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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
 FORM 10-Q x
    

QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934For the quarterly period ended March 31, 2004o
    

TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE 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, California
    
    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 May 3, 2004 there were 237,610,271 shares outstanding of the
Registrants Common Stock.




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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 MARCH 31, 2004 AND DECEMBER 31, 2003
    
    
    2CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2004 AND 2003
    
    
    3CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED MARCH 31, 2004 AND 2003
    
    
    4NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
    
    
    5ITEM 2.
    
    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    17ITEM 3.
    
    MARKET RISK
    
    
    32ITEM 4.
    
    CONTROLS AND PROCEDURES
    
    
    33PART II.
    
    OTHER INFORMATIONITEM 1.
    
    LEGAL PROCEEDINGS
    
    
    34ITEM 2.
    
    CHANGES IN SECURITIES AND USE OF PROCEEDS
    
    
    36ITEM 3.
    
    DEFAULTS UPON SENIOR SECURITIES
    
    
    36ITEM 4.
    
    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    
    
    36ITEM 5.
    
    OTHER INFORMATION
    
    
    36ITEM 6.
    
    EXHIBITS AND REPORTS ON FORM 8-K
    
    
    36SIGNATURES
    
    
    38EXHIBIT 2.1EXHIBIT 4.1EXHIBIT 4.2EXHIBIT 4.3EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
 1




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PART I. FINANCIAL INFORMATION 
 Item 1.Condensed Consolidated Financial Statements (Unaudited) COVAD COMMUNICATIONS GROUP, INC.
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (Amounts in thousands,
except par value)
 March 31,
    
    December 31,2004
    
    2003(as restated)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    109,048
    
    
    $
    65,376Short-term investments
    
    
    57,599
    
    
    
    48,969Restricted cash and cash equivalents
    
    
    2,942
    
    
    
    2,892Accounts receivable, net of allowances of $5,548 at March 31, 2004 ($4,951 at December 31, 2003)
    
    
    31,418
    
    
    
    28,528Unbilled revenues
    
    
    4,824
    
    
    
    5,127Other receivables
    
    
    507
    
    
    
    637Inventories
    
    
    4,529
    
    
    
    5,335Prepaid expenses and other current assets
    
    
    6,057
    
    
    
    3,761Total current assets
    
    
    216,924
    
    
    
    160,625Property and equipment, net
    
    
    91,264
    
    
    
    94,279Collocation fees and other intangible assets, net of accumulated amortization of $54,449 at
March 31, 2004 ($49,698 at December 31, 2003)
    
    
    38,989
    
    
    
    40,848Deferred costs of service activation
    
    
    30,969
    
    
    
    31,486Deferred customer incentives
    
    
    3,994
    
    
    
    4,431Deferred debt issuance cost
    
    
    4,836
    
    
    
    Other long-term assets
    
    
    2,841
    
    
    
    3,042Total assets
    
    $
    389,817
    
    
    $
    334,711LIABILITIES AND STOCKHOLDERS DEFICITCurrent liabilities:Accounts payable
    
    $
    11,066
    
    
    $
    12,982Accrued compensation
    
    
    21,299
    
    
    
    21,661Accrued collocation and network service fees
    
    
    23,719
    
    
    
    18,714Accrued transaction-based taxes
    
    
    34,131
    
    
    
    35,268Accrued interest
    
    
    208
    
    
    
    5,683Accrued market development funds and customer incentives
    
    
    5,368
    
    
    
    7,024Unresolved claims related to bankruptcy proceedings
    
    
    392
    
    
    
    7,378Collateralized customer deposit
    
    
    7,864
    
    
    
    Unearned revenues
    
    
    4,821
    
    
    
    Other accrued liabilities
    
    
    7,029
    
    
    
    5,607Total current liabilities
    
    
    115,897
    
    
    
    114,317Long-term debt
    
    
    125,000
    
    
    
    50,000Collateralized customer deposit
    
    
    50,426
    
    
    
    60,258Deferred gain resulting from deconsolidation of subsidiary
    
    
    53,963
    
    
    
    53,963Unearned revenues
    
    
    54,633
    
    
    
    61,726Total liabilities
    
    
    399,919
    
    
    
    340,264Contingencies (Note 6)Stockholders deficit:Preferred stock, $0.001 par value; 5,000 shares authorized; no shares issued and outstanding
at March 31, 2004 and December 31, 2003
    
    
    
    
    
    
    Common Stock, $0.001 par value; 590,000 shares authorized; 237,515 shares issued and
outstanding at March 31, 2004 (230,163 shares issued and outstanding at December 31, 2003)
    
    
    238
    
    
    
    230Common Stock
- Class B, $0.001 par value; 10,000 shares authorized; no shares issued
and outstanding at March 31, 2004 and December 31, 2003
    
    
    
    
    
    
    Additional paid-in capital
    
    
    1,652,936
    
    
    
    1,651,267Deferred stock-based compensation
    
    
    (7,150
    )
    
    
    (14,459
    )Accumulated other comprehensive loss
    
    
    (957
    )
    
    
    (953
    )Accumulated deficit
    
    
    (1,655,169
    )
    
    
    (1,641,638
    )Total stockholders deficit
    
    
    (10,102
    )
    
    
    (5,553
    )Total liabilities and stockholders deficit
    
    $
    389,817
    
    
    $
    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 EndedMarch 31,2004
    
    2003(Note 1)Revenues, net
    
    $
    108,477
    
    
    $
    90,860Operating expenses:Network and product costs
    
    
    68,294
    
    
    
    68,877Sales, marketing, general and administrative
    
    
    33,302
    
    
    
    37,093Depreciation and amortization of property and equipment
    
    
    14,495
    
    
    
    14,593Amortization of collocation fees and other intangible assets
    
    
    4,751
    
    
    
    3,996Provision for restructuring expenses
    
    
    547
    
    
    
    631Total operating expenses
    
    
    121,389
    
    
    
    125,190Loss from operations
    
    
    (12,912
    )
    
    
    (34,330
    )Other income (expense):Interest income
    
    
    351
    
    
    
    716Provision for impairment of investments in unconsolidated affiliates
    
    
    
    
    
    
    (112
    )Equity in losses of unconsolidated affiliates
    
    
    
    
    
    
    (104
    )Interest expense
    
    
    (1,141
    )
    
    
    (1,379
    )Miscellaneous income
    
    
    171
    
    
    
    487Other expense, net
    
    
    (619
    )
    
    
    (392
    )Net loss
    
    $
    (13,531
    )
    
    $
    (34,722
    )Basic and diluted net loss per share
    
    $
    (0.06
    )
    
    $
    (0.16
    )Weighted-average number of common shares used in computing
basic and diluted net loss per share
    
    
    233,257
    
    
    
    223,445
 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)
 Three Months EndedMarch 31,2004
    
    2003Operating Activities:Net loss
    
    $
    (13,531
    )
    
    $
    (34,722
    )Adjustments to reconcile net loss to net cash used in operating activities:Provision for bad debts (bad debt recoveries)
    
    
    (25
    )
    
    
    198Depreciation and amortization
    
    
    19,246
    
    
    
    18,589Loss on disposition of property and equipment
    
    
    1
    
    
    
    13Amortization of deferred stock-based compensation
    
    
    796
    
    
    
    36Other non-cash charges
    
    
    425
    
    
    
    325Accretion of interest on investments, net
    
    
    (101
    )
    
    
    (316
    )Equity in losses of unconsolidated affiliates
    
    
    
    
    
    
    104Provision for impairment of investments in unconsolidated affiliates
    
    
    
    
    
    
    112Net changes in operating assets and liabilities:Accounts receivable
    
    
    (2,865
    )
    
    
    (2,988
    )Unbilled revenues
    
    
    303
    
    
    
    (796
    )Inventories
    
    
    806
    
    
    
    (1,290
    )Prepaid expenses and other current assets
    
    
    (2,166
    )
    
    
    922Deferred costs of service activation
    
    
    517
    
    
    
    3,173Accounts payable
    
    
    (1,916
    )
    
    
    3,599Unresolved claims related to bankruptcy proceedings
    
    
    (35
    )
    
    
    (12
    )Collateralized customer deposit
    
    
    (1,968
    )
    
    
    (1,930
    )Other current liabilities
    
    
    (2,203
    )
    
    
    (1,113
    )Unearned revenues
    
    
    (2,272
    )
    
    
    (3,374
    )Net cash used in operating activities
    
    
    (4,988
    )
    
    
    (19,470
    )Investing Activities:Purchases of short-term investments
    
    
    (49,563
    )
    
    
    (82,643
    )Maturities of short-term investments
    
    
    41,030
    
    
    
    38,305Restricted cash and cash equivalents
    
    
    (50
    )
    
    
    101Purchases of property and equipment
    
    
    (11,502
    )
    
    
    (7,371
    )Proceeds from sales of property and equipment
    
    
    21
    
    
    
    53Recovery of internal-use software costs
    
    
    
    
    
    
    435Payment of collocation fees and purchase of other intangible assets
    
    
    (2,892
    )
    
    
    (1,451
    )Decrease in other long-term assets
    
    
    201
    
    
    
    105Net cash used in investing activities
    
    
    (22,755
    )
    
    
    (52,466
    )Financing Activities:Principal payments under capital lease obligations
    
    
    
    
    
    
    (43
    )Principal payment of long term debt
    
    
    (50,000
    )
    
    
    Proceeds from issuance of long term debt, net of issuance costs
    
    
    120,151
    
    
    
    Proceeds from common stock issuance, net of repurchase
    
    
    1,264
    
    
    
    246Net cash provided by financing activities
    
    
    71,415
    
    
    
    203Net increase (decrease in) cash and cash equivalents
    
    
    43,672
    
    
    
    (71,733
    )Cash and cash equivalents at beginning of period
    
    
    65,376
    
    
    
    96,491Cash and cash equivalents at end of period
    
    $
    109,048
    
    
    $
    24,758Supplemental Disclosures of Cash Flow Information:Cash paid during the period for interest
    
    $
    6,569
    
    
    $
    4Common stock issued in settlement of claims related to bankruptcy
    
    $
    6,951
    
    
    $
    
 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. 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 months ended March 31, 2004 are not necessarily indicative of the results
that may be expected for the year ending December 31, 2004. The Companys 2004 business plan includes certain discretionary spending
that is based on several assumptions, including growth of the Companys
subscriber base with a reasonable per subscriber profit margin and improvements
in productivity. If necessary, the Company will curtail this discretionary
spending so that it can continue as a going concern at least through March 31,
2005 using only the Companys unrestricted cash, cash equivalents and
short-term investments balances. The consolidated balance sheet as of December 31, 2003 has been derived
from the audited consolidated financial statements at that date but does not
include some of the information and footnotes required by accounting principles
generally accepted in the United States for complete financial statements. All information included in this report should be read in conjunction with
the Companys audited consolidated financial statements and notes thereto
included in the Companys Annual Report on Form 10-K for the year ended
December 31, 2003. Restatements 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 for the
year ended December 31, 2003. 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 is summarized below (only line items that were
impacted are presented): As of
December 31, 2003Previously
Reported
  
  AsRestatedAdditional paid-in capital
  
  $
  1,624,489
  
  
  $
  1,651,267Deferred variable stock-based
compensation
  
  $
  (52
  )
  
  $
  (14,459
  )Accumulated deficit
  
  $
  (1,629,267
  )
  
  $
  (1,641,638
  ) 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 and employment-related tax liabilities, (vii) liabilities for
market development funds and customer incentives and (viii) valuation
allowances associated with deferred tax assets. During the three months ended March 31, 2003, the Company changed its
estimates of some accrued liabilities for customer incentives based on the
compilation of sufficient historical data with which to estimate sales
incentives that will ultimately be claimed by customers. This change in
accounting estimate increased the Companys revenues by $735 and decreased the
Companys net loss by $1,449 ($0.01 per share) during the three months ended
March 31, 2003. The Company did not make similar changes in its estimates
during the three months ended March 31, 2004. 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. 5




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Under the intrinsic value method, when the exercise price of the Companys
employee stock options equals or exceeds the market price of the underlying
stock on the date of grant, no compensation expense is recognized. The
following table illustrates the pro forma effect on net loss and net loss per
share for the three months ended March 31, 2004 and 2003 had the Company
applied the fair value method to account for stock-based awards to employees: Three Months EndedMarch 31,2004
    
    2003Net loss, as reported
    
    $
    (13,531
    )
    
    $
    (34,722
    )Stock-based employee compensation expense included in the determination of net loss, as reported
    
    
    796
    
    
    
    36Stock-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
    
    
    (6,184
    )
    
    
    (2,080
    )Pro forma net loss
    
    $
    (18,819
    )
    
    $
    (36,766
    )Basic and diluted net loss per common share:As reported
    
    $
    (0.06
    )
    
    $
    (0.16
    )Pro forma
    
    $
    (0.08
    )
    
    $
    (0.16
    )
 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 EndedMarch 31,2004
    
    2003Weighted-average number of common shares used in computing basic and diluted
net loss per share
    
    
    233,257
    
    
    
    223,445
 For
the three months ended March 31, 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 March 3, 2004 were 24.7 million and 6.5 million shares
at a weighted-average exercise price of $6.40 and $2.85, respectively. Total
outstanding options and warrants to purchase common stock at March 31, 2003
were 29.5 million and 6.5 million shares at a weighted-average exercise price of $6.41 and
$2.85, respectively. For the three months ended March 31, 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. 6




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Comprehensive Loss Significant components of the Companys comprehensive loss are as follows: Three Months EndedCumulative
    
    March 31,Amounts
    
    2004
    
    2003Net loss
    
    $
    (1,655,169
    )
    
    $
    (13,531
    )
    
    $
    (34,722
    )Unrealized gains (losses) on available-for-sale securities
    
    
    5
    
    
    
    (4
    )
    
    
    (90
    )Foreign currency translation adjustment
    
    
    (962
    )
    
    
    
    
    
    
    Comprehensive loss
    
    $
    (1,656,126
    )
    
    $
    (13,535
    )
    
    $
    (34,812
    )
 Recent Accounting Pronouncements On May 15, 2003, the Financial Accounting Standards Board, or FASB, issued
Statement of Financial Accounting Standards, or 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 months ended March 31, 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 a significant effect on the
Companys condensed consolidated financial statements as of and for the three
months ended March 31, 2004. In March 2004, the FASB approved EITF Issue 03-6, Participating
Securities and the Two-Class Method under FAS 128. EITF 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 EPS. The Company is currently in the
process of evaluating the impact that adoption of EITF Issue 03-6 will have on
its financial position and results of operations. 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. Revenues earned for which the customer has not been billed are
recorded as Unbilled revenues in the condensed consolidated balance sheets.
Amounts billed in advance of providing service are deferred and recorded as an
element of the condensed consolidated balance sheet caption Unearned
revenues. Included in revenues are Federal 7




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Universal Service Fund (FUSF) charges billed to customers aggregating
$1,405 and $976 for the three months ended March 31, 2004 and 2003,
respectively. The Company recognizes up-front fees associated with service activation
over the expected term of the customer relationship, which is presently
estimated to be 24 months, using the straight-line method. 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 months. Significant Customers As of March 31, 2004, the Company had over 320 resellers. For the three
months ended March 31, 2004 and 2003, the Companys 30 largest customers
collectively comprised 93.5% and 94.4%, respectively, of the Companys total
wholesale gross revenues, and 68.2% and 76.2%, respectively, of the Companys
total gross revenues. As of March 31, 2004 and 2003, receivables from these
customers collectively comprised 69.4% and 74.9%, respectively, of the
Companys gross accounts receivable balance. For the three months ended March 31, 2004, EarthLink, Inc. and AT&T Corp.,
two of the Companys wholesale customers, accounted for 18.4% and 12.6%,
respectively, of the Companys total net revenues. As of March 31, 2004,
receivables from these customers comprised 17.9% and 17.2%, respectively, of
the Companys gross accounts receivable balance. For the three months ended
March 31, 2003, EarthLink, Inc. and AT&T Corp., two of the Companys wholesale
customers, accounted for 21.1% and 12.3% of the Companys total net revenues,
respectively. As of March 31, 2003, receivables from these customers comprised
25.3% and 11.9% of the Companys gross accounts receivable balance,
respectively. Wholesaler Financial Difficulties Some of the Companys resellers are experiencing financial difficulties.
During the three months ended March 31, 2004 and 2003, certain of these
customers either (i) were not current in their payments for the Companys
services or (ii) were essentially current in their payments but, subsequent to
the end of the reporting period, the financial condition of such customers
deteriorated significantly and some of them have filed for bankruptcy
protection. Based on this information, the Company determined that the
collectibility of revenues from these customers was not reasonably assured or
its ability to retain some or all of the payments received from some of these
customers that have filed for bankruptcy protection was not reasonably assured.
Accordingly, the Company classified 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. A number of the Companys customers are currently in bankruptcy
proceedings. Payments received from financially distressed customers during a
defined period prior to their filing of petitions for bankruptcy protection are
recorded in the condensed consolidated balance sheet caption Unearned
revenues if the Companys ability to retain these payments is not reasonably
assured. Revenues from these customers accounted for approximately 0.4% and
3.1% of the Companys total net revenues for the three months ended March 31,
2004 and 2003, respectively. Although MCI, formerly known as WorldCom, filed
for bankruptcy protection on July 21, 2002, the Company continued to recognize
revenues from MCI on an accrual basis during 2004 and 2003 based on its
specific facts and circumstances in relation to the revenue recognition
criteria described above. Consequently, the disclosures in the following
paragraph related to financially distressed customers exclude amounts
pertaining to MCI because the Company does not currently classify it as a
financially distressed customer for revenue recognition purposes. On April 20,
2004, MCI announced that it had formally emerged from Chapter 11 protection. During the three months ended March 31, 2004 and 2003, the Company issued
billings to its financially distressed customers aggregating $902 and $2,677,
respectively, which were not initially recognized as revenues or accounts
receivable in the accompanying condensed consolidated financial statements.
However, the Company ultimately recognized revenues from some of these
customers for cash that was collected (as described above) aggregating $662 and
$2,402 during the three months ended March 31, 2004 and 2003, respectively,
some of which relates to services provided in prior periods. The Company had
contractual receivables from its financially distressed customers totaling $877
and $6,204 as of March 31, 2004 and 2003, respectively, that are not reflected
in the accompanying condensed consolidated balance sheets as of such dates. The Company believes that some of its customers who (i) were essentially
current in their payments for the Companys services prior to March 31, 2004,
or (ii) have subsequently paid all or significant portions of the respective
amounts recorded as accounts 8




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receivable as of March 31, 2004, may become financially distressed.
Revenues from these customers accounted for approximately 9.8% and 27.2% of the
Companys total net revenues for the three months ended March 31, 2004 and
2003, respectively. As of March 31, 2004, and 2003, receivables from these
customers comprised 14.0% and 31.9% of the Companys gross accounts receivable
balance, respectively. If these customers are unable to demonstrate their
ability to pay for the Companys services in a timely manner in periods ending
subsequent to March 31, 2004, revenues from such customers will only be
recognized when cash is collected. The Company has billing disputes with some of its customers. These
disputes arise in the ordinary course of business in the telecommunications
industry and their impact on the Companys accounts receivable and revenues can
be reasonably estimated based on historical experience. In addition, certain
revenues are subject to refund if the end-user terminates service within thirty
days of service activation. Accordingly, the Company maintains allowances,
through charges to revenues, based on the Companys estimates of (i) the
ultimate resolution of the disputes and (ii) future service cancellations.
These charges to revenues amounted to $1,640 and $1,084 during the three months
ended March 31, 2004 and 2003, respectively. 3. Customer Warrants On January 1, 2003, in conjunction with an amendment to an Agreement for
Broadband Internet Access Services with AT&T Corp., the Company granted AT&T
Corp., a wholesale customer, 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 Corp. 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 expired as of March 31, 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 March 31, 2004. The Company recorded amortization on the above described warrants in the
amount of $437 and $322 for the three months ended March 31, 2004 and 2003,
respectively. 4. Reduction in Force During the three months ended March 31, 2004 and 2003, the Company reduced
its workforce by approximately 41 and 70 employees, respectively, which
represented approximately 3.7% and 5.4% of the Companys workforce,
respectively. The reductions covered employees in the areas of sales and
marketing, operations and corporate functions. In connection with the reductions in force, the Company recorded charges
to operations for the three months ended March 31, 2004 and 2003 of $547 and
$631, respectively, relating to employee severance benefits that met the
requirements for accrual. For the three months ended March 31, 2004 and 2003,
$64 and $148, respectively, of these expenses were charged to network and
product costs and the remaining $483 and $483, respectively, were charged to
sales, marketing, general and administrative expenses. During the three months
ended March 31, 2004 and 2003, the Company paid severance benefits of
approximately $446 and $569, respectively. The Company paid the remainder of
the severance benefits accrued as of March 31, 2004 and 2003 in April of 2004
and 2003, respectively. The expenses associated with the reductions in force
for the three months ended March 31, 2004 and 2003 were $186 and $72,
respectively, related to the Companys Wholesale business segment and $123 and
$29, respectively, related to the 9




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Companys Direct business segment. The remaining expenses associated with
these reductions in force during the three months ended March 31, 2004 and 2003
of $238 and $530, respectively, 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 $120,151 after commission
and other transaction costs. The Company incurred approximately $4,849 in
issuance costs in conjunction with the placement of the Debentures. The debt
issuance costs are being amortized to operations over the period through to the
first date that holders have the option to require the Company to purchase the
Debentures. On March 11, 2004, the Company used a portion of the net proceeds of the
offering to repay its 11% note payable to SBC. The payment amounted to $56,569,
including $50,000 of principal and $6,569 of accrued interest. 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.
    
    Disputed claims made by GE Capital and its subsidiary, Heller Financial Group. As of March 31, 2004 and 2003, there were approximately $1,355 and $8,331
in unresolved claims related to the Companys Chapter 11 bankruptcy
proceedings. As of March 31, 2004, the Company had recorded $392 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 10




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plaintiffs voted in favor of the plan. Consequently, the Company recorded
a liability of approximately $18,578 in its condensed consolidated balance
sheet as of December 31, 2001 through a charge to litigation-related expenses
for the year then ended in connection with this anticipated settlement. As a
result of changes in the fair market value of the Companys common stock, the
Company decreased this liability to $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 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 is seeking an
appeal of this decision before 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 Eleventh Circuit also relied in part on the Trinko decision when
it reversed the lower courts dismissal of the Companys claims against
BellSouth. 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 have filed motions with the appellate courts requesting
affirmance of the district courts rulings. The Company has opposed those
motions and they remain pending. 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 has appealed the dismissal of its lawsuit. The Company believes it has
strong defenses to this lawsuit, but litigation is inherently unpredictable and
there is no guarantee it will prevail. Several stockholders 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 11




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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 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. In this action Mr. Khanna seeks recovery on behalf of
the company from the individual defendants for their purported breach of
fiduciary duty. Mr. Khanna also seeks to invalidate the Companys election of
directors in 2002 and 2003 because he claims that the Companys proxy
statements were misleading. On December 12, 2003, the Company filed a motion
to dismiss Mr. Khannas claims in their entirety. The Court has not yet ruled
on the motion. 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. 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 On August 21, 2003, the Federal Communication Commission, or FCC, issued
its order in the Triennial Review. This order is a significant development for
the Company for a number of reasons, the most important of which the Company
believes to be as follows: 12




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
    
    The FCC is phasing out its rule requiring line-sharing over a
three-year period. Line-sharing currently allows the Company to
provision services using asymmetric DSL, or ADSL, technology over the
same telephone line that the local telephone company is using to provide
voice services. The phase-out period will be handled in the following
manner:  o
    
    The Companys 235,800 line-shared customers as of October 2, 2003
will be grandfathered indefinitely at current rates, terms and
conditions. These line-shared customers provided approximately
$33,710, or 31.1%, of the Companys revenues for the three months
ended March 31, 2004.o
    
    The Company can only acquire new line-shared customers at
regulated rates until October 2, 2004. For customers acquired during
this period, 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, the Company will be
required to transition these customers to new arrangements.o
    
    Beginning on October 3, 2004, the Company cannot acquire new
line-shared customers unless it reaches agreements with the local
telephone companies that provide it with continued access to
line-sharing or obtain favorable regulatory rulings from the FCC or
state regulators. The Company has entered into one agreement with
Qwest Communications International, Inc., that will allow it to
continue to provide services using line-sharing in the seven states in
the Qwest region where the Company offers its services. In the event
that the Company does not reach these agreements or obtain such
rulings, it will be required to purchase a separate telephone line in
order to provide services to an end-user. If this occurs the Company
may stop selling stand-alone consumer grade services to new customers,
because the cost of a separate telephone line is significantly higher
than what the Company currently pays for a shared line. The Companys
inability to acquire new line-shared customers would slow its growth
and could require it to significantly change its business plan  
    
    The local telephone companies are not required to allow the Company
to access the packet-switching functions of fiber-fed telephone lines to
provision DSL services. This means that, unless the Company reaches
agreements with the local telephone companies or obtain favorable
regulatory rulings from the FCC or state regulators, it will continue to
be unable to provide its most commonly-used services to end-users served
by fiber-fed lines. The Companys inability to access fiber-fed
packet-switching functions is significant for its business because it
preserves a substantial limit on the addressable market for its DSL
services, thereby limiting its growth. In addition, the local telephone
companies are increasing their deployment of fiber-fed remote terminal
architectures.
    
    The local telephone companies can petition the various state utility
commissions for authority to stop providing data transport between the
telephone companies central offices as an unbundled network element on
routes that have sufficient competitive alternatives to telephone
company data transport services. The Company currently purchases this
interoffice transport from the traditional telephone companies in order
to carry traffic over its network. It is unclear whether any state
commissions will grant these requests, or whether such requests will be
granted on routes that impact the Company. The removal of any of these
transport links from the list of available network elements could
increase the price the Company pays for such connectivity.
    
    Companies that compete with the local telephone companies continue to
have access to the local telephone companies networks in order to
provide their services under an arrangement known as the Unbundled
Network Element platforms, or UNE-P, so long as the state public
utilities commissions deem it appropriate under the standards specified
by the FCC. Under this arrangement these competitive telecommunications
companies like AT&T Corp. and MCI purchase telephone lines in order to
provide voice and data services. The continued existence of the UNE-P
platform would allow the Company to continue to bundle its data services
with the voice services of these competitive telecommunications
providers through line-splitting arrangements. 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. If this decision is not overturned or
otherwise modified by the United States Supreme Court the FCC will be
required to adopt new rules, which could limit UNE-P availability in a
way that limits the Companys ability to bundle its data services
using line-splitting with partners that use UNE-P. 13




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
    
    Vacated the FCCs decision to make data transport between the
telephone companies central offices available as an unbundled network
element 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 unbundled network elements. Some
of the traditional telephone companies have claimed that if this
decision is not overturned or otherwise modified by the United States
Supreme Court, they will no longer be required to provide the Company
with this interoffice data transport at regulated rates. If the
telephone companies are successful in this effort, the Company could be
forced to pay significantly higher rates for such transport, which would
increase its network costs.
    
    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. The Courts decision to vacate aspects of the Triennial Review order was
originally stayed until the later of May 1, 2004 or the denial of a petition
for rehearing. No party filed a petition for rehearing within the deadline
imposed by the court. The D.C. Circuit subsequently extended the stay from May
1 until June 15, 2004, in response to an unopposed request from the FCC. If
this subsequent stay is not extended and the FCC does not otherwise act within
the stay period, the affected rules no longer would be in effect upon the
expiration of the stay, and it is unclear what rules, if any, would apply. This
could impact the Companys ability to access interoffice transport at regulated
prices. In addition, this would be extremely disruptive to the Companys
partners who utilize UNE-P to provide competitive voice services as part of a
bundle with the Companys DSL services, and also could result in disruption of,
and increases in prices for, affected data transport services that the Company
purchases. A majority of the FCC announced in March 2004 that it will seek an
additional stay of this decision and request review by the United States
Supreme Court. It is unclear at this time whether the Department of Justice,
which is ultimately responsible for filing such review, will support the FCC
and seek such review. Whether or not Supreme Court review is sought, once the
appellate process is completed, further FCC proceedings will be required to
address continuing unbundling requirements consistent with a final court
ruling. The direction and success of the Companys 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 its Triennial Review order, the FCC also concluded that October 2, 2003
is the trigger date for change of law provisions in the Companys
interconnection agreements with the various traditional telephone companies.
These agreements contain the prices and other terms for the telephone lines
that the Company purchases from these traditional telephone companies. Each of
the traditional telephone companies has informed the Company that it wants to
change the line-sharing terms and conditions of its agreements with it. The
Company is negotiating these agreements and has entered into one agreement with
Qwest Communications International, Inc., that will allow it to continue to
provide services using line-sharing in the seven states in the Qwest region
where the Company offers its services. If the Company is unable to reach
agreements it will attempt to resolve its disputes with the traditional
telephone companies in arbitrations before the state public utility
commissions. In addition, at least two of the traditional telephone companies have
taken the position that their obligation to provide so-called high capacity
loops will be lifted 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. If the traditional telephone companies stop providing T-1 loops as
unbundled network elements, and instead provide those loops under
special access or other prices, the Companys costs to provide business-class T-1 services, such as its
TeleXtend product, will increase significantly. As of March 31, 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. In addition, the Company is engaged in a variety of negotiations,
arbitrations and regulatory and court proceedings with multiple telephone
companies. These negotiations, arbitrations and proceedings concern the
telephone companies denial of physical central office space to the Company in
certain central offices, the cost and delivery of transmission facilities and
telephone lines and central office space, billing issues and other operational
issues. An unfavorable outcome in any of these negotiations, arbitrations and 14




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##### Table of Contents



proceedings could have a material adverse effect on the Companys
consolidated financial position and results of operations if it is denied
access to, or charged higher rates for transmission lines or central office
spaces. The Company 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 respective
transaction-based tax liabilities. It is the Companys opinion that such
analysis will be concluded without a material adverse effect on its
consolidated financial position and results of operations. However, it is
reasonably possible that the Companys estimates of its transaction-based tax
liabilities, as reflected in the accompanying condensed consolidated balance
sheets, could change in the near term, and the effects could be material to the
Companys consolidated financial position and results of operations. During the
three months ended March 31, 2003, the Company changed its estimate of certain
accrued liabilities for transaction-based and property taxes based on
settlement agreements reached with the tax authorities of certain jurisdictions
in which the Company does business. This change in accounting estimate reduced
the Companys net loss by $2,506 ($0.01 per share) for the three months ended
March 31, 2003. The Company is analyzing the applicability of employment-related taxes for
certain stock-based compensation provided to employees in prior periods. Due to
the probable applicability of these taxes, the Company recorded an estimated
liability through a charge to operations in the amount of $5,938 during the
three months ended March 31, 2003. 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 sheet as of March 31, 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 sell its services directly to business and consumer end-users
through its field sales force, telephone sales, referral agents and our 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
maintain CSP and CBS as separate business units. The Company believes this
realignment will lead to more efficient product development, sales and
marketing because the Company will no longer have two separate groups providing
these functions. 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, enterprise and telecommunications
carrier customers. The Companys direct segment, or Direct, is a provider of
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,
including depreciation and amortization, and other income and expense items.
The Company does not allocate such operating expenses and other income and
expense items to its business segments because it believes that these expenses
and other income items are not directly managed by the business segments. Segment information, including a reconciliation to the respective balances
in the Companys condensed consolidated financial statements, as of and for the
three months ended March 31, 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



As of and for theThree Months Ended
    
    
    
    
    
    
    
    
    
    Total
    
    Corporate
    
    Intercompany
    
    ConsolidatedMarch 31, 2004:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    Eliminations
    
    TotalDomestic revenues from external customers, net
    
    $
    79,097
    
    
    $
    29,380
    
    
    $
    108,477
    
    
    $
    
    
    
    $
    
    
    
    $
    108,477Network and product costs
    
    $
    46,792
    
    
    $
    11,402
    
    
    $
    58,194
    
    
    $
    10,100
    
    
    $
    
    
    
    $
    68,294Sales, marketing, general and administrative expenses
    
    $
    2,680
    
    
    $
    5,163
    
    
    $
    7,843
    
    
    $
    25,459
    
    
    $
    
    
    
    $
    33,302Depreciation and amortization
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    19,246
    
    
    $
    
    
    
    $
    19,246Other expenses, net
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    1,166
    
    
    $
    
    
    
    $
    1,166Net income (loss)
    
    $
    29,625
    
    
    $
    12,815
    
    
    $
    42,440
    
    
    $
    (55,971
    )
    
    $
    
    
    
    $
    (13,531
    )Total assets
    
    $
    62,593
    
    
    $
    8,612
    
    
    $
    71,205
    
    
    $
    318,612
    
    
    $
    
    
    
    $
    389,817
 As of and for theThree Months Ended
    
    
    
    
    
    
    
    
    
    Total
    
    Corporate
    
    Intercompany
    
    ConsolidatedMarch 31, 2003:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    Eliminations
    
    TotalDomestic revenues from external customers, net
    
    $
    73,370
    
    
    $
    17,490
    
    
    $
    90,860
    
    
    $
    
    
    
    $
    
    
    
    $
    90,860Network and product costs
    
    $
    49,278
    
    
    $
    9,578
    
    
    $
    58,856
    
    
    $
    10,021
    
    
    $
    
    
    
    $
    68,877Sales, marketing, general and administrative expenses
    
    $
    3,104
    
    
    $
    5,980
    
    
    $
    9,084
    
    
    $
    28,009
    
    
    $
    
    
    
    $
    37,093Depreciation and amortization
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    18,589
    
    
    $
    
    
    
    $
    18,589Other expenses, net
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    1,023
    
    
    $
    
    
    
    $
    1,023Net income (loss)
    
    $
    20,988
    
    
    $
    1,932
    
    
    $
    22,920
    
    
    $
    (57,642
    )
    
    $
    
    
    
    $
    (34,722
    )
 8. GoBeam Acquisition On March 3, 2004, the Company announced that it entered into an agreement
to acquire GoBeam, Inc., a provider of VoIP services for businesses, as part of
its strategy to accelerate its development of VoIP services ( GoBeam
Acquisition). Under the agreement and plan of merger, the Company will issue
shares of its common stock having an aggregate value up to $48,000 at the
closing of the acquisition, which is expected to occur in the second quarter of
2004. The exchange ratio to be used to determine the number of shares issued
at closing will be based on the average closing price of the Companys common
stock during the ten consecutive trading days ending three days prior to the
closing date of the acquisition. The agreement also contains provisions that
limit the maximum number of shares to be issued in the transaction to
approximately 20.2 million shares of the Companys common stock. 9. Related Party Transactions The Company acquired an equity interest in a supplier during 1999 and
disposed of this interest in 2001. Purchases from this supplier totaled $1,069
and $1,592 during the three months ended March 31, 2004 and 2003, respectively.
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 $105 and $207 during the three months ended March
31, 2004 and 2003, respectively. L. Dale Crandall, one of the Companys
directors, is also a director of BEA Systems, one of the Companys vendors. The
Company paid $472 and $8 to BEA Systems during the three months ended March 31,
2004 and 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 $20,264 as of March 31, 2004. During the three
months ended March 31, 2004 the Company amortized $781 to
operations. The remaining net deferred stock compensation balance of
$7,112 at March 31, 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. 16




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##### Table of Contents



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-Kfiled with the Securities and
Exchange Commission on February 27, 2004. 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 amounts are presented in thousands, except per share amounts) Overview Background We are a leading provider of high-speed Internet connectivity and related
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. With over 1,800 collocation facilities, we believe
we have the largest contiguous national broadband network. We provide services
throughout the United States in 96 metropolitan statistical areas, or MSAs. We
also plan to add approximately 200 new collocation facilities to our network in
2004, which will expand our coverage to 109 MSAs, passing more than 50 million
homes and businesses. As of March 31, 2004, we had approximately 516,000 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 believe this realignment will lead to more efficient product
development, sales and marketing because we will no longer have two separate
groups providing these functions. Triennial Review As a result of the Federal Communications Commission, or FCC, decision in
the Triennial Review, on October 3, 2004 the traditional telephone companies
will no longer be 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 are grandfathered at current rates, terms and
conditions. Consequently, our future ability to offer stand alone Internet
access over a telephone line that is being used by a traditional telephone
company to provide voice service, 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 new agreements with the traditional
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 Triennial Review decision, companies that compete with the
traditional telephone companies will continue to have the ability to access the
local telephone networks to provide bundled voice and data services, so long as
these arrangements are deemed appropriate by the state public utility
commissions, subject to federal guidelines. This situation affords us the
opportunity to continue to partner with voice providers, such as AT&T Corp., to
provide our data services in line-splitting relationships. This
aspect of the FCCs decision was reversed by the United States
Court of Appeals for the D.C. Circuit as described in
Recent Developments. 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 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. 17




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##### Table of Contents



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: Achieve cash flow sufficiency.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 March 31, 2004 with net working
capital of approximately $101,000. Without reflecting the impact on cash usage
resulting from future operating activities associated with the pending GoBeam
acquisition, we believe we will achieve positive cash flows from our existing
operating activities in mid-2004. Our outlook is based on assumptions that we
believe are reasonable, but some of which are out of our control. We anticipate
that following the closing of the GoBeam acquisition we will use additional
cash resources to increase sales and marketing activities as we expand the
offering of GoBeams VoIP services to new markets across our broadband network.
The additional usage of cash from the GoBeam Acquisition will depend on many
variables including the amount of capital expenditures that is required to
expand this new business, the cost of development of operating support systems
and software, our ability to generate VoIP service revenues, and our ability to
control expenditures, primarily incremental sales, marketing, general and
administrative expenses. Manage through a transition in the delivery of broadband Internet access
services to consumers.The delivery of stand-alone broadband internet access
services by our ISP customers is facing intense competition from the incumbent
telephone carriers, wireless service providers and cable providers like
Comcast, Adelphia and Cox Communications, who are aggressively pricing their
consumer broadband services and placing pricing pressure on us. We believe
these market conditions have reduced the number of orders for our services and
are also causing a higher level of churn among our ultimate end users, and we
expect this situation to continue. One of our wholesale customers, AOL stopped
taking orders directly for our services in the first quarter, instead, it has
moved to a bring your own access model where it refers customers to access
providers like us. Anticipating these conditions, we have entered into
line-splitting arrangements with voice providers, particularly AT&T Corp.,
which are bundling our data services with their voice services. Our
growth in
2004 and beyond will be significantly dependent on whether we can achieve
growth in the sales of our services under these line-splitting relationships
that more than offsets the decline in sales of our stand-alone consumer-grade
data services. Obtain acceptable line-sharing terms from the incumbent telephone
companies.While we expect that the revenues we generate from line-sharing with
the incumbent telephone companies will constitute a smaller portion of our
business in future periods, we think this market will continue to be important
to us. Our ability to remain viable in this market will depend on whether we
are able to reach agreements with the telephone companies, like our recently
announced agreement with Qwest Communications International, or obtain
favorable regulatory rulings that will allow us to share telephone lines to 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 announced our plan to
expand our network by adding 200 central office locations, which will allow us
offer our services to more end-users. Second, we will continue our efforts to
diversify our revenue sources by adding new services like Voice over
Internet Protocol, and by adding new resellers like Broadwing, a
wholly-owned subsidiary of Corvis Corporation, and Global Crossing, that
primarily resell our higher-priced business-grade services. New Market Opportunities.We recently announced our plan to offer voice
over Internet protocol, or VoIP, services 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 process of developing 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. As part of this plan, we
announced on March 3, 2004 that we entered into an agreement to acquire GoBeam,
Inc., a provider of VoIP services for businesses, as part of our strategy to
accelerate our development of VoIP services ( GoBeam Acquisition). Under the
agreement and plan of merger, we will issue shares of our common stock having
an aggregate value up to $48,000 at the closing of the acquisition, which is
expected to occur in the second quarter of 2004. The exchange ratio to be used
to determine the number of shares issued at closing will be based on the
average closing price of our common stock during the ten consecutive trading
days ending three days prior to the closing date of the acquisition. The
agreement also contains provisions that limit the maximum number of shares to
be issued in the transaction to approximately 20.2 million shares of our common
stock. We anticipate that our acquisition of GoBeam will significantly shorten
our time to market for our VoIP services, and will provide us with access to
GoBeams customer base. 18




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##### Table of Contents



Recent Developments On April 15, 2004, we announced that we had entered into a three-year
agreement with Qwest Communications International, Inc. that will allow us to
continue to provide services using line-sharing in the seven states in the
Qwest region where we offer our services. On March 10, 2004, we completed a private placement of $125,000 in
aggregate principal amount of our 3% Convertible Senior Debentures
(Debentures), due 2024, which are convertible into shares of our common stock
at a conversion price of approximately $3.1742, subject to certain adjustments.
See Part II, Item 2. Changes in Securities and Use of Proceeds for further
details about this offering. On August 21, 2003, the FCC issued its order in the Triennial Review. This
order is 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 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 local telephone company 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 $33,710, or 31.1%,
of our revenues for the three months ended March 31, 2004.o
    
    We can only acquire new line-shared customers at regulated rates
until October 2, 2004. For customers acquired during this period, 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
    
    Beginning on October 3, 2004, we cannot acquire new line-shared
customers unless we reach agreements with the local telephone
companies that provide us with continued access to line-sharing or
obtain favorable regulatory rulings from the FCC or state regulators.
In the event that we do not reach these agreements or obtain such
rulings, we will be required to purchase a separate telephone line in
order to provide services to an end-user. 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.  
    
    The local telephone companies are not required to allow us to access
the packet-switching functions of fiber-fed telephone lines to provision
DSL services. This means that, unless we reach agreements with the local
telephone companies 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 local telephone companies are increasing their deployment
of fiber-fed remote terminal architectures.
    
    The local telephone companies can petition the various state utility
commissions for authority to stop providing data transport between the
telephone companies central offices as an unbundled network element on
routes that have sufficient competitive alternatives to telephone
company data transport services. We currently purchase this interoffice
transport from the traditional telephone companies in order to carry
traffic over our network. It is unclear whether any state commissions
will grant these requests, or whether such requests will be granted on
routes that impact us. The removal of any of these transport links from
the list of available network elements could increase the price we pay
for such connectivity.
    
    Companies that compete with the local telephone companies continue to
have access to the local telephone companies networks in order to
provide their services under an arrangement known as the Unbundled
Network Element platforms, or UNE-P, so long as the state public
utilities commissions deem it appropriate under the standards specified
by the FCC. Under this arrangement these competitive telecommunications
companies like AT&T Corp. and MCI purchase telephone lines in order to
provide voice and data services. The continued existence of the UNE-P
platform would allow us to continue to bundle our data services with the
voice services of these competitive telecommunications providers through
line-splitting arrangements. 19




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##### Table of Contents



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. If this decision is not overturned or
otherwise modified by the United States Supreme Court the FCC will be
required to adopt new rules, which could limit UNE-P availability in a
way that limits our ability to bundle our data services using
line-splitting with partners that use UNE-P.
    
    Vacated the FCCs decision to make data transport between the
telephone companies central offices available as an unbundled network
element 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 unbundled network elements. Some
of the traditional telephone companies have claimed that if this
decision is not overturned or otherwise modified by the United States
Supreme Court, they will no longer be required to provide us with this
interoffice data transport at regulated rates. If the telephone
companies are successful in this effort, we could be forced to pay
significantly higher rates for such transport, which would increase our
network costs.
    
    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. The Courts decision to vacate aspects of the Triennial Review order was
originally stayed until the later of May 1, 2004 or the denial of a petition
for rehearing. No party filed a petition for rehearing within the deadline
imposed by the court. The D.C. Circuit subsequently extended the stay from May
1 until June 15, 2004, in response to an unopposed request from the FCC. If
this subsequent stay is not extended and the FCC does not otherwise act within
the stay period, the affected rules no longer would be in effect upon the
expiration of the stay, and it is unclear what rules, if any, would apply. This
could impact our ability to access interoffice transport at regulated prices.
In addition, this would be extremely disruptive to our partners who utilize
UNE-P to provide competitive voice services as part of a bundle with our DSL
services, and also could result in disruption of, and increases in prices for,
affected data transport services that we purchase. A majority of the FCC announced in March 2004 that it will seek an
additional stay of this decision and request review by the United States
Supreme Court. It is unclear at this time whether the Department of Justice,
which is ultimately responsible for filing such review, will support the FCC
and seek such review. Whether or not Supreme Court review is sought, once the
appellate process is completed, further FCC proceedings will be required to
address continuing unbundling requirements consistent with a final court
ruling. 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 its Triennial Review order, the FCC also concluded that October 2, 2003
is the trigger date for change of law provisions in our interconnection
agreements with the various traditional telephone companies. These agreements
contain the prices and other terms for the telephone lines that we purchase
from these traditional telephone companies. Each of the traditional telephone
companies has informed us that it wants to change the line-sharing terms and
conditions of its agreements with us. We are negotiating these agreements, but
if we are unable to reach agreements we will attempt to resolve our disputes in
arbitrations before the state public utility commissions. In addition, at least two of the traditional telephone companies have
taken the position that their obligation to provide so-called high capacity
loops will be lifted 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. If the traditional telephone companies stop providing T-1 loops as
unbundled network elements, and instead provide those loops under
special access or other prices, our costs to provide business-class T-1 services, such as our TeleXtend
product, will increase significantly. Investors should review the above-referenced discussion of the Triennial
Review and the subsequent court decision carefully to understand the
potentially significant effects that this ruling will have on our ability to
continue to engage in our business as we have in the past, as the FCCs ruling
and the court decision create a number of uncertainties, challenges and
opportunities for us. The final effect of the FCCs ruling and the court
decision will be subject to the reactions of various participants in the
telecommunications 20




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##### Table of Contents



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 an
arrangement between the customer and us 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 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 twenty four months.
    
    We have concentrations of credit risk with several customers,
some of which were experiencing financial difficulties as of March
31, 2004 and 2003 and were not current in their payments for our
services as of those dates. Accordingly, we recognize revenues from
some of these customers in the period in which cash is collected, but
only after the collection of all previous outstanding accounts
receivable balances. We perform ongoing credit evaluations of our
customers financial condition and maintain an allowance for
estimated credit losses. In addition, we have billing disputes with
some of our customers. These disputes arise in the ordinary course of
business in the telecommunications industry and their impact on our
accounts receivable and revenues can be reasonably estimated based on
historical experience. In addition, certain customer revenues are
subject to refund if the end-user terminates service within thirty
days of service activation. Accordingly, we maintain allowances,
through charges to revenues, based on our estimate of the ultimate
resolution of these disputes and future service cancellations, and
our reported revenue in any period could be different than what is
reported if we employed different assumptions in estimating the
outcomes of these items.
    
    We state our inventories at the lower of cost 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 consummated a plan of reorganization under Chapter 11 of the
United States Bankruptcy Code on December 20, 2001. As of March 31,
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 March 31, 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 21




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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. Recent Accounting Pronouncements On May 15, 2003, the Financial Accounting Standards Board, or FASB, issued
Statement of Financial Accounting Standards, or 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 and for the three months ended March 31, 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 22




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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 and for the three months ended March 31, 2004. In March 2004, the FASB approved EITF Issue 03-6, Participating
Securities and the Two-Class Method under FAS 128. EITF 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 EPS. We are currently in the process
of evaluating the impact that adoption of EITF Issue 03-6 will have on its
financial position and results of operations. Results of Operations Business Segment Information During the three months ended March 31, 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 ISP, enterprise and telecommunications
carrier customers. Our direct segment, or Direct, is a provider of high-speed
connectivity, Internet access and other services to individuals, small and
medium-sized businesses, corporations 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 by our business segments. Our 2003 segment information has been restated to conform to our
organizational structure in 2004. Reclassifications Certain balances in our 2003 condensed consolidated financial statements
have been reclassified to conform to the presentation in 2004. Three Months Ended March 31, 2004 and 2003 Revenues, net The primary component of our net revenues is earned monthly broadband
subscription billings for DSL products. We also earn revenues from monthly
billings for high-capacity circuits sold to our wholesale customers and to a
lesser degree for dial-up services. Because we do not recognize revenue from
sales to financially distressed customers until we receive payment and until
our ability to keep the payment is reasonably assured, our reported revenues
for the three months ended March 31, 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 services and
equipment, 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 revenue. Our net revenues of $108,477 for the three months ended March 31, 2004
increased by $17,617, or 19.4%, over our net revenues of $90,860 for the three
months ended March 31, 2003. The increase in 2004 was primarily due to the
net addition of approximately 100,000 DSL end-users to our network, which led to an
increase in broadband subscription billings. We expect our revenues and
broadband subscription billings to continue to grow as we execute on our
current sales and marketing programs. In addition, we plan to introduce new
sales and marketing programs and create new services for our customers which we
anticipate will lead to higher 23




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revenues and broadband subscription billings. The increase in our revenues
and broadband subscription billings for the three months ended March 31, 2004
was offset by several factors. Our high-capacity circuit revenues and billings
for the three months ended March 31, 2003 decreased by $545, primarily driven
by customer network configuration changes and consolidation in our customer
transport circuits. We do not expect a significant increase or decrease in
high-capacity circuit billings in 2004. In addition, our dial-up revenues and
billings decreased by $675 during March 31, 2004, primarily driven by the
decrease in demand for this service. We expect that demand for this service
will continue to decrease in 2004. During the three months ended March 31,
2004, we had lower customer rebates and incentives, which increased our
revenues by $3,319. We expect customer rebates and incentives to continue to be
an element of our sales and marketing programs due to competitive market
conditions. Revenue from installation services and equipment billings, which we
recognize over the expected life of the end-user, decreased by $1,390 during
the three months ended March 31, 2004, primarily driven by lower net selling
prices, some of which is attributable to lower prices from our vendors and
competitive pricing in the marketplace. We expect prices for these services and
equipment to continue to decline in the future. FUSF charges billed to our
customers, which we recognize as revenue, increased by $429 during the three
months ended March 31, 2004, primarily driven by of the increase in the number
of our wholesale customers. 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. These charges to revenues were
$1,640 and $1,084 during the three months ended March 31, 2004 and 2003,
respectively. During the three months ended March 31, 2004 and 2003,
respectively, we recovered $53 and $1,092 of accounts receivable balances
previously written-off against such allowance. Segment Revenues and Significant Customers Our segment net revenues were as follows: Three Months Ended March 31,2004
    
    2003Wholesale
    
    $
    79,097
    
    
    $
    73,370Percent of total net revenues
    
    
    72.9
    %
    
    
    80.8
    %Direct
    
    $
    29,380
    
    
    $
    17,490Percent of total net revenues
    
    
    27.1
    %
    
    
    19.2
    %
 We had over 320 wholesale customers as of March 31, 2004 compared to
approximately 180 as of March 31, 2003. The increase in 2004 from 2003 resulted
primarily from the addition of smaller resellers. For the three months ended
March 31, 2004 and 2003, our 30 largest wholesale customers
comprised 68.2% and
76.2% of our total gross revenues, respectively. As of March 31, 2004 and 2003,
receivables from these customers collectively comprised 69.4% and 74.9%,
respectively, of our gross accounts receivable balance. We had over 70,700 direct end users as of March 31, 2004 compared to
approximately 55,500 as of March 31, 2003. For the three months ended March 31,
2004 and 2003, our direct end users comprised 27.1% and 19.2% of our total net
revenue, respectively. As of March 31, 2004 and 2003, receivables from these
end users collectively comprised 27.0% and 18.9%, respectively, of our gross
accounts receivable balance. For the three months ended March 31, 2004, EarthLink, Inc. and AT&T Corp.,
two wholesale customers in our wholesale business segment, accounted for 18.4%
and 12.6%, respectively, of our total net revenues. For the three months ended
March 31, 2003, these customers accounted for 21.1% and 12.3%, respectively, of
our total net revenues. As of March 31, 2004, receivables from these customers
comprised 17.9% and 17.2%, respectively, of our gross accounts receivable
balance. As of March 31, 2003, receivables from these customers comprised 25.3%
and 11.9%, respectively, of our gross accounts receivable balance. Wholesaler Financial Difficulties Some of our resellers are experiencing financial difficulties. During the
three months ended March 31, 2004 and 2003, certain of these customers either
were not current in their payments for our services or were essentially current
in their payments but, subsequent to the end of the reporting period, their
financial condition deteriorated significantly and some of them filed for
bankruptcy protection. Based on this information, we determined that the
collectibility of revenues from these customers was not reasonably assured or
our ability to retain some or all of the payments received from some of these
customers that filed for bankruptcy protection was not reasonably assured.
Accordingly, we have classified this group of customers as financially
distressed for revenue recognition 24




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purposes. Although MCI, formerly known as WorldCom, Inc., filed for
bankruptcy protection on July 21, 2002, we have not classified it as a
financially distressed customer based on MCIs specific facts and circumstances
in relation to the revenue recognition criteria described in Note 2 to our
condensed consolidated financial statements. Therefore, we continued to
recognize revenues from MCI on an accrual basis during 2004 and 2003. On April
20, 2004, MCI announced that it had formally emerged from Chapter 11
protection. During the three months ended March 31, 2004 and 2003, we issued billings
to our financially distressed customers aggregating $902 and $2,677,
respectively, that were not initially recognized as revenues or accounts
receivable in our consolidated financial statements. However, we recognized net
revenues from certain of these customers when cash was collected aggregating
$662 and $2,402 during the three months ended March 31, 2004 and 2003,
respectively. We had contractual receivables from our financially distressed
customers totaling $877 and $6,204, respectively, as of March 31, 2004 and 2003
that are not reflected in our condensed consolidated financial statements. We have identified certain of our customers, including MCI, who were
essentially current in their payments for our services prior to March 31, 2004,
or have subsequently paid all or significant portions of the respective amounts
that we recorded as accounts receivable as of March 31, 2004, that we believe
may have a high risk of becoming financially distressed. Revenues from these
customers accounted for approximately 9.8% and 27.2% of our total net revenues
for the three months ended March 31, 2004 and 2003, respectively. As of March
31, 2004 and 2003, receivables from these customers comprised 14.0% and 31.9%
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 March 31, 2004, revenue from such customers
will only be recognized when cash is collected, as described above. Operating Expenses Operating expenses include network and product costs, sales, marketing,
general and administrative expenses, depreciation and amortization expenses and
provision for restructuring expenses. Our total operating expenses were as follows: Three Months Ended March 31,2004
    
    2003Amount
    
    $
    121,389
    
    
    $
    125,190Percent of net revenues
    
    
    111.9
    %
    
    
    137.8
    %
 Network and Product Costs Network and product costs consist primarily of the costs of provisioning
and maintaining telecommunications circuits and central office space, equipment
sold to our customers, and labor related expenses and other non-labor items to
operate and maintain our network and related system infrastructure. Our network and product costs were as follows: Three Months Ended March 31,2004
    
    2003Amount
    
    $
    68,294
    
    
    $
    68,877Percent of net revenue
    
    
    63.0
    %
    
    
    75.8
    %
 Our network and product costs for the three months ended March 31, 2004,
decreased by $583, or 0.8%, when compared to our network and product costs for
the three months ended March 31, 2003. For the three months ended March 31,
2004, our network and product costs, as a percent of revenues, improved by
12.8% when compared to the three months ended March 31, 2003. For the three
months ended March 31, 2004 and 2003, network and product costs were comprised
of $46,792 and $49,278, respectively, from our wholesale business segment,
$11,402 and $9,578, respectively, from our direct business segment and, $10,100
and $10,021, respectively, from our Corporate Operations. The decrease in
network and product costs during the three months ended March 31, 2004 is
primarily attributable to continued efforts to lower network costs by more
efficiently managing our network capacity and a reduction in our workforce
within the operations and engineering groups. During the three months ended
March 31, 2003, we changed our estimates of certain liabilities for
transaction-based and property taxes based on settlements reached with various
states and local jurisdictions on our transaction-based taxes and additional
compilation of data on the valuation of our taxable property and equipment.
This change in accounting estimate decreased our network and product costs by
$2,506 and decreased our net loss by $2,506 ($0.01 25




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per share) during the three months ended March 31, 2003. In addition,
network and product costs for the three months ended March 31, 2003 include a
charge of $2,137 for the probable applicability of employment-related taxes
related to certain stock-based compensation provided to employees in prior
periods. We expect network and product costs to increase in future periods to
the extent we are able to add subscribers and services to our network, but to
decrease as a percentage of revenue if we are able to increase our revenue more
rapidly than we increase our network and product costs. 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, there is uncertainty concerning our ability to
purchase line-shared services from the traditional telephone companies as a
result of the FCCs Triennial Review decision. As a result of those legal and
regulatory proceedings, it is possible that the traditional telephone companies
could substantially increase the cost or reduce the availability of line-shared
services, which would substantially increase our overall network cost structure
and might cause us to discontinue our consumer grade services for new and
existing customers. Following the completion of our acquisition of GoBeam, which we expect to
happen in the second quarter, we also expect to incur higher network and
product costs as a result of the addition of GoBeams employees and other
network and product costs associated with the sale of GoBeams services. Sales, Marketing, General and Administrative Expenses Sales, marketing, general and administrative expenses consist primarily of
salaries and related expenses and our promotional and advertising expenses. Our sales, marketing, general and administrative expenses were as follows: Three Months Ended March 31,2004
    
    2003Amount
    
    $
    33,302
    
    
    $
    37,093Percent of net revenue
    
    
    30.7
    %
    
    
    40.8
    %
 Our sales, marketing, general and administrative expenses for the three
months ended March 31, 2004, decreased by $3,791, or 10.2%, when compared to
our sales, marketing, general and administrative expenses for the three months
ended March 31, 2003. For the three months ended March 31, 2004, sales,
marketing, general and administrative expenses as a percentage of revenues were
30.7%, a 10.1% improvement from the three months ended March 31, 2003. For the
three months ended March 31, 2004 and 2003, sales, marketing, general and
administrative expenses were comprised of $2,680 and $3,104, respectively, from
our wholesale business segment, $5,163 and $5,980, respectively, from our
direct business segment and, $25,459 and $28,009, respectively, from our
Corporate Operations. The decrease in sales, marketing, general and administrative expenses
during the three months ended March 31, 2004 is primarily attributable to lower
advertising and transaction-based tax expenses. During the three months ended
March 31, 2003, we recorded a charge of $3,800 for the potential applicability
of employment-related taxes related to certain stock-based compensation
provided to employees in prior periods. We expect sales, marketing, general and
administrative expense levels to increase in the near future as a result of
increased marketing efforts. Following the completion of our acquisition of
GoBeam, which we expect to happen in the second quarter, we also expect to
incur higher sales, general and administrative expenses as a result of adding
GoBeams employees and increased marketing efforts associated with sales of
GoBeams services. Depreciation and Amortization We recorded depreciation and amortization expense for property and
equipment in the amount of $14,495 for the three months ended March 31, 2004, a
decrease of $98, or 0.7%, over depreciation and amortization expense for
property and equipment of $14,593 recorded for the three months ended March 31,
2003. The decrease from 2003 to 2004 was due principally to asset retirements
and certain assets becoming fully depreciated during 2003 and 2004. We expect
depreciation and amortization to increase in the future as we expand the
footprint of our network and add more end-users, the increase in depreciation
will be partially offset as historical assets become fully depreciated. Amortization of intangible assets for the three months ended March 31,
2004 and 2003 was $4,751 and $3,996, respectively. The increase from 2003 to
2004 resulted from the resumption of our network build or augmentation in
selected markets during the latter 26




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portion of 2003 and the three months ended March 31, 2004, which increased
collocation fee expenditures and related amortization expenses. As explained above, we do not allocate depreciation and amortization
expense to our business segments. Reduction in Force During the three months ended March 31, 2004 and 2003, we reduced our
workforce by approximately 41 and 70 employees, respectively, which represented
approximately 3.7% and 5.4% of our workforce, respectively. The reductions
covered employees in the areas of sales and marketing, operations and corporate
functions. In connection with the reductions in force, we recorded charges to
operations for the three months ended March 31, 2004 and 2003 of $547 and $631,
respectively, relating to employee severance benefits that met the requirements
for accrual. For the three months ended March 31, 2004 and 2003, $64 and $148,
respectively, of these expenses were charged to network and product costs and
the remaining $483 and $483, respectively, were charged to sales, marketing,
general and administrative expenses. During the three months ended March 31,
2004 and 2003, we paid severance benefits of approximately $446 and $569,
respectively. We paid the remainder of the severance benefits accrued as of
March 31, 2004 and 2003 in the second quarter of 2004 and 2003, respectively.
The expenses associated with the reductions in force for the three months ended
March 31, 2004 and 2003 were $186 and $72, respectively, related to our
Wholesales business segment and $123 and $29, respectively, related to our
Direct business segment. The remaining expenses associated with these
reductions in force during the three months ended March 31, 2004 and 2003 of
$238 and $530, respectively, were related to our Corporate Operations. We
currently do not expect significant reduction in force in the near future. Other Income (Expense) Net Interest Expense Net interest expense was $790 and $663 for the three months ended March
31, 2004 and 2003, respectively. Net interest expense during the three months
ended March 31, 2004 and 2003 consisted principally of interest expense on our
11% long-term note payable to SBC Communications Inc., which we repaid in March
of 2004, less interest income earned on our cash, cash equivalents and
short-term investments balances. Net interest expense for the three months
ended March 31, 2004 included interest on our 3% convertible senior debentures.
We expect future net interest expense to be limited to interest on our 3%
convertible senior debentures offset by interest earned on our cash balances.
We may, however, seek additional debt financing in the future if it is
available on terms that we believe are favorable. If we seek additional debt
financing, our interest expense would increase. Investment Losses We recorded losses and write-downs on investments for the three months
ended March 31, 2003 in the amount of $216. This included an impairment
write-down of an equity investment of $112 and our equity in the losses of
unconsolidated affiliates of $104. We did not record similar losses or
write-downs on investments during the three months ended March 31, 2004. Miscellaneous Income We recorded miscellaneous income for the three months ended March 31, 2004
and 2003 in the amount of $171 and $487, respectively. Miscellaneous income is
primarily comprised of trade purchase discounts. 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 We acquired an equity interest in a supplier during 1999 and disposed of
this interest in 2001. Purchases from this supplier totaled $1,069 and $1,592
during the three months ended March 31, 2004 and 2003, respectively. 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
$105 and 27




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$207 during the three months ended March 31, 2004 and 2003, respectively.
L. Dale Crandall, one of our directors, is also a director of BEA Systems, one
of our vendors. We paid $472 and $8 to BEA Systems during the three months
ended March 31, 2004 and 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 Our operations have required substantial capital investment for the
procurement, design and construction of our central office collocation
facilities, the design, creation, implementation and maintenance of our
software, the purchase of telecommunications equipment and the design,
development and maintenance of our networks. Our capital expenditures were
$14,394 for the three months ended March 31, 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 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 March 31, 2004, we had an accumulated deficit of $1,655,169 and
unrestricted cash, cash equivalents and short-term investments of $166,647. In
addition, we had stockholders deficit of $ 10,102 as of March 31, 2004. Net cash used in our operating activities was $4,988 for the three months
ended March 31, 2004. The net cash used in our operating activities during this
period was primarily due to the net loss of $13,531, an increase in accounts
receivable of $2,865, primarily driven by the timing of the payment
for one of our wholesale customers, a decrease in accounts payable of
$1,916, primarily driven by the timing of payments to certain
vendors, a decrease in
collateralized customer deposits of $1,968, a decrease in unearned revenues of
$2,272, and a decrease in other current liabilities of $2,203, offset by
depreciation and amortization charges of $19,246, and a decrease in deferred
costs of service activation of $517. Net cash used in our investing activities was $22,755 for the three months
ended March 31, 2004. The net cash used in our investing activities during this
period was primarily due to purchases of short-term investments of $49,563 and
capital expenditures of $14,394, offset by maturities of short-term investments
of $41,030. Net cash provided by our financing activities was $71,415 for the three
months ended March 31, 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 $1,264, offset by principal payments under long term debt of $50,000
and payments of $4,849 expenses associated with our offering. As of March 31, 2004, we had $109,048 in unrestricted cash and cash
equivalents, and $57,599 in unrestricted short-term investments. We anticipate
that after we complete the GoBeam acquisition we will 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
additional usage of cash from the GoBeam acquisition will depend on many
uncertainties including the amount of capital expenditures that are required to
expand this new business, development of operating support systems and
software, our ability to generate VoIP service revenues, and our ability to
control expenditures (primarily incremental sales, marketing, general and
administrative expenses). Adverse business, legal, regulatory or legislative developments, such as
the inability to continue line-sharing, may require us to raise additional
financing, raise our prices or decrease our cost structure. We
also recognize that we may not be able to raise additional capital. If we are
unable to acquire additional capital on favorable terms if needed, or are
required to raise it on terms that are less satisfactory than we desire, our
financial condition will be adversely affected. Our future cash requirements for the next twelve months and for the
long-term for developing, deploying and enhancing our network and operating our
business, as well as our revenues, will depend on a number of factors
including:  
    
    the recently announced 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; 28




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##### Table of Contents




    
    the effect of the FCCs decision in the Triennial Review, our
continuing ability to access line-shared telephone wires and our
ability to obtain access to the traditional telephone companies
remote terminals 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;
    
    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 March 31, 2004
for the next five years, and thereafter, were as follows: 2004
    
    2005-2006
    
    2007-2008
    
    Thereafter
    
    TotalNote payable to debentures
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    125,000
    
    
    $
    125,000Office leases
    
    
    3,328
    
    
    
    6,087
    
    
    
    3,355
    
    
    
    269
    
    
    
    13,039Other operating leases
    
    
    189
    
    
    
    213
    
    
    
    2
    
    
    
    
    
    
    
    404Purchase obligations
    
    
    15,499
    
    
    
    4,475
    
    
    
    
    
    
    
    
    
    
    
    19,974$
    19,016
    
    
    $
    10,775
    
    
    $
    3,357
    
    
    $
    125.269
    
    
    $
    158,417
 We lease certain vehicles, equipment and office facilities under various
non-cancelable operating leases that expire at various dates through 2009. The
facility leases generally require us to pay operating costs, including property
taxes, insurance and maintenance, and contain scheduled rent increases and
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 $9,380 as of March 31,
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 $11,500 for 2004 of which $8,625 remains
unutilized at March 31, 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 $1,969 as
of March 31, 2004. 29




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##### Table of Contents



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 unbundled network elements are generally outside of
our control because they are proposed by the traditional telephone
companies and are subject to costly regulatory approval processes.
    
    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 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 would 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. 30




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##### Table of Contents




    
    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 obligation 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. Forward-Looking Statements We include certain estimates, projections, and other forward-looking
statements in our reports, in presentations to analysts and others, and in
other publicly available material. Future performance cannot be ensured. Actual
results may differ materially from those in forward-looking statements. The
statements contained in this Report on Form 10-Q that are not historical facts
are forward-looking statements (as such term is defined in Section 27A of the
Securities Act and Section 21E of the Exchange Act), which can be identified by
the use of forward-looking terminology such as estimates, projects,
anticipates, expects, intends, believes, or the negative thereof or
other variations thereon or comparable terminology, or by discussions of
strategy that involve risks and uncertainties. Examples of such forward-looking
statements include but are not limited to:  
    
    the impact of the FCCs decision in the Triennial Review and
our ability to obtain access to line-sharing at rates that allow us
to sell consumer-grade services;
    
    expectations regarding the continuing deployment of local voice
services by providers other than the traditional telephone companies
and our ability to bundle our data services with their voice
services;
    
    expectations regarding our ability to become cash-flow positive;
    
    expectations regarding the extent to which customers purchase our services;
    
    expectations regarding our relationships with our strategic partners and other potential third parties;
    
    expectations as to pricing for our services in the future;
    
    expectations as to the impact of our service offerings on our margins;
    
    the possibility that we will increase our revenues;
    
    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; 31




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
    
    plans to enter into business arrangements with broadband-related service providers;
    
    the effect of regulatory changes;
    
    the effect of litigation currently pending; and
    
    other statements contained in this Report on Form 10-Q regarding matters that are not historical facts. These statements are only estimates or predictions and cannot be relied
upon. We can give you no assurance that future results will be achieved. Actual
events or results may differ materially as a result of risks facing us or
actual results differing from the assumptions underlying such statements. Such
risks and assumptions that could cause actual results to vary materially from
the future results indicated, expressed or implied in such forward-looking
statements include our ability to:  
    
    adapt our business plan in response to further developments
resulting from the FCCs Triennial Review order and appellate
proceedings;
    
    collect receivables from customers;
    
    retain end-users that are served by customers facing financial difficulties;
    
    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 traditional telephone companies in the areas
where we provide service, all in a timely manner, at reasonable costs
and on satisfactory terms that provide us with access to line-sharing
and remote terminals. All written and oral forward-looking statements made in connection with
this Report on Form 10-Q which are attributable to us or persons acting on our
behalf are expressly qualified in their entirety by the Risk Factors and
other cautionary statements included in this document and in our Annual Report
on Form 10-K for the year ended December 31, 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 in fixed-rate, short-term
securities. We do not have any derivative instruments. The fair value of our
investment portfolio or related income would not be significantly impacted by
either a 100 basis point increase or decrease in interest rates due mainly to
the fixed-rate, short-term nature of the substantial majority of our investment
portfolio. In addition, all of our outstanding indebtedness as of March 31,
2004 is fixed-rate debt. 32




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Item 4.Controls and Procedures Evaluation of Disclosure Controls and Procedures.The Securities and
Exchange Commission defines the term disclosure controls and procedures to
mean a companys controls and other procedures that are designed to ensure that
information required to be disclosed in the reports that it files or submits
under the Securities Exchange Act of 1934 is recorded, processed, summarized
and reported, within the time periods specified in the Commissions rules and
forms. Our chief executive officer and chief financial officer have
concluded, based on the evaluation of the effectiveness of the disclosure
controls and procedures by our management, with the participation of our chief
executive officer and chief financial officer, as of the end of the period
covered by this report, that our disclosure controls and procedures were
effective for this purpose, with the exception of the item described
below. During
the review process for our condensed consolidated financial
statements as of March 31, 2004 and for the quarter then ended,
we determined that certain stock-based compensation that we began
offering to employees in the third quarter of 2003 should have been
subject to variable accounting and that the financial statements for
the quarters ended September 30, 2003 and December 31,
2003, as well as for the year ended December 31, 2003, need to
be restated to account for this compensation. The restatement
involves a non-cash compensation charge which reflects the impact of
stock-based compensation expense for options subject to variable
accounting that were issued under our 2003 Employee Stock Purchase
Plan. See Note 15 in the financial statements included in
Item 8 of our annual report on Form 10-K/A (Amendment
No. 1) filed on May 17, 2004, for further discussion of
this restatement. To address these matters, we have implemented
additional procedures to ensure that stock-based compensation is
properly evaluated and recorded when we implement or make changes to
our stock-based compensation plans. Changes
in Internal Controls.During the fiscal quarter covered by this
report, there were no changes in our internal control over financial
reporting that have materially affected or are reasonably likely to
materially affect our internal control over financial reporting.
Subsequent to the end of that quarter, we did make the change
described in the preceding paragraph with respect to accounting for
stock-based compensation. 33




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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 Eleventh Circuit also relied in part on
the Trinko decision when it reversed the lower courts dismissal of our claims
against BellSouth. 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 have filed motions
with the appellate courts requesting affirmance of the district courts
rulings. We have opposed those motions and they remain pending. 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 has appealed the dismissal of its lawsuit. We believe we have
strong defenses to this lawsuit, but litigation is inherently unpredictable and
there is no guarantee we will prevail. Several stockholders filed complaints in the United States District Court
for the Southern District of New York, on behalf of themselves and purported
classes of stockholders, against us and several former and current officers and
directors in addition to some of the underwriters in our stock offerings. These
lawsuits are so-called IPO allocation cases, challenging practices allegedly
used by certain underwriters of public equity offerings during the late 1990s
and 2000. On April 19, 2002 the plaintiffs amended their complaint and removed
us as a defendant. Certain directors and officers are still named in the
complaint. The plaintiffs claim that we failed to disclose the arrangements
that some of these underwriters purportedly made with certain investors. The
plaintiffs and the issuer defendants have reached a tentative agreement to
settle the matter, and we believe the tentative settlement will not have a
material adverse effect on our consolidated financial position or results of
operations. That settlement, however, has not been 34




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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. In this action Mr. Khanna seeks recovery on behalf of the
company from the individual defendants for their purported breach of fiduciary
duty. Mr. Khanna also seeks to invalidate our election of directors in 2002 and
2003 because he claims that our proxy statements were misleading. On December
12, 2003, the Company filed a motion to dismiss Mr. Khannas claims in their
entirety. The Court has not yet ruled on the motion. 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. 35




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Item 2.Changes in Securities and Use of Proceeds Under the terms of a Purchase Agreement dated March 4, 2004, we sold
$125.0 million aggregate principal amount of our 3% Convertible Senior
Debentures due 2024 (Debentures) to Banc of America Securities LLC, Jeffries
& Company, Inc., Needham & Company, Inc. and Kaufman Bros., L.P. The issuance
and sale of the Debentures and the subsequent offering by the initial
purchasers were exempt from the registration provisions of the Securities Act
of 1933, as amended, by Section 4(2) of the Securities Act and Rule 144A
promulgated under the Securities Act. We sold the Debentures for cash. The
aggregate offering price was $125.0 million and our net proceeds were
approximately $120.6 million. The Debentures will mature on March 15, 2024 and are convertible into our
common stock on or before the maturity date, under certain circumstances, at an
initial conversion rate of 315.04 shares per $1,000 principal amount of notes,
subject to adjustment. At the initial conversion rate, the Debentures will be
convertible into common stock at a conversion price of $3.1742 per share. The
Debentures will be redeemable for cash at our option beginning on March 20,
2009. Holders of the Debentures have the option to require us to purchase the
Debentures in cash, in whole or in part, on March 15 in each of 2009, 2014 and
2019. The holders of the Debentures will also have the ability to require us to
purchase the Debentures in the event that we undergo a change in control. In
each such case, the redemption or purchase price would be at 100% of the
principal amount of the Debentures, plus accrued and unpaid interest to, but
excluding, the redemption or purchase date, as the case may be. We used a portion of the proceeds from the Debentures to repay $56.6
million in principal and accrued interest on an 11% note payable to SBC
Communications, Inc. We plan to use the remaining net proceeds to expand
various strategic initiatives including, but not limited to, accelerating our
deployment of Voice over Internet Protocol services as well as for working
capital and general corporate purposes. In connection with the settlement of complaints that were filed in the
United States District Court for the Northern District of California in the
fourth quarter of 2000 by purchasers of our common stock and purchasers of the
convertible notes we issued in September 2000 against us and certain of our
present and former officers and directors, we issued 6,495,844 shares of common
stock, which was completed in April 2004. Please see Part II. Other
Information  Item 1 Legal Proceedings for further details. 
 Item 3.Defaults upon Senior Securities None. 
 Item 4.Submission of Matters to a Vote of Security Holders None. 
 Item 5.Other Information On April 12, 2004, the Company filed a current report on Form 8-K,
pursuant to Item 4 thereof, reporting that the Company had dismissed Ernst &
Young LLP as its independent accountant and had determined to engage
PricewaterhouseCoopers LLP as its independent accountant for the fiscal year
2004. 
 Item 6.Exhibits and Reports on Form 8-K a. Exhibits: Incorporated by ReferenceExhibit
    
    
    
    
    
    
    
    
    
    ExhibitNumber
    
    Exhibit Description
    
    Form
    
    File No.
    
    Date of First Filing
    
    Number
    
    Filed Herewith2.1
    
    Agreement and Plan of Merger, dated as
of March 2, 2004, among Covad
Communications Group, Inc., Covad
Communications Investment Corp., GoBeam,
Inc. and Eduardo Briceño, as
Representative.
    
    
    
    
    
    
    
    
    
    X
 36




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4.1
    
    Indenture, dated as of March 10, 2004,
between the Registrant and The Bank of
New York, as Trustee.
    
    
    
    
    
    
    
    
    
    X4.2
    
    Resale Registration Rights Agreement,
dated as of March 10, 2004 between the
Registrant and Banc of America
Securities LLC.
    
    
    
    
    
    
    
    
    
    X4.3
    
    Form of Debenture for the Registrants
3% Convertible Senior Debentures due
2024.
    
    
    
    
    
    
    
    
    
    X31.1
    
    Certification Pursuant to Rule 13a-14(a).
    
    
    
    
    
    
    
    
    
    X31.2
    
    Certification Pursuant to Rule 13a-14(a).
    
    
    
    
    
    
    
    
    
    X32.1*
    
    Certification Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of
2002.
    
    
    
    
    
    
    
    
    
    X32.2*
    
    Certification Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of
2002.
    
    
    
    
    
    
    
    
    
    X
   *
    
    These certifications accompany the Registrants Quarterly Report on Form 10-Q
and are not deemed filed with the SEC. b. Reports on Form 8-K We reported the following items on Form 8-K during the quarter ended March
31, 2004: On January 6, 2004, the Company furnished a current report on Form 8-K,
pursuant to Item 12 thereof, attaching a press release announcing its
subscriber line count as of December 31, 2003 and confirming its financial
guidance for the fourth quarter of 2003. On February 18, 2004, the Company furnished a current report on Form 8-K,
pursuant to Item 12 thereof, attaching a press release announcing its financial
results for the year ended December 31, 2003. On March 9, 2004, the Company filed a current report on Form 8-K, pursuant
to Item 5 thereof, reporting that the Company raised $125,000 million through a
private offering of Convertible Senior Debentures due 2024. On March 25, 2004, the Company filed a current report on Form 8-K,
pursuant to Item 5 thereof, reporting that the Company entered into an
agreement to acquire GoBeam, Inc. a provider of VoIP services for business. 37




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##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. COVAD COMMUNICATIONS GROUP, INC.By:
    
    /s/ CHARLES E. HOFFMANCharles E. HoffmanPresident, Chief ExecutiveOfficer and DirectorDate: May 17, 2004
    
    
    
    By:
    
    /s/ MARK A. RICHMANMark A. RichmanExecutive Vice President andDate: May 17, 2004
    
    
    
    
    
    Chief Financial Officer
 38




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##### Table of Contents



Incorporated by ReferenceExhibit
    
    
    
    
    
    
    
    
    
    ExhibitNumber
    
    Exhibit Description
    
    Form
    
    File No.
    
    Date of First Filing
    
    Number
    
    Filed Herewith2.1
    
    Agreement and Plan of Merger, dated as
of March 2, 2004, among Covad
Communications Group, Inc., Covad
Communications Investment Corp., GoBeam,
Inc. and Eduardo Briceño, as
Representative.
    
    
    
    
    
    
    
    
    
    X4.1
    
    Indenture, dated as of March 10, 2004,
between the Registrant and The Bank of
New York, as Trustee.
    
    
    
    
    
    
    
    
    
    X4.2
    
    Resale Registration Rights Agreement,
dated as of March 10, 2004 between the
Registrant and Banc of America
Securities LLC.
    
    
    
    
    
    
    
    
    
    X4.3
    
    Form of Debenture for the Registrants
3% Convertible Senior Debentures due
2024.
    
    
    
    
    
    
    
    
    
    X31.1
    
    Certification Pursuant to Rule 13a-14(a).
    
    
    
    
    
    
    
    
    
    X31.2
    
    Certification Pursuant to Rule 13a-14(a).
    
    
    
    
    
    
    
    
    
    X32.1*
    
    Certification Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of
2002.
    
    
    
    
    
    
    
    
    
    X32.2*
    
    Certification Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of
2002.
    
    
    
    
    
    
    
    
    
    X
   *
    
    These certifications accompany the Registrants Quarterly Report on Form 10-Q
and are not deemed filed with the SEC. 39