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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 SECURITIESEXCHANGE ACT OF 1934For the quarterly period ended September 30, 2004o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934For 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. Employerof incorporation or organization)
    
    Identification Number)110 Rio RoblesSan Jose, CA
    
    95134(Address of principal executive offices)
    
    (Zip Code)
 (408) 952-6400(Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes x No o Indicate by check mark whether the registrant is an accelerated filer (as
described by Rule 12b-2 of the Exchange Act).
Yes x No o APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes x No o As of October 18, 2004 there were 260,652,933 shares outstanding of the
Registrants Common Stock, including Class B Common Stock.




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##### Table of Contents



TABLE OF CONTENTS COVAD COMMUNICATIONS GROUP, INC. FORM 10-Q TABLE OF CONTENTS PagePART I.
    
    FINANCIAL INFORMATIONITEM 1.
    
    CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
    
    
    2CONDENSED CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER
30, 2004 AND DECEMBER 31, 2003
    
    
    2CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR
THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30,
2004 AND 2003
    
    
    3CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
    
    
    4NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
    
    
    5ITEM 2.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    19ITEM 3.
    
    MARKET RISK
    
    
    37ITEM 4.
    
    CONTROLS AND PROCEDURES
    
    
    37PART II.
    
    OTHER INFORMATIONITEM 1.
    
    LEGAL PROCEEDINGS
    
    
    39ITEM 2.
    
    CHANGES IN SECURITIES AND USE OF PROCEEDS
    
    
    41ITEM 3.
    
    DEFAULTS UPON SENIOR SECURITIES
    
    
    41ITEM 4.
    
    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    
    
    41ITEM 5.
    
    OTHER INFORMATION
    
    
    41ITEM 6.
    
    EXHIBITS
    
    
    41SIGNATURES
    
    
    42EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
 1




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PART I. FINANCIAL INFORMATION 
 Item 1.Condensed Consolidated Financial Statements COVAD COMMUNICATIONS GROUP, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except par value)
 September 30,
    
    December 31,2004
    
    2003(Unaudited)
    
    (Restated)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    97,623
    
    
    $
    65,376Short-term investments
    
    
    65,287
    
    
    
    48,969Restricted cash and cash equivalents
    
    
    2,842
    
    
    
    2,892Accounts receivable, net of allowances of $2,511 at September 30, 2004 ($4,951 at December 31, 2003)
    
    
    30,094
    
    
    
    28,528Unbilled revenues
    
    
    4,552
    
    
    
    5,127Other receivables
    
    
    945
    
    
    
    637Inventories
    
    
    4,432
    
    
    
    5,335Prepaid expenses and other current assets
    
    
    5,400
    
    
    
    3,761Total current assets
    
    
    211,175
    
    
    
    160,625Property and equipment, net
    
    
    82,161
    
    
    
    94,279Collocation fees and other intangible assets, net
    
    
    39,453
    
    
    
    40,848Goodwill
    
    
    36,626
    
    
    
    Deferred costs of service activation
    
    
    29,582
    
    
    
    31,486Deferred customer incentives
    
    
    3,120
    
    
    
    4,431Deferred debt issuance costs
    
    
    4,446
    
    
    
    Other long-term assets
    
    
    2,357
    
    
    
    3,042Total assets
    
    $
    408,920
    
    
    $
    334,711LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)Current liabilities:Accounts payable
    
    $
    18,440
    
    
    $
    12,982Accrued compensation
    
    
    16,951
    
    
    
    21,661Accrued collocation and network service fees
    
    
    22,363
    
    
    
    18,714Accrued transaction-based taxes
    
    
    33,469
    
    
    
    35,268Accrued interest
    
    
    156
    
    
    
    5,683Accrued market development funds and customer incentives
    
    
    5,260
    
    
    
    7,024Unresolved claims related to bankruptcy proceedings
    
    
    364
    
    
    
    7,378Collateralized customer deposit
    
    
    7,864
    
    
    
    Unearned revenues
    
    
    4,542
    
    
    
    Other accrued liabilities
    
    
    7,150
    
    
    
    5,607Total current liabilities
    
    
    116,559
    
    
    
    114,317Long-term debt
    
    
    125,000
    
    
    
    50,000Collateralized customer deposit
    
    
    46,508
    
    
    
    60,258Deferred gain resulting from deconsolidation of subsidiary
    
    
    53,963
    
    
    
    53,963Unearned revenues
    
    
    51,714
    
    
    
    61,726Other long-term liabilities
    
    
    2,357
    
    
    
    Total liabilities
    
    
    396,101
    
    
    
    340,264Contingencies (Note 6)Stockholders equity (deficit):Preferred stock, $0.001 par value; 5,000 shares authorized; no shares issued and outstanding at
September 30, 2004 and December 31, 2003
    
    
    
    
    
    
    Common Stock, $0.001 par value; 590,000 shares authorized; 260,642 shares issued and outstanding at
September 30, 2004 (230,163 shares issued and outstanding at December 31, 2003)
    
    
    261
    
    
    
    230Common Stock  Class B, $0.001 par value; 10,000 shares authorized; no shares issued and
outstanding at September 30, 2004 and December 31, 2003
    
    
    
    
    
    
    Additional paid-in capital
    
    
    1,691,549
    
    
    
    1,651,267Deferred stock-based compensation
    
    
    (1,602
    )
    
    
    (14,459
    )Accumulated other comprehensive loss
    
    
    (1,010
    )
    
    
    (953
    )Accumulated deficit
    
    
    (1,676,379
    )
    
    
    (1,641,638
    )Total stockholders equity (deficit)
    
    
    12,819
    
    
    
    (5,553
    )Total liabilities and stockholders equity (deficit)
    
    $
    408,920
    
    
    $
    334,711
 See accompanying notes to the condensed consolidated financial statements. 2




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COVAD COMMUNICATIONS GROUP, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share amounts)
(Unaudited) Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003(Restated)
    
    
    
    
    
    (Restated)Revenues, net
    
    $
    105,687
    
    
    $
    100,507
    
    
    $
    321,490
    
    
    $
    283,812Operating expenses:Cost of sales (exclusive of depreciation and amortization)
    
    
    65,939
    
    
    
    77,215
    
    
    
    196,981
    
    
    
    214,724Selling, general and administrative
    
    
    35,488
    
    
    
    37,627
    
    
    
    100,668
    
    
    
    106,347Depreciation and amortization of property and equipment
    
    
    14,078
    
    
    
    13,054
    
    
    
    42,735
    
    
    
    41,399Amortization of collocation fees and other intangible assets
    

    
    5,328
    
    
    
    4,775
    
    
    
    15,121
    
    
    
    12,795Provision for restructuring expenses
    
    
    145
    
    
    
    
    
    
    
    915
    
    
    
    1,235Total operating expenses
    
    
    120,978
    
    
    
    132,671
    
    
    
    356,420
    
    
    
    376,500Loss from operations
    
    
    (15,291
    )
    
    
    (32,164
    )
    
    
    (34,930
    )
    
    
    (92,688
    )Other income (expense):Interest income
    
    
    1,044
    
    
    
    448
    
    
    
    1,879
    
    
    
    1,737Provision for impairment of investments in unconsolidated
affiliates
    
    
    
    
    
    
    (538
    )
    
    
    
    
    
    
    (747
    )Equity in losses of unconsolidated affiliates
    
    
    
    
    
    
    (83
    )
    
    
    
    
    
    
    (279
    )Interest expense
    
    
    (1,281
    )
    
    
    (1,376
    )
    
    
    (3,646
    )
    
    
    (4,148
    )Miscellaneous income, net
    
    
    1,724
    
    
    
    282
    
    
    
    1,956
    
    
    
    685Other income (expense), net
    
    
    1,487
    
    
    
    (1,267
    )
    
    
    189
    
    
    
    (2,752
    )Net loss
    
    $
    (13,804
    )
    
    $
    (33,431
    )
    
    $
    (34,741
    )
    
    $
    (95,440
    )Basic and diluted net loss per share
    
    $
    (0.05
    )
    
    $
    (0.15
    )
    
    $
    (0.14
    )
    
    $
    (0.43
    )Weighted-average number of common shares used in computing
basic and diluted net loss per share
    
    
    260,304
    
    
    
    224,873
    
    
    
    245,219
    
    
    
    224,019
 See accompanying notes to the condensed consolidated financial statements. 3




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COVAD COMMUNICATIONS GROUP, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
(Unaudited)
 Nine Months Ended September 30,2004
    
    2003(Restated)Operating Activities:Net loss
    
    $
    (34,741
    )
    
    $
    (95,440
    )Adjustments to reconcile net loss to net cash used in operating activities:Provision for bad debts (bad debt recoveries), net
    
    
    (1,903
    )
    
    
    26Depreciation and amortization
    
    
    57,856
    
    
    
    54,194Loss on disposition of property and equipment
    
    
    152
    
    
    
    221Amortization of deferred stock-based compensation
    
    
    896
    
    
    
    9,613Amortization of deferred customer incentives
    
    
    1,311
    
    
    
    Other stock-based compensation
    
    
    14
    
    
    
    86Other non-cash charges
    
    
    530
    
    
    
    1,311Accretion of interest on investments, net
    
    
    (540
    )
    
    
    (956
    )Equity in losses of unconsolidated affiliates
    
    
    
    
    
    
    279Provision for impairment of investments in unconsolidated affiliates
    
    
    
    
    
    
    747Net changes in operating assets and liabilities, net of assets acquired
and liabilities assumed in purchase acquisition:Accounts receivable
    
    
    870
    
    
    
    (6,050
    )Unbilled revenues
    
    
    575
    
    
    
    (1,881
    )Inventories
    
    
    927
    
    
    
    (2,133
    )Prepaid expenses and other current assets
    
    
    (1,847
    )
    
    
    3,332Deferred costs of service activation
    
    
    1,904
    
    
    
    8,438Accounts payable
    
    
    2,092
    
    
    
    1,609Unresolved claims related to bankruptcy proceedings
    
    
    (64
    )
    
    
    151Collateralized customer deposit
    
    
    (5,886
    )
    
    
    (5,987
    )Other current liabilities
    
    
    (9,075
    )
    
    
    6,842Unearned revenues
    
    
    (5,470
    )
    
    
    (10,327
    )Net cash provided by (used in) operating activities
    
    
    7,601
    
    
    
    (35,925
    )Investing Activities:Purchases of short-term investments
    
    
    (125,864
    )
    
    
    (113,486
    )Maturities of short-term investments
    
    
    110,030
    
    
    
    155,644Restricted cash and cash equivalents
    
    
    50
    
    
    
    (145
    )Purchases of property and equipment
    
    
    (28,841
    )
    
    
    (30,401
    )Proceeds from sales of property and equipment
    
    
    84
    
    
    
    60Recovery of internal use software costs
    
    
    
    
    
    
    1,592Payment of collocation fees and purchase of other intangible assets
    
    
    (7,005
    )
    
    
    (11,020
    )Cash acquired through acquisition
    
    
    107
    
    
    
    Acquisition costs
    
    
    (473
    )
    
    
    Decrease of other long-term assets
    
    
    720
    
    
    
    21Net cash used in investing activities
    
    
    (51,192
    )
    
    
    2,265Financing Activities:Principal payments under capital lease obligations
    
    
    (132
    )
    
    
    (134
    )Proceeds from common stock issuance
    
    
    4,190
    
    
    
    5,172Proceeds from common stock issuance related to acquisition
    
    
    1,781
    
    
    
    Proceeds from issuance of senior unsecured convertible bond, net
    
    
    119,999
    
    
    
    Principal payments of long-term debt
    
    
    (50,000
    )
    
    
    Net cash provided by financing activities
    
    
    75,838
    
    
    
    5,038Net increase (decrease) in cash and cash equivalents
    
    
    32,247
    
    
    
    (28,622
    )Cash and cash equivalents at beginning of period
    
    
    65,376
    
    
    
    94,416Cash and cash equivalents at end of period
    
    $
    97,623
    
    
    $
    65,794Supplemental Disclosures of Cash Flow Information:Cash paid during the period for interest
    
    $
    8,513
    
    
    $
    9Common stock issued in settlement of claims related to bankruptcy
    
    $
    6,951
    
    
    $
    Common stock, options, and warrants issued for acquisition of business
    
    $
    39,363
    
    
    $
    
 See accompanying notes to the condensed consolidated financial statements. 4




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COVAD COMMUNICATIONS GROUP, INC. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(All dollar and share amounts are presented in thousands, except per share amounts)
(Unaudited) 1. Basis of Presentation and Summary of Significant Accounting Policies The condensed consolidated financial statements include the accounts of
Covad Communications Group, Inc. (Covad) and its wholly-owned subsidiaries
(the Company, or Covad). All significant intercompany accounts and
transactions have been eliminated in consolidation. The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States for interim financial information, the instructions to
Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include
some of the information and footnotes required by accounting principles
generally accepted in the United States for complete financial statements. In
the opinion of management, all adjustments (consisting of normal recurring
adjustments) considered necessary for a fair presentation of the condensed
consolidated financial statements have been included. Operating results for the
three and nine months ended September 30, 2004 are not necessarily indicative
of the results that may be expected for the year ending December 31, 2004. The condensed consolidated balance sheet as of December 31, 2003 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, as amended for the year
ended December 31, 2003. Restatement As disclosed in the Companys Form 10-K/A for the year ended December 31,
2003, as filed on May 17, 2004, the Company restated its previously filed
financial statements for a misstatement related to the accounting for its 2003
Employee Stock Purchase Plan. For more information regarding the changes, refer
to the Companys Form 10-K/A as filed on May 17, 2004. The total impact of the restatement and prior period adjustments included
in the filing as compared to the financial statements previously reported in
the Companys Form 10-K for the year ended December 31, 2003 and Form 10-Q for
the three and nine months ended September 30, 2003 are summarized below (only
line items that were impacted are presented): As of December 31, 2003Previously
    
    AsReported
    
    RestatedCondensed consolidated balance sheets:Additional paid-in capital
    
    $
    1,624,489
    
    
    $
    1,651,267Deferred variable stock-based compensation
    
    $
    (52
    )
    
    $
    (14,459
    )Accumulated deficit
    
    $
    (1,629,267
    )
    
    $
    (1,641,638
    )
 Three Months Ended September 30, 2003
    
    Nine Months Ended September 30, 2003Previously
    
    As
    
    Previously
    
    AsReported
    
    Restated
    
    Reported
    
    RestatedCondensed consolidated statement of operations:Cost of sales (exclusive of depreciation and
amortization)
    
    $
    74,052
    
    
    $
    77,215
    
    
    $
    211,803
    
    
    $
    214,724Selling, general and administrative
    
    $
    32,510
    
    
    $
    37,627
    
    
    $
    102,189
    
    
    $
    106,347Total operating expenses
    
    $
    124,383
    
    
    $
    132,671
    
    
    $
    368,212
    
    
    $
    376,500Loss from operations
    
    $
    (23,876
    )
    
    $
    (32,164
    )
    
    $
    (84,400
    )
    
    $
    (92,688
    )Net loss
    
    $
    (25,143
    )
    
    $
    (33,431
    )
    
    $
    (87,152
    )
    
    $
    (95,440
    )Basic and diluted net loss per share
    
    $
    (0.11
    )
    
    $
    (0.15
    )
    
    $
    (0.39
    )
    
    $
    (0.43
    )
 5




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Use of Estimates The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results may differ
materially from these estimates. The Companys critical accounting estimates
include (i) revenue recognition and the establishment of accounts receivable
allowances, (ii) inventory valuation, (iii) useful life assignments and
impairment evaluations associated with property and equipment, collocation fees
and other intangible assets, (iv) reorganization and restructuring liabilities,
(v) anticipated outcomes of legal proceedings and other disputes, (vi)
transaction-based tax liabilities, (vii) employment-related tax liabilities,
(viii) liabilities for market development funds and customer incentives and
(ix) valuation allowances associated with deferred tax assets. During the three and nine months ended September 30, 2004, the Company
reduced its estimates on property tax liabilities, primarily caused by lower
property tax valuations and actual tax assessments on our network assets. For
the three and nine months ended September 30, 2004 this change in accounting
estimate reduced the Companys cost of sales by $1,050 and $1,824,
respectively, selling general and administrative expenses by $313 and $544,
respectively, and net loss by approximately $1,363 ( $0.01 per share) and
$2,368 ($0.01 per share), respectively. In addition, during the three months
ended June 30, 2004, the Company ceased the accrual of a transaction-based tax
because it determined it should not be subject to this tax. The determination
was based on the Companys revised interpretation of the applicability of the
tax. The Company believes that such determination prospectively removes the
probable condition required by Statement of Financial Accounting Standard 5
(SFAS 5) to accrue a contingent liability. For the three and nine months
ended September 30, 2004, this change in accounting estimate had the effect of lowering the
Companys cost of sales and net loss, compared to the prior year period, by
approximately $1,041 ($0.00 per share) and $2,141 ($0.01 per share),
respectively. The Company did not reverse the liability of approximately
$19,455 that was accrued at the statutory tax rate as of March 31, 2004, because the Company
believes that the liability was properly recorded based upon its interpretation
of the tax law at that time coupled with the guidance provided by SFAS 5. The
Company believes that the criteria for derecognizing the liability for the tax
reflected in its condensed consolidated balance sheet as of March 31, 2004,
will be met when one of the following occurs: (i) a ruling, either judicial or
from the Internal Revenue Service (IRS), that it is not subject to the tax,
(ii) a ruling, either judicial or from the IRS that a company with similar
facts and circumstances to the Company is not subject to the tax, (iii) a
settlement with the IRS on this matter or, (iv) the expiration of the
applicable statute of limitations. Furthermore, during the three and nine
months ended September 30, 2004, the Company recorded a bad debt recovery in
the amount of $1,600 as a result of a settlement of a previously written down
account receivables balance from one of its wholesale customers. For the three
and nine months ended September 30, 2004, this change in accounting estimate
reduced the Companys selling, general and administrative expenses and net loss
by $1,600 ($0.01 per share). During the nine months ended September 30, 2004, the Company reduced its
estimates of a transaction-based tax liability and certain employment related
tax liabilities due to the expiration of the prescribed statutory period for
the corresponding tax returns. For the nine months ended September 30, 2004,
these changes in accounting estimates reduced the Companys cost of sales by
$2,023, selling, general and administrative expenses by $1,971 and net loss by
$3,994 ($0.02 per share). During the three and nine months ended September 30, 2003, the Company
reduced its estimates of 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. For the three and
nine months ended September 30, 2003, this change in accounting estimate
increased the Companys revenues by $927 and $1,662, respectively, and reduced
the Companys net loss by $927 ($0.00 per share) and $2,376 ($0.01 per share),
respectively. Stock-Based Compensation The Company accounts for stock-based awards to (i) employees (including
non-employee directors) using the intrinsic value method and (ii) non-employees
using the fair value method. Under the intrinsic value method, when the
exercise price of the Companys employee stock options equals or exceeds the
market price of the underlying stock on the date of grant, no compensation
expense is recognized. 6




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The following table illustrates the pro forma effect on net loss and net
loss per share for the three and nine months ended September 30, 2004 and 2003
had the Company applied the fair value method to account for stock-based awards
to employees: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(Restated)
    
    
    
    
    
    (Restated)Net loss, as reported
    
    $
    (13,804
    )
    
    $
    (33,431
    )
    
    $
    (34,741
    )
    
    $
    (95,440
    )Stock-based employee compensation expense
(reversal) included in the determination of
net loss, as reported
    
    
    (1,079
    )
    
    
    8,311
    
    
    
    896
    
    
    
    9,613Stock-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
    
    
    (6,719
    )
    
    
    (6,487
    )
    
    
    (18,224
    )
    
    
    (11,967
    )Pro forma net loss
    
    $
    (21,602
    )
    
    $
    (31,607
    )
    
    $
    (52,069
    )
    
    $
    (97,794
    )Basic and diluted net loss per common share:As reported
    
    $
    (0.05
    )
    
    $
    (0.15
    )
    
    $
    (0.14
    )
    
    $
    (0.43
    )Pro forma
    
    $
    (0.08
    )
    
    $
    (0.14
    )
    
    $
    (0.21
    )
    
    $
    (0.44
    )
 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. The following table presents the calculation of weighted-average common
shares used in the computations of basic and diluted net loss per share
presented in the accompanying condensed consolidated statements of operations: Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Weighted-average
number of shares of
common stock
outstanding
    
    
    260,495
    
    
    
    224,873
    
    
    
    245,299
    
    
    
    224,019Less
weighted-average
number of shares of
common stock
subject to
repurchase
    
    
    (191
    )
    
    
    
    
    
    
    (80
    )
    
    
    Weighted-average
number of common
shares used in
computing basic and
diluted net loss
per share
    
    
    260,304
    
    
    
    224,873
    
    
    
    245,219
    
    
    
    224,019
 For the three and nine months ended September 30, 2004 and 2003,
outstanding options and warrants were excluded from the calculation of diluted
net loss per share, as the effect would be anti-dilutive. Total outstanding
options and warrants to purchase common stock at September 30, 2004 were 23,847
and 6,514 shares at weighted-average exercise price of $6.08 and $2.85,
respectively. Total outstanding options and warrants to purchase common stock
at September 30, 2003 were 26,659 and 6,512 shares at a weighted-average
exercise price of $6.35 and $2.85, respectively. For the three and nine months ended September 30, 2004, common stock
issuable upon the assumed conversion of convertible debentures were excluded
from the calculation of diluted net loss per share as the effect would be
anti-dilutive. 7




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##### Table of Contents



Comprehensive Loss Significant components of the Companys comprehensive loss are as follows: Three Months Ended
    
    Nine Months EndedCumulative
    
    September 30,
    
    September 30,Amounts
    
    2004
    
    2003
    
    2004
    
    2003(Restated)Net loss
    
    $
    (1,676,379
    )
    
    $
    (13,804
    )
    
    $
    (33,431
    )
    
    $
    (34,741
    )
    
    $
    (95,440
    )Unrealized gains (losses) on available-for-sale securities
    
    
    (48
    )
    
    
    50
    
    
    
    (66
    )
    
    
    (57
    )
    
    
    (194
    )Foreign currency translation adjustment
    
    
    (962
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Comprehensive loss
    
    $
    (1,677,389
    )
    
    $
    (13,754
    )
    
    $
    (33,497
    )
    
    $
    (34,798
    )
    
    $
    (95,634
    )
 Goodwill Goodwill is recorded when the consideration paid for an acquisition
exceeds the fair value of net tangible and intangible assets acquired. Goodwill
is measured and tested for impairment on an annual basis or more frequently if
the Company believes indicators of impairment exist. The performance of the
test involves a two-step process. The first step compares the fair value of the
reporting unit to its carrying amount, including goodwill. The fair value of
the reporting unit is determined by calculating the market capitalization of
the reporting unit as derived from quoted market prices or other generally
accepted valuation methods if quoted market prices are not available. A
potential impairment exists if the fair value of the reporting unit is lower
than its carrying amount. The second step of the process is only performed if a
potential impairment exists, and it involves determining the difference between
the fair value of the reporting units net assets, other than goodwill, to the
fair value of the reporting unit. If the difference is less than the net book
value of goodwill, an impairment exists and is recorded. The Company determines its reporting units, for purposes of testing for
impairment, by determining (i) how the Company manages its operations, (ii) if
a component of an operating unit constitutes a business for which discrete
financial information is available and the Company management regularly reviews
such financial information, and (iii) how the acquired entity, is integrated
with the Company. Based on these criteria, the Company determined that its
Wholesale and Direct segments are its reporting units. On June 8, 2004, the Company completed its acquisition of all of the
outstanding shares of privately-held GoBeam, Inc., as described in Note 8,
Acquisition of GoBeam, Inc.The Company integrated and manages the GoBeam
business within its Direct segment. Accordingly, the recorded goodwill from the
acquisition of GoBeam was allocated to the Direct segment for purposes of
testing for impairment. Collateralized Customer Deposit The Company entered into a 10-year resale agreement with SBC
Communications (SBC) in December of 2001 under which SBC, its affiliates or
special agents will resell the Companys digital subscriber line (DSL)
services. Under the arrangement with SBC, the Company recognizes revenue
consistent with its revenue recognition policy, which is described in Note 2,
Revenue Recognition,to its condensed consolidated financial statements. As
part of the resale agreement, SBC made a $75,000 noninterest-bearing
prepayment, which is collateralized by substantially all of the Companys
domestic assets. As the Company provides certain products and services to SBC,
the resultant billings are recognized as revenue in accordance with the
Companys revenue recognition policy and are offset by the prepayment to the
extent of SBCs right to do so under the resale agreement. The Company
categorizes a portion of the prepayment liability as a current liability, based
upon the amount of expected billings over the next twelve months, with the
remainder classified as long term. The amount of billings expected over the
next twelve months is an estimate based on the current quantity of products and
services for which SBC is being billed, and the actual amount sold during this
period may be greater or lesser then this estimated amount. Recent Accounting Pronouncements In March 2004, the Financial Accounting Standards Board (FASB) approved
Emerging Issue Task Force (EITF) Issue 03-6, Participating Securities and
the Two-Class Method under Statement of Financial Accounting Standards (SFAS)
128. EITF Issue 03-6 supersedes the guidance in Topic No. D-95, Effect of
Participating Convertible Securities on the Computation of Basic Earnings per
Share, and requires the use of the two-class method of participating
securities. The two-class method is an earnings allocation formula that
determines earnings per share for each class of common stock and participating
security according to dividends declared 8




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##### Table of Contents



(or accumulated) and participation rights in undistributed earnings. In
addition, EITF Issue 03-6 addresses other forms of participating securities,
including options, warrants, forwards and other contracts to issue an entitys
common stock, with the exception of stock-based compensation (unvested options
and restricted stock) subject to the provisions of Opinion 25 and SFAS 123.
EITF Issue 03-6 is effective for reporting periods beginning after March 31,
2004. The adoption of EITF Issue 03-6 did not have a significant effect on the
Companys condensed consolidated financial statements as of and for the three
and nine months ended September 30, 2004. On May 15, 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity.
SFAS No. 150 establishes standards for classifying and measuring as liabilities
certain financial instruments that embody obligations of the issuer and have
characteristics of both liabilities and equity, such as mandatorily redeemable
equity instruments. SFAS No. 150 must be applied immediately to instruments
entered into or modified after May 31, 2003 and to all other instruments that
exist as of the beginning of the first interim financial reporting period
beginning after June 15, 2003, except for mandatorily redeemable instruments of
non-public companies, to which the provisions of SFAS No. 150 must be applied
in fiscal periods beginning after December 15, 2003. The application of SFAS
No. 150 to pre-existing instruments should be recognized as the cumulative
effect of a change in accounting principle. The adoption of SFAS No. 150 had no
effect on the Companys condensed consolidated financial statements as of and
for the three and nine months ended September 30, 2004. In January 2003, the FASB issued Interpretation, (FIN) No. 46,
Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulleting No. 51, Consolidated Financial Statements. FIN 46 applies
to any business enterprise that has a controlling interest, contractual
relationship or other business relationship with a variable interest entity,
(VIE), and establishes guidance for the consolidation of VIEs that function
to support the activities of the primary beneficiary. FIN 46 was effective
immediately for enterprises with VIEs created after January 31, 2003, and it
was effective March 31, 2004 for enterprises with VIEs created before February
1, 2003. The adoption of FIN 46 did not have a significant effect on the
Companys condensed consolidated financial statements as of and for the three
and nine months ended September 30, 2004. Reclassifications Certain balances in the Companys 2003 condensed consolidated financial
statements have been reclassified to conform to the presentation in 2004. 2. Revenue Recognition Revenues from recurring service are recognized when (i) persuasive
evidence of an arrangement between the Company and the customer exists, (ii)
service has been provided to the customer, (iii) the price to the customer is
fixed or determinable and (iv) collectibility of the sales prices is reasonably
assured. If a customer is (i) experiencing financial difficulties and, (ii) is
not current in making payments for the Companys services or, (iii) is
essentially current in making payments but, subsequent to the end of the
reporting period, the financial condition of such customer deteriorates
significantly or such customer files for bankruptcy protection, then, based on
this information, the Company may determine that the collectibility of revenues
from this customer is not reasonably assured or its ability to retain some or
all of the payments received from a customer that has filed for bankruptcy
protection is not reasonably assured. Accordingly, the Company classifies this
group of customers as financially distressed for revenue recognition
purposes. Revenues from financially distressed customers are recognized when
cash for the services to those customers is collected, assuming all other
criteria for revenue recognition have been met, but only after the collection
of all previous outstanding accounts receivable balances. Payments received
from financially distressed customers during a defined period prior to their
filing of petitions for bankruptcy protection are recorded in the condensed
consolidated balance sheets caption Unearned revenues if the Companys
ability to retain these payments is not reasonably assured. Revenues earned for which the customer has not been billed are recorded as
Unbilled revenues in the condensed consolidated balance sheets. Amounts
billed in advance of providing service are deferred and recorded as an element
of the condensed consolidated balance sheets caption Unearned revenues.
Included in revenues are Federal Universal Service Fund (FUSF) charges billed
to customers aggregating $1,356 and $4,022 for the three and nine months ended
September 30, 2004, respectively, and $1,422 and $3,681 for the three and nine
months ended September 30, 2003, respectively. The Company recognizes up-front fees associated with service activation
over the expected term of the customer relationships, which ranges from 24 to
48 months, using the straight-line method. The Company treats the incremental
direct costs of service activation (which consist principally of customer
premises equipment, service activation fees paid to other telecommunications
companies and sales commissions) as deferred charges in amounts that are no
greater than the up-front fees that are deferred. These deferred incremental
direct costs are amortized to expense using the straight-line method over 24 to
48 months. 9




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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 30
days of service activation. Accordingly, the Company maintains allowances,
through charges to revenues, based on the Companys estimates of (i) the
ultimate resolution of the disputes and (ii) future service cancellations.
These charges to revenues amounted to $872 and $4,549 during the three and nine
months ended September 30, 2004, respectively, and $459 and $2,079 during the
three and nine months ended September 30, 2003, respectively. Significant Customers As of September 30, 2004, the Company had over 370 resellers. For the
three and nine months ended September 30, 2004, the Companys 30 largest
customers collectively comprised 92.8% and 93.3%, respectively, of the
Companys total wholesale revenues and 66.1% and 67.6%, respectively, of the
Companys total revenues. As of September 30, 2004, receivables from these 30
customers collectively comprised 68.3% of the Companys gross accounts
receivable balance. For the three and nine months ended September 30, 2003,
these customers collectively comprised 95.9% and 95.2%, respectively, of the
Companys total wholesale revenues and 72.5% and 74.1%, respectively, of the
Companys total revenues. As of September 30, 2003, receivables from these
customers collectively comprised 75.5% of the Companys gross accounts
receivable balance. For the three months ended September 30, 2004, Earthlink, Inc. and AT&T
Corp. (AT&T), two of the Companys wholesale customers, accounted for 16.1%
and 13.5%, respectively, of the Companys total net revenues. For the nine
months ended September 30, 2004, these customers accounted for 17.2% and 13.3%,
respectively, of the Companys total net revenues. As of September 30, 2004,
receivables from these customers comprised 18.1% and 18.8%, respectively, of
the Companys gross accounts receivable balance. No other individual customer
accounted for more than 10% of the Companys total net revenues during the
three and nine months ended September 30, 2004. For the three months ended September 30, 2003, Earthlink, Inc. and AT&T
accounted for 22.4% and 10.9%, respectively, of the Companys total net
revenues. For the nine months ended September 30, 2003, these customers
accounted for 22.3% and 11.3%, respectively, of the Companys total net
revenues. As of September 30, 2003, receivables from these customers comprised
23.9% and 11.7%, respectively, of the Companys gross accounts receivable
balance. No other individual customer accounted for more than 10% of the
Companys total net revenues during the three and nine months ended September
30, 2003. Wholesaler Financial Difficulties The Company believes that some of its reseller customers who (i) were
essentially current in their payments for the Companys services prior to
September 30, 2004, or (ii) have subsequently paid all or significant portions
of the respective amounts recorded as accounts receivable as of September 30,
2004, may be at risk of becoming financially distressed. Revenues from these
customers accounted for approximately 6.9% and 7.9% of the Companys total net
revenues for the three and nine months ended September 30, 2004, respectively,
and 18.8% and 22.5% of the Companys total net revenues for the three and nine
months ended September 30, 2003, respectively. As of September 30, 2004 and
2003, receivables from these customers comprised 9.0% and 25.8%, respectively,
of the Companys gross accounts receivable balance. If these customers are
unable to demonstrate their ability to pay for the Companys services in a
timely manner in periods ending subsequent to September 30, 2004, revenues from
such customers will only be recognized when cash is collected. 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
shares for $0.94 per share; 1,000 shares for $3.00 per share; and 1,000 shares
for $5.00 per share. Such warrants were immediately exercisable, fully vested
and nonforfeitable at the date of grant. Accordingly, the measurement date for
these warrants was the date of grant. The aggregate fair value of such warrants
of $2,640 was recorded as a deferred customer incentive during the three months
ended March 31, 2003 and is being recognized as a reduction of revenues on a
straight-line basis over the three-year term of the agreement because
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%. None of these warrants had been exercised or had 10




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##### Table of Contents



expired as of September 30, 2004. On September 4, 2002, in conjunction with the execution of a five-year
agreement with America Online, Inc. (AOL), a wholesale customer, the Company
granted AOL three warrants to purchase 1,500 shares of the Companys common
stock for $1.06 per share, 1,000 shares of the Companys common stock for $3.00
per share and 1,000 shares of the Companys common stock for $5.00 per share.
Such warrants were immediately exercisable, fully vested and nonforfeitable at
the date of grant. Accordingly, the measurement date for these warrants was the
date of grant. The aggregate fair value of such warrants of $3,790, which was
determined using the Black-Scholes option valuation model and the following
assumptions: closing price of the Companys common stock on September 4, 2002
of $1.14 per share; expected life of seven years (which is also the contractual
life of the warrants); dividend yield of zero; volatility of 1.56; and a
risk-free interest rate of 3.63%, was recorded as a deferred customer incentive
and is being recognized as a reduction of revenues on a straight-line basis
over the five-year term. None of these warrants had been exercised or had
expired as of September 30, 2004. The Company recorded amortization on the above described warrants in the
amount of $437 and $1,311 for the three and nine months ended September 30,
2004, respectively, and $668 and $1,311 for the three and nine months ended
September 30, 2003, respectively. As of September 30, 2004, the remaining
balance to be amortized of such warrants was $3,120. 4. Reductions in Force During the three and nine months ended September 30, 2004, the Company
reduced its workforce by approximately 8 and 61 employees, respectively, which
represented approximately 0.7% and 5.5% of the Companys workforce,
respectively. The reductions covered employees in the areas of sales and
marketing, operations and corporate functions. During the nine months ended
September 30, 2003, the Company reduced its workforce by approximately 113
employees, which represented approximately 10.2% of the Companys workforce.
The reductions covered employees in the areas of sales and marketing,
operations and corporate functions. None of these reductions occurred during
the three months ended September 30, 2003. In connection with the reductions in force, the Company recorded charges
to operations for the three and nine months ended September 30, 2004 of $145
and $915, respectively, relating to employee severance benefits that met the
requirements for accrual. For the three and nine months ended September 30,
2004, $9 and $150, respectively, of these expenses related to cost of sales and
the remaining $136 and $765, respectively, related to selling, general and
administrative expenses. During the three and nine months ended September 30,
2004, the Company paid severance benefits of approximately $185 and $833,
respectively. The Company is expected to pay substantially all of the remainder
of the severance benefits accrued as of September 30, 2004 in the fourth
quarter of 2004. The expenses associated with the reductions in force for the
three and nine months ended September 30, 2004 were $8 and $287, respectively,
related to the Companys Wholesale business segment, and none and $253,
respectively, related to the Companys Direct business segment. The remaining
expenses associated with these reductions in force during the three and nine
months ended September 30, 2004 of $137 and $375, respectively, were related to
the Companys Corporate Operations. The Company recorded charges to operations for the nine months ended
September 30, 2003 of $1,235, relating to employee severance benefits that met
the requirements for accrual. For the nine months ended September 30, 2003,
$242 of these expenses were charged to cost of sales and the remaining $993
were charged to selling, general and administrative expenses. During the three
and nine months ended September 30, 2003, the Company paid severance benefits
of approximately $147 and $1,235, respectively. The expenses associated with
the reductions in force were $103 related to the Companys Wholesale business
segment, $349 related to the Companys Direct business segment. The remaining
$783 in expenses associated with these reductions in force were related to the
Companys Corporate Operations. 5. Long-Term Debt On March 10, 2004, the Company completed a private placement of $125,000
in aggregate principal amount of 3% Convertible Senior Debentures
(Debentures) due 2024, which are convertible into shares of the Companys
common stock at a conversion price of approximately $3.1742 per share, subject
to certain adjustments. The Debentures mature on March 15, 2024. The Company
may redeem some or all of the Debentures for cash at any time on or after March
20, 2009. Holders of the Debentures have the option to require the Company to
purchase the Debentures in cash, in whole or in part, on March 15, 2009, 2014
and 2019. The holders of the Debentures will also have the ability to require
the Company to purchase the Debentures in the event that the Company undergoes
a change in control. In each case, the redemption or purchase price would be at
100% of their principal amount, plus accrued and unpaid interest thereon. Net
proceeds from the Debentures were approximately $119,999 after commission and
other transaction costs. The Company incurred approximately $5,001 in
transaction costs in conjunction with the placement of the Debentures. The debt
issuance costs are being amortized to operations over sixty months, the period
through to the first date that holders have the option to require 11




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##### Table of Contents



the Company to purchase the Debentures. Under a resale registration rights agreement that the Company entered into
in connection with the private placement of the Debentures, the Company agreed
to file a registration statement on Form S-3 to register the resale of the
Debentures and the common stock issuable upon conversion of the Debentures, by
June 8, 2004, and to use reasonable best efforts to have it declared effective
by October 6, 2004. If the registration statement is not declared effective by
October 6, 2004, the Company must pay interest penalties until the earlier of
the date in which the registration statement is declared effective or the date
in which the registration statement is no longer required to be kept effective.
Since the registration statement was not declared effective by this date, the
Company must pay interest penalties that accrues at a rate equal to 0.25% per
year of the aggregate principal amount of the Debentures until January 4, 2005.
If the registration statement is not declared effective by January 4, 2005,
the interest penalties will increase and will accrue at a rate equal to 0.50%
per year of the aggregate principal amount of the Debentures. On March 11, 2004, the Company used a portion of the net proceeds of the
offering to repay its 11% note payable to SBC. The payment amounted to $56,569,
which included $50,000 of principal and $6,569 of accrued interest. 6. Contingencies Litigation On December 13, 2001, the United States Bankruptcy Court for the District
of Delaware (the Bankruptcy Court) entered an order confirming the Companys
pre-negotiated First Amended Plan of Reorganization as modified on November 26,
2001 (the Plan). On December 20, 2001 (the Effective Date), the Plan was
consummated and the Company emerged from bankruptcy. Under the Plan, the
Company settled several claims against it. 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 September 30, 2004 and 2003, there were approximately $1,327 and
$8,494, respectively, in unresolved claims related to the Companys Chapter 11
bankruptcy proceedings. As of September 30, 2004 and 2003, the Company had
recorded $364 and $7,378, respectively, 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 have been 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
consolidated balance sheets as of December 31, 2001 through a charge to
litigation-related expenses for the year then ended in connection with this
anticipated settlement. As a result of changes in the fair market value of the
Companys common stock, the Company decreased this liability to $6,950 as of
March 31, 2002 through credits to litigation-related expenses in the amount of
$11,628 for the three months ended March 31, 2002. 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 subsequently filed an appeal pertaining to the final judgment, but
this appeal only related to the allocation of the settlement proceeds 12




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##### Table of Contents



between the plaintiffs and their attorneys. On February 18, 2004, the
Ninth Circuit affirmed the District Courts final judgment. Consequently, on
such date the Company considered the 6,495,844 shares validly issued and
outstanding. The distribution of the shares was completed in April of 2004. In April 1999, the Company filed a lawsuit against Bell Atlantic (now
Verizon) and its affiliates in the United States District Court for the
District of Columbia. The Company is pursuing antitrust and other claims in
this lawsuit arising out of Verizons conduct as a supplier of network
facilities, including central office space, transmission facilities and
telephone lines. In December 2000, the Company also filed a lawsuit against
BellSouth Telecommunications and its subsidiaries in the United States District
Court for the Northern District of Georgia. The Company is pursuing claims in
this lawsuit that are similar to its claims against Verizon. Both courts
dismissed some of the Companys claims based on the ruling of the Seventh
Circuit in Goldwasser v. Ameritech. The court in the Verizon case also
dismissed the Companys remaining claims on other grounds. The Company
voluntarily dismissed its remaining claims in the BellSouth case so it could
pursue certain issues on appeal. The Company appealed these decisions to the
United States Court of Appeals for the Eleventh Circuit and the United States
Court of Appeals for the District of Columbia. On August 2, 2002, the Eleventh
Circuit Court of Appeals reversed the lower courts decision in the BellSouth
case and remanded the case for further proceedings. BellSouth appealed this
decision to the United States Supreme Court. On January 20, 2004, the United
States Supreme Court reversed a decision entitled Verizon Communications v. Law
Offices of Curtis Trinko, which rejected the Goldwasser decision. The Supreme
Court also vacated the Eleventh Circuits decision in the Companys case
against BellSouth and remanded the case to the Eleventh Circuit for review in
light of the Trinko decision. Although the Company believes the Trinko decision
does not impact these cases, both BellSouth and Verizon claim that Trinko
supports the dismissal of the Companys lawsuits and BellSouth and Verizon
filed motions with the appellate courts requesting affirmance of the district
courts rulings. On May 12, 2004, the D.C. Circuit denied Verizons motion for
summary affirmance and ordered the parties to submit additional briefs. On June
25, 2004, the Eleventh Circuit reversed portions of the lower courts decision
in the BellSouth case and remanded that case for further proceedings. The
Company cannot predict the outcome of these proceedings at this time. 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 telephone
lines that 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 appealed the dismissal of its lawsuit and in July 2004 the Ninth
Circuit Court of Appeals partially reversed the District Courts decision and
indicated that Verizon could attempt to pursue a claim against the Company for
breach of contract. The matter has been sent back to the District Court for
further proceedings. The Company believes it has strong defenses to this
lawsuit, but litigation is inherently unpredictable and there is no guarantee
it will prevail. Several stockholders have filed complaints in the United States District
Court for the Southern District of New York, on behalf of themselves and
purported classes of stockholders, against the Company and several former and
current officers and directors in addition to some of the underwriters who
handled the Companys stock offerings. These lawsuits are so-called IPO
allocation cases, challenging practices allegedly used by certain underwriters
of public equity offerings during the late 1990s and 2000. On April 19, 2002,
the plaintiffs amended their complaint and removed the Company as a defendant.
Certain directors and officers are still named in the complaint. The plaintiffs
claim that the Company and others failed to disclose the arrangements that some
of these underwriters purportedly made with certain investors. The plaintiffs
and the issuer defendants have reached a tentative agreement to settle the
matter, and the Company believes the tentative settlement will not have a
material adverse effect on its consolidated financial position or results of
operations. That settlement, however, has not been finalized. If the settlement
is not finalized, the Company believes it has strong defenses to these lawsuits
and intends to contest them vigorously. However, litigation is inherently
unpredictable and there is no guarantee that the Company will prevail. In June 2002, Dhruv Khanna was relieved of his duties as the Companys
General Counsel and Secretary. Shortly thereafter, Mr. Khanna alleged that,
over a period of years, certain current and former directors and officers had
breached their fiduciary duties to the Company by engaging in or approving
actions that constituted waste and self-dealing, that certain current and
former directors and officers had provided false representations to the
Companys auditors and that he had been relieved of his duties in retaliation
for his being a purported whistleblower and because of racial or national
origin discrimination. He threatened to file a shareholder derivative action
against 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 13




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Hellene Runtagh, to investigate the allegations made by Mr. Khanna.
Richard Jalkut was appointed to this committee shortly after he joined the
Companys Board of Directors. This committee retained an independent law firm
to assist in its investigation. Based on this investigation, the committee
concluded that Mr. Khannas allegations were without merit and that it would
not be in the best interests of the Company to commence litigation based on
these allegations. The committee considered, among other things, that many of
Mr. Khannas allegations were not accurate, that certain allegations challenged
business decisions lawfully made by management or the Board, that the
transactions challenged by Mr. Khanna in which any director had an interest
were approved by a majority of disinterested directors in accordance with
Delaware law, that the challenged director and officer representations to the
auditors were true and accurate, and that Mr. Khanna was not relieved of his
duties as a result of retaliation for alleged whistleblowing or racial or
national origin discrimination. Mr. Khanna has disputed the committees work
and the outcome of its investigation. After the committees findings had been presented and analyzed, the
Company concluded in January 2003 that it would not be appropriate to continue
Mr. Khanna on paid leave status, and determined that there was no suitable role
for him at the Company. Accordingly, he was terminated as an employee of the
Company. Based on the events mentioned above, in September 2003, Mr. Khanna filed a
purported class action and a derivative action against the Companys current
and former directors in the Court of Chancery of the State of Delaware in and
for New Castle County. On August 3, 2004, Mr. Khanna amended his Complaint and
two additional purported shareholders joined the lawsuit. In this action the
plaintiffs seek recovery on behalf of the Company from the individual
defendants for their purported breach of fiduciary duty. The plaintiffs also
seek to invalidate the Companys election of directors in 2002, 2003 and 2004
because they claim that the Companys proxy statements were misleading. The
Company is unable to predict the outcome of this lawsuit. The Company is also a party to a variety of other pending or threatened
legal proceedings as either plaintiff or defendant, or is engaged in business
disputes that arise in the ordinary course of business. Failure to resolve
these various legal disputes and controversies without excessive delay and cost
and in a manner that is favorable to the Company could significantly harm its
business. The Company does not believe the ultimate outcome of these matters
will have a material impact on its 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. In September 2004 the Company reached a settlement in a legal dispute. In
connection with this settlement the Company received a payment of $1.6 million. 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. In addition, the Company is engaged in a variety of legal negotiations,
arbitrations and regulatory and court proceedings with multiple telephone
companies. These negotiations, arbitrations and proceedings concern the
telephone companies denial of central office space, the cost and delivery of
transmission facilities and telephone lines and central office spaces, 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, the
Company does not believe that these matters will result in material liability
to it and the potential gains are not quantifiable at this time. An unfavorable
result in any of these negotiations, arbitrations and proceedings, however,
could have a material adverse effect on the Companys consolidated financial
position and results of operations if it is denied or charged higher rates for
transmission lines or central office spaces. Other contingencies As of September 30, 2004, 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. 14




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##### Table of Contents



The Company performs ongoing analysis of the applicability of certain
transaction-based taxes to (i) sales of its products and services and (ii)
purchases of telecommunications circuits from various carriers. This analysis
includes discussions with authorities of significant jurisdictions in which the
Company does business to determine the extent of its transaction-based tax
liabilities. It is the Companys opinion that this analysis will be concluded
without a material adverse effect on its 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. 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. During the nine months ended September 30,
2004, the Company determined that it does not owe a portion of this tax,
approximately $3,079. The Company intends to engage in discussions with state
and federal tax authorities to settle these estimated tax liabilities. It is
the Companys opinion that such discussions will be concluded without a
material adverse effect on its consolidated financial position and results of
operations. However, it is reasonably possible that the Companys estimates of
these tax liabilities, as reflected in the accompanying condensed consolidated
balance sheets as of September 30, 2004, could change in the near term, and the
effects could be material to the Companys consolidated financial position and
results of operations. 7. Business Segments The Company sells to businesses and consumers indirectly through Internet
service providers, or ISPs, telecommunications carriers and other resellers.
The Company also sells its services directly to business and consumer end-users
through its field sales force, telephone sales, referral agents and its Web
site. The Company was managed in 2003 as two strategic business units, Covad
Strategic Partnerships, or CSP, and Covad Broadband Solutions, or CBS.
Beginning in January 2004, the Company realigned its business and no longer
maintains CSP and CBS as separate business units. The Company presently
operates two business segments, wholesale and direct, which are described below
in more detail. The Companys business segments are strategic business units that are
managed based upon differences in customers, services and marketing channels,
even though the assets and cash flows from these operations are not independent
of each other. The Companys wholesale segment, or Wholesale, is a provider of
high-speed connectivity services to ISPs and enterprise and telecommunications
carrier customers. The Companys direct segment, or Direct, is a provider of
voice over Internet protocol, or VoIP, high-speed connectivity, Internet access
and other services to individuals, small and medium-sized businesses,
corporations and other organizations. All other business operations and
activities of the Company are reported as Corporate Operations. These
operations and activities are primarily comprised of general corporate
functions to support the Companys revenue producing segments as well as costs
and expenses for headquarters facilities and equipment, depreciation and
amortization, network capacity and other non-recurring or unusual items not
directly attributable or allocated to the segments, gains and losses on the
Companys investments, and income and expenses from the Companys treasury and
financing activities. The Company evaluates performance and allocates resources to the segments
based on income or loss from operations, excluding certain operating expenses,
such as depreciation and amortization, and other income and expense items. The
Company does not segregate its assets or its cash flows between its two
segments because these resources are not managed separately by segment. The
Company similarly manages its capital expenditures and cash needs as one
entity. Therefore, the Company does not allocate such operating expenses and
other income and expense items to its business segments because it believes
that these expenses and other income items are not directly managed or
controlled by its business segments. Segment information, including a reconciliation to the respective balances
in the Companys condensed consolidated financial statements, as of and for the
three and nine months ended September 30, 2004 and 2003 are as follows (the
Companys 2003 segment information has been restated to conform to the
Companys organizational structure in 2004): 15




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##### Table of Contents



For the Three Months Ended
    
    
    
    
    
    
    
    
    
    Total
    
    Corporate
    
    Intercompany
    
    ConsolidatedSeptember 30, 2004:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    Eliminations
    
    TotalRevenues, net
    
    $
    75,296
    
    
    $
    30,391
    
    
    $
    105,687
    
    
    $
    
    
    
    
    
    
    
    $
    105,687Cost of sales (exclusive of depreciation and amortization)
    
    
    41,893
    
    
    
    14,576
    
    
    
    56,469
    
    
    
    9,470
    
    
    
    
    
    
    
    65,939Selling, general and administrative
    
    
    2,310
    
    
    
    13,307
    
    
    
    15,617
    
    
    
    19,871
    
    
    
    
    
    
    
    35,488Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,406
    
    
    
    
    
    
    
    19,406Provision for restructuring expenses
    
    
    8
    
    
    
    
    
    
    
    8
    
    
    
    137
    
    
    
    
    
    
    
    145Income (loss) from operations
    
    
    31,085
    
    
    
    2,508
    
    
    
    33,593
    
    
    
    (48,884
    )
    
    
    
    
    
    
    (15,291
    )Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,487
    
    
    
    
    
    
    
    1,487Net income (loss)
    
    $
    31,085
    
    
    $
    2,508
    
    
    $
    33,593
    
    
    $
    (47,397
    )
    
    
    
    
    
    $
    (13,804
    )Total assets
    
    $
    49,328
    
    
    $
    54,646
    
    
    $
    103,974
    
    
    $
    304,946
    
    
    
    
    
    
    $
    408,920
 For the Three Months Ended
    
    
    
    
    
    
    
    
    
    Total
    
    Corporate
    
    Intercompany
    
    ConsolidatedSeptember 30, 2003:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    Eliminations
    
    TotalRevenues, net
    
    $
    75,968
    
    
    $
    24,539
    
    
    $
    100,507
    
    
    $
    
    
    
    
    
    
    
    $
    100,507Cost of sales (exclusive of depreciation and amortization)
    
    
    55,084
    
    
    
    15,394
    
    
    
    70,478
    
    
    
    6,737
    
    
    
    
    
    
    
    77,215Selling, general and administrative
    
    
    4,446
    
    
    
    5,216
    
    
    
    9,662
    
    
    
    27,965
    
    
    
    
    
    
    
    37,627Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17,829
    
    
    
    
    
    
    
    17,829Provision for restructuring expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Income (loss) from operations
    
    
    16,438
    
    
    
    3,929
    
    
    
    20,367
    
    
    
    (52,531
    )
    
    
    
    
    
    
    (32,164
    )Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,267
    )
    
    
    
    
    
    
    (1,267
    )Net income (loss)
    
    $
    16,438
    
    
    $
    3,929
    
    
    $
    20,367
    
    
    $
    (53,798
    )
    
    
    
    
    
    $
    (33,431
    )Total assets
    
    $
    53,446
    
    
    $
    16,843
    
    
    $
    70,289
    
    
    $
    285,894
    
    
    
    
    
    
    $
    356,183
 For the Nine Months Ended
    
    
    
    
    
    
    
    
    
    Total
    
    Corporate
    
    Intercompany
    
    ConsolidatedSeptember 30, 2004:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    Eliminations
    
    TotalRevenues, net
    
    $
    232,900
    
    
    $
    88,590
    
    
    $
    321,490
    
    
    $
    
    
    
    
    
    
    
    $
    321,490Cost of sales (exclusive of depreciation and amortization)
    
    
    132,377
    
    
    
    38,860
    
    
    
    171,237
    
    
    
    25,744
    
    
    
    
    
    
    
    196,981Selling, general and administrative
    
    
    7,467
    
    
    
    25,133
    
    
    
    32,600
    
    
    
    68,068
    
    
    
    
    
    
    
    100,668Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    57,856
    
    
    
    
    
    
    
    57,856Provision for restructuring expenses
    
    
    287
    
    
    
    253
    
    
    
    540
    
    
    
    375
    
    
    
    
    
    
    
    915Income (loss) from operations
    
    
    92,769
    
    
    
    24,344
    
    
    
    117,113
    
    
    
    (152,043
    )
    
    
    
    
    
    
    (34,930
    )Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    189
    
    
    
    
    
    
    
    189Net income (loss)
    
    $
    92,769
    
    
    $
    24,344
    
    
    $
    117,113
    
    
    $
    (151,854
    )
    
    
    
    
    
    $
    (34,741
    )
 For the Nine Months Ended
    
    
    
    
    
    
    
    
    
    Total
    
    Corporate
    
    Intercompany
    
    ConsolidatedSeptember 30, 2004:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    Eliminations
    
    TotalRevenues, net
    
    $
    220,819
    
    
    $
    62,993
    
    
    $
    283,812
    
    
    $
    
    
    
    
    
    
    
    $
    283,812Cost of sales (exclusive of depreciation and amortization)
    
    
    155,044
    
    
    
    33,953
    
    
    
    188,997
    
    
    
    25,727
    
    
    
    
    
    
    
    214,724Selling, general and administrative
    
    
    9,908
    
    
    
    16,444
    
    
    
    26,352
    
    
    
    79,995
    
    
    
    
    
    
    
    106,347Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    54,194
    
    
    
    
    
    
    
    54,194Provision for restructuring expenses
    
    
    103
    
    
    
    349
    
    
    
    452
    
    
    
    783
    
    
    
    
    
    
    
    1,235Income (loss) from operations
    
    
    55,764
    
    
    
    12,247
    
    
    
    68,011
    
    
    
    (160,699
    )
    
    
    
    
    
    
    (92,688
    )Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,752
    )
    
    
    
    
    
    
    (2,752
    )Net income (loss)
    
    $
    55,764
    
    
    $
    12,247
    
    
    $
    68,011
    
    
    $
    (163,451
    )
    
    
    
    
    
    $
    (95,440
    )
 8. Acquisition of GoBeam, Inc. On June 8, 2004, the Company completed its acquisition of all of the
outstanding shares of privately-held GoBeam, Inc., a Delaware corporation based
in Pleasanton, California, that provides VoIP solutions to small and
medium-sized businesses. The Company acquired GoBeam to accelerate its plan to
enter the VoIP market. As a result of the acquisition, the Company has added a
VoIP offering to its current portfolio of products and services. In addition,
the Company also plans to realize costs synergies and strategic value from
combining the two enterprises. These factors contributed to a purchase price
that was in excess of the fair value of GoBeams net tangible and intangible
assets acquired and, as a result, the Company recorded goodwill in connection
with this transaction. The acquisition was effectuated by merging a
wholly-owned subsidiary of the Company with and into GoBeam, with GoBeam
surviving the merger as a wholly-owned subsidiary of the Company. The merger is
intended to qualify as a tax-free reorganization. As a result of the merger, the Company issued 18,724 shares of its common
stock. Additionally, the Company has reserved 266 shares to cover shares
issuable upon exercise of assumed GoBeam stock options and 3 shares to cover
assumed warrants. Of the shares issued in conjunction with the merger, 2,216
shares have been placed in an escrow account until August 2005 to cover
GoBeams 16




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##### Table of Contents



indemnification obligations under the merger agreement. The Company accounted for the acquisition of GoBeam using the purchase
method of accounting. Accordingly, the Companys condensed consolidated
financial statements include the results of operations of GoBeam for periods
ending after the date of acquisition. The Company valued the common share
options and warrants issued, for accounting purposes, based on an average
market price of $2.08 per share, which is based on the average closing price
for a range of two trading days before and after the measurement date of the
transaction, June 4, 2004. The outstanding GoBeam stock options were converted
into options to purchase approximately 266 shares of the Companys common
stock. In addition, the outstanding GoBeam warrants were converted into
warrants to purchase 3 shares of the Companys common stock. The value of the
options and warrants was determined using the Black-Scholes option pricing
model with inputs of 1.284 for volatility, four-year expected life and a
risk-free interest rate of 3.27%. The values of the options and assumed
warrants, as well as direct acquisition costs, were included as elements of the
total purchase cost. The total purchase cost of the GoBeam acquisition has been allocated to
the assets and liabilities of GoBeam based upon estimates of their fair values.
The following tables set forth the total purchase cost and the allocation
thereof: Total purchase cost:Value of common shares issued
    
    $
    38,910Value of assumed GoBeam options and warrants
    
    
    45439,364Acquisition costs
    
    
    473Total purchase cost
    
    $
    39,837Purchase price allocation:Tangible net liabilities acquired
    
    $
    (4,479
    )Intangible assets acquired:Customer relationships
    
    
    6,600Internal use software
    
    
    1,090Goodwill
    
    
    36,626Total purchase consideration
    
    $
    39,837
 The tangible assets of GoBeam acquired by the Company aggregating $1,723
consisted principally of cash, accounts receivable and property and equipment.
The liabilities of GoBeam assumed by the Company aggregating $6,202 consisted
principally of accounts payable and accrued expenses. The customer relationships were valued using an income approach, which
projects the associated revenue, expenses and cash flows attributable to the
customer base. These cash flows are then discounted to their present value.
Through September 30, 2004, this intangible asset was being amortized on a
straight-line basis over a period of forty-eight months which represents the
expected life of the customer relationships. The internal use software was valued using the replacement cost approach.
This approach estimates value based upon estimated cost to recreate the
software with equivalent functionality. Through September 30, 2004, this
intangible asset was being amortized on a straight-line basis over a period of
sixty months. Goodwill was determined based on the residual difference between the
purchase cost and the values assigned to identified tangible and intangible
assets and liabilities, and is not deductible for tax purposes. The Company
will test for impairment of these assets on at least an annual basis. The following unaudited pro forma financial information presents the
consolidated results of operations of the Company as if the acquisition of
GoBeam had occurred at the beginning of the periods presented. For the nine
months ended September 30, 2004, net loss included GoBeam merger expenses of
$4,247 (none for the three months ended September 30, 2004). For the three and
nine months ended September 30, 2003, net loss included a charge of $1,848 for
cost associated with the exit of a real estate property lease. This financial
information does not purport to be indicative of the results of the operations
that would have occurred had the acquisition been made at the beginning of the
periods presented, or the results that may occur in the future: 17




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Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Revenue
    
    $
    105,687
    
    
    $
    101,661
    
    
    $
    324,441
    
    
    $
    286,687Net loss
    
    $
    (13,804
    )
    
    $
    (36,183
    )
    
    $
    (42,311
    )
    
    $
    (105,664
    )Basic and diluted net loss per share
    
    $
    (0.05
    )
    
    $
    (0.15
    )
    
    $
    (0.16
    )
    
    $
    (0.43
    )
 Upon closing of the acquisition of GoBeam, the Company effectively granted
337 shares of restricted common stock to certain employees of GoBeam. The
restricted stock was valued on the date of issuance at $1.96 and vested over a
period of two years. Accordingly the Company recorded deferred stock-based
compensation of $660 during the three months ended June 30, 2004. During the
three months ended September 30, 2004, as a result of the resignation of one of
the Companys executive, the Company reversed $289 of such deferred stock-based
compensation and cancelled 148 shares of the restricted common stock. The
remaining net deferred stock-based compensation balance of $371 at September
30, 2004 is being amortized on an accelerated basis over the vesting period
consisted with the method described in FIN 28. As part of the acquisition of GoBeam the Company sold 834 shares for
$1,781, or $2.13 per share, to pay for GoBeams merger expenses. 9. Related Party Transactions A member of the Companys Board of Directors, Richard Jalkut, is the
President and CEO of TelePacific, one of the Companys resellers. The Company
recognized revenues from TelePacific of $87 and $285 during the three and nine
months ended September 30, 2004, respectively, and $169 and $560 for the three
and nine months ended September 30, 2003, respectively. L. Dale Crandall, one
of the Companys directors, is also a director of BEA Systems, one of the
Companys suppliers. The Company paid $30 and $563 to BEA Systems during the
three and nine months ended September 30, 2004, respectively, and $0 and $209
for the three and nine months ended September 30, 2003, respectively. 10. 2003 Employee Stock Purchase Plan In June 2003, the Company adopted the 2003 Employee Stock Purchase Plan.
Under this plan, eligible employees may purchase common stock at 85% of: (i)
the fair market value of the Companys common stock on the first day of the
applicable twenty-four month offering period; or (ii) the fair market value on
the last day of the applicable six-month purchase period. The offering period
that commenced in July 2003 and ends in June 2005 is subject to variable
accounting and accordingly the Company recorded deferred stock-based
compensation of $14,448 as of September 30, 2004. During the three and nine
months ended September 30, 2004 the Company recognized an expense (reversal) of
$(1,143) and $759, respectively. The remaining net deferred stock compensation
balance of $1,318 at September 30, 2004, which will fluctuate with changes in
the Companys stock price, is being amortized to operations over the remainder
of the life of the offering period that is subject to variable accounting. 18




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Item 2.Managements Discussion and Analysis of Financial Condition and Results
of Operations The following discussion of our financial condition and results of
operations should be read in conjunction with the unaudited condensed
consolidated financial statements and the related notes thereto included
elsewhere in this Report onForm 10-Qand the audited consolidated financial
statements and notes thereto and managements discussion and analysis of
financial condition and results of operations for the year ended December 31,
2003 included in our Annual Report onForm 10-Kand 10-K/A filed with the
Securities and Exchange Commission on February 27, 2004 and May 17, 2004,
respectively. This discussion contains forward-looking statements, the accuracy
of which is subject to risks and uncertainties. Our actual results could differ
materially from those expressed in forward-looking statements for many reasons
including, but not limited to, those discussed herein and in the Risk Factors
section of our Annual Report onForm 10-K, which is contained in Part I, Item
1, Business  Risk Factors, of that report. We disclaim any obligation to
update information contained in any forward-looking statement. See Forward
Looking Statements. (All dollar and share amounts in thousands, except per share amounts) Overview Background We are a leading provider of voice over Internet Protocol, or VoIP, and
high-speed data communications services. Our services include a range of
high-speed, high-capacity, or broadband, Internet access connectivity and
related services using digital subscriber line, or DSL, T-1, Virtual Private
Network, or VPN, and Firewall technologies. In addition, we provide voice
services using VoIP to small and medium-sized businesses. With approximately
2,050 collocation facilities, we believe we have the largest contiguous
national broadband network. We provide services throughout the United States in
110 major metropolitan areas, giving us the ability to offer our services to
more than 50 million homes and businesses. As of September 30, 2004, we had
approximately 524,000 DSL and other high-speed lines in service. We sell to businesses and consumers indirectly through Internet service
providers, or ISPs, 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. We managed the
Company in 2003 in two strategic business units, Covad Strategic Partnerships,
or CSP, and Covad Broadband Solutions, or CBS. Beginning in January 2004, we
realigned our business and no longer maintain CSP and CBS as separate business
units. We presently operate two business segments, wholesale and direct, which
are described in more detail below. We believe this realignment will lead to
more efficient product development, sales and marketing because we will no
longer have two separate groups providing similar functions. Triennial Review As a result of the Federal Communications Commission, or FCC, decision in
the Triennial Review, the incumbent local telephone companies, which include
the four regional Bell operating companies, or RBOCs, are no longer required by
law to provide us with line-shared telephone lines under Section 251 of the
1996 Telecommunications Act, although existing customers as of October 2, 2003
were grandfathered at current rates, terms and conditions. Line-sharing allows
us to provide our Internet access services over the same telephone line that is
being used by the incumbent local telephone company to provide voice services
to an end-user. Consequently, our future ability to offer stand-alone Internet
access using line-sharing which is the primary service that we and our
resellers have historically used to provide services to consumers, will depend
on whether we are able to enter into and maintain agreements with the incumbent
local telephone companies to share access to the high frequency portion of
their telephone lines on terms that are acceptable to us, or whether we are
able to obtain favorable regulatory rulings. Pursuant to the FCCs original Triennial Review decision, companies that
compete with the incumbent local telephone companies retained access to
switching and telephone lines provided by incumbent local telephone companies
at discounted rates under an arrangement known as the Unbundled Network Element
platform, or UNE-P, which these competing companies used to provide bundled
voice and data services. This aspect of the order afforded us the opportunity
to continue to partner with voice providers utilizing UNE-P to provide our data
services in line-splitting relationships. In a line-splitting arrangement, the
company that is competing with the incumbent local telephone company purchases
a telephone line from the incumbent local telephone company and then sells
voice service to an end-user in a bundle along with our Internet connectivity
services. In contrast, in a line-sharing arrangement the voice service is
provided to the end-user by the incumbent local telephone company and we
separately provide our data services over the same telephone line. The UNE-P
aspects of the FCCs original decision were reversed by the United States Court
of Appeals for the D.C. Circuit as described in Recent Developments. Two of
our UNE-P provider customers have announced 19




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that they will stop marketing their services in several states as a result
of recent regulatory developments. AT&T has also announced that it will stop
marketing traditional voice and DSL services to consumers in all states. Our
customers may make further changes in their strategies as a result of these
developments, which could negatively affect us. The FCCs ruling and the subsequent decision by the D.C. Circuit create a
number of other uncertainties, challenges and opportunities for us. The final
effect of these developments will be subject to further proceedings at the FCC
and the reactions of the various participants in the telecommunications
industry, and many of these components are, or likely will be, the subject of
continuing litigation that could influence their ultimate impact. As such, it
is very difficult for us to predict with a high level of certainty the final
effects of the Triennial Review. The direction and success of our strategy to
utilize line splitting to support voice and data bundles offered by our
reseller customers is likely to be substantially and negatively affected by
these developments. As a result of these events we are exploring alternative
methods of selling bundled voice and data services directly to end-users and to
our resellers. We may be unsuccessful in identifying feasible or profitable
alternatives. Our Opportunities and Challenges Given the highly competitive, dynamic and heavily regulated nature of our
business environment, we face a complex array of factors that create challenges
and opportunities for us. Key matters upon which we are focused at this time
include the following: Efficient Use of Cash.Since we exited our voluntary bankruptcy
proceedings at the end of 2001, we have been able to decrease the amount of
cash used in our operations, and concluded September 30, 2004 with net working
capital of approximately $95,000. During the three and nine months ended
September 30, 2004, we generated $3,769 and $7,601, respectively, in positive
cash flow from our operating activities. For the three months ending December
31, 2004, as part of our continued rollout of VoIP services we expect to
continue quarterly spending levels of approximately $6,000 on promotions and
advertising and lead generation activities. We also expect to incur additional
expenses of approximately $2,000 for increased sales headcount to sell VoIP
services. The additional usage of cash from the VoIP rollout will depend on
many variables including our ability to control expenditures, primarily
incremental selling, general and administrative expenses, the amount of capital
expenditures that is required to expand this new business, the cost of
development of operating support systems and software, and our ability to
generate VoIP service revenues. Manage through a transition in the delivery of broadband Internet access
services to consumers.The delivery of stand-alone high-speed Internet
connectivity services by our ISP customers is facing intense competition from
the incumbent telephone carriers and cable providers like Comcast, Adelphia and
Cox Communications, who are aggressively pricing their consumer broadband
services typically as part of a bundled service offering. We believe these
market conditions have placed additional pricing pressure on Covad, reduced the
number of orders for our services, and has caused a higher level of churn among
our end-users. For the three months ended March 31, 2004 and June 30, 2004,
these conditions caused reductions of approximately 1,200 and 1,400,
respectively, in our total number of end-users. However, during the three
months ended September 30, 2004, the company experienced an increase in net
additions of approximately 10,500 subscribers, and we anticipate similar
results in the number of net add additions for the three months ending December
31, 2004. A significant portion of our current orders are generated by
line-splitting arrangements with voice providers, particularly AT&T, which are
bundling our data services with their voice services. AT&T has, however,
announced that it will stop marketing traditional voice and DSL services to
consumers in all states. The viability of these line-splitting arrangements is
dependent on the outcome of legal and FCC proceedings affecting UNE-P. We are
also exploring other methods of selling bundled voice and data services
directly to end-users and to our resellers. We may be unsuccessful in
identifying feasible or profitable alternatives. Our operational results in
2004 and beyond will be significantly dependent on the extent to which we can
continue sales of our services under bundling arrangements. Obtain acceptable line-sharing terms from the RBOCs.While we expect that
the revenues we generate from line-sharing with the incumbent local telephone
companies will decline in future periods, we think this market will continue to
be important to us. Since the RBOCs are the incumbent local phone companies in
almost all of the metropolitan areas where we offer our services, our ability
to remain viable in these markets will depend on whether we are able to reach
long-term agreements with the RBOCs, like our agreement with Qwest
Communications International, or obtain favorable regulatory rulings that will
allow us to share telephone lines for new customers on reasonable terms Expand and Diversify our Sources of Revenue.We are taking steps to
improve our prospects for revenue growth. First, we have expanded our network
by adding central office locations, which will allow us to offer our services
to more end-users. Second, we will continue our efforts to diversify our
revenue sources by adding new services such as VoIP and by adding new
resellers. 20




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New Market Opportunities.We plan to offer VoIP services in all of our
markets by the end of 2004. We believe that VoIP services have the potential to
be a significant contributor to our revenue growth in 2005 and beyond.
Therefore, we are in the early stages of offering this capability, and our
success in providing this new service will depend on our ability to offer a
service that operates as a replacement for the voice services provided by other
telephone companies and to continue to improve this service. Recent Developments On August 21, 2003, the FCC issued its order in the Triennial Review. This
order represented a significant development for us for a number of reasons, the
most important of which we believe to be as follows:  
    
    The FCC is phasing out its rule requiring line-sharing pursuant to
Section 251 of the 1996 Telecommunications Act over a three-year period.
Line-sharing currently allows us to provision services using asymmetric
DSL, or ADSL, technology over the same telephone line that the RBOC is
using to provide voice services. The phase-out period will be handled in
the following manner:  o
    
    Our 235,800 line-shared customers as of October 2, 2003 will be
grandfathered indefinitely at current rates, terms and conditions.
These line-shared customers provided approximately $14,978 and
$58,694, or 14.2% and 18.3%, of our revenues for the three and nine
months ended September 30, 2004, respectively.  o
    
    For line-shared customers acquired from October 3, 2003 to
October 2, 2004, the FCC-mandated maximum price for the high-frequency
portion of the telephone line will be 25% of the cost of a separate
telephone line during the first year, 50% during the second year and
75% during the third year. After the third year, we will be required
to transition these customers to new arrangements.  o
    
    As of October 3, 2004, we cannot acquire new line-shared
customers at regulated rates under Section 251 of the
Telecommunications Act of 1996. We have reached agreements with three
of the four RBOCs that provide us with continued access to
line-sharing. Our agreement with Verizon expires January 31, 2005 and
our agreement with SBC expires in September 2005. In the event that
we do not obtain favorable regulatory rulings or enter into and
maintain line-sharing agreements with the RBOCs, we will be required
to purchase a separate telephone line in order to provide services to
an end-user in the areas served by RBOCs. If this occurs we may stop
selling stand-alone consumer grade services to new customers, because
the cost of a separate telephone line is significantly higher than
what we currently pay for a shared line. Our inability to acquire new
line-shared customers would slow our growth and could require us to
significantly change our business plan.  
    
    Incumbent local telephone companies are not required to allow us to
access the packet-switching functions of fiber-fed telephone lines to
provision DSL services. This means that, unless we reach agreements with
the RBOCs or obtain favorable regulatory rulings from the FCC or state
regulators, we will continue to be unable to provide our most
commonly-used services to end-users served by fiber-fed lines. Our
inability to access fiber-fed packet-switching functions is significant
for our business because it preserves a substantial limit on the
addressable market for our DSL services, thereby limiting our growth. In
addition, the RBOCs are increasing their deployment of fiber-fed remote
terminal architectures.
    
    Incumbent local telephone companies were permitted to petition the
various state utility commissions for authority to stop providing data
transport between the telephone companies central offices at regulated
rates, which are usually lower, on routes that have sufficient
competitive alternatives to telephone company data transport services.
We currently purchase this interoffice transport from the incumbent
local telephone companies in order to carry traffic over our network.
    
    Companies that compete with the incumbent local telephone companies
continued to have access to the incumbent local telephone companies
networks in order to provide their services under an arrangement known
as the Unbundled Network Element platform, or UNE-P, subject to state
public utilities commissions decisions removing this obligation under
standards specified by the FCC. The continued existence of the UNE-P
platform allowed us to continue to bundle our data services with the
voice services of competitive telecommunications providers through
line-splitting arrangements.  The FCC also concluded that October 2, 2003 is the trigger date for
change of law provisions in our interconnection agreements with the various
incumbent local telephone companies. These agreements contain the prices and
other terms for the telephone lines that we purchase from these incumbent local
telephone companies, including the RBOCs. Each of the RBOCs has informed us
that it wants to change the line-sharing terms and conditions of its agreements
with us. We are negotiating these agreements and have entered into agreements
with Qwest, Verizon and SBC. Our agreement with Verizon expires on January 21




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31, 2005 and our agreement with SBC expires in September 2005. In
addition to seeking long-term commercial agreements for line-sharing with each
of the RBOCs (other than Qwest), we also intend to pursue continued access to
line-sharing in arbitrations pursuant to our interconnection agreements with
these RBOCs and through requests for regulatory relief from the FCC. On March 2, 2004, the United States Court of Appeals for the District of
Columbia Circuit, or the Court, vacated aspects of the Triennial Review order.
The Court:  
    
    Vacated the FCCs decision to find nationwide impairment for mass
market switching for UNE-P and to delegate to the state public utility
commissions the authority to determine whether UNE-P should be made
available. The Court concluded that the FCC does not have statutory
authority to grant the states decision making power regarding the
continued availability of UNE-P.
    
    Vacated the FCCs decision to make data transport between the
telephone companies central offices available at regulated rates on a
nationwide basis and to delegate to the state public utility commissions
the authority to remove data transport on specific central office routes
from the list of elements that are available at regulated rates. Based
on this decision, some of the RBOCs have claimed that they no longer are
required to provide us with this interoffice data transport at regulated
rates. At least two of the incumbent local telephone companies have
taken the position that their obligation to provide so-called
high-capacity loops was removed as of the effective date of the D.C.
Circuit decision. Although those companies have not specified what
specific loop types they believe are included within the definition of
high-capacity loops, the FCC has traditionally included T-1 loops
within the definition of high-capacity loops.
    
    Upheld the FCCs decision to phase out line-sharing, and also upheld
the FCCs decision not to require the unbundling of access to fiber to
the home and the packet-switching functions of fiber-fed telephone lines
to provision DSL services. Requests for a stay of the D.C. Circuit Courts decision pending Supreme
Court review were denied. As a result, the Courts decision to vacate aspects
of the Triennial Review order became effective on June 15, 2004, and the
portions of the rules that were vacated were no longer in effect. The FCC has begun a proceeding to develop new rules in light of the
Courts decision. Pending the completion of this proceeding, the FCC adopted
interim rules on August 20, 2004. These interim rules require the incumbent
local telephone companies to continue to provide mass-market switching for
UNE-P, T-1s and transport between central offices at existing terms and
conditions for a period of one year. During the first six months the prices
for these network elements would remain the same. During the second six months
the FCC has proposed that rates would increase by one dollar per line for
UNE-P and by 15% for transport between central offices. As a result of the FCCs proceeding to develop new rules and ongoing
disputes regarding the interpretation of the interim rules, there is
substantial uncertainty with respect to the incumbent local telephone
companies continued obligations to provide network elements and services
affected by the courts decision. This process has been extremely disruptive to
our partners who utilize UNE-P to provide competitive voice services as part of
a bundle with our DSL services. Two of our UNE-P customers, including AT&T,
have announced that they will stop offering consumer voice services in several
states as a result of recent regulatory developments. Further, AT&T has
announced that it will stop marketing traditional voice and DSL services to
consumers in all states. The direction and success of our strategy could be substantially affected
by changes in the critical elements of the original Triennial Review order,
described above, as a result of these further proceedings. In addition, new
rules, or unilateral actions by the incumbent local telephone companies in the
absence of new rules, could impact our ability to access interoffice transport
at regulated prices. As a result, we could be forced to pay significantly
higher rates for such transport, which would increase our network costs. In the FCCs pending proceeding to develop new permanent unbundling rules,
the FCC is considering whether to retain unbundling requirements and associated
regulated pricing for interoffice transport services we use to connect our
central office facilities, as well as for T-1 loops that we use to provide
services. Modifications of transport unbundling and pricing requirements could
significantly increase our costs. If the Incumbent local telephone companies
stop providing T-1 loops at regulated rates, and instead provide those loops
under special access or other prices, our costs to provide business-class T-1
services, such as our TeleXtend and VoIP products, will increase significantly. Investors should review this discussion of the Triennial Review and the
subsequent court decisions carefully to understand the potentially significant
effects that these proceedings will have on our ability to continue to engage
in our business as we have in the past, as the FCCs rulings and the court
decision create a number of uncertainties, challenges and opportunities for us.
The final effect of the FCCs rulings and related court decisions will be
subject to the reactions of various participants in the telecommunications 22




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industry, and many of these components are, or likely will be, the subject
of continuing litigation that could influence their ultimate impact. As such,
it is very difficult for us to predict the final effects of the Triennial
Review with a high level of certainty. Critical Accounting Policies and Estimates Our discussion and analysis of financial condition and results of
operations are 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 persuasive evidence of our arrangement
with the customer exists, service has been provided to the customer, the
price to the customer is fixed or determinable and collectibility of the
sales price is reasonably assured. We recognize up-front fees associated
with service activation over the expected term of the customer
relationship, which is presently estimated to be twenty-four to
forty-eight months using the straight-line method. Similarly, we treat
the incremental direct costs of service activation, which consist
principally of customer premises equipment, service activation fees paid
to other telecommunications companies and sales commissions, as deferred
charges in amounts no greater than the up-front fees that are deferred,
and such incremental direct costs are amortized to expense using the
straight-line method over a range of twenty-four to forty-eight months.  
    
    We have credit risk with several customers. We perform ongoing credit
evaluations of our customers financial condition and maintain an
allowance for estimated credit losses. In addition, we have billing
disputes with some of our customers. These disputes arise in the
ordinary course of business in the telecommunications industry and we
believe that their impact on our accounts receivable and revenues can be
reasonably estimated based on historical experience. In addition,
certain customer revenues are subject to refund if the end-user
terminates service within thirty days of service activation.
Accordingly, we maintain allowances, through charges to revenues, based
on our estimate of the ultimate resolution of these disputes and future
service cancellations, and our reported revenue in any period could be
different than what is reported if we employed different assumptions in
estimating the outcomes of these items.  
    
    We state our inventories at the lower of cost or market. In assessing
the ultimate recoverability of inventories, we are required to make
estimates regarding future customer demand.  
    
    We record property and equipment and intangible assets at cost,
subject to adjustments for impairment. We depreciate or amortize
property and equipment and intangible assets using the straight-line
method over their estimated useful lives. In assessing the
recoverability of our property and equipment and intangible assets, we
must make assumptions regarding estimated future cash flows and other
factors to determine the fair value of the respective assets. If these
estimates and assumptions change in the future, we may be required to
record additional impairment charges relating to our property and
equipment and intangible assets.  
    
    We record goodwill when the consideration paid for an acquisition
exceeds the fair value of net tangible and intangible assets acquired.
We measure and test goodwill for impairment on an annual basis or more
frequently if we believe indicators of impairment exist. The performance
of the test involves a two-step process. The first step compares the
fair value of the reporting unit to its carrying amount, including
goodwill. The fair value of the reporting unit is determined by
calculating the market capitalization of the reporting unit as derived
from quoted market prices or other generally accepted valuation methods
if quoted market prices are not available. A potential impairment exists
if the fair value of the reporting unit is lower than its carrying
amount. The second step of the process is only performed if a potential
impairment exists, and it involves determining the difference between
the fair value of the reporting units net assets, other than goodwill,
to the fair value of the reporting unit. If the difference is less than
the net book value of goodwill, an impairment exists and is recorded. We
determine our reporting units, for purposes of testing for impairment,
by determining (i) how we manage our operations, (ii) if a component of
an operating unit constitutes a business for which discrete financial
information is available and our management regularly review such
financial information, and (iii) how the acquired entity, is integrated
with our operations. Based on these criteria, we determined that our
Wholesale and Direct segments are our reporting units. On June 8, 2004,
we completed the acquisition of all of the outstanding shares of
privately-held GoBeam, Inc., as described in Note 8 to our condensed
consolidated financial 23




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statements, Acquisition of GoBeam, Inc.We integrated and manage the
GoBeam business within our Direct segment. Accordingly, the recorded
goodwill from the acquisition of GoBeam was allocated to the Direct segment
for purposes of testing for impairment.  
    
    We consummated a plan of reorganization under Chapter 11 of the
United States Bankruptcy Code on December 20, 2001. As of September 30,
2004, we had certain unresolved claims relating to our Chapter 11
bankruptcy proceedings that remain in dispute. Therefore, it is
reasonably possible that such disputed bankruptcy claims could
ultimately be settled for amounts that differ from the aggregate
liability for such claims reflected in our condensed consolidated
balance sheet as of September 30, 2004.  
    
    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.  
    
    We are performing ongoing analysis of analyzing the applicability of
certain transaction-based taxes to sales of our products and services
and, purchases of telecommunications circuits from various carriers.
This analysis includes discussions with authorities of jurisdictions in
which we do business 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 possible engagement in 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, or MDF, available to certain
customers for the reimbursement of co-branded advertising expenses and
other purposes. To the extent that MDF is used by our customers for
co-branded advertising, and the customers provide us with third-party
evidence of such co-branded advertising and we can reasonably estimate
the fair value of our portion of the advertising, such amounts are
charged to advertising expense as incurred. Nonqualified MDF activities
are recorded as reductions of revenues as incurred. Amounts payable to
customers relating to rebates and customer incentives are recorded as
reductions of revenues based on our estimate of sales incentives that
will ultimately be claimed by customers.  
    
    We account for income taxes using the liability method, under which
deferred tax assets and liabilities are determined based on differences
between the financial reporting and tax bases of our assets and
liabilities. We record a valuation allowance on our deferred tax assets
to arrive at an amount that is more likely than not to be realized. In
the future, should we determine that we are able to realize all or part
of our deferred tax assets, which presently are fully reserved, an
adjustment to our deferred tax assets would increase income in the
period in which the determination was made.  
    
    We account for stock-based awards to employees using the intrinsic
value method, and non-employees using the fair value method. Under the
intrinsic value method, when the exercise price of our employee stock
options equals or exceeds the market price of the underlying stock on
the date of grant, we do not record compensation expense in our
condensed consolidated 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. 24




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Recent Accounting Pronouncements In March 2004, the Financial Accounting Standards Board, or FASB, approved
Emerging Issue Task Force, or EITF, Issue 03-6, Participating Securities and
the Two-Class Method under Statement of Financial Accounting Standards, or
SFAS, 128. EITF Issue 03-6 supersedes the guidance in Topic No. D-95, Effect
of Participating Convertible Securities on the Computation of Basic Earnings
per Share, and requires the use of the two-class method of participating
securities. The two-class method is an earnings allocation formula that
determines earnings per share for each class of common stock and participating
security according to dividends declared (or accumulated) and participation
rights in undistributed earnings. In addition, EITF Issue 03-6 addresses other
forms of participating securities, including options, warrants, forwards and
other contracts to issue an entitys common stock, with the exception of
stock-based compensation (unvested options and restricted stock) subject to the
provisions of Opinion 25 and SFAS 123. EITF Issue 03-6 is effective for
reporting periods beginning after March 31, 2004 and should be applied by
restating previously reported earnings per share. The adoption of EITF Issue
03-6 did not have a significant effect on our condensed consolidated financial
statements as of and for the three and nine months ended September 30, 2004. On May 15, 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity.
SFAS No. 150 establishes standards for classifying and measuring as liabilities
certain financial instruments that embody obligations of the issuer and have
characteristics of both liabilities and equity, such as mandatorily redeemable
equity instruments. SFAS No. 150 must be applied immediately to instruments
entered into or modified after May 31, 2003 and to all other instruments that
exist as of the beginning of the first interim financial reporting period
beginning after June 15, 2003, except for mandatorily redeemable instruments of
non-public companies, to which the provisions of SFAS No. 150 must be applied
in fiscal periods beginning after December 15, 2003. The application of SFAS
No. 150 to pre-existing instruments should be recognized as the cumulative
effect of a change in accounting principle. The adoption of SFAS No. 150 had no
effect on our condensed consolidated financial statements as of September 30,
2004 and for the three and nine months ended September 30, 2004. In January 2003, the FASB issued Interpretation, or 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, or
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
was effective March 31, 2004 for enterprises with VIEs created before February
1, 2003. The adoption of FIN 46 did not have an effect on our condensed
consolidated financial statements as of September 30, 2004 and for the three
and nine months ended September 30, 2004. Results of Operations for the three and nine months ended September 30, 2004 Business Segment Information During the three and nine months ended September 30, 2004 and 2003, 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. Our wholesale segment, or Wholesale, is a
provider of high-speed connectivity services to ISPs, and enterprise and
telecommunications carrier customers. Our direct segment, or Direct, is a
provider of voice and data communication services, which include, VoIP,
high-speed connectivity, Internet access and other services to individuals,
small and medium-sized businesses, and other organizations. 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 or controlled by our business segments. We measure our business segments profitability as income from operations,
excluding certain operating expenses such as depreciation and amortization, and
other income and expenses items. We record business segments net revenues based
upon the differences in customers and related marketing channels. Wholesale net
revenues are primarily driven by products and services sold to large resellers,
whereas Direct net revenues are primarily driven by products and services sold
directly to end-users. Our business segments operating expenses are primarily
comprised of network costs and labor and related non-labor expenses to
provision services and to provide support to our customers. Our business
segments network costs consist of end-user circuits, aggregation circuits, 25




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central office space, Internet transit charges, customer premises
equipment and equipment maintenance. Operating expenses also consist of labor
and related non-labor expenses for customer care, dispatch, and repair and
installation activities. We allocate network costs to our business segments based on their
consumption of circuit or equipment capacity. End-user circuit costs are
directly assigned to the segment based on the products and services sold.
Aggregation circuits are allocated based on actual capacity usage determined by
the total number of customers in a segment utilizing those circuits. Customer
premises equipment, or CPE, cost is directly assigned to the business segment
based on installations performed and the cost of each product lines specific
CPE. Labor costs from our operations forces are allocated to our business
segments based on resource consumption formulas primarily based on
installations and percentage of total lines in service. Employee compensation
for our sales forces are directly assigned to the business segments based on
the customers they sell to and serve. Advertising and promotions are assigned
to the business segments primarily based on expenditures incurred to stimulate
demand for the target customer. Reclassifications Certain balances in our 2003 condensed consolidated financial statements
have been reclassified to conform to the presentation in 2004. Revenues, net The primary component of our net revenues is earned monthly broadband
subscription billings for DSL services. We also earn revenues from monthly
subscription and usage billings related to our VoIP services, monthly billings
for high-capacity circuits sold to our wholesale customers and to a lesser
degree from dial-up services sold to end-users. Because we do not recognize
revenue from billings to financially distressed customers until we receive
payment and until our ability to keep the payment is reasonably assured, our
reported revenues for the three and nine months ended September 30, 2004 and
2003 have been impacted by whether we receive, and the timing of receipt of,
payments from these customers. Our revenues also include billings for
installation fees and equipment sales, which are recognized as revenue over the
expected life of the relationship with the end-user, and Federal Universal
Service Fund, or FUSF, charges billed to our customers. Customer incentives and
rebates that we offer to attract and retain customers are recorded as
reductions to gross revenues. We regularly have billing disputes with our
customers. These disputes arise in the ordinary course of business in the
telecommunications industry and we believe their impact on our accounts
receivable and revenues can be reasonably estimated based on historical
experience. In addition, certain revenues are subject to refund if 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. Our net revenues of $105,687 for the three months ended September 30, 2004
increased by $5,180, or 5.2%, over our net revenues of $100,507 for the three
months ended September 30, 2003. The increase in our net revenues was primarily
attributable to a $6,335 increase in broadband and VoIP revenue as a result of
adding end-users to our network and a $3,274 reduction in customer rebates and
incentives, which we record as reductions of revenue. The reduction in
incentives and rebates resulted from lower sales to our wholesale customers.
These increases were offset by a $3,878 reduction in installation fees and
equipment sales, primarily driven by lower selling prices, some of which is
attributable to the fact that we passed suppliers price reductions to our
customers, and by a reduction of $638 in dial-up revenue. Reductions to
revenues for billing disputes and money-back guarantees for early service
termination were $872 and $459 during the three months ended September 30, 2004
and 2003, respectively. Our net revenues of $321,490 for the nine months ended September 30, 2004
increased by $37,678, or 13.3%, over our net revenues of $283,812 for the nine
months ended September 30, 2003. The increase in our net revenues was primarily
attributable to a $36,418 increase in broadband and VoIP revenue as a result of
adding end-users to our network and a $10,572 reduction in customer rebates and
incentives caused by lower sales to our wholesale customers. These increases
were offset by a $8,904 reduction in installation fees and equipment sales,
primarily driven by lower selling prices. Reductions to revenues for billing
disputes and money-back guarantees for early service termination were $4,549
and $2,079 during the nine months ended September 30, 2004 and 2003,
respectively. We expect the total of broadband and VoIP subscription billings and
revenues to remain relatively flat for the three months ending December 31,
2004 because we do not expect our total number of end-users to change
significantly. We believe that Incumbent local telephone companies and the
cable companies will continue to offer aggressive price discounts on their
consumer data communications services, which will continue to make it more
difficult for our wholesale partners to add and retain end-users. In response
to our competitors discounts, we have also decided to lower the prices for
many of our high-speed data services, which will make it more difficult to
increase our revenue. We expect that we will continue to lower our prices for
many of our services. We plan 26




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to introduce new sales and marketing programs and create new services for
our customers, which we anticipate will create additional sources of broadband
and VoIP subscription billings and revenues. We expect the demand for our
dial-up service to continue to decrease, which will continue to result in lower
revenues from this service. We also expect customer rebates and incentives to
continue to be an element of our sales and marketing programs to respond to
competitive market conditions. As discussed in OverviewRecent Developments, a variety of regulatory
events have created uncertainty for resellers who purchase our data services
and combine them with their own UNE-P voice services and sell the resulting
bundle to their customers. This uncertainty may cause these resellers to stop
marketing these services or otherwise change their strategies. It is possible
that these conditions will cause our revenue to decline in future periods. Segment Revenues and Significant Customers Our segment net revenues were as follows: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Wholesale
    
    $
    75,296
    
    
    $
    75,968
    
    
    $
    232,900
    
    
    $
    220,819Percent of total net revenues
    
    
    71.2
    %
    
    
    75.6
    %
    
    
    72.4
    %
    
    
    77.8
    %Direct
    
    $
    30,391
    
    
    $
    24,539
    
    
    $
    88,590
    
    
    $
    62,993Percent of total net revenues
    
    
    28.8
    %
    
    
    24.4
    %
    
    
    27.6
    %
    
    
    22.2
    %
 We had over 370 wholesale customers as of September 30, 2004 compared to
approximately 270 as of September 30, 2003. The increase in 2004 from 2003
resulted primarily from the addition of smaller resellers. Our 30 largest
wholesale customers comprised 66.1% and 67.6% of our total gross revenues for
the three and nine months ended September 30, 2004, respectively, and 72.5% and
74.1% of our total gross revenues for the three and nine months ended September
30, 2003, respectively. As of September 30, 2004 and 2003, receivables from
these customers collectively comprised 68.3% and 75.5%, respectively, of our
gross accounts receivable balance. For the three months ended September 30, 2004, Earthlink, Inc. and AT&T
Corp., two customers in our wholesale business segment, accounted for 16.1% and
13.5%, respectively, of our total net revenues. For the nine months ended
September 30, 2004, these customers accounted for 17.2% and 13.3%,
respectively, of our total net revenues. As of September 30, 2004, receivables
from these customers comprised 18.1% and 18.8%, respectively, of our gross
accounts receivable balance. For the three months ended September 30, 2003, Earthlink and AT&T Corp.
accounted for 22.4% and 10.9%, respectively, of our total net revenues. For the
nine months ended September 30, 2003, these customers accounted for 22.3% and
11.3%, respectively, of our total net revenues. As of September 30, 2003,
receivables from these customers comprised 23.9% and 11.7%, respectively, of
our gross accounts receivable balance. We had over 76,000 direct end-users as of September 30, 2004 compared to
approximately 71,000 as of September 30, 2003. The increase in net revenues
from our Direct business segment was primarily attributable to the increase in
the subscriber base. As of September 30, 2004, we had approximately 373 business customers
utilizing our small business VoIP services, a 20 percent increase over the 311 customers at the end
of June 30, 2004. End-user VoIP stations increased to approximately 17,900 contributing approximately $2,200 in revenue
for the three months ended September 30, 2004. Wholesaler Financial Difficulties We have identified certain of our customers who were essentially current
in their payments for our services prior to September 30, 2004, or have
subsequently paid all or significant portions of the respective amounts that we
recorded as accounts receivable as of September 30, 2004, that we believe may
have a high risk of becoming financially distressed. Revenues from these
customers accounted for approximately 6.9% and 7.9% of our total net revenues
for the three and nine months ended September 30, 2004, respectively, and 18.8%
and 22.5% of our total net revenues for the three and nine months ended
September 30, 2003, respectively. As of September 30, 2004 and 2003,
receivables from these customers comprised 9.0% and 25.8% of our gross accounts
receivable balance, respectively. If these customers are unable to demonstrate
their ability to pay for our services in a timely manner in periods ending
subsequent to September 30, 2004, revenue from such customers will be
recognized when cash is collected, as described above. 27




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Operating Expenses Operating expenses include cost of sales, selling, general and
administrative expenses, depreciation and amortization expenses and provision
for restructuring expenses. Our total operating expenses were as follows: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Amount
    
    $
    120,978
    
    
    $
    132,671
    
    
    $
    356,420
    
    
    $
    376,500Percent of total net revenues
    
    
    114.5
    %
    
    
    132.0
    %
    
    
    110.9
    %
    
    
    132.7
    %
 Cost of sales (exclusive of depreciation and amortization) Cost of sales consist primarily of the costs of provisioning and
maintaining telecommunications circuits and central office space, equipment
sold to our customers, labor and related expenses and other non-labor items to
operate and maintain our network and related system infrastructure. Our cost of sales was as follows: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Amount
    
    $
    65,939
    
    
    $
    77,215
    
    
    $
    196,981
    
    
    $
    214,724Percent of total net revenues
    
    
    62.4
    %
    
    
    76.8
    %
    
    
    61.3
    %
    
    
    75.7
    %
 Our cost of sales for the three months ended September 30, 2004, decreased
by $11,276, or 14.6%, when compared to our cost of sales for the three months
ended September 30, 2003. The decrease in our cost of sales in absolute dollars
and as a % of revenue for the three months ended September 30, 2004, was
attributable to (i) a decrease in network costs of $339, primarily caused by a
$2,659 reduction in installations expenses, offset by a $2,157 increase in
network costs, primarily due to our new VoIP business, (ii) a $2,833 reduction
in the cost of equipment sold, primarily resulting from the migration expenses
associated with the Qwest customer lines acquisition that occurred during the
three months ended September 30, 2003, (iii) a decrease in the amortization of
network and product costs subject to deferral of $2,313, and (iv) a decrease in
labor and other operating expenses of $3,700, primarily caused by a $4,641
reduction in incentive and stock-based compensation expenses, principally due
to our 2003 employee stock purchase plan, or ESPP, which is subject to variable
accounting, a $1,293 reduction in contract labor and other services, offset by
$2,375 of transaction-based taxes associated with various tax settlements that
occurred during the three months ended September 30, 2003. In addition, during
the three months ended September 30, 2004, we reduced our estimates on property
tax liabilities, primarily caused by lower property tax valuations and actual
tax assessments on our network assets. This change in accounting estimate
reduced our cost of sales and our net loss by approximately $1,050 during the
three months ended September 30, 2004. Furthermore, during the three months
ended June 30, 2004, we ceased the accrual of a transaction-based tax because
we determined we should not be subject to this tax. This change in accounting
estimate reduced, when compared to the prior period, our cost of sales and our
net loss by approximately $1,041 during the three months ended September 30,
2004. Our cost of sales for the nine months ended September 30, 2004, decreased
by $17,743, or 8.3%, when compared to our cost of sales for the nine months
ended September 30, 2003. The decrease in our cost of sales in absolute dollars
and as a % of revenue for the nine months ended September 30, 2004 was
attributable to (i) a decrease in network costs of $2,470, primarily caused by
a $5,561 reduction in installation expenses and continued network cost
management, offset by a $2,919 increase in network costs, primarily due to the
addition of subscribers to our network, (ii) a reduction in the cost of
equipment sold of $3,016, primarily caused by the migration expenses associated
with the Qwest customer line acquisition that occurred during the nine months
ended September 30, 2003, (iii) a decrease in the amortization of network and
product costs subject to deferral of $5,517, and (iv) a decrease in labor and
other operating expenses of $753, primarily caused by a $8,141 reduction in
salaries and incentive and stock-based compensation expenses, and $2,137 from
charges recorded during the nine months ended September 30, 2003 for the
probable applicability of employment-related taxes related to certain
stock-based compensation provided to employee in prior periods, offset by a
$4,896 increase in contract labor and other services, $3,716 from
transaction-based tax settlements that occurred during the nine months ended
September 30, 2003, a $934 increase in transaction-based taxes. Furthermore,
during the nine months ended September 30, 28




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2004, we ceased the accrual of a transaction-based tax because we
determined we should not be subject to this tax. This change in accounting
estimate reduced our cost of sales and our net loss by approximately $2,141, or
$0.01 per share, during the nine months ended September 30, 2004. Lastly,
during the nine months ended September 30, 2004, we changed our estimates of
certain property, transaction-based and employment-related tax liabilities due
to the expiration of the prescribed statutory period for the corresponding tax
returns and due to lower property tax valuations and actual tax assessments on
our network assets. These changes in accounting estimates reduced our cost of
sales and our net loss by approximately $3,846 during the nine months ended
September 30, 2004. For the three months ended September 30, 2004 and 2003, cost of sales were
comprised of $41,893 and $55,084, respectively, from our Wholesale segment,
$14,576 and $15,394, respectively, from our Direct segment and $9,470 and
$6,737, respectively, from our Corporate Operations. The decrease in cost of
sales for our Wholesale segment was primarily attributable to (i) a decrease in
network related costs of $2,871, resulting from a reduction in installations,
(ii) $3,553 from a decrease in labor and incentive expenses, (iii) $2,221
decrease in stock-based compensation expenses, due to our 2003 ESPP, (iv)
$2,225 from a decrease in amortization of network and product costs subject to
deferral, and (v) a $1,293 reduction in contract labor and other services. In
addition, we ceased the accrual of a transaction-based tax of $1,041 as
described above. The decrease in cost of sales for our Direct segment was
primarily caused by a $2,833 reduction in the cost of equipment sold, primarily
resulting from the migration expenses associated with the Qwest customer lines
acquisition that occurred during the three months ended September 30, 2003,
offset by an increase in network costs of $1,161 due to our new VoIP business
and a $621 increase in labor and other operating expenses. The increase in cost
of sales in our Corporate Operations was primarily attributable to a $1,039
increase in network related costs due to the addition of central office
locations, $2,375 of transaction-based taxes associated with various tax
settlements that occurred during the three months ended September 30, 2003, and
a $1,900 increase in labor and other operating expenses, offset by a $1,378
decrease in stock-based compensation expenses related to our 2003 ESPP. In
addition, we reduced our estimates on property tax liabilities by $1,050 as
describe above. For the nine months ended September 30, 2004 and 2003, cost of sales were
comprised of $132,377 and $155,044, respectively, from our Wholesale segment,
$38,860 and $33,953, respectively, from our Direct segment and $25,744 and
$25,727, respectively, from our Corporate Operations. The decrease in cost of
sales for our Wholesale segment was primarily attributable to (i) a decrease in
network related costs of $2,834, resulting from a reduction in installations,
(ii) a $4,704 decrease in labor and other operating expenses, (iii) a $9,267
reduction in amortization of network and product cost subject to deferral, (iv)
a $1,773 decrease in stock-based compensation expenses related our 2003 ESPP,
and (v) a $1,293 reduction in contract labor and other service expenses. During
the nine months ended September 30, 2004, we changed our estimates of certain
liabilities for some elements of our network costs that are not yet billed by
our suppliers, which caused a $889 reduction in our cost of sales. In addition,
we ceased the accrual of a transaction-based tax, as described above, which
reduced our cost of sales by $2,141. The increase in cost of sales for our
Direct segment was due to a (i) a $315 increase in network related costs,
primarily caused by $1,774 of cost improvements as a result of our continued
network cost management activities, offset by a $2,385 increase in network
costs, primarily due to the addition of subscribers to our network, (ii) a
$2,737 increase in amortization of network an product costs subject to
deferral, (iii) a $4,430 increase in labor, contract labor and other services;
offset by a $3,016 decrease in the cost of equipment, due to the migration
expenses associated with the Qwest customer lines acquisition that occurred
during the nine months ended September 30, 2003. The slight increase in cost of
sales in our Corporate Operations was primarily attributable to (i) a $1,268
increase in network costs due to the addition of central office locations, (ii)
$3,716 of transaction-based taxes associated with various tax settlements that
occurred during the nine months ended September 30, 2003, and (iii) a $1,709
increase in contract labor and other service expenses; offset by a (i) $1,100
decrease in stock-based compensation expenses related to our 2003 ESPP, and
(ii) $2,137 from charges recorded during the nine
months ended September 30, 2003 for the probable applicability of
employment-related taxes related to certain stock-based compensation provided
to employee in prior periods. In addition, we reduced our estimates on property
tax liabilities by $3,846 as describe above. We expect our cost of sales to increase in future periods to the extent we
are able to add subscribers and services to our network. In addition, with the
acquisition of GoBeam, we also expect to incur higher cost of sales as a result
of the addition of GoBeams employees and other cost of sales associated with
the sale of VoIP services. Our ability to add subscribers to our network is,
however, subject to the regulatory uncertainty noted in the following
paragraph. As discussed in the Overview  Recent Developments and in Part II, Item
1 Legal Proceedings, as a result of the FCCs Triennial Review decision, and
subsequent proceedings, there is uncertainty concerning our ability to purchase
some of the network elements we purchase from the incumbent local phone
companies. As a result of those legal and regulatory proceedings, it is
possible that the incumbent local phone companies could substantially increase
the cost or reduce the availability of some network elements. Other state or
federal regulatory proceedings could also reduce our access to, or increase the
prices for, unbundled network elements. These regulatory decisions could
substantially increase our overall network cost structure or cause us to cease
delivering certain services, and, accordingly, adversely affecting our revenue. 29




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Selling, General and Administrative Expenses Selling, general and administrative expenses consist primarily of salaries
and related expenses and our promotional and advertising expenses. Our selling, general and administrative expenses were as follows: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Amount
    
    $
    35,488
    
    
    $
    37,627
    
    
    $
    100,668
    
    
    $
    106,347Percent of total net revenues
    
    
    33.6
    %
    
    
    37.4
    %
    
    
    31.3
    %
    
    
    37.5
    %
 Our selling, general and administrative expenses for the three months
ended September 30, 2004, decreased by $2,139, or 5.7%, when compared to our
selling, general and administrative expenses for the three months ended
September 30, 2003. The decrease in selling, general and administrative
expenses for the three months ended September 30, 2004 was primarily
attributable to (i) a $7,793 reduction in incentive and stock-based
compensation expenses, principally due to our 2003 ESPP, which is subject to
variable accounting, (ii) $1,678 from bad debt recoveries, primarily as a
result of a distribution by MCI, (iii) a reduction of $419 contract labor and
professional services; offset by (i) an increase of $6,650 in advertising
expenses, primarily to promote our VoIP product line, and (ii) a $1,239
increase in employee compensation, principally due to our acquisition of
GoBeam. In addition, during the three months ended September 30, 2004, we
reduced our estimates on our property tax liabilities, primarily caused by
lower property tax valuations and actual tax assessments on our network assets.
This change in accounting estimate reduced our selling, general and
administrative expenses and our net loss, compared to the prior period, by
approximately $313 during the three months ended September 30, 2004. For the nine months ended September 30, 2004, our selling, general and
administrative expenses decreased by $5,679, or 5.3%, when compared to our
selling, general and administrative expenses for the nine months ended
September 30, 2003. The decrease in selling, general and administrative
expenses for the nine months ended September 30, 2004 was primarily
attributable to (i) a $8,380 reduction in incentive and stock-based
compensation expenses, principally due to our 2003 ESPP, which is subject to
variable accounting, (ii) $3,800 from charges recorded during the nine months
ended September 30, 2003 for the probable applicability of employment-related
taxes related to certain stock-based compensation provided to employee in prior
periods, (iii) $1,928 from bad debt recoveries, offset by a $11,056 increase in
advertising expenses, which include expenditures to promote our VoIP
product line. In addition, during the nine months ended September 30, 2004, we
changed our estimates of certain property, transaction-based and
employment-related tax liabilities due to the expiration of the prescribed
statutory period for the corresponding tax returns and due to lower property
tax valuations and actual tax assessments on our network assets. These changes
in accounting estimates reduced our selling, general and administrative
expenses and our net loss by approximately $2,515 during the nine months ended
September 30, 2004. For the three months ended September 30, 2004 and 2003, selling, general
and administrative expenses were comprised of $2,310 and $4,446, respectively,
from our Wholesale segment, $13,307 and $5,216, respectively, from our Direct
segment and $19,871 and $27,965, respectively, from our Corporate Operations.
The decrease in selling, general and administrative expenses in our Wholesale
segment was primarily attributable to a $1,634 reduction in incentive and
stock-based compensation expenses, principally due to our 2003 ESPP, and $502
decrease in advertising expenses. The increase in selling, general and
administrative expenses in our Direct segment was attributable to a $7,262
increase in sales and advertising expenses, and a $1,239 increase in employee
compensation, principally due to our acquisition of GoBeam. The decrease in
selling, general and administrative expenses in our Corporate Operations was
primarily due to $5,934 reduction in incentive and stock-based compensation
expenses, principally due to our 2003 ESPP, and $1,678 from bad debt
recoveries. In addition, we reduced our estimates on our property tax
liabilities by $313 as described above. For the nine months ended September 30, 2004 and 2003, selling, general
and administrative expenses were comprised of $7,467 and $9,908, respectively,
from our Wholesale segment, $25,133 and $16,444, respectively, from our Direct
segment and $68,068 and $79,995, respectively, from our Corporate Operations.
The decrease in selling, general and administrative expenses in our Wholesale
segment was primarily attributable to $1,932 reduction in incentive and
stock-based compensation expenses, primarily due to our 2003 ESPP, and $509
decrease in advertising expenses. The increase in selling, general and
administrative expenses in our Direct segment was primarily attributable to
$10,720 increase in sales and advertising expenses, offset by $2,031 decrease
in incentive and stock-based compensation expenses related to our 2003 ESPP.
The decrease in selling, general and administrative expenses in our Corporate
Operations was primarily due to $4,438 reduction in incentive and stock-based
compensation expenses, principally due to our 2003 ESPP, $3,800 from charges
recorded during the nine months ended September 30, 2003 for the probable
applicability of employment-related taxes related to certain stock-based
compensation provided to employee in prior periods, and $1,928 from bad 30




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debt recoveries, offset by $1,045 increase in other expenses. In addition, we
reduced $2,515 in our estimates of certain property, transaction-based and
employment-related tax liabilities due to the expiration of the prescribed
statutory period for the corresponding tax returns and due to lower property
tax valuations and actual tax assessments on our network assets as described
above. We expect to incur higher selling, general and administrative expenses as
a result of the addition of GoBeams employees and increased marketing efforts
associated with sales of VoIP services. Depreciation and Amortization We recorded depreciation and amortization expense for property and
equipment in the amount of $14,078 for the three months ended September 30,
2004, an increase of $1,024, or 7.8%, from depreciation and amortization
expense for property and equipment of $13,054 recorded for the three months
ended September 30, 2003. We recorded depreciation and amortization expense for
property and equipment in the amount of $42,735 for the nine months ended
September 30, 2004, an increase of $1,336, or 3.2% from depreciation and
amortization expense for property and equipment of $41,399 recorded for the
nine months ended September 30, 2003. The increase in depreciation is primarily
attributable to the expansion of our network during 2004. We expect
depreciation and amortization to increase in future periods as we expand
the footprint of our network and add more end-users. This increase in
depreciation will be partially offset as historical assets become fully
depreciated. Amortization of intangible assets was $5,328 for the three months ended
September 30, 2004, representing an increase of $553, or 11.6%, over the
amortization of intangible assets of $4,775 for the three months ended
September 30, 2003. Amortization of intangible assets was $15,121 for the nine
months ended September 30, 2004, representing an increase of $2,326, or 18.2%,
over the amortization of intangible assets of $12,795 for the nine months ended
September 30, 2003. The increase from 2003 to 2004 resulted from the resumption
of our network build and augmentation in selected markets during the latter
portion of 2003 and the nine months ended September 30, 2004, which increased
collocation fee expenditures and related amortization expenses. In addition
amortization of other intangibles, primarily resulting from the acquisition of GoBeam,
contributed to the increase in amortization. As explained above, we do not allocate depreciation and amortization
expense to our business segments. Provision for Restructuring Expenses During the three and nine months ended September 30, 2004, we reduced our
workforce by approximately 8 and 61 employees, respectively, which represented
approximately 0.7% and 5.5% of our workforce, respectively. The reductions
covered employees in the areas of sales and marketing, operations and corporate
functions. During the nine months ended September 30, 2003, we reduced our
workforce by approximately 113 employees, which represented approximately 10.2%
of our workforce. The reductions covered employees in the areas of sales and
marketing, operations and corporate functions. None of these reductions
occurred during the three months ended September 30, 2003. In connection with the reductions in force, we recorded charges to
operations for the three and nine months ended September 30, 2004 of $145 and
$915, respectively, relating to employee severance benefits that met the
requirements for accrual. For the three and nine months ended September 30,
2004, $9 and $150, respectively, of these expenses related to cost of sales and
the remaining $136 and $765, respectively, related to selling, general and
administrative expenses. During the three and nine months ended September 30,
2004, we paid severance benefits of approximately $185 and $833, respectively.
We are expected to pay substantially all of the remainder of the severance
benefits accrued as of September 30, 2004 in the fourth quarter of 2004. The
expenses associated with the reductions in force for the three and nine months
ended September 30, 2004 were $8 and $287, respectively, related to our
Wholesale business segment, and none and $253, respectively, related to our
Direct business segment. The remaining expenses associated with these
reductions in force during the three and nine months ended September 30, 2003
of $137 and $375, respectively, were related to our Corporate Operations. We recorded charges to operations for the nine months ended September 30,
2003 of $1,235, relating to employee severance benefits that met the
requirements for accrual. For the nine months ended September 30, 2003, $242 of
these expenses were charged to cost of sales and the remaining $993 were
charged to selling, general and administrative expenses. During the three and
nine months ended September 30, 2003, we paid severance benefits of
approximately $147 and $1,235, respectively. The expenses associated with the
reductions in force were $103 related to our Wholesale business segment, $349
related to our Direct business segment. The remaining $783 in expenses
associated with these reductions in force were related to our Corporate
Operations. 31




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Other Income (Expense) Net Interest Expense Net interest expense was $237 and $1,767 for the three and nine months
ended September 30, 2004, respectively, and $928 and $2,411 for the three and
nine months ended September 30, 2003, respectively. Net interest expense during
the three and nine months ended September 30, 2004 consisted principally of
interest expense on our 3% convertible senior debentures due 2004 and 11%
long-term note payable to SBC Communications Inc., which we repaid in March of
2004, less interest income earned on our cash, cash equivalents and short-term
investments balances. Net interest expense during the three and nine months
ended September 30, 2003 consisted of interest expense on our 11% long-term
note payable to SBC Communications Inc., less interest income earned on our
cash, cash equivalents and short-term investments balances. We expect future
net interest to be limited to the interest on our 3% convertible senior
debentures due 2004 offset by interest income on our cash balances. We expect
this interest expense to increase in the fourth quarter of 2004 because we were
unable to register on Form S-3 these Debentures, and the common stock into
which they may be converted, by October 6, 2004. Since we were unable to
complete this registration process by that date, the interest on the Debentures
increased to 3.25% on October 6, 2004, and will remain at this rate until the
registration process is completed. We are continuing our efforts to complete
the registration process, however, if the Company is unable to complete the
registration process by January 4, 2005, the interest rate will increase to
3.50%. We may, however, seek additional debt financing in the future if it is
available on terms that we believe are favorable. If we seek additional debt
financing, our interest expense would increase. Investment Losses We recorded losses and write-downs on investments for the three months
ended September 30, 2003 in the amount of $621. This included an impairment
write-down of an equity investment of $538 and our equity in the losses of
unconsolidated affiliates of $83. We recorded losses and write-downs on
investments for the nine months ended September 30, 2003 in the amount of
$1,026. This included an impairment write-down of an equity investment of $747
and our equity in the losses of unconsolidated affiliates of $279. We did not
record similar losses or write-downs on investments during the three and nine
months ended September 30, 2004. Miscellaneous Income (Expense) We recorded miscellaneous income (expense) of $1,724 and $1,956 for the
three and nine months ended September 30, 2004, respectively, and $282 and $685
for the three and nine months ended September 30, 2003, respectively. The
increase from 2003 to 2004 resulted principally from a litigation settlement
that resulted in a cash receipt of approximately $1,600 during the three and
nine months ended September 30, 2004. 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. Related Party Transactions 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 $87 and $285 during the three and nine months ended September
30, 2004, respectively, and $169 and $560 during the three and nine months
ended September 30, 2003, respectively. L. Dale Crandall, one of our directors
and chairman of the Audit Committee, is also a director of BEA Systems, one of
our vendors. We paid $30 and $563 to BEA Systems during the three and nine
months ended September 30, 2004, respectively, and none and $209 during the
three and nine months September 30, 2003,
respectively. We believe the terms of these transactions are comparable to
transactions that would likely be negotiated with clearly independent parties. Liquidity and Capital Resources We have invested substantial capital for the procurement, design and
construction of our central office collocation facilities, the design,
creation, implementation and maintenance of our software, the purchase of
telecommunications equipment and the design, development and maintenance of our
networks. Our capital expenditures were $35,846 for the nine months ended
September 30, 2004. 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 relatively lower than the current period while 32




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incremental, or
success-based, capital expenditures related to the addition of subscribers in
existing regions will increase proportionately in relation to the number of new
subscribers that we add to our network. As of September 30, 2004, we had an accumulated deficit of $1,676,379 and
unrestricted cash, cash equivalents and short-term investments of $162,910. In
addition, we had stockholders equity of $12,819 as of September 30, 2004. Net cash provided in our operating activities was $7,601 for the nine
months ended September 30, 2004, due primarily to the net loss of $34,741; a
decrease in collateralized customer deposits of $5,886 as a result of one of
our wholesale customers utilizing part of its prepayment; a decrease in other
current liabilities of $9,075, primarily driven by the payment of accrued
interest on our debt; a decrease in unearned revenues of $5,470 and a decrease
in deferred costs of service activation of $1,904, which were both driven by
decrease in initial set up fees and related costs; offset by depreciation and
amortization charges of $57,856; an increase in prepaid expenses and other
current assets of $1,847, and a decrease in accounts payable of $2,092,
primarily driven by the timing of our payments to vendors. Net cash used in our investing activities was $51,192 for the nine months
ended September 30, 2004. The net cash used in our investing activities during
this period was primarily due to purchases of short-term investments of
$125,864 and capital expenditures of $35,846, offset by maturities of
short-term investments of $110,030. Net cash provided by our financing activities was $75,838 for the nine
months ended September 30, 2004. The net cash provided by our financing
activities during this period was primarily due to proceeds from issuance of
our 3% senior convertible debentures of $125,000 and proceeds from the issuance
of common stock of $5,971, offset by principal payments of our long term debt
of $50,000 and payments of $5,001 expenses associated with our debenture
offering. As of September 30, 2004, we had $97,623 in unrestricted cash and cash
equivalents, and $65,287 in unrestricted short-term investments. As a result of
the GoBeam acquisition, we expect to use additional cash resources primarily to
increase sales and marketing activities as we expand the offering of VoIP
services to new markets across our broadband network. The amount of this
additional usage of cash from the GoBeam acquisition will depend on our ability
to control incremental selling, general and administrative expenses, the amount
of capital expenditures that are required to expand this new business,
development of operating support systems and software, and our ability to
generate VoIP service revenues. Adverse business, legal, regulatory or legislative developments may
require us to raise additional financing, raise our prices or decrease our cost
structure. If we are unable to acquire additional capital on favorable terms if
needed, or are required to raise it on terms that are less satisfactory than we
desire, our financial condition will be adversely affected. Our future cash
requirements for the next twelve months and for the long-term for developing,
deploying and enhancing our network and operating our business will depend on a
number of factors including:  
    
    our acquisition of GoBeam, Inc., including cash we use to further
develop our VoIP capabilities, improve our systems and software to
support VoIP and expand the marketing of VoIP services following the
closing of the acquisition;
    
    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 Incumbent local telephone companies remote
terminals and other facilities, all at reasonable prices;
    
    the availability of UNE-P to our customers who purchase our DSL
services and bundle them with their competitive telephone services;
    
    the rate at which resellers 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; 33




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
    
    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. Our contractual debt, lease and purchase obligations as of September 30,
2004 for the next five years, and thereafter, were as follows: 2004
    
    2005-2006
    
    2007-2008
    
    Thereafter
    
    TotalNote payable to debentures
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    125,000
    
    
    $
    125,000Capital leases
    
    
    15
    
    
    
    470
    
    
    
    24
    
    
    
    
    
    
    
    509Office leases
    
    
    1,228
    
    
    
    7,583
    
    
    
    4,780
    
    
    
    735
    
    
    
    14,326Other operating leases
    
    
    34
    
    
    
    218
    
    
    
    3
    
    
    
    
    
    
    
    255Purchase obligations
    
    
    5,166
    
    
    
    4,475
    
    
    
    
    
    
    
    
    
    
    
    9,641$
    6,443
    
    
    $
    12,746
    
    
    $
    4,807
    
    
    $
    125,735
    
    
    $
    149,731
 We lease certain vehicles, equipment and office facilities under various
non-cancelable operating leases that expire at various dates through 2009. Our
office leases generally require us to pay operating costs, including property
taxes, insurance and maintenance, and contain scheduled rent increases and
certain other rent escalation clauses. Rent expense is reflected in
our consolidated financial statements on a straight-line basis over the
terms of the respective leases. In 2002, we entered into a three-year, non-exclusive agreement with MCI,
for the right to provide certain network services to us. We have a monthly
minimum usage requirement which began in June 2002. The agreement expires in
May 2005 and has a remaining purchase obligation of $5,360 as of September 30,
2004. Similarly, in 2002 we entered into a three-year, non-exclusive agreement
with AT&T Corp. for the right to provide certain data services to us. We have
an annual minimum usage requirement which began in January 2002. The agreement
expires in December 2004 and we have a minimum remaining aggregate purchase
obligation of approximately $2,875 for 2004 all of which remains unutilized at
September 30, 2004. In addition, in 2002, we entered into a four-year,
non-exclusive agreement with AT&T Corp. for the right to provide long distance
services to us. We have an annual minimum usage requirement which began in
April 2002. The agreement expires in March 2006 and has a minimum remaining
aggregate usage commitment of approximately $1,406 as of September 30, 2004. 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 2003
Annual Report on Form 10-K, which was filed with the SEC on February 28, 2004.  
    
    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.
    
    Charges for network elements are generally outside of our control
because they are proposed by the Incumbent local telephone companies and
are subject to costly regulatory approval processes.
    
    Our business will suffer if our interconnection agreements are not
renewed or if they are modified on unfavorable terms.
    
    We may need to raise additional capital under difficult financial
market conditions.
    
    In order to become cash flow positive and to achieve profitability,
we must add end-users to our network and sell additional 34




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services to our
existing end-users 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.
    
    If we fail to improve and maintain our internal controls, our ability
to provide accurate financial statements could be impaired, and any
failure to maintain our internal controls and provide accurate financial
statements could cause our stock price to decline substantially.
    
    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 resellers are facing financial difficulties, which makes
it more difficult to predict our revenues.
    
    Our development of our direct business poses operational challenges
and may cause our resellers to place fewer orders with us or may cause
us to lose resellers.
    
    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.
    
    A breach of network security could delay or interrupt service to our
customers, which could reduce demand for our services.
    
    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 and if we are unable to obtain these items from
these third parties we may not be able to deliver our services as
required.
    
    We 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.
    
    We use third party vendors in India for tasks that were previously
done by our employees.
    
    We must pay federal, state and local taxes 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.
    
    Substantial leverage and debt service obligations may adversely affect our cash flow.
    
    Changes in stock option accounting rules may adversely impact our
reported operating results prepared in accordance with generally
accepted accounting principles, our stock price and our competitiveness
in the employee marketplace. 35




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Forward-Looking Statements We include certain estimates, projections, and other forward-looking
statements in our reports, in presentations to analysts and others, and in
other publicly available material. Future performance cannot be ensured. Actual
results may differ materially from those in forward-looking statements. The
statements contained in this Report on Form 10-Q that are not historical facts
are forward-looking statements (as such term is defined in Section 27A of the
Securities Act and Section 21E of the Exchange Act), which can be identified by
the use of forward-looking terminology such as estimates, projects,
anticipates, expects, intends, believes, or the negative thereof or
other variations thereon or comparable terminology, or by discussions of
strategy that involve risks and uncertainties. Examples of such forward-looking
statements include but are not limited to:  
    
    the impact of the FCCs decisions in the Triennial Review and our
continuing ability to purchase 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 incumbent local telephone companies
and our ability to bundle our data services with their voice services,
particularly in light of the recent decision of the United States Court
of Appeals for the D.C. Circuit vacating portions of the Triennial
Review order;  
    
    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;  
    
    the impact of advertising on brand recognition and operating results;  
    
    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 burn rate
and the number of installed lines;  
    
    plans to develop and commercialize value-added services;  
    
    our anticipated capital expenditures;  
    
    plans to enter into business arrangements with broadband-related service providers;  
    
    the effect of regulatory changes;  
    
    the effect of litigation currently pending; and  
    
    other statements contained in this Report on Form 10-Q regarding matters that are not historical facts. These statements are only estimates or predictions and cannot be relied
upon. We can give you no assurance that future results will be achieved. Actual
events or results may differ materially as a result of risks facing us or
actual results differing from the assumptions underlying such statements. Such
risks and assumptions that could cause actual results to vary materially from
the future results indicated, expressed or implied in such forward-looking
statements include our ability to:  
    
    adapt our business plan in response to further developments resulting from the FCCs Triennial Review order;  
    
    collect receivables from customers;  
    
    retain end-users that are served by customers facing financial difficulties; 36




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
    
    market our services to customers;  
    
    generate customer demand for our services;  
    
    defend our company against litigation;  
    
    reduce our operating costs and overhead while continuing to provide good customer service;  
    
    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 incumbent local 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, 2003. We disclaim any obligation to update information contained in any
forward-looking statement. 
 Item 3.Market Risk Quantitative and Qualitative Disclosures about Market Risk Our exposure to financial market risk, including changes in interest and
marketable equity security prices, relates primarily to our investment
portfolio and outstanding debt obligations. We typically do not attempt to
reduce or eliminate our market exposure on our investment securities because a
substantial majority of our investments are short-term securities. We do not
have any derivative instruments. The fair value of our investment portfolio or
related income would not be significantly impacted by either a 100 basis point
increase or decrease in interest rates due mainly to the fixed-rate, short-term
nature of the substantial majority of our investment portfolio. In addition,
all of our outstanding indebtedness as of September 30, 2004 is fixed-rate
debt. The table below presents the carrying value and related weighted-average
interest rates for our cash and cash equivalents, short-term investments and
restricted cash and cash equivalents as of September 30, 2004 (in thousand): Carrying Value
    
    Interest RateCash and cash equivalents
    
    $
    97,623
    
    
    
    1.32
    %Short-term investments
    
    
    65,287
    
    
    
    1.52
    %Restricted cash and cash equivalents
    
    
    2,842
    
    
    
    1.65
    %$
    165,752
    
    
    
    1.40
    %
 
 Item 4.Controls and Procedures Evaluation of Disclosure Controls and Procedures.The Securities and
Exchange Commission defines the term disclosure controls and procedures to
mean a companys controls and other procedures that are designed to ensure that
information required to be disclosed in the reports that it files or submits
under the Securities Exchange Act of 1934 is recorded, processed, summarized
and reported, within the time periods specified in the Commissions rules and
forms. Our chief executive officer and chief financial officer have concluded,
based on the evaluation of the effectiveness of the disclosure controls and
procedures by our management, with the participation of our chief executive
officer and chief financial officer, as of the end of the period covered by
this report, that our disclosure controls and procedures were effective for
this purpose. 37




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Changes in Internal Controls.During the fiscal quarter covered by this
report, we did not make any change in our internal control over financial
reporting that materially affected or is reasonably likely to materially affect
our internal control over financial reporting. Sarbanes-Oxley Section 404 Compliance.Pursuant to Section 404 of the
Sarbanes-Oxley Act (Section 404) our management will be required to provide
an assessment of the effectiveness of our internal controls over financial
reporting in our annual report for our fiscal year 2005, and our independent
auditors will be required to attest to this assessment. We are in the process
of completing the documentation of our controls and testing their effectiveness
and expect that our management will be able to provide a favorable assessment
and that our auditors will concur with this assessment. However, this
evaluation and attestation process is new and neither we nor our auditors have
significant experience with it, and we cannot be assured that we and our
auditors will reach a favorable conclusion under Section 404. If we or our
auditors fail to do so on a timely basis, investor confidence in us could be
adversely affected and our results of operations could be adversely affected as
we seek to address any shortcomings, and as a result our stock price could
decline. 38




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PART II. OTHER INFORMATION 
 Item 1.Legal Proceedings (all dollar amounts are presented in thousands) Purchasers of our common stock and purchasers of the convertible notes we
issued in September 2000 have filed complaints 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, or
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, or
MOU, with counsel for the lead plaintiffs in this litigation that tentatively
resolves the litigation, providing 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 subsequently filed an appeal relating to the allocation of the
settlement proceeds between the plaintiffs and their attorneys. On February 18,
2004, the Ninth Circuit affirmed the District Courts final judgment and on
February 24, 2004 we were informed that the class member who had filed the
appeal would not be pursuing the matter any further. The distribution of the
6,495,844 shares was completed in April of 2004. In April 1999, we filed a lawsuit against Bell Atlantic, now Verizon, and
its affiliates in the United States District Court for the District of
Columbia. We are pursuing antitrust and other claims in this lawsuit arising
out of Verizons conduct as a supplier of network facilities, including central
office space, transmission facilities and telephone lines. In December 2000, we
also filed a lawsuit against BellSouth Telecommunications and its subsidiaries
in the United States District Court for the Northern District of Georgia. We
are pursuing claims in this lawsuit that are similar to our claims against
Verizon. Both courts dismissed some of our claims based on the ruling of the
United States Court of Appeals of the Seventh Circuit in Goldwasser v.
Ameritech. The court in the Verizon case also dismissed our remaining claims on
other grounds. We voluntarily dismissed our remaining claims in the BellSouth
case so we could pursue certain issues on appeal. We appealed the BellSouth and
Verizon decisions to the United States Court of Appeals for the Eleventh
Circuit and the United States Court of Appeals for the District of Columbia,
respectively. On August 2, 2002, the Eleventh Circuit Court of Appeals reversed
the lower courts decision in the BellSouth case and remanded the case for
further proceedings. BellSouth appealed this decision to the United States
Supreme Court. On January 20, 2004, the United States Supreme Court reversed a
decision entitled Verizon Communications v. Law Offices of Curtis Trinko, which
rejected the Goldwasser decision. The Supreme Court also vacated the Eleventh
Circuits decision in our case against BellSouth and remanded the case to the
Eleventh Circuit for review in light of the Trinko decision. Although we
believe the Trinko decision does not impact our cases, both BellSouth and
Verizon claim that Trinko supports the dismissal of our lawsuits and both filed
motions with the appellate courts requesting affirmance of the district courts
rulings. On May 12, 2004, the D.C. Circuit denied Verizons motion for summary
affirmance and ordered the parties to submit additional briefs. On June 25,
2004, the Eleventh Circuit reversed portions of the lower courts decision in
the BellSouth case and remanded the case for further proceedings. We cannot
predict the outcome of these proceedings at this time. On June 11, 2001, Verizon Communications filed a lawsuit against us in the
United States District Court for the Northern District of California. Verizon
is a supplier of telephone lines that we use to provide services to our
customers. In its amended complaint, Verizon claims that we falsified trouble
ticket reports with respect to the telephone lines that we ordered and seeks
unspecified monetary damages, characterized as being in the millions, and
injunctive relief. 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 appealed the dismissal of its lawsuit and in July 2004 the
Ninth Circuit Court of Appeals partially reversed the District Courts decision
and indicated that Verizon could attempt to pursue a claim against us for
breach of contract. The matter has been sent back to the District Court for
further proceedings. We believe we have strong defenses to this lawsuit, but
litigation is inherently unpredictable and there is no guarantee we will
prevail. Several stockholders filed complaints in the United States District Court
for the Southern District of New York, on behalf of themselves and purported
classes of stockholders, against us and several former and current officers and
directors in addition to some of the underwriters in our stock offerings. These
lawsuits are so-called IPO allocation cases, challenging practices allegedly
used by certain underwriters of public equity offerings during the late 1990s
and 2000. On April 19, 2002 the plaintiffs amended their complaint and removed
us as a defendant. Certain directors and officers are still named in the
complaint. The plaintiffs claim that we failed to disclose the arrangements
that some of these underwriters purportedly made with certain investors. The
plaintiffs and the issuer defendants have reached a tentative agreement to
settle the matter, and we believe the tentative settlement will not have a 39




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material adverse effect on our consolidated financial position or results
of operations. That settlement, however, has not been finalized. If the
settlement is not finalized, we believe we have strong defenses to these
lawsuits and we intend to contest them vigorously. However, litigation is
inherently unpredictable and there is no guarantee we will prevail. In June 2002, Dhruv Khanna was relieved of his duties as our General
Counsel and Secretary. Shortly thereafter, Mr. Khanna alleged that, over a
period of years, certain current and former directors and officers had breached
their fiduciary duties to the Company by engaging in or approving actions that
constituted waste and self-dealing, that certain current and former directors
and officers had provided false representations to our auditors and that he had
been relieved of his duties in retaliation for his being a purported
whistleblower and because of racial or national origin discrimination. He
threatened to file a shareholder derivative action against those current and
former directors and officers, as well as a wrongful termination lawsuit. Mr.
Khanna was placed on paid leave while his allegations were being investigated. Our Board of Directors appointed a special investigative committee, which
initially consisted of Dale Crandall and Hellene Runtagh, to investigate the
allegations made by Mr. Khanna. Richard Jalkut was appointed to this committee
shortly after he joined our Board of Directors. This committee retained an
independent law firm to assist in its investigation. Based on this
investigation, the committee concluded that Mr. Khannas allegations were
without merit and that it would not be in the best interests of the Company to
commence litigation based on these allegations. The committee considered, among
other things, that many of Mr. Khannas allegations were not accurate, that
certain allegations challenged business decisions lawfully made by management
or the Board, that the transactions challenged by Mr. Khanna in which any
director had an interest were approved by a majority of disinterested directors
in accordance with Delaware law, that the challenged director and officer
representations to the auditors were true and accurate, and that Mr. Khanna was
not relieved of his duties as a result of retaliation for alleged
whistleblowing or racial or national origin discrimination. Mr. Khanna has
disputed the committees work and the outcome of its investigation. After the committees findings had been presented and analyzed, we
concluded in January 2003 that it would not be appropriate to continue Mr.
Khanna on paid leave status, and determined that there was no suitable role for
him at the Company. Accordingly, he was terminated as an employee of the
Company. Based on the events mentioned above, in September 2003, Mr. Khanna filed a
purported class action and a derivative action against our current and former
directors in the Court of Chancery of the State of Delaware in and for New
Castle County. On August 3, 2004, Mr. Khanna amended his Complaint and two
additional purported shareholders joined the lawsuit. In this action the
plaintiffs seek recovery on behalf of the company from the individual
defendants for their purported breach of fiduciary duty. The plaintiffs also
seek to invalidate our election of directors in 2002, 2003 and 2004 because
they claim that our proxy statements were misleading. While we believe the
contentions of Mr. Khanna referred to above are without merit, and the company
and its directors will vigorously defend themselves, we are unable to predict
the outcome of this lawsuit. We are also a party to a variety of pending or threatened legal
proceedings as either plaintiff or defendant, or are engaged in business
disputes that arise in the ordinary course of business. Failure to resolve
these various legal disputes and controversies without excessive delay and cost
and in a manner that is favorable to us could significantly harm our business.
We do not believe the ultimate outcome of these matters will have a material
impact on our consolidated financial position and results of operations.
However, litigation is inherently unpredictable and there is no guarantee we
will prevail or otherwise not be adversely affected. We are subject to state public utility commission, FCC and other
regulatory and court decisions as they relate to the interpretation and
implementation of the 1996 Telecommunications Act, the interpretation of
competitive telecommunications company interconnection agreements in general,
and our interconnection agreements in particular. In some cases we may be bound
by or may otherwise be significantly impacted by the results of ongoing
proceedings of these bodies or the legal outcomes of other contested
interconnection agreements that are similar to our agreements. The results of
any of these proceedings could harm our business. In addition, we are engaged in a variety of legal negotiations,
arbitrations and regulatory and court proceedings with multiple telephone
companies. These negotiations, arbitrations and proceedings concern the
telephone companies denial of central office space, the cost and delivery of
transmission facilities and telephone lines and central office spaces, billing
issues and other operational issues. Other than the payment of legal fees and
expenses, which are not quantifiable but are expected to be material, we do not
believe that these matters will result in material liability to us and the
potential gains are not quantifiable at this time. An unfavorable result in any
of these negotiations, arbitrations and proceedings, however, could have a
material adverse effect on our consolidated financial position and results of
operations if we are denied or charged higher rates for transmission lines or
central office spaces. 40




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##### Table of Contents



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 a.Exhibits: Exhibit
    
    
    
    
    
    Incorporated by Reference
    
    ExhibitNumber
    
    Exhibit Description
    
    Form
    
    File No.
    
    Date of First Filing
    
    Number
    
    Filed Herewith31.1
    
    Certification Pursuant to Rule 13a-14(a).
    
    
    
    
    
    
    
    
    
    X31.2
    
    Certification Pursuant to Rule 13a-14(a).
    
    
    
    
    
    
    
    
    
    X32.1*
    
    Certification Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of
2002.
    
    
    
    
    
    
    
    
    
    X32.2*
    
    Certification Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of
2002.
    
    
    
    
    
    
    
    
    
    X
   *
    
    These certifications accompany the Registrants Quarterly Report on Form 10-Q
and are not deemed filed with the SEC. 41




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##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. COVAD COMMUNICATIONS GROUP, INC.By:
    
    /s/ CHARLES E. HOFFMANCharles E. HoffmanPresident, Chief ExecutiveOfficer and DirectorDate: November 9, 2004By:
    
    /s/ MARK A. RICHMANMark A. RichmanExecutive Vice President andChief Financial OfficerDate: November 9, 2004
 42




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##### Table of Contents



ExhibitNumber
    
    Description31.1
    
    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.