##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, DC 20549
 FORM 10-Q
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2006
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the transition period from  to.
 Commission file number: 001-32588
 COVAD COMMUNICATIONS GROUP, INC.
  Delaware
    
    77-0461529(State or other jurisdiction
    
    (I.R.S. Employerof incorporation or organization)
    
    Identification Number)110 Rio RoblesSan Jose, California(Address of principal executive
    
    95134offices)
    
    (Zip Code)
 (408) 952-6400  (Registrants telephone number, including area code)
 þ o
  Large Accelerated Filer o
    
    Accelerated Filer þ
    
    Non-accelerated Filer o
 o þ
 APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS:
 þ o




---



##### 



COVAD COMMUNICATIONS GROUP, INC.
 For the Quarterly Period Ended March 31, 2006
 TABLE OF CONTENTS
 PagePART I. FINANCIAL INFORMATIONITEM 1. Financial Statements
    
    
    2Condensed Consolidated Balance Sheets
    
    
    2Condensed Consolidated Statements of Operations
    
    
    3Condensed Consolidated Statements of Cash Flows
    
    
    4Notes to Condensed Consolidated Financial Statements
    
    
    5ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    26ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    42ITEM 4. Controls and Procedures
    
    
    42PART II. OTHER INFORMATIONITEM 1. Legal Proceedings
    
    
    43ITEM 1A. Risks Factors
    
    
    44ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    56ITEM 3. Defaults Upon Senior Securities
    
    
    56ITEM 4. Submission of Matters to a Vote of Security Holders
    
    
    56ITEM 5. Other Information
    
    
    56ITEM 6. Exhibits
    
    
    56SIGNATURES
    
    
    57EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  1




---



##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 ITEM 1. Financial Statements
 COVAD COMMUNICATIONS GROUP, INC.
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (All dollar and share amounts are presented in thousands, except par value)
 (Unaudited)
 March 31,
    
    
    December 31,2006
    
    
    2005(Note 1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    78,756
    
    
    $
    84,291Short-term investments in debt securities
    
    
    6,229
    
    
    
    12,210Restricted cash and cash equivalents
    
    
    55,310
    
    
    
    5,503Accounts receivable, net
    
    
    29,729
    
    
    
    28,074Unbilled revenues
    
    
    3,940
    
    
    
    3,326Inventories
    
    
    4,122
    
    
    
    5,245Prepaid expenses and other current assets
    
    
    4,607
    
    
    
    2,400Total current assets
    
    
    182,693
    
    
    
    141,049Property and equipment, net
    
    
    70,035
    
    
    
    71,663Collocation fees and other intangible assets, net
    
    
    26,314
    
    
    
    20,715Goodwill
    
    
    50,020
    
    
    
    36,626Deferred costs of service activation
    
    
    24,534
    
    
    
    25,456Deferred debt issuance costs, net
    
    
    4,470
    
    
    
    3,223Other long-term assets
    
    
    1,848
    
    
    
    1,849Total assets
    
    $
    359,914
    
    
    $
    300,581LIABILITIES AND STOCKHOLDERS DEFICITCurrent liabilities:Accounts payable
    
    $
    28,713
    
    
    $
    23,331Accrued compensation
    
    
    17,617
    
    
    
    16,277Accrued collocation and network service fees
    
    
    14,479
    
    
    
    14,583Accrued transaction-based taxes
    
    
    29,930
    
    
    
    30,159Collateralized and other customer deposits
    
    
    36,381
    
    
    
    33,230Unearned revenues
    
    
    4,820
    
    
    
    6,500Other accrued liabilities
    
    
    10,427
    
    
    
    9,137Total current liabilities
    
    
    142,367
    
    
    
    133,217Long-term debt
    
    
    166,014
    
    
    
    125,000Collateralized and other long-term customer deposits
    
    
    7,585
    
    
    
    16,912Unearned revenues
    
    
    42,074
    
    
    
    43,758Other long-term liabilities
    
    
    2,460
    
    
    
    1,863Total liabilities
    
    
    360,500
    
    
    
    320,750Commitments and contingencies (Notes 5 and 6)Stockholders deficit:Preferred stock, $0.001 par value; 5,000 shares
authorized; no shares issued and outstanding at
March 31, 2006 and December 31, 2005
    
    
    
    
    
    
    Common Stock, $0.001 par value; 590,000 shares
authorized; 291,933 shares issued and outstanding
at March 31, 2006 (268,353 shares issued and
outstanding at December 31, 2005)
    
    
    292
    
    
    
    268Common Stock  Class B, $0.001 par value; 10,000
shares authorized; no shares issued and outstanding
at March 31, 2006 and December 31, 2005
    
    
    
    
    
    
    Additional paid-in capital
    
    
    1,726,513
    
    
    
    1,697,686Deferred stock-based compensation
    
    
    
    
    
    
    (5
    )Accumulated other comprehensive income
    
    
    10
    
    
    
    3Accumulated deficit
    
    
    (1,727,401
    )
    
    
    (1,718,121
    )Total stockholders deficit
    
    
    (586
    )
    
    
    (20,169
    )Total liabilities and stockholders deficit
    
    $
    359,914
    
    
    $
    300,581
  2




---



##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (All dollar and share amounts are presented in thousands, except per share amounts)
 (Unaudited)
 Three months ended March 31,2006
    
    
    2005Revenues, net
    
    $
    117,751
    
    
    $
    107,718Operating expenses:Cost of sales (exclusive of depreciation and amortization)
    
    
    79,937
    
    
    
    72,749Selling, general and administrative
    
    
    34,965
    
    
    
    42,374Depreciation and amortization of property and equipment
    
    
    8,648
    
    
    
    13,785Amortization of collocation fees and other intangible assets
    
    
    2,400
    
    
    
    5,364Provision for restructuring and post-employment benefits
    
    
    763
    
    
    
    Total operating expenses
    
    
    126,713
    
    
    
    134,272Loss from operations
    
    
    (8,962
    )
    
    
    (26,554
    )Other income (expense):Interest income
    
    
    977
    
    
    
    899Gain on sale of equity securities
    
    
    
    
    
    
    7,246Gain on deconsolidation of subsidiary
    
    
    
    
    
    
    53,963Interest expense
    
    
    (1,322
    )
    
    
    (1,238
    )Miscellaneous income, net
    
    
    27
    
    
    
    58Other income (expense), net
    
    
    (318
    )
    
    
    60,928Net income (loss)
    
    $
    (9,280
    )
    
    $
    34,374Earnings (loss) per common share:Basic
    
    $
    (0.03
    )
    
    $
    0.13Diluted
    
    $
    (0.03
    )
    
    $
    0.11Weighted-average number of common shares outstanding used in
computing earnings (loss) per common share:Basic
    
    
    276,488
    
    
    
    263,690Diluted
    
    
    276,488
    
    
    
    310,755
  3




---



##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (All dollar amounts are presented in thousands)
 (Unaudited)
 Three months ended March 31,2006
    
    
    2005Operating Activities:Net income (loss)
    
    $
    (9,280
    )
    
    $
    34,374Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:Provision for bad debts, net
    
    
    59
    
    
    
    137Depreciation and amortization
    
    
    11,048
    
    
    
    19,149(Gain) loss on disposition of property and equipment
    
    
    (2
    )
    
    
    23Stock-based compensation expense (reversal)
    
    
    681
    
    
    
    (1,331
    )Amortization of deferred customer incentives
    
    
    189
    
    
    
    437Other non-cash charges
    
    
    284
    
    
    
    252Accretion of interest on investments, net
    
    
    (86
    )
    
    
    (159
    )Gain on sale of equity securities
    
    
    
    
    
    
    (7,246
    )Gain on deconsolidation of subsidiary
    
    
    
    
    
    
    (53,963
    )Net changes in operating assets and liabilities, net of assets acquired
and liabilities assumed in purchase acquisition:Accounts receivable
    
    
    (1,282
    )
    
    
    2,042Unbilled revenues
    
    
    (614
    )
    
    
    (577
    )Inventories
    
    
    1,124
    
    
    
    (199
    )Prepaid expenses and other current assets
    
    
    (1,725
    )
    
    
    (1,899
    )Deferred costs of service activation
    
    
    922
    
    
    
    1,024Accounts payable
    
    
    4,278
    
    
    
    (3,700
    )Collateralized and other customer deposits
    
    
    (6,176
    )
    
    
    (2,086
    )Other current liabilities
    
    
    206
    
    
    
    (3,529
    )Unearned revenues
    
    
    (3,760
    )
    
    
    (1,705
    )Net cash used in operating activities
    
    
    (4,134
    )
    
    
    (18,956
    )Investing Activities:Restricted cash and cash equivalents, net
    
    
    (49,807
    )
    
    
    Purchase of short-term investments in debt securities
    
    
    (6,176
    )
    
    
    (16,013
    )Maturities of short-term investments in debt securities
    
    
    12,250
    
    
    
    26,100Proceeds from the sale of equity securities
    
    
    
    
    
    
    7,439Purchase of property and equipment
    
    
    (3,423
    )
    
    
    (6,500
    )Proceeds from sale of property and equipment
    
    
    2
    
    
    
    7Payment of collocation fees and purchase of other intangible assets
    
    
    (329
    )
    
    
    (255
    )Payment in connection with business acquisition, net of cash acquired
    
    
    (3,187
    )
    
    
    (Increase) decrease in other long-term assets
    
    
    (136
    )
    
    
    21Net cash provided by (used in) investing activities
    
    
    (50,806
    )
    
    
    10,799Financing Activities:Proceeds from the issuance of senior secured note, net of issuance costs
    
    
    38,469
    
    
    
    Principal payment of long-term debt
    
    
    (17
    )
    
    
    Principal payments under capital lease obligations
    
    
    (159
    )
    
    
    (135
    )Proceeds from the issuance of common stock, net of issuance costs
    
    
    11,112
    
    
    
    234Net cash provided by financing activities
    
    
    49,405
    
    
    
    99Net decrease in cash and cash equivalents
    
    
    (5,535
    )
    
    
    (8,058
    )Cash and cash equivalents at beginning of period
    
    
    84,291
    
    
    
    117,506Cash and cash equivalents at end of period
    
    $
    78,756
    
    
    $
    109,448Supplemental Disclosures of Cash Flow Information:Cash paid during the period for interest
    
    $
    1,905
    
    
    $
    1,913Supplemental Schedule of Non-Cash Investing and Financing Activities:Equipment purchased through capital leases
    
    $
    
    
    
    $
    156Common stock issued for acquisition of business
    
    $
    16,314
    
    
    $
    
  4




---



##### Table of Contents



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
   Subsequent
Events,
   Use of Estimates
  5




---



##### Table of Contents



Restricted Cash and Cash Equivalents
 Long-Term Debt.
 Inventories
  Goodwill
   Acquisition of NextWeb.
 Collateralized and Other Customer Deposit s
 Revenue
Recognition
 6




---



##### Table of Contents



Revenue
Recognition
 Post-Employment Benefits
  Earnings (Loss) Per Share
   7




---



##### Table of Contents



Three months ended March 31,2006
    
    
    2005Basic:Net income (loss) as reported
    
    $
    (9,280
    )
    
    $
    34,374Diluted:Add back interest on 3% convertible debentures
    
    
    
    
    
    
    1,190Net income (loss) adjusted for assumed conversions
    
    $
    (9,280
    )
    
    $
    35,564
  Three months ended March 31,2006
    
    
    2005Basic:Weighted-average number of common shares outstanding
    
    
    276,498
    
    
    
    263,881Less weighted-average number of common shares
outstanding subject to repurchase
    
    
    10
    
    
    
    191Weighted-average number of common shares
outstanding used in the computations of basic
earnings (loss) per share
    
    
    276,488
    
    
    
    263,690Diluted:Dilutive stock options and warrants
    
    
    
    
    
    
    7,494Assumed conversion of convertible debentures
    
    
    
    
    
    
    39,380Common shares subject to repurchase
    
    
    
    
    
    
    191Weighted-average number of common shares
outstanding used in the computations of diluted
earnings (loss) per share
    
    
    276,488
    
    
    
    310,755
   Three months ended March 31,2006
    
    2005Stock options
    
    
    25,123
    
    
    
    23,539Options under employee stock purchase plan
    
    
    1,598
    
    
    
    5,126Warrants
    
    
    6,514
    
    
    
    5,573Common shares issuable under the assumed
conversion of convertible debentures and
notes
    
    
    60,885
    
    
    
    
 8




---



##### Table of Contents



Comprehensive Income (Loss)
  Cumulative
    
    
    Three months ended March 31,amounts
    
    
    2006
    
    
    2005Net income (loss)
    
    $
    (1,727,401
    )
    
    $
    (9,280
    )
    
    $
    34,374Unrealized gains on available-for-sale securities
    
    
    10
    
    
    
    7
    
    
    
    27,680Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    192Comprehensive income (loss)
    
    $
    (1,727,391
    )
    
    $
    (9,273
    )
    
    $
    62,246
 Recent Accounting Pronouncements
 Share-Based Payment Accounting for Stock Issued to Employees, Share-Based Payment, Stock-Based Compensation,
 Risks and Uncertainties
  
    
    changes in government policy, regulation and enforcement or adverse judicial or
administrative interpretations and rulings or legislative action relating to regulations,
enforcement and pricing, including, but not limited to, changes that affect the continued
availability of the unbundled network elements of the local exchange carriers network and
the costs associated therewith;
    
    dependence on the availability and functionality of the networks of the incumbent local
exchange carriers;
    
    increased price competition in local and long distance services, including bundled
services, and overall competition within the telecommunications industry; and
    
    adverse determinations in certain litigation matters.
  2. Revenue Recognition
  9




---



##### Table of Contents



March 31, 2006
    
    
    December 31, 2005Gross accounts receivable
    
    $
    32,758
    
    
    $
    31,398Allowance for service credits
    
    
    (2,786
    )
    
    
    (2,838
    )Allowance for bad debt
    
    
    (243
    )
    
    
    (486
    )Accounts receivable, net
    
    $
    29,729
    
    
    $
    28,074
 Significant Customers
   10




---



##### Table of Contents



Wholesaler Financial Difficulties
   3. Warrants
   11




---



##### Table of Contents



4. Restructuring and Post-Employment Benefits
 Reduction in Force
  Other Restructuring Activities
    12




---



##### Table of Contents



5. Long-Term Debt
 12% Senior Secured Convertible Note
     13




---



##### Table of Contents



3% Convertible Senior Debentures
  Line of Credit
  6. Commitments and Contingencies
 Litigation
    14




---



##### Table of Contents



Other Contingencies
 .
  15




---



##### Table of Contents



Indemnification Agreements
   Commitments
  7. Stock-Based Compensation
 Impact of adopting SFAS 123R
 Accounting for Stock-Based Compensation, Accounting for
Stock-Based Compensation  Transition and Disclosures.
 16




---



##### Table of Contents



Valuation Assumptions
   17




---



##### Table of Contents



Stock Options
    
    Employee Stock Purchase PlanThree months ended March 31,
    
    Three months ended March 31,2006
    
    2005
    
    2006
    
    2005Expected life of options in years
    
    
    3.5
    
    
    
    4.0
    
    
    
    0.5
    
    
    
    0.5Volatility
    
    
    86.80
    %
    
    
    121.60
    %
    
    
    77.30
    %
    
    
    121.60
    %Risk-free interest rate
    
    
    4.69
    %
    
    
    4.03
    %
    
    
    4.80
    %
    
    
    3.15
    %Expected dividend yield
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
 Equity Incentive Programs
  2003 Employee Stock Purchase Plan
    Stock Option Plans
  18




---



##### Table of Contents



Number ofsecuritiesNumber of
    
    Weighted-
    
    remaining availablesecurities to be
    
    average exercise
    
    for future issuanceissued upon
    
    price of
    
    under equityexercise of
    
    outstanding
    
    compensationoutstanding
    
    options,
    
    plans (excludingoptions, warrants
    
    warrants and
    
    securities reflectedand rights
    
    rights
    
    in column (a))Plan Category
    
    (a)
    
    (b)
    
    (c)Equity
compensation plans
approved by
security holders(1)
    
    
    25,009
    
    
    $
    4.47
    
    
    
    24,305Equity compensation
plans not approved
by security
holders(2)
    
    
    114
    
    
    
    3.67
    
    
    
    Total
    
    
    25,123
    
    
    $
    4.47
    
    
    
    24,305
 
 (1)
    
    1997 Stock Plan and 2003 ESPP. Securities available for future issuance under the Companys
2003 ESPP are included in column (c) but are not included in columns (a) and (b) because
amount and price of securities purchased in an offering period are determined at the end of
such offering period. The Companys next offering period ends in June 2006.(2)
    
    These plans consist of the Laser Link 1997 Stock Plan, the BlueStar 2000 Stock Incentive
Plan, and the GoBeam 2000 Employee and Consultant Equity Incentive Plan, all of which were
assumed by the Company in connection with the acquisitions of each company. 19




---



##### Table of Contents



Number of Shares of
    
    
    Option Price perCommon Stock
    
    
    ShareBalance as of December 31, 2003
    
    
    21,677
    
    
    $
    0.001
    
    
    
    
    $
    149.79Granted
    
    
    6,867
    
    
    $
    1.460
    
    
    
    
    $
    3.51Exercised
    
    
    (1,951
    )
    
    $
    0.001
    
    
    
    
    $
    3.72Cancelled, expired and forfeited
    
    
    (3,596
    )
    
    $
    0.001
    
    
    
    
    $
    149.79Balance as of December 31, 2004
    
    
    22,997
    
    
    $
    0.001
    
    
    
    
    $
    149.79Granted and assumed
    
    
    7,162
    
    
    $
    0.730
    
    
    
    
    $
    1.69Exercised
    
    
    (774
    )
    
    $
    0.296
    
    
    
    
    $
    2.16Cancelled, expired and forfeited
    
    
    (4,412
    )
    
    $
    0.022
    
    
    
    
    $
    149.79Balance as of December 31, 2005
    
    
    24,973
    
    
    $
    0.001
    
    
    
    
    $
    149.79Granted
    
    
    3,232
    
    
    $
    1.180
    
    
    
    
    $
    1.93Exercised
    
    
    (1,378
    )
    
    $
    0.296
    
    
    
    
    $
    1.90Cancelled, expired and forfeited
    
    
    (1,704
    )
    
    $
    0.001
    
    
    
    
    $
    63.33Balance as of March 31, 2006
    
    
    25,123
    
    
    $
    0.296
    
    
    
    
    $
    149.79
  Options Outstanding
    
    
    Options ExercisableWeighted-
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Weighted-Average
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    AverageRemaining
    
    
    Weighted-
    
    
    
    
    
    
    
    
    
    
    Remaining
    
    
    Weighted-Contractual
    
    
    Average
    
    
    Aggregate
    
    
    
    
    
    
    Contractual
    
    
    Average
    
    
    AggregateRange of Exercise
    
    
    Number of
    
    
    Term (in
    
    
    Exercise
    
    
    Intrinsic
    
    
    Number of
    
    
    Term (in
    
    
    Exercise
    
    
    IntrinsicPrices
    
    
    Shares
    
    
    years)
    
    
    Price
    
    
    Value
    
    
    Shares
    
    
    years)
    
    
    Price
    
    
    Value$
    0.30
    
    
    -
    
    $
    0.84
    
    
    
    3,911
    
    
    
    
    
    
    $
    0.73
    
    
    
    
    
    
    
    3,739
    
    
    
    
    
    
    $
    0.73$
    0.86
    
    
    -
    
    $
    1.24
    
    
    
    3,891
    
    
    
    
    
    
    
    1.18
    
    
    
    
    
    
    
    831
    
    
    
    
    
    
    
    1.14$
    1.26
    
    
    -
    
    $
    1.28
    
    
    
    2,945
    
    
    
    
    
    
    
    1.28
    
    
    
    
    
    
    
    2,219
    
    
    
    
    
    
    
    1.28$
    1.29
    
    
    -
    
    $
    1.50
    
    
    
    1,739
    
    
    
    
    
    
    
    1.35
    
    
    
    
    
    
    
    946
    
    
    
    
    
    
    
    1.39$
    1.52
    
    
    -
    
    $
    1.54
    
    
    
    3,388
    
    
    
    
    
    
    
    1.54
    
    
    
    
    
    
    
    3,387
    
    
    
    
    
    
    
    1.54$
    1.56
    
    
    -
    
    $
    2.56
    
    
    
    3,260
    
    
    
    
    
    
    
    2.28
    
    
    
    
    
    
    
    3,177
    
    
    
    
    
    
    
    2.29$
    2.59
    
    
    -
    
    $
    3.34
    
    
    
    3,370
    
    
    
    
    
    
    
    3.33
    
    
    
    
    
    
    
    3,369
    
    
    
    
    
    
    
    3.33$
    3.51
    
    
    -
    
    $
    63.33
    
    
    
    2,608
    
    
    
    
    
    
    
    28.47
    
    
    
    
    
    
    
    2,607
    
    
    
    
    
    
    
    28.47$
    64.75
    
    
    -
    
    $
    64.75
    
    
    
    10
    
    
    
    
    
    
    
    64.75
    
    
    
    
    
    
    
    10
    
    
    
    
    
    
    
    64.75$
    149.79
    
    
    -
    
    $
    149.79
    
    
    
    1
    
    
    
    
    
    
    
    149.79
    
    
    
    
    
    
    
    1
    
    
    
    
    
    
    
    149.79$
    0.30
    
    
    -
    
    $
    149.79
    
    
    
    25,123
    
    
    
    5.23
    
    
    $
    4.48
    
    
    $
    11,998
    
    
    
    20,286
    
    
    
    4.71
    
    
    $
    5.26
    
    
    $
    8,574
   20




---



##### Table of Contents



Stock OptionsWeighted-AverageGrant-Date FairNumber of Shares
    
    
    ValueNon-vested at
December 31, 2005
    
    
    2,240
    
    
    $
    0.43Awards granted
    
    
    3,232
    
    
    
    0.82Awards vested
    
    
    1,069
    
    
    
    0.30Awards
cancelled, expired and forfeited
    
    
    (1,704
    )
    
    
    0.09Non-vested at March
31, 2006
    
    
    4,837
    
    
    $
    0.65
 Prior to adopting SFAS 123R
  Three months endedMarch 31, 2005Basic:Net income, as reported
    
    $
    34,374Stock-based employee compensation reversal included in the determination of net income, as
reported
    
    
    (1,331
    )Stock-based employee compensation expense that would have been included in the determination of net income if
the fair value method had been applied to all
awards
    
    
    (4,190
    )Net income, pro forma
    
    
    28,853Diluted:Add back interest on 3% convertible debentures
    
    
    1,190Net income adjusted for assumed conversions
    
    $
    30,043Basic:Weighted-average number of common shares outstanding used in the computations of basic earnings per
share
    
    
    263,690Diluted:Dilutive stock options and
warrants
    
    
    3,985Assumed conversion of convertible debentures
    
    
    39,380Common shares subject to repurchase
    
    
    191Weighted-average number of common shares outstanding used in the computations of diluted earnings per
share
    
    
    307,246Earnings per common share, pro forma:Basic
    
    $
    0.11Diluted
    
    $
    0.10Earnings per common share, as reported:Basic
    
    $
    0.13Diluted
    
    $
    0.11
 8. Business Segments
   21




---



##### Table of Contents



Total
    
    Corporate
    
    ConsolidatedAs of and for the three months ended March 31, 2006:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    TotalRevenues, net
    
    $
    81,084
    
    
    $
    36,667
    
    
    $
    117,751
    
    
    $
    
    
    
    $
    117,751Cost of sales (exclusive of
depreciation and amortization)
    
    
    46,234
    
    
    
    22,291
    
    
    
    68,525
    
    
    
    11,412
    
    
    
    79,937Selling, general and administrative
    
    
    2,229
    
    
    
    10,403
    
    
    
    12,632
    
    
    
    22,333
    
    
    
    34,965Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,048
    
    
    
    11,048Provision for restructuring and
post-employment benefits
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    763
    
    
    
    763Income (loss) from operations
    
    
    32,621
    
    
    
    3,973
    
    
    
    36,594
    
    
    
    (45,556
    )
    
    
    (8,962
    )Other expense, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (318
    )
    
    
    (318
    )Net income (loss)
    
    $
    32,621
    
    
    $
    3,973
    
    
    $
    36,594
    
    
    $
    (45,874
    )
    
    $
    (9,280
    )Total assets
    
    $
    38,700
    
    
    $
    20,578
    
    
    $
    59,278
    
    
    $
    300,636
    
    
    $
    359,914
 22




---



##### Table of Contents



Total
    
    Corporate
    
    ConsolidatedAs of and for the three months ended March 31, 2005:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    TotalRevenues net
    
    $
    76,261
    
    
    $
    31,457
    
    
    $
    107,718
    
    
    $
    
    
    
    $
    107,718Cost of sales (exclusive of
depreciation and amortization)
    
    
    47,698
    
    
    
    17,819
    
    
    
    65,517
    
    
    
    7,232
    
    
    
    72,749Selling, general and administrative
    
    
    1,938
    
    
    
    13,692
    
    
    
    15,630
    
    
    
    26,744
    
    
    
    42,374Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,149
    
    
    
    19,149Income (loss) from operations
    
    
    26,625
    
    
    
    (54
    )
    
    
    26,571
    
    
    
    (53,125
    )
    
    
    (26,554
    )Other income, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    60,928
    
    
    
    60,928Net income (loss)
    
    $
    26,625
    
    
    $
    (54
    )
    
    $
    26,571
    
    
    $
    7,803
    
    
    $
    34,374Total assets
    
    $
    45,631
    
    
    $
    18,444
    
    
    $
    64,075
    
    
    $
    317,338
    
    
    $
    381,413
  9. Acquisition of NextWeb
      23




---



##### Table of Contents



Total purchase cost:Cash
    
    $
    3,683Value of common shares issued
    
    
    16,31419,997Acquisition costs
    
    
    327Total purchase cost
    
    $
    20,324Purchase price allocation:Tangible assets acquired
    
    $
    4,918Liabilities assumed
    
    
    (5,662
    )Intangible assets acquired:Customer relationships
    
    
    7,630Non-compete covenant
    
    
    40Goodwill
    
    
    13,398Total purchase consideration
    
    $
    20,324
     10. Related Party Transactions
    24




---



##### Table of Contents



11. Sale of Investments
  12. Income Taxes
   13. Subsequent Events
    25




---



##### 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 on Form 10-Q and the audited consolidated financial
statements and notes thereto and managements discussion and analysis of financial condition and
results of operations for the year ended December 31, 2005 included in our Annual Report on Form
10-K filed with the Securities and Exchange Commission, or SEC, on March 1, 2006. This discussion
contains forward-looking statements, the accuracy of which is subject to risks and uncertainties.
Our actual results could differ materially from those expressed in forward-looking statements for
many reasons including, but not limited to, those discussed herein and in the Risk Factors
section of our Annual Report on Form 10-K , which is contained in Part I, Item 1, Business  Risk
Factors, of that report. We disclaim any obligation to update information contained in any
forward-looking statement. See Forward Looking Statements.
 (All dollar and share amounts are presented in thousands, except per share amounts)
 Overview
 Our Business
     26




---



##### Table of Contents



Our Opportunities and Challenges
   Efficient use of cash
 Efficiently deliver broadband Internet access services to consumers
  Respond to Changes in Telecommunications Regulations 
 27




---



##### Table of Contents



Enter and maintain acceptable line-sharing terms with the ILECs
 Expand and diversify our sources of revenue
 New market opportunities
 Recent Developments
  Critical Accounting Policies and Estimates
  
    
    We recognize revenues when persuasive evidence of our arrangement with the
customer exists, service has been provided to the customer, the price to the customer is
fixed or determinable and collectibility of the sales price is reasonably assured. We
recognize up-front fees associated with service activation over the expected term of the
customer relationship, which is presently estimated to be twenty-four to forty-eight months
using the straight-line method. Similarly, we treat the incremental direct costs of service
activation, which consist principally of customer premises equipment, or CPE, 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
 28




---



##### Table of Contents



deferred, and such incremental direct costs are amortized to expense using the straight-line
method over a range of twenty-four to forty-eight months.
 
    
    We perform ongoing credit evaluations of our customers financial condition and
maintain an allowance for estimated credit losses. In addition, we have billing disputes with
some of our customers. These disputes arise in the ordinary course of business in the
telecommunications industry and we believe that their impact on our accounts receivable and
revenues can be reasonably estimated based on historical experience. In addition, certain
customer revenues are subject to refund if the end-user terminates service within thirty days
of service activation. Accordingly, we maintain allowances, through charges to revenues,
based on our estimate of the ultimate resolution of these disputes and future service
cancellations, and our reported revenue in any period could be different than what is
reported if we employed different assumptions in estimating the outcomes of these items.
 
    
    We state our inventories at the lower of cost or market, determined using the
first-in, first-out method. In assessing the ultimate recoverability of inventories, we are
required to make estimates regarding future customer demand.
 
    
    We record property and equipment and intangible assets at cost, subject to
adjustments for impairment. We depreciate or amortize property and equipment and intangible
assets using the straight-line method over their estimated useful lives. In assessing the
recoverability of our property and equipment and intangible assets, we must make assumptions
regarding estimated future cash flows and other factors to determine the fair value of the
respective assets. If these estimates and assumptions change in the future, we may be
required to record additional impairment charges relating to our property and equipment and
intangible assets.
 
    
    We record goodwill when the consideration paid for an acquisition exceeds the
fair value of net tangible and intangible assets acquired. We measure and test goodwill for
impairment on an annual basis or more frequently if we believe indicators of impairment
exists. The performance of the test involves a two-step process. The first step compares the
fair value of the reporting unit to its carrying amount, including goodwill. The fair value
of the reporting unit is determined by calculating the market capitalization of the reporting
unit as derived from quoted market prices or other generally accepted valuation methods if
quoted market prices are not available. A potential impairment exists if the fair value of
the reporting unit is lower than its carrying amount. The second step of the process is only
performed if a potential impairment exists, and it involves determining the difference
between the fair values of the reporting units net assets, other than goodwill, to the fair
value of the reporting unit. If the difference is less than the net book value of goodwill,
impairment exists and is recorded.
 
    
    We are a party to a variety of legal proceedings, as either plaintiff or
defendant, and are engaged in other disputes that arise in the ordinary course of business.
We are required to assess the likelihood of any adverse judgments or outcomes to these
matters, as well as potential ranges of probable losses for certain of these matters. The
determination of the liabilities to be recognized, if any, for loss contingencies is made
after analysis of each individual situation based on the facts and circumstances. However, it
is reasonably possible that the liabilities reflected in our condensed consolidated balance
sheets for loss contingencies and business disputes could change in the near term due to new
facts and circumstances, the effects of which could be material to our condensed consolidated
financial position, results of operations or cash flows.
 
    
    We perform on-going research and analysis of the applicability of
transaction-based taxes to sales of our products and services and purchases of
telecommunications circuits from various carriers. This research and analysis may include
discussions with authorities of jurisdictions in which we do business and transaction-based
tax experts to determine the extent of our transaction-based tax liabilities. We believe that
these activities will be concluded without a material adverse effect on our condensed
consolidated financial position and results of operations. In addition, we continue to
analyze the probable applicability of employment-related taxes for certain stock-based
compensation provided to employees in prior periods. We believe that the analysis of the
probable applicability of these taxes will be concluded without a material adverse effect to
our condensed 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
condensed consolidated financial position and results of operations.
 29




---



##### Table of Contents




    
    We make market development funds, or MDF, available to certain customers for the
reimbursement of co-branded advertising expenses and other purposes. To the extent that MDF
is used by our customers for co-branded advertising, and the customers provide us with
third-party evidence of such co-branded advertising and we can reasonably estimate the fair
value of our portion of the advertising, such amounts are charged to advertising expense as
incurred. Other MDF activities are recorded as reductions of revenues as incurred. Amounts
payable to customers relating to rebates and customer incentives are recorded as reductions
of revenues based on our estimate of sales incentives that will ultimately be claimed by
customers.
 
    
    We account for income taxes using the liability method, under which deferred tax
assets and liabilities are determined based on differences between the financial reporting
and tax bases of our assets and liabilities. We record a valuation allowance on our deferred
tax assets to arrive at an amount that is more likely than not to be realized. In the future,
should we determine that we are able to realize all or part of our deferred tax assets, which
presently are fully reserved, an adjustment to our deferred tax assets would increase income
in the period in which the determination was made.
 
    
    Effective January 1, 2006, we adopted the provisions of Financial Accounting
Standards Board, or FASB, Statement of Financial Accounting Standards, or SFAS, No. 123
(revised 2004), Share-Based Payment, or SFAS 123R. Accordingly, we account for stock-based
awards exchanged for employee services based on the fair value of the award. We measure the
stock-based compensation cost at the grant date and recognize such cost over the employee
requisite service period. Prior to January 1, 2006, we accounted for stock-based compensation
under the recognition and measurement provisions of Accounting Principles Board Opinion No.
25, or APB 25, and related Interpretations, and provided the required pro forma disclosures
prescribed by SFAS No. 123, Accounting for Stock-Based Compensation,as amended by SFAS
No.148, Accounting for Stock-Based Compensation  Transition and Disclosures.In accordance
with APB 25, we did not recognize compensation cost for awards that had an exercise price
equal to, or greater than, the market value of the underlying common stock on the date of
grant. We elected to adopt the modified prospective transition method as provided by SFAS
123R. Under this transition method, compensation cost recognized in our condensed
consolidated statement of operations includes (i) compensation cost for all shared-based
payments granted prior to, but not yet vested as of December 31, 2005, based on the
grant-date fair value estimated in accordance with the original provisions of SFAS 123, and
(ii) compensation cost for all share-based payments granted subsequent to December 31, 2005,
based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R.
The results for prior periods have not been restated. We currently do not recognize and do
not expect to recognize in the near future, any tax benefit related to employee stock-based
compensation cost as a result of the full valuation allowance on our net deferred tax assets
and because of our net operating loss carryforwards. We capitalize stock-based compensation
as part of the cost of our network when we perform major build or enhancement projects. We
did not capitalize any portion of our stock-based compensation cost for the three months
ended March 31, 2006. We estimate the fair value of stock options using a Black-Scholes
valuation model, consistent with the provisions of SFAS 123R, SECs Staff Accounting Bulletin
No. 107, or SAB 107, and our prior period pro forma disclosures of net earnings, including
stock-based compensation (determined under a fair value method as prescribed by SFAS 123). We
determine the expected life of the options using historical data for options exercised,
cancelled after vesting and outstanding. We determine the expected stock price volatility
assumption using historical volatility of our common stock over a period equal to the
expected life of the option. These assumptions are consistent with our estimates prior the
adoption of SFAS 123R. We determine the forfeiture rate using historical pre-vesting
cancellation data for all options issued after 2001. Prior to the adoption of SFAS 123R, we
accounted for forfeitures upon occurrence.
 Recent Accounting Pronouncements
  30




---



##### Table of Contents



Business Segment Information
    Results of Operations For The Three Months Ended March 31, 2006 and 2005
 Revenues, net
  31




---



##### Table of Contents



Segment Revenues and Significant Customers
  Three months ended March 31,2006
    
    
    2005Wholesale
    
    $
    81,084
    
    
    $
    76,261Percent of net revenues
    
    
    68.9
    %
    
    
    70.8
    %Direct
    
    $
    36,667
    
    
    $
    31,457Percent of net revenues
    
    
    31.1
    %
    
    
    29.2
    %
    32




---



##### Table of Contents



Revenue Recognition
  Wholesaler Financial Difficulties
  Operating Expenses
   Three months ended March 31,2006
    
    
    2005Amount
    
    $
    126,713
    
    
    $
    134,272Percent of net revenues
    
    
    107.6
    %
    
    
    124.7
    %
 Cost of sales (exclusive of depreciation and amortization)
  33




---



##### Table of Contents



Three months ended March 31,2006
    
    
    2005Amount
    
    $
    79,937
    
    
    $
    72,749Percent of net revenues
    
    
    67.9
    %
    
    
    67.5
    %
    Three months ended March 31,2006
    
    
    2005Wholesale Segment
    
    $
    46,234
    
    
    $
    47,698Direct Segment
    
    
    22,291
    
    
    
    17,819Corporate Operations
    
    
    11,412
    
    
    
    7,232Total
    
    $
    79,937
    
    
    $
    72,749
  34




---



##### Table of Contents



Selling, General and Administrative Expenses
   Three months ended March 31,2006
    
    
    2005Amount
    
    $
    34,965
    
    
    $
    42,374Percent of net revenues
    
    
    29.7
    %
    
    
    39.3
    %
    Three months ended March 31,2006
    
    
    2005Wholesale Segment
    
    $
    2,229
    
    
    $
    1,938Direct Segment
    
    
    10,403
    
    
    
    13,692Corporate Operations
    
    
    22,333
    
    
    
    26,744Total
    
    $
    34,965
    
    
    $
    42,374
  35




---



##### Table of Contents



Stock-Based Compensation
 Stock-Based Compensation,
 Depreciation and Amortization
    Provision for Restructuring and Post-Employment Benefits
  Other Income (Expense)
 Net Interest Expense
  36




---



##### Table of Contents



Investment Gains
  Gain on Deconsolidation of Subsidiary
 Other Restructuring
Activities,
 Income Taxes
  Related Party Transactions
    Liquidity and Capital Resources
  37




---



##### Table of Contents



Three months ended March 31,2006
    
    
    2005Net cash provided by (used in):Operating activities
    
    $
    (4,134
    )
    
    $
    (18,956
    )Investing activities
    
    
    (50,806
    )
    
    
    10,799Financing activities
    
    
    49,405
    
    
    
    99Total
    
    $
    (5,535
    )
    
    $
    (8,058
    )
 Operating Activities
   Investing Activities
   Financing Activities
  38




---



##### Table of Contents



Liquidity
      39




---



##### Table of Contents




    
    contractual milestones in the deployment of our LPVA services with EarthLink
    
    our continuing ability to obtain access to ILEC facilities, including telephone
lines, remote terminals, interoffice transport and high-capacity circuits, all at
reasonable prices;
    
    rates at which resellers and end-users purchase and pay for our services and the pricing of such services;
· financial condition of our customers;
    
    levels of marketing required to acquire and retain customers and to attain a
competitive position in the marketplace;
    
    rates at which we invest in engineering, equipment, development and
intellectual property with respect to existing and future technology;
    
    operational costs that we incur to install, maintain and repair end-user lines and our network as a whole;
    
    pending and any future litigation;
    
    existing and future technology, including wireless;
    
    unanticipated opportunities;
    
    network development schedules and associated costs; and
    
    number of regions entered and the timing of entry and services offered.
 Contractual Cash Obligations
  2006
    
    
    2007-2008
    
    
    2009-2010
    
    
    Thereafter
    
    
    Total3% convertible senior debentures
    
    $
    
    
    
    $
    
    
    
    $
    125,000
    
    
    $
    
    
    
    $
    125,00012% senior secured convertible note
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    40,000
    
    
    
    40,000Bank loan
    
    
    75
    
    
    
    1,039
    
    
    
    
    
    
    
    
    
    
    
    1,114Interest on notes payable
    
    
    6,694
    
    
    
    17,154
    
    
    
    10,381
    
    
    
    1,000
    
    
    
    35,229Capital leases
    
    
    247
    
    
    
    384
    
    
    
    92
    
    
    
    3
    
    
    
    726Office leases
    
    
    3,728
    
    
    
    9,741
    
    
    
    5,615
    
    
    
    480
    
    
    
    19,564Other operating leases
    
    
    937
    
    
    
    1,593
    
    
    
    526
    
    
    
    13
    
    
    
    3,069Purchase obligations
    
    
    4,547
    
    
    
    6,300
    
    
    
    
    
    
    
    
    
    
    
    10,847$
    16,228
    
    
    $
    36,211
    
    
    $
    141,614
    
    
    $
    41,496
    
    
    $
    235,549
   40




---



##### Table of Contents



Forward-Looking Statements
  
    
    impact of federal, state and local telecommunications regulations, decisions
and related litigation, and our ability to obtain ILEC network elements and facilities at
reasonable rates;
    
    continuing deployment of LPVA and our ability to bundle our data services with
the voice services of Earthlink and other alternative voice providers;
    
    timing of our cash flows;
    
    extent to which customers purchase our services;
    
    relationships with our strategic partners and other potential third parties;
    
    pricing for our services in the future;
    
    plans regarding new financing arrangements;
    
    margins on our service offerings;
    
    possibilities that we will increase our revenues;
    
    plans to make strategic investments and acquisitions and the effect of such investments and acquisitions;
    
    estimates and expectations of future operating results, including our selling,
general and administrative expenses declining in future periods, adequacy of our cash
reserves, and the number of anticipated installed lines;
    
    plans to increase sales of value-added services, like VoIP;
    
    anticipated capital expenditures;
    
    plans to enter into business arrangements with broadband-related service providers;
    
    regulatory changes;
    
    feasibility of alternative access solutions, like wireless;
 41




---



##### Table of Contents




    
    effects of litigation currently pending; and
    
    other statements contained in this Report on Form 10-Q regarding matters that are not historical facts.
   
 ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
 (All dollar amounts are presented in thousands)
   Carrying Value
    
    
    Interest RateCash and cash equivalents
    
    $
    78,756
    
    
    
    2.39
    %Short-term investments in debt securities
    
    
    6,229
    
    
    
    0.20
    %Restricted cash and cash equivalents
    
    
    55,310
    
    
    
    1.80
    %$
    140,295
    
    
    
    4.39
    %
 
 ITEM 4. Controls and Procedures
 Evaluation of Disclosure Controls and Procedures:
  Changes in Internal Controls.
  42




---



##### Table of Contents



PART II. OTHER INFORMATION
 
 ITEM 1. Legal Proceedings
       43




---



##### Table of Contents



ITEM 1A. Risk Factors
 (All dollar amounts are presented in thousands, except monthly service subscription fees)
 Investing in and holding our common stock involve a degree of risk. Many factors, including
those described below and set forth elsewhere in this report and in other documents we file with
the Securities and Exchange Commission, or SEC, could cause actual results to differ materially
from the results contemplated by the forward-looking statements contained in this report. If any of
these risk materialize, our business, financial condition and results of operations could suffer.
These risks are not the only ones we face. Additional risks that we currently do not know about or
that we currently believe to be immaterial may also impair our business.
 Our services are subject to government regulation, and changes in current or future laws or
regulations and the methods of enforcing the law and regulations could adversely affect our
business.
    Charges for network elements are generally outside of our control because they are proposed by the
ILECs and are subject to costly regulatory approval processes.
  44




---



##### Table of Contents



Our business will be adversely affected if our interconnection agreements are not renewed or if
they are modified on unfavorable terms.
    We depend on a limited number of customers for the preponderance of our revenues, and we are
highly dependent on sales through our resellers.
   45




---



##### Table of Contents



The markets in which we operate are highly competitive, and we may not be able to compete
effectively, especially against established industry competitors with significantly greater
financial resources.
  
    
    develop and adopt new or emerging technologies;
    
    respond to changes in customer requirements more quickly;
    
    devote greater resources to the development, promotion and sale of their products and services;
    
    form new alliances and rapidly acquire significant market share;
    
    undertake more extensive marketing campaigns;
    
    adopt more aggressive pricing policies; and
    
    devote substantially more resources to developing new services.
    New competitors in the market for VoIP services and improvements in the quality of VoIP service
provided by competitors over the public Internet could increase competition for our VoIP services.
  46




---



##### Table of Contents



Failure to complete development, testing and introduction of new services, including VoIP
services, could affect our ability to compete in the industry.
  We may need to raise additional capital under difficult financial market conditions.
   
    
    customer disconnection rates that reduce our revenues;
    
    significant price reductions by our competitors;
    
    higher levels of marketing expense required to acquire and retain end-users that purchase
our services from us and from our resellers;
    
    the need to upgrade our systems by investing in our existing and future technology and infrastructure;
    
    investment opportunities in complementary businesses, acquisitions or other opportunities;
    
    changes in government regulations and legal actions challenging government regulations; and
    
    additional risk factors mentioned throughout this section.
  47




---



##### Table of Contents



In order to become cash flow positive and to achieve profitability, we must add end-users and sell
additional services to our existing end-users while minimizing the cost to expand our network
infrastructure.
  
    
    acquire new end-users;
    
    efficiently deploy line-powered voice access, or LPVA, services under our agreement with EarthLink;
    
    enter into and maintain agreements with the RBOCs or obtain favorable regulatory rulings
that provide us with access to unbundled network elements on terms and conditions that allow
us to profitably sell our consumer services;
    
    enhance, improve and increase sales of our VoIP services;
    
    upgrade our network to improve reliability and remain competitive;
    
    efficiently deploy wireless services and integrate NextWeb;
    
    expand our direct sales capability and infrastructure in a cost-effective manner; and
    
    continue to implement and improve our management information systems, including our
client ordering, provisioning, dispatch, trouble ticketing, customer billing, accounts
receivable, payable tracking, collection, fixed assets, transaction-based taxes and other
management information systems.
  Our end-user disconnection rate reduces our revenue and end-user growth.
  
    
    move to a new location;
    
    disconnect because of better offers in the market; or
 48




---



##### Table of Contents




    
    disconnect because they do not like our service or the service provided by our resellers.
  We may experience decreasing margins on the sale of our services, which may impair our ability to
achieve profitability or positive cash flow.
  If our internal controls over financial reporting do not comply with the requirements of the
Sarbanes-Oxley Act, our business, reputation and stock price could be adversely affected.
   Some of our resellers are facing financial difficulties, which makes it more difficult to predict
our revenues.
  The 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.
  
    
    recruit, hire and train additional direct sales teams;
    
    reduce our cost of acquiring new customers;
 49




---



##### Table of Contents




    
    create effective automated systems to provision, manage and bill for VoIP services;
    
    manage expanding and increasingly diverse distribution channels;
    
    effectively manage additional vendors; and
    
    continue to enhance our network and access products to provide business-class VoIP services.
  The communications industry is undergoing rapid technological changes and new technologies may be
superior to the technology we use.
  
    
    third parties, including some of our competitors and potential competitors, to develop
and provide us with access to new communications and networking technology;
    
    our ability to anticipate or adapt to new technology on a timely basis; and
    
    our ability to adapt to new products and technologies that may be superior to, or may not
be compatible with, our products and technologies.
  A system failure could delay or interrupt service to our customers, which could reduce demand for
our services.
   50




---



##### Table of Contents



A breach of network security could delay or interrupt service to our customers, which could reduce
demand for our services.
  Our success depends on our retention of certain key personnel, our ability to hire additional key
personnel and the maintenance of good labor relations.
   We depend on a limited number of third parties for equipment supply, software utilities, service
and installation and if we are unable to obtain these items from these third parties we may not be
able to deliver our services as required.
  
    
    DSLAMs;
    
    CPE, including modems, routers, bridges and other devices;
    
    network routing and switching hardware;
    
    customer support;
    
    installation services;
    
    customized software design and maintenance;
    
    network management software;
    
    systems management software;
    
    database management software;
    
    collocation space;
 51




---



##### Table of Contents




    
    software used in our products;
    
    hosting, email and IP provisioning services;
    
    softswitches, used to provide VoIP services; and
    
    Internet connectivity and Internet protocol services.
   
    
    the possibility that some of our vendors will leave the DSL equipment business or will
stop supporting equipment that we already have installed;
    
    the absence of guaranteed capacity;
    
    the possibility that software vendors will stop supporting software that we use; and
    
    reduced control over delivery schedules, quality assurance, production yields and costs.
  We use third-party vendors offshore for tasks that were previously done by our employees.
    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.
  52




---



##### Table of Contents



We must pay federal, state and local taxes and other surcharges on our service, the applicability
and 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.
  53




---



##### Table of Contents



Our intellectual property protection may be inadequate to protect our proprietary rights.
    Third parties may claim we infringe their intellectual property rights.
  
    
    be time-consuming, costly and result in litigation;
    
    divert managements time and attention from developing our business;
    
    require us to pay monetary damages or enter into royalty and licensing agreements that we
would not normally find acceptable;
    
    require us to stop selling or to redesign certain of our products; or
    
    require us to satisfy indemnification obligations to our customers.
  The price of our common stock may continue to fluctuate significantly.
  
    
    state and federal regulatory and legislative actions;
    
    general economic conditions and the condition of the telecommunications industry;
 54




---



##### Table of Contents




    
    our ability to maintain existing customers and add new customers and recognize revenue
from distressed customers;
    
    our ability to execute our operational plan and reach profitability and cash flow positive from operations;
    
    our ability to maintain sufficient liquidity to fund our operations;
    
    adverse litigation results;
    
    announcements of new products, services or pricing by our competitors or the emergence of
new competing technologies;
    
    our failure to meet the expectations of investors or of analysts;
    
    the adoption of new, or changes in existing, accounting rules, guidelines and practices,
which may materially impact our financial statements and may materially alter the
expectations of securities analysts or investors;
    
    the level of demand for broadband Internet access services and VoIP telephony services;
    
    departures of key personnel; and
    
    effective internal controls over financial reporting.
  Substantial leverage and debt service obligations may adversely affect our cash flow. (Refer to
Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations 
Liquidity and Capital Resources for additional information)
   
    
    increasing our vulnerability to general adverse economic and industry conditions;
    
    limiting our ability to obtain additional financing;
    
    requiring the dedication of a portion of our expected cash flow from operations to
service our indebtedness, thereby reducing the amount of our expected cash flow available
for other purposes, including capital expenditures;
    
    limiting our flexibility in planning for, or reacting to, changes in our business and the
industry in which we compete; and
    
    placing us at a possible competitive disadvantage relative to less leveraged competitors
and competitors that have better access to capital resources.
 55




---



##### Table of Contents



ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
  
 ITEM 3. Defaults Upon Senior Securities
  
 ITEM 4. Submission of Matters to a Vote of Security Holders
  
 ITEM 5. Other Information
  
 ITEM 6. Exhibits
 Incorporated by ReferenceExhibit
    
    
    
    
    
    
    
    
    
    ExhibitNumber
    
    Exhibit Description
    
    Form
    
    File No.
    
    Date of First Filing
    
    Number
    
    Filed Herewith4.01
   
    
    12% Senior Secured Convertible Note
due 2011, dated as of March 29,
2006, entered into by Covad
Communications Group, Inc. and
Covad Communications Company for
the benefit of EarthLink, Inc.
    
    8-K
    
    001-32588
    
    4/4/06

    
    99.14.02
   
    
    Registration Rights Agreement,
dated as of March 29, 2006, by and
between Covad Communications Group,
Inc. and EarthLink, Inc.
    
    8-K
    
    001-32588
    
    4/4/06

    
    99.34.03
   
    
    Amendment to Amended and Restated
Stockholder Protection Rights
Agreement, dated as of March 29,
2006, by and between Covad
Communications Group, Inc. and
Mellon Investor Services
    
    8-K
    
    001-32588
    
    4/4/06
    

    99.510.1
   
    
    Agreement between Covad
Communications Group, Inc. and P.
Michael Hanley
    
    8-K
    
    001-32588
    
    1/23/06

    
    10.110.2
   
    
    Covad Communications 2006 Bonus Plan
    
    8-K
    
    001-32588
    
    3/8/06

    
    10.110.3
   
   

    Purchase Agreement, dated as of
March 15, 2006, by and among Covad
Communcations Group, Inc., Covad
Communications Company and
EarthLink, Inc.
    
    8-K
    
    001-32588
    
    3/17/06
   
    99.110.4
   
    
    Security Agreement, dated as of
March 29, 2006, by and among Covad
Communications Group, Inc., Covad
Communications Company and
EarthLink, Inc.
    
    8-K
    
    001-32588
    
    4/4/06

    
    99.210.5
   
    
    Agreement for XGDSL Services, dated
as of March 29, 2006, by and among
Covad Communications Company and
EarthLink, Inc.
    
    8-K
    
    001-32588
    
    4/4/06

    
    99.410.6
   
    
    Loan and Security Agreement, dated
as of April 13, 2006, between Covad
Communications Group, Inc., Covad
Communications Company and Silicon
Valley Bank
    
    8-K
    
    001-32588
    
    4/18/06

    
    10.110.7
   
    
    Indemnification Agreement between
Covad Communications Group, Inc.
and Robert Neumeister
    
    8-K
    
    001-32588
    
    4/26/06

    
    10.131.1
    
    
    Certification Pursuant
to Rule 13a-14(a)
    
    
    
    
    
    
    
    
    
    X31.2
    
    
    Certification Pursuant
to Rule 13a-14(a)
Certification Pursuant
to 18
    
    
    
    
    
    
    
    
    
    X32.1*
    
    
    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. 56




---



##### Table of Contents



SIGNATURES
  COVAD COMMUNICATIONS GROUP, INC.By:
    /s/ CHARLES E. HOFFMANCharles E. HoffmanPresident, Chief Executive
Officer and Director  By:
    /s/ CHRISTOPHER DUNNChristopher DunnDate: May 4, 2006
    
    Senior Vice President and
Chief Financial Officer 57




---



##### Table of Contents



EXHIBIT
INDEX
 Incorporated by ReferenceExhibit
    
    
    
    
    
    
    
    
    
    ExhibitNumber
    
    Exhibit Description
    
    Form
    
    File No.
    
    Date of First Filing
    
    Number
    
    Filed Herewith4.01
   
    
    12% Senior Secured Convertible Note
due 2011, dated as of March 29,
2006, entered into by Covad
Communications Group, Inc. and
Covad Communications Company for
the benefit of EarthLink, Inc.
    
    8-K
    
    001-32588
    
    4/4/06

    
    99.14.02
   
    
    Registration Rights Agreement,
dated as of March 29, 2006, by and
between Covad Communications Group,
Inc. and EarthLink, Inc.
    
    8-K
    
    001-32588
    
    4/4/06

    
    99.34.03
   
    
    Amendment to Amended and Restated
Stockholder Protection Rights
Agreement, dated as of March 29,
2006, by and between Covad
Communications Group, Inc. and
Mellon Investor Services
    
    8-K
    
    001-32588
    
    4/4/06
    

    99.510.1
   
    
    Agreement between Covad
Communications Group, Inc. and P.
Michael Hanley
    
    8-K
    
    001-32588
    
    1/23/06

    
    10.110.2
   
    
    Covad Communications 2006 Bonus Plan
    
    8-K
    
    001-32588
    
    3/8/06

    
    10.110.3
   
   

    Purchase Agreement, dated as of
March 15, 2006, by and among Covad
Communcations Group, Inc., Covad
Communications Company and
EarthLink, Inc.
    
    8-K
    
    001-32588
    
    3/17/06
   
    99.110.4
   
    
    Security Agreement, dated as of
March 29, 2006, by and among Covad
Communications Group, Inc., Covad
Communications Company and
EarthLink, Inc.
    
    8-K
    
    001-32588
    
    4/4/06

    
    99.210.5
   
    
    Agreement for XGDSL Services, dated
as of March 29, 2006, by and among
Covad Communications Company and
EarthLink, Inc.
    
    8-K
    
    001-32588
    
    4/4/06

    
    99.410.6
   
    
    Loan and Security Agreement, dated
as of April 13, 2006, between Covad
Communications Group, Inc., Covad
Communications Company and Silicon
Valley Bank
    
    8-K
    
    001-32588
    
    4/18/06

    
    10.110.7
   
    
    Indemnification Agreement between
Covad Communications Group, Inc.
and Robert Neumeister
    
    8-K
    
    001-32588
    
    4/26/06

    
    10.131.1
    
    
    Certification Pursuant
to Rule 13a-14(a)
    
    
    
    
    
    
    
    
    
    X31.2
    
    
    Certification Pursuant
to Rule 13a-14(a)
Certification Pursuant
to 18
    
    
    
    
    
    
    
    
    
    X32.1*
    
    
    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. 58