##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, DC 20549
 FORM 10-Q
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended June 30, 2007
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the transition period fromto.
 Commission file number: 001-32588
 COVAD COMMUNICATIONS GROUP, INC.
  Delaware
    
    77-0461529(State or other jurisdiction
    
    (I.R.S. Employerof incorporation or organization)
    
    Identification Number)110 Rio RoblesSan Jose, California(Address of principal executive
    
    95134offices)
    
    (Zip Code)
 (408) 952-6400  (Registrants telephone number, including area code)
 þ o
  o þ o
 o þ




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##### 



COVAD COMMUNICATIONS GROUP, INC.
 For the Quarterly Period Ended June 30, 2007
 TABLE OF CONTENTS
 PagePART I. FINANCIAL INFORMATIONITEM 1.
    
    Financial Statements
    
    
    2Condensed Consolidated Balance Sheets
    
    
    2Condensed Consolidated Statements of  Operations
    
    
    3Condensed Consolidated Statements of Cash  Flows
    
    
    4Notes to Condensed Consolidated Financial  Statements
    
    
    5ITEM 2.
    
    Managements Discussion and Analysis of  Financial Condition and Results of Operations
    
    
    24ITEM 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    44ITEM 4.
    
    Controls and Procedures
    
    
    44PART II. OTHER INFORMATIONITEM 1.
    
    Legal Proceedings
    
    
    45ITEM 1A.
    
    Risk Factors
    
    
    46ITEM 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    59ITEM 3.
    
    Defaults Upon Senior Securities
    
    
    59ITEM 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    59ITEM 5.
    
    Other Information
    
    
    59ITEM 6.
    
    Exhibits
    
    
    60SIGNATURES
    
    
    
    
    61EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  1




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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 ITEM 1. Financial Statements
 COVAD COMMUNICATIONS GROUP, INC.
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (All dollar and share amounts are presented in thousands, except par value)
 (Unaudited)
 June 30,
    
    
    December 31,2007
    
    
    2006(Note 1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    34,643
    
    
    $
    46,279Short-term investments in debt securities
    
    
    18,708
    
    
    
    15,793Restricted cash and cash equivalents
    
    
    12,202
    
    
    
    19,578Accounts receivable, net
    
    
    35,750
    
    
    
    31,151Unbilled revenues
    
    
    3,869
    
    
    
    2,567Inventories
    
    
    3,378
    
    
    
    3,602Prepaid expenses and other current assets
    
    
    4,839
    
    
    
    4,979Total current assets
    
    
    113,389
    
    
    
    123,949Property and equipment, net
    
    
    77,509
    
    
    
    87,586Collocation fees and other intangible assets, net
    
    
    18,690
    
    
    
    22,768Goodwill
    
    
    50,002
    
    
    
    50,002Deferred costs of service activation
    
    
    25,923
    
    
    
    24,268Deferred debt issuance costs, net
    
    
    3,043
    
    
    
    3,823Other long-term assets
    
    
    1,961
    
    
    
    912Total assets
    
    $
    290,517
    
    
    $
    313,308LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)Current liabilities:Accounts payable
    
    $
    35,173
    
    
    $
    34,189Accrued compensation
    
    
    10,504
    
    
    
    14,539Accrued collocation and network service fees
    
    
    15,075
    
    
    
    15,594Accrued transaction-based taxes
    
    
    8,086
    
    
    
    7,754Collateralized and other customer deposits
    
    
    4,825
    
    
    
    5,585Unearned revenues
    
    
    6,300
    
    
    
    6,528Loan payable to bank
    
    
    6,100
    
    
    
    6,100Other accrued liabilities
    
    
    12,670
    
    
    
    11,381Total current liabilities
    
    
    98,733
    
    
    
    101,670Long-term debt
    
    
    169,774
    
    
    
    167,240Unearned revenues
    
    
    39,628
    
    
    
    39,506Other long-term liabilities
    
    
    4,329
    
    
    
    2,538Total liabilities
    
    
    312,464
    
    
    
    310,954Commitments and contingencies (Notes 5 and 6)Stockholders equity (deficit):Preferred stock, $0.001 par value; 5,000 shares
authorized; no shares issued and outstanding at June
30, 2007 and December 31, 2006
    
    
    
    
    
    
    Common stock, $0.001 par value; 590,000 shares
authorized; 297,978 shares issued and outstanding at
June 30, 2007 (296,877 shares issued and outstanding
at December 31, 2006)
    
    
    298
    
    
    
    297Common stock  Class B, $0.001 par value; 10,000
shares authorized; no shares issued and outstanding at
June 30, 2007 and December 31, 2006
    
    
    
    
    
    
    Additional paid-in capital
    
    
    1,735,946
    
    
    
    1,734,124Accumulated other comprehensive income (loss)
    
    
    (2
    )
    
    
    3Accumulated deficit
    
    
    (1,758,189
    )
    
    
    (1,732,070
    )Total stockholders equity (deficit)
    
    
    (21,947
    )
    
    
    2,354Total liabilities and stockholders equity (deficit)
    
    $
    290,517
    
    
    $
    313,308
  2




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COVAD COMMUNICATIONS GROUP, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (All dollar and share amounts are presented in thousands, except per share amounts)
 (Unaudited)
 Three months ended June 30,
    
    
    Six months ended June 30,2007
    
    
    2006
    
    
    2007
    
    
    2006Revenues, net
    
    $
    120,585
    
    
    $
    118,535
    
    
    $
    240,735
    
    
    $
    236,286Operating expenses:Cost of sales (exclusive of depreciation
and amortization)
    
    
    87,136
    
    
    
    80,802
    
    
    
    175,131
    
    
    
    160,739Benefit from federal excise tax adjustment
    
    
    
    
    
    
    (19,455
    )
    
    
    
    
    
    
    (19,455
    )Selling, general and administrative
    
    
    28,455
    
    
    
    31,889
    
    
    
    59,789
    
    
    
    66,854Depreciation and amortization of property
and equipment
    
    
    10,796
    
    
    
    8,080
    
    
    
    21,806
    
    
    
    16,728Amortization of collocation fees and
other intangible assets
    
    
    2,345
    
    
    
    2,636
    
    
    
    4,694
    
    
    
    5,036Provision for post-employment benefits
    
    
    1,357
    
    
    
    511
    
    
    
    1,357
    
    
    
    1,274Total operating expenses
    
    
    130,089
    
    
    
    104,463
    
    
    
    262,777
    
    
    
    231,176Income (loss) from operations
    
    
    (9,504
    )
    
    
    14,072
    
    
    
    (22,042
    )
    
    
    5,110Other income (expense), net:Interest income
    
    
    695
    
    
    
    1,127
    
    
    
    1,511
    
    
    
    2,104Interest expense
    
    
    (2,837
    )
    
    
    (2,732
    )
    
    
    (5,666
    )
    
    
    (4,054
    )Miscellaneous income, net
    
    
    43
    
    
    
    6
    
    
    
    78
    
    
    
    33Other income (expense), net
    
    
    (2,099
    )
    
    
    (1,599
    )
    
    
    (4,077
    )
    
    
    (1,917
    )Net income (loss)
    
    $
    (11,603
    )
    
    $
    12,473
    
    
    $
    (26,119
    )
    
    $
    3,193Earnings (loss) per common share:Basic
    
    $
    (0.04
    )
    
    $
    0.04
    
    
    $
    (0.09
    )
    
    $
    0.01Diluted
    
    $
    (0.04
    )
    
    $
    0.04
    
    
    $
    (0.09
    )
    
    $
    0.01Weighted-average number of common shares
outstanding used in computing earnings
(loss) per common share:Basic
    
    
    296,955
    
    
    
    292,993
    
    
    
    296,941
    
    
    
    284,791Diluted
    
    
    296,955
    
    
    
    340,064
    
    
    
    296,941
    
    
    
    290,220
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COVAD COMMUNICATIONS GROUP, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (All dollar amounts are presented in thousands)
 (Unaudited)
 Six months ended June 30,2007
    
    
    2006Operating Activities:Net income (loss)
    
    $
    (26,119
    )
    
    $
    3,193Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities:Provision for bad debts, net
    
    
    273
    
    
    
    110Benefit from federal excise tax adjustment
    
    
    
    
    
    
    (19,455
    )Depreciation and amortization
    
    
    26,500
    
    
    
    21,764Loss on disposition of property and equipment
    
    
    21
    
    
    
    19Stock-based compensation expense
    
    
    1,098
    
    
    
    1,543Amortization of deferred customer incentives
    
    
    379
    
    
    
    379Amortization of deferred debt issuance costs
    
    
    780
    
    
    
    734Accretion of interest on investments, net
    
    
    (153
    )
    
    
    (108
    )Other non-cash items
    
    
    (300
    )
    
    
    Net changes in operating assets and liabilities, net of assets acquired and
liabilities assumed in acquisition:Accounts receivable
    
    
    (4,872
    )
    
    
    (5,614
    )Unbilled revenues
    
    
    (1,302
    )
    
    
    (55
    )Inventories
    
    
    224
    
    
    
    144Prepaid expenses and other current assets
    
    
    140
    
    
    
    217Deferred costs of service activation
    
    
    (1,655
    )
    
    
    693Other long-term assets
    
    
    (1,443
    )
    
    
    Accounts payable
    
    
    5,262
    
    
    
    3,858Collateralized and other customer deposits
    
    
    (760
    )
    
    
    (10,257
    )Redemption of collateralized customer deposit
    
    
    
    
    
    
    (33,538
    )Other liabilities
    
    
    2,095
    
    
    
    900Unearned revenues
    
    
    (106
    )
    
    
    (2,594
    )Net cash provided by (used in) operating activities
    
    
    62
    
    
    
    (38,067
    )Investing Activities:Restricted cash and cash equivalents, net
    
    
    7,376
    
    
    
    (33,925
    )Purchase of short-term investments in debt securities
    
    
    (20,267
    )
    
    
    (6,176
    )Maturities of short-term investments in debt securities
    
    
    17,500
    
    
    
    18,250Purchase of property and equipment
    
    
    (16,033
    )
    
    
    (20,000
    )Proceeds from sale of property and equipment
    
    
    5
    
    
    
    26Payment of collocation fees and purchase of other intangible assets
    
    
    (616
    )
    
    
    (2,004
    )Payment in connection with business and asset acquisitions, net of cash acquired
    
    
    (177
    )
    
    
    (3,187
    )Other long-term assets
    
    
    15
    
    
    
    (732
    )Net cash used in investing activities
    
    
    (12,197
    )
    
    
    (47,748
    )Financing Activities:Proceeds from the issuance of senior secured note, net of issuance costs
    
    
    
    
    
    
    38,457Proceeds from utilization of credit facility
    
    
    12,200
    
    
    
    6,100Principal payments on credit facility
    
    
    (12,200
    )
    
    
    Principal payment of long-term debt
    
    
    
    
    
    
    (1,031
    )Principal payments under capital lease obligations
    
    
    (526
    )
    
    
    (277
    )Payment of issuance costs related to credit facility
    
    
    
    
    
    
    (651
    )Proceeds from the issuance of common stock, net of issuance costs
    
    
    1,025
    
    
    
    14,555Net cash provided by financing activities
    
    
    499
    
    
    
    57,153Net decrease in cash and cash equivalents
    
    
    (11,636
    )
    
    
    (28,662
    )Cash and cash equivalents at beginning of period
    
    
    46,279
    
    
    
    84,291Cash and cash equivalents at end of period
    
    $
    34,643
    
    
    $
    55,629Supplemental Disclosures of Cash Flow Information:Cash paid during the period for interest
    
    $
    2,079
    
    
    $
    2,011Supplemental Schedule of Non-Cash Investing and Financing Activities:Interest obligation settled with the issuance of additional convertible
long-term notes
    
    $
    2,534
    
    
    $
    Equipment purchased through capital leases
    
    $
    1,201
    
    
    $
    Common stock issued for acquisition of business
    
    $
    
    
    
    $
    16,314Accrued equipment purchases
    
    $
    3,096
    
    
    $
    4,777
  4




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




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Benefit from federal excise tax adjustment 
   Restricted Cash and Cash Equivalents
 Long-Term Debt.
 6




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Inventories
  Goodwill
   Business Acquisition.
  Collateralized and Other Customer Deposit s
   7




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Revenue Recognition
 Post-Employment Benefits
  Earnings (Loss) Per Share
    Three months ended June 30,
    
    
    Six months ended June 30,2007
    
    
    2006
    
    
    2007
    
    
    2006Basic:Net income (loss) as reported
    
    $
    (11,603
    )
    
    $
    12,473
    
    
    $
    (26,119
    )
    
    $
    3,193Diluted:Add back interest on 3%
convertible debentures
    
    
    
    
    
    
    1,190
    
    
    
    
    
    
    
    Net income (loss) adjusted
for assumed conversions
    
    $
    (11,603
    )
    
    $
    13,663
    
    
    $
    (26,119
    )
    
    $
    3,193
 8




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Three months ended June 30,
    
    
    Six months ended June 30,2007
    
    
    2006
    
    
    2007
    
    
    2006Basic:Weighted-average number of common
shares outstanding used in the
computations of basic earnings
(loss) per share
    
    
    296,955
    
    
    
    292,993
    
    
    
    296,941
    
    
    
    284,791Diluted:Dilutive stock options and warrants
    
    
    
    
    
    
    7,691
    
    
    
    
    
    
    
    5,429Assumed conversion of 3%
convertible debentures
    
    
    
    
    
    
    39,380
    
    
    
    
    
    
    
    Weighted-average number of common
shares outstanding used in the
computations of diluted earnings
(loss) per share
    
    
    296,955
    
    
    
    340,064
    
    
    
    296,941
    
    
    
    290,220
   Three months ended June 30,
    
    
    Six months ended June 30,2007
    
    
    2006
    
    
    2007
    
    
    2006Stock options
    
    
    24,417
    
    
    
    18,139
    
    
    
    24,417
    
    
    
    19,677Warrants
    
    
    6,514
    
    
    
    5,192
    
    
    
    6,514
    
    
    
    5,525Common shares
issuable under the
assumed conversion
of convertible
debentures and
notes
    
    
    63,452
    
    
    
    21,505
    
    
    
    63,452
    
    
    
    60,885
 Comprehensive Income (Loss)
  Three months ended June 30,
    
    
    Six months ended June 30,2007
    
    
    2006
    
    
    2007
    
    
    2006Net income (loss)
    
    $
    (11,603
    )
    
    $
    12,473
    
    
    $
    (26,119
    )
    
    $
    3,193Unrealized gains (loss) on
available-for-sale
securities
    
    
    (6
    )
    
    
    (3
    )
    
    
    (5
    )
    
    
    4Comprehensive income (loss)
    
    $
    (11,609
    )
    
    $
    12,470
    
    
    $
    (26,124
    )
    
    $
    3,197
 Recent Accounting Pronouncements
 The Fair Value Option for Financial Assets and
Financial Liabilities  Including an Amendment of FASB Statement No. 115.
 9




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Fair Value Measurements.
 How Taxes Collected from Customers and Remitted to Governmental Authorities should be presented in
the Income Statement. Disclosure of Accounting Policies.
 Accounting for Uncertainty in
Income Taxes Accounting for Income Taxes.
 Risks and Uncertainties
  
    
    changes in government policy, regulation and enforcement or adverse judicial or
administrative interpretations and rulings or legislative action including, but not limited
to, changes that affect the continued availability of the unbundled network elements of the
local exchange carriers networks and the costs associated therewith;
    
    the Companys dependence on the availability and functionality of the networks of the
incumbent local exchange carriers;
    
    ability to generate cash flows or obtain adequate financing;
    
    increased price competition in local and long distance services, including bundled
services, and overall competition within the telecommunications industry; and
    
    adverse determinations in certain litigation matters.
  10




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2. Revenue Recognition
      June 30, 2007
    
    
    December 31, 2006Gross accounts receivable
    
    $
    38,693
    
    
    $
    34,123Allowance for service credits
    
    
    (2,652
    )
    
    
    (2,729
    )Allowance for bad debts
    
    
    (291
    )
    
    
    (243
    )Accounts receivable, net
    
    $
    35,750
    
    
    $
    31,151
 11




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Significant Customers
   Wholesaler Financial Difficulties
   12




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3. Warrants
     4. Post-Employment Benefits
    13




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5. Long-Term Debt
 12% Senior Secured Convertible Notes
      14




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3% Convertible Senior Debentures
  Line of Credit
   6. Commitments and Contingencies
 Litigation
  15




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16




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Other Contingencies
 .
   Indemnification Agreements
   17




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7. Stock-Based Compensation
     18




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Stock Options
    
    Employee Stock Purchase PlanThree months ended June 30,
    
    Three and six months ended June 30,2007
    
    2006
    
    2007
    
    2006Expected life of options in years
    
    
    3.5
    
    
    
    3.3
    
    
    
    0.5
    
    
    
    0.5Volatility
    
    
    63.40
    %
    
    
    84.00
    %
    
    
    52.30
    %
    
    
    77.30
    %Risk-free interest rate
    
    
    4.93
    %
    
    
    5.09
    %
    
    
    5.08
    %
    
    
    4.80
    %Expected dividend yield
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
 Stock OptionsSix months ended June 30,2007
    
    2006Expected life of options in years
    
    
    3.5
    
    
    
    3.4Volatility
    
    
    66.21
    %
    
    
    85.40
    %Risk-free interest rate
    
    
    4.73
    %
    
    
    4.90
    %Expected dividend yield
    
    
    0.00
    %
    
    
    0.00
    %
  Number of Shares of
    
    Option Price per
    
    Weighted-AverageCommon Stock
    
    Share
    
    Exercise PriceBalance as of December 31, 2006
    
    
    23,082
    
    
    
    $0.350 - $149.79
    
    
    
    $4.31Granted
    
    
    3,935
    
    
    
    $0.900 -   $  1.360
    
    
    
    $1.16Exercised
    
    
    (169
    )
    
    
    $0.560 -   $  1.280
    
    
    
    $0.67Cancelled, expired and forfeited
    
    
    (2,431
    )
    
    
    $0.360 - $63.333
    
    
    
    $7.96Balance as of June 30, 2007
    
    
    24,417
    
    
    
    $0.350 - $149.79
    
    
    
    $3.47
 8. Business Segments
    19




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Total
    
    
    Corporate
    
    
    ConsolidatedAs of and for the three months ended June 30, 2007:
    
    Wholesale
    
    
    Direct
    
    
    Segments
    
    
    Operations
    
    
    TotalRevenues, net
    
    $
    76,629
    
    
    $
    43,956
    
    
    $
    120,585
    
    
    $
    
    
    
    $
    120,585Cost of sales (exclusive of depreciation and
amortization)
    
    
    48,339
    
    
    
    26,932
    
    
    
    75,271
    
    
    
    11,865
    
    
    
    87,136Selling, general and administrative
    
    
    1,847
    
    
    
    6,886
    
    
    
    8,733
    
    
    
    19,722
    
    
    
    28,455Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,141
    
    
    
    13,141Provision for post-employment benefits
    
    
    435
    
    
    
    475
    
    
    
    910
    
    
    
    447
    
    
    
    1,357Income (loss) from operations
    
    
    26,008
    
    
    
    9,663
    
    
    
    35,671
    
    
    
    (45,175
    )
    
    
    (9,504
    )Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,099
    )
    
    
    (2,099
    )Net income (loss)
    
    $
    26,008
    
    
    $
    9,663
    
    
    $
    35,671
    
    
    $
    (47,274
    )
    
    $
    (11,603
    )Total assets
    
    $
    43,347
    
    
    $
    22,195
    
    
    $
    65,542
    
    
    $
    224,975
    
    
    $
    290,517
 Total
    
    
    Corporate
    
    
    ConsolidatedAs of and for the three months ended June 30, 2006:
    
    Wholesale
    
    
    Direct
    
    
    Segments
    
    
    Operations
    
    
    TotalRevenues, net
    
    $
    78,898
    
    
    $
    39,637
    
    
    $
    118,535
    
    
    $
    
    
    
    $
    118,535Cost of sales (exclusive of depreciation and
amortization)
    
    
    45,712
    
    
    
    23,762
    
    
    
    69,474
    
    
    
    11,328
    
    
    
    80,802Benefit from federal excise tax adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (19,455
    )
    
    
    (19,455
    )Selling, general and administrative
    
    
    2,052
    
    
    
    10,153
    
    
    
    12,205
    
    
    
    19,684
    
    
    
    31,889Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,716
    
    
    
    10,716Provision for post-employment benefits
    
    
    156
    
    
    
    226
    
    
    
    382
    
    
    
    129
    
    
    
    511Income (loss) from operations
    
    
    30,978
    
    
    
    5,496
    
    
    
    36,474
    
    
    
    (22,402
    )
    
    
    14,072Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,599
    )
    
    
    (1,599
    )Net income (loss)
    
    $
    30,978
    
    
    $
    5,496
    
    
    $
    36,474
    
    
    $
    (24,001
    )
    
    $
    12,473Total assets
    
    $
    40,880
    
    
    $
    21,274
    
    
    $
    62,154
    
    
    $
    263,869
    
    
    $
    326,023
 20




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Total
    
    
    Corporate
    
    
    ConsolidatedAs of and for the six months ended June 30, 2007:
    
    Wholesale
    
    
    Direct
    
    
    Segments
    
    
    Operations
    
    
    TotalRevenues, net
    
    $
    153,380
    
    
    $
    87,355
    
    
    $
    240,735
    
    
    $
    
    
    
    $
    240,735Cost of sales (exclusive of depreciation and
amortization)
    
    
    95,939
    
    
    
    52,832
    
    
    
    148,771
    
    
    
    26,360
    
    
    
    175,131Selling, general and administrative
    
    
    3,909
    
    
    
    15,666
    
    
    
    19,575
    
    
    
    40,214
    
    
    
    59,789Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    26,500
    
    
    
    26,500Provision for post-employment benefits
    
    
    435
    
    
    
    475
    
    
    
    910
    
    
    
    447
    
    
    
    1,357Income (loss) from operations
    
    
    53,097
    
    
    
    18,382
    
    
    
    71,479
    
    
    
    (93,521
    )
    
    
    (22,042
    )Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,077
    )
    
    
    (4,077
    )Net income (loss)
    
    $
    53,097
    
    
    $
    18,382
    
    
    $
    71,479
    
    
    $
    (97,598
    )
    
    $
    (26,119
    )
 Total
    
    
    Corporate
    
    
    ConsolidatedAs of and for the six months ended June 30, 2006:
    
    Wholesale
    
    
    Direct
    
    
    Segments
    
    
    Operations
    
    
    TotalRevenues, net
    
    $
    159,982
    
    
    $
    76,304
    
    
    $
    236,286
    
    
    $
    
    
    
    $
    236,286Cost of sales (exclusive of depreciation and
amortization)
    
    
    91,946
    
    
    
    46,053
    
    
    
    137,999
    
    
    
    22,740
    
    
    
    160,739Benefit from federal excise tax adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (19,455
    )
    
    
    (19,455
    )Selling, general and administrative
    
    
    4,281
    
    
    
    20,556
    
    
    
    24,837
    
    
    
    42,017
    
    
    
    66,854Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    21,764
    
    
    
    21,764Provision for post-employment benefits
    
    
    156
    
    
    
    226
    
    
    
    382
    
    
    
    892
    
    
    
    1,274Income (loss) from operations
    
    
    63,599
    
    
    
    9,469
    
    
    
    73,068
    
    
    
    (67,958
    )
    
    
    5,110Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,917
    )
    
    
    (1,917
    )Net income (loss)
    
    $
    63,599
    
    
    $
    9,469
    
    
    $
    73,068
    
    
    $
    (69,875
    )
    
    $
    3,193Total
    
    Corporate
    
    ConsolidatedAs of December 31, 2006:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    TotalTotal assets
    
    $
    35,795
    
    
    $
    22,191
    
    
    $
    57,986
    
    
    $
    255,322
    
    
    $
    313,308
 9. Business Acquisition
     21




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Total purchase cost:Cash
    
    $
    3,683Value of common shares issued
    
    
    16,31419,997Acquisition costs
    
    
    327Total purchase cost
    
    $
    20,324Purchase price allocation:Tangible assets acquired
    
    $
    4,918Liabilities assumed
    
    
    (5,662
    )Intangible assets acquired:Customer relationships
    
    
    7,630Non-compete covenant
    
    
    40Goodwill
    
    
    13,398Total purchase consideration
    
    $
    20,324
     10. Related Party Transactions
   22




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11. Income Taxes
  Accounting for Income Taxes.
   23




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ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 The following discussion of our financial condition and results of operations should be read
in conjunction with the unaudited condensed consolidated financial statements and the related notes
thereto included elsewhere in this Report on Form 10-Q and the audited consolidated financial
statements and notes thereto and managements discussion and analysis of financial condition and
results of operations for the year ended December 31, 2006 included in our Annual Report on Form
10-K filed with the Securities and Exchange Commission, or SEC, on February 28, 2007. This
discussion contains forward-looking statements, the accuracy of which is subject to risks and
uncertainties. Our actual results could differ materially from those expressed in forward-looking
statements for many reasons including, but not limited to, those discussed herein and in the Risk
Factors section of our Annual Report on Form 10-K , which is contained in Part I, Item 1, Business
- Risk Factors, of that report. We disclaim any obligation to update information contained in any
forward-looking statement. See Forward Looking Statements.
 (All dollar and share amounts are presented in thousands, except per share amounts)
 Overview
 Our Business
      24




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##### Table of Contents



Our Opportunities and Challenges
  
    
    T-1 access;
    
    business asymmetric DSL, or ADSL;
    
    line-powered voice access service, or LPVA;
    
    VoIP; and
    
    Fixed wireless broadband access.
   Efficient use of cash
 Efficiently deliver broadband Internet access services
 Long-Term Debt
 Respond to Changes in Telecommunications Regulations 
 25




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Enter and maintain acceptable line-sharing terms with the RBOCs
 Expand and diversify our sources of revenue
 New market opportunities
  Critical Accounting Policies and Estimates
  
    
    We recognize revenues when persuasive evidence of our arrangement with the
customer exists, service has been provided to the customer, the price to the customer is fixed
or determinable and collectibility of the sales price is reasonably assured. We recognize
up-front fees associated with service activation, which includes set-up fees and revenue from
customer premises equipment, or CPE, using the straight-line method, over the expected term of
the customer relationship, which ranges from twenty-four to forty-eight months. We include
revenue from sales of CPE and the set-up fees for service activation as up-front fees because
neither is considered a separate unit of accounting. We treat the incremental direct costs of
service activation, which consist principally of CPE, service activation fees paid to other
telecommunications
 26




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##### Table of Contents



companies and sales commissions, as deferred charges in amounts no greater than the aggregate
up-front fees that are deferred. These deferred incremental direct costs are amortized to
operations using the straight-line method over a range of twenty-four to forty-eight months.
 
    
    We perform ongoing credit evaluations of our customers financial condition and
maintain an allowance for estimated credit losses. In addition, we have billing disputes with
some of our customers. These disputes arise in the ordinary course of business in the
telecommunications industry and we believe that their impact on our accounts receivable and
revenues can be reasonably estimated based on historical experience. In addition, certain
customer revenues are subject to refund if the end-user terminates service within thirty days
of service activation. Accordingly, we maintain allowances, through charges to revenues, based
on our estimate of the ultimate resolution of these disputes and future service cancellations,
and our reported revenue in any period could be different than what is reported if we employed
different assumptions in estimating the outcomes of these items.
 
    
    We state our inventories at the lower of cost or market, determined using the
first-in, first-out method. In assessing the ultimate recoverability of inventories, we are
required to make estimates regarding future customer demand.
 
    
    We record property and equipment and intangible assets at cost, subject to
adjustments for impairment. We depreciate or amortize property and equipment and intangible
assets using the straight-line method over their estimated useful lives. In assessing the
recoverability of our property and equipment and intangible assets, we must make assumptions
regarding estimated future cash flows and other factors to determine the fair value of the
respective assets. If these estimates and assumptions change in the future, we may be required
to record additional impairment charges relating to our property and equipment and intangible
assets.
 
    
    We record goodwill when the consideration paid for an acquisition exceeds the fair
value of net tangible and intangible assets acquired. We measure and test goodwill for
impairment on an annual basis or more frequently if we believe indicators of impairment
exists. The performance of the test involves a two-step process. The first step compares the
fair value of the reporting unit to its carrying amount, including goodwill. The fair value of
the reporting unit is determined by calculating the market capitalization of the reporting
unit as derived from quoted market prices or other generally accepted valuation methods if
quoted market prices are not available. A potential impairment exists if the fair value of the
reporting unit is lower than its carrying amount. The second step of the process is only
performed if a potential impairment exists, and it involves determining the difference between
the fair values of the reporting units net assets, other than goodwill, to the fair value of
the reporting unit. If the difference is less than the net book value of goodwill, impairment
exists and is recorded.
 
    
    We are a party to a variety of legal proceedings, as either plaintiff or
defendant, and are engaged in other disputes that arise in the ordinary course of business. We
are required to assess the likelihood of any adverse judgments or outcomes to these matters,
as well as potential ranges of probable losses for certain of these matters. The determination
of the liabilities to be recognized, if any, for loss contingencies is made after analysis of
each individual situation based on the facts and circumstances. We also have billing disputes
with our telecommunication vendors that arise in the ordinary course of business. These
disputes are primarily driven by the timing of implementation and interpretation of complex
rate structures and the related agreements with these vendors in various states in which we
operate. Upon receiving an actual credit or a firm commitment to issue the credit by the
vendor, we record the recovery through an adjustment to cost of sales and the related
liability. Estimated recoveries are recorded if there is a legal basis, otherwise such amounts
are recorded when the actual credit or a firm commitment to issue a credit is received from
the vendor. However, it is reasonably possible that the liabilities reflected in our
consolidated balance sheets for loss contingencies and business disputes could change in the
near term due to new facts and circumstances, the effects of which could be material to our
consolidated financial position, results of operations or cash flows.
 
    
    We perform on-going research and analysis of the applicability of
transaction-based taxes to sales of our products and services and purchases of
telecommunications circuits from various carriers. This research
 27




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and analysis may include discussions with authorities of jurisdictions in which we do business
and transaction-based tax experts to determine the extent of our transaction-based tax
liabilities. In addition, we continue to analyze the probable applicability of
employment-related taxes for certain stock-based compensation provided to employees in prior
periods. It is reasonably possible that our estimates of our transaction-based and
employment-related tax liabilities could change in the near term, the effects of which could be
material to our consolidated financial position and results of operations.
 
    
    We make market development funds, or MDF, available to certain customers for the
reimbursement of co-branded advertising expenses and other purposes. To the extent that MDF is
used by our customers for co-branded advertising, and the customers provide us with
third-party evidence of such co-branded advertising and we can reasonably estimate the fair
value of our portion of the advertising, such amounts are charged to advertising expense as
incurred. Other MDF activities are recorded as reductions of revenues as incurred. Amounts
payable to customers relating to rebates and customer incentives are recorded as reductions of
revenues based on our estimate of sales incentives that will ultimately be claimed by
customers.
 
    
    We record post-employment benefits which primarily consist of our severance plans.
These plans are primarily designed to provide severance benefits to our eligible employees
whose employment is terminated in connection with reductions in our workforce. We do not
accrue for this employee benefit, other than for individuals that have been notified of
termination, because we cannot reasonably determine the probability or the amount of such
payments.
 
    
    We account for income taxes using the liability method, under which deferred tax
assets and liabilities are determined based on differences between the financial reporting and
tax bases of our assets and liabilities. We record a valuation allowance on our deferred tax
assets to arrive at an amount that is more likely than not to be realized. In the future,
should we determine that we are able to realize all or part of our deferred tax assets, which
presently are fully reserved, an adjustment to our deferred tax assets would increase income
in the period in which the determination was made.
 
    
    Effective January 1, 2006, we adopted the provisions of Financial Accounting
Standards Board, or FASB, Statement of Financial Accounting Standards, or SFAS, No. 123R
(revised 2004), Share-Based Payment.Accordingly, we account for stock-based awards
exchanged for employee services based on the fair value of the award. We measure the
stock-based compensation cost at the grant-date and recognize such cost over the employee
requisite service period. We estimate the fair value of stock options using a Black-Scholes
valuation model, consistent with the provisions of SFAS No. 123R, SECs Staff Accounting
Bulletin, or SAB, No. 107, including stock-based compensation (determined under a fair value
method as prescribed by SFAS No. 123R). We determine the expected life of the options using
historical data for options exercised, cancelled after vesting and outstanding. We determine
the expected stock price volatility assumption using historical volatility of our common
stock over a period equal to the expected life of the option. These assumptions are
consistent with our estimates prior the adoption of SFAS No. 123R. We determine the
forfeiture rate using historical pre-vesting cancellation data for all options issued after
2001. Determining assumptions, such as expected term, expected volatility and expected
forfeiture rates, requires significant judgment. Changes in those assumptions could
materially impact reported results in future periods.
 Recent Accounting Pronouncements
 The Fair Value Option for Financial Assets and
Financial Liabilities  Including an Amendment of FASB Statement No. 115.
 28




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Fair Value Measurements.
 How Taxes Collected from Customers and Remitted to Governmental Authorities should be
Presented in the Income Statement. Disclosure of Accounting Policies.
 Accounting for Uncertainty in
Income Taxes. Accounting for Income Taxes.
 Business Segment Information
   29




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Results of Operations For The Three and Six months Ended June 30, 2007 and 2006
 Revenues, net
     30




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Segment Revenues and Significant Customers
  Three months ended June 30,
    
    Six months ended June 30,2007
    
    2006
    
    2007
    
    2006Wholesale
    
    $
    76,629
    
    
    $
    78,898
    
    
    $
    153,380
    
    
    $
    159,982Percent of net revenues
    
    
    63.5
    %
    
    
    66.6
    %
    
    
    63.7
    %
    
    
    67.7
    %Direct
    
    $
    43,956
    
    
    $
    39,637
    
    
    $
    87,355
    
    
    $
    76,304Percent of net revenues
    
    
    36.5
    %
    
    
    33.4
    %
    
    
    36.3
    %
    
    
    32.3
    %
     31




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##### Table of Contents



Revenue Recognition
  Wholesaler Financial Difficulties
  Operating Expenses
   Three months ended June 30,
    
    Six months ended June 30,2007
    
    2006
    
    2007
    
    2006Amount
    
    $
    130,089
    
    
    $
    104,463
    
    
    $
    262,777
    
    
    $
    231,176Percent of net revenues
    
    
    107.9
    %
    
    
    88.1
    %
    
    
    109.2
    %
    
    
    97.8
    %
 Cost of Sales (exclusive of depreciation and amortization)
  32




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Three months ended June 30,
    
    Six months ended June 30,2007
    
    2006
    
    2007
    
    2006Amount
    
    $
    87,136
    
    
    $
    80,802
    
    
    $
    175,131
    
    
    $
    160,739Percent of net revenues
    
    
    72.3
    %
    
    
    68.2
    %
    
    
    72.7
    %
    
    
    68.0
    %
    33




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##### Table of Contents



Three months ended June 30,
    
    
    Six months ended June 30,2007
    
    
    2006
    
    
    2007
    
    
    2006Wholesale Segment
    
    $
    48,339
    
    
    $
    45,712
    
    
    $
    95,939
    
    
    $
    91,946Direct Segment
    
    
    26,932
    
    
    
    23,762
    
    
    
    52,832
    
    
    
    46,053Corporate Operations
    
    
    11,865
    
    
    
    11,328
    
    
    
    26,360
    
    
    
    22,740Total
    
    $
    87,136
    
    
    $
    80,802
    
    
    $
    175,131
    
    
    $
    160,739
   34




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Benefit from Transaction Tax Adjustment
 Accounting for Contingencies
  Selling, General and Administrative Expenses
   Three months ended June 30,
    
    Six months ended June 30,2007
    
    2006
    
    2007
    
    2006Amount
    
    $
    28,455
    
    
    $
    31,889
    
    
    $
    59,789
    
    
    $
    66,854Percent of net revenues
    
    
    23.6
    %
    
    
    26.9
    %
    
    
    24.8
    %
    
    
    28.3
    %
  35




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##### Table of Contents



Three months ended June 30,
    
    
    Six months ended June 30,2007
    
    
    2006
    
    
    2007
    
    
    2006Wholesale Segment
    
    $
    1,847
    
    
    $
    2,052
    
    
    $
    3,909
    
    
    $
    4,281Direct Segment
    
    
    6,886
    
    
    
    10,153
    
    
    
    15,666
    
    
    
    20,556Corporate Operations
    
    
    19,722
    
    
    
    19,684
    
    
    
    40,214
    
    
    
    42,017Total
    
    $
    28,455
    
    
    $
    31,889
    
    
    $
    59,789
    
    
    $
    66,854
  36




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Stock-Based Compensation
  Depreciation and Amortization
   37




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##### Table of Contents



Provision for Post-Employment Benefits
    Other Expense
 Net Interest Expense
  Income Taxes
  Accounting for Income Taxes.
 38




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Related Party Transactions
      Liquidity, Capital Resources and Contractual Cash Obligations
  39




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Six months ended June 30,2007
    
    
    2006Net cash provided by (used in):Operating activities
    
    $
    62
    
    
    $
    (38,067
    )Investing activities
    
    
    (12,197
    )
    
    
    (47,748
    )Financing activities
    
    
    499
    
    
    
    57,153Total
    
    $
    (11,636
    )
    
    $
    (28,662
    )
 Operating Activities
   Investing Activities
   Financing Activities
  40




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##### Table of Contents




    
    $38,457 in proceeds, net of transaction and issuance costs, from the sale of
a 12% senior secured convertible note to EarthLink in connection with the agreement for
the expansion of our LPVA services (refer to Note 5, Long-Term Debt,to our
consolidated Financial Statements for a description of the EarthLink transaction);
    
    $13,530 in proceeds from the issuance of our common stock to EarthLink in
connection with the above mentioned agreement and from the exercise of employee stock
options; and
    
    $6,100 in proceeds from draws on our credit facility.
   Liquidity
    41




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##### Table of Contents




    
    our continuing ability to obtain access to ILEC facilities, including
telephone lines, remote terminals, interoffice transport and high-capacity circuits, all
at reasonable prices;
    
    rates at which resellers and end-users purchase and pay for our services and
the pricing of such services;
    
    financial condition of our customers;
    
    levels of marketing required to acquire and retain customers and to attain a
competitive position in the marketplace;
    
    rates at which we invest in engineering, equipment, development and
intellectual property with respect to existing and future technology;
    
    operational costs that we incur to install, maintain and repair end-user
lines and our network as a whole;
    
    pending and any future litigation;
    
    existing and future technology, including any expansion of fixed wireless services;
    
    ability to generate cash flows or obtain adequate financing;
    
    unanticipated opportunities; and
    
    network development schedules and associated costs.
 Contractual Cash Obligations
  2007
    
    
    2008
    
    
    2009
    
    
    2010
    
    
    2011
    
    
    Thereafter
    
    
    Total3% convertible senior
debentures
    
    $
    
    
    
    $
    
    
    
    $
    125,000
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    125,00012% senior secured
convertible note
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    42,240
    
    
    
    2,534
    
    
    
    
    
    
    
    44,774Bank loan
    
    
    6,100
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,100Interest on notes payable
    
    
    7,222
    
    
    
    9,123
    
    
    
    6,154
    
    
    
    5,373
    
    
    
    1,119
    
    
    
    
    
    
    
    28,991Capital leases
    
    
    437
    
    
    
    828
    
    
    
    785
    
    
    
    182
    
    
    
    4
    
    
    
    
    
    
    
    2,236Office leases
    
    
    2,645
    
    
    
    5,014
    
    
    
    3,593
    
    
    
    2,268
    
    
    
    572
    
    
    
    15
    
    
    
    14,107Other operating leases
    
    
    856
    
    
    
    1,318
    
    
    
    745
    
    
    
    442
    
    
    
    196
    
    
    
    57
    
    
    
    3,614Purchase obligations
(network costs)
    
    
    2,155
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,155$
    19,415
    
    
    $
    16,283
    
    
    $
    136,277
    
    
    $
    50,505
    
    
    $
    4,425
    
    
    $
    72
    
    
    $
    226,977
 42




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##### Table of Contents



Forward-Looking Statements
  
    
    impact of federal, state and local telecommunications regulations, decisions
and related litigation, and our ability to obtain ILEC network elements and facilities
at reasonable rates;
    
    continuing deployment of LPVA and our ability to bundle our data services
with the voice services of EarthLink and other alternative voice providers;
    
    timing of our cash flows;
    
    extent to which customers purchase our services;
    
    relationships with our strategic partners and other potential third parties;
    
    pricing for our services in the future;
    
    plans regarding new financing arrangements;
    
    our ability to increase our revenues and the margins we generate on our service offerings;
    
    plans to make strategic investments and acquisitions and the effect of such
investments and acquisitions;
    
    estimates and expectations of future operating results, including
improvements in cash flow from operating activities, our selling, general and
administrative expenses, adequacy of our cash reserves, and the number of anticipated
installed lines;
    
    plans to increase sales of value-added services, like e-mail, security, web
hosting and fixed wireless;
    
    anticipated capital expenditures;
    
    plans to enter into business arrangements with broadband-related service providers;
    
    feasibility of alternative access solutions, like fixed wireless;
    
    effects of litigation currently pending; and
    
    other statements contained in this Report on Form 10-Q regarding matters
that are not historical facts
 
 43




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ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
 (All dollar amounts are presented in thousands)
   Carrying Value
    
    
    Interest RateCash and cash equivalents
    
    $
    34,643
    
    
    
    2.50
    %Short-term investments in debt securities
    
    
    18,708
    
    
    
    1.50
    %Restricted cash and cash equivalents
    
    
    12,202
    
    
    
    0.96
    %$
    65,553
 
 ITEM 4. Controls and Procedures
 Evaluation of Disclosure Controls and Procedures:
  Changes in Internal Controls.
  44




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PART II. OTHER INFORMATION
 
 ITEM 1. Legal Proceedings
       45




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ITEM 1A. Risk Factors
 (All dollar amounts are presented in thousands, except monthly service subscription fees)
 Investing in and holding our common stock involve a degree of risk. Many factors, including
those described below and set forth elsewhere in this report and in other documents we file with
the Securities and Exchange Commission, or SEC, could cause actual results to differ materially
from the results contemplated by the forward-looking statements contained in this report. If any of
these risks materialize, our business, financial condition and results of operations could suffer.
These risks are not the only ones we face. Additional risks that we currently do not know about or
that we currently believe to be immaterial may also impair our business.
 Our services are subject to government regulation, and changes in current or future laws or
regulations and the methods of enforcing the law and regulations could adversely affect our
business.
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Charges for network elements are generally outside of our control because they are proposed by the
ILECs and are subject to costly regulatory approval processes.
   Our business will be adversely affected if our interconnection agreements are not renewed or if
they are modified on unfavorable terms.
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We depend on a limited number of customers for the preponderance of our revenues, and we are
highly dependent on sales through our resellers.
   The markets in which we operate are highly competitive, and we may not be able to compete
effectively, especially against established industry competitors with significantly greater
financial resources.
  
    
    develop and adopt new or emerging technologies;
    
    respond to changes in customer requirements more quickly;
    
    devote greater resources to the development, promotion and sale of their products and services;
    
    form new alliances and rapidly acquire significant market share;
    
    undertake more extensive marketing campaigns;
    
    adopt more aggressive pricing policies; and
    
    devote substantially more resources to developing new services.
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New competitors in the market for VoIP services and improvements in the quality of VoIP service
provided by competitors over the public Internet could increase competition for our VoIP services.
   Failure to complete development, upgrades, testing and introduction of new services, including
VoIP services, could affect our ability to compete in the industry.
  We may need to raise additional capital under difficult financial market conditions.
  49




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
    
    customer disconnection rates that reduce our revenues;
    
    significant price reductions by our competitors;
    
    higher levels of marketing expense required to acquire and retain end-users that purchase
our services from us and from our resellers;
    
    the need to upgrade our systems by investing in our existing and future technology and infrastructure;
    
    investment opportunities in complementary businesses, acquisitions or other opportunities;
    
    changes in government regulations and legal actions challenging government regulations; and
    
    additional risk factors mentioned throughout this section.
   In order to become profitable, we must add end-users and sell additional services to our existing
end-users while minimizing the cost to upgrade and expand our network infrastructure.
  
    
    acquire new end-users at a reasonable cost of acquisition;
    
    efficiently deploy LPVA services under our agreement with EarthLink;
    
    enter into and maintain agreements with the RBOCs or obtain favorable regulatory rulings
that provide us with access to unbundled network elements on terms and conditions that allow
us to profitably sell our consumer services;
    
    upgrade our network to improve reliability and remain competitive;
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
    
    efficiently expand fixed wireless broadband services;
    
    expand our direct sales capability and infrastructure in a cost-effective manner; and
    
    continue to implement and improve our management information systems, including our
client ordering, provisioning, dispatch, trouble ticketing, customer billing, accounts
receivable, payable tracking, collection, fixed assets, transaction-based taxes and other
management information systems.
  Our end-user disconnection rate reduces our revenue and end-user growth.
  
    
    move to a new location;
    
    are moved off our network when one of our customers acquires, or is acquired by, a
competitor with network facilities;
    
    disconnect because of better offers in the market; or
    
    disconnect because they do not like our service or the service provided by our resellers.
  We may experience decreasing margins on the sale of our services, which may impair our ability to
achieve profitability or positive cash flow.
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If our internal control over financial reporting does not comply with the requirements of the
Sarbanes-Oxley Act, our business, reputation and stock price could be adversely affected.
   Some of our resellers are facing financial difficulties, which makes it more difficult to predict
our revenues.
  The existence of our direct business poses challenges and may cause our resellers to place fewer
orders with us or may cause us to lose resellers.
  
    
    recruit, hire and train additional direct sales teams;
    
    reduce our cost of acquiring new customers;
    
    improve our provisioning, network management and monitoring and billing systems;
    
    manage expanding and increasingly diverse distribution channels;
    
    effectively manage additional vendors; and
    
    continue to enhance our network and improve our services.
  The communications industry is undergoing rapid technological changes and new technologies may be
superior to the technology we use.
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
    
    third parties, including some of our competitors and potential competitors, developing
and providing us with access to new communications and networking technology;
    
    our ability to anticipate or adapt to new technology on a timely basis; and
    
    our ability to adapt to new products and technologies that may be superior to, or may not
be compatible with, our products and technologies.
  A system failure could delay or interrupt service to our customers, which could reduce demand for
our services.
   Our use of fixed broadband wireless technology presents several challenges.
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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, software utilities, service
and installation and if we are unable to obtain these items from these third parties we may not be
able to deliver our services as required.
  
    
    DSLAMs;
    
    CPE, including modems, routers, bridges and other devices;
    
    network routing and switching hardware;
    
    customer support;
    
    installation services;
    
    customized software design and maintenance;
    
    network management software;
    
    systems management software;
    
    database management software;
 54




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
    
    collocation space;
    
    software used in our products;
    
    hosting, email and IP provisioning services;
    
    softswitches, used to provide VoIP services; and
    
    Internet connectivity and Internet protocol services.
   
    
    the possibility that some of our vendors will leave the DSL equipment business or will
stop supporting equipment that we already have installed;
    
    the absence of guaranteed capacity;
    
    the possibility that vendors may become insolvent;
    
    the possibility that vendors will stop supporting software or equipment that we use or
will no longer offer supplemental or replacement parts; and
    
    reduced control over delivery schedules, quality assurance, production yields and costs.
  We use third-party vendors offshore for tasks that were previously done by our employees.
    55




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We have made and may make acquisitions of complementary technologies or businesses in the future,
which may disrupt our business and be dilutive to our existing stockholders.
    We must pay federal, state and local taxes and other surcharges on our services, the applicability
and levels of which are uncertain.
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We are a party to litigation and adverse results of such litigation matters could negatively
impact our financial condition and results of operations.
 Legal
Proceedings.
 Our intellectual property protection may be inadequate to protect our proprietary rights.
    Third parties may claim we infringe their intellectual property rights.
  
    
    be time-consuming, costly and result in litigation;
    
    divert managements time and attention from developing our business;
    
    require us to pay monetary damages or enter into royalty and licensing agreements that we
would not normally find acceptable;
    
    require us to stop selling or to redesign certain of our products; or
    
    require us to satisfy indemnification obligations to our customers.
 
 57




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The price of our common stock may continue to fluctuate significantly.
  
    
    state and federal regulatory and legislative actions;
    
    general economic conditions and the condition of the telecommunications industry;
    
    our ability to maintain existing customers and add new customers and recognize revenue
from distressed customers;
    
    our ability to execute our operational plan and reach profitability and cash flow
positive from operations;
    
    our ability to maintain sufficient liquidity to fund our operations;
    
    adverse litigation results;
    
    announcements of new products, services or pricing by our competitors or the emergence of
new competing technologies;
    
    our failure to meet the expectations of investors or of analysts;
    
    the adoption of new, or changes in existing, accounting rules, guidelines and practices,
which may materially impact our financial statements and may materially alter the
expectations of securities analysts or investors;
    
    the level of demand for broadband Internet access services and VoIP telephony services;
    
    departures of key personnel; and
    
    effective internal controls over financial reporting.
  Substantial leverage and debt service obligations may adversely affect our cash flow. (Refer to
Part I, Item 2  Managements Discussion and Analysis of Financial Condition and Results of
Operations  Liquidity and Capital Resources for additional information)
  58




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
    
    increasing our vulnerability to general adverse economic and industry conditions;
    
    limiting our ability to obtain additional financing;
    
    requiring the dedication of a portion of our expected cash flow from operations to
service our indebtedness, thereby reducing the amount of our expected cash flow available
for other purposes, including capital expenditures;
    
    limiting our flexibility in planning for, or reacting to, changes in our business and the
industry in which we compete; and
    
    placing us at a possible competitive disadvantage relative to less leveraged competitors
and competitors that have better access to capital resources.
 
 ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
  
 ITEM 3. Defaults Upon Senior Securities
  
 ITEM 4. Submission of Matters to a Vote of Security Holders
   Name
    
    For
    
    WithheldL. Dale Crandall
    
    
    245,610,563
    
    
    
    22,886,891Diana Leonard
    
    
    245,424,190
    
    
    
    23,073,264Robert Neumeister
    
    
    245,587,956
    
    
    
    22,909,498
   
 ITEM 5. Other Information
  59




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ITEM 6. Exhibits
 Incorporated by ReferenceExhibit
    
    
    
    
    
    
    
    
    
    ExhibitNumber
    
    Exhibit Description
    
    Form
    
    File No.
    
    Date of First Filing
    
    Number
    
    Filed Herewith10.1
    
    Covad Communications
Group, Inc 2007 Equity
Incentive Plan
    
    8-K
    
    001-32588
    
    6/12/07
    
    
    10.110.2
    
    Covad Communications
Group, Inc 2007 Equity
Incentive Plan-Form of
Notice of Stock Option
Grant and Stock Option
Award Agreement
    
    8-K
    
    001-32588
    
    6/12/07
    
    
    10.210.3
    
    Covad Communications
Group, Inc 2007 Equity
Incentive Plan-Form of
Notice of Restricted
Stock Award and
Restricted Share
Agreement
    
    8-K
    
    001-32588
    
    6/12/07
    
    
    10.310.4
    
    Covad Communications
Group, Inc 2007 Equity
Incentive Plan-Form of
Notice of Stock Bonus
Award
    
    8-K
    
    001-32588
    
    6/12/07
    
    
    10.410.5
    
    Covad Communications
Group, Inc 2007 Equity
Incentive Plan-Form of
Notice of Restricted
Stock Unit Award and
Award Agreement
    
    8-K
    
    001-32588
    
    6/12/07
    
    
    10.510.6
    
    Covad Communications
Group, Inc 2007 Equity
Incentive Plan-Form of
Notice of Stock
Appreciation Right
Award and Award
Agreement
    
    8-K
    
    001-32588
    
    6/12/07
    
    
    10.610.7
    
    Indemnification
Agreement between Covad
Communications Group,
Inc. and Justin Spencer
    
    8-K
    
    001-32588
    
    4/17/07
    
    
    10.110.8
    
    Amendment No. 2 to Loan
and Security Agreement
    
    8-K
    
    001-32588
    
    4/26/07
    
    
    10.131.1
    
    Certification Pursuant
to Rule 13a-14(a)
    
    
    
    
    
    
    
    
    
    
    
    X31.2
    
    Certification Pursuant
to Rule 13a-14(a)
    
    
    
    
    
    
    
    
    
    
    
    X32.1*
    
    Certification Pursuant
to 18 U.S.C. Section
1350, as Adopted
Pursuant to Section 906
of the Sarbanes-Oxley
Act of 2002
    
    
    
    
    
    
    
    
    
    
    
    X32.2*
    
    Certification Pursuant
to 18 U.S.C. Section
1350, as Adopted
Pursuant to Section 906
of the Sarbanes-Oxley
Act of 2002
    
    
    
    
    
    
    
    
    
    
    
    X
 
 *
    
    These certifications accompany the Registrants Quarterly Report on Form 10-Q and are not
deemed filed with the SEC. 60




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##### Table of Contents



SIGNATURES
  COVAD COMMUNICATIONS GROUP, INC.By:
    
    /s/ CHARLES E. HOFFMAN

Charles E. HoffmanPresident, Chief ExecutiveOfficer and DirectorDate: August 2, 2007By:
    
    /s/ JUSTIN SPENCER

Justin SpencerSenior Vice President andDate: August 2, 2007
    
    
    
    Chief Financial Officer
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##### Table of Contents



Incorporated by ReferenceExhibit
    
    
    
    
    
    
    
    
    
    ExhibitNumber
    
    Exhibit Description
    
    Form
    
    File No.
    
    Date of First Filing
    
    Number
    
    Filed Herewith10.1
    
    Covad Communications
Group, Inc 2007 Equity
Incentive Plan
    
    8-K
    
    001-32588
    
    6/12/07
    
    
    10.110.2
    
    Covad Communications
Group, Inc 2007 Equity
Incentive Plan-Form of
Notice of Stock Option
Grant and Stock Option
Award Agreement
    
    8-K
    
    001-32588
    
    6/12/07
    
    
    10.210.3
    
    Covad Communications
Group, Inc 2007 Equity
Incentive Plan-Form of
Notice of Restricted
Stock Award and
Restricted Share
Agreement
    
    8-K
    
    001-32588
    
    6/12/07
    
    
    10.310.4
    
    Covad Communications
Group, Inc 2007 Equity
Incentive Plan-Form of
Notice of Stock Bonus
Award
    
    8-K
    
    001-32588
    
    6/12/07
    
    
    10.410.5
    
    Covad Communications
Group, Inc 2007 Equity
Incentive Plan-Form of
Notice of Restricted
Stock Unit Award and
Award Agreement
    
    8-K
    
    001-32588
    
    6/12/07
    
    
    10.510.6
    
    Covad Communications
Group, Inc 2007 Equity
Incentive Plan-Form of
Notice of Stock
Appreciation Right
Award and Award
Agreement
    
    8-K
    
    001-32588
    
    6/12/07
    
    
    10.610.7
    
    Indemnification
Agreement between Covad
Communications Group,
Inc. and Justin Spencer
    
    8-K
    
    001-32588
    
    4/17/07
    
    
    10.110.8
    
    Amendment No. 2 to Loan
and Security Agreement
    
    8-K
    
    001-32588
    
    4/26/07
    
    
    10.131.1
    
    Certification Pursuant
to Rule 13a-14(a)
    
    
    
    
    
    
    
    
    
    
    
    X31.2
    
    Certification Pursuant
to Rule 13a-14(a)
    
    
    
    
    
    
    
    
    
    
    
    X32.1*
    
    Certification Pursuant
to 18 U.S.C. Section
1350, as Adopted
Pursuant to Section 906
of the Sarbanes-Oxley
Act of 2002
    
    
    
    
    
    
    
    
    
    
    
    X32.2*
    
    Certification Pursuant
to 18 U.S.C. Section
1350, as Adopted
Pursuant to Section 906
of the Sarbanes-Oxley
Act of 2002
    
    
    
    
    
    
    
    
    
    
    
    X
 
 *
    
    These certifications accompany the Registrants Quarterly Report on Form 10-Q and are not
deemed filed with the SEC.