CBS business segment and $50,266 and $63,896, respectively, from our
corporate operations. For the six months ended June 30, 2003 and 2002,
operating expenses were comprised of $86,949 and $98,426, respectively, from
our CSP business segment, $50,095 and $52,069, respectively, from our CBS
business segment and $106,785 and $144,802, respectively, from our corporate
operations.

Provision for Bad Debts (Bad Debt Recoveries), Net

We recorded net bad debt expenses (recoveries) of $(164) and $2,116 for
the three months ended June 30, 2003 and 2002, respectively. Bad debt expenses
(recoveries) were 0.2% and 2.2% of net revenues for the three months ended June
30, 2003 and 2002, respectively. We recorded net bad debt expenses (recoveries)
of $34 and $2,043 for the six months ended June 30, 2003 and 2002,
respectively. Bad debt expenses (recoveries) were 0.02% and 1.0% of net
revenues for the six months ended June 30, 2003 and 2002, respectively. The
decrease in bad debt expense is the result of better collection efforts and bad
debt recoveries.

Depreciation and Amortization

We recorded depreciation and amortization expense for property and
equipment in the amount of $13,752 for the three months ended June 30, 2003, a
decrease of $14,779, or 51.8%, from depreciation and amortization expense for
property and equipment of $28,531 for the three months ended June 30, 2002. We
recorded depreciation and amortization expense for property and equipment in
the amount of $28,345 for the six months ended June 30, 2003, a decrease of
$31,039, or 52.3% from depreciation and amortization expense for property and
equipment of $59,384 for the six months ended June 30, 2002. The decrease from
2002 to 2003 was due principally to asset retirements and certain assets
becoming fully depreciated during 2002 and 2003. We expect depreciation and
amortization to decrease in the future because we anticipate that our capital
expenditures in the near term will be less than historical amounts and
additional assets will become fully depreciated. We believe that the geographic
footprint of our network will remain relatively unchanged and that near term
capital expenditures will be mostly limited to adding capacity to our network
to support new users.

Amortization of intangible assets was $4,024 for the three months ended
June 30, 2003, representing an increase of $363, or 9.9%, over the
amortization of intangible assets of $3,661 for the three months ended June 30,
2002. Amortization of intangible assets was $8,020 for the six months ended
June 30, 2003, representing an increase of $730, or 10.0%, over the
amortization of intangible assets of $7,290 for the six months ended June 30,
2002. The increase from 2002 to 2003 resulted from the resumption of our
network build and augmentation of our network in selected markets during the
latter portion of 2002 and the six months ended June 30, 2003, which increased
collocation fee expenditures and related amortization expenses. We do not
expect to 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.

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Reductions in Force

During the three and six months ended June 30, 2003, we reduced our
workforce by approximately 43 and 113 employees, respectively, which
represented approximately 3.3% and 8.7% of our workforce, respectively. The
reductions covered employees in the areas of sales and marketing, operations
and corporate functions.

In connection with the reductions in force, we recorded charges to
operations for the three and six months ended June 30, 2003 of $604 and $1,235,
respectively, relating to employee severance benefits that met the requirements
for accrual. For the three and six months ended June 30, 2003, $95 and $242,
respectively, of these expenses were charged to network and product costs and
the remaining $509 and $993, respectively, were charged to sales, marketing,
general and administrative expenses. During the three and six months ended June
30, 2003, we paid severance benefits of approximately $519 and $1,088,
respectively. We paid the remainder of the severance benefits accrued as of
June 30, 2003 in July 2003. The expenses associated with the reductions in
force for the three and six months ended June 30, 2003 were $31 and $103,
respectively, related to our Covad Strategic Partnerships business segment and
$320 and $349, respectively, related to our Covad Broadband Solutions business
segment. The remaining expenses associated with these reductions in force
during the three and six months ended June 30, 2003 of $253 and $783,
respectively, were related to our Corporate Operations.

Litigation-related Expenses

We recorded a credit to litigation-related expenses of $7,146 and $10,913
for the three and six months ended June 30, 2002. The credit represents 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 credits for the three and six months ended June 30, 2003.

Net Interest Income (Expense)

Net interest income (expense) was $(820) and $(1,483) for the three and
six months ended June 30, 2003, respectively, and $(331) and $(237) for the
three and six months ended June 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 equivalents and short-term investments 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 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 June 30, 2003 in the amount of $189. This included an impairment
write-down of an equity investment of $97 and our equity in the losses of
unconsolidated affiliates of $92. We recorded losses and write-downs on
investments for the six months ended June 30, 2003 in the amount of $405. This
included an impairment write-down of an equity investment of $209 and our
equity in the losses of unconsolidated affiliates of $196.

We recorded losses and write-downs on investments for the three months
ended June 30, 2002 in the amount of $1,208. This included a net realized loss
on the sale of certain investments in unconsolidated affiliates of $996 and our
equity in the losses of unconsolidated affiliates of $212. We recorded losses
and write-downs on investments for the six months ended June 30, 2002 in the
amount of $1,256. 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 $603 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.

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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. 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,
some of which were experiencing financial difficulties as of June 30,
2003 and 2002 and were not current in their payments for our services
as of those dates. 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 June 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 June 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 matters, as
well as potential ranges of probable losses for certain of these
matters. The determination of the liabilities required, 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                            

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| |  |  | 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 to determine the extent of our
transaction-based tax liabilities. We believe that these discussions
will be concluded without a material adverse effect to 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 and the discussions with
applicable jurisdictions 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 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

In January 2003, the Financial Accounting Standards Board (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 July 1, 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 the our consolidated financial position
as of June 30, 2003 or the results of our operations for the three and six
months ended June 30, 2003.

In December 2002, the FASB issued Statement of Financial Accounting
Standards (SFAS) number (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 June 30, 2003, we
have 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. 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 six months ended June 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 six months ended June 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 six months ended June 30, 2003.

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 six
months ended June 30, 2003.

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
software, the purchase of telecommunications equipment and the design,
development and maintenance of our networks. Capital expenditures were $13,775
and $22,597 for the three and six months ended June 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 current
period. 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 June 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

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payable), a $75,000 collateralized deposit and $719,000 in net proceeds
raised from public equity offerings. As of June 30, 2003, we had an accumulated
deficit of $1,591,345 and unrestricted cash, cash equivalents and short-term
investments of $154,199. In addition, we had stockholders equity as of June
30, 2003 of $24,523.

Net cash used in our operating activities was $29,792 for the six months
ended June 30, 2003. The net cash used in our operating activities during this
period was primarily due to the net loss of $60,772, partially offset by
depreciation and amortization charges of $36,365 and net usage of cash from
changes in our current assets and liabilities.

Net cash used in our investing activities was $31,522 for the six months
ended June 30, 2003. The net cash used in our investing activities during this
period was primarily due to purchases of short-term investments of $93,580 and
capital expenditures of $22,597, offset by maturities of short-term investments
of $83,555.

Net cash provided by our financing activities was $318 for the six months
ended June 30, 2003. The net cash provided by our financing activities during
this period was due to proceeds from the issuance of common stock of $406,
offset by principal payments under capital lease obligations of $88.

As of June 30, 2003, we had $35,495 in unrestricted cash and cash
equivalents, and $118,704 in unrestricted short-term investments. We expect to
experience negative cash flow from operating and investing activities 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 decision in the Triennial Review, 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 February 20, 2003, the FCC announced the results of the Triennial
Review of its rules for network unbundling obligations of Incumbent Local
Exchange Carriers. Among other things, the FCC announced that it will phase-out
its rule requiring line-sharing over a three-year period. While the FCC has not
yet issued its order pursuant to the Triennial Review, the ultimate impact of
the FCCs February 20, 2003 announcement 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, although it has not yet issued its final order. The order,
when issued, 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 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. 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 the second half of
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 has not yet issued its order in the Triennial
Review, and we may be adversely affected by the manner in which the
FCC implements that decision.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | 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.                                                                                                                                                                                                                                     
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | We do not currently have 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 and additional deployment of
fiber-fed lines by the ILECs will continue to reduce our addressable
market.              
|
| |  |  | We are developing 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 have only deployed this
service on a limited basis and we are experiencing operational
challenges as we work with the traditional telephone companies.                            
|
| |  |  | We may need to raise additional capital under difficult
financial market conditions in order to maintain our operations.                                                                                                                                                                                                                                     
|
| |  |  | Employees of Qwest Communications and Verizon Communications
have threatened to go on strike in August of this year. If these
labor stoppages occur, they may impair our ability to provide service
to new end-users and perform maintenance for existing end-users.
These events could impair our revenue growth and increase our network
and product costs.
|
| |  |  | 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.                                                                                                                                                                                     
|
| |  |  | If we do not reduce our end-user disconnection rate our revenue
and end-user growth will decline.                                                                                                                                                                                                                                                            
|
| |  |  | We may experience decreasing 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.                                                                                                                                                                                                                                                                           

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| |  |  | 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.                                                                                                                      
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | 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;                                                                                    
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | 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 as to the impact of our service offerings on our margins;                                                                                                                                                                               
|
| |  |  | 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;                                                                                                                                                                                                                

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| |  |  | plans to enter into business arrangements with broadband-related service providers;                    
| | - |  | -------------------------------------------------------------------------------------------------------
|
| |  |  | 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 announcement and 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.

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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 June 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
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 June 30, 2003, there were approximately $8,346 in unresolved claims
related to our Chapter 11 bankruptcy proceedings. As of June 30, 2003, we have
recorded $7,383 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 has
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. While we believe the contentions of Mr. Khanna referred to above are
without merit, and will be vigorously defended if brought, we are unable to
predict the outcome of any potential 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.

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.

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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

None.




Item 3.Defaults upon Senior Securities

None.




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

None.




Item 5.Other Information

None.




Item 6.Exhibits and Reports on Form 8-K

a.     Exhibits:

|        |  |                                                                                                                        
|------- |  | -----------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                        
|Number  |  | Description                                                                                                            
|        |  |                                                                                                                        
|10.38   |  | Covad Communications Group, Inc. 2003 Employee Stock Purchase Plan                                                     
|        |  |                                                                                                                        
|10.39   |  | Covad Communications
Group, Inc. Executive Severance Plan and Summary Plan Description                                 
|        |  |                                                                                                                        
|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 April 14, 2003, we furnished a current report on Form 8-K, pursuant to
Item 12 thereof, attaching a copy of a press release dated April 10, 2003.

On May 15, 2003, we furnished a current report on Form 8-K, pursuant to
Item 12 thereof, attaching a copy of a press release dated May 15, 2003.

On June 24, 2003, we filed a current report on Form 8-K, pursuant to Item
5 thereof, announcing that Brad Sonnenberg had resigned as our Senior Vice
President and General Counsel.

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.

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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: July 31, 2003 |  |                                  |     |                             
|                    |  |                                  | By: | /s/ MARK A. RICHMAN         
|                    |  |                                  |     |                             
|                    |  |                                  |     | Mark A. Richman             
|                    |  |                                  |     | Executive Vice President and
|Date: July 31, 2003 |  |                                  |     | Chief Financial Officer     

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|        |  |                                                                                                                        
|------- |  | -----------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                        
|Number  |  | Description                                                                                                            
|        |  |                                                                                                                        
|10.38   |  | Covad Communications Group, Inc. 2003 Employee Stock Purchase Plan.                                                    
|        |  |                                                                                                                        
|10.39   |  | Covad Communications
Group, Inc. Executive Severance Plan and Summary Plan Description.                                
|        |  |                                                                                                                        
|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.



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