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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 June 30, 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, CA
    
    95134(Address of principal executive offices)
    
    (Zip Code)
 (408) 952-6400(Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes x No o Indicate by check mark whether the registrant is an accelerated filer (as
described by Rule 12b-2 of the Exchange Act).
Yes x No o APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes x No o As of July 20, 2004 there were 260,580,784 shares outstanding of the
Registrants Common Stock, including Class B Common Stock.




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TABLE OF CONTENTS COVAD COMMUNICATIONS GROUP, INC. FORM 10-Q TABLE OF CONTENTS PagePART I.
    
    FINANCIAL INFORMATIONITEM 1.
    
    CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
    
    
    1CONDENSED CONSOLIDATED BALANCE SHEETS AS OF JUNE 30, 2004 AND DECEMBER 31, 2003
    
    
    1CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003
    
    
    2CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003
    
    
    3NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
    
    
    4ITEM 2.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    19ITEM 3.
    
    MARKET RISK
    
    
    36ITEM 4.
    
    CONTROLS AND PROCEDURES
    
    
    36PART II.
    
    OTHER INFORMATIONITEM 1.
    
    LEGAL PROCEEDINGS
    
    
    37ITEM 2.
    
    CHANGES IN SECURITIES AND USE OF PROCEEDS
    
    
    39ITEM 3.
    
    DEFAULTS UPON SENIOR SECURITIES
    
    
    39ITEM 4.
    
    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    
    
    39ITEM 5.
    
    OTHER INFORMATION
    
    
    39ITEM 6.
    
    EXHIBITS AND REPORTS ON FORM 8-K
    
    
    39SIGNATURES
    
    
    41EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2




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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)
 June 30,
    
    December 31,2004
    
    2003(Unaudited)
    
    (Restated)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    74,517
    
    
    $
    65,376Short-term investments
    
    
    94,875
    
    
    
    48,969Restricted cash and cash equivalents
    
    
    2,942
    
    
    
    2,892Accounts receivable, net of allowances of $5,474 at June 30, 2004 ($4,951 at December 31, 2003)
    
    
    29,956
    
    
    
    28,528Unbilled revenues
    
    
    5,976
    
    
    
    5,127Other receivables
    
    
    592
    
    
    
    637Inventories
    
    
    4,993
    
    
    
    5,335Prepaid expenses and other current assets
    
    

    3,679
    
    
    
    3,761Total current assets
    
    
    217,530
    
    
    
    160,625Property and equipment, net
    
    
    86,605
    
    
    
    94,279Collocation fees and other intangible assets, net
    
    
    43,357
    
    
    
    40,848Goodwill
    
    
    36,648
    
    
    
    Deferred costs of service activation
    
    
    30,406
    
    
    
    31,486Deferred customer incentives
    
    
    3,557
    
    
    
    4,431Deferred
debt issuance costs
    
    
    4,673
    
    
    
    Other long-term assets
    
    
    2,675
    
    
    
    3,042Total assets
    
    $
    425,451
    
    
    $
    334,711LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)Current liabilities:Accounts payable
    
    $
    13,021
    
    
    $
    12,982Accrued compensation
    
    
    17,446
    
    
    
    21,661Accrued collocation and network service fees
    
    
    22,920
    
    
    
    18,714Accrued transaction-based taxes
    
    
    34,097
    
    
    
    35,268Accrued interest
    
    
    1,146
    
    
    
    5,683Accrued market development funds and customer incentives
    
    
    6,082
    
    
    
    7,024Unresolved claims related to bankruptcy proceedings
    
    
    388
    
    
    
    7,378Collateralized customer deposit
    
    
    7,864
    
    
    
    Unearned revenues
    
    
    4,750
    
    
    
    Other accrued liabilities
    
    
    7,229
    
    
    
    5,607Total current liabilities
    
    
    114,943
    
    
    
    114,317Long-term debt
    
    
    125,000
    
    
    
    50,000Collateralized customer deposit
    
    
    48,476
    
    
    
    60,258Deferred gain resulting from deconsolidation of subsidiary
    
    
    53,963
    
    
    
    53,963Unearned revenues
    
    
    53,305
    
    
    
    61,726Other long-term liabilities
    
    
    2,397
    
    
    
    Total liabilities
    
    
    398,084
    
    
    
    340,264Contingencies (Note 6)Stockholders equity (deficit):Preferred stock, $0.001 par value; 5,000 shares authorized; no shares issued and outstanding
at June 30, 2004 and December 31, 2003
    
    
    
    
    
    
    Common Stock, $0.001 par value; 590,000 shares authorized; 260,388 shares issued and
outstanding at June 30, 2004 (230,163 shares issued and outstanding at December 31, 2003)
    
    
    260
    
    
    
    230Common Stock
- Class B, $0.001 par value; 10,000 shares authorized; no shares issued and
outstanding at June 30, 2004 and December 31, 2003
    
    
    
    
    
    
    Additional paid-in capital
    
    
    1,694,866
    
    
    
    1,651,267Deferred stock-based compensation
    
    
    (4,124
    )
    
    
    (14,459
    )Accumulated other comprehensive loss
    
    
    (1,060
    )
    
    
    (953
    )Accumulated deficit
    
    
    (1,662,575
    )
    
    
    (1,641,638
    )Total stockholders equity (deficit)
    
    
    27,367
    
    
    
    (5,553
    )Total liabilities and stockholders equity (deficit)
    
    $
    425,451
    
    
    $
    334,711
 See accompanying notes to the condensed consolidated financial statements. 1




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COVAD COMMUNICATIONS GROUP, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share amounts)
(Unaudited) Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003Revenues, net
    
    $
    107,326
    
    
    $
    92,445
    
    
    $
    215,803
    
    
    $
    183,305Operating expenses:Cost of sales (exclusive of depreciation and
amortization)
    
    
    62,748
    
    
    
    68,632
    
    
    
    131,042
    
    
    
    137,509Selling, general and administrative
    
    
    31,878
    
    
    
    31,627
    
    
    
    65,180
    
    
    
    68,720Depreciation and amortization of property and
equipment
    
    
    14,162
    
    
    
    13,752
    
    
    
    28,657
    
    
    
    28,345Amortization of collocation fees and other
intangible assets
    
    
    5,042
    
    
    
    4,024
    
    
    
    9,793
    
    
    
    8,020Provision for restructuring expenses
    
    
    223
    
    
    
    604
    
    
    
    770
    
    
    
    1,235Total operating expenses
    
    
    114,053
    
    
    
    118,639
    
    
    
    235,442
    
    
    
    243,829Loss from operations
    
    
    (6,727
    )
    
    
    (26,194
    )
    
    
    (19,639
    )
    
    
    (60,524
    )Other income (expense):Interest income
    
    
    484
    
    
    
    573
    
    
    
    835
    
    
    
    1,289Provision for impairment of investments in
unconsolidated affiliates
    
    
    
    
    
    
    (97
    )
    
    
    
    
    
    
    (209
    )Equity in losses of unconsolidated affiliates
    
    
    
    
    
    
    (92
    )
    
    
    
    
    
    
    (196
    )Interest expense
    
    
    (1,224
    )
    
    
    (1,393
    )
    
    
    (2,365
    )
    
    
    (2,772
    )Miscellaneous income (expense), net
    
    
    61
    
    
    
    (84
    )
    
    
    232
    
    
    
    403Other expense, net
    
    
    (679
    )
    
    
    (1,093
    )
    
    
    (1,298
    )
    
    
    (1,485
    )Net loss
    
    $
    (7,406
    )
    
    $
    (27,287
    )
    
    $
    (20,937
    )
    
    $
    (62,009
    )Basic and diluted net loss per share
    
    $
    (0.03
    )
    
    $
    (0.12
    )
    
    $
    (0.09
    )
    
    $
    (0.28
    )Weighted-average number of common shares used in
computing basic and diluted net loss per share
    
    
    242,359
    
    
    
    223,724
    
    
    
    237,593
    
    
    
    223,585
 See accompanying notes to the condensed consolidated financial statements. 2




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COVAD COMMUNICATIONS GROUP, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
 (Unaudited)
 Six Months Ended June 30,2004
    
    2003Operating Activities:Net loss
    
    $
    (20,937
    )
    
    $
    (62,009
    )Adjustments to reconcile net loss to net cash used in operating activities:Provision for bad debts (bad debt recoveries), net
    
    
    (217
    )
    
    
    34Depreciation and amortization
    
    
    38,450
    
    
    
    36,365Loss on disposition of property and equipment
    
    
    176
    
    
    
    220Amortization of deferred stock-based compensation
    
    
    1,975
    
    
    
    1,302Amortization of deferred customer incentives
    
    
    874
    
    
    
    643Other stock-based compensation
    
    
    13
    
    
    
    13Other non-cash charges
    
    
    280
    
    
    
    Accretion of interest on investments, net
    
    
    (321
    )
    
    
    (731
    )Equity in losses of unconsolidated affiliates
    
    
    
    
    
    
    196Provision for impairment of investments in unconsolidated affiliates
    
    
    
    
    
    
    209Net changes in operating assets and liabilities, net of assets acquired and liabilities assumed in
purchase acquisition:Accounts receivable
    
    
    (678
    )
    
    
    (3,393
    )Unbilled revenues
    
    
    (849
    )
    
    
    (2,307
    )Inventories
    
    
    366
    
    
    
    (3,268
    )Prepaid expenses and other current assets
    
    
    228
    
    
    
    2,709Deferred costs of service activation
    
    
    1,080
    
    
    
    5,618Accounts payable
    
    
    (3,327
    )
    
    
    (1,887
    )Unresolved claims related to bankruptcy proceedings
    
    
    (40
    )
    
    
    2Collateralized customer deposit
    
    
    (3,918
    )
    
    
    (4,008
    )Other current liabilities
    
    
    (5,652
    )
    
    
    6,082Unearned revenues
    
    
    (3,671
    )
    
    
    (5,683
    )Net cash provided by (used in) operating activities
    
    
    3,832
    
    
    
    (29,893
    )Investing Activities:Purchases of short-term investments
    
    
    (108,222
    )
    
    
    (93,580
    )Maturities of short-term investments
    
    
    62,530
    
    
    
    83,555Restricted cash and cash equivalents
    
    
    (50
    )
    
    
    101Purchases of property and equipment
    
    
    (19,207
    )
    
    
    (15,906
    )Proceeds from sales of property and equipment
    
    
    59
    
    
    
    60Recovery of internal use software costs
    
    
    
    
    
    
    986Payment of collocation fees and purchase of other intangible assets
    
    
    (5,580
    )
    
    
    (6,691
    )Cash acquired through acquisition
    
    
    107
    
    
    
    Acquisition costs
    
    
    (495
    )
    
    
    Decrease of other long-term assets
    
    
    402
    
    
    
    54Net cash used in investing activities
    
    
    (70,456
    )
    
    
    (31,421
    )Financing Activities:Principal payments under capital lease obligations
    
    
    (4
    )
    
    
    (88
    )Proceeds from common stock issuance
    
    
    3,906
    
    
    
    406Proceeds from common stock issuance related to acquisition
    
    
    1,781
    
    
    
    Proceeds from issuance of senior unsecured convertible bond
    
    
    120,082
    
    
    
    Principal payments of long-term debt
    
    
    (50,000
    )
    
    
    Net cash provided by financing activities
    
    
    75,765
    
    
    
    318Net increase (decrease) in cash and cash equivalents
    
    
    9,141
    
    
    
    (60,996
    )Cash and cash equivalents at beginning of period
    
    
    65,376
    
    
    
    96,491Cash and cash equivalents at end of period
    
    $
    74,517
    
    
    $
    35,495Supplemental Disclosures of Cash Flow Information:Cash paid during the period for interest
    
    $
    6,571
    
    
    $
    7Common stock issued in settlement of claims related to bankruptcy
    
    $
    6,951
    
    
    $
    Common stock, options, and warrants issued for acquisition of business
    
    $
    39,363
    
    
    $
    
 See accompanying notes to the condensed consolidated financial statements. 3




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COVAD COMMUNICATIONS GROUP, INC. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(All dollar and share amounts are presented in thousands, except per share amounts)
(Unaudited) 1. Basis of Presentation and Summary of Significant Accounting Policies The condensed consolidated financial statements include the accounts of
Covad Communications Group, Inc. (Covad) and its wholly-owned subsidiaries
(the Company, or Covad). All significant intercompany accounts and
transactions have been eliminated in consolidation. The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States for interim financial information, the instructions to
Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include
some of the information and footnotes required by accounting principles
generally accepted in the United States for complete financial statements. In
the opinion of management, all adjustments (consisting of normal recurring
adjustments) considered necessary for a fair presentation of the condensed
consolidated financial statements have been included. Operating results for the
three and six months ended June 30, 2004 are not necessarily indicative of the
results that may be expected for the year ending December 31, 2004. The condensed consolidated balance sheet as of December 31, 2003 has been
derived from the audited consolidated financial statements at that date but
does not include all of the information and footnotes required by accounting
principles generally accepted in the United States for complete financial
statements. All information included in this report should be read in conjunction with
the Companys audited consolidated financial statements and notes thereto
included in the Companys Annual Report on Form 10-K and 10-K/A for the year
ended December 31, 2003. Restatement As disclosed in the Companys Form 10-K/A for the year ended December 31,
2003, as filed on May 17, 2004, the Company restated its previously filed
financial statements for a misstatement related to the accounting for its 2003
Employee Stock Purchase Plan. For more information regarding the changes, refer
to the Companys Form 10-K/A as filed on May 17, 2004 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
    
    AsReported
    
    RestatedAdditional 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 tax liabilities, (vii) employment-related tax liabilities,
(viii) liabilities for market development funds and customer incentives and
(ix) valuation allowances associated with deferred tax assets. 4




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During
the three months ended June 30, 2004, the Company stopped
accruing a transaction-based tax because it determined it should not
be subject to this tax. The Company did not reverse the liability of
approximately $19,455 that was accrued for this tax prior to the
three months ended June 30, 2004, because it believes the
determination does not completely remove the possibility of it being
subject to this tax. This change in accounting estimate reduced the
Companys cost of sales and its net loss by approximately $1,100
($0.00 per share) during the three and six months ended June 30,
2004. In addition, during the three months ended June 30, 2004,
the Company reduced its estimates of a transaction-based tax liability and certain
employment related tax liabilities due to the expiration of the
prescribed statutory period for the corresponding tax returns. These changes in accounting estimates
reduced the Companys cost of sales, selling, general and
administrative expense and net loss by approximately $2,023, $1,971
and $3,994 ($0.02 per share), respectively, during the three and six
months ended June 30, 2004. Furthermore, during the three months
ended June 30, 2004, the Company reduced its estimates of
property tax liabilities as a result of property tax assessments that
were lower than its estimates. This change in accounting estimate
reduced the Companys cost of sales, selling, general and
administrative expense and net loss by approximately $774, $231 and
$1,005 ($0.00 per share), respectively, during the three and six
months ended June 30, 2004. During the six months ended June 30, 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 not 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) for the six months ended June
30, 2003. There were no similar changes during the three or six months ended
June 30, 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. Under the intrinsic value method, when the exercise price of the Companys
employee stock options equals or exceeds the market price of the underlying
stock on the date of grant, no compensation expense is recognized. The
following table illustrates the pro forma effect on net loss and net loss per
share for the three and six months ended June 30, 2004 and 2003 had the Company
applied the fair value method to account for stock-based awards to employees: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net loss, as reported
    
    $
    (7,406
    )
    
    $
    (27,287
    )
    
    $
    (20,937
    )
    
    $
    (62,009
    )Stock-based employee compensation expense included in the
determination of net loss, as reported
    
    
    1,179
    
    
    
    1,266
    
    
    
    1,975
    
    
    
    1,302Stock-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
    
    
    (5,321
    )
    
    
    (3,367
    )
    
    
    (11,505
    )
    
    
    (5,480
    )Pro forma net loss
    
    $
    (11,548
    )
    
    $
    (29,388
    )
    
    $
    (30,467
    )
    
    $
    (66,187
    )Basic and diluted net loss per common share:As reported
    
    $
    (0.03
    )
    
    $
    (0.12
    )
    
    $
    (0.09
    )
    
    $
    (0.28
    )Pro forma
    
    $
    (0.05
    )
    
    $
    (0.13
    )
    
    $
    (0.13
    )
    
    $
    (0.30
    )
 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. 5




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The following table presents the calculation of weighted-average common
shares used in the computations of basic and diluted net loss per share
presented in the accompanying condensed consolidated statements of operations: Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003Weighted-average number of shares of
common stock outstanding
    
    
    242,439
    
    
    
    223,724
    
    
    
    237,634
    
    
    
    223,585Less weighted-average number of shares
of common stock subject to repurchase
    
    
    (80
    )
    
    
    
    
    
    
    (41
    )
    
    
    Weighted-average number of common
shares used in computing basic and
diluted net loss per share
    
    
    242,359
    
    
    
    223,724
    
    
    
    237,593
    
    
    
    223,585
 For the three and six months ended June 30, 2004 and 2003, outstanding
options and warrants were excluded from the calculation of diluted net loss per
share, as the effect would be anti-dilutive. Total outstanding options and
warrants to purchase common stock at June 30, 2004 were 24,966 and 6,514 shares
at a weighted-average exercise price of $6.15 and $2.85, respectively. Total
outstanding options and warrants to purchase common stock at June 30, 2003 were
27,207 and 6,514 shares at a weighted-average exercise price of $6.32 and
$2.85, respectively. For the three and six months ended June 30, 2004, common stock issuable
upon the assumed conversion of convertible debentures were excluded from the
calculation of diluted net loss per share as the effect would be anti-dilutive. Comprehensive Loss Significant components of the Companys comprehensive loss are as follows: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,CumulativeAmounts
    
    2004
    
    2003
    
    2004
    
    2003Net loss
    
    $
    (1,662,575
    )
    
    $
    (7,406
    )
    
    $
    (27,287
    )
    
    $
    (20,937
    )
    
    $
    (62,009
    )Unrealized losses on available-for-sale
securities
    
    
    (98
    )
    
    
    (103
    )
    
    
    (38
    )
    
    
    (107
    )
    
    
    (128
    )Foreign currency translation adjustment
    
    
    (962
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Comprehensive loss
    
    $
    (1,663,635
    )
    
    $
    (7,509
    )
    
    $
    (27,325
    )
    
    $
    (21,044
    )
    
    $
    (62,137
    )
 Goodwill Goodwill
is recorded when the consideration paid for an acquisition exceeds
the fair value of net tangible and intangible assets acquired.
Goodwill is measured and tested for impairment on an annual basis or
more frequently if we believe indicators of impairment exist. The
performance of the test involves a two-step process. The first step
compares the fair value of the reporting unit to its net
book value, including goodwill. The fair value of the reporting unit
is determined by taking the market capitalization of the reporting
unit as determined through quoted market prices. A potential
impairment exists if the fair value of the reporting unit is lower
than its net book value. The second step of the process is only
performed if a potential impairment exists, and it involves
determining the difference between the fair value of the reporting
units net assets, other than goodwill, to the fair value of the
reporting unit. If the difference is less than the net book value
of goodwill, an impairment exists and is recorded. Recent Accounting Pronouncements In March 2004, the Financial Accounting Standards Board (FASB) approved
Emerging Issue Task Force (EITF) Issue 03-6, Participating Securities and
the Two-Class Method under Statement of Financial Accounting Standards (SFAS)
128. EITF Issue 03-6 supersedes the guidance in Topic No. D-95, Effect of
Participating Convertible Securities on the Computation of Basic Earnings per
Share, and requires the use of the two-class method of participating
securities. The two-class method is an earnings allocation formula that
determines earnings per share for each class of common stock and participating
security according to dividends declared (or accumulated) and participation
rights in undistributed earnings. In addition, EITF Issue 03-6 addresses other
forms of participating securities, including options, warrants, forwards and
other contracts to issue an entitys common stock, with the exception of
stock-based compensation (unvested options and restricted stock) subject to the
provisions of Opinion 25 and SFAS 123. EITF Issue 03-6 is effective for
reporting periods beginning after March 31, 2004 and should be applied by
restating previously reported earnings per share. The adoption of EITF Issue
03-6 did not have a significant effect on the Companys condensed consolidated
financial statements as of and for the three and six months ended June 30,
2004. On May 15, 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity.
SFAS No. 150 establishes standards for classifying and measuring as liabilities
certain financial instruments that embody obligations of the issuer and have
characteristics of both liabilities and equity, such as mandatorily redeemable
equity instruments. SFAS No. 150 must be applied immediately to instruments
entered into or modified after May 31, 2003 and to all other instruments that
exist as of the beginning of the first interim financial reporting period
beginning after June 15, 2003, except for mandatorily redeemable instruments of
non-public companies, to which the provisions of SFAS No. 150 must be applied
in fiscal periods beginning after December 15, 2003. The application of SFAS
No. 150 to pre-existing instruments should be recognized as the cumulative
effect of a change in accounting principle. The adoption of SFAS No. 150 had no
effect on the Companys condensed consolidated financial statements as of and
for the three and six months ended June 30, 2004. 6




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In January 2003, the FASB issued Interpretation, (FIN) No. 46,
Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulleting No. 51, Consolidated Financial Statements. FIN 46 applies
to any business enterprise that has a controlling interest, contractual
relationship or other business relationship with a variable interest entity,
(VIE), and establishes guidance for the consolidation of VIEs that function
to support the activities of the primary beneficiary. FIN 46 was effective
immediately for enterprises with VIEs created after January 31, 2003, and it
was effective March 31, 2004 for enterprises with VIEs created before February
1, 2003. The adoption of FIN 46 did not have a significant effect on the
Companys condensed consolidated financial statements as of and for the three
and six months ended June 30, 2004. Reclassifications Certain balances in the Companys 2003 condensed consolidated financial
statements have been reclassified to conform to the presentation in 2004. 2. Revenue Recognition Revenues from recurring service are recognized when (i) persuasive
evidence of an arrangement between the Company and the customer exists, (ii)
service has been provided to the customer, (iii) the price to the customer is
fixed or determinable and (iv) collectibility of the sales prices is reasonably
assured. Revenues earned for which the customer has not been billed are
recorded as Unbilled revenues in the condensed consolidated balance sheets.
Amounts billed in advance of providing service are deferred and recorded as an
element of the condensed consolidated balance sheets caption Unearned
revenues. Included in revenues are Federal Universal Service Fund (FUSF)
charges billed to customers aggregating $1,261 and $2,666 for the three and six
months ended June 30, 2004, respectively, and $1,282 and $2,258 for the three
and six months ended June 30, 2003, respectively. The Company recognizes up-front fees associated with service activation
over the expected term of the customer relationships, which ranges from 24 to
48 months, using the straight-line method. The Company treats the incremental
direct costs of service activation (which consist principally of customer
premises equipment, service activation fees paid to other telecommunications
companies and sales commissions) as deferred charges in amounts that are no
greater than the up-front fees that are deferred. These deferred incremental
direct costs are amortized to expense using the straight-line method over 24 to 48 months. Significant Customers As of June 30, 2004, the Company had over 350 resellers. For the three and
six months ended June 30, 2004, the Companys 30 largest customers collectively
comprised 93.3% and 93.6%, respectively, of the Companys total wholesale
revenues and 68.2% and 68.3%, respectively, of the Companys total revenues. As
of June 30, 2004, receivables from these customers collectively comprised 72.4%
of the Companys gross accounts receivable balance. For the three and six
months ended June 30, 2003, these customers collectively comprised 97.4% and
95.7%, respectively, of the Companys total wholesale revenues and 75.3% and
75.6%, respectively, of the Companys total revenues. As of June 30, 2003,
receivables from these customers collectively comprised 77.8% of the Companys
gross accounts receivable balance. For the three months ended June 30, 2004, Earthlink, Inc. and AT&T Corp.
(AT&T), two of the Companys wholesale customers, accounted for 17.0% and
14.2%, respectively, of the Companys total net revenues. For the six months
ended June 30, 2004, these customers accounted for 17.7% and 13.3%,
respectively, of the Companys total net revenues. As of June 30, 2004,
receivables from these customers comprised 19.1% and 17.4%, respectively, of
the Companys gross accounts receivable balance. No other individual customer
accounted for more than 10% of the Companys total net revenues during the
three and six months ended June 30, 2004. For the three months ended June 30, 2003, Earthlink, Inc. and AT&T, two of
the Companys wholesale customers, accounted for 23.2% and 11.6%, respectively,
of the Companys total net revenues. For the six months ended June 30, 2003,
these customers accounted for 22.2% and 11.5%, respectively, of the Companys
total net revenues. As of June 30, 2003, receivables from these customers
comprised 25.5% and 12.3%, respectively, 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 and six months ended June 30, 2004 and 2003, certain of these
customers either (i) were not current in their payments for the Companys
services or (ii) were essentially 7




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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 sheets 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
0.4% of the Companys total net revenues for the three and six months ended
June 30, 2004, respectively, and 1.1% and 2.3% of the Companys total net
revenues for the three and six months ended June 30, 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 and six months ended June 30, 2004, the Company issued
billings to its financially distressed customers aggregating $900 and $1,802,
respectively, which were not recognized as revenues or accounts receivable in
the accompanying condensed consolidated financial statements, as compared to
the corresponding amounts of $763 and $3,440 for the three and six months ended
2003, respectively. However, the Company ultimately recognized revenues from
certain of these customers when cash was collected (as described above)
aggregating $754 and $1,416 during the three and six months ended June 30,
2004, respectively, and $850 and $3,286 during the three and six months ended
June 30, 2003, respectively, some of which relates to services provided in
prior periods. The Company had contractual receivables from its financially
distressed customers totaling $1,025 and $5,857 as of June 30, 2004 and 2003,
respectively, which 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 June 30, 2004, or
(ii) have subsequently paid all or significant portions of the respective
amounts recorded as accounts receivable as of June 30, 2004, may be at risk of
becoming financially distressed. Revenues from these customers accounted for
approximately 6.8% of the Companys total net revenues for both the three and
six months ended June 30, 2004, and 21.9% and 22.3% of the Companys total net
revenues for the three and six months ended June 30, 2003, respectively. As of
June 30, 2004 and 2003, receivables from these customers
comprised 7.6% and
33.8%, respectively, of the Companys gross accounts receivable balance. If
these customers are unable to demonstrate their ability to pay for the
Companys services in a timely manner in periods ending subsequent to June 30,
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 30
days of service activation. Accordingly, the Company maintains allowances,
through charges to revenues, based on the Companys estimates of (i) the
ultimate resolution of the disputes and (ii) future service cancellations.
These charges to revenues amounted to $2,037 and $3,677 during the three and
six months ended June 30, 2004, respectively, and $950 and $1,621 during the
three and six months ended June 30, 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, the Company granted AT&T three
warrants to purchase shares of the Companys common stock as follows: 1,000
shares for $0.94 per share; 1,000 shares for $3.00 per share; and 1,000 shares
for $5.00 per share. Such warrants were immediately exercisable, fully vested
and nonforfeitable at the date of grant. Accordingly, the measurement date for
these warrants was the date of grant. The aggregate fair value of such warrants
of $2,640 was recorded as a deferred customer incentive during the three months
ended March 31, 2003 and is being recognized as a reduction of revenues on a
straight-line basis over the three-year term of the agreement because
management believes that future revenues from AT&T will exceed the fair value
of the warrants described above. This value was 8




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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 June 30, 2004. On September 4, 2002, in conjunction with the execution of a five-year
agreement with America Online, Inc. (AOL), a wholesale customer, the Company
granted AOL three warrants to purchase 1,500 shares of the Companys common
stock for $1.06 per share, 1,000 shares of the Companys common stock for $3.00
per share and 1,000 shares of the Companys common stock for $5.00 per share.
Such warrants were immediately exercisable, fully vested and nonforfeitable at
the date of grant. Accordingly, the measurement date for these warrants was the
date of grant. The aggregate fair value of such warrants of $3,790, which was
determined using the Black-Scholes option valuation model and the following
assumptions: closing price of the Companys common stock on September 4, 2002
of $1.14 per share; expected life of seven years (which is also the contractual
life of the warrants); dividend yield of zero; volatility of 1.56; and a
risk-free interest rate of 3.63%, was recorded as a deferred customer incentive
and is being recognized as a reduction of revenues on a straight-line basis
over the five-year term. None of these warrants had been exercised or had
expired as of June 30, 2004. The Company recorded amortization on the above described warrants in the
amount of $437 and $874 for the three and six months ended June 30, 2004,
respectively, and $322 and $643 for the three and six months ended June 30,
2003, respectively. 4. Reductions in Force During the three and six months ended June 30, 2004, the Company reduced
its workforce by approximately 12 and 53 employees, respectively, which
represented approximately 1.1% and 4.7% of the Companys workforce,
respectively. The reductions covered employees in the areas of sales and
marketing, operations and corporate functions. During the three and six months
ended June 30, 2003, the Company reduced its workforce by approximately 43 and
113 employees, respectively, which represented approximately 3.3% and 8.7% of
the Companys workforce, respectively. The reductions covered employees in the
areas of sales and marketing, operations and corporate functions. In connection with the reductions in force, the Company recorded charges
to operations for the three and six months ended June 30, 2004 of $223 and
$770, respectively, relating to employee severance benefits that met the
requirements for accrual. For the three and six months ended June 30, 2004, $77
and $141, respectively, of these expenses related to cost of sales and the
remaining $146 and $629, respectively, related to selling, general and
administrative expenses. During the three and six months ended June 30, 2004,
the Company paid severance benefits of approximately $160 and $648,
respectively. The Company paid the remainder of the severance benefits accrued
as of June 30, 2004 in July 2004. The expenses associated with
the reductions in force for the three and six months ended June 30, 2004 were
$92 and $279, respectively, related to the Companys Wholesale business segment
and $131 and $253, respectively, related to the Companys Direct business
segment. The remaining expenses associated with these reductions in force
during the three and six months ended June 30, 2003 of $0 and $238,
respectively, were related to the Companys Corporate Operations. The Company recorded charges to operations for the three and six months
ended June 30, 2003 of $604 and $1,235, respectively, relating to employee
severance benefits that met the requirements for accrual. For the three and six
months ended June 30, 2003, $95 and $242, respectively, of these expenses were
charged to cost of sales and the remaining $509 and $993, respectively, were
charged to selling, general and administrative expenses. During the three and
six months ended June 30, 2003, the Company paid severance benefits of
approximately $519 and $1,088, respectively. The Company paid the remainder of
the severance benefits accrued as of June 30, 2003 in July 2003. The expenses
associated with the reductions in force for the three and six months ended June
30, 2003 were $31 and $103, respectively, related to the Companys Wholesale
business segment and $320 and $349, respectively, related to the Companys
Direct business segment. The remaining expenses associated with these
reductions in force during the three and six months ended June 30, 2003 of $253
and $783, respectively, were related to the Companys Corporate Operations. 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 9




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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 $120,082 after commission and other transaction
costs. The Company incurred approximately $4,918 in issuance costs in
conjunction with the placement of the Debentures. The debt issuance costs are
being amortized to operations over sixty months, the period through to the
first date that holders have the option to require 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,
which included $50,000 of principal and $6,569 of accrued interest. 6. Contingencies Litigation On December 13, 2001, the United States Bankruptcy Court for the District
of Delaware (the Bankruptcy Court) entered an order confirming the Companys
pre-negotiated First Amended Plan of Reorganization as modified on November 26,
2001 (the Plan). On December 20, 2001 (the Effective Date), the Plan was
consummated and the Company emerged from bankruptcy. Under the Plan, the
Company settled several claims against it. These claims include:  
    
    The class action lawsuits filed in the United States District Court
for the Northern District of California. This settlement is described in
more detail below.
    
    The lawsuits filed in the Superior Court of the State of California
for the County of Santa Clara by six purchasers of the convertible notes
that the Company issued in September 2000.
    
    Disputed claims made by former shareholders of Laser Link.net, Inc.
    
    Disputed claims made by GE Capital and its subsidiary, Heller Financial Group. As of June 30, 2004 and 2003, there were approximately $1,351 and $8,346,
respectively, in unresolved claims related to the Companys Chapter 11
bankruptcy proceedings. As of June 30, 2004, the Company had recorded $388 for
these unresolved claims in its condensed consolidated balance sheet. However,
it is reasonably possible that the Companys unresolved Chapter 11 bankruptcy
claims could ultimately be settled for amounts that differ from the amounts
recorded in the Companys condensed consolidated balance sheet. Purchasers of the Companys common stock and purchasers of the convertible
senior notes the Company issued in September 2000 filed complaints on behalf of
themselves and alleged classes of stockholders and holders of convertible notes
against the Company and certain present and former officers of the Company in
the United States District Court for the Northern District of California (the
District Court). The complaints have been consolidated and the lead plaintiff
filed its amended consolidated complaint. The amended consolidated complaint
alleges violations of federal securities laws on behalf of persons who
purchased or otherwise acquired the Companys securities, including common
stock and notes, during the period from April 19, 2000 to May 24, 2001. The
relief sought includes monetary damages and equitable relief. In 2001, the
Company and the officer and director defendants entered into a Memorandum of
Understanding (MOU) with counsel for the lead plaintiffs in this litigation
that tentatively resolves the litigation. The MOU sets forth the terms upon
which the Company, the officer and director defendants and the plaintiffs agree
to settle the litigation. Pursuant to the MOU, the plaintiffs agreed to support
and vote in favor of the Plan if it provided for the distribution of $16,500 in
cash to be funded by the Companys insurance carriers and 6,495,844 shares of
the Companys common stock. The plaintiffs voted in favor of the plan.
Consequently, the Company recorded a liability of approximately $18,578 in its
consolidated balance sheets as of December 31, 2001 through a charge to
litigation-related expenses for the year then ended in connection with this
anticipated settlement. As a result of changes in the fair market value of the
Companys common stock, the Company decreased this liability to $6,950 as of
March 31, 2002 through credits to litigation-related expenses in the amount of
$11,628 for the three months ended March 31, 2002. The settlement provided for
in the MOU was subject to the approval of the District Court and, on December
18, 2002, the District Court issued its final judgment and dismissal order. One
class member subsequently filed an appeal pertaining to the final judgment, but
this appeal only related to the allocation of the settlement proceeds 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. 10




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In April 1999, the Company filed a lawsuit against Bell Atlantic (now
Verizon) and its affiliates in the United States District Court for the
District of Columbia. The Company is pursuing antitrust and other claims in
this lawsuit arising out of Verizons conduct as a supplier of network
facilities, including central office space, transmission facilities and
telephone lines. In December 2000, the Company also filed a lawsuit against
BellSouth Telecommunications and its subsidiaries in the United States District
Court for the Northern District of Georgia. The Company is pursuing claims in
this lawsuit that are similar to its claims against Verizon. Both courts
dismissed some of the Companys claims based on the ruling of the Seventh
Circuit in Goldwasser v. Ameritech. The court in the Verizon case also
dismissed the Companys remaining claims on other grounds. The Company
voluntarily dismissed its remaining claims in the BellSouth case so it could
pursue certain issues on appeal. The Company appealed these decisions to the
United States Court of Appeals for the Eleventh Circuit and the United States
Court of Appeals for the District of Columbia. On August 2, 2002, the Eleventh
Circuit Court of Appeals reversed the lower courts decision in the BellSouth
case and remanded the case for further proceedings. BellSouth appealed this
decision to the United States Supreme Court. On January 20, 2004, the United
States Supreme Court reversed a decision entitled Verizon Communications v. Law
Offices of Curtis Trinko, which rejected the Goldwasser decision. The Supreme
Court also vacated the Eleventh Circuits decision in the Companys case
against BellSouth and remanded the case to the Eleventh Circuit for review in
light of the Trinko decision. Although the Company believes the Trinko decision
does not impact these cases, both BellSouth and Verizon claim that Trinko
supports the dismissal of the Companys lawsuits and BellSouth and Verizon
filed motions with the appellate courts requesting affirmance of the district
courts rulings. On May 12, 2004, the D.C. Circuit denied Verizons motion for
summary affirmance and ordered the parties to submit additional briefs. On
June 25, 2004, the Eleventh Circuit reversed portions of the lower courts
decision in the BellSouth case and remanded that case for further proceedings.
The Company cannot predict the outcome of these proceedings at this time. On June 11, 2001, Verizon Communications filed a lawsuit against the
Company in the United States District Court for the Northern District of
California. Verizon is a supplier of telephone lines that the Company uses to
provide services to its customers. In its amended complaint, Verizon claims
that the Company falsified trouble ticket reports with respect to the telephone
lines that the Company ordered and seeks unspecified monetary damages
(characterized as being in the millions) and injunctive relief. The current
complaint asserts causes of action for negligent and intentional
misrepresentation and violations of Californias unfair competition statute. On
November 13, 2002, the District Court entered summary judgment in favor of the
Company and dismissed Verizons claims against the Company in their entirety.
Verizon appealed the dismissal of its lawsuit and in July 2004 the Ninth
Circuit Court of Appeals partially reversed the District Courts decision and
indicated that Verizon could attempt to pursue a claim against the Company for
breach of contract. The matter has been sent back to the District Court for
further proceedings. The Company believes it has strong defenses to this
lawsuit, but litigation is inherently unpredictable and there is no guarantee
it will prevail. Several stockholders have filed complaints in the United States District
Court for the Southern District of New York, on behalf of themselves and
purported classes of stockholders, against the Company and several former and
current officers and directors in addition to some of the underwriters who
handled the Companys stock offerings. These lawsuits are so-called IPO
allocation cases, challenging practices allegedly used by certain underwriters
of public equity offerings during the late 1990s and 2000. On April 19, 2002,
the plaintiffs amended their complaint and removed the Company as a defendant.
Certain directors and officers are still named in the complaint. The plaintiffs
claim that the Company and others failed to disclose the arrangements that some
of these underwriters purportedly made with certain investors. The plaintiffs
and the issuer defendants have reached a tentative agreement to settle the
matter, and the Company believes the tentative settlement will not have a
material adverse effect on its consolidated financial position or results of
operations. That settlement, however, has not been finalized. If the settlement
is not finalized, the Company believes it has strong defenses to these lawsuits
and intends to contest them vigorously. However, litigation is inherently
unpredictable and there is no guarantee that the Company will prevail. In June 2002, Dhruv Khanna was relieved of his duties as the Companys
General Counsel and Secretary. Shortly thereafter, Mr. Khanna alleged that,
over a period of years, certain current and former directors and officers had
breached their fiduciary duties to the Company by engaging in or approving
actions that constituted waste and self-dealing, that certain current and
former directors and officers had provided false representations to the
Companys auditors and that he had been relieved of his duties in retaliation
for his being a purported whistleblower and because of racial or national
origin discrimination. He threatened to file a shareholder derivative action
against those current and former directors and officers, as well as a wrongful
termination lawsuit. Mr. Khanna was placed on paid leave while his allegations
were being investigated. The Companys Board of Directors appointed a special investigative
committee, which initially consisted of Dale Crandall and 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 11




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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. In addition, one state public
utility commission is considering applying a higher price for transmission
lines on a retroactive basis to September 2002, which could result in the
Company being required to pay the difference between the billed rate and the
higher rate that may be set by the public utility commission. Other Contingencies On August 21, 2003, the Federal Communication Commission, or FCC, issued
its order in the Triennial Review. This order represented a significant
development for the Company for a number of reasons, the most important of
which the Company believes to be as follows:  
    
    The FCC is phasing out its rule requiring line-sharing pursuant to
Section 251 of the Telecommunications Act of 1996 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 regional bell operating companies, or RBOCs, are 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 $32,975
and $66,685, or 30.7% and 30.9%, of the Companys revenues for the
three and six months ended June 30, 2004, respectively. 12




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##### Table of Contents



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 RBOCs 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
similar agreements with other RBOCs or obtain favorable regulatory
rulings, it will be required to purchase a separate telephone line in
order to provide services to an end-user in the areas served by RBOCs.
If this occurs 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 RBOCs 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 RBOCs 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 RBOCs are increasing their deployment of
fiber-fed remote terminal architectures.
    
    The RBOCs were permitted to petition the various state utility
commissions for authority to stop providing data transport between the
telephone companies central offices at regulated rates on routes that
have sufficient competitive alternatives to telephone company data
transport services. The Company currently purchases this interoffice
transport from the RBOCs in order to carry traffic over its network.
    
    Companies that compete with the RBOCs would have continued to have
access to the RBOCs networks in order to provide their services under
an arrangement known as the Unbundled Network Element platform, or
UNE-P, subject to state public utilities commissions decisions removing
this obligation under standards specified by the FCC. The continued
existence of the UNE-P platform allowed the Company to continue to
bundle its data services with the voice services of these competitive
telecommunications providers through line-splitting arrangements.
    
    The FCC concluded that October 2, 2003 is the trigger date for
change of law provisions in the Companys interconnection agreements
with the various RBOCs. These agreements contain the prices and other
terms for the telephone lines that the Company purchases from these
RBOCs. Each of the RBOC 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, 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 with the remaining RBOCs, it will attempt to resolve its
disputes with the RBOCs in arbitrations before the state public utility
commissions. On March 2, 2004, the United States Court of Appeals for the District of
Columbia Circuit, or the Court, vacated aspects of the Triennial Review order.
The Court:  
    
    Vacated the FCCs decision to find nationwide impairment for mass
market switching for UNE-P and to delegate to the state public utility
commissions the authority to determine whether UNE-P should be made
available. The Court concluded that the FCC does not have statutory
authority to grant the states decision making power regarding the
continued availability of UNE-P.
    
    Vacated the FCCs decision to make data transport between the
telephone companies central offices available at regulated rates on a
nationwide basis and to delegate to the state public utility commissions
the authority to remove data transport on specific central office routes
from the list of network elements that are available at regulated rates.
Based on this decision, some of the RBOCs have claimed they no longer
are required to provide the Company with this interoffice data transport
at regulated rates. 13




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##### Table of Contents




    
    Upheld the FCCs decision to phase out line-sharing and also upheld
the FCCs decision not to require the unbundling of access to fiber to
the home and the packet-switching functions of fiber-fed telephone lines
to provision DSL services. Requests for stay of the D.C. Circuit Courts decision pending Supreme
Court review were denied. As a result, the Courts decision to vacate aspects
of the Triennial Review order became effective on June 15, 2004, and the
portions of the rules that were vacated are no longer in effect. In addition,
the Solicitor General declined to seek Supreme Court review. While competitive
local exchange carriers have requested Supreme Court review, we believe it is
considered unlikely under the circumstances that the Supreme Court will agree
to hear the case. The FCC has indicated that it will start a proceeding to develop new rules
in light of the Courts decision. Pending the completion of this proceeding or
the adoption of interim rules while new permanent rules are finalized, there is
substantial uncertainty with respect to RBOCs continued obligations to provide
network elements and services affected by the D.C. Circuit Courts decision.
This process has been 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. Two prominent UNE-P providers who are customers of
the Company, including AT&T, have announced that they will stop offering
consumer voice services in several states as a result of recent regulatory
developments. Further, AT&T has announced that it will stop
marketing traditional
voice and DSL services to consumers in all states. The direction and success of 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 addition, new rules, or unilateral actions by the RBOCs
in the absence of new rules, could impact the Companys ability to access
interoffice transport at regulated prices. As a result, the Company could be
forced to pay significantly higher prices for such transport, which could
increase its network costs. At least two of the RBOCs have taken the position that their obligation to
provide so-called high-capacity loops was removed as of the effective date of
the D.C. Circuit decision. Although those companies have not specified what
specific loop types they believe are included within the definition of
high-capacity loops, the FCC has traditionally included T-1 loops within the
definition of high-capacity loops. If the RBOCs stop providing T-1 loops at
regulated rates, 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 June 30, 2004, the Company had disputes with a number of
telecommunications companies concerning the balances owed to such carriers for
collocation fees and certain network services. The Company believes that such
disputes will be resolved without a material adverse effect on its consolidated
financial position and results of operations. However, it is reasonably
possible that the Companys estimates of its collocation fee and network
service obligations, as reflected in the accompanying condensed consolidated
balance sheets, could change in the near term, and the effects could be
material to the Companys consolidated financial position and results of
operations. The Company performs ongoing analysis of the applicability of certain
transaction-based taxes to (i) sales of its products and services and (ii)
purchases of telecommunications circuits from various carriers. This analysis
includes discussions with authorities of significant jurisdictions in which the
Company does business to determine the extent of its transaction-based tax
liabilities. It is the Companys opinion that this analysis will be concluded
without a material adverse effect on its consolidated financial position and
results of operations. However, it is reasonably possible that the Companys
estimates of its transaction-based tax liabilities, as reflected in the
accompanying condensed consolidated balance sheets, could change in the near
term, and the effects could be material to the Companys consolidated financial
position and results of operations. The Company is analyzing the applicability of employment-related taxes for
certain stock-based compensation provided to employees in prior periods. Due to
the probable applicability of these taxes, the Company recorded an estimated
liability through a charge to operations in the amount of $5,938 during the
three months ended March 31, 2003. During the three months ended June 30, 2004,
the Company determined that it does not owe a portion of this tax,
approximately $3,079. The Company intends to engage in discussions with state
and federal tax authorities to settle these estimated tax liabilities. It is
the Companys opinion that such discussions will be concluded without a
material adverse effect on its consolidated financial position and results of
operations. However, it is reasonably possible that the Companys estimates of
these tax liabilities, as reflected in the accompanying condensed consolidated
balance sheets as of June 30, 2004, could change in the near term, and the
effects could be material to the Companys consolidated financial position and
results of operations. 14




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##### Table of Contents



7. Business Segments The Company sells to businesses and consumers indirectly through Internet
service providers, or ISPs, telecommunications carriers and other resellers.
The Company also sells its services directly to business and consumer end-users
through its field sales force, telephone sales, referral agents and its Web
site. The Company was managed in 2003 as two strategic business units, Covad
Strategic Partnerships, or CSP, and Covad Broadband Solutions, or CBS.
Beginning in January 2004, the Company realigned its business and no longer
maintain CSP and CBS as separate business units. The Company presently operates
two business segments, wholesale and direct, which are described below in more
detail. The Company 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,
such as depreciation and amortization, and other income and expense items. The
Company does not segregate its assets or its cash flows between its two segments because these resources are not managed separately by segment. The
Company similarly manages its capital expenditures and cash needs as one entity.
Therefore, the Company does not allocate such operating expenses and other
income and expense items to its business segments because it believes that
these expenses and other income items are not directly managed or controlled by
its business segments. Segment information, including a reconciliation to the respective balances
in the Companys condensed consolidated financial statements, as of and for the
three and six months ended June 30, 2004 and 2003 are as follows (the Companys
2003 segment information has been restated to conform to the Companys
organizational structure in 2004): For theThree Months Ended
    
    
    
    
    
    
    
    
    
    Total
    
    Corporate
    
    Intercompany
    
    ConsolidatedJune 30, 2004:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    Eliminations
    
    TotalDomestic revenues from external
customers, net
    
    $
    78,507
    
    
    $
    28,819
    
    
    $
    107,326
    
    
    $
    
    
    
    $
    
    
    
    $
    107,326Cost of sales (exclusive of
depreciation and amortization)
    
    $
    43,659
    
    
    $
    12,857
    
    
    $
    56,516
    
    
    $
    6,232
    
    
    $
    
    
    
    $
    62,748Selling, general and administrative
expenses
    
    $
    2,299
    
    
    $
    6,565
    
    
    $
    8,864
    
    
    $
    23,014
    
    
    $
    
    
    
    $
    31,878Depreciation and amortization
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    19,204
    
    
    $
    
    
    
    $
    19,204Provision for restructuring
expenses
    
    $
    92
    
    
    $
    131
    
    
    $
    223
    
    
    $
    
    
    
    $
    
    
    
    $
    223Other expenses, net
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    679
    
    
    $
    
    
    
    $
    679Net income (loss)
    
    $
    32,457
    
    
    $
    9,266
    
    
    $
    41,723
    
    
    $
    (49,129
    )
    
    $
    
    
    
    $
    (7,406
    )Total assets
    
    $
    51,456
    
    
    $
    18,439
    
    
    $
    69,895
    
    
    $
    355,556
    
    
    $
    
    
    
    $
    425,451
 For theThree Months Ended
    
    
    
    
    
    
    
    
    
    Total
    
    Corporate
    
    Intercompany
    
    ConsolidatedJune 30, 2003:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    Eliminations
    
    TotalDomestic revenues from external
customers, net
    
    $
    71,481
    
    
    $
    20,964
    
    
    $
    92,445
    
    
    $
    
    
    
    $
    
    
    
    $
    92,445Cost of sales (exclusive of
depreciation and amortization)
    
    $
    50,065
    
    
    $
    9,597
    
    
    $
    59,662
    
    
    $
    8,970
    
    
    $
    
    
    
    $
    68,632Selling, general and administrative
expenses
    
    $
    2,556
    
    
    $
    5,248
    
    
    $
    7,804
    
    
    $
    23,823
    
    
    $
    
    
    
    $
    31,627Depreciation and amortization
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    17,776
    
    
    $
    
    
    
    $
    17,776Provision for restructuring
expenses
    
    $
    31
    
    
    $
    320
    
    
    $
    351
    
    
    $
    253
    
    
    $
    
    
    
    $
    604Other expenses, net
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    1,093
    
    
    $
    
    
    
    $
    1,093Net income (loss)
    
    $
    18,829
    
    
    $
    5,799
    
    
    $
    24,628
    
    
    $
    (51,915
    )
    
    $
    
    
    
    $
    (27,287
    )Total assets
    
    $
    56,273
    
    
    $
    15,265
    
    
    $
    71,538
    
    
    $
    307,257
    
    
    $
    
    
    
    $
    378,795
 15




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##### Table of Contents



For theSix Months Ended
    
    
    
    
    
    
    
    
    
    Total
    
    Corporate
    
    Intercompany
    
    ConsolidatedJune 30, 2004:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    Eliminations
    
    TotalDomestic revenues from external
customers, net
    
    $
    157,604
    
    
    $
    58,199
    
    
    $
    215,803
    
    
    $
    
    
    
    $
    
    
    
    $
    215,803Cost of sales (exclusive of
depreciation and amortization)
    
    $
    90,484
    
    
    $
    24,284
    
    
    $
    114,768
    
    
    $
    16,274
    
    
    $
    
    
    
    $
    131,042Selling, general and administrative
expenses
    
    $
    5,157
    
    
    $
    11,826
    
    
    $
    16,983
    
    
    $
    48,197
    
    
    $
    
    
    
    $
    65,180Depreciation and amortization
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    38,450
    
    
    $
    
    
    
    $
    38,450Provision for restructuring
expenses
    
    $
    279
    
    
    $
    253
    
    
    $
    532
    
    
    $
    238
    
    
    $
    
    
    
    $
    770Other expenses, net
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    1,298
    
    
    $
    
    
    
    $
    1,298Net income (loss)
    
    $
    61,684
    
    
    $
    21,836
    
    
    $
    83,520
    
    
    $
    (104,457
    )
    
    $
    
    
    
    $
    (20,937
    )
 For theSix Months Ended
    
    
    
    
    
    
    
    
    
    Total
    
    Corporate
    
    Intercompany
    
    ConsolidatedJune 30, 2003:
    
    Wholesale
    
    Direct
    
    Segments
    
    Operations
    
    Eliminations
    
    TotalDomestic revenues from external
customers, net
    
    $
    144,851
    
    
    $
    38,454
    
    
    $
    183,305
    
    
    $
    
    
    
    $
    
    
    
    $
    183,305Cost of sales (exclusive of
depreciation and amortization)
    
    $
    99,960
    
    
    $
    18,559
    
    
    $
    118,519
    
    
    $
    18,990
    
    
    $
    
    
    
    $
    137,509Selling, general and
administrative expenses
    
    $
    5,462
    
    
    $
    11,228
    
    
    $
    16,690
    
    
    $
    52,030
    
    
    $
    
    
    
    $
    68,720Depreciation and amortization
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    36,365
    
    
    $
    
    
    
    $
    36,365Provision for restructuring
expenses
    
    $
    103
    
    
    $
    349
    
    
    $
    452
    
    
    $
    783
    
    
    $
    
    
    
    $
    1,235Other expenses, net
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    1,485
    
    
    $
    
    
    
    $
    1,485Net income (loss)
    
    $
    39,326
    
    
    $
    8,318
    
    
    $
    47,644
    
    
    $
    (109,653
    )
    
    $
    
    
    
    $
    (62,009
    )
 8. Acquisition of GoBeam, Inc. On June 8, 2004, the Company completed its acquisition of all of the
outstanding shares of privately-held GoBeam, Inc., a Delaware corporation based
in Pleasanton, California, that provides voice over Internet Protocol, or VoIP
solutions to small and medium-sized businesses. The Company acquired GoBeam to
accelerate its plan to enter the VoIP market. As a result of the acquisition,
the Company has added a VoIP offering to its current portfolio of products and
services. In addition, the Company also plans to realize costs synergies and
strategic value from combining the two enterprises. These factors contributed
to a purchase price that was in excess of the fair value of Gobeams net
tangible and intangible assets acquired and, as a result, the Company recorded
goodwill in connection with this transaction. The acquisition was effectuated
by merging a wholly-owned subsidiary of the Company with and into GoBeam, with
GoBeam surviving the merger as a wholly-owned subsidiary of the Company. The
merger is intended to qualify as a tax-free reorganization. As a result of the merger, the Company issued 18,724 shares of its common
stock.
Additionally, the Company has reserved 266 shares to cover shares issuable upon
exercise of assumed GoBeam stock options and 3 shares to cover assumed
warrants. Of the shares issued in conjunction with the merger, 2,216 shares
have been placed in an escrow account until August of 2005 to cover GoBeams
indemnification obligations under the merger agreement. The Company accounted for the acquisition of GoBeam using the purchase
method of accounting. Accordingly, the Companys condensed consolidated
financial statements include the results of operations of GoBeam for periods
ending after the date of acquisition. The Company valued the common shares
options and warrants issued, for accounting purposes, based on an average
market price of $2.08 per share, which is based on the average closing price
for a range of two trading days before and after the measurement date of the
transaction, June 4, 2004. The outstanding GoBeam stock options were converted
into options to purchase approximately 266 shares of the Companys common stock. In addition, the outstanding GoBeam
warrants were converted into warrants to purchase 3 shares of the Companys
common stock. The value of the options and
warrants was determined using the Black-Scholes option pricing model with
inputs of 1.284 for volatility, four-year expected life and a risk-free
interest rate of 3.27%. The values of the options and assumed warrants, as well
as direct acquisition costs, were included as elements of the total purchase
cost. 16




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##### Table of Contents



The total purchase cost of the GoBeam acquisition has been allocated to
the assets and liabilities of GoBeam based upon estimates of their fair values.
The following tables set forth the total purchase cost and the allocation
thereof: Total purchase cost:Value of common shares issued
    
    $
    38,910Value of assumed GoBeam options and warrants
    
    
    45439,364Acquisition costs
    
    
    495Total purchase cost
    
    $
    39,859Purchase price allocation:Tangible net liabilities acquired
    
    $
    (4,479
    )Intangible assets acquired:Customer relationships
    
    
    6,600Internal use software
    
    
    1,090Goodwill
    
    
    36,648Total purchase consideration
    
    $
    39,859
 The tangible assets of GoBeam acquired by the Company aggregating $1,723
consisted principally of cash, accounts receivable and property and equipment.
The liabilities of GoBeam assumed by the Company aggregating $6,202 consisted
principally of accounts payable and accrued expenses. The customer relationships were valued using an income approach, which
projects the associated revenue, expenses and cash flows attributable to the
customer base. These cash flows are then discounted to their present value.
Through June 30, 2004, this intangible asset was being amortized on a
straight-line basis over a period of forty-eight months which represent the
expected life of the customer relationships. The internal use software was valued using the replacement cost approach.
This approach estimates value based upon estimated cost to recreate the
software, with equivalent functionality. Through June 30, 2004, this intangible
asset was being amortized on a straight-line basis over a period of sixty
months. Goodwill was determined based on the residual difference between the
purchase cost and the values assigned to identified tangible and intangible
assets and liabilities, and is not deductible for tax purposes. The Company
will test for impairment of these assets on at least an annual basis. The following unaudited pro forma financial information presents the
consolidated results of operations of the Company as if the acquisition of
GoBeam had occurred at the beginning of the periods presented. For the three
and six months ended June 30, 2004, net loss included GoBeam merger expenses of
$3,871 and $4,247, respectively. For the three and six months ended June 30,
2003, net loss included a charge of $1,731 for cost associated with the exist
of a real estate property lease. This financial information does not purport to
be indicative of the results of the operations that would have occurred had the
acquisition been made at the beginning of the periods presented, or the results
that may occur in the future: Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003Revenue
    
    $
    108,677
    
    
    $
    93,392
    
    
    $
    218,754
    
    
    $
    185,026Net loss
    
    $
    (12,791
    )
    
    $
    (31,970
    )
    
    $
    (28,507
    )
    
    $
    (69,481
    )Basic and diluted net loss per share
    
    $
    (0.05
    )
    
    $
    (0.13
    )
    
    $
    (0.11
    )
    
    $
    (0.29
    )
 Upon closing of the acquisition of GoBeam, the Company effectively granted
337 shares of restricted common stock to certain employees of GoBeam. The
restricted stock was valued on the date of issuance at $1.96 and vested over a
period of two years. Accordingly, the Company recorded deferred stock-based
compensation of $660 that is amortized on an accelerated basis over the
vesting period consisted with the method described in FIN 28. As
part of the acquisition of GoBeam the Company sold 834 shares
for $1,781, or $2.13 per share, to pay for GoBeams merger expenses. 9. Related Party Transactions The Company acquired an equity interest in a supplier during 1999 and
disposed of this interest in 2001. Purchases from this supplier totaled $1,972
and $3,041 during the three and six months ended June 30, 2004, respectively, and
$2,289 and $3,881 for the three and six months ended June 30, 2003,
respectively. A member of the Companys Board of Directors, Richard Jalkut, is
the President 17




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and CEO of TelePacific, one of the Companys resellers. The Company
recognized revenues from TelePacific of $93 and $198 during the three and six
months ended June 30, 2004, respectively, and $184 and $391 for the three and
six months ended June 30, 2003, respectively. L. Dale Crandall, one of the
Companys directors, is also a director of BEA Systems, one of the Companys
suppliers. The Company paid $61 and $533 to BEA Systems during the three and
six months ended June 30, 2004, respectively, and $201 and $209 for the three
and six months ended June 30, 2003, respectively. 10. 2003 Employee Stock Purchase Plan In June 2003, the Company adopted the 2003 Employee Stock Purchase Plan.
Under this plan, eligible employees may purchase common stock at 85% of: (i)
the fair market value of the Companys common stock on the first day of the
applicable twenty-four month offering period; or (ii) the fair market value on
the last day of the applicable six-month purchase period. The offering period
that commenced in July 2003 and ends in June 2005 is subject to variable
accounting and accordingly the Company recorded deferred stock-based
compensation of $17,760 as of June 30, 2004. During the three and six months
ended June 30, 2004 the Company recognized an expense of $1,121 and $1,902,
respectively. The remaining net deferred stock compensation balance of $3,487
at June 30, 2004, which will fluctuate with changes in the Companys stock
price, is being amortized to operations over the remainder of the life of the
offering period that is subject to variable accounting. 18




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Item 2.Managements Discussion and Analysis of Financial Condition and Results of Operations The following discussion of our financial condition and results of
operations should be read in conjunction with the unaudited condensed
consolidated financial statements and the related notes thereto included
elsewhere in this Report onForm 10-Qand the audited consolidated financial
statements and notes thereto and managements discussion and analysis of
financial condition and results of operations for the year ended December 31,
2003 included in our Annual Report onForm 10-Kand 10-K/A filed with the
Securities and Exchange Commission on February 27, 2004 and May 17, 2004,
respectively. This discussion contains forward-looking statements, the accuracy
of which is subject to risks and uncertainties. Our actual results could differ
materially from those expressed in forward-looking statements for many reasons
including, but not limited to, those discussed herein and in the Risk Factors
section of our Annual Report onForm 10-K, which is contained in Part I, Item
1, Business  Risk Factors, of that report. We disclaim any obligation to
update information contained in any forward-looking statement. See Forward
Looking Statements. (All dollar and share amounts in thousands, except per share amounts) Overview Background We are a leading provider of high-speed voice and data communications
services. Our services include a range of high-speed, high-capacity, or
broadband, Internet access connectivity and related services using digital
subscriber line, or DSL, T-1, Virtual Private Network, or VPN, and Firewall
technologies. In addition, we provide voice services using voice over Internet
Protocol, or VoIP, to small and medium-sized businesses. With
approximately 2,000
collocation facilities, we believe we have the largest contiguous national
broadband network. We provide services throughout the United States in 96 major
metropolitan areas. We also plan to add approximately 50 new collocation
facilities to our network during the remaining part of 2004, which will expand
our coverage to 109 major metropolitan areas. We expect this expansion will
give us the ability to offer our services to more than 50 million homes and
businesses. As of June 30, 2004, we had approximately 514,400 DSL and other
high-speed lines in service. We sell to businesses and consumers indirectly through Internet service
providers, or ISPs, telecommunications carriers and other resellers. We also
sell our services directly to business and consumer end-users through our field
sales force, telephone sales, referral agents and our Web site. We managed the
Company in 2003 in two strategic business units, Covad Strategic Partnerships,
or CSP, and Covad Broadband Solutions, or CBS. Beginning in January 2004, we
realigned our business and no longer maintain CSP and CBS as separate business
units. We presently operate two business segments, wholesale and direct, which
are described in more detail below. We believe this realignment will lead to
more efficient product development, sales and marketing because we will no
longer have two separate groups providing these functions. Triennial Review As a result of the Federal Communications Commission, or FCC, decision in
the Triennial Review, on October 3, 2004 the regional bell operating companies,
or RBOCs, 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. Line-sharing allows us to provide our Internet access
services over the same telephone line that is being used by the regional bell
operating company to provide voice services to an end-user. Consequently, our
future ability to offer stand-alone Internet access using line-sharing which is
the primary service that we and our resellers have historically used to provide
services to consumers, will depend on whether we are able to enter into new
agreements with the RBOCs to share access to the high frequency portion of
their telephone lines on terms that are acceptable to us, or whether we are
able to obtain favorable regulatory rulings. Pursuant to the FCCs original Triennial Review decision, companies that
compete with the RBOCs retained access to switching and telephone lines
provided by RBOCs at discounted rates under an arrangement known as the
Unbundled Network Element platform, or UNE-P, which these competing companies
used to provide bundled voice and data services. This aspect of the order
afforded us the opportunity to continue to partner with voice providers
utilizing UNE-P to provide our data services in line-splitting relationships.
In a line-splitting arrangement, the company that is competing with the
RBOC purchases a telephone line from the RBOC and then sells voice service to an end user in a bundle along
with our Internet connectivity services. In contrast, in a line-sharing
arrangement the voice service is provided to the end user by the RBOC and we separately provide our data services over the same
telephone line. The UNE-P aspects of the FCCs decision were reversed by the
United States Court of Appeals for the D.C. Circuit as described in Recent
Developments. Two prominent UNE-P providers who are also our customers,
including AT&T, have announced that they will stop marketing their 19




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services in several states as a result of recent regulatory developments.
AT&T has announced that it will stop marketing traditional voice
and DSL services to consumers in all
states. Our customers may make further changes in their strategies as a result
of these developments, which could negatively affect us. The FCCs ruling and the subsequent decision by the D.C. Circuit create a
number of other uncertainties, challenges and opportunities for us. The final
effect of these developments will be subject to further proceedings at the FCC
and the reactions of the various participants in the telecommunications
industry, and many of these components are, or likely will be, the subject of
continuing litigation that could influence their ultimate impact. As such, it
is very difficult for us to predict with a high level of certainty the final
effects of the Triennial Review. The direction and success of our strategy to
utilize line splitting to support voice and data bundles offered by our
reseller customers could be substantially and negatively affected by these
developments. As a result of these events we are exploring alternative methods
of selling bundled voice and data services directly to end-users and to our
resellers. We may be unsuccessful in identifying feasible or profitable
alternatives. Our Opportunities and Challenges Given the highly competitive, dynamic and heavily regulated nature of our
business environment, we face a complex array of factors that create challenges
and opportunities for us. Key matters upon which we are focused at this time
include the following: Efficient Use of Cash.Since we exited our voluntary bankruptcy
proceedings at the end of 2001, we have been able to decrease the amount of
cash used in our operations, and concluded June 30, 2004 with net working
capital of approximately $102,000. During the three months ended June 30, 2004,
we generated $8,820 in positive cash flow from our operating activities in the
quarter-ended June 30, 2004. In the third quarter of 2004, as part of our rollout of VoIP services we expect to increase our
spending on promotions and advertising by approximately $6,000. We also expect an additional amount of approximately
$1,000 for increased headcount to sell VoIP services. We expect to record these as selling, general and
administrative expenses in the third quarter of 2004. The
additional usage of cash from the GoBeam acquisition will depend on many
variables including our ability to control expenditures, primarily incremental
selling, general and administrative expenses, the amount of capital
expenditures that is required to expand this new business, the cost of
development of operating support systems and software, and our ability to
generate VoIP service revenues. Manage through a transition in the delivery of broadband Internet access
services to consumers.The delivery of stand-alone high-speed Internet
connectivity services by our ISP customers is facing intense competition from
the incumbent telephone carriers and cable
providers like Comcast, Adelphia and Cox Communications, who are aggressively
pricing their consumer broadband services 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. In the three months ended
March 31, 2004, and June 30, 2004, these conditions caused reductions of 1,200
and 1,400, respectively, in our total number of end-users, and we do not expect
our total number of end-users to change significantly in the third quarter of
2004. One of our wholesale customers stopped taking orders directly for our
services in the first quarter and has instead moved to a bring your own
access model where it refers customers to access providers like us. We have
also entered into line-splitting arrangements with voice providers,
particularly AT&T, which are bundling our data services with their voice
services. AT&T has announced that it will stop marketing
traditional voice and DSL services to consumers in all states. The success of these line-splitting arrangements is
dependent on the outcome of legal and FCC proceedings affecting UNE-P. We are
also exploring other methods of selling bundled voice and data services
directly to end-users and to our resellers. We may be unsuccessful in
identifying feasible or profitable alternatives. Our growth in 2004 and beyond
will be significantly dependent on whether we can achieve growth in the sales
of our services under these bundling arrangements. Obtain acceptable line-sharing terms from the RBOCs.While we expect that
the revenues we generate from line-sharing with the RBOC 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 RBOCs, like our
recently announced agreement with Qwest Communications International, or obtain
favorable regulatory rulings that will allow us to share telephone lines for
new customers on reasonable terms. Expand and Diversify our Sources of Revenue.We are taking steps to
improve our prospects for revenue growth. First, we have expanded our network by adding central office locations, which will allow us offer our services to more end-users.
Second, we will continue our efforts to diversify our revenue sources by adding
new services like VoIP and by adding new resellers. 20




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New Market Opportunities.We recently announced our plan to offer VoIP
services to our top 100 markets by the end of 2004. We believe that VoIP
services have the potential to be a significant contributor to our revenue
growth in 2005 and beyond. Therefore, we are in the 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. Recent Developments On August 21, 2003, the FCC issued its order in the Triennial Review. This
order represented a significant development for us for a number of reasons, the
most important of which we believe to be as follows:  
    
    The FCC is phasing out its rule requiring line-sharing pursuant to
Section 251 of the 1996 Telecommunications Act over a three-year period.
Line-sharing currently allows us to provision services using asymmetric
DSL, or ADSL, technology over the same telephone line that the RBOC is
using to provide voice services. The phase-out period will be handled in
the following manner:  o
    
    Our 235,800 line-shared customers as of October 2, 2003 will be
grandfathered indefinitely at current rates, terms and conditions.
These line-shared customers provided approximately $32,975 and
$66,685, or 30.7% and 30.9%, of our revenues for the three and six
months ended June 30, 2004, respectively.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 RBOCs 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 similar agreements with other RBOCs or obtain favorable
regulatory rulings, we will be required to purchase a separate
telephone line in order to provide services to an end-user in the
areas served by other RBOCs. If this occurs we may stop selling
stand-alone consumer grade services to new customers, because the cost
of a separate telephone line is significantly higher than what we
currently pay for a shared line. Our inability to acquire new
line-shared customers would slow our growth and could require us to
significantly change our business plan.  
    
    The RBOCs are not required to allow us to access the packet-switching
functions of fiber-fed telephone lines to provision DSL services. This
means that, unless we reach agreements with the RBOCs or obtain
favorable regulatory rulings from the FCC or state regulators, we will
continue to be unable to provide our most commonly-used services to
end-users served by fiber-fed lines. Our inability to access fiber-fed
packet-switching functions is significant for our business because it
preserves a substantial limit on the addressable market for our DSL
services, thereby limiting our growth. In addition, the RBOCs are
increasing their deployment of fiber-fed remote terminal architectures.
    
    The RBOCs were permitted to petition the various state utility
commissions for authority to stop providing data transport between the
telephone companies central offices at regulated rates, which are
usually lower, on routes that have sufficient competitive alternatives
to telephone company data transport services. We currently purchase this
interoffice transport from the RBOCs in order to carry traffic over our
network.
    
    Companies that compete with the RBOCs continued to have access to the
RBOCs networks in order to provide their services under an arrangement
known as the Unbundled Network Element platform, or UNE-P, subject to
state public utilities commissions decisions removing this obligation
under standards specified by the FCC. The continued existence of the
UNE-P platform allowed us to continue to bundle our data services with
the voice services of competitive telecommunications providers through
line-splitting arrangements.
    
    The FCC also concluded that October 2, 2003 is the trigger date for
change of law provisions in our interconnection agreements with the
various RBOCs. These agreements contain the prices and other terms for
the telephone lines that we purchase from these RBOCs. Each of the RBOC
has informed us that it wants to change the line-sharing terms and
conditions of its agreements with us. We are negotiating these
agreements and have entered into one agreement with Qwest, but if we are 21




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unable to reach agreements with the remaining RBOCs we will attempt to
resolve our disputes in arbitrations before the state public utility
commissions. On March 2, 2004, the United States Court of Appeals for the District of
Columbia Circuit, or the Court, vacated aspects of the Triennial Review order.
The Court:  
    
    Vacated the FCCs decision to find nationwide impairment for mass
market switching for UNE-P and to delegate to the state public utility
commissions the authority to determine whether UNE-P should be made
available. The Court concluded that the FCC does not have statutory
authority to grant the states decision making power regarding the
continued availability of UNE-P.
    
    Vacated the FCCs decision to make data transport between the
telephone companies central offices available at regulated rates on a
nationwide basis and to delegate to the state public utility commissions
the authority to remove data transport on specific central office routes
from the list of elements that are available at regulated rates. Based
on this decision, some of the RBOCs have claimed that they no longer are
required to provide us with this interoffice data transport at regulated
rates
    
    Upheld the FCCs decision to phase out line-sharing, and also upheld
the FCCs decision not to require the unbundling of access to fiber to
the home and the packet-switching functions of fiber-fed telephone lines
to provision DSL services. Requests for a stay of the D.C. Circuit Courts decision pending Supreme
Court review were denied. As a result, the Courts decision to vacate aspects
of the Triennial Review order became effective on June 15, 2004, and the
portions of the rules that were vacated are no longer in effect. While
competitive local exchange carriers have requested Supreme Court review of the
D.C. Circuit Courts decision, we believe it is unlikely under the
circumstances that the Supreme Court will agree to hear the case. The FCC has indicated that it will start a proceeding to develop new rules
in light of the Courts decision. Pending the completion of this proceeding or
the adoption of interim rules while new permanent rules are finalized, there is
substantial uncertainty with respect to the RBOCs continued obligations to
provide network elements and services affected by the courts decision. This
process has been extremely disruptive to our partners who utilize UNE-P to
provide competitive voice services as part of a bundle with our DSL services.
Two prominent UNE-P providers who are also our customers, including AT&T, have
announced that they will stop offering consumer voice services in several
states as a result of recent regulatory developments. Further, AT&T has
announced that it will stop marketing traditional voice and DSL services to
consumers in all states. The direction and success of our strategy could be substantially affected by
changes in the critical elements of the original Triennial Review order,
described above, as a result of these further proceedings. In addition, new
rules, or unilateral actions by the RBOCs in the absence of new rules, could
impact our ability to access interoffice transport at regulated prices. As a
result, we could be forced to pay significantly higher rates for such
transport, which could increase our network costs. At least two of the RBOCs have taken the position that their obligation to
provide so-called high-capacity loops was removed as of the effective date of
the D.C. Circuit decision. Although those companies have not specified what
specific loop types they believe are included within the definition of
high-capacity loops, the FCC has traditionally included T-1 loops within the
definition of high-capacity loops. If the RBOCs stop providing T-1 loops at
regulated rates, and instead provide those loops under special access or other
prices, our costs to provide business-class T-1 services, such as our TeleXtend
product, will increase significantly. Investors should review this 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 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 22




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are believed to be reasonable under the circumstances. However, actual
results may vary from these estimates under different assumptions or
conditions. We have discussed the development and selection of critical
accounting policies and estimates with our audit committee. The following is a
summary of our critical accounting policies and estimates:  
    
    We recognize revenues when persuasive evidence of our arrangement
with the customer exists, service has been provided to the customer,
the price to the customer is fixed or determinable and collectibility
of the sales price is reasonably assured. We recognize up-front fees
associated with service activation over the expected term of the
customer relationship, which is presently estimated to be twenty four
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 June 30,
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 June 30,
2004, we had certain unresolved claims relating to our Chapter 11
bankruptcy proceedings that remain in dispute. Therefore, it is
reasonably possible that such disputed bankruptcy claims could
ultimately be settled for amounts that differ from the aggregate
liability for such claims reflected in our condensed consolidated
balance sheet as of June 30, 2004.
    
    We are a party to a variety of legal proceedings, as either
plaintiff or defendant, and are engaged in other disputes that arise
in the ordinary course of business. We are required to assess the
likelihood of any adverse judgments or outcomes to these matters, as
well as potential ranges of probable losses for certain of these
matters. The determination of the liabilities required, if any, for
loss contingencies is made after careful analysis of each individual
situation based on the facts and circumstances. However, it is
reasonably possible that the liabilities reflected in our condensed
consolidated balance sheets for loss contingencies and business
disputes could change in the near term due to new facts and
circumstances, the effects of which could be material to our
consolidated financial position and results of operations.
    
    We are performing ongoing analysis of analyzing the applicability
of certain transaction-based taxes to sales of our products and
services and, purchases of telecommunications circuits from various
carriers. This analysis includes discussions with authorities of
jurisdictions in which we do business to determine the extent of our
transaction-based tax liabilities. We believe that these discussions
will be concluded without a material adverse effect to our
consolidated financial position and results of operations. In
addition, we are currently analyzing the probable applicability of
employment-related taxes for certain stock-based compensation provided
to employees in prior periods. We believe that the analysis of the
probable applicability of these taxes and the possible engagement in
discussions with applicable 23




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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 In March 2004, the Financial Accounting Standards Board, or FASB, approved
Emerging Issue Task Force, or EITF, Issue 03-6, Participating Securities and
the Two-Class Method under Statement of Financial Accounting Standards, or
SFAS, 128. EITF Issue 03-6 supersedes the guidance in Topic No. D-95, Effect
of Participating Convertible Securities on the Computation of Basic Earnings
per Share, and requires the use of the two-class method of participating
securities. The two-class method is an earnings allocation formula that
determines earnings per share for each class of common stock and participating
security according to dividends declared (or accumulated) and participation
rights in undistributed earnings. In addition, EITF Issue 03-6 addresses other
forms of participating securities, including options, warrants, forwards and
other contracts to issue an entitys common stock, with the exception of
stock-based compensation (unvested options and restricted stock) subject to the
provisions of Opinion 25 and SFAS 123. EITF Issue 03-6 is effective for
reporting periods beginning after March 31, 2004 and should be applied by
restating previously reported earnings per share. The adoption of EITF Issue
03-6 did not have a significant effect on the Companys condensed consolidated
financial statements as of and for the three and six months ended June 30,
2004. On May 15, 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity.
SFAS No. 150 establishes standards for classifying and measuring as liabilities
certain financial instruments that embody obligations of the issuer and have
characteristics of both liabilities and equity, such as mandatorily redeemable
equity instruments. SFAS No. 150 must be applied immediately to instruments
entered into or modified after May 31, 2003 and to all other instruments that
exist as of the beginning of the first interim financial reporting period
beginning after June 15, 2003, except for mandatorily redeemable instruments of
non-public companies, to which the provisions of SFAS No. 150 must be applied
in fiscal periods beginning after December 15, 2003. The application of SFAS
No. 150 to pre-existing instruments should be recognized as the cumulative
effect of a change in accounting principle. The adoption of SFAS No. 150 had no
effect on our condensed consolidated financial statements as of June 30, 2004
and for the three and six months ended June 30, 2004. In January 2003, the FASB issued Interpretation, or FIN, No. 46,
Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulleting No. 51, Consolidated Financial Statements. FIN 46 applies
to any business enterprise that has a 24




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controlling interest, contractual relationship or other business
relationship with a variable interest entity, or VIE, and establishes guidance
for the consolidation of VIEs that function to support the activities of the
primary beneficiary. FIN 46 was effective immediately for enterprises with VIEs
created after January 31, 2003, and it was effective March 31, 2004 for
enterprises with VIEs created before February 1, 2003. The adoption of FIN 46
did not have an effect on our condensed consolidated financial statements as of
June 30, 2004 and for the three and six months ended June 30, 2004. Results of Operations for the three and six months ended June 30, 2004 Business Segment Information During the three and six months ended June 30, 2004 and 2003 we managed
our business segments based upon differences in customers, services and
marketing channels, even though the assets and cash flows from these operations
were not independent of each other. Our wholesale segment, or Wholesale, is a
provider of high-speed connectivity services to ISPs, 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 or controlled by
our business segments. Reclassifications Certain balances in our 2003 condensed consolidated financial statements
have been reclassified to conform to the presentation in 2004. Revenues, net The primary component of our net revenues is earned monthly broadband
subscription billings for DSL services. We also earn revenues from monthly
billings for high-capacity circuits sold to our wholesale customers and to a
lesser degree from dial-up services sold to end-users. Because we do not
recognize revenue from billings to financially distressed customers until we
receive payment and until our ability to keep the payment is reasonably
assured, our reported revenues for the three and six months ended June 30, 2004
and 2003 have been impacted by whether we receive, and the timing of receipt
of, payments from these customers. Our revenues also include billings for
installation fees and equipment sales, which are recognized as revenue over the
expected life of the relationship with the end-user, and Federal Universal
Service Fund, or FUSF, charges billed to our customers. Customer incentives and
rebates that we offer to attract and retain customers are recorded as
reductions to gross revenues. We regularly have billing disputes with our
customers. These disputes arise in the ordinary course of business in the
telecommunications industry and we believe their impact on our accounts
receivable and revenues can be reasonably estimated based on historical
experience. In addition, certain revenues are subject to refund if the end-user
terminates service within thirty days of service activation. Accordingly, we
maintain allowances, through charges to revenues, based on our estimate of the
ultimate resolution of these disputes and future service cancellations. Our net revenues of $107,326 for the three months ended June 30, 2004
increased by $14,881, or 16.1%, over our net revenues of $92,445 for the three
months ended June 30, 2003. This increase in net revenues was primarily
attributable to an increase of $11,790 as a result of adding end-users to our
network and a $4,837 reduction in customer rebates and incentives, which are
recorded as reductions of revenue, resulting from lower sales to some of our
wholesale customers. These increases were offset by a reduction of $2,396 in
installation fees and equipment sales, primarily driven by lower selling
prices, some of which is attributable to price reductions from our suppliers.
Charges to revenues for billing disputes and money-back guarantees for early
service termination were $2,037 and $950 during the three months ended June 30,
2004 and 2003, respectively. During the three months ended June 30, 2004 and
2003, we recovered $303 and $170, respectively, of accounts receivable balances previously
written-off against revenue. Our net revenues of $215,803 for the six months ended June 30, 2004
increased by $32,498, or 17.7%, over our net revenues of $183,305 for the six
months ended June 30, 2003. This increase in net revenues was primarily
attributable to an increase of $29,221 as a result of adding end-users to our
network and a $8,156 reduction in customer rebates and incentives resulting
from lower sales to some our wholesale customers. These increases were offset
by a $5,400 reduction in revenues from installation fees and equipment 25




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sales, primarily driven by lower selling prices, some of which is
attributable to price reductions from our suppliers. Charges to revenues for
billing disputes and money-back guarantees for early service termination were
$3,677 and $1,621 during the six months ended June 30, 2004 and 2003,
respectively. During the six months ended June 30, 2004 and 2003, we recovered
$356 and $1,262, respectively, of accounts receivable balances previously written-off against
revenue. We expect our broadband subscription billings and revenues to decrease
slightly in the third quarter of 2004 because we do not expect our total number
of end-users to change significantly. We believe that RBOCs and the cable
companies will continue to offer aggressive price discounts on their consumer
data communications services, which will continue to make it more difficult for
our wholesale partners to add and, or, retain end-users. We plan to introduce
new sales and marketing programs and create new services for our customers
which we anticipate will create additional sources of broadband subscription
billings and revenues. In addition, we expect that the acquisition of GoBeam
will contribute additional revenues. We expect the demand for our dial-up
service to continue to decrease in 2004 which will continue to result in lower
revenues from this service. We also expect customer rebates and incentives to
continue to be an element of our sales and marketing programs to respond to
competitive market conditions. As discussed in the OverviewRecent Developments, there is uncertainty
concerning our ability to purchase line-shared and high-capacity loops from the
RBOCs as a result of the Triennial Review order. Our inability to purchase
these services at a reasonable price may cause us to stop selling some of our
services to new customers. In addition, as discussed in the OverviewRecent
Developments, the United States Court of Appeals for the District of Columbia
Circuit recently vacated aspects of the Triennial Review order, including the
rules that required the local telephone companies to provide access to UNE-P.
This creates uncertainty for resellers who purchase our data services and
combine them with their own UNE-P voice services and sell the resulting bundle
to their customers. This uncertainty may cause these resellers to
stop marketing these services or otherwise change their strategies. It is
possible that these conditions will cause our revenue to decline in future
periods. Segment Revenues and Significant Customers Our segment net revenues were as follows: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Wholesale
    
    $
    78,507
    
    
    $
    71,481
    
    
    $
    157,604
    
    
    $
    144,851Percent of total net revenues
    
    
    73.1
    %
    
    
    77.3
    %
    
    
    73.0
    %
    
    
    79.0
    %Direct
    
    $
    28,819
    
    
    $
    20,964
    
    
    $
    58,199
    
    
    $
    38,454Percent of total net revenues
    
    
    26.9
    %
    
    
    22.7
    %
    
    
    27.0
    %
    
    
    21.0
    %
 We had over 350 wholesale customers as of June 30, 2004 compared to
approximately 230 as of June 30, 2003. The increase in 2004 from 2003 resulted
primarily from the addition of smaller resellers. Our 30 largest wholesale
customers comprised 68.2% and 68.3% of our total gross revenues for the three
and six months ended June 30, 2004, respectively, and 75.3% and 75.6% of our
total gross revenues for the three and six months ended June 30, 2003,
respectively. As of June 30, 2004 and 2003, receivables from these customers
collectively comprised 72.4% and 77.8%, respectively, of our gross accounts
receivable balance. For the three months ended June 30, 2004, Earthlink, Inc. and AT&T Corp.,
two customers in our wholesale business segment, accounted for 17.0% and 14.2%,
respectively, of our total net revenues. For the six months ended June 30,
2004, these customers accounted for 17.7% and 13.3%, respectively, of our total net revenues.
As of June 30, 2004, receivables from these customers comprised 19.1% and
17.4%, respectively, of our gross accounts receivable balance. For the three months ended June 30, 2003, Earthlink and AT&T Corp.
accounted for 23.2% and 11.6%, respectively, of our total net revenues. For the
six months ended June 30, 2003, these customers accounted for 22.2% and 11.5%, respectively,
of our total net revenues. As of June 30, 2003, receivables from these
customers comprised 25.5% and 12.3%, respectively, of our gross accounts
receivable balance. We had over 73,500 direct end-users as of June 30, 2004 compared to
approximately 58,700 as of June 30, 2003. The increase in net revenues from our
Direct business segment was primarily attributable to the increase in the
subscriber base. 26




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Wholesaler Financial Difficulties Some of our resellers are experiencing financial difficulties. During the
three and six months ended June 30, 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 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 and six months ended June 30, 2004, we issued billings to
our financially distressed customers aggregating $900 and $1,802, respectively,
that were not initially recognized as revenues or accounts receivable in our
condensed consolidated financial statements, as compared to the corresponding
amounts of $763 and $3,440 for the three and six months ended 2003,
respectively. However, we ultimately recognized revenues from certain of these
customers when cash was collected aggregating $754 and $1,416 during the three
and six months ended June 30, 2004, respectively, and $850 and $3,286 during
the three and six months ended June 30, 2003, respectively, some of which
relates to services provided in prior periods. We had contractual receivables
from our financially distressed customers totaling $1,025 and $5,857 as of June
30, 2004 and 2003, respectively, which are not reflected in our condensed
consolidated balance sheet as of such dates. We
have identified certain of our customers who were
essentially current in their payments for our services prior to June 30, 2004,
or have subsequently paid all or significant portions of the respective amounts
that we recorded as accounts receivable as of June 30, 2004, that we believe
may have a high risk of becoming financially distressed. Revenues from these
customers accounted for approximately 6.8% of our total net revenues for both
the three and six months ended June 30, 2004, and 21.9% and 22.3% of our total
net revenues for the three and six months ended June 30, 2003, respectively. As
of June 30, 2004 and 2003, receivables from these customers
comprised 7.6% and
33.8% of our gross accounts receivable balance, respectively. If these
customers are unable to demonstrate their ability to pay for our services in a
timely manner in periods ending subsequent to June 30, 2004, revenue from such
customers will only be recognized when cash is collected, as described above. Operating Expenses Operating expenses include cost of sales, selling, general and
administrative expenses, depreciation and amortization expenses and provision
for restructuring expenses. Our total operating expenses were as follows: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Amount
    
    $
    114,053
    
    
    $
    118,639
    
    
    $
    235,442
    
    
    $
    243,829Percent of total net revenues
    
    
    106.3
    %
    
    
    128.3
    %
    
    
    109.1
    %
    
    
    133.0
    %
 Cost of sales Cost of sales consist primarily of the costs of provisioning and
maintaining telecommunications circuits and central office space, equipment
sold to our customers, labor and related expenses and other non-labor items to
operate and maintain our network and related system infrastructure. Our cost of sales was as follows: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Amount
    
    $
    62,748
    
    
    $
    68,632
    
    
    $
    131,042
    
    
    $
    137,509Percent of total net revenues
    
    
    58.5
    %
    
    
    74.2
    %
    
    
    60.7
    %
    
    
    75.0
    %
 27




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Our cost of sales for the three months ended June 30, 2004, decreased by
$5,884, or 8.6%, when compared to our cost of sales for the three months ended
June 30, 2003. For the three months ended June 30, 2004, our cost of sales, as
a percent of revenues, was 15.7% lower than the three months ended June 30,
2003. The decrease in our cost of sales was primarily attributable to
reductions of network related expenses of approximately $3,700 resulting from
our continued efforts to lower network costs by more efficiently managing our
network and the associated workforce within the operations and engineering
groups. During the three months ended June 30, 2004, we reduced our estimates
of certain liabilities for some elements of our network costs that are not yet
billed by our suppliers. This change in estimate reduced our cost of sales and
our net loss by approximately $1,185, $0.00 per share, during the three months
ended June 30, 2004. In addition, during the three months ended June 30, 2004,
we stopped accruing transaction-based tax because we determined that we should
not be subject to such tax. We did not reverse the liability of approximately
$19,455 that was accrued for this tax prior to the three months ended June 30,
2004, because we believe our determination does not completely remove the
possibility of us being subject to such tax in prior periods. This change in
accounting estimate reduced our cost of sales and our net loss by approximately
$1,100, or $0.00 per share, during the three months ended June 30, 2004.
Furthermore, during the three months ended June 30, 2004, we reduced our
estimates of some property, transaction-based and employment-related tax
liabilities because we determined we do not owe some of these taxes. This
change in accounting estimate reduced our cost of sales and our net loss by
approximately $2,797 or $0.01 per share, during the three months ended June 30,
2004. The above described decreases in cost of sales for the three months ended
June 30, 2004 were partially offset by $2,388 of additional expenses for
outsourced services and an increase of approximately $1,300 in our network related costs as a
result of adding end-users to our network. Our cost of sales for the six months ended June 30, 2004, decreased by
$6,467, or 4.7%, when compared to our cost of sales for the six months ended
June 30, 2003. For the six months ended June 30, 2004, our cost of sales, as a
percent of revenues, was 14.3% lower when compared to the six months ended June
30, 2003. The decrease in our cost of sales was primarily attributable to
reductions of network related expenses of approximately $7,300 resulting from
our continued efforts to lower network costs by more efficiently managing our
network and the related workforce within the operations and engineering groups.
A lower amortization of our network and product cost subject to deferral
contributed $4,538 to the decrease in our cost of sales. During the six months
ended June 30, 2004, we changed our estimates of certain liabilities for some
elements of our network costs that are not yet billed by our revenue, this
change in estimate reduced our cost of sales and our net loss by approximately
$1,185, or $0.00 per share during the six month ended June 30, 2004. In
addition, the six months ended June 30, 2004, we stopped accruing a
transaction-based tax because we determined that we are not subject to such
tax. This change in accounting estimate reduced our cost of sales and our net
loss by approximately $1,100, or $0.00 per share, during the six months ended
June 30, 2004. Furthermore, during the six months ended June 30, 2004, we
changed our estimates of certain property, transaction-based and
employment-related tax liabilities because we believe we do not owe certain
aspects of these taxes. This change in accounting estimate reduced our cost of
sales and our net loss by approximately $2,797 amount in, or $0.01 per share,
during the six months ended June 30, 2004. The above described decreases in
cost of sales for the six months ended June 30, 2004 were partially offset by
$4,542 of additional expenses for outsourced services, $1,666 of FUSF fees and
an increase of approximately $4,300 in our network-related costs as a result of adding
end-users to our network. For the three months ended June 30, 2004 and 2003, cost of sales were
comprised of $43,659 and $50,065, respectively, from our Wholesale business
segment, $12,857 and $9,597, from our Direct business segment and $6,232 and
$8,970, respectively, from our Corporate Operations. The decrease in cost of
sales for our Wholesale business segment was primarily attributable to
reductions of network related expenses of $3,263 resulting from continued
improvements in the efficiency of our network and in our operations and
engineering groups, and $2,340 from lower amortization of deferred costs of service activation. The increase in cost of sales for our Direct
business segment was primarily driven by an increase in the cost of end-user
support and by an increase in costs resulting from adding end-users to our
network. The decrease in cost of sales in our Corporate Operations was
primarily due to changes in our estimates of various property,
transaction-based and employment-related tax liabilities which are described
above. For the six months ended June 30, 2004 and 2003, cost of sales were
comprised of $90,484 and $99,960, respectively, from our Wholesale business
segment, $24,284 and $18,559, respectively, from our Direct business segment
and $16,274 and $18,990, respectively, from our Corporate Operations. The
decrease in cost of sales for our Wholesale business was primarily attributable
to reductions of network related expenses of $3,444 resulting from continued
improvements in the efficiency of our network and in our operations and
engineering groups, and $7,041 from lower amortization of deferred costs of service activation. The increase in cost of sales for our Direct
business segment was primarily driven by an increase in the cost of end-user
support an increase in costs resulting from adding end-users to our network,
and by $2,504 of higher amortization of deferred costs of service activation. The decrease in cost of sales in our Corporate Operations was
primarily due to changes in our estimates of various property,
transaction-based and employment-related tax liabilities which are described
above. We expect cost of sales to increase in future periods to the extent we are
able to add subscribers and services to our network. In addition, with the
acquisition of GoBeam, we also expect to incur higher cost of sales as a result
of the addition of GoBeams employees and other cost of sales associated with
the sale of GoBeams services. Our ability to add subscribers to our network
is, however, subject to the regulatory uncertainty noted in the following
paragraph. As discussed in the Overview  Recent Developments and in Part II, Item
1 Legal Proceedings, there is uncertainty concerning our ability to purchase
line-shared services from the RBOCs as a result of the FCCs Triennial Review
decision. As a result of those legal and regulatory proceedings, it is possible
that the RBOCs could substantially increase the cost or reduce the availability
of line-shared services. Other state or federal regulatory proceedings could
also reduce our access to, or increase the prices for, unbundled network
elements. These regulatory decisions could substantially increase our overall
network cost structure and might cause us to discontinue our consumer grade
services for new and existing customers. 28




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Selling, General and Administrative Expenses Selling, general and administrative expenses consist primarily of salaries
and related expenses and our promotional and advertising expenses. Our selling, general and administrative expenses were as follows: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Amount
    
    $
    31,878
    
    
    $
    31,627
    
    
    $
    65,180
    
    
    $
    68,720Percent of total net revenues
    
    
    29.7
    %
    
    
    34.2
    %
    
    
    30.2
    %
    
    
    37.5
    %
 Our selling, general and administrative expenses for the three months
ended June 30, 2004, increased by $251, or 0.8%, when compared to our selling,
general and administrative expenses for the three months ended June 30, 2003.
The increase in selling, general and administrative expenses was primarily
attributable to an increase of $2,087 related to marketing programs
and $663 related to professional services; offset by a decrease of
$523 related to
stock-based compensation charges. In addition, during the three months ended
June 30, 2004, we changed our estimates of certain property and
employment-related tax liabilities because we determined we do not owe some of
these taxes. This change in accounting estimate reduced our selling, general
and administrative expenses and our net loss by approximately $2,202, or $0.01
per share, during the three months ended June 30, 2004. For the six months ended June 30, 2004, our selling, general and
administrative expenses decreased by $3,540, or 5.2%, when compared to our
selling, general and administrative expenses for the six months ended June 30,
2003. The decrease in selling, general and administrative expenses was
primarily attributable to a decrease of $2,102 related to employee
compensation, offset by an increase of $4,406 related to marketing programs. In
addition, during the six months ended June 30, 2004, we changed our estimates
of certain property and employment-related tax liabilities because we
determined we do not owe some of these taxes. This change in accounting
estimate reduced our selling, general and administrative expenses and our net
loss by approximately $2,202, or $0.01 per share, during the six months ended
June 30, 2004. For the six months ended June 30, 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, which
contributed to the decrease in selling, general and administrative expenses for
the six months ended June 30, 2004 when compared to the six
months ended June 30, 2003. For the three months ended June 30, 2004 and 2003, selling, general and
administrative expenses were comprised of $2,299 and $2,556, respectively, from
our Wholesale business segment, $6,565 and $5,248, respectively, from our
Direct business segment and $23,014 and $23,823, respectively, from our
Corporate Operations. The decrease in selling, general and administrative
expenses for our Wholesale business segment is primarily attributable to a
decrease in compensation and related expenses. The increase in selling, general
and administrative expenses for our Direct business segment is primarily
attributable to an increase in marketing programs, offset by a decrease in
compensation and related expenses. The decrease in selling, general and
administrative expenses for our Corporate Operations was primarily due to a
decrease in compensation and related expenses and the effects of changes in
accounting estimates of various property and employment related tax liabilities
as described above. For the six months ended June 30, 2004 and 2003, selling, general and
administrative expenses were comprised of $5,157 and $5,462, respectively, from
our Wholesale business segment, $11,826 and $11,228, respectively from our
Direct business segment and $48,197 and $52,030, respectively, from our
Corporate Operations. The decrease in selling, general and administrative
expenses for our Wholesale business segment was primarily due to a decrease in
compensation and related expenses. The increase in selling, general and
administrative expenses for our Direct business segment was primarily
attributable to an increase in marketing programs, offset by a decrease in
compensation and related expenses. The decrease in selling, general and
administrative expenses for our Corporate Operations was primarily attributable
to a decrease in compensation and related expenses and the effect of changes in
accounting estimates of various property and employment related tax liabilities
as described above. We expect selling, general and administrative expense levels to increase
in future periods as a result of increased marketing efforts. We also expect to
incur higher selling, general and administrative expenses as a result of the
addition of GoBeams employees and increased marketing efforts associated with
sales of GoBeams services. Depreciation and Amortization We recorded depreciation and amortization expense for property and
equipment in the amount of $14,162 for the three months ended June 30, 2004, an
increase of $410, or 3.0%, from depreciation and amortization expense for
property and equipment of $13,752 for the three months ended June 30, 2003. We
recorded depreciation and amortization expense for property and equipment in
the amount of $28,657 for the six months ended June 30, 2004, an increase of
$312, or 1.1% from depreciation and amortization expense for property and
equipment of $28,345 for the six months ended June 30, 2003. The increase in
depreciation is primarily attributable to the expansion of our network during
2004. We expect depreciation and amortization to increase in future periods as
we expand the footprint of our network and add more end-users. This increase in
depreciation will be partially offset as historical assets become fully
depreciated. Amortization of intangible assets was $5,042 for the three months ended
June 30, 2004, representing an increase of $1,018, or 25.3%, over the
amortization of intangible assets of $4,024 for the three months ended June 30,
2003. Amortization of intangible assets was $9,793 for the six months ended
June 30, 2004, representing an increase of $1,773, or 22.1%, over the
amortization of intangible assets of $8,020 for the six months ended June 30,
2003. The increase from 2003 to 2004 resulted from the resumption of 29




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our network build and augmentation in selected markets during the latter
portion of 2003 and the six months ended June 30, 2004, which increased
collocation fee expenditures and related amortization expenses. In addition
amortization of certain intangibles contributed to the increase in
amortization. As explained above, we do not allocate depreciation and amortization
expense to our business segments. Reductions in Force During the three and six months ended June 30, 2004, we reduced our
workforce by approximately 12 and 53 employees, respectively, which represented
approximately 1.1% and 4.7% of our workforce, respectively. The reductions
covered employees in the areas of sales and marketing, operations and corporate
functions. During the three and six months ended June 30, 2003, we reduced our
workforce by approximately 43 and 113 employees, respectively, which
represented approximately 3.3% and 8.7% of our workforce, respectively. The
reductions covered employees in the areas of sales and marketing, operations
and corporate functions. In connection with the reductions in force, we recorded charges to
operations for the three and six months ended June 30, 2004 of $223 and $770,
respectively, relating to employee severance benefits that met the requirements
for accrual. For the three and six months ended June 30, 2004, $77 and $141,
respectively, of these expenses related to cost of sales and the remaining $146
and $629, respectively, related to selling, general and administrative
expenses. During the three and six months ended June 30, 2004, we paid
severance benefits of approximately $160 and $648, respectively. We paid the
remainder of the severance benefits accrued as of June 30, 2004 in July 2004.
The expenses associated with the reductions in force for the
three and six months ended June 30, 2004 were $92 and $279, respectively,
related to our Wholesale business segment and $131 and $253, respectively,
related to the our Direct business segment. The remaining expenses associated
with these reductions in force during the three and six months ended June 30,
2004 of $0 and $238, respectively, were related to the our Corporate
Operations. We recorded charges to operations for the three and six months ended June
30, 2003 of $604 and $1,235, respectively, relating to employee severance
benefits that met the requirements for accrual. For the three and six months
ended June 30, 2003, $95 and $242, respectively, of these expenses were charged
to cost of sales and the remaining $509 and $993, respectively, were charged to
selling, general and administrative expenses. During the three and six months
ended June 30, 2003, we paid severance benefits of approximately $519 and
$1,088, respectively. We paid the remainder of the severance benefits accrued
as of June 30, 2003 in July 2003. The expenses associated with the reductions
in force for the three and six months ended June 30, 2003 were $31 and $103,
respectively, related to our Wholesale business segment and $320 and $349,
respectively, related to our Direct business segment. The remaining expenses
associated with these reductions in force during the three and six months ended
June 30, 2003 of $253 and $783, respectively, were related to our Corporate
Operations. Other Income (Expenses) Net Interest Expense Net interest expense was $740 and $1,530 for the three and six months
ended June 30, 2004, respectively, and $820 and $1,483 for the three and six
months ended June 30, 2003, respectively. Net interest expense during the three
and six months ended June 30, 2004 consisted principally of interest expense on
our 3% convertible senior debentures due 2004 and 11% long-term note payable to
SBC Communications Inc., which we repaid in March of 2004, less interest income
earned on our cash, cash equivalents and short-term investments balances. Net
interest expense during the three and six months ended June 30, 2003 consisted
of interest expense on our 11% long-term note payable to SBC Communications
Inc., less interest income earned on our cash, cash equivalents and short-term
investments balances. We expect future net interest to be limited to the
interest on our 3% convertible senior debentures due 2004 offset by interest
income on our cash balances. We may, however, seek additional debt financing in
the future if it is available on terms that we believe are favorable. If we
seek additional debt financing, our interest expense would increase. Investment Losses We recorded losses and write-downs on investments for the three months
ended June 30, 2003 in the amount of $189. This included an impairment
write-down of an equity investment of $97 and our equity in the losses of
unconsolidated affiliates of $92. We recorded losses and write-downs on
investments for the six months ended June 30, 2003 in the amount of $405. This
included an impairment write-down of an equity investment of $209 and our
equity in the losses of unconsolidated affiliates of $196. We did not record
similar losses or write-downs on investments during the three and six months
ended June 30, 2004. 30




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Miscellaneous Income (Expense) We recorded miscellaneous income (expense) of $61 and $232 for the three
and six months ended June 30, 2004, respectively, and $(84) and $403 for the
three and six months ended June 30, 2003, 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 $1,972 and $3,041
during the three and six months ended June 30, 2004, respectively, and $2,289
and $3,881 during the three and six months ended June 30, 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
$93 and $198 during the three and six months ended June 30, 2004, respectively,
and $184 and $391 during the three and six months ended June 30, 2003,
respectively. L. Dale Crandall, one of our directors and chairman of the Audit
Committee, is also a director of BEA Systems, one of our vendors. We paid $61
and $583 to BEA Systems during the three and six months ended June 30, 2004,
respectively, and $201 and $209 during the three and six months June 30, 2003,
respectively. We believe the terms of these transactions are comparable to transactions
that would likely be negotiated with clearly independent parties. Liquidity and Capital Resources 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
$24,787 for the six months ended June 30, 2004. We expect that in future
periods our capital expenditures related to the purchase of infrastructure
equipment necessary for the development and expansion of our networks and the
development of new regions will be relatively lower than the current period
while 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 June 30, 2004, we had an accumulated deficit of $1,662,575 and
unrestricted cash, cash equivalents and short-term investments of $169,392. In
addition, we had stockholders equity of $27,367 as of June 30, 2004. Net cash used in our operating activities was $3,832 for the six months
ended June 30, 2004, due primarily to: the net loss of $20,937; an
increase in accounts receivable of $678, driven by the timing of a payment from
one of our wholesale customers; a decrease in accounts payable of $3,327,
primarily driven by the timing of our payments to vendors; a decrease in
collateralized customer deposits of $3,918 as a result of the utilization of a
deposit to satisfy accounts receivable balances from one of our wholesale
customer; a decrease in other current liabilities of $5,652, primarily driven
by the payment of accrued interest on our debt; a decrease in unearned revenues
of $3,671 and a decrease in deferred costs of service activation of $1,080,
which were both driven by the deferral and amortization of initial set up fees
and related costs; offset by depreciation and amortization charges of $38,450. Net cash used in our investing activities was $70,456 for the six months
ended June 30, 2004. The net cash used in our investing activities during this
period was primarily due to purchases of short-term investments of $108,222 and
capital expenditures of $24,787, offset by maturities of short-term investments
of $62,530. Net cash provided by our financing activities was $75,765 for the six
months ended June 30, 2004. The net cash provided by our financing activities
during this period was primarily due to proceeds from issuance of our 3% senior
convertible debentures of $125,000 and proceeds from the issuance of common
stock of $5,687, offset by principal payments under long term debt of $50,000
and payments of $4,918 expenses associated with our offering. As of June 30, 2004, we had $74,517 in unrestricted cash and cash
equivalents, and $94,875 in unrestricted short-term investments. Following the
completion of the GoBeam acquisition, we expect to use additional cash
resources primarily to increase 31




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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 our ability
to control expenditures, primarily incremental selling, general and
administrative expenses, the amount of capital expenditures that are required
to expand this new business, development of operating support systems and
software, and our ability to generate VoIP service revenues. Adverse business, legal, regulatory or legislative developments, such as
the inability to continue line-sharing, may require us to raise additional
financing, raise our prices or decrease our cost structure. If we are unable to
acquire additional capital on favorable terms if needed, or are required to
raise it on terms that are less satisfactory than we desire, our financial
condition will be adversely affected. Our future cash requirements for the next twelve months and for the
long-term for developing, deploying and enhancing our network and operating our
business, as well as our revenues, will depend on a number of factors
including:  
    
    our acquisition of GoBeam, Inc., including cash we use to further
develop our VoIP capabilities, improve our systems and software to
support VoIP and expand the marketing of VoIP services following the
closing of the acquisition;
    
    the effect of the FCCs decision in the Triennial Review, our
continuing ability to access line-shared telephone wires and our
ability to obtain access to the RBOCs 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 June 30, 2004
for the next five years, and thereafter, were as follows: 2004
    
    2005-2006
    
    2007-2008
    
    Thereafter
    
    TotalNote payable to debentures
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    125,000
    
    
    $
    125,000Capital leases
    
    
    29
    
    
    
    108
    
    
    
    24
    
    
    
    
    
    
    
    161Office leases
    
    
    2,455
    
    
    
    7,110
    
    
    
    4,384
    
    
    
    719
    
    
    
    14,668Other operating leases
    
    
    96
    
    
    
    213
    
    
    
    2
    
    
    
    
    
    
    
    311Purchase obligations
    
    
    10,333
    
    
    
    4,475
    
    
    
    
    
    
    
    
    
    
    
    14,808$
    12,913
    
    
    $
    11,906
    
    
    $
    4,410
    
    
    $
    125,719
    
    
    $
    154,948
 32




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We lease certain vehicles, equipment and office facilities under various
non-cancelable operating leases that expire at various dates through 2009. Our
office leases generally require us to pay operating costs, including property
taxes, insurance and maintenance, and contain scheduled rent increases and
certain other rent escalation clauses. Rent expense is reflected in our
consolidated financial statements on a straight-line basis over the terms of
the respective leases. In 2002, we entered into a three-year, non-exclusive agreement with MCI,
for the right to provide certain network services to us. We have a monthly
minimum usage requirement which began in June 2002. The agreement expires in
May 2005 and has a remaining purchase obligation of $7,370 as of June 30, 2004.
Similarly, in 2002 we entered into a three-year, non-exclusive agreement with
AT&T Corp. for the right to provide certain data services to us. We have an
annual minimum usage requirement which began in January 2002. The agreement
expires in December 2004 and we have a minimum remaining aggregate purchase
obligation of approximately $8,625 for 2004 of which $5,750 remains unutilized
at June 30, 2004. In addition, in 2002, we entered into a four-year,
non-exclusive agreement with AT&T Corp. for the right to provide long distance
services to us. We have an annual minimum usage requirement which began in
April 2002. The agreement expires in March 2006 and has a minimum remaining
aggregate usage commitment of approximately $1,687 as of June 30, 2004. Risk Factors The following is a summary list of some of the risk factors relating to
our Company. For additional detail regarding these and other risk factors,
please refer to Part I, Item 1, Business  Risk Factors found in our 2003
Annual Report on Form 10-K, which was filed with the SEC on February 28, 2004.  
    
    Our services are subject to government regulation, and changes in
current or future laws or regulations and the methods of enforcing the
law and regulations could adversely affect our business.
    
    Charges for network elements are generally outside of our control
because they are proposed by the RBOCs and are subject to costly
regulatory approval processes.
    
    Our business will suffer if our interconnection agreements are
not renewed or if they are modified on unfavorable terms.
    
    We may need to raise additional capital under difficult financial
market conditions.
    
    In order to become cash flow positive and to achieve
profitability, we must add end-users to our network and sell
additional services to our existing end-users while minimizing the
cost to expand our network infrastructure.
    
    If we do not reduce our end-user disconnection rate our revenue
and end-user growth will decline.
    
    We may experience decreasing margins on the sale of our services,
which may impair our ability to achieve profitability or positive cash
flow.
    
    If we fail to improve and maintain our internal controls, our
ability to provide accurate financial statements could be impaired,
and any failure to maintain our internal controls and provide accurate
financial statements 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. 33




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
    
    A system failure could delay or interrupt service to our
customers, which could reduce demand for our services.
    
    A breach of network security could delay or interrupt service to
our customers, which could reduce demand for our services.
    
    Our success depends on our retention of certain key personnel,
our ability to hire additional key personnel and the maintenance of
good labor relations.
    
    We depend on a limited number of third parties for equipment
supply, service and installation and if we are unable to obtain these
items from these third parties we may not be able to deliver our
services as required.
    
    We have made and may make acquisitions of complementary
technologies or businesses in the future, which may disrupt our
business and be dilutive to our existing stockholders.
    
    The unpredictability of our revenues, along with other factors,
may cause the price of our common stock to fluctuate and could cause
it to decline.
    
    We use third party vendors in India for tasks that were previously done by our employees.
    
    We must pay federal, state and local taxes and other surcharges on our service, the levels of which are uncertain.
    
    We are a party to litigation and adverse results of such
litigation matters could negatively impact our financial condition and
results of operations.
    
    Our intellectual property protection may be inadequate to protect our proprietary rights.
    
    Substantial leverage and debt service obligations may adversely affect our cash flow.
    
    Changes in stock option accounting rules may adversely impact our
reported operating results prepared in accordance with generally
accepted accounting principles, our stock price and our
competitiveness in the employee marketplace. 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 RBOCs and our ability to bundle
our data services with their voice services, particularly in light of
the recent decision of the United States Court of Appeals for the D.C.
Circuit vacating portions of the Triennial Review order;
    
    expectations regarding our ability to be cash-flow positive on a sustained basis;
    
    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; 34




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
    
    expectations as to the impact of our service offerings on our margins;
    
    the possibility that we will increase our revenues;
    
    the impact of advertising on brand recognition and operating results;
    
    plans to make strategic investments and acquisitions and the effect of such investments and acquisitions;
    
    estimates and expectations of future operating results, including
expectations regarding when we anticipate operating on a cash flow
positive basis, the adequacy of our cash reserves, our monthly burn
rate and the number of installed lines;
    
    plans to develop and commercialize value-added services;
    
    our anticipated capital expenditures;
    
    plans to enter into business arrangements with broadband-related service providers;
    
    the effect of regulatory changes;
    
    the effect of litigation currently pending; and
    
    other statements contained in this Report on Form 10-Q regarding matters that are not historical facts. These statements are only estimates or predictions and cannot be relied
upon. We can give you no assurance that future results will be achieved. Actual
events or results may differ materially as a result of risks facing us or
actual results differing from the assumptions underlying such statements. Such
risks and assumptions that could cause actual results to vary materially from
the future results indicated, expressed or implied in such forward-looking
statements include our ability to:  
    
    adapt our business plan in response to further developments
resulting from the FCCs Triennial Review order and related 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 RBOCs 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 35




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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 June 30, 2004
is fixed-rate debt. The table below presents the carrying value and related weighted-average
interest rates for our cash and cash equivalents, short-term investments and
restricted cash and cash equivalents as of June 30, 2004 (in thousand): Carrying Value
    
    Interest RateCash and cash equivalents
    
    $
    74,517
    
    
    
    1.10
    %Short-term investments
    
    
    94,875
    
    
    
    1.25
    %Restricted cash and cash equivalents
    
    
    2,942
    
    
    
    1.10
    %$
    172,334
    
    
    
    1.18
    %
 
 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, needed to be
restated to account for this compensation. The restatement involved 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.Except as described in the preceding
paragraph, 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. 36




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PART II. OTHER INFORMATION 
 Item 1.Legal Proceedings (all dollar amounts are presented in thousands) Purchasers of our common stock and purchasers of the convertible notes we
issued in September 2000 have filed complaints against us and certain of our
present and former officers and directors. These complaints were filed in the
United States District Court for the Northern District of California, or
District Court, in the fourth quarter of 2000. The complaints were consolidated
and the lead plaintiff has filed its amended consolidated complaint. The
amended consolidated complaint alleges violations of federal securities laws on
behalf of persons who purchased or otherwise acquired our securities, including
common stock and notes, during the period from April 19, 2000 to May 24, 2001.
The relief sought includes monetary damages and equitable relief. We and the
officer and director defendants entered into a Memorandum of Understanding, or
MOU, with counsel for the lead plaintiffs in this litigation that tentatively
resolves the litigation, providing for the distribution of $16,500 in cash to
be funded by our insurance carriers and 6,495,844 shares of our common stock.
The plaintiffs voted in favor of the Plan. The settlement provided for in the
MOU was subject to the approval of the District Court and, on December 18,
2002, the District Court issued its final judgment and dismissal order. One
class member subsequently filed an appeal relating to the allocation of the
settlement proceeds between the plaintiffs and their attorneys. On February 18,
2004, the Ninth Circuit affirmed the District Courts final judgment and on
February 24, 2004 we were informed that the class member who had filed the
appeal would not be pursuing the matter any further. The distribution of the
6,495,844 shares was completed in April of 2004. In April 1999, we filed a lawsuit against Bell Atlantic, now Verizon, and
its affiliates in the United States District Court for the District of
Columbia. We are pursuing antitrust and other claims in this lawsuit arising
out of Verizons conduct as a supplier of network facilities, including central
office space, transmission facilities and telephone lines. In December 2000, we
also filed a lawsuit against BellSouth Telecommunications and its subsidiaries
in the United States District Court for the Northern District of Georgia. We
are pursuing claims in this lawsuit that are similar to our claims against
Verizon. Both courts dismissed some of our claims based on the ruling of the
United States Court of Appeals of the Seventh Circuit in Goldwasser v.
Ameritech. The court in the Verizon case also dismissed our remaining claims on
other grounds. We voluntarily dismissed our remaining claims in the BellSouth
case so we could pursue certain issues on appeal. We appealed the BellSouth and
Verizon decisions to the United States Court of Appeals for the Eleventh
Circuit and the United States Court of Appeals for the District of Columbia,
respectively. On August 2, 2002, the Eleventh Circuit Court of Appeals reversed
the lower courts decision in the BellSouth case and remanded the case for
further proceedings. BellSouth appealed this decision to the United States
Supreme Court. On January 20, 2004, the United States Supreme Court reversed a
decision entitled Verizon Communications v. Law Offices of Curtis Trinko, which
rejected the Goldwasser decision. The Supreme Court also vacated the Eleventh
Circuits decision in our case against BellSouth and remanded the case to the
Eleventh Circuit for review in light of the Trinko decision. Although we
believe the Trinko decision does not impact our cases, both BellSouth and
Verizon claim that Trinko supports the dismissal of our lawsuits and both filed
motions with the appellate courts requesting affirmance of the district courts
rulings. On May 12, 2004, the D.C. Circuit denied Verizons motion for summary
affirmance and ordered the parties to submit additional briefs. On June 25,
2004, the Eleventh Circuit reversed portions of the lower courts decision in
the BellSouth case and remanded the case for further proceedings. We cannot
predict the outcome of these proceedings at this time. On June 11, 2001, Verizon Communications filed a lawsuit against us in the
United States District Court for the Northern District of California. Verizon
is a supplier of telephone lines that we use to provide services to our
customers. In its amended complaint, Verizon claims that we falsified trouble
ticket reports with respect to the telephone lines that we ordered and seeks
unspecified monetary damages, characterized as being in the millions, and
injunctive relief. The current complaint asserts causes of action for negligent
and intentional misrepresentation and violations of Californias unfair
competition statute. On November 13, 2002, the District Court entered summary
judgment in favor of us and dismissed Verizons claims against us in their
entirety. Verizon appealed the dismissal of its lawsuit and in
July 2004 the Ninth Circuit Court of Appeals partially reversed the
District Courts decision and indicated that Verizon could
attempt to pursue a claim against us for breach of contract. The
matter has been sent back to the District Court for further
proceedings. We believe we have
strong defenses to this lawsuit, but litigation is inherently unpredictable and
there is no guarantee we will prevail. Several stockholders filed complaints in the United States District Court
for the Southern District of New York, on behalf of themselves and purported
classes of stockholders, against us and several former and current officers and
directors in addition to some of the underwriters in our stock offerings. These
lawsuits are so-called IPO allocation cases, challenging practices allegedly
used by certain underwriters of public equity offerings during the late 1990s
and 2000. On April 19, 2002 the plaintiffs amended their complaint and removed
us as a defendant. Certain directors and officers are still named in the
complaint. The plaintiffs claim that we failed to disclose the arrangements
that some of these underwriters purportedly made with certain investors. The
plaintiffs and the issuer defendants have reached a tentative agreement to
settle the matter, and we believe the tentative settlement will not have a
material adverse effect on our consolidated financial position or results of
operations. That settlement, however, has not been 37




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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. In addition, one state public utility commission is
considering applying a higher price for transmission lines on a retroactive
basis to September 2002, which could result in our being required to pay the
difference between the billed rate and the higher rate that may be set by the
public utility commission. 38




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Item 2.Changes in Securities and Use of Proceeds On June 8, 2004, we issued an aggregate of 19,558,953 shares of our common
stock in connection with the acquisition of GoBeam, Inc. The offer and sale of
the securities were effected without registration in reliance on the exemption
afforded by Section 3(a)(10) of the Securities Act of 1933, as amended. The
issuance was approved, after a hearing upon the fairness of the terms and
conditions of the transaction, by the California Department of Corporations
under authority to grant such approval as expressly authorized by the laws of
the State of California. We also sold 336,842 shares of our stock to three
GoBeam employees at a purchase price of $0.001 per share pursuant to restricted
stock purchase agreements. We have a right to repurchase these shares at the
original purchase price and this right lapses over four years. On May 24, 2004, we issued 8,000 shares of our common stock to a
consultant in exchange for his services. These shares were issued in a private
placement under Section 4(2) of the Securities Exchange Act of 1933. 
 Item 3.Defaults upon Senior Securities None. 
 Item 4.Submission of Matters to a Vote of Security Holders On June 10, 2004 we held our Annual Meeting of Stockholders. Set forth
below is a summary of each matter voted upon at the meeting and the number of
votes cast for, against or withheld, as well as the number of abstentions and
broker non-votes. Proposal
1 - The election of two Class II directors to serve on our Board
of Directors for a term to expire at the third succeeding annual meeting
(expected to be the 2007 annual meeting) and until their successors are elected
and qualified. Name
    
    For
    
    WithheldL. Dale Crandall
    
    
    204,364,622
    
    
    
    2,926,765Hellene S. Runtagh
    
    
    204,398,068
    
    
    
    2,893,319
 Proposal 2 -
Ratification of independent registered public accounting firm, PricewaterhouseCoopers
LLP, for the 2004 fiscal year: 205,826,506 votes in favor, 1,226,564 votes
against and 238,317 votes abstained. 
 Item 5.Other Information None. 
 Item 6.Exhibits and Reports on Form 8-K a. Exhibits: Exhibit
    
    
    
    
    
    Incorporated by Reference
    
    ExhibitNumber
    
    Exhibit Description
    
    Form
    
    File No.
    
    Date of First Filing
    
    Number
    
    Filed Herewith31.1
    
    Certification Pursuant to Rule
13a-14(a).
    
    
    
    
    
    
    
    
    
    X31.2
    
    Certification Pursuant to Rule
13a-14(a).
    
    
    
    
    
    
    
    
    
    X32.1*
    
    Certification Pursuant to 18
U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
    
    
    
    
    
    
    
    
    
    X32.2*
    
    Certification Pursuant to 18
U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
    
    
    
    
    
    
    
    
    
    X
   *
    
    These certifications accompany the Registrants Quarterly Report on Form
10-Q and are not deemed filed with the SEC. 39




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b. Reports on Form 8-K We reported the following items on Form 8-K during the quarter ended June
30, 2004: On April 12, 2004, the Company issued a current report on Form 8-K,
pursuant to Item 4 thereof, announcing its decision to retain
PricewaterhouseCoopers LLP as its independent accountant for fiscal year 2004. On May 12, 2004, the Company furnished a current report on Form 8-K,
pursuant to Item 12 thereof, announcing that it was filing for an extension of
time to file its Form 10-Q for the quarter ended March 31, 2004. On May 17, 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 quarter ended March 31, 2004. On June 1, 2004, the Company issued a current report on Form 8-K, pursuant
to Item 5 thereof, attaching revised Items 7 and 8 to its amended Annual Report
on Form 10-K/A for the fiscal year ended December 31, 2003, to reflect the
effect of a change in its segments. On June 22, 2004, the Company issued a current report on Form 8-K,
pursuant to Item 2 thereof, announcing the completion of its acquisition of
GoBeam, Inc. 40




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. COVAD COMMUNICATIONS GROUP, INC.By:
    /s/ CHARLES E. HOFFMANCharles E. HoffmanPresident, Chief Executive
Officer and Director Date: July 29, 2004 By:
    /s/ MARK A. RICHMANMark A. RichmanExecutive Vice President and
Chief Financial Officer Date: July 29, 2004 41




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ExhibitNumber
    
    Description31.1
    
    Certification Pursuant to Rule 13a-14(a).31.2
    
    Certification Pursuant to Rule 13a-14(a).32.1*
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.32.2*
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
   *
    
    These certifications accompany the Registrants Quarterly Report on Form
10-Q and are not deemed filed with the SEC.