##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, DC 20549


Form 10-Q

|  |  |                                                                                                 
|- |  | ------------------------------------------------------------------------------------------------
|þ |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934 
| 
|  |  | For the quarterly period ended
    September 30, 2002                                           
| 
|o |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
| 
|  |  | For the transition period
    from           to           .                                     

Commission file number: 000-25271

Covad Communications Group, Inc.

(Exact name of registrant as specified in its
charter)


|                                                                   |  |                                            
|------------------------------------------------------------------ |  | -------------------------------------------
|Delaware                                                           |  | 77-0461529                                 
|(State or other jurisdiction
    of incorporation or organization) |  | (I.R.S. Employer
    Identification Number)
|                                                                  
|3420 Central Expressway                                            |  |                                            
|Santa Clara, California                                            |  | 95051                                      
|(Address of principal executive
    offices)                       |  | (Zip Code)                                 

(408) 616-6500

(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 þ          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 þ          No o

As of November 4, 2002 there were
222,999,936 shares outstanding of the Registrants Common
Stock, including Class B Common Stock.



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TABLE OF CONTENTS



|                              |                                                                                               |  |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|TABLE OF CONTENTS            
|PART I. FINANCIAL INFORMATION
|                              | Item 1. Condensed Consolidated Financial Statements (Unaudited)                              
|                              | CONDENSED CONSOLIDATED BALANCE SHEETS                                                        
|                              | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS                                              
|                              | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                              | Item 3. Market Risk                                                                          
|                              | Item 4. Controls and Procedures                                                              
|PART II. OTHER INFORMATION   
|                              | Item 1. Legal Proceedings (all dollar amounts are presented in thousands)                    
|                              | Item 2. Changes in Securities and Use of Proceeds                                            
|                              | Item 3. Defaults upon Senior Securities                                                      
|                              | Item 4. Submission of Matters to a Vote of Security Holders                                  
|                              | Item 5. Other Information                                                                    
|                              | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURES                   
|CERTIFICATIONS               
|EXHIBIT 99.1                 
|EXHIBIT 99.2                 



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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.

FORM 10-Q






TABLE OF CONTENTS


|                                   |  |                                                                                                                     |    |      |    | 
|---------------------------------- |  | ------------------------------------------------------------------------------------------------------------------- | -- | ---- | -- | 
|                                   |  |                                                                                                                     |    | Page
|                                   |  |                                                                                                                     |    |     
|PART I.  FINANCIAL
    INFORMATION
|ITEM 1.                            |  | CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
    (UNAUDITED)                                                         |    |      | 1  | 
|                                   |  | CONDENSED CONSOLIDATED BALANCE SHEETS AS OF
    SEPTEMBER 30, 2002 AND DECEMBER 31, 2001                            |    |      | 1  | 
|                                   |  | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
    FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001 |    |      | 2  | 
|                                   |  | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
    FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001           |    |      | 3  | 
|                                   |  | NOTES TO CONDENSED CONSOLIDATED FINANCIAL
    STATEMENTS                                                            |    |      | 4  | 
|ITEM 2.                            |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF
    FINANCIAL CONDITION AND RESULTS OF OPERATIONS                           |    |      | 22 | 
|ITEM 3.                            |  | MARKET RISK                                                                                                         |    |      | 39 | 
|ITEM 4.                            |  | CONTROLS AND PROCEDURES                                                                                             |    |      | 40 | 
|PART II.  OTHER
    INFORMATION   
|ITEM 1.                            |  | LEGAL PROCEEDINGS                                                                                                   |    |      | 40 | 
|ITEM 2.                            |  | CHANGES IN SECURITIES AND USE OF PROCEEDS                                                                           |    |      | 43 | 
|ITEM 3.                            |  | DEFAULTS UPON SENIOR SECURITIES                                                                                     |    |      | 43 | 
|ITEM 4.                            |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY
    HOLDERS                                                             |    |      | 43 | 
|ITEM 5.                            |  | OTHER INFORMATION                                                                                                   |    |      | 43 | 
|ITEM 6.                            |  | EXHIBITS AND REPORTS ON FORM 8-K                                                                                    |    |      | 43 | 
|SIGNATURES                         |  |                                                                                                                     | 45 |     
|CERTIFICATIONS                     |  |                                                                                                                     | 46 |     

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##### Table of Contents






PART I.     FINANCIAL
INFORMATION




Item 1.     Condensed
Consolidated Financial Statements (Unaudited)

COVAD COMMUNICATIONS GROUP, INC.






CONDENSED CONSOLIDATED BALANCE
SHEETS


|                                                               |                                                                                                                                                                                                             |                                            |         |              |         |  |         |            |         | 
|-------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------- | ------------ | ------- |  | ------- | ---------- | ------- | 
|                                                               |                                                                                                                                                                                                             | September 30,                              |         | December 31,
|                                                               |                                                                                                                                                                                                             | 2002                                       |         | 2001        
|                                                               |                                                                                                                                                                                                             |                                            |         |             
|                                                               |                                                                                                                                                                                                             | (Unaudited)                                |         | (Note 1)    
|                                                               |                                                                                                                                                                                                             |                                           
|                                                               |                                                                                                                                                                                                             | (Amounts in thousands, except             
|                                                               |                                                                                                                                                                                                             | share and per share amounts)              
|ASSETS                                                        
|Current assets:                                                |                                                                                                                                                                                                             |                                            |         |              |         |  |         |           
|                                                               | Cash and cash equivalents                                                                                                                                                                                   |                                            | $       | 49,120       |         |  | $       | 207,810    |        
|                                                               | Short-term investments                                                                                                                                                                                      |                                            |         | 179,087      |         |  |         | 76,053     |        
|                                                               | Restricted cash and investments                                                                                                                                                                             |                                            |         | 500          |         |  |         | 9,203      |        
|                                                               | Accounts receivable, net of allowances of $6,093
    at September 30, 2002 ($8,483 at December 31, 2001)                                                                                                    |                                            |         | 32,392       |         |  |         | 23,245     |        
|                                                               | Unbilled revenue                                                                                                                                                                                            |                                            |         | 3,934        |         |  |         | 4,964      |        
|                                                               | Other receivables                                                                                                                                                                                           |                                            |         | 1,560        |         |  |         | 3,885      |        
|                                                               | Inventories                                                                                                                                                                                                 |                                            |         | 5,068        |         |  |         | 7,249      |        
|                                                               | Prepaid expenses and other current assets                                                                                                                                                                   |                                            |         | 12,367       |         |  |         | 6,689      |        
|                                                               |                                                                                                                                                                                                             |                                            |         |              |         |  |         |           
|                                                               |                                                                                                                                                                                                             | Total current assets                       |         |              | 284,028 |  |         |            | 339,098 | 
|Property and equipment, net                                    |                                                                                                                                                                                                             |                                            | 119,654 |              |         |  | 215,804 |           
|Collocation fees, net                                          |                                                                                                                                                                                                             |                                            | 45,787  |              |         |  | 53,464  |           
|Investments in unconsolidated affiliates                       |                                                                                                                                                                                                             |                                            | 1,516   |              |         |  | 4,874   |           
|Deferred costs of service activation                           |                                                                                                                                                                                                             |                                            | 44,635  |              |         |  | 57,962  |           
|Deferred customer incentive                                    |                                                                                                                                                                                                             |                                            | 3,730   |              |         |  |        |           
|Other long-term assets                                         |                                                                                                                                                                                                             |                                            | 3,461   |              |         |  | 3,966   |           
|                                                               |                                                                                                                                                                                                             |                                            |         |              |         |  |         |           
|                                                               |                                                                                                                                                                                                             | Total assets                               |         | $            | 502,811 |  |         | $          | 675,168 | 
|                                                               |                                                                                                                                                                                                             |                                            |         |              |         |  |         |           
|LIABILITIES AND STOCKHOLDERS
    EQUITY                      
|Current liabilities:                                           |                                                                                                                                                                                                             |                                            |         |              |         |  |         |           
|                                                               | Accounts payable                                                                                                                                                                                            |                                            | $       | 13,302       |         |  | $       | 15,842     |        
|                                                               | Accrued compensation                                                                                                                                                                                        |                                            |         | 14,910       |         |  |         | 16,268     |        
|                                                               | Current portion of capital lease obligations                                                                                                                                                                |                                            |         |             |         |  |         | 11         |        
|                                                               | Accrued collocation and network service fees                                                                                                                                                                |                                            |         | 32,603       |         |  |         | 40,839     |        
|                                                               | Accrued transaction-based taxes                                                                                                                                                                             |                                            |         | 37,384       |         |  |         | 31,263     |        
|                                                               | Accrued interest                                                                                                                                                                                            |                                            |         | 4,308        |         |  |         | 183        |        
|                                                               | Accrued market development funds and customer
    incentives                                                                                                                                                |                                            |         | 5,550        |         |  |         | 1,733      |        
|                                                               | Unresolved claims related to bankruptcy
    proceedings                                                                                                                                                     |                                            |         | 9,997        |         |  |         | 22,200     |        
|                                                               | Other accrued liabilities                                                                                                                                                                                   |                                            |         | 10,452       |         |  |         | 8,103      |        
|                                                               |                                                                                                                                                                                                             |                                            |         |              |         |  |         |           
|                                                               |                                                                                                                                                                                                             | Total current liabilities                  |         |              | 128,506 |  |         |            | 136,442 | 
|Long-term debt                                                 |                                                                                                                                                                                                             |                                            | 50,000  |              |         |  | 50,000  |           
|Collateralized customer deposit                                |                                                                                                                                                                                                             |                                            | 70,080  |              |         |  | 75,000  |           
|Deferred gain resulting from deconsolidation of
    subsidiary |                                                                                                                                                                                                             |                                            | 55,200  |              |         |  | 55,200  |           
|Unearned revenues                                              |                                                                                                                                                                                                             |                                            | 79,185  |              |         |  | 98,697  |           
|                                                               |                                                                                                                                                                                                             |                                            |         |              |         |  |         |           
|                                                               |                                                                                                                                                                                                             | Total liabilities                          |         |              | 382,971 |  |         |            | 415,339 | 
|Commitments and contingencies                                  |                                                                                                                                                                                                             |                                            |         |              |         |  |         |           
|Stockholders equity:                                          |                                                                                                                                                                                                             |                                            |         |              |         |  |         |           
|                                                               | Preferred stock, $0.001 par value; 5,000,000
    shares authorized; no shares issued and outstanding at
    September 30, 2002 and December 31, 2001.                                                       |                                            |         |             |         |  |         |           |        
|                                                               | Common Stock, $0.001 par value; 590,000,000
    shares authorized; 220,499,687 shares issued and outstanding at
    September 30, 2002 (216,542,210 shares issued and
    outstanding at December 31, 2001) |                                            |         | 220          |         |  |         | 216        |        
|                                                               | Additional paid-in capital                                                                                                                                                                                  |                                            |         | 1,614,422    |         |  |         | 1,606,737  |        
|                                                               | Deferred stock-based compensation                                                                                                                                                                           |                                            |         | (203         | )       |  |         | (257       | )      
|                                                               | Accumulated other comprehensive loss                                                                                                                                                                        |                                            |         | (752         | )       |  |         | (2,359     | )      
|                                                               | Accumulated deficit                                                                                                                                                                                         |                                            |         | (1,493,847   | )       |  |         | (1,344,508 | )      
|                                                               |                                                                                                                                                                                                             |                                            |         |              |         |  |         |           
|                                                               |                                                                                                                                                                                                             | Total stockholders equity                 |         |              | 119,840 |  |         |            | 259,829 | 
|                                                               |                                                                                                                                                                                                             |                                            |         |              |         |  |         |           
|                                                               |                                                                                                                                                                                                             | Total liabilities and stockholders equity |         | $            | 502,811 |  |         | $          | 675,168 | 
|                                                               |                                                                                                                                                                                                             |                                            |         |              |         |  |         |           

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.






CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS


|                                                                                                    |                                                                                                                                                       |                                                            |             |                   |         |      |             |         |         |   |             |         |         |   |             |         |         | 
|--------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------- | ----------- | ----------------- | ------- | ---- | ----------- | ------- | ------- | - | ----------- | ------- | ------- | - | ----------- | ------- | ------- | 
|                                                                                                    |                                                                                                                                                       |                                                            |             |                  
|                                                                                                    |                                                                                                                                                       | Three Months Ended                                         |             | Nine Months Ended
|                                                                                                    |                                                                                                                                                       | September 30,                                              |             | September 30,    
|                                                                                                    |                                                                                                                                                       |                                                            |             |                  
|                                                                                                    |                                                                                                                                                       | 2002                                                       |             | 2001              |         | 2002 |             | 2001   
|                                                                                                    |                                                                                                                                                       |                                                            |             |                   |         |      |             |        
|                                                                                                    |                                                                                                                                                       |                                                           
|                                                                                                    |                                                                                                                                                       | (Amounts in thousands, except share and per share amounts)
|                                                                                                    |                                                                                                                                                       | (Unaudited)                                               
|Revenues, net                                                                                       |                                                                                                                                                       | $                                                          | 96,206      |                   |         | $    | 84,784      |         |         | $ | 295,605     |         |         | $ | 243,128     |        
|Operating expenses:                                                                                 |                                                                                                                                                       |                                                            |             |                   |         |      |             |         |         |   |             |         |         |   |             |        
|                                                                                                    | Network and product costs                                                                                                                             |                                                            |             | 68,112            |         |      |             | 103,290 |         |   |             | 231,576 |         |   |             | 359,896 |        
|                                                                                                    | Sales, marketing, general and administrative                                                                                                          |                                                            |             | 42,607            |         |      |             | 46,601  |         |   |             | 116,636 |         |   |             | 168,696 |        
|                                                                                                    | Provision for bad debts (bad debt recoveries), net                                                                                                    |                                                            |             | (1,731            | )       |      |             | 3,572   |         |   |             | 312     |         |   |             | 523     |        
|                                                                                                    | Depreciation and amortization of property and
    equipment                                                                                           |                                                            |             | 33,498            |         |      |             | 36,092  |         |   |             | 92,882  |         |   |             | 103,796 |        
|                                                                                                    | Amortization of collocation fees                                                                                                                      |                                                            |             | 3,700             |         |      |             | 1,763   |         |   |             | 10,990  |         |   |             | 9,333   |        
|                                                                                                    | Provision for restructuring expenses                                                                                                                  |                                                            |             |                  |         |      |             | (130    | )       |   |             |        |         |   |             | 17,617  |        
|                                                                                                    | Provision for long-lived asset impairment                                                                                                             |                                                            |             |                  |         |      |             | (241    | )       |   |             |        |         |   |             | 1,989   |        
|                                                                                                    | Litigation-related expenses                                                                                                                           |                                                            |             | 1,884             |         |      |             | 1,907   |         |   |             | (9,029  | )       |   |             | 5,907   |        
|                                                                                                    |                                                                                                                                                       |                                                            |             |                   |         |      |             |         |         |   |             |         |         |   |             |        
|                                                                                                    |                                                                                                                                                       | Total operating expenses                                   |             |                   | 148,070 |      |             |         | 192,854 |   |             |         | 443,367 |   |             |         | 667,757 | 
|                                                                                                    |                                                                                                                                                       |                                                            |             |                   |         |      |             |         |         |   |             |         |         |   |             |        
|Loss from operations                                                                                |                                                                                                                                                       |                                                            | (51,864     | )                 |         |      | (108,070    | )       |         |   | (147,762    | )       |         |   | (424,629    | )      
|Other income (expense):                                                                             |                                                                                                                                                       |                                                            |             |                   |         |      |             |         |         |   |             |         |         |   |             |        
|                                                                                                    | Interest income                                                                                                                                       |                                                            |             | 1,559             |         |      |             | 5,063   |         |   |             | 4,072   |         |   |             | 23,290  |        
|                                                                                                    | Realized gain (loss) on short-term
    investments                                                                                                    |                                                            |             |                  |         |      |             | 75      |         |   |             | (17     | )       |   |             | 5,912   |        
|                                                                                                    | Other than temporary losses on short-term
    investments                                                                                             |                                                            |             |                  |         |      |             |        |         |   |             |        |         |   |             | (1,311  | )      
|                                                                                                    | Provision for impairment of investments in
    unconsolidated affiliates                                                                              |                                                            |             |                  |         |      |             | (9,467  | )       |   |             |        |         |   |             | (9,467  | )      
|                                                                                                    | Equity in losses of unconsolidated affiliates                                                                                                         |                                                            |             | (101              | )       |      |             | (5,011  | )       |   |             | (704    | )       |   |             | (11,626 | )      
|                                                                                                    | Gain (loss) on disposal of investments in
    unconsolidated affiliates                                                                               |                                                            |             |                  |         |      |             |        |         |   |             | (636    | )       |   |             | 178     |        
|                                                                                                    | Interest expense (contractual interest expense
    was $36,169 and $110,415 for the three and nine months ended
    September 30, 2001, respectively) |                                                            |             | (1,375            | )       |      |             | (18,345 | )       |   |             | (4,125  | )       |   |             | (92,591 | )      
|                                                                                                    | Miscellaneous income (expense), net                                                                                                                   |                                                            |             | 74                |         |      |             | (98     | )       |   |             | (167    | )       |   |             | 394     |        
|                                                                                                    | Reorganization expenses, net                                                                                                                          |                                                            |             |                  |         |      |             | (3,896  | )       |   |             |        |         |   |             | (3,896  | )      
|                                                                                                    |                                                                                                                                                       |                                                            |             |                   |         |      |             |         |         |   |             |         |         |   |             |        
|                                                                                                    | Other income (expense), net                                                                                                                           |                                                            |             | 157               |         |      |             | (31,679 | )       |   |             | (1,577  | )       |   |             | (89,117 | )      
|                                                                                                    |                                                                                                                                                       |                                                            |             |                   |         |      |             |         |         |   |             |         |         |   |             |        
|Net loss                                                                                            |                                                                                                                                                       | $                                                          | (51,707     | )                 |         | $    | (139,749    | )       |         | $ | (149,339    | )       |         | $ | (513,746    | )      
|                                                                                                    |                                                                                                                                                       |                                                            |             |                   |         |      |             |         |         |   |             |         |         |   |             |        
|Basic and diluted net loss per share                                                                |                                                                                                                                                       | $                                                          | (0.23       | )                 |         | $    | (0.79       | )       |         | $ | (0.68       | )       |         | $ | (2.94       | )      
|                                                                                                    |                                                                                                                                                       |                                                            |             |                   |         |      |             |         |         |   |             |         |         |   |             |        
|Weighted average number of common shares used in
    computing basic and diluted net loss per share |                                                                                                                                                       |                                                            | 220,432,609 |                   |         |      | 176,829,127 |         |         |   | 218,901,267 |         |         |   | 174,507,085 |        
|                                                                                                    |                                                                                                                                                       |                                                            |             |                   |         |      |             |         |         |   |             |         |         |   |             |        

See accompanying notes.

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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                   |                                                                                    |                                                                                 |                                                                                |                                                         |         |         |         |          |         |         |          |  
|-------------------------------------------------- | ---------------------------------------------------------------------------------- | ------------------------------------------------------------------------------- | ------------------------------------------------------------------------------ | ------------------------------------------------------- | ------- | ------- | ------- | -------- | ------- | ------- | -------- | -
|                                                   |                                                                                    |                                                                                
|                                                   |                                                                                    | Nine Months Ended September 30,                                                
|                                                   |                                                                                    |                                                                                
|                                                   |                                                                                    | 2002                                                                            |                                                                                | 2001                                                   
|                                                   |                                                                                    |                                                                                 |                                                                                |                                                        
|                                                   |                                                                                    |                                                                                
|                                                   |                                                                                    | (Amounts in thousands)                                                         
|                                                   |                                                                                    |                                                                                
|                                                   |                                                                                    | (Unaudited)                                                                    
|Operating Activities:                              |                                                                                    |                                                                                 |                                                                                |                                                         |         |         |         |         
|                                                   | Net loss                                                                           |                                                                                 | $                                                                              | (149,339                                                | )       |         | $       | (513,746 | )      
|                                                   | Adjustments to reconcile net loss to net cash
    used in operating activities:    |                                                                                 |                                                                                |                                                         |         |         |         |          |        
|                                                   |                                                                                    | Provision for bad debts, net                                                    |                                                                                |                                                         | 312     |         |         |          | 523     |        
|                                                   |                                                                                    | Depreciation and amortization                                                   |                                                                                |                                                         | 103,872 |         |         |          | 113,129 |        
|                                                   |                                                                                    | Loss on disposition of property and equipment                                   |                                                                                |                                                         | 332     |         |         |          | 382     |        
|                                                   |                                                                                    | Provision for restructuring expenses                                            |                                                                                |                                                         |        |         |         |          | 17,617  |        
|                                                   |                                                                                    | Provision for long-lived asset impairment                                       |                                                                                |                                                         |        |         |         |          | 1,989   |        
|                                                   |                                                                                    | Non-cash litigation-related expenses                                            |                                                                                |                                                         | (9,029  | )       |         |          | 3,140   |        
|                                                   |                                                                                    | Amortization of deferred stock-based compensation                               |                                                                                |                                                         | 227     |         |         |          | 1,431   |        
|                                                   |                                                                                    | Other stock-based compensation                                                  |                                                                                |                                                         | 282     |         |         |          | 4       |        
|                                                   |                                                                                    | Amortization (accretion) of interest on
    investments, net                    |                                                                                |                                                         | (92     | )       |         |          | (6,837  | )      
|                                                   |                                                                                    | Realized loss (gain) on short-term
    investments                              |                                                                                |                                                         | 17      |         |         |          | (5,912  | )      
|                                                   |                                                                                    | Other than temporary losses on short-term
    investments                       |                                                                                |                                                         |        |         |         |          | 1,311   |        
|                                                   |                                                                                    | Equity in losses of unconsolidated affiliates                                   |                                                                                |                                                         | 704     |         |         |          | 11,626  |        
|                                                   |                                                                                    | Provision for impairment of investment in
    unconsolidated affiliates         |                                                                                |                                                         |        |         |         |          | 9,467   |        
|                                                   |                                                                                    | (Gain) loss on disposal of investments in
    unconsolidated affiliates         |                                                                                |                                                         | 636     |         |         |          | (178    | )      
|                                                   |                                                                                    | Accretion of debt discount and amortization of
    deferred debt issuance costs |                                                                                |                                                         |        |         |         |          | 20,845  |        
|                                                   |                                                                                    | Net changes in operating assets and liabilities:                                |                                                                                |                                                         |         |         |         |          |         |        
|                                                   |                                                                                    |                                                                                 | Restricted cash                                                                |                                                         |         | 8,703   |         |          |         | 13,206  |         
|                                                   |                                                                                    |                                                                                 | Accounts receivable                                                            |                                                         |         | (9,459  | )       |          |         | (6,968  | )       
|                                                   |                                                                                    |                                                                                 | Unbilled revenue                                                               |                                                         |         | 1,030   |         |          |         | 756     |         
|                                                   |                                                                                    |                                                                                 | Inventories                                                                    |                                                         |         | 2,181   |         |          |         | 5,488   |         
|                                                   |                                                                                    |                                                                                 | Prepaid expenses and other current assets                                      |                                                         |         | (3,191  | )       |          |         | 1,473   |         
|                                                   |                                                                                    |                                                                                 | Deferred costs of service activation                                           |                                                         |         | 13,327  |         |          |         | (9,038  | )       
|                                                   |                                                                                    |                                                                                 | Accounts payable                                                               |                                                         |         | (2,540  | )       |          |         | (45,024 | )       
|                                                   |                                                                                    |                                                                                 | Unresolved claims related to bankruptcy
    proceedings                        |                                                         |         | (2,913  | )       |          |         |        |         
|                                                   |                                                                                    |                                                                                 | Prepetition accounts payable and accrued
    liabilities subject to compromise |                                                         |         |        |         |          |         | (7,621  | )       
|                                                   |                                                                                    |                                                                                 | Postpetition accounts payable and accrued
    liabilities                      |                                                         |         |        |         |          |         | 14,670  |         
|                                                   |                                                                                    |                                                                                 | Collateralized customer deposit                                                |                                                         |         | (4,920  | )       |          |         |        |         
|                                                   |                                                                                    |                                                                                 | Other current liabilities                                                      |                                                         |         | 8,417   |         |          |         | (14,611 | )       
|                                                   |                                                                                    |                                                                                 | Unearned revenues                                                              |                                                         |         | (19,109 | )       |          |         | (13,845 | )       
|                                                   |                                                                                    |                                                                                 |                                                                                |                                                         |         |         |         |         
|                                                   |                                                                                    |                                                                                 |                                                                                | Net cash used in operating activities                   |         |         | (60,552 | )        |         |         | (406,723 | )
|Investing Activities:                              |                                                                                    |                                                                                 |                                                                                |                                                         |         |         |         |         
|                                                   | Cash relinquished as a result of deconsolidating
    a subsidiary                  |                                                                                 |                                                                                |                                                        |         |         |         | (1,599   | )      
|                                                   | Purchases of short-term investments                                                |                                                                                 |                                                                                | (213,681                                                | )       |         |         | (561,986 | )      
|                                                   | Maturities of short-term investments                                               |                                                                                 |                                                                                | 70,988                                                  |         |         |         | 487,508  |        
|                                                   | Sales of short-term investments                                                    |                                                                                 |                                                                                | 40,000                                                  |         |         |         | 335,376  |        
|                                                   | Purchase of restricted investments in connection
    with bankruptcy proceedings   |                                                                                 |                                                                                |                                                        |         |         |         | (257,202 | )      
|                                                   | Redemption of restricted investments in
    connection with bankruptcy proceedings |                                                                                 |                                                                                |                                                        |         |         |         |         |        
|                                                   | Redemption of other restricted investments                                         |                                                                                 |                                                                                |                                                        |         |         |         | 13,437   |        
|                                                   | Purchases of property and equipment                                                |                                                                                 |                                                                                | (12,323                                                 | )       |         |         | (16,685  | )      
|                                                   | Proceeds from sales of property and equipment                                      |                                                                                 |                                                                                | 13,451                                                  |         |         |         | 1,483    |        
|                                                   | Recovery of internal use software costs                                            |                                                                                 |                                                                                | 458                                                     |         |         |         | 2,000    |        
|                                                   | Payment of collocation fees                                                        |                                                                                 |                                                                                | (1,963                                                  | )       |         |         | (4,233   | )      
|                                                   | Proceeds from sales of investments in
    unconsolidated affiliates                |                                                                                 |                                                                                | 3,360                                                   |         |         |         | 1,223    |        
|                                                   |                                                                                    |                                                                                 |                                                                                |                                                         |         |         |         |         
|                                                   |                                                                                    |                                                                                 |                                                                                | Net cash used in investing activities                   |         |         | (99,710 | )        |         |         | (678     | )
|Financing Activities:                              |                                                                                    |                                                                                 |                                                                                |                                                         |         |         |         |         
|                                                   | Principal payments on long-term debt                                               |                                                                                 |                                                                                |                                                        |         |         |         | (8,394   | )      
|                                                   | Principal payments under capital lease obligations                                 |                                                                                 |                                                                                | (11                                                     | )       |         |         | (1,086   | )      
|                                                   | Proceeds from common stock issuance                                                |                                                                                 |                                                                                | 1,583                                                   |         |         |         | 3,924    |        
|                                                   | Repurchase of restricted stock                                                     |                                                                                 |                                                                                |                                                        |         |         |         | (172     | )      
|                                                   |                                                                                    |                                                                                 |                                                                                |                                                         |         |         |         |         
|                                                   |                                                                                    |                                                                                 |                                                                                | Net cash provided by (used in) financing
    activities |         |         | 1,572   |          |         |         | (5,728   | )
|                                                   |                                                                                    |                                                                                 |                                                                                |                                                         |         |         |         |         
|                                                   | Net decrease in cash and cash equivalents                                          |                                                                                 |                                                                                | (158,690                                                | )       |         |         | (413,129 | )      
|                                                   | Cash and cash equivalents at beginning of period                                   |                                                                                 |                                                                                | 207,810                                                 |         |         |         | 558,440  |        
|                                                   |                                                                                    |                                                                                 |                                                                                |                                                         |         |         |         |         
|                                                   | Cash and cash equivalents at end of period                                         |                                                                                 | $                                                                              | 49,120                                                  |         |         | $       | 145,311  |        
|                                                   |                                                                                    |                                                                                 |                                                                                |                                                         |         |         |         |         
|Supplemental Disclosures of Cash Flow Information: |                                                                                    |                                                                                 |                                                                                |                                                         |         |         |         |         
|                                                   | Cash paid during the period for interest                                           |                                                                                 | $                                                                              |                                                        |         |         | $       | 66,542   |        
|                                                   |                                                                                    |                                                                                 |                                                                                |                                                         |         |         |         |         

See accompanying notes.

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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

September 30, 2002 and 2001


(All dollar amounts are presented in
thousands, except share and 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
(collectively, the Company). All significant
intercompany accounts and transactions have been eliminated in
consolidation.

The 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 all 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 accruals)
considered necessary for a fair presentation of the condensed
consolidated financial statements have been included. Operating
results for the three and nine months ended September 30,
2002 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2002.

The Companys business plan includes certain
discretionary spending in 2002 that is predicated on certain
revenue growth assumptions. If necessary, the Company will
curtail this discretionary spending so that it can continue as a
going concern at least through January 1, 2003 using only
its unrestricted cash, cash equivalents and short-term
investment balances in existence as of December 31, 2001.
Additionally, based on the advice of legal counsel, the Company
believes it is more likely than not that certain securities
litigation described in Note 8 will ultimately be settled
in accordance with the terms of the memorandum of understanding
(MOU) dated August 10, 2001 executed by the
Company and the plaintiffs in such securities litigation.
Therefore, the Company does not believe that the ultimate
settlement of this securities litigation will have a material
adverse effect on its ability to continue as a going concern at
least through January 1, 2003. However, in the event
(i) the MOU is not ultimately approved by the United States
District Court and/or (ii) the settlement of the
aforementioned securities litigation ultimately requires the
Company to disburse additional cash, the Company will reduce
other discretionary spending so that it can continue as a going
concern at least through January 1, 2003 using only its
unrestricted cash, cash equivalents and short-term investment
balances in existence as of December 31, 2001. The Company
does not believe any such curtailment of its discretionary
spending, if necessary, will have a material adverse effect on
the overall execution of its business plan.

The condensed consolidated balance sheet as of
December 31, 2001 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 for the year
ended December 31, 2001.

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) reorganization and restructuring liabilities,
(iv) useful life assignments and impairment evaluations
associated with property and equipment and collocation fees,
(v) anticipated

4



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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

outcomes of legal proceedings and other disputes,
(vi) transaction-based tax liabilities and
(vii) valuation allowances associated with deferred tax
assets.



| |                  
| | -----------------
| | Long-Lived Assets

As of December 31, 2001, the Companys
estimated annual amortization expenses associated with
collocation fees for the next five years were as follows:

|     |  |   |        | 
|---- |  | - | ------ | 
|2002 |  | $ | 13,177 | 
|2003 |  | $ | 13,177 | 
|2004 |  | $ | 13,177 | 
|2005 |  | $ | 13,177 | 
|2006 |  | $ | 756    | 

Effective January 1, 2001, the Company
reduced the remaining estimated useful lives of all long-lived
assets, excluding building and leasehold improvements, that
previously had estimated useful lives in excess of five years
such that the residual balances and any subsequent additions are
now depreciated or amortized over five years using the
straight-line method. This change in accounting estimate
increased the Companys net loss by $2,900 ($0.02 per
share) and $9,200 ($0.05 per share) for the three and nine
months ended September 30, 2001, respectively.

As part of the continuing evaluation of the
Companys network assets during the three months ended
September 30, 2002, certain matters were identified related
to prior financial reporting periods that necessitated the
recording of additional expenses. Such matters were related to
(i) changes in the Companys network configuration,
which necessitated reductions of the remaining estimated useful
lives of certain network equipment and (ii) the
capitalization of certain network and product costs that should
have been charged to operating expenses. Accordingly, for the
three months ended September 30, 2002, the Company has
recorded (i) additional depreciation expense of $9,584 and
(ii) additional network and product costs of $1,215. The
Company does not believe these amounts are material to the
periods in which they should have been recorded, nor does it
expect that the expenses will be material to its consolidated
operating results for the year ending December 31, 2002.
However, if these adjustments are ultimately deemed to be
material to the Companys consolidated operating results
for the year ending December 31, 2002, the Company will
need to restate prior financial reporting periods, including the
current period. The impact on prior financial reporting periods
would be as follows: net loss for the three months ended
June 30, 2002 would be increased by $1,292 ($0.01 per
share), net loss for the three months ended March 31, 2002
would be increased by $1,099 ($0.01 per share), net income for
the year ended December 31, 2001 would be decreased by
$8,057 ($0.04 per share) and net loss for the year ended
December 31, 2000 would be increased by $351 ($0.00 per
share).



| |                                         
| | ----------------------------------------
| | 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,
(ii) the

5



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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

assumed exercise of outstanding stock options and
warrants and (iii) the assumed conversion of convertible
debt instruments is not dilutive.

The following table presents the calculation of
weighted average common shares used in the computations of basic
and diluted net loss per share presented in the accompanying
condensed consolidated statements of operations:

|                                                                                                    |  |                    |             |                   |  |      |             |      |  |  |             |  |  |  |             | 
|--------------------------------------------------------------------------------------------------- |  | ------------------ | ----------- | ----------------- |  | ---- | ----------- | ---- |  |  | ----------- |  |  |  | ----------- | 
|                                                                                                    |  |                    |             |                  
|                                                                                                    |  | Three Months Ended |             | Nine Months Ended
|                                                                                                    |  | September 30,      |             | September 30,    
|                                                                                                    |  |                    |             |                  
|                                                                                                    |  | 2002               |             | 2001              |  | 2002 |             | 2001
|                                                                                                    |  |                    |             |                   |  |      |             |     
|Weighted-average number of shares of common stock
    outstanding                                   |  |                    | 220,433,234 |                   |  |      | 177,653,940 |      |  |  | 218,910,100 |  |  |  | 175,585,866 | 
|Less weighted average number of shares of common
    stock subject to repurchase                    |  |                    | 625         |                   |  |      | 824,813     |      |  |  | 8,833       |  |  |  | 1,078,781   | 
|                                                                                                    |  |                    |             |                   |  |      |             |      |  |  |             |  |  |  |             | 
|Weighted average number of common shares used in
    computing basic and diluted net loss per share |  |                    | 220,432,609 |                   |  |      | 176,829,127 |      |  |  | 218,901,267 |  |  |  | 174,507,085 | 
|                                                                                                    |  |                    |             |                   |  |      |             |      |  |  |             |  |  |  |             | 



| |                   
| | ------------------
| | Comprehensive Loss

Significant components of the Companys
comprehensive loss are as follows:

|                                                               |  |                    |            |                    |  |                   |         |      |  |      |          |   |  |   |          |   |  |   |          |  
|-------------------------------------------------------------- |  | ------------------ | ---------- | ------------------ |  | ----------------- | ------- | ---- |  | ---- | -------- | - |  | - | -------- | - |  | - | -------- | -
|                                                               |  |                    |            |                    |  |                  
|                                                               |  |                    |            | Three Months Ended |  | Nine Months Ended
|                                                               |  |                    |            | September 30,      |  | September 30,    
|                                                               |  |                    |            |                    |  |                  
|                                                               |  | Cumulative Amounts |            | 2002               |  | 2001              |         | 2002 |  | 2001
|                                                               |  |                    |            |                    |  |                   |         |      |  |     
|Net loss                                                       |  | $                  | (1,493,847 | )                  |  | $                 | (51,707 | )    |  | $    | (139,749 | ) |  | $ | (149,339 | ) |  | $ | (513,746 | )
|Unrealized gains (losses) on available-for-sale
    securities |  |                    | 210        |                    |  |                   | 78      |      |  |      | (675     | ) |  |   | 265      |   |  |   | (2,132   | )
|Foreign currency translation adjustment                        |  |                    | (962       | )                  |  |                   |        |      |  |      | (32      | ) |  |   | 1,342    |   |  |   | (706     | )
|                                                               |  |                    |            |                    |  |                   |         |      |  |      |          |   |  |   |          |   |  |   |          |  
|Comprehensive loss                                             |  | $                  | (1,494,599 | )                  |  | $                 | (51,629 | )    |  | $    | (140,456 | ) |  | $ | (147,732 | ) |  | $ | (516,584 | )
|                                                               |  |                    |            |                    |  |                   |         |      |  |      |          |   |  |   |          |   |  |   |          |  



| |                                     
| | ------------------------------------
| | Recent Accounting
    Pronouncements

In July 2002, the Financial Accounting Standards
Board (FASB) issued Statement of Financial
Accounting Standards (SFAS) No. 146,
Accounting for Costs Associated with an Exit or Disposal
Activity. SFAS No. 146 revises the accounting for
exit and disposal activities under Emerging Issues Task Force
(EITF) Issue 94-3, Liability Recognition
for Certain Employee Termination Benefits and Other Costs to
Exit an Activity (Including Certain Costs Incurred in a
Restructuring) by extending the period in which expenses
related to restructuring activities are reported. A commitment
to a plan to exit an activity or dispose of long-lived assets
will no longer be sufficient to record a one-time charge for
most restructuring activities. Instead, companies will record
exit or disposal costs when they are incurred and can be
measured at fair value. In addition, the resultant liabilities
will be subsequently adjusted for changes in estimated cash
flows. SFAS No. 146 is effective prospectively for exit or
disposal activities initiated after December 31, 2002.
Companies may not restate previously issued financial statements
for the effect of the provisions of SFAS No. 146, and
liabilities that a company previously recorded under EITF
Issue 94-3 are grandfathered. The Company will adopt SFAS
No. 146 on January 1, 2003 and does not believe that
the adoption of SFAS No. 146 will have a material effect on
its consolidated financial statements.

6



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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In April 2002, the FASB issued SFAS No. 145,
Rescission of FASB Statements No. 4, 44, and 64,
Amendment of FASB Statement No. 13, and Technical
Corrections. SFAS No. 145 rescinds SFAS No. 4,
Reporting Gains and Losses from Extinguishment of
Debt, which required all gains and losses from
extinguishment of debt to be aggregated and, if material,
classified as an extraordinary item, net of related income tax
effect. SFAS No. 145, which is effective in periods
beginning after May 15, 2002, requires that gains or losses
from extinguishment of debt be classified as extraordinary items
only if they meet the criteria of APB Opinion No. 30. The
Company is required to adopt the provisions of SFAS No. 145
on January 1, 2003 and does not believe that the adoption
of SFAS No. 145 will have a material effect on its
consolidated financial statements.

On January 1, 2002, the Company adopted SFAS
No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, which supersedes SFAS No. 121,
Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of, and provides a single
accounting model for long-lived assets to be disposed of. The
adoption of SFAS No. 144 had no effect on the
Companys condensed consolidated financial statements.

On January 1, 2002, the Company adopted SFAS
No. 141, Business Combinations, and SFAS
No. 142, Goodwill and Other Intangibles Assets.
SFAS No. 141 eliminates the pooling-of-interests method of
accounting for business combinations, except for qualifying
business combinations that were initiated prior to July 1,
2001. Under SFAS No. 142, goodwill and indefinite-lived
intangible assets are no longer amortized, but are reviewed
annually for impairment or more frequently if impairment
indicators arise. The adoption of SFAS Nos. 141 and 142 had
no effect on the Companys condensed consolidated financial
statements.

On January 1, 2002, the Company adopted EITF
guidance regarding the provision in EITF Issue 00-25,
Vendor Income Statement Characterization of Consideration
from a Vendor to a Retailer, dealing with consideration
from a vendor to a reseller under cooperative advertising and
other arrangements. This provision of EITF Issue 00-25
states that consideration from a vendor to a reseller of the
vendors products or services is presumed to be a reduction
of the selling price of the vendors products or services,
unless the vendor (i) receives an identifiable benefit in
return for the consideration and (ii) can reasonably
estimate the fair value of the benefit received. If the amount
of consideration paid by the vendor exceeds the estimated fair
value of the benefit received, the excess amount is to be
recorded by the vendor as a reduction of revenues. The adoption
of this new guidance did not have a material effect on the
Companys condensed consolidated financial statements.

In August 2001, the FASB issued SFAS
No. 143, Accounting for Asset Retirement
Obligations. SFAS No. 143 requires that the fair
value of a liability for an asset retirement obligation be
recognized in the period in which it is incurred if a reasonable
estimate of fair value can be made. The associated asset
retirement costs are capitalized as part of the carrying amount
of the long-lived assets. The Company is required to adopt SFAS
No. 143 on January 1, 2003, and it does not believe
the adoption of SFAS No. 143 will have a material effect on
its consolidated financial statements.

On January 1, 2001, the Company adopted SFAS
No. 133, Accounting for Derivative Instruments and
Hedging Activities, as amended. SFAS No. 133
standardizes the accounting for derivatives and hedging
activities and requires that all derivatives be recognized in
the statement of financial position as either assets or
liabilities at fair value. Changes in the fair value of
derivatives that do not meet the hedge accounting criteria are
required to be reported in operations. The adoption of SFAS
No. 133 had no effect on the Companys condensed
consolidated financial statements.



| |                  
| | -----------------
| | Reclassifications

Certain balances in the Companys 2001
condensed consolidated financial statements have been
reclassified to conform to the presentation in 2002.

7



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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                                                           
|-- | ----------------------------------------------------------
|2. | Revenue Recognition and Change in Accounting
    Principle

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 and determinable and (iv) collectibility of the
sales price is reasonably assured. Revenues earned for which the
customer has not been billed are recorded as Unbilled
revenues in the condensed consolidated balance sheets.
Amounts billed in advance of providing service are deferred and
recorded as an element of the condensed consolidated balance
sheet caption Unearned revenues. Included in
revenues are Federal Universal Service Fund charges billed to
customers aggregating $1,861 and $7,757 for the three and nine
months ended September 30, 2002, respectively, and $2,967
and $10,094 for the three and nine months ended
September 30, 2001, respectively.

The Company has over 140 wholesale customers.
However, for the three and nine months ended September 30,
2002, the Companys 30 largest wholesale customers
collectively comprised 93.6% and 93.4%, respectively, of its
total wholesale revenues and 80.1% and 80.3%, respectively, of
its total revenues. As of September 30, 2002, receivables
from these customers collectively comprised 81.9% of the
Companys gross accounts receivable balance. For the three
and nine months ended September 30, 2001, the
Companys 30 largest wholesale customers collectively
comprised 90.6% and 82.6%, respectively, of its total wholesale
revenues and 81.0% and 74.1%, respectively, of its total
revenues. As of September 30, 2001, receivables from these
customers collectively comprised 86.2% of the Companys
gross accounts receivable balance.

For the three months ended September 30,
2002, two wholesale customers (Earthlink, Inc. and AT&T
Internet Services) individually accounted for 20.7% and 10.0%,
respectively, of the Companys total revenues. For the nine
months ended September 30, 2002, these wholesale customers
individually accounted for 20.5% and 9.2%, respectively, of the
Companys total revenues. As of September 30, 2002,
receivables from these wholesale customers individually
accounted for 39.3% and 8.2%, respectively, of the
Companys gross accounts receivable balance.

For the three months ended September 30,
2001, two wholesale customers (Earthlink, Inc. and XO
Communications) individually accounted for 17.8% and 10.9%,
respectively, of the Companys total revenues. For the nine
months ended September 30, 2001, these wholesale customers
individually accounted for 16.8% and 10.8%, respectively, of the
Companys total revenues. As of September 30, 2001,
receivables from these wholesale customers comprised 16.9% and
16.5%, respectively, of the Companys gross accounts
receivable balance.

Some of the Companys Internet service
provider (ISP) and telecommunications carrier
customers are experiencing financial difficulties. During the
three and nine months ended September 30, 2002 and 2001,
certain of these financially distressed customers either
(i) were not current in their payments for the
Companys services or (ii) were essentially current in
their payments but, subsequent to the end of the reporting
period, the financial condition of such customers deteriorated
significantly and certain of them have filed for bankruptcy
protection. Based on this information, the Company determined
that (i) the collectibility of revenues from these
customers was not reasonably assured or (ii) its ability to
retain some or all of the payments received from the customers
who have filed for bankruptcy protection was not reasonably
assured. Revenue related to customers that do not demonstrate
the ability to pay for services in a timely manner, but who have
not filed for bankruptcy protection, is recognized when cash for
those services is received, after the collection of all previous
outstanding accounts receivable balances. Payments received from
financially distressed customers during a defined period prior
to their filing of petitions for bankruptcy protection are
recorded in the consolidated balance sheet caption
Unearned revenues if the Companys ability to
retain these payments is not reasonably assured. During the
three months ended March 31, 2002, as a result of
developments in the bankruptcy proceedings of certain of the
Companys customers, the Company determined that its
ability to retain certain payments received from these bankrupt
customers prior to January 1, 2002 was now reasonably
assured. Accordingly, during the three months ended
March 31, 2002, the Company

8



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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

recognized revenues that were deferred as of
December 31, 2001 aggregating $3,307 (none during the three
months ended June 30, 2002). During the three months ended
September 30, 2002, due to developments in the bankruptcy
proceeding of another customer, the Company determined that its
ability to retain certain payments received from this bankrupt
customer prior to January 1, 2002 was now reasonably
assured. Accordingly, the Company recognized revenues of $1,120
that were deferred as of December 31, 2001.

A number of the Companys customers are
currently in bankruptcy proceedings. Revenues from these
customers accounted for approximately 18.9% and 19.6% of the
Companys total revenues for the three and nine months
ended September 30, 2002, respectively, and 17.7% and 20.4%
of its total revenues for the three and nine months ended
September 30, 2001, respectively. Although WorldCom, a
wholesale customer of the Company, filed for bankruptcy
protection in July 2002, the Company continued to recognize
revenues from WorldCom on an accrual basis based on the revenue
recognition criteria described above. Consequently, the
disclosures in the following paragraph exclude amounts
pertaining to WorldCom because this customer is not presently
classified as financially distressed by the Company. The Company
continues to attempt to migrate end users from certain of these
financially distressed customers to the extent it is legally and
operationally feasible.

The Company issued billings to its financially
distressed customers, including those that have filed for
bankruptcy protection (excluding WorldCom, as noted above),
aggregating $7,447 and $39,779 during the three and nine months
ended September 30, 2002, respectively, that were not
recognized as revenues or accounts receivable in the condensed
consolidated financial statements, as compared to the
corresponding amounts of $15,317 and $52,636 for the three and
nine months ended September 30, 2001, respectively.
However, the Company ultimately recognized revenues from certain
of these financially distressed customers on a cash basis (as
described above) aggregating $12,077 and $43,446 during the
three and nine months ended September 30, 2002,
respectively, and $5,839 and $15,715 during the three and nine
months ended September 30, 2001, respectively, some of
which related to services provided in prior periods. The Company
had contractual receivables from its financially distressed
customers, including receivables of $6,026 from customers that
have filed for bankruptcy protection (excluding WorldCom, as
noted above), totaling $6,250 as of September 30, 2002 that
are not reflected in the accompanying condensed consolidated
balance sheet as of such date.

The Company has obtained information indicating
that some of its customers, including WorldCom, who
(i) were essentially current in their payments for the
Companys services prior to September 30, 2002, and
(ii) have subsequently paid all or significant portions of
the respective amounts recorded as accounts receivable by the
Company as of September 30, 2002, may become financially
distressed. Revenues from these customers accounted for
approximately 25.6% and 25.1% of the Companys total
revenues for the three and nine months ended September 30,
2002, respectively. As of September 30, 2002, receivables
from these customers comprised 28.6% of the Companys gross
accounts receivable balance. If these customers are unable to
demonstrate their ability to pay for the Companys services
in a timely manner in periods ending subsequent to
September 30, 2002, revenue from these customers will be
recognized on a cash basis as described above.

The Company has obtained persuasive evidence
indicating that the financial condition of one of its customers,
which was designated as financially distressed in 2000, improved
significantly during the three months ended June 30, 2002,
principally as a result of a capital infusion during this
period. Consequently, management concluded that collection of
the Companys billings to this customer was now reasonably
assured. Therefore, the Company resumed recognition of revenues
from this customer on an accrual basis during the second quarter
of 2002, which resulted in the recognition of a receivable
balance and revenues in the amount of approximately $1,542 as of
and for the three months ended June 30, 2002 that relate to
services rendered in periods ended prior to April 1, 2002.
The Company collected such receivable balance in full during

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COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

July 2002. No similar amounts were recognized
during the other periods reported in the accompanying condensed
consolidated financial statements.

The Company has billing disputes with certain 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.
Accordingly, the Company maintains an allowance, through charges
to revenues (which amounted to $540 and $2,130 during the three
and nine months ended September 30, 2002, respectively, and
$1,293 and $9,253 during the three and nine months ended
September 30, 2001, respectively), based on its estimate of
the ultimate resolution of these disputes.

During the fourth quarter of 2000, retroactive to
January 1, 2000, the Company changed its method of
accounting for up-front fees associated with service activation
and the related incremental direct costs in accordance with SEC
Staff Accounting Bulletin (SAB) No. 101,
Revenue Recognition in Financial Statements.
Previously, the Company had recognized up-front fees as revenues
upon activation of service. Under the new accounting method,
which was adopted retroactive to January 1, 2000, the
Company now recognizes up-front fees associated with service
activation over the expected term of the customer relationship,
which is presently estimated to be 24 months, using the
straight-line method. Also as a result of the adoption of SAB
No. 101, retroactive to January 1, 2000, the Company
now treats the incremental direct costs of service activation
(which consist principally of customer premise 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,
and such deferred incremental direct costs are amortized to
network and product costs using the straight-line method over
24 months. The cumulative effect of the change in
accounting principle resulted in a charge to operations of
$9,249, which was included in net loss for the year ended
December 31, 2000. For the three and nine months ended
September 30, 2001, the Company recognized $2,697 and
$10,640, respectively, in revenue that was included in the
cumulative effect adjustment as of January 1, 2000 (none
during the three or nine months ended September 30, 2002).
The effect of that revenue during the three and nine months
ended September 30, 2001 was to reduce net loss by $688 and
$2,777, respectively.



|   |                  
|-- | -----------------
|3. | Customer Warrants

On September 4, 2002, in conjunction with
the execution of a five-year Broadband Internet Access Service
Agreement (the Broadband Agreement) with America
Online, Inc. (AOL), a wholesale customer, the
Company granted AOL three warrants to purchase an aggregate of
3,500,000 shares of its common stock at prices of $1.06,
$3.00 and $5.00 per share. Such warrants were immediately
exercisable, fully vested and non-forfeitable 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
approximately $3,800, which was determined using a Black-Scholes
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 will be recognized
as a reduction of revenues on a straight-line basis over the
five-year term of the Broadband Agreement because management
believes that future revenues from AOL will exceed the fair
value of the warrants described above. However, because the
Broadband Agreement contains no minimum purchase commitment and
is cancelable under certain circumstances by AOL, the Company
will continue to monitor the recoverability of the deferred
customer incentive balance described above in periods ending
subsequent to September 30, 2002.

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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |               
|-- | --------------
|4. | Asset Purchase

On January 3, 2002, the Company purchased
substantially all of the assets of InternetConnect, a related
party, in an auction supervised by the United States Bankruptcy
Court for the Central District of California. The purchase price
for these assets was $5,470 in cash, $235 of which had been
deposited with InternetConnects agent prior to
December 31, 2001. (Under the terms of the asset purchase
agreement, the Company may be required to pay additional cash of
up to $1,880, depending upon the outcome of a previous
post-petition bankruptcy claim filed against InternetConnect by
the Company, which is still pending before the court.) The
Company did not assume any liabilities or obligations of
InternetConnect or hire any of InternetConnects employees.
In addition, the Company does not believe the assets acquired
from InternetConnect constitute a self-sustaining business.

The tangible assets of InternetConnect purchased
by the Company consisted of accounts receivable, refundable
deposits and property and equipment. The Company also purchased
the right, but not the obligation, to assume
InternetConnects customer contracts. However, the Company
did not exercise this right. Instead, the Company solicited the
approximate 9,250 digital subscriber line (DSL),
T-1, virtual private network (VPN) and dial-up
customers of InternetConnect, and approximately 6,200 of such
customers executed new contracts with the Company and its
resellers subsequent to January 3, 2002.

The Company has allocated the aforementioned
purchase price based on the estimated fair values of the
elements of this transaction as of January 3, 2002, as
follows:

|                           |  |   |       | 
|-------------------------- |  | - | ----- | 
|Accounts receivable        |  | $ | 1,386 | 
|Refundable deposits        |  |   | 349   | 
|Property and equipment     |  |   | 61    | 
|Customer acquisition costs |  |   | 3,674 | 
|                           |  |   |       | 
|                           |  | $ | 5,470 | 
|                           |  |   |       | 

The customer acquisition costs of $3,674
described above were charged to network and product costs for
the three months ended March 31, 2002 (i) because the
Companys relationship with InternetConnects former
customers did not exist as of January 3, 2002 and
(ii) based on the Companys accounting policy for
costs of this nature that are not accompanied by up-front fees
(Note 2).

5.     Property
Sale

During the fourth quarter of 2001, the Company
tentatively decided to sell land, a building and certain
improvements located in Manassas, Virginia. This property was
part of the Companys wholesale segment. In March 2002, the
Company entered into a non-binding letter of intent with a third
party to sell such property for $14,000, which was subject to
approval by the Companys board of directors. In April
2002, the Company received the necessary approval from its board
of directors to proceed with the sale of this property (at which
time the Company suspended depreciation of the building and
related improvements when such assets had an aggregate carrying
value of $13,201). In June 2002, the Company completed the sale
of this property and recognized a gain of $133 in the
accompanying condensed consolidated statements of operations,
which represents the net proceeds of $13,334 less the aggregate
carrying value of the property as described above.

6.     Reorganization
Under Bankruptcy Proceedings

On August 15, 2001 (the Petition
Date), Covad, excluding its operating subsidiaries, filed
a voluntary petition (the Petition) under
Chapter 11 of the United States Bankruptcy Code (the
Bankruptcy Code) for the purpose of confirming its
pre-negotiated First Amended Plan of Reorganization, as modified
on November 26, 2001 (the Plan), with the
majority holders of its senior notes. The Petition was filed
with the

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COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

United States Bankruptcy Court for the District
of Delaware (the Bankruptcy Court) and was assigned
Case No.01-10167 (JJF). As of the Petition Date, Covad
commenced operating its business and managing its properties as
a debtor-in-possession. On December 13, 2001, the
Bankruptcy Court entered an order confirming the Plan and, on
December 20, 2001, the Plan was consummated and Covad
emerged from bankruptcy. However, the Bankruptcy Court still
maintains jurisdiction over certain administrative matters
related to the implementation of the Plan, including the
unresolved claims described below.

Condensed financial information of Covad as of
and for the three and nine months ended September 30, 2001
is as follows:

CONDENSED BALANCE SHEET

As of September 30, 2001


(Unaudited)


|                                                               |                                                                                                                  |                                             |                                           |            |           |   | 
|-------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------- | ------------------------------------------- | ----------------------------------------- | ---------- | --------- | - | 
|ASSETS                                                         |                                                                                                                  |                                             |                                           |           
|Current assets:                                                |                                                                                                                  |                                             |                                           |           
|                                                               | Cash and cash equivalents                                                                                        |                                             | $                                         | 28,000     |          
|                                                               | Restricted cash and investments                                                                                  |                                             |                                           | 270,600    |          
|                                                               | Other receivables                                                                                                |                                             |                                           | 700        |          
|                                                               |                                                                                                                  |                                             |                                           |           
|                                                               |                                                                                                                  | Total current assets                        |                                           |            | 299,300   |  
|Investments in and net advances to subsidiaries                |                                                                                                                  |                                             | 454,100                                   |           
|Deferred debt issuance costs                                   |                                                                                                                  |                                             | 33,300                                    |           
|                                                               |                                                                                                                  |                                             |                                           |           
|                                                               |                                                                                                                  | Total assets                                |                                           | $          | 786,700   |  
|                                                               |                                                                                                                  |                                             |                                           |           
|                                                               |                                                                                                                  |                                             | LIABILITIES AND STOCKHOLDERS
    DEFICIT |            |           |   | 
|Current liabilities:                                           |                                                                                                                  |                                             |                                           |           
|                                                               | Prepetition liabilities subject to compromise,
    net of discount of $9,500                                     |                                             | $                                         | 1,410,000  |          
|                                                               | Postpetition liabilities                                                                                         |                                             |                                           | 14,700     |          
|                                                               |                                                                                                                  |                                             |                                           |           
|                                                               |                                                                                                                  | Total current liabilities                   |                                           |            | 1,424,700 |  
|Deferred gain resulting from deconsolidation of
    subsidiary |                                                                                                                  |                                             | 55,300                                    |           
|                                                               |                                                                                                                  |                                             |                                           |           
|                                                               |                                                                                                                  | Total liabilities                           |                                           |            | 1,480,000 |  
|Commitments and contingencies                                  |                                                                                                                  |                                             |                                           |           
|                                                               | Stockholders deficit:                                                                                           |                                             |                                           |            |          
|                                                               | Preferred stock, $0.001 par value; 5,000,000
    shares authorized; no shares issued and outstanding             |                                             |                                           |           |          
|                                                               | Common Stock, $0.001 par value; 590,000,000
    shares authorized; 177,818,753 shares issued and outstanding     |                                             |                                           | 200        |          
|                                                               | Common Stock  Class B, $0.001 par
    value; 10,000,000 shares authorized; no shares issued and
    outstanding |                                             |                                           |           |          
|                                                               | Additional paid-in capital                                                                                       |                                             |                                           | 1,512,200  |          
|                                                               | Deferred stock-based compensation                                                                                |                                             |                                           | (400       | )        
|                                                               | Accumulated other comprehensive income (loss)                                                                    |                                             |                                           | (2,300     | )        
|                                                               | Accumulated deficit                                                                                              |                                             |                                           | (2,203,000 | )        
|                                                               |                                                                                                                  |                                             |                                           |           
|                                                               |                                                                                                                  | Total stockholders deficit                 |                                           |            | (693,300  | )
|                                                               |                                                                                                                  |                                             |                                           |           
|                                                               |                                                                                                                  | Total liabilities and stockholders deficit |                                           | $          | 786,700   |  
|                                                               |                                                                                                                  |                                             |                                           |           

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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

CONDENSED STATEMENTS OF OPERATIONS

For the Period Ended September 30,
2001


(Unaudited)


|                                                                                         |                                                                                                                                                       |              |             |             |   |   |             |          |  
|---------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------- | ------------ | ----------- | ----------- | - | - | ----------- | -------- | -
|                                                                                         |                                                                                                                                                       | Three Months |             | Nine Months
|                                                                                         |                                                                                                                                                       |              |             |            
|Other income (expense):                                                                  |                                                                                                                                                       |              |             |             |   |   |             |         
|                                                                                         | Interest income                                                                                                                                       |              | $           | 3,700       |   |   | $           | 20,500   |  
|                                                                                         | Realized gain on short-term investments                                                                                                               |              |             |            |   |   |             | 6,100    |  
|                                                                                         | Other than temporary losses on short-term
    investments                                                                                             |              |             |            |   |   |             | (1,300   | )
|                                                                                         | Other expenses                                                                                                                                        |              |             | (200        | ) |   |             | (500     | )
|                                                                                         | Equity in losses of subsidiaries                                                                                                                      |              |             | (121,000    | ) |   |             | (442,000 | )
|                                                                                         | Interest expense (Contractual interest expense
    was $36,200 and $110,400 for the three and nine months ended
    September 30, 2001, respectively) |              |             | (18,300     | ) |   |             | (92,600  | )
|                                                                                         | Reorganization expenses, net                                                                                                                          |              |             | (3,900      | ) |   |             | (3,900   | )
|                                                                                         |                                                                                                                                                       |              |             |             |   |   |             |         
|                                                                                         | Other income (expense), net                                                                                                                           |              |             | (139,700    | ) |   |             | (513,700 | )
|                                                                                         |                                                                                                                                                       |              |             |             |   |   |             |         
|Net loss                                                                                 |                                                                                                                                                       | $            | (139,700    | )           |   | $ | (513,700    | )       
|                                                                                         |                                                                                                                                                       |              |             |             |   |   |             |         
|Basic and diluted net loss per common share                                              |                                                                                                                                                       | $            | (0.79       | )           |   | $ | (2.94       | )       
|                                                                                         |                                                                                                                                                       |              |             |             |   |   |             |         
|Weighted average common shares used in computing
    basic and diluted per share amounts |                                                                                                                                                       |              | 176,829,127 |             |   |   | 174,507,085 |         
|                                                                                         |                                                                                                                                                       |              |             |             |   |   |             |         

CONDENSED STATEMENT OF CASH FLOWS

For the Nine Months Ended September 30,
2001


(Unaudited)


|                                      |                                                                                 |                                                                                 |                                                                                |          |         |        |  
|------------------------------------- | ------------------------------------------------------------------------------- | ------------------------------------------------------------------------------- | ------------------------------------------------------------------------------ | -------- | ------- | ------ | -
|Operating Activities:                 |                                                                                 |                                                                                 |                                                                                |         
|                                      | Net loss                                                                        |                                                                                 | $                                                                              | (513,700 | )      
|                                      | Adjustments to reconcile net loss to net cash
    used in operating activities: |                                                                                 |                                                                                |          |        
|                                      |                                                                                 | Amortization of deferred stock-based compensation                               |                                                                                |          | 1,400   |       
|                                      |                                                                                 | Accretion of interest on investments                                            |                                                                                |          | (6,500  | )     
|                                      |                                                                                 | Accretion of debt discount and amortization of
    deferred debt issuance costs |                                                                                |          | 21,000  |       
|                                      |                                                                                 | Realized gain on short-term investments                                         |                                                                                |          | (6,100  | )     
|                                      |                                                                                 | Other than temporary losses on short-term
    investments                       |                                                                                |          | 1,300   |       
|                                      |                                                                                 | Equity in losses of subsidiaries                                                |                                                                                |          | 442,000 |       
|                                      |                                                                                 | Net changes in operating assets and liabilities:                                |                                                                                |          |         |       
|                                      |                                                                                 |                                                                                 | Prepetition accounts payable and accrued
    liabilities subject to compromise |          |         | (7,600 | )
|                                      |                                                                                 |                                                                                 | Postpetition accounts payable and accrued
    liabilities                      |          |         | 14,700 |  
|                                      |                                                                                 |                                                                                 | Other liabilities                                                              |          |         | (2,700 | )
|                                      |                                                                                 |                                                                                 |                                                                                |         
|Net cash used in operating activities |                                                                                 |                                                                                 | (56,200                                                                        | )       
|Investing Activities:                 |                                                                                 |                                                                                 |                                                                                |         
|                                      | Purchase of short-term investments                                              |                                                                                 |                                                                                | (442,100 | )      
|                                      | Maturities of short-term investments                                            |                                                                                 |                                                                                | 434,800  |        

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COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                      |                                                                                     |  |   |          |  
|--------------------- | ----------------------------------------------------------------------------------- |  | - | -------- | -
|                      | Sale of short-term investments                                                      |  |   | 329,800  |  
|                      | Purchase of restricted investments in connection
    with the bankruptcy proceeding |  |   | (257,200 | )
|                      | Advances to subsidiary and affiliated undertakings                                  |  |   | (541,500 | )
|                      |                                                                                     |  |   |         
|                      | Net cash used in investing activities                                               |  |   | (476,200 | )
|Financing Activities: |                                                                                     |  |   |         
|                      | Proceeds from common stock issuance                                                 |  |   | 3,900    |  
|                      |                                                                                     |  |   |         
|                      | Net cash provided by financing activities                                           |  |   | 3,900    |  
|                      |                                                                                     |  |   |         
|                      | Net decrease in cash and cash equivalents                                           |  |   | (528,500 | )
|                      | Cash and cash equivalents at beginning of period                                    |  |   | 556,500  |  
|                      |                                                                                     |  |   |         
|                      | Cash and cash equivalents at end of period                                          |  | $ | 28,000   |  
|                      |                                                                                     |  |   |         

Operating cash receipts and payments made by
Covad resulting from the Plan are as follows for the period of
August 15, 2001 through September 30, 2001:

|                    |                   |                          |   |     |     | 
|------------------- | ----------------- | ------------------------ | - | --- | --- | 
|Cash receipts:      |                   |                          |   |    
|                    | Interest received |                          | $ | 600 |    
|                    |                   |                          |   |    
|                    |                   | Total cash receipts      |   | $   | 600 | 
|                    |                   |                          |   |    
|Cash disbursements: |                   |                          |   |    
|                    | Interest paid     |                          | $ | 100 |    
|                    |                   |                          |   |    
|                    |                   | Total cash disbursements |   | $   | 100 | 
|                    |                   |                          |   |    

As of September 30, 2001, the Plan had not
been confirmed by the Bankruptcy Court. Accordingly, all
unsecured, prepetition obligations that had not been approved
for payment by the Bankruptcy Court were segregated in the
Companys condensed consolidated balance sheet as of
September 30, 2001 as Prepetition liabilities subject
to compromise.

As of September 30, 2001, Covads
prepetition liabilities subject to compromise consisted of the
following:

|                                                             |       |   |           |           | 
|------------------------------------------------------------ | ----- | - | --------- | --------- | 
|Long-term debt (net of discount of $9,500)                   |       | $ | 1,342,000 |          
|Accrued interest                                             |       |   | 40,900    |          
|Accrued market development funds and customer
    incentives |       |   | 15,000    |          
|Unearned revenue and other                                   |       |   | 5,000     |          
|Accounts payable                                             |       |   | 1,300     |          
|Accrued collocation and network service fees                 |       |   | 1,200     |          
|Other accrued liabilities                                    |       |   | 4,600     |          
|                                                             |       |   |           |          
|                                                             | Total |   | $         | 1,410,000 | 
|                                                             |       |   |           |          

As of September 30, 2001, since the Plan had
not been confirmed and no claims had been allowed by the
Bankruptcy Court, Covads prepetition liabilities subject
to compromise were reported at their historical amounts in the
Companys condensed consolidated balance sheet as of
September 30, 2001 in accordance with AICPA Statement of
Position (SOP) 90-7, Financial Reporting by
Entities in Reorganization Under the Bankruptcy Code.

Furthermore, for financial reporting purposes,
the Company was required to recognize interest expense during
the Chapter 11 proceedings only to the extent that it would
be paid during the proceedings or it was

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COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

probable that it would be an allowed claim.
Accordingly, the Company did not recognize interest expense on
its long-term obligations that were subject to compromise. For
the three and nine months ended September 30, 2001, the
Companys reported interest expense was $18,300 and
$92,600, respectively. For the three and nine months ended
September 30, 2001, the Companys contractual interest
expense was $36,169 and $110,415, respectively.

As of September 30, 2001, Covads
postpetition liabilities consisted of the following:

|                                             |       |   |       |        | 
|-------------------------------------------- | ----- | - | ----- | ------ | 
|Accrued collocation and network service fees |       | $ | 5,000 |       
|Accounts payable                             |       |   | 4,100 |       
|Other accrued liabilities                    |       |   | 5,600 |       
|                                             |       |   |       |       
|                                             | Total |   | $     | 14,700 | 
|                                             |       |   |       |       

All other liabilities reflected in the
Companys condensed consolidated balance sheet as of
September 30, 2001 represent liabilities that were not
subject to compromise as a result of the Plan.

In accordance with SOP 90-7, expenses
resulting from the restructuring are reported separately as
reorganization items. For the three and nine months ended
September 30, 2001, the Company recognized expenses
directly associated with Covads Chapter 11 bankruptcy
proceeding in the amount of $4,100 (none during the three and
nine months ended September 30, 2002). These reorganization
expenses consisted primarily of professional fees for legal and
financial advisory services. In addition, for the three and nine
months ended September 30, 2001, the Company recognized
interest income in the amount of $204 on accumulated cash that
Covad did not disburse as a result of its Chapter 11
reorganization proceedings (none during the three and nine
months ended September 30, 2002). Such interest income has
been offset against the aforementioned reorganization expenses
in the Companys condensed consolidated statements of
operations for the three and nine months ended
September 30, 2001.

There were unresolved claims related to
Covads Chapter 11 bankruptcy proceedings aggregating
$31,608 and $10,959 as of December 31, 2001 and
September 30, 2002, respectively. The Company has recorded
these unresolved claims in its condensed consolidated balance
sheets based on the amount of such claims allowed by the
Bankruptcy Court (adjusted for changes in the value of the
Companys common stock after December 20, 2001),
unless the Company has persuasive evidence indicating that a
claim is duplicative with another allowed claim that was settled
previously or is otherwise in error. In these cases, the
unresolved claim does not meet the criteria for recognition in
the Companys condensed consolidated financial statements.
However, it is reasonably possible that the Companys
unresolved Chapter 11 bankruptcy claims could ultimately be
settled for amounts that differ from the aggregate liability for
Unresolved claims related to bankruptcy proceedings
reflected in the accompanying condensed consolidated balance
sheet as of September 30, 2002.

As of December 31, 2001 and
September 30, 2002, the Company (i) held $8,000 and
$500, respectively, of cash in a reserve fund, classified as
Restricted cash and investments in the accompanying
condensed consolidated balance sheets, and (ii) had
reserved 7,295,844 and 6,528,733 shares of common stock,
respectively, pending the resolution of the aforementioned
unresolved claims.

7.     Other
Restructuring Activities

BlueStar Communications Group, Inc. and its
subsidiaries (collectively, BlueStar), which were
acquired by the Company on September 22, 2000 in a
transaction accounted for as a purchase, provided broadband
communications and Internet services to small and medium sized
businesses in smaller cities using a direct sales model.
Continued losses at BlueStar, with no near term possibility of
improvement, caused the Companys board of directors to
decide to cease the Companys funding of BlueStars
operations on June 22, 2001. Subsequently, on June 25,
2001, BlueStar terminated all of its 365 employees.
However, 59 of

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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

BlueStars former employees were temporarily
retained by the Company for varying periods through
July 31, 2001 to assist with the migration of certain
BlueStar end user lines to the Companys network, as
described below. In addition, the Company hired 69 of
BlueStars former employees after June 25, 2001.

On June 24, 2001, the Company and BlueStar
entered into a Purchase Agreement (PA) under which
the Company has purchased the right to offer service to
BlueStars customers, subject to BlueStars right to
seek higher offers. The Company paid approximately $2,000 in
2001 under the PA and has no additional liabilities under the PA
as of September 30, 2002. To facilitate the migration of
Bluestars customers, the Company and BlueStar entered into
a Migration Agreement on July 12, 2001 that required the
Company to pay certain amounts contemplated in the PA directly
to certain former employees of BlueStar and certain BlueStar
vendors, including the Assignee, as defined below. The Company
made payments aggregating approximately $700 and $5,100 in
connection with BlueStars cessation of operations during
the three and nine months ended September 30, 2001,
respectively. Of this aggregate amount, approximately $1,300
represented employee severance benefits, approximately $2,000
represented customer acquisition costs under the PA and
approximately $1,800 represented legal and other professional
fees relating to the liquidation of BlueStar, as described
below. Such (i) severance benefits and professional fees
and (ii) customer acquisition costs were charged to
(i) restructuring expenses and (ii) network and
product costs, respectively, in the Companys condensed
consolidated statement of operations for the three and nine
months ended September 30, 2001.

On June 25, 2001, BlueStar made an
irrevocable assignment for the benefit of creditors
(ABC) of all its assets to an independent trustee
(the Assignee) in the State of Tennessee.
Immediately thereafter, the Assignee began an orderly
liquidation of BlueStar that was initially expected to be
completed in the fourth quarter of 2002. However, the Assignee
has informed the Company that it is still in the process of
resolving some matters among BlueStars creditors and that
the process may extend into the second half of 2003.

An ABC under Tennessee law is a non-judicial
alternative to a plan of liquidation under Chapter 7 of the
Bankruptcy Code. As a result of the ABC, BlueStars former
assets are no longer controlled by BlueStar or the Company and
cannot be used by either BlueStars or the Companys
board of directors to satisfy the liabilities of BlueStar.
Consequently, the liquidation of BlueStars assets and the
discharging of its liabilities are currently under the sole
control of the Assignee and the control of BlueStars
assets no longer rests with the Company. Therefore, the Company
deconsolidated BlueStar effective June 25, 2001, which
resulted in the recognition of a deferred gain in the amount of
$55,200 in the Companys condensed consolidated balance
sheets as of September 30, 2002 and December 31, 2001.
Such deferred gain represents the difference between the
carrying values of BlueStars assets (aggregating
approximately $7,900) and liabilities (aggregating approximately
$63,100) as of June 25, 2001. The Company will recognize
such deferred gain in its statement of operations when the
liquidation of BlueStar is complete and its liabilities have
been discharged.

Under the terms of the acquisition agreement
dated September 22, 2000, up to 5.0 million additional
shares of the Companys common stock were to be issued to
BlueStars former stockholders if BlueStar achieved certain
specified levels of revenues and earnings before interest,
taxes, depreciation and amortization in 2001. However, during
April 2001, the Company reached an agreement with the BlueStar
stockholders representative to resolve this matter, as
well as the matters that caused 0.8 million of the
Companys common shares to be held in escrow as of
December 31, 2000, by providing the BlueStar stockholders
with 3.25 million of the 5.0 million shares, in
exchange for a release of claims against the Company. The
0.8 million common shares were ultimately returned to the
Company under this agreement. These transactions were approved
by more than 80% of BlueStars stockholders on
June 27, 2001. BlueStars former stockholders received
the additional shares of the Companys common stock
subsequent to June 30, 2001. Consequently, the Company
recorded an estimated liability in the amount of $2,230 through
a charge to goodwill during the three months ended June 30,
2001. However, the Company determined that such goodwill was
impaired based on BlueStars continued operating losses, as
described above. Therefore, such goodwill balance was
written-off through a charge to operations of $2,230 during the
three months ended June 30, 2001, which was

16



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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

subsequently reduced by $241 during the three
months ended September 30, 2002 due to a revision of the
initial estimate.

During the fourth quarter of 2000, the Company
announced a comprehensive restructuring plan that involved the
following steps:



| |   |                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | raising revenue by reducing rebates and other
    incentives that the Company provides to customers and reducing
    new line addition plans for 2001 to improve margins and reduce
    subscriber payback times;
|
| |  | closing approximately 200 under-performing or not
    fully built-out central offices and reducing the size of the
    Companys network to approximately 1,700 central offices;                                 
|
| |  | reducing the Companys workforce by 638
    employees, which represented approximately 21% of the
    Companys workforce;                                                                                       
|
| |  | closing a facility in Alpharetta, Georgia and
    consolidating offices in Manassas, Virginia, Santa Clara,
    California and Denver, Colorado.                                                                 
|
| |  | continued downsizing of the Companys
    international operations and discontinuing plans to fund
    additional international expansion while continuing to manage
    existing investments;                   
|
| |  | enhancing productivity in the Companys
    operations to increase customer satisfaction while reducing
    costs;                                                                                               
|
| |  | restructuring the Companys direct sales and
    marketing channel; and                                                                                                                                          
|
| |  | evaluating and implementing other cost reduction
    strategies, including salary freezes and reductions in travel,
    facilities and advertising expenses.                                                     

In connection with this restructuring plan, the
Company recorded a charge to operations of $4,988 in the fourth
quarter of 2000 relating to employee severance benefits that met
the requirements for accrual as of December 31, 2000.
During the three months ended September 30, 2001, the
Company reduced its workforce by three employees and paid
severance benefits of $200, which were charged against the
restructuring liability recorded as of December 31, 2000.
For the nine months ended September 30, 2001, the total
workforce was reduced by 638 employees and the Company paid
$4,000 in severance benefits, which were charged against the
restructuring liability recorded as of December 31, 2000.

The Company recorded additional restructuring
expenses aggregating $14,805 and $1,000 during the first and
second quarters of 2001, respectively. These expenses consisted
principally of collocation and building lease termination costs
that met the requirements for accrual during these periods. No
additional restructuring expenses were recorded by the Company
during the three months ended September 30, 2001. During
the three and nine months ended September 30, 2001, the
Company paid collocation and building lease termination costs of
$400 and $4,900, respectively, which were charged against the
restructuring liabilities recorded during the first and second
quarters of 2001. The Company completed the restructuring
activities that were initiated in 2000 during the fourth quarter
of 2001. Therefore, the Company neither recognized nor paid any
restructuring expenses during the three and nine months ended
September 30, 2002. However, management continues to
consider whether additional restructuring is necessary, and
additional charges to operations related to any further
restructuring activities may be incurred in future periods.

17



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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

8.     Contingencies

Litigation

As described in Note 6, on December 13,
2001, the Bankruptcy Court entered an order confirming the Plan
and, on December 20, 2001, 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,
    provided that this settlement will not be final unless it is
    approved by that court. This settlement is described in more
    detail below.
|
| |  | The lawsuits filed in the Superior Court of the
    State of California for the County of Santa Clara by six
    purchasers of the convertible notes that the Company issued in
    September 2000.                                                                 
|
| |  | Disputed claims made by former shareholders of
    Laser Link.net.                                                                                                                                                                                                  
|
| |  | Disputed claims made by GE Capital and its
    subsidiary, Heller Financial Group.                                                                                                                                                                                  

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. On August 10, 2001, the Company signed an MOU with
counsel for the lead plaintiffs in this litigation that
tentatively resolves the litigation. Under this agreement, the
Company is to contribute 6,495,844 common shares to the
settlement. The Companys insurance carriers would fund the
cash portion of the settlement. This settlement was approved by
the Bankruptcy Court on December 20, 2001. Final settlement
is contingent on the additional approval by the District Court,
which preliminarily approved the settlement on October 29,
2002. Additionally, the Company, based on the advice of legal
counsel, believes it is more likely than not that this
settlement will ultimately be approved by the District Court.
Consequently, the Company recorded a liability of approximately
$4,000 in its condensed consolidated balance sheet as of
June 30, 2001 through a charge to litigation-related
expenses for the three months 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 $2,400 as of September 30, 2001
through a credit to litigation-related expenses in the amount of
$1,600 for the three months then ended, increased this liability
to $18,578 as of December 31, 2001 through a charge to
litigation-related expenses in the amount of $16,178 for the
three months then ended and decreased this liability to $9,549
as of September 30, 2002 through charges (credits) to
litigation-related expenses in the amount of $1,884 and $(9,029)
for the three and nine months ended September 30, 2002,
respectively. The Company will continue to remeasure this
liability in future periods, based on changes in the underlying
value of the Companys common stock until this litigation
is resolved.

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
Company believes it has strong

18



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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

defenses to these lawsuits and intends to contest
them vigorously. However, because these lawsuits are at an early
stage, the Company is unable to provide an evaluation of the
ultimate outcome of the litigation.

In September 2000, a manufacturer of
telecommunications hardware filed a complaint against the
Company in the United States District Court for the District of
Arizona, alleging claims for false designation of origin,
infringement and unfair competition. The plaintiff is seeking an
injunction to stop the Company from using the COVAD trademark,
as well as an award of monetary damages. The Company does not
believe these claims have any merit, but the outcome of this
litigation cannot presently be determined.

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. 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 pursing antitrust and other claims in
this lawsuit similar to its claims against Verizon. Both courts
have dismissed some of the Companys claims on the basis of
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 has
appealed these rulings to the Eleventh Circuit Court of Appeals
and the 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 has
requested a rehearing before the Eleventh Circuit and that
request is still pending. The Company cannot predict the outcome
of these matters.

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 its services to its customers. The complaint claims that
the Company falsified trouble ticket reports with respect to the
phone lines that the Company ordered and seeks unspecified
monetary damages and injunctive relief. The current complaint
asserts causes of action for negligent and intentional
misrepresentation and violations of Californias unfair
competition statute. This lawsuit is at an early stage, so the
Company is unable to provide an evaluation of the ultimate
outcome.

An unfavorable outcome in any of the pending
legal proceedings described above could have a material adverse
effect on the Companys consolidated financial position and
results of operations.

The Company is also a party to a variety of other
legal proceedings, as either plaintiff or defendant, and is
engaged in other disputes that arise in the ordinary course of
its business. The Company believes these other matters will be
resolved without a material adverse effect on the its
consolidated financial position and results of operations, other
than the fees and expenses necessary to defend these actions.

Other
Contingencies

On May 24, 2002, the United States Court of
Appeals for the District of Columbia vacated the Federal
Communications Commissions (FCC) decision
granting Competitive Local Exchange Carriers like the Company
the ability to purchase line-shared services from the
traditional telephone companies. The Court of Appeals remanded
the matter to the FCC and it is unclear when the FCC will issue
a new order concerning line-sharing. The FCC and the Company
filed a Motion for Reconsideration and a request to stay
vacature of the line sharing order with the Court of Appeals
pending the FCCs review of the line sharing order. On
September 4, 2002, the Court of Appeal denied the
FCCs and the Companys Motion for Reconsideration,
but granted the request to stay vacature of the line sharing
order until January 2, 2003. The Company therefore has the
continued right to line sharing until at least January 2,
2003. Management also believes that the Company has a continued
right to line-sharing under its interconnection agreements with
the traditional

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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

telephone companies, but those agreements do
allow the traditional telephone companies to renegotiate their
terms based on a change in law. If the traditional telephone
companies invoke this change-in-law provision, or if the FCC
does not issue a new order allowing the Company to purchase
line-shared services, it is possible that the traditional
telephone companies could either refuse to sell the Company such
services or could substantially increase the cost of line-shared
services, either of which would have a material adverse effect
on the Company and could even result in a liquidation or sale of
the Company. The court also remanded the list of unbundled
network elements that had been developed by the FCC. The FCC is
in the process of reviewing the list of unbundled network
elements, which include the transmission facilities and
telephone lines that the Company purchases from the traditional
telephone companies in order to provide services to its
customers. If the FCC removes any of the Companys existing
transmission facilities or telephone lines from the previous
list of unbundled network elements, the traditional telephone
companies could either increase the cost of obtaining such
transmission facilities and telephone lines or deny the Company
access entirely, which would adversely affect the Company.

As of September 30, 2002, the Company had
disputes with a number of telecommunications companies
concerning the balances owed to such carriers for collocation
fees and certain network services. The Company believes that
such disputes will be resolved without a material adverse effect
on its consolidated financial position and results of
operations. However, it is reasonably possible that the
Companys estimates of its collocation fee and network
service obligations, as reflected in the accompanying condensed
consolidated balance sheets, could change in the near term, and
the effects could be material to the Companys consolidated
financial position and results of operations. In this regard, in
May 2002, the Company executed a settlement agreement with a
telecommunications company involving certain disputed network
service obligations. Under the terms of this settlement
agreement, the Company was relieved of a network service
obligation with a recorded balance of $6,018 through a
combination of a $468 payment and a $5,550 credit that reduced
network and product costs during the three months ended
June 30, 2002 (none during the three months ended
September 30, 2002).

In addition, the Company is engaged in a variety
of negotiations, arbitrations and regulatory and court
proceedings with several traditional telephone companies. These
negotiations, arbitrations and proceedings concern the
traditional telephone companies denial of physical central
office space to the Company in certain central offices, the cost
and delivery of transmission facilities and telephone lines and
central office 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 the Company and the potential gains are
not quantifiable at this time. However, an unfavorable outcome
in any of these negotiations, arbitrations and regulatory
proceedings 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.

As of September 30, 2002, the Company was
analyzing the applicability of certain transaction-based taxes
to sales of its products and services. This analysis includes
discussions with authorities of significant jurisdictions in
which the Company does business to determine the extent of its
respective transaction-based tax liabilities. It is the
Companys opinion that such analysis will be concluded
without a material adverse effect on its consolidated financial
position and results of operations. However, it is reasonably
possible that the Companys estimates of its
transaction-based tax liabilities, as reflected in the
accompanying condensed consolidated balance sheets, could change
in the near term, and the effects could be material to the
Companys consolidated financial position and results of
operations.



|   |                  
|-- | -----------------
|9. | Business Segments

The Company disaggregates its business operations
based upon differences in services and marketing channels, even
though the cash flows from these operations are not independent
of each other. The Companys

20



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COVAD COMMUNICATIONS GROUP, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

wholesale division (Wholesale) is a
provider of high-speed connectivity services, including DSL, T-1
and VPN services, to ISP, enterprise and telecommunications
carrier customers. The Companys direct division
(Direct) is a provider of high-speed connectivity,
Internet access and other services to individuals, small and
medium-sized businesses, and other organizations. Corporate
operations represent general corporate expenses, headquarters
facilities and equipment, investments, and other non-recurring
and unusual items not allocated to the segments.

The Company evaluates performance of the segments
based on segment operating results, excluding nonrecurring and
unusual items.

Set forth below is additional information about
the Companys business segments as of and for the three and
nine months ended September 30, 2002 and 2001 (the
Companys 2001 segment information has been restated to
conform to the Companys organizational structure in 2002):

|                                                   |  |           |         |        |  |          |         |            |  |              |         |              |  |   |         |   |  |   |   |  |  |   |         |  
|-------------------------------------------------- |  | --------- | ------- | ------ |  | -------- | ------- | ---------- |  | ------------ | ------- | ------------ |  | - | ------- | - |  | - | - |  |  | - | ------- | -
|As of and for the Three Months Ended               |  |           |         |        |  | Total    |         | Corporate  |  | Intercompany |         | Consolidated
|September 30, 2002:                                |  | Wholesale |         | Direct |  | Segments |         | Operations |  | Eliminations |         | Total       
|                                                   |  |           |         |        |  |          |         |            |  |              |         |             
|Domestic revenues from unaffiliated customers, net |  | $         | 82,324  |        |  | $        | 13,882  |            |  | $            | 96,206  |              |  | $ |        |   |  | $ |  |  |  | $ | 96,206  |  
|Net loss                                           |  | $         | (22,672 | )      |  | $        | (10,526 | )          |  | $            | (33,198 | )            |  | $ | (18,509 | ) |  | $ |  |  |  | $ | (51,707 | )
|Assets                                             |  | $         | 481,923 |        |  | $        | 13,054  |            |  | $            | 494,977 |              |  | $ | 7,834   |   |  | $ |  |  |  | $ | 502,811 |  

|                                                   |  |           |          |        |  |          |        |            |  |              |          |              |  |   |         |   |  |   |   |  |  |   |          |  
|-------------------------------------------------- |  | --------- | -------- | ------ |  | -------- | ------ | ---------- |  | ------------ | -------- | ------------ |  | - | ------- | - |  | - | - |  |  | - | -------- | -
|As of and for the Three Months Ended               |  |           |          |        |  | Total    |        | Corporate  |  | Intercompany |          | Consolidated
|September 30, 2001:                                |  | Wholesale |          | Direct |  | Segments |        | Operations |  | Eliminations |          | Total       
|                                                   |  |           |          |        |  |          |        |            |  |              |          |             
|Domestic revenues from unaffiliated customers, net |  | $         | 75,842   |        |  | $        | 8,942  |            |  | $            | 84,784   |              |  | $ |        |   |  | $ |  |  |  | $ | 84,784   |  
|Net loss                                           |  | $         | (109,571 | )      |  | $        | (2,859 | )          |  | $            | (112,430 | )            |  | $ | (27,319 | ) |  | $ |  |  |  | $ | (139,749 | )
|Assets                                             |  | $         | 933,354  |        |  | $        | (228   | )          |  | $            | 933,126  |              |  | $ | 23,815  |   |  | $ |  |  |  | $ | 956,941  |  

|                                                   |  |           |         |        |  |          |         |            |  |              |          |              |  |   |         |   |  |   |   |  |  |   |          |  
|-------------------------------------------------- |  | --------- | ------- | ------ |  | -------- | ------- | ---------- |  | ------------ | -------- | ------------ |  | - | ------- | - |  | - | - |  |  | - | -------- | -
|As of and for the Nine Months Ended                |  |           |         |        |  | Total    |         | Corporate  |  | Intercompany |          | Consolidated
|September 30, 2002:                                |  | Wholesale |         | Direct |  | Segments |         | Operations |  | Eliminations |          | Total       
|                                                   |  |           |         |        |  |          |         |            |  |              |          |             
|Domestic revenues from unaffiliated customers, net |  | $         | 254,253 |        |  | $        | 41,352  |            |  | $            | 295,605  |              |  | $ |        |   |  | $ |  |  |  | $ | 295,605  |  
|Net loss                                           |  | $         | (86,070 | )      |  | $        | (14,813 | )          |  | $            | (100,883 | )            |  | $ | (48,456 | ) |  | $ |  |  |  | $ | (149,339 | )

|                                                   |  |           |          |        |  |          |         |            |  |              |          |              |  |   |          |   |  |   |   |  |  |   |          |  
|-------------------------------------------------- |  | --------- | -------- | ------ |  | -------- | ------- | ---------- |  | ------------ | -------- | ------------ |  | - | -------- | - |  | - | - |  |  | - | -------- | -
|As of and for the Nine Months Ended                |  |           |          |        |  | Total    |         | Corporate  |  | Intercompany |          | Consolidated
|September 30, 2001:                                |  | Wholesale |          | Direct |  | Segments |         | Operations |  | Eliminations |          | Total       
|                                                   |  |           |          |        |  |          |         |            |  |              |          |             
|Domestic revenues from unaffiliated customers, net |  | $         | 206,364  |        |  | $        | 36,764  |            |  | $            | 243,128  |              |  | $ |         |   |  | $ |  |  |  | $ | 243,128  |  
|Net loss                                           |  | $         | (343,307 | )      |  | $        | (53,822 | )          |  | $            | (397,129 | )            |  | $ | (116,617 | ) |  | $ |  |  |  | $ | (513,746 | )

21



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##### Table of Contents








|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 2. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

The following discussion of our financial
condition and results of operations should be read in
conjunction with the unaudited condensed consolidated financial
statements and the related notes thereto included elsewhere in
this Report on Form 10-Q and the audited consolidated
financial statements and notes thereto and managements
discussion and analysis of financial condition and results of
operations for the year ended December 31, 2001 included in
our Annual Report on Form 10-K filed with the Securities
and Exchange Commission on March 29, 2002. This discussion
contains forward-looking statements, the accuracy of which is
subject to risks and uncertainties. Our actual results could
differ materially from those expressed in forward-looking
statements for many reasons including, but not limited to, those
discussed herein and in the Risk Factors section of
our Annual Report on Form 10-K, which is contained in
Part I, Item 1, Business-Risk Factors, of that report.
We disclaim any obligation to update information contained in
any forward-looking statement. See  Forward
Looking Statements.

(All dollar amounts are presented in
thousands, except per share amounts)

Overview

We are a leading provider of high-speed Internet
connectivity (broadband) and related communications
services, which we sell to businesses and consumers indirectly
through Internet service providers (ISP),
telecommunications carriers and other resellers. These wholesale
partners generally sell our services to their business and
consumer end-users. We also sell our services directly to
business and consumer end-users through our field sales force,
telephone sales and our website. Our services include a range of
high-speed, high-capacity Internet access connectivity and
related services using digital subscriber line
(DSL), T-1, Virtual Private Network
(VPN) and firewall technologies.

We have a relatively short operating history. We
introduced our services commercially in the San Francisco Bay
Area in December 1997. As of September 30, 2002, we believe
we have one of the largest nationally deployed DSL networks
based on approximately 1,750 operational central offices that
pass more than 40 million homes and businesses in the U.S.
As of September 30, 2002, we had approximately 359,000
high-speed Internet access lines in service using DSL technology
(approximately 9.0% of these lines are associated with wholesale
customers for which we recognize revenue on a cash basis due to
their financial condition, primarily concentrated among two such
customers). We have received orders for our services from more
than 140 ISP and telecommunications carrier customers,
including AT&T Corporation, Sprint Corporation, SBC
Communications, Earthlink, Inc., XO Communications and UUNET
Technologies (a WorldCom company), as well as Megapath Networks
and Speakeasy.net, both privately owned companies. We also
provide dial-up Internet access service to over 55,000 customers
through our direct sales channel. We are also developing a
variety of services that are enhanced or enabled by our
high-speed network.

Since our inception, we have generated
significant net losses and we continue to experience negative
operating cash flow. As of September 30, 2002, we had an
accumulated deficit of $1,493,847. We expect losses and negative
cash flow to continue at least into 2004. Although we currently
have a plan in place that we believe will ultimately allow us to
achieve positive cash flows from our operating activities
without raising additional capital, our cash reserves are
limited and our plan is based on assumptions, some of which are
out of our immediate control. If our assumptions are not met, we
may need to raise additional capital on terms that are less
favorable than we desire, which may have a material adverse
effect on our financial condition and could cause significant
dilution to our shareholders. The inability to raise additional
capital could also result in a liquidation or sale of our
company.

In the course of preparing our financial
statements for the year ended December 31, 2000, internal
control weaknesses were discovered, some of which continued into
2001 and 2002. The improvements we have made over the last
several quarters to our internal policies and procedures and
systems capabilities have significantly improved controls.
However, as discussed in Part I. Item 4, we have
identified some control weaknesses associated with certain
operational tracking procedures for our network assets. Based on
controls that have

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been recently developed and implemented as well
as other planned enhancements, we do not expect any material
adjustments in a subsequent period related to this control issue.


Recent Developments

On September 23, 2002, we announced that we
signed a three-year agreement with AT&T Corp. that provides
it with the ability to purchase certain of our wholesale
consumer-grade broadband Internet access services. Covad expects
AT&T to begin placing orders for these services in the
fourth quarter of 2002.

On September 23, 2002, we launched the
Popularizing Broadband marketing campaign to educate
consumers and businesses about the benefits of broadband. The
national campaign includes programs, promotions and an
advertising campaign to educate consumers about the benefits of
broadband. It also includes lower prices for our tiered
consumer-grade DSL services.

On September 5, 2002, we announced that we
signed a five-year agreement with America Online, Inc.
(AOL) that provides them with the ability to
purchase our wholesale DSL services. Covad expects AOL to begin
placing orders for our services in the fourth quarter of 2002.

In conjunction with the execution of the AOL
agreement, we granted AOL three warrants to purchase an
aggregate of 3,500,000 shares of our common stock at prices of
$1.06, $3.00 and $5.00 per share. Such warrants were immediately
exercisable, fully vested and non-forfeitable at the date of
grant. Accordingly, the measurement date for accounting purposes
for the warrants was the date of grant. The aggregate fair value
of such warrants of approximately $3,800 was recorded as a
deferred customer incentive and will be recognized as a
reduction of revenues on a straight-line basis over the
five-year term of the agreement because we believe that future
revenues from AOL will exceed the fair value of the warrants.
However, because the agreement with AOL contains no minimum
purchase commitment and is cancelable under certain
circumstances by AOL, we will continue to monitor the
recoverability of the deferred customer incentive balance
described above in periods ending after September 30, 2002.

On July 29, 2002, we announced that we
signed a two year agreement with Sprint Corporation that
provides them with the ability to purchase our wholesale DSL
services. Sprint Corporation began placing orders for our
services in August of 2002. The agreement does not contain any
volume or revenue commitments by Sprint Corporation.

Effective October 16, 2002, Chuck Haas
terminated his employment with Covad as our Executive Vice
President and General Manager, Covad Wholesale. Mr. Haas
will continue to serve the Company in an advisory role.

On July 25, 2002, we announced that Andrew
S. Lockwood was appointed as our senior vice president of
marketing. Mr. Lockwood will be responsible for driving
demand for our consumer and business class services. He will
also lead our branding efforts, advertising, and overall
marketing direction, which includes product marketing and
development, marketing communications and strategic planning.

We also recently added two new members to our
Board of Directors: Richard A. Jalkut and L. Dale Crandall.
Mr. Crandall was also appointed chairman of the Audit
Committee of our Board of Directors. Richard Shapero has
resigned as a member of our Board of Directors.

Restructuring Activities

On November 13, 2001, we announced the
signing of a loan agreement and the restructuring of our resale
and marketing agreement with SBC Communications Inc.
(SBC). We expect that the cash generated from these
agreements will enable us to fully fund our operations until we
generate positive cash flows from our operating activities. The
agreements included four elements: a one-time $75,000
prepayment, collateralized by substantially all of our domestic
assets, that SBC can use toward the purchase of our services
during the next 10 years; a $50,000 four-year loan
collateralized by substantially all of our domestic assets; a
payment to us of a $10,000 restructuring fee in exchange for
eliminating SBCs revenue commitments under the original
resale and marketing agreement and the elimination of a $15,000
co-op marketing fee owed by us to SBC under the

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previous resale and marketing agreement. We
received these funds on December 20, 2001. Under these
agreements, upon a change of control, we are required to repay
any outstanding principal and interest on the loan and any
unused portion of the prepayment. In addition, under these
agreements, SBC may accelerate any unpaid portion of the
prepayment and the loan in the event that we default.


On August 15, 2001 (the Petition
Date), we filed a voluntary petition (the
Petition) under Chapter 11 of the United States
Bankruptcy Code (the Bankruptcy Code) as
contemplated by, and to implement, the agreements we entered
into with the holders of our then-outstanding debt securities
(the Noteholders), and to restructure various of our
financial obligations. The Petition was filed with the United
States Bankruptcy Court for the District of Delaware (the
Bankruptcy Court) and was assigned Case
No. 01-10167 (JJF). Our operating subsidiaries did not
commence bankruptcy proceedings and continued to operate in the
ordinary course of business. We filed our First Amended Plan of
Reorganization, as modified on November 26, 2001 (the
Plan). On December 13, 2001, the Bankruptcy
Court entered an order confirming the Plan and, on
December 20, 2001 (the Effective Date), the
Plan was consummated and we emerged from bankruptcy. However,
the Bankruptcy Court still maintains jurisdiction over certain
administrative matters related to the implementation of the
Plan, including certain unresolved claims. Under our Plan, we
were able to extinguish approximately $1,394,020 in aggregate
face amount of outstanding debt securities, including accrued
interest, in exchange for a combination of approximately
$271,708 in cash and 35,292,800 common shares, or 15% of the
reorganized company. We also recorded an extraordinary gain on
the extinguishment of debt in the amount of $1,033,727 in the
fourth quarter of 2001.

On June 25, 2001, our former subsidiary,
BlueStar, made an irrevocable assignment for the benefit of its
creditors (ABC) of all its assets to an independent
trustee (the Assignee) in the state of Tennessee.
Immediately thereafter, the Assignee began an orderly
liquidation of BlueStar that was initially expected to be
completed in the fourth quarter of 2002. However, the Assignee
has informed the Company that it is still in the process of
resolving some matters among BlueStars creditors and that
the process may extend into the second half of 2003. An ABC
under Tennessee law is a non-judicial alternative to a plan of
liquidation under Chapter 7 of the United States Bankruptcy
Code. As a result of the ABC, BlueStars former assets are
no longer controlled by us or BlueStar and cannot be used by
either BlueStars or our board of directors to satisfy the
liabilities of BlueStar. Consequently, the liquidation of
BlueStars assets and the discharging of its liabilities
are currently under the sole control of the Assignee. Therefore,
we deconsolidated BlueStar effective June 25, 2001, which
resulted in the recognition of a deferred gain in the amount of
approximately $55,200 in our condensed consolidated balance
sheet as of September 30, 2002. Such deferred gain
represents the difference between the carrying values of
BlueStars assets (aggregating approximately $7,900) and
liabilities (aggregating approximately $63,100) as of
June 25, 2001. We will recognize such deferred gain in our
consolidated statement of operations when the liquidation of
BlueStar is complete and its liabilities have been discharged.

During the year ended December 31, 2000, in
response to changes in the economy and the capital markets, we
implemented a business plan that helped to lower our cost
structure in an effort to reach profitability earlier than
previously planned. Specific steps we took included: the
BlueStar subsidiary ABC; elimination of our high yield bond debt
through a reorganization under the Bankruptcy Code; reduction of
our workforce by as many as 2,600 employees from a peak of
approximately 4,000 employees in 2000; reduction of the
size of our network to approximately 1,700 central offices;
reevaluating the amount and quantity of rebates and other
incentives that we provide to our customers; consolidation
and/or closing of administrative offices throughout the United
States; enhancement of productivity in our operations to
increase customer satisfaction while reducing costs;
streamlining our direct sales and marketing channel and
supplementing it with telephone sales and sales through our
website; and evaluation and implementation of other cost
reduction strategies, including reductions in travel and
facilities expenditures.



| |                                                           
| | ----------------------------------------------------------
| | Revenue Recognition and Change in
    Accounting Principle

During the fourth quarter of 2000, we changed our
method of accounting for up-front fees associated with service
activation and the related incremental direct costs in
accordance with SEC Staff Accounting Bulletin (SAB)
No. 101, Revenue Recognition in Financial
Statements. Previously, we had recognized up-front

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fees as revenues upon activation of service.
Under the new accounting method, which was adopted retroactive
to January 1, 2000, we now recognize up-front fees
associated with service activation over the expected term of the
customer relationship, which is presently estimated to be
24 months, using the straight-line method. Also as a result
of the adoption of SAB No. 101, retroactive to
January 1, 2000, we now treat the incremental direct costs
of service activation, which consist principally of customer
premises equipment, service activation fees paid to other
telecommunications companies, service delivery and sales
commissions, as deferred charges in amounts that are no greater
than the up-front fees that are deferred, and such deferred
incremental direct costs are amortized to expense using the
straight-line method over 24 months.


The cumulative effect of the change in accounting
principle resulted in a charge to operations of $9,249, which
was included in our net loss for the year ended
December 31, 2000. For the three and nine months ended
September 30, 2001, we recognized approximately $2,697 and
$10,640, respectively, in revenue that was included in the
cumulative effect adjustment as of January 1, 2000 (none
during the three and nine months ended September 30, 2002).
The effect of that revenue during the three and nine months
ended September 30, 2001 was to decrease our net loss by
$688 and $2,777, respectively. Although SAB 101 substantially
alters the timing of recognition of certain revenues and
treatment of certain costs in our consolidated financial
statements, it does not affect our consolidated cash flows.



| |                                                                          
| | -------------------------------------------------------------------------
| | Internet Service Provider and
    Telecommunications Carrier Difficulties

In order to limit our exposure to the potential
financial difficulties of some of our wholesale partners, we
have implemented certain policies and taken a series of actions.
We may stop taking new orders from these partners but continue
to install and maintain previously accepted orders. We may
terminate our contracts with those partners who are unresponsive
to our efforts to maintain an on-going business relationship.
While our goal is to maintain consistent high quality service to
end-users, we may also decide to disconnect some end-users that
are purchasing our services from customers facing financial
difficulties and, in some cases, we may attempt to migrate these
end users to another wholesale partner or to our own Covad
Direct service. Although we have successfully migrated
end-users, there can be no assurance that these migrated
end-users will continue to purchase our services. Even if we are
able to migrate end-users, this process requires a significant
amount of our resources, which may impair our ability to install
new lines as they are ordered. Any of these circumstances could
adversely affect our business. We have also worked proactively
to collect outstanding amounts billed to these customers.

Even though we are making progress in reducing
the number of subscribers for which we are not currently
recognizing revenue on an accrual basis, we may be unable to
completely restore the remaining lines to normal revenue
producing status and we may encounter future payment problems
with our customers. In addition, in light of the financial
position of many ISPs and certain telecommunications carriers,
should a particular ISP or telecommunications carrier customer
become subject to reorganization or bankruptcy proceedings, we
may be unable to collect payments owed to us or retain payments
or other consideration (including subscriber lines) already
received by us.



| |                           
| | --------------------------
| | Related Party Transactions

Our Vice-Chairman and former interim chief
executive officer, Frank Marshall, who is also a member of our
board of directors, was a minority stockholder and former member
of the board of directors of one of our former ISP customers,
InternetConnect, which filed for bankruptcy protection in 2001.
We recognized revenues of $2,569 and $3,623 related to this
customer during the three and nine months ended
September 30, 2001, respectively (none during the three and
nine months ended September 30, 2002). Gross accounts
receivable from this customer amounted to $7,301 as of
September 30, 2001 (none at September 30, 2002). On
January 3, 2002, we purchased substantially all of the
assets of InternetConnect in an auction supervised by the United
States Bankruptcy Court for the Central District of California.
The purchase price for the assets of InternetConnect was $5,470
in cash. Under the terms of the asset purchase agreement, we may
be required to pay additional cash of up to $1,880 for the
assets of InternetConnect, depending upon the outcome of a
previous post-petition bankruptcy claim filed by us against
InternetConnect. Such claim is still unresolved. We did not
assume any liabilities or obligations of InternetConnect or hire
any of InternetConnects employees.

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The tangible assets purchased from
InternetConnect consisted of accounts receivable, refundable
deposits and property and equipment. We also purchased the
right, but not the obligation, to assume InternetConnects
customer contracts. However, we did not exercise this right.
Instead, we solicited approximately 9,250 DSL, T-1, VPN and
dial-up customers of InternetConnect, and approximately 6,200 of
such customers executed new contracts with us and our resellers
subsequent to January 3, 2002.


We acquired an equity interest in a supplier
during 1999 and disposed of this interest in 2001. Purchases
from this supplier totaled $1,596 and $4,009 for the three and
nine months ended September 30, 2002, respectively, and
$1,142 and $19,160 for the three and nine months ended
September 30, 2001, respectively. We also purchased certain
products from a company in which our vice-chairman and former
interim chief executive officer, Frank Marshall, serves as a
director. Purchases from this vendor totaled $52 and $109 during
the three and nine months ended September 30, 2002,
respectively, and $0 and $21 for the three and nine months ended
September 30, 2001, respectively.

Results of Operations

We regard our business as being operated in two
distinct segments based upon differences in services and
marketing channels even though the cash flows from these
segments are not independent of each other. Our wholesale
division (Wholesale) is a provider of high-speed
connectivity services, which include DSL technology, to ISP,
enterprise and telecommunications carrier customers. Our direct
division (Direct), is a provider of Internet access
services to individuals, corporations, small businesses and
other organizations. We evaluate performance of the segments
based on segment operating results.



| |                                                            
| | -----------------------------------------------------------
| | Three and Nine Months Ended
    September 30, 2002 and 2001

Revenues,
net

We recorded net revenues of $96,206 for the three
months ended September 30, 2002, an increase of $11,422, or
13.5%, over net revenues of $84,784 for the three months ended
September 30, 2001. We recorded net revenues of $295,605
for the nine months ended September 30, 2002, an increase
of $52,477, or 21.6%, over net revenues of $243,128 for the nine
months ended September 30, 2001. As described in the
overview section above, we deconsolidated our BlueStar
subsidiary effective June 25, 2001. Net revenues from
BlueStar were $11,977 during the nine months ended
September 30, 2001 (none during the three months ended
September 30, 2001 or the three and nine months ended
September 30, 2002). The increase in revenues for the nine
months ended September 30, 2002, as compared to the nine
months ended September 30, 2001, is mainly attributable to
growth in the number of customers and end-users. Revenues for
the three months ended September 30, 2002 decreased by
1.6%, as compared to the three months ended June 30, 2002.
The decrease was caused by lower selling prices, promotional
rebates and our continuing high end user disconnection rate
during the three months ended September 30, 2002. Although
we expect our subscriber base to grow, lower selling prices,
promotional rebates and the loss of end users may continue to
impair our ability to increase our revenues. During the three
months ended September 30, 2002, we recognized revenues of
$1,010 from one of our wholesale partners resulting from the
short fall in their contractual revenue commitment. In addition,
as a result of developments in the bankruptcy proceedings of one
of our wholesale customers, as discussed further below, we
recognized revenues of $1,120 during the three months ended
September 30, 2002 that were deferred as of
December 31, 2001.

Included in net revenues are Federal Universal
Service Fund charges billed to our customers aggregating $1,861
and $7,757 for the three and nine months ended
September 30, 2002, respectively, and $2,967 and $10,094
for the three and nine months ended September 30, 2001,
respectively.

We recorded net revenues of $82,324 from our
Wholesale channel and $13,882 from our Direct channel for the
three months ended September 30, 2002, an increase of
$6,482, or 8.5%, and $4,940, or 55.2%, over net revenues of
$75,842 and $8,942 for the three months ended September 30,
2001, respectively. We recorded net revenues of $254,253 from
our Wholesale channel and $41,352 from our Direct channel for
the nine months ended September 30, 2002, an increase of
$47,889, or 23.2%, and $4,588, or 12.5%, over revenues of
$206,364 and $36,764 for the nine months ended
September 30, 2001, respectively.

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We have over 140 wholesale customers. However,
for the three and nine months ended September 30, 2002, our
30 largest wholesale customers collectively comprised 93.6% and
93.4%, respectively, of our total wholesale net revenues and
80.1% and 80.3%, respectively, of our total net revenues. As of
September 30, 2002, receivables from these customers
collectively comprised 81.9% of our gross accounts receivable
balance. For the three and nine months ended September 30,
2001, our 30 largest wholesale customers collectively comprised
90.6% and 82.6%, respectively, of our total wholesale net
revenues and 81.0% and 74.1%, respectively, of our total net
revenues. As of September 30, 2001, receivables from these
customers collectively comprised 86.2% of our gross accounts
receivable balance.

For the three months ended September 30,
2002, two wholesale customers (Earthlink, Inc. and AT&T
Internet Services) individually accounted for 20.7% and 10.0%,
respectively, of our total net revenues. For the nine months
ended September 30, 2002, these wholesale customers
individually accounted for 20.5% and 9.2%, respectively, of our
total revenues. As of September 30, 2002, receivables from
these wholesale customers individually accounted for 39.3%
and 8.2%, respectively, of our gross accounts receivable balance.

For the three months ended September 30,
2001, two wholesale customers (Earthlink, Inc. and XO
Communications) individually accounted for 17.8% and 10.9%,
respectively, of our total net revenues. For the nine months
ended September 30, 2001, these wholesale customers
individually accounted for 16.8% and 10.8%, respectively, of our
total net revenues. As of September 30, 2001, receivables
from these wholesale customers comprised 16.9% 16.5%,
respectively, of our gross accounts receivable balance.

A number of our customers are currently in
bankruptcy proceedings. Revenues from these customers accounted
for approximately 18.9% and 19.6% of our total net revenues for
the three and nine months ended September 30, 2002,
respectively, and 17.7% and 20.4% of our total net revenues for
the three and nine months ended September 30, 2001,
respectively. Although WorldCom filed for bankruptcy protection
during the three months ended September 30, 2002, we
continued to recognize revenues from WorldCom on an accrual
basis based on the revenue recognition criteria described in
Note 2. Consequently, the disclosures in the following
paragraph exclude amounts pertaining to WorldCom because we have
not presently classified them as financially distressed. We
continue to attempt to migrate end users from certain of these
financially distressed customers to the extent it is legally and
operationally feasible.

During the three and nine months ended
September 30, 2002, we issued billings to our financially
distressed customers, including those that have filed for
bankruptcy protection (excluding WorldCom, as noted above),
aggregating $7,447 and $39,779, respectively, that were not
recognized as revenues or accounts receivable in our condensed
consolidated financial statements, as compared to the
corresponding amounts of $15,317 and $52,636 for the three and
nine months ended September 30, 2001, respectively.
However, we ultimately recognized revenues from certain of these
customers on a cash basis aggregating $12,077 and $43,446 during
the three and nine months ended September 30, 2002,
respectively, and $5,839 and $15,715 during the three and nine
months ended September 30, 2001, respectively, some of
which relates to services provided in prior periods. In
addition, revenues recognized during the three months ended
March 31, 2002 include payments totaling $3,307 from
certain bankrupt customers that we received prior to
January 1, 2002 and recorded as unearned revenues in our
consolidated balance sheet as of December 31, 2001 because
our ability to retain these payments was not reasonably assured
as of that date. However, as a result of subsequent developments
in the bankruptcy proceedings of such customers, we determined
that our ability to retain these payments was reasonably assured
prior to March 31, 2002. Consequently, we recognized these
payments as revenues during the three months then ended. No such
payments were recognized as revenues during the three months
ended June 30, 2002. However, during the three months ended
September 30, 2002, due to the developments in the
bankruptcy proceeding of another customer, we determined our
ability to retain certain payments received from this bankrupt
customer prior to January 1, 2002 was now reasonably
assured. Accordingly, we recognized revenues of $1,120 that were
deferred as of December 31, 2001. We had contractual
receivables from our financially distressed customers, including
receivables of $6,026 from customers that have filed for
bankruptcy protection (excluding WorldCom, as noted above),
totaling $6,250 as of September 30, 2002 that are not
reflected in our condensed consolidated financial statements.

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We have obtained information indicating that some
of our customers, including WorldCom, who (i) were
essentially current in their payments for our services prior to
September 30, 2002, or (ii) have subsequently paid all
or significant portions of the respective amounts that we
recorded as accounts receivable as of September 30, 2002,
may become financially distressed. Revenues from these customers
accounted for approximately 25.6% and 25.1% of our total net
revenues for the three and nine months ended September 30,
2002, respectively. As of September 30, 2002, receivables
from these customers comprised 28.6% of our gross accounts
receivable balance. If these customers are unable to demonstrate
their ability to pay for our services in a timely manner, in
periods ending subsequent to September 30, 2002, revenue
from these customers will be recognized on a cash basis as
described above.

We have obtained persuasive evidence indicating
that the financial condition of one of our customers, which was
designated as financially distressed in 2000, improved
significantly during the three months ended June 30, 2002,
principally as a result of a capital infusion during this
period. Consequently, we concluded that collection of our
billings to this customer was now reasonably assured. Therefore,
we resumed the recognition of revenues from this customer on an
accrual basis during the second quarter of 2002, which resulted
in the recognition of a receivable balance and revenues in the
amount of approximately $1,542 as of and for the three months
ended June 30, 2002 that relate to services rendered in
periods ended prior to April 1, 2002. We collected such
receivable balance in full during July 2002. No similar amounts
were recognized during the other periods reported in the
accompanying condensed consolidated financial statements.

We have billing disputes with certain 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. Accordingly, we maintain an
allowance, through charges to revenues (which amounted to $540
and $2,130 during the three and nine months ended
September 30, 2002, respectively, and $1,293 and $9,253
during the three and nine months ended September 30, 2001,
respectively), based on our estimate of the ultimate resolution
of these disputes.

Network and
Product Costs

We recorded network and product costs of $68,112
for the three months ended September 30, 2002, a decrease
of $35,178, or 34.1%, over network and product costs of $103,290
for the three months ended September 30, 2001. For the
three months ended September 30, 2002, network and product
costs were 70.8% of net revenues, a significant improvement from
the three months ended September 30, 2001, when network and
product costs were 121.8% of net revenues. We recorded network
and product costs of $231,576 for the nine months ended
September 30, 2002, a decrease of $128,320, or 35.7%, over
network and product costs of $359,896 for the nine months ended
September 30, 2001. For the nine months ended
September 30, 2002, network and product costs were 78.3% of
net revenues, a significant improvement from the nine months
ended September 30, 2001, when network and product costs
were 148.0% of net revenues. The decrease in network and product
costs, in absolute dollars and as a percentage of revenues,
during the three and nine months ended September 30, 2002
is primarily attributable to the downsizing of our network from
historical levels, cost reduction efforts to lower network costs
related to data transport, lower costs in customer premise
equipment, a reduction in headcount within our operations and
engineering groups and the deconsolidation of our BlueStar
subsidiary effective June 25, 2001 (network and product
costs related to BlueStar were $34,768 during the nine months
ended September 30, 2001 and none during the three months
ended September 30, 2001 or three and nine months ended
September 30, 2002), offset by increased costs resulting
from a larger subscriber base.

Network and product costs for the three months
ended June 30, 2002 include a credit of $5,550 from the
settlement of certain disputed network service obligations
during the quarter. Network and product costs for the three
months ended March 31, 2002 include acquisition costs of
$3,674 associated with certain of InternetConnects former
customers, as described above (none during the three months
ended June 30, 2002 or September 30, 2002). We expect
network and product costs to increase in future periods if we
can increase sales activity and grow revenue, but to decrease as
a percentage of revenue as we leverage the economies of scale
that we expect.

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As discussed below in Part II,
Item 1, Legal Proceedings, there is uncertainty
concerning our ability to purchase line-shared services from the
traditional telephone companies as a result of a decision issued
by the United States Court of Appeals for the District of
Columbia on May 24, 2002 and the ongoing Triennial Review
and other regulatory proceedings at the FCC. As a result of
those legal and regulatory proceedings, it is possible that the
traditional telephone companies could either refuse to sell us
line-shared services or could substantially increase the cost of
line-shared services, which could substantially increase our
network costs for line-shared services and could cause us to
discontinue our consumer grade services for new and existing
customers.



| |                                                          
| | ---------------------------------------------------------
| | Sales, Marketing, General and Administrative
    Expenses

Sales, marketing, general and administrative
expenses consist primarily of salaries, expenses for the
development of business and our promotional and advertising
expenses and expenses attributable to our management team.
Sales, marketing, general and administrative expenses were
$42,607 for the three months ended September 30, 2002, a
decrease of $3,994, or 8.6%, over sales, marketing, general and
administrative expenses of $46,601 for the three months ended
September 30, 2001. For the three months ended
September 30, 2002, sales, marketing, general and
administrative expenses were 44.3% of net revenues, an
improvement from the three months ended September 30, 2001,
when these expenses were 55.0% of net revenues. Sales,
marketing, general and administrative expenses were $116,636 for
the nine months ended September 30, 2002, a decrease of
$52,060, or 30.9%, over sales, marketing, general and
administrative expenses of $168,696 for the nine months ended
September 30, 2001. For the nine months ended
September 30, 2002, sales, marketing, general and
administrative expenses were 39.5% of net revenues, an
improvement from the nine months ended September 30, 2001,
when these expenses were 69.4% of net revenues. The decrease in
expenses from 2001 to 2002 is attributable to a reduction in our
workforce, a reduction in office space throughout the United
States, reduced travel by employees and the deconsolidation of
our BlueStar subsidiary effective June 25, 2001 (sales,
marketing, general and administrative expenses related to
BlueStar were $11,510 during nine months ended
September 30, 2001 and none during the three months ended
September 30, 2001 or the three and nine months ended
September 30, 2002).

Sales, marketing, general and administrative
expenses for the three months ended September 30, 2002
increased by $7,215, or 20.4%, over the three months ended
June 30, 2002. The increase was primarily attributable to
our radio, television and other various media marketing and
advertising programs related to our Popularizing
Broadband campaign. We expect sales, marketing, general
and administrative expense levels to increase in the near future
as we continue our marketing efforts.

Total operating expenses, which include network
and product costs, sales, marketing, general and administrative
expenses, depreciation and amortization, restructuring expenses,
impairment of long-lived assets and litigation-related expenses,
were $148,070 and $443,367 for the three and nine months ended
September 30, 2002, respectively. These expenses for the
three and nine months ended September 30, 2002 were
comprised of $105,416 and $338,877, respectively, from our
Wholesale channel, $24,094 and $57,306, respectively, from our
Direct channel and $18,560 and $47,184 respectively, from our
Corporate Operations.

Provision for
Bad Debts

We recorded net bad debt recoveries of $1,731 for
the three months ended September 30, 2002, as compared to
bad debt expense of $3,572 for the three months ended
September 30, 2001. Bad debt expense (recoveries) was
(1.8%) and 4.2% of net revenues for the three months ended
September 30, 2002 and 2001, respectively. We recorded net
bad debt expense of $312 for the nine months ended
September 30, 2002, as compared to $523 for the nine months
ended September 30, 2001. The decrease in the amount of bad
debt expense is the result of improved collection of outstanding
receivables. In addition, as a result of developments in the
bankruptcy proceedings of one of our customers during the three
months ended September 30, 2002, we recognized bad debt
recoveries of $2,491.

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Depreciation and
Amortization

Depreciation and amortization of property and
equipment was $33,498 and $92,882 for the three and nine months
ended September 30, 2002, respectively, and $36,092 and
$103,796 for the three and nine months ended September 30,
2001, respectively. The decrease in 2002 was due principally to
asset retirements and certain assets becoming fully depreciated
during this period, offset by additional depreciation expense of
$9,584 recognized during the three months ended
September 30, 2002, as discussed further below. We expect
depreciation and amortization to decrease because we anticipate
that our capital expenditures in the near term will be less than
historical amounts. We believe that the geographic footprint of
our network will remain relatively unchanged and that near term
capital expenditures will be mostly limited to adding capacity
to our network to support new users.

Amortization expenses associated with collocation
fees were $3,700 and $10,990 for the three and nine months ended
September 30, 2002, respectively, and $1,763 and $9,333 for
the three and nine months ended September 30, 2001,
respectively. The increase in 2002 resulted from the suspension
of our network build during 2000 and 2001 and the resumption of
our network build for selected markets during the last
15 months. We do not expect to incur significant capital
expenditures in connection with this expansion.

Effective January 1, 2001, we reduced the
remaining estimated useful lives of all long-lived assets,
excluding building and leasehold improvements, that previously
had estimated useful lives in excess of five years such that the
residual balances and any subsequent additions are now
depreciated or amortized over five years. This change in
accounting estimate increased our net loss by $2,900 ($0.02 per
share) and $9,200 ($0.05 per share) during the three and nine
months ended September 30, 2001, respectively.

As part of the continuing evaluation of our
network assets during the three months ended September 30,
2002, certain matters were identified related to prior financial
reporting periods that necessitated the recording of additional
expenses. Such matters were related to (i) changes in our
network configuration, which necessitated reductions of the
remaining estimated useful lives of certain network equipment
and (ii) the capitalization of certain network and product
costs that should have been charged to operating expenses.
Accordingly, for the three months ended September 30, 2002,
we have recorded (i) additional depreciation expense of
$9,584 and (ii) additional network and product costs of
$1,215. We do not believe these amounts are material to the
periods in which they should have been recorded, nor do we
expect that the expenses will be material to our consolidated
operating results for the year ending December 31, 2002.
However, if these adjustments are ultimately deemed to be
material to our consolidated operating results for the year
ending December 31, 2002, we will need to restate prior
financial reporting periods, including the current period. The
impact on prior financial reporting periods would be as follows:
net loss for the three months ended June 30, 2002 would be
increased by $1,292 ($0.01 per share), net loss for the three
months ended March 31, 2002 would be increased by $1,099
($0.01 per share), net income for the year ended
December 31, 2001 would be decreased by $8,057 ($0.04 per
share) and net loss for the year ended December 31, 2000
would be increased by $351 ($0.00 per share).

Depreciation and amortization expenses for the
three and nine months ended September 30, 2002 were $37,198
and $103,872, respectively, and were comprised of $35,979 and
$99,702, respectively, from our Wholesale channel, $420 and
$1,419, respectively, from our Direct channel, and $799 and
$2,751, respectively, from our Corporate Operations.

Restructuring
Expenses

In connection with the restructuring plan we
announced in December 2000, we recorded a charge to operations
of $4,988 during the fourth quarter of 2000 relating to employee
severance benefits that met the requirements for accrual as of
December 31, 2000.

Results of operations for the nine months ended
September 30, 2001 include restructuring expenses of
$17,617 for severance benefits, professional fees and
collocation and building lease termination costs that met the
requirements for accrual during these periods, including
severance benefits and professional fees associated with the
deconsolidation of our BlueStar subsidiary on June 25, 2001
as discussed above. No additional

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restructuring expenses were recognized for the
three months ended September 30, 2001. However, we paid
severance benefits of approximately $200 and $4,000 during the
three and nine months ended September 30, 2001,
respectively, which were charged against the restructuring
liability. We completed the restructuring activities that were
initiated in 2000 during the fourth quarter of 2001. Therefore,
we neither recognized nor paid any restructuring expenses during
the three or nine months ended September 30, 2002. However,
we continue to consider whether additional restructuring is
necessary, and we may incur additional expenses related to
further restructuring activities in future periods.


Reorganization
Expenses

For the three and nine months ended
September 30, 2001, we recognized net reorganization
expenses directly associated with our Chapter 11 proceeding
of $3,896 (none during the three and nine months ended
September 30, 2002) in accordance with AICPA Statement of
Position (SOP) 90-7, Financial Reporting by
Entities in Reorganization Under the Bankruptcy Code,
which requires that expenses resulting from the reorganization
of a business in a bankruptcy proceeding be reported separately
as reorganization items. For the three and nine months ended
September 30, 2001, we recognized expenses associated with
our reorganization in the amount of $4,105 (none during the
three and nine months ended September 30, 2002). These
expenses consisted primarily of legal and financial advisory
services. In addition, SOP 90-7 requires that interest income
earned by an entity in a bankruptcy proceeding that would not
have been earned but for the proceedings be reported as a
reorganization item. For the three and nine months ended
September 30, 2001, we recognized interest income in the
amount of $209 (none during the three and nine months ended
September 30, 2002) on accumulated cash that we did not
disburse as a result of the bankruptcy proceedings.

Long-Lived Asset
Impairment

During the nine months ended September 30,
2001, we recorded a charge of $1,989 relating to the write-off
of certain goodwill associated with our BlueStar subsidiary.
There were no similar charges during the three months ended
September 30, 2001, during which period $241 of previously
recorded charges were reversed, or the three and nine months
ended September 30, 2002.

Litigation-related
Expenses

We recorded charges (credits) to
litigation-related expenses of $1,884 and $(9,029) for the three
and nine months ended September 30, 2002, respectively, and
$1,907 and $5,907 for the three and nine months ended
September 30, 2001, respectively. The charges
(credits) for the three and nine months ended
September 30, 2002 represent non-cash valuation adjustments
for the change in value of the 6,495,844 shares of common
stock that are expected to be distributed upon the approval of
an MOU as described in Part II. Item 1. Legal
Proceedings. We will adjust this charge in subsequent
quarters based on changes in our stock price until such time the
settlement is finalized. The charge for the three and nine
months ended September 30, 2001 includes charges (credits)
of $(1,600) and 2,400, respectively, resulting from the initial
measurement of such MOU and subsequent non-cash valuation
adjustments, as described above, as well as a cash payment of
$467 and a non-cash charge of $3,040 related to tentative
settlements reached by us with certain other plaintiffs during
the three months ended September 30, 2001.

Net Interest
Income (Expense)

Net interest income (expense) was $184 and $(53)
for the three and nine months ended September 30, 2002,
respectively, and $(13,282) and $(69,301) for the three and nine
months ended September 30, 2001, respectively. Net interest
income (expense) during the three and nine months ended
September 30, 2002 consisted principally of interest
expense on our long-term note payable to SBC, which is further
described below, less interest income earned on our cash, cash
equivalents and short-term investments balances. Net interest
income (expense) during the three and nine months ended
September 30, 2001 consisted primarily of interest expense
on our senior notes, which were extinguished in December 2001,
and capital lease obligations, less interest income on our cash,
cash equivalents and short-term investments balances.

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For the three and nine months ended
September 30, 2001, as required by SOP 90-7, we
recognized interest expense only to the extent that it would be
paid during the bankruptcy proceedings or it was probable that
it would be an allowed priority, secured or unsecured claim. The
reported interest expense as well as the contractual interest
expense for the three and nine months ended September 30,
2001 are disclosed in the accompanying condensed consolidated
statements of operations. In addition, as described above,
interest income earned as a result of the bankruptcy proceedings
for the three and nine months ended September 30, 2001
amounted to $209 (none during the three and nine months ended
September 30, 2002) and has been included as a
reorganization item in the accompanying condensed consolidated
statements of operations.

Upon our emergence from Chapter 11
bankruptcy on December 20, 2001, a series of new agreements
with SBC became effective. One such agreement involves a
long-term note payable with a principal amount of $50,000 that
is collateralized by substantially all of our domestic assets.
This note accrues interest at 11.0% per annum, which is payable
quarterly beginning in December 2003. The entire unpaid
principal balance is payable in December 2005. However, we have
the right to prepay the principal amount of the note, in whole
or in part, at any time without penalty.

We expect future interest expense to be limited
principally to interest on our 11.0% note payable to SBC. 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 Gains and Losses

We recorded a net loss on investments for the
three months ended September 30, 2002 of $101 as a result
of our equity in the losses of unconsolidated affiliates. For
the nine months ended September 30, 2002, we recorded a net
loss on investments of $1,357. This included a net realized loss
on the sale of certain investments in unconsolidated affiliates
of $636, our equity in the losses of unconsolidated affiliates
of $704 and a net realized loss on short-term investments of $17.

We recorded a net loss on investments for the
three months ended September 30, 2001 of $14,403. This
included a net realized gain on short-term investments of $75,
equity in the losses of unconsolidated affiliates of $5,011 and
a provision for the impairment of investments in unconsolidated
affiliates of $9,467. For the nine months ended
September 30, 2001, we recorded a net loss on investments
of $16,314. This included equity in the losses of unconsolidated
affiliates of $11,626, the recognition of other than temporary
losses on short-term investments of $1,311 and a provision for
the impairment of investments in unconsolidated affiliates of
$9,467, offset by a net realized gain on short-term investments
of $5,912 and a gain on disposal of investments in
unconsolidated affiliates of $178.



| |             
| | ------------
| | Income Taxes

We made no provision for income taxes because we
operated at a loss during all periods presented.



| |                                               
| | ----------------------------------------------
| | 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 financial statements
requires us to make estimates that affect the reported amounts
of assets, liabilities, revenues and expenses, and related
disclosures of contingent assets and liabilities. We base our
accounting estimates on historical experience and other factors
that are believed to be reasonable under the circumstances.
However, actual results may vary from these estimates under
different assumptions or conditions. The following is a summary
of our critical accounting policies and estimates:



| |   |                                                                                                                                                                                                                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We recognize revenues when (i) persuasive
    evidence of an arrangement between the customer and us exists,
    (ii) service has been provided to the customer,
    (iii) the price to the customer is fixed and determinable
    and (iv) collectibility of the sales price is reasonably
    assured. We recognize up-front fees

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | associated with service activation over the
    expected term of the customer relationship, which is presently
    estimated to be 24 months, using the straight-line method.
    Similarly, we treat the incremental direct costs of service
    activation (which consist principally of customer premise
    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 24 months.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|
| |  | We have concentrations of credit risk with
    several customers, certain of which were experiencing financial
    difficulties as of September 30, 2002 and 2001 and were not
    current in their payments for our services as of those dates.
    Accordingly, we recognize revenues from certain of these
    financially distressed customers in the period in which cash is
    received, 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 certain 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. We maintain an allowance, through charges
    to revenues, based on our estimate of the ultimate resolution of
    these disputes and our reported revenue in any period could be
    different than what is reported if we employed different
    assumptions in estimating the outcome of these disputes.
|
| |  | 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 implemented significant reorganization and
    restructuring plans in 2001 and 2000. In this regard, we
    consummated a plan of reorganization under Chapter 11 of
    the United States Bankruptcy Code on December 20, 2001.
    However, as of September 30, 2002, we had certain claims
    relating to our Chapter 11 bankruptcy proceedings that were
    unresolved. Therefore, it is reasonably possible that such
    unresolved bankruptcy claims could ultimately be settled for
    amounts that differ from the aggregate liability for such claims
    reflected in our condensed consolidated balance sheet as of
    September 30, 2002. In addition, we tentatively settled
    certain securities litigation in connection with our emergence
    from Chapter 11 bankruptcy in 2001. However, the final
    settlement of such litigation is still subject to court approval.                                                                                                                                                                                                                                                                                                                                             
|
| |  | Property and equipment and intangible assets are
    recorded at cost, subject to adjustments for impairment.
    Property and equipment and intangible assets are depreciated or
    amortized using the straight-line method over their estimated
    useful lives, certain of which were significantly revised in
    2001. 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. See further
    discussion below concerning the recent adoption of SFAS
    Nos. 142 and 144 and our framework for evaluating the
    impairment of long-lived assets in periods ending after
    December 31, 2001.                                                                                                                                                                                                                                                         
|
| |  | 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,
    including disputes with a number of telecommunications companies
    related to the balances we owe them for collocation and network
    service fees. 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 issue. 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 developments, the effects of which
    could be material to our consolidated financial position and
    results of operations.                                                                                                                                                                                                                   
|
| |  | We are currently analyzing the applicability of
    certain transaction-based taxes to sales of our products and
    services. This analysis includes discussions with authorities of
    jurisdictions in which we do business                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | to determine the extent of our transaction-based
    tax liabilities. We believe that such negotiations will be
    concluded without a material adverse effect on our consolidated
    financial position and results of operations. However, it is
    reasonably possible that our estimates of our transaction-based
    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 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.



| |                                 
| | --------------------------------
| | Recent Accounting Pronouncements

In July 2002, the Financial Accounting Standard
Board (FASB) issued Statement of Financial
Accounting Standards (SFAS) No. 146,
Accounting for Costs Associated with an Exit or Disposal
Activity. SFAS No. 146 revises the accounting for
exit and disposal activities under Emerging Issues Task Force
(EITF) Issue 94-3, Liability Recognition
for Certain Employee Termination Benefits and Other Costs to
Exit an Activity (Including Certain Costs Incurred in a
Restructuring) by extending the period in which expenses
related to restructuring activities are reported. A commitment
to a plan to exit an activity or dispose of long-lived assets
will no longer be sufficient to record a one-time charge for
most restructuring activities. Instead, companies will record
exit or disposal costs when they are incurred and can be
measured at fair value. In addition, the resultant liabilities
will be subsequently adjusted for changes in estimated cash
flows. SFAS No. 146 is effective prospectively for exit or
disposal activities initiated after December 31, 2002.
Companies may not restate previously issued financial statements
for the effect of the provisions of SFAS No. 146, and
liabilities that a company previously recorded under EITF
Issue 94-3 are grandfathered. We will adopt SFAS
No. 146 on January 1, 2003, and we do not believe the
adoption of SFAS No. 146 will have a material effect on our
consolidated financial statements.

In April 2002, the FASB issued SFAS No. 145
Rescission of FASB Statements No. 4, 44, and 64,
Amendment of FASB Statement No. 13, and Technical
Corrections. SFAS No. 145 rescinds SFAS No. 4,
Reporting Gains and Losses from Extinguishment of
Debt, which required all gains and losses from
extinguishment of debt to be aggregated and, if material,
classified as an extraordinary item, net of related income tax
effect. SFAS No. 145, which is effective in periods
beginning after May 15, 2002 requires that gains or losses
from extinguishment of debt be classified as extraordinary items
only if they meet the criteria of APB Opinion No. 30. We
are required to adopt the provisions of SFAS No. 145 on
January 1, 2003, and we do not believe the adoption of SFAS
No. 145 will have a material effect on our consolidated
financial statements.

On January 1, 2002, we adopted SFAS
No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, which supersedes SFAS No. 121,
Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of, and provides a single
accounting model for long-lived assets to be disposed of. The
adoption of SFAS No. 144 had no effect on our condensed
consolidated financial statements.

On January 1, 2002, we adopted SFAS
No. 141, Business Combinations and SFAS
No. 142, Goodwill and Other Intangibles Assets.
SFAS No. 141 eliminates the pooling-of-interests method of
accounting for business combinations, except for qualifying
business combinations that were initiated prior to July 1,
2001. Under SFAS No. 142, goodwill and indefinite-lived
intangible assets are no longer amortized, but are reviewed
annually for impairment, or more frequently if impairment
indicators arise. The adoption of SFAS Nos. 141 and 142 had
no effect on our condensed consolidated financial statements.

On January 1, 2002, we adopted the EITF
guidance regarding the provision in EITF Issue 00-25,
Vendor Income Statement Characterization of Consideration
from a Vendor to a Retailer, dealing with consideration
from a vendor to a reseller under cooperative advertising and
other arrangements. This provision of EITF Issue 00-25
states that consideration from a vendor to a reseller of the
vendors products or services is

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presumed to be a reduction of the selling price
of the vendors products or services, unless the vendor
(i) receives an identifiable benefit in return for the
consideration and (ii) can reasonably estimate the fair
value of the benefit received. If the amount of consideration
paid by the vendor exceeds the estimated fair value of the
benefit received, the excess amount is to be recorded by the
vendor as a reduction of revenues. The adoption of this new
guidance did not have a material effect on our condensed
consolidated financial statements.


In August 2001, the FASB issued SFAS
No. 143, Accounting for Asset Retirement
Obligations. SFAS No. 143 requires that the fair
value of a liability for an asset retirement obligation be
recognized in the period in which it is incurred if a reasonable
estimate of fair value can be made. The associated asset
retirement costs are capitalized as part of the carrying amount
of the long-lived asset. We are required to adopt SFAS
No. 143 on January 1, 2003, and we do not believe the
adoption of SFAS No. 143 will have a material effect on our
consolidated financial statements.

On January 1, 2001, we adopted SFAS
No. 133, Accounting for Derivative Instruments and
Hedging Activities, as amended. SFAS No. 133
standardizes the accounting for derivatives and hedging
activities and requires that all derivatives be recognized in
the statement of financial position as either assets or
liabilities at fair value. Changes in the fair value of
derivatives that do not meet the hedge accounting criteria are
required to be reported in operations. The adoption of SFAS
No. 133 had no effect on our condensed consolidated
financial statements.



| |                                
| | -------------------------------
| | Liquidity and Capital Resources

Our operations have required substantial capital
investment for the procurement, design and construction of our
central office spaces, the design, creation, implementation and
maintenance of our operational support system, the purchase of
telecommunications equipment and the design and development of
our networks. Capital expenditures were $5,058 and $14,286 for
the three and nine months ending September 30, 2002,
respectively. Capital expenditures increased during the three
months ended September 30, 2002 as compared to the three
months ended June 30, 2002 primarily due to expenditures
related to recently signed wholesale agreements. We expect that
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 flat in future periods while 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.

From our inception through September 30,
2002, we financed our operations primarily through private
placements of $220,600 of equity securities, $1,282,000 in net
proceeds raised from the issuance of notes (including our recent
agreement with SBC for a $50,000 note payable), a $75,000
collateralized deposit and $719,000 in net proceeds raised from
public equity offerings. As of September 30, 2002, we had
an accumulated deficit of $1,493,847, and unrestricted cash,
cash equivalents, and short-term investments of $228,207. In
addition, we had stockholders equity as of
September 30, 2002 of $119,840.

Net cash used in our operating activities was
$60,552 for the nine months ending September 30, 2002. The
net cash used in our operating activities during this period was
primarily due to the net loss of $149,339, an increase in
accounts receivable of $9,459, a decrease in collateralized
customer deposits of $4,920, a decrease in unearned revenues of
$19,109 and a reduction of non-cash litigation-related expenses
of $9,029, offset by depreciation and amortization charges of
$103,872, a decrease in deferred costs of service activation of
$13,327, a decrease in restricted cash of $8,703, and an
increase in other current liabilities of $8,417.

Net cash used in our investing activities was
$99,710 for the nine months ending September 30, 2002. The
net cash used in our investing activities during this period was
primarily due to purchases of short-term investments of
$213,681, and purchases of property and equipment of $12,323,
offset by maturities of short-term investments of $70,988, sales
of short-term investments of $40,000, proceeds from sales of
property and equipment of $13,451 and proceeds from sales of
investments in unconsolidated subsidiaries of $3,360.

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Net cash provided by our financing activities was
$1,572 for the nine months ending September 30, 2002. The
net cash provided by our financing activities during this period
was primarily due to proceeds from common stock issuances of
$1,583.

As of September 30, 2002, we had $49,120 in
unrestricted cash and cash equivalents and $179,087 in
unrestricted short-term investments. We expect to experience
negative cash flow from operating and investing activities at
least into 2004 due to continued development of new services and
the addition of new end-users to our networks. Our future cash
requirements for developing, deploying and enhancing our
networks and operating our business, as well as our revenues,
will depend on a number of factors including:



| |   |                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------
| |  | the rate at which customers 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 maintain 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 litigation;                                                                                                                      
|
| |  | regulatory developments;                                                                                                                 
|
| |  | 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 and lease obligations as of
December 31, 2001 for the next five fiscal years, and
thereafter, were as follows:

|                       |  |      |       |           |  |           |        |            |  |       |        |  |  |   |       |  |  |   |        | 
|---------------------- |  | ---- | ----- | --------- |  | --------- | ------ | ---------- |  | ----- | ------ |  |  | - | ----- |  |  | - | ------ | 
|                       |  | 2002 |       | 2003-2004 |  | 2005-2006 |        | Thereafter |  | Total
|                       |  |      |       |           |  |           |        |            |  |      
|Note payable to SBC    |  | $    |      |           |  | $         |       |            |  | $     | 50,000 |  |  | $ |      |  |  | $ | 50,000 | 
|Capital leases         |  |      | 11    |           |  |           |       |            |  |       |       |  |  |   |      |  |  |   | 11     | 
|Office leases          |  |      | 5,540 |           |  |           | 9,226  |            |  |       | 5,742  |  |  |   | 1,829 |  |  |   | 22,337 | 
|Other operating leases |  |      | 2,371 |           |  |           | 1,575  |            |  |       | 5      |  |  |   |      |  |  |   | 3,951  | 
|                       |  |      |       |           |  |           |        |            |  |       |        |  |  |   |       |  |  |   |        | 
|                       |  | $    | 7,922 |           |  | $         | 10,801 |            |  | $     | 55,747 |  |  | $ | 1,829 |  |  | $ | 76,299 | 
|                       |  |      |       |           |  |           |        |            |  |       |        |  |  |   |       |  |  |   |        | 

We lease certain vehicles, equipment and office
facilities under noncancelable operating leases that expire at
various dates through 2009. The facility leases generally
require us to pay operating costs, including property taxes,
insurance and maintenance, and contain scheduled rent increases
and certain other rent escalation clauses. Rent expense is
reflected in our consolidated financial statements on a
straight-line basis over the terms of the respective leases. We
were also obligated under a capital equipment lease, which
expired during 2002.

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Our business plan includes certain discretionary
spending that is predicated on certain revenue growth
assumptions. If necessary, we will curtail this discretionary
spending so that we can continue as a going concern at least
through January 1, 2003 using only our unrestricted cash,
cash equivalent and short-term investment balances in existence
as of December 31, 2001. Additionally, based on the advice
of our legal counsel, we believe it is more likely than not that
certain securities litigation described in Note 8 to our
September 30, 2002 condensed consolidated financial
statements will ultimately be settled in accordance with the
terms of the MOU dated August 10, 2001 executed by us and
the plaintiffs in such securities litigation. Therefore, we do
not believe that the ultimate settlement of this securities
litigation will have a material adverse effect on our ability to
continue as a going concern at least through January 1,
2003. However, in the event (1) the MOU is not ultimately
approved by the United States District Court and/or (2) the
settlement of the aforementioned securities litigation
ultimately requires us to disburse additional cash, we will
reduce discretionary spending so that we can continue as a going
concern at least through January 1, 2003 using only our
unrestricted cash, cash equivalent and short-term investment
balances in existence as of December 31, 2001. We do not
believe the curtailment of our discretionary spending, if
necessary, will have a material adverse effect on the overall
execution of our business plan.

We believe that our current cash, cash
equivalents and short-term investments will be sufficient to
meet our anticipated cash needs for working capital and capital
expenditures until we generate positive cash flows from our
operating activities, which we currently anticipate will be in
2004. An adverse business, legal, regulatory or legislative
development may require us to raise additional financing or to
change our business plan. We also recognize that we may be
required to raise additional capital, the amount and timing of
which is uncertain considering current capital market
conditions. If we are unable to acquire additional capital or
are required to raise it on terms that are unfavorable, it will
have a material adverse effect on our financial condition, which
could require a restructuring, sale or liquidation of our
company.



| |             
| | ------------
| | 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 2001 Annual Report on Form 10-K,
which was filed with the SEC on March 29, 2002.



| |   |                                                                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We may not be able to expand as quickly as we
    need to achieve profitability.                                                                                                                                                                                 
|
| |  | We are dependent on a limited number of customers
    for the preponderance of our revenues, and we are highly
    dependent on sales through our resellers.                                                                                                     
|
| |  | We may experience decreasing margins on the sale
    of our services, which may impair our ability to achieve
    profitability or positive cash flow.                                                                                                           
|
| |  | The markets we face are highly competitive and we
    may not be able to compete effectively, especially against
    established industry competitors with significantly greater
    financial resources.                                                        
|
| |  | Charges for unbundled network elements are
    generally outside of our control because they are proposed by
    the traditional telephone companies and are subject to costly
    regulatory approval processes.                                                
|
| |  | We may lose the ability to purchase line-shared
    services from the traditional telephone companies.                                                                                                                                                           
|
| |  | We may be unable to obtain access on acceptable
    terms to remote terminals and other facilities that provide
    services to end users who are not served by a standard copper
    phone line from a central office where we can obtain collocation
    space.
|
| |  | Our services are subject to government
    regulation, and changes in current or future laws or regulations
    and the methods of enforcing the laws and regulations could
    adversely affect our business.                                                   
|
| |  | Our business will suffer if our interconnection
    agreements are not renewed or if they are modified on
    unfavorable terms.                                                                                                                                 

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| |   |                                                                                                                                                                                                                           
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We may not be able to obtain space for our
    equipment on premises owned by the traditional local telephone
    companies on terms that are economical to our business.                                                 
|
| |  | We cannot predict whether we will be successful
    because our business strategy is largely unproven.                                                                                                                    
|
| |  | Our business is difficult to evaluate because we
    have a limited operating history.                                                                                                                                    
|
| |  | We have a history of losses and expect losses in
    the future.                                                                                                                                                          
|
| |  | We are a party to litigation, and adverse results
    of such litigation could negatively impact our financial
    condition and results of operations.                                                                   
|
| |  | Our business may suffer unless financial market
    conditions improve.                                                                                                                                                   
|
| |  | The financial uncertainty of the competitive
    telecommunications industry may continue to cause us to lose
    orders for our services.                                                                                
|
| |  | We may need to raise additional capital under
    difficult financial market conditions in order to maintain our
    operations.                                                                                          
|
| |  | Our internal controls need to be improved.                                                                                                                                                                                
|
| |  | We have experienced increased order cancellations
    and end-user disconnections.                                                                                                                                        
|
| |  | We were delisted from the Nasdaq National Market
    and this limits the public market for our common stock.                                                                                                              
|
| |  | The price of our common stock may fluctuate
    significantly, which may result in losses for investors.                                                                                                                  
|
| |  | Future sales or issuances of our common stock may
    depress our stock price.                                                                                                                                            
|
| |  | Anti-takeover effects of certain charter and
    bylaw provisions, Delaware law, our indebtedness, our
    Stockholder Protection Rights Plan and our compensation
    arrangements could prevent a change in our control.
|
| |  | Our operating results are likely to fluctuate in
    future periods and may fail to meet the expectations of
    securities analysts and investors.                                                                       
|
| |  | 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.                                                                                                                        
|
| |  | 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 broadband communications industry is
    undergoing rapid technological changes and new technologies may
    be superior to the technology we use.                                                                    
|
| |  | A failure of our network could delay or interrupt
    service to our customers.                                                                                                                                           
|
| |  | A breach of network security could delay or
    interrupt service to our customers.                                                                                                                                       
|
| |  | Interference in the traditional telephone
    companies copper plant could degrade the performance of
    our services.                                                                                                  
|
| |  | Our intellectual property protection may be
    inadequate to protect our proprietary rights.                                                                                                                             
|
| |  | We must comply with federal, state and local tax
    and other surcharges on our service, the levels of which are
    uncertain.                                                                                          

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. Expected or projected future

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performance cannot be ensured. Actual results may
differ materially from those in forward-looking statements due
to a number of factors, including those referred to above under
Risk Factors. 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,
is likely, is probable, is
possible, or the negative thereof or other variations
thereon or comparable terminology, or by discussions of facts,
events or strategies that involve risks and uncertainties.
Examples of such forward-looking statements include but are not
limited to:




| |   |                                                                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | expectations regarding our ability to become
    cash-flow positive;                                                                                                                                                                                             
|
| |  | expectations regarding the extent to which
    customers roll out our service;                                                                                                                                                                                   
|
| |  | expectations regarding our relationships with our
    strategic partners and other potential third parties;                                                                                                                                                      
|
| |  | expectations as to pricing for our services in
    the future;                                                                                                                                                                                                   
|
| |  | expectations as to the impact of our service
    offerings on our margins;                                                                                                                                                                                       
|
| |  | the possibility that we may obtain significantly
    increased sales volumes;                                                                                                                                                                                    
|
| |  | 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 cash usage and the number of
    installed lines;
|
| |  | expectations regarding the time frames, rates,
    terms and conditions for utilizing line sharing;                                                                                                                                                            
|
| |  | plans to develop and commercialize value-added
    services;                                                                                                                                                                                                     
|
| |  | our anticipated capital expenditures;                                                                                                                                                                                                                            
|
| |  | plans to enter into business arrangements with
    broadband-related service providers;                                                                                                                                                                          
|
| |  | expectations regarding the development and
    commencement of our voice services;                                                                                                                                                                               
|
| |  | our plans to expand our existing networks or to
    commence service in new metropolitan statistical areas;                                                                                                                                                      
|
| |  | estimates regarding the timing of launching our
    service in new metropolitan statistical areas;                                                                                                                                                               
|
| |  | the effect of regulatory reform and litigation;
    and                                                                                                                                                                                                          
|
| |  | other statements contained in this Report on
    Form 10-Q regarding matters that are not historical facts.                                                                                                                                                      

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 September 30, 2002 is
fixed-rate debt.

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Item 4.     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 our chief financial
officer, based on their evaluation of the effectiveness of our
disclosure controls and procedures within
90 days before the filing date of this quarterly report,
have concluded that our disclosure controls and procedures were
effective for this purpose, with the exception of controls
related to certain network assets as described below.

As part of the continuing evaluation of our
network assets during the three months ended September 30,
2002, we recorded additional depreciation expense of $9,584
related to equipment that was deployed in the network and
subsequently replaced as a result of a change in technology. Due
to a deficiency in our internal controls related to certain
operational procedures for tracking network assets which
prevented this matter from being recognized for accounting
purposes in a timely manner, the depreciable life of these
assets was not adjusted to their remaining economic useful life
in prior periods. To address these matters, we have implemented
additional operational controls and systems capabilities to
track network assets more precisely as they are added to or
removed from our network. Additionally, we are making
improvements to the process for tracking network assets not
deployed in the network.

During the quarter ended September 30, 2002,
we also recorded in network and product costs an additional
charge of $1,215 related to the capitalization of certain
operating expenses in prior periods. To address this matter, we
are adding additional internal processing controls to prevent
the capitalization of these operating expenses.

We believe that these initiatives will adequately
address these control matters and we do not anticipate
additional material adjustments related to network assets in
subsequent periods related to the above described items.

Except as noted above, there were not any
significant changes in our internal controls or in other factors
that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material
weaknesses.




PART II.     OTHER
INFORMATION




Item 1.     Legal
Proceedings (all dollar amounts are presented in
thousands)

On May 24, 2002, the United States Court of
Appeals for the District of Columbia vacated the Federal
Communications Commissions (FCC) decision
granting competitive local exchange carriers like us the ability
to purchase line-shared services from the traditional telephone
companies. It is unclear when and if the FCC will issue a new
order concerning line-sharing. The FCC and the Company filed a
Motion for Reconsideration and a request to stay vacature of the
line sharing order with the Court of Appeals pending the
FCCs review of the line sharing order. On
September 4, 2002, the Court of Appeal denied the
FCCs and our Motion for Reconsideration, but granted the
request to stay vacature of the line sharing order until
January 2, 2003. We therefore have the continued right to
line sharing until at least January 2, 2003. We also
believe that we have a continued right to line-sharing under our
interconnection agreements with the traditional telephone
companies, but those agreements do allow the traditional
telephone companies to renegotiate their terms based on a change
in law. If the traditional telephone companies invoke this
change-in-law provision, or if the FCC does not issue a new
order allowing us to purchase line-shared services, it is
possible that the traditional telephone companies could either
refuse to sell us such services or could substantially increase
the cost of line-shared services, either of which would have a
material adverse effect on our business and could even result in
a liquidation or sale of our business. The court also remanded
the list of unbundled network elements that had been developed
by the FCC. The FCC is in the process of reviewing the list of
unbundled network elements, which include the transmission
facilities and telephone lines that we purchase from the
traditional telephone

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companies in order to provide our services to our
customers. If the FCC removes any of our existing transmission
facilities or telephone lines from the previous list of
unbundled network elements, the traditional telephone companies
could either increase the cost of obtaining such transmission
facilities and telephone lines or deny us access entirely, which
would adversely affect our business.


On December 13, 2001, the United States
Bankruptcy Court for the District of Delaware (the
Bankruptcy Court) entered an order confirming our
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 we emerged from bankruptcy. Under our
Plan, we settled several claims against us. These claims include:



| |   |                                                                                                                                                                                                                                                                     
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The class action lawsuits filed in the United
    States District Court for the Northern District of California,
    provided that this settlement will not be final unless it is
    approved by that court. 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 we issued in September
    2000.                                                                          
|
| |  | Disputed claims made by former shareholders of
    Laser Link.net.                                                                                                                                                                                                  
|
| |  | Disputed claims made by GE Capital and its
    subsidiary, Heller Financial Group.                                                                                                                                                                                  

As of September 30, 2002, there were
approximately $10,959 in unresolved claims related to our
Chapter 11 bankruptcy proceedings. As of September 30,
2002, we have recorded $9,997 for these unresolved claims in our
condensed consolidated balance sheet. However, it is reasonably
possible that our unresolved Chapter 11 bankruptcy claims
could ultimately be settled for amounts that differ from the
amounts recorded in our condensed consolidated balance sheet.

Purchasers of our common stock and purchasers of
the convertible notes we issued in September 2000 have filed
complaints on behalf of themselves and alleged classes of
stockholders and holders of convertible notes 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 (District Court)
in the fourth quarter of 2000. The complaints have been
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 (MOU) with counsel for the lead
plaintiffs in this litigation that tentatively resolves the
litigation. The MOU sets forth the terms upon which we, 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 our bankruptcy plan if it
provided 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 is subject to the approval of the
District Court, which preliminarily approved the settlement on
October 29, 2002. The 6,495,844 shares issuable to the
plaintiffs upon such approval by the District Court were issued
on the Effective Date of the bankruptcy and are being held by us
in escrow, pending approval by the District Court. We believe we
have strong defenses to the claims alleged in the lawsuit and
intend to contest the lawsuit vigorously if the District Court
does not approve the final settlement. Because this action is at
an early stage, however, we are unable to provide an evaluation
of the ultimate outcome of the litigation if the court does not
approve the final settlement agreement. Although we believe it
is more likely than not that this settlement will be completed,
we do not expect this process to be completed for several months.

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

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our claims based on the ruling 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
have 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 has requested a
rehearing before the Eleventh Circuit and that request is still
pending. We cannot predict the outcome of these matters.


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. It claims that we falsified trouble ticket reports
with respect to the phone lines that we ordered and made false
statements to the public and governmental authorities critical
of Verizon, 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. We
believe we have strong defenses to this lawsuit, but litigation
is inherently unpredictable and there is no guarantee we 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 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. We believe
we have strong defenses to these lawsuits and we intend to
contest them vigorously. However, because these lawsuits are at
an early stage, we are unable to provide an evaluation of the
ultimate outcome of the litigation.

A manufacturer of telecommunications hardware
named COVID has filed an opposition to our trademark
application for the mark COVAD and design and is
seeking to cancel our registration of the COVAD trademark. We do
not believe that this opposition has merit, but trademark
proceedings are unpredictable and there is no guarantee we will
prevail. If we do not succeed, it could limit our ability to
provide our services under the COVAD name. In
September 2000, COVID also filed a complaint in the United
States District Court for the District of Arizona, alleging
claims for false designation of origin, infringement and unfair
competition. COVID is seeking an injunction to stop us from
using the COVAD trademark, as well as an award of monetary
damages. We do not believe that these claims have any merit, but
the outcome of litigation is unpredictable and we cannot
guarantee that we will prevail.

We are also a party to a variety of 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 commission, FCC 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 deemed to be
bound by or we 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
negotiations, arbitrations and regulatory and court proceedings
with several traditional telephone companies. These
negotiations, arbitrations and proceedings concern the
traditional telephone companies denial of physical central
office space to us in certain central offices, the cost

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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. However, an unfavorable outcome in
any of these negotiations, arbitrations and regulatory
proceedings 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.





Item 2.     Changes
in Securities and Use of Proceeds

On September 4, 2002, in conjunction with
the execution of a five-year Broadband Internet Access Service
Agreement (the Broadband Agreement) with America
Online, Inc. (AOL), a wholesale customer, we granted
AOL three warrants to purchase an aggregate of 3,500,000 shares
of the our common stock. We did not receive any additional
purchase price for our issuance of the warrants. The first
warrant is for 1.5 million shares at $1.06 per share, the
second warrant is for 1 million shares at $3.00 per share
and the third warrant is for 1 million shares at $5.00 per
share.

Such warrants were immediately exercisable, fully
vested and non-forfeitable at the date of grant. The warrants
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 July 25, 2002, 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 three Class II
directors to serve on our Board of Directors for a term to
expire at the third succeeding annual meeting and until their
successors are elected and qualified.

|                   |  |     |             |          |  |  |           | 
|------------------ |  | --- | ----------- | -------- |  |  | --------- | 
|Name               |  | For |             | Withheld
|                   |  |     |             |         
|Charles E. Hoffman |  |     | 191,919,970 |          |  |  | 6,433,748 | 
|Charles McMinn     |  |     | 192,859,746 |          |  |  | 5,493,972 | 
|Robert Hawk        |  |     | 191,221,803 |          |  |  | 7,131,915 | 

Proposal 2 Ratification of independent auditors,
Ernst & Young LLP, for the 2002 fiscal year:
191,346,619 votes in favor, 6,726,753 votes against, and 280,347
votes abstained.




Item 5.     Other
Information

None




Item 6.     Exhibits
and Reports on Form 8-K

a.     Exhibits:

|        |    |             |  |                                                                                                                                
|------- | -- | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|Number  |    | Description
|        |    |            
|        | 99 | .1          |  | Certification Pursuant to 18 U.S.C.
    Section 1350, as Adopted Pursuant to Section 906 of
    the Sarbanes-Oxley Act of 2002.
|        | 99 | .2          |  | Certification Pursuant to 18 U.S.C.
    Section 1350, as Adopted Pursuant to Section 906 of
    the Sarbanes-Oxley Act of 2002.

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b.     Reports on
Form 8-K

On July 2, 2002, the Company filed a current
report on Form 8-K, pursuant to Item 5 thereof,
reporting (i) that L. Dale Crandall joined the
Companys Board of Directors and will serve on its audit
committee and (ii) that Brad Sonnenberg was promoted to
senior vice president and general counsel of the Company.

On July 26, 2002, the Company filed a
current report on Form 8-K, pursuant to Item 5
thereof, reporting that Richard A. Jalkut joined the
Companys Board of Directors.

On September 5, 2002, the Company filed a
current report on Form 8-K, pursuant to Item 5
thereof, reporting that the Company signed a five year Broadband
Internet Access Services Agreement with America Online, Inc.

On September 23, 2002, the Company filed a
current report on Form 8-K, pursuant to Item 5
thereof, reporting that the Company signed a three year
Broadband Internet Access Services Agreement with AT&T Corp.

44



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of the Securities
Exchange Act of 1934, the Registrant has duly caused this report
to be signed on its behalf by the undersigned thereunto duly
authorized.



| |                                 
| | --------------------------------
| | COVAD COMMUNICATIONS GROUP, INC.



| |     |                       
| | --- | ----------------------
| | By: | /s/ CHARLES E. HOFFMAN

| |                                                    
| | ---------------------------------------------------
| |                                                    
| | Charles E. Hoffman                                 
| | President, Chief Executive Officer and
    Director

Date: November 7, 2002



| |     |                 
| | --- | ----------------
| | By: | /s/ MARK RICHMAN

| |                             
| | ----------------------------
| |                             
| | Mark Richman                
| | Executive Vice President and
| | Chief Financial Officer     

Date: November 7, 2002

45



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##### Table of Contents






CERTIFICATIONS

I, Charles E. Hoffman, certify that:



| |                                                                                                                                                                                                                                                                                                                                                              
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1.     I have reviewed
    this quarterly report on Form 10-Q of Covad Communications
    Group, Inc.;                                                                                                                                                                                                                                                       
|
| | 2.     Based on my
    knowledge, this quarterly report does not contain any untrue
    statement of a material fact or omit to state a material fact
    necessary to make the statements made, in light of the
    circumstances under which such statements were made, not
    misleading with respect to the period covered by this quarterly
    report;
|
| | 3.     Based on my
    knowledge, the financial statements, and other financial
    information included in this quarterly report, fairly present in
    all material respects the financial condition, results of
    operations and cash flows of the registrant as of, and for, the
    periods presented in this quarterly report;                       
|
| | 4.     The
    registrants other certifying officers and I are
    responsible for establishing and maintaining disclosure controls
    and procedures (as defined in Exchange Act Rules 13a-14 and
    15d-14) for the registrant and we have:                                                                                                             



| |                                                                                                                                                                                                                                                                                                                   
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this quarterly report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this
    quarterly report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this quarterly report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                



| |                                                                                                                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 5.     The
    registrants other certifying officers and I have
    disclosed, based on our most recent evaluation, to the
    registrants auditors and the audit committee of
    registrants board of directors (or persons performing the
    equivalent functions):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    



| |                                                                                                                                                                                                                                                                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 6.     The
    registrants other certifying officers and I have indicated
    in this quarterly report whether or not there were significant
    changes in internal controls or in other factors that could
    significantly affect internal controls subsequent to the date of
    our most recent evaluation, including any corrective actions
    with regard to significant deficiencies and material weaknesses.



| |                                 
| | --------------------------------
| | COVAD COMMUNICATIONS GROUP, INC.



| |     |                       
| | --- | ----------------------
| | By: | /s/ CHARLES E. HOFFMAN

| |                                                    
| | ---------------------------------------------------
| |                                                    
| | Charles E. Hoffman                                 
| | President, Chief Executive Officer and
    Director

Date: November 7, 2002

46



---



##### Table of Contents



I, Mark Richman, certify that:



| |                                                                                                                                                                                                                                                                                                                                                              
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1.     I have reviewed
    this quarterly report on Form 10-Q of Covad Communications
    Group, Inc.;                                                                                                                                                                                                                                                       
|
| | 2.     Based on my
    knowledge, this quarterly report does not contain any untrue
    statement of a material fact or omit to state a material fact
    necessary to make the statements made, in light of the
    circumstances under which such statements were made, not
    misleading with respect to the period covered by this quarterly
    report;
|
| | 3.     Based on my
    knowledge, the financial statements, and other financial
    information included in this quarterly report, fairly present in
    all material respects the financial condition, results of
    operations and cash flows of the registrant as of, and for, the
    periods presented in this quarterly report;                       
|
| | 4.     The
    registrants other certifying officers and I are
    responsible for establishing and maintaining disclosure controls
    and procedures (as defined in Exchange Act Rules 13a-14 and
    15d-14) for the registrant and we have:                                                                                                             



| |                                                                                                                                                                                                                                                                                                                   
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this quarterly report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this
    quarterly report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this quarterly report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                



| |                                                                                                                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 5.     The
    registrants other certifying officers and I have
    disclosed, based on our most recent evaluation, to the
    registrants auditors and the audit committee of
    registrants board of directors (or persons performing the
    equivalent functions):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    



| |                                                                                                                                                                                                                                                                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 6.     The
    registrants other certifying officers and I have indicated
    in this quarterly report whether or not there were significant
    changes in internal controls or in other factors that could
    significantly affect internal controls subsequent to the date of
    our most recent evaluation, including any corrective actions
    with regard to significant deficiencies and material weaknesses.



| |                                 
| | --------------------------------
| | COVAD COMMUNICATIONS GROUP, INC.



| |     |                 
| | --- | ----------------
| | By: | /s/ MARK RICHMAN

| |                             
| | ----------------------------
| |                             
| | Mark Richman                
| | Executive Vice President and
| | Chief Financial Officer     

Date: November 7, 2002

47



---



##### Table of Contents



|        |    |             |  |                                                                                                                                
|------- | -- | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|Number  |    | Description
|        |    |            
|        | 99 | .1          |  | Certification Pursuant to 18 U.S.C.
    Section 1350, as Adopted Pursuant to Section 906 of
    the Sarbanes-Oxley Act of 2002.
|        | 99 | .2          |  | Certification Pursuant to 18 U.S.C.
    Section 1350, as Adopted Pursuant to Section 906 of
    the Sarbanes-Oxley Act of 2002.

48