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SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549
 FORM 10-K/A AMENDMENT NO. 1
TO (Mark One)x
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934For the fiscal year ended December 31, 2003o
    
    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
(State or Other Jurisdiction
of Incorporation or Organization)
    
    77-0461529
(I.R.S. Employer
Identification No.)
 110 Rio Robles, San Jose, California 95134 Registrants telephone number, including area code:
(408) 952-6400 Securities registered pursuant to Section 12(b) of the Act:
None Securities registered pursuant to Section 12(g) of the Act: Common Stock, Par Value $0.001 Per Share
(Title of Class) Stock Purchase Rights Pursuant To Rights Agreement
(Title of Class) Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes x No o Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. o Indicate by check mark whether the registrant is an accelerated filer (as
defined by Exchange Act Rule 12b-2) Yes x No o The aggregate market value of the voting and non-voting common equity held
by non-affiliates computed by reference to the price at which the common equity
was sold on June 30, 2003 as reported on the OTC Bulletin Board, was
approximately $226.1 million. Shares of common equity held by each officer and
director and by each person who owns 5% or more of the outstanding common
equity have been excluded in that such persons may be deemed to be affiliates.
This determination of affiliate status is not necessarily a conclusive
determination for other purposes. APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS
DURING THE PRECEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. YES x NO o APPLICABLE ONLY TO CORPORATE ISSUERS: As of February 10, 2004, there were 230,606,167 shares outstanding of the
Registrants Common Stock and no shares outstanding of the Registrants Class B
Common Stock.


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TABLE OF CONTENTS  PART IIItem 6. Selected Financial DataItem 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsItem 8. Financial Statements and Supplementary DataItem 9. Changes In and Disagreements with Accountants on Accounting and Financial DisclosureItem 9A. Controls and ProceduresPART IVItem 15. Financial Statement Schedules, Reports on Form 8-K and ExhibitsSIGNATURESEXHIBIT INDEXEXHIBIT 23.1EXHIBIT 31.1EXHIBIT 31.1EXHIBIT 32.1EXHIBIT 32.1    Table of Contents  EXPLANATORY NOTE This Annual Report on Form 10-K/A is being filed as Amendment No. 1 to our
Annual Report on Form 10-K for the fiscal year ended December 31, 2003 filed
with the Securities and Exchange Commission on February 27,
2004. See Part II. Item 7. Managements Discussion and
Analysis of Financial Condition and Results of Operations and Note 15
to our Consolidated Financial Statements included in Item 8 for further
discussion of this restatement. This amendment is also filed in connection with
the restatement of our financial statements for the quarters ended September
30, 2003 and December 31, 2003, as well as for the year ended December 31,
2003. This report speaks as of the original filing date and, except as
indicated, has not been updated to reflect events occurring subsequent to the
original filing date. The following is a list of the items of the annual report amended hereby
(including a brief description of the change to each such item): 
 PART II 
 Item 6. Selected Financial Data  
    
    Inclusion of restated 2003 Consolidated Statement of Operations Data. 
 Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations  
    
    Under Operating Expenses, restated total operating
expenses and restated Network and Products Costs (and related
disclosure regarding deferred variable stock-based compensation
expenses) and restated Sales, Marketing, General and
Administrative expenses (and related disclosure regarding deferred
variable stock-based compensation expenses); and
    
    Under Quarterly Financial Information (Unaudited),
restated quarterly information for the three months ended
September 30, 2003 and December 31, 2003 and restated net
loss and effect of certain corrections for the three months
ended September 30, 2003 and December 31, 2003 and the year
ended December 31, 2003; and
    
    Under Liquidity and Capital Resources, corrections of
the accumulated deficit data, net loss data and net cash used in
operating activities data in the third
and fourth paragraph, respectively. 
 Item 8. Financial Statements and Supplementary Data  
    
    Report of Ernst & Young LLP, Independent Auditors;
    
    Restated Consolidated Balance Sheets;
    
    Restated Consolidated Statements of Operations;
    
    Restated Consolidated Statement of Stockholders Equity
(deficit);
    
    Restated Consolidated Statements of Cash Flows; and
    
    Notes to Consolidated Financial Statements,
including amendments to Note 1 under Stock-Based
Compensation and Comprehensive Income (Loss), Note 12
(revised reconciliation of income taxes table to include
deferred variable stock-based compensation), Note 13 (add disclosure
regarding deferred variable stock-based compensation expenses in the
disclosure following the summary of status of stock options
table) and Note 14 (restating the segment information data as
of and for the year ended December 31, 2003, as well as the
addition of Note 15 describing the restatement of our
financial statements. Item 9A. Controls and Procedures  
    
    Disclosure relating to the restatement pertaining to deferred
variable stock-based compensation expenses. PART IV Item 15. Financial Statement Schedules, Reports on Form 8-K and Exhibits  
    
    Amendment to reflect the exhibits filed with this amendment. 1




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Item 6.Selected Financial Data For the Year Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999(Restated)Consolidated Statement of
Operations Data:Revenues, net
    
    $
    388,851
    
    
    $
    383,496
    
    
    $
    332,596
    
    
    $
    158,736
    
    
    $
    66,488Depreciation and amortization
    
    
    73,884
    
    
    
    127,088
    
    
    
    150,839
    
    
    
    178,425
    
    
    
    37,602Provision for restructuring expenses
    
    
    1,235
    
    
    
    
    
    
    
    14,364
    
    
    
    4,988
    
    
    
    Provision for long-lived asset impairment
    
    
    
    
    
    
    
    
    
    
    11,988
    
    
    
    589,388
    
    
    
    Loss from operations
    
    
    (114,570
    )(1)
    
    
    (180,992
    )
    
    
    (536,880
    )
    
    
    (1,354,192
    )
    
    
    (171,601
    )Interest expense
    
    
    (5,526
    )
    
    
    (5,581
    )
    
    
    (92,782
    )
    
    
    (109,863
    )
    
    
    (44,472
    )Reorganization expenses, net
    
    
    
    
    
    
    
    
    
    
    (62,620
    )
    
    
    
    
    
    
    Gain on extinguishment of debt
    
    
    
    
    
    
    
    
    
    
    1,033,727
    
    
    
    
    
    
    
    Income (loss) before cumulative effect of change
in accounting principle
    
    
    (112,302
    )(1)
    
    
    (184,828
    )
    
    
    344,758
    
    
    
    (1,433,887
    )
    
    
    (195,397
    )Cumulative effect of change in accounting principle
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9,249
    )
    
    
    Net income (loss)
    
    $
    (112,302
    )(1)
    
    $
    (184,828
    )
    
    $
    344,758
    
    
    $
    (1,443,136
    )
    
    $
    (195,397
    )Basic and diluted per share
amounts:Net income (loss) before cumulative effect of
change in accounting principle
    
    $
    (0.50
    )(1)
    
    $
    (0.84
    )
    
    $
    1.94
    
    
    $
    (9.41
    )
    
    $
    (1.83
    )Cumulative effect of accounting change
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    (0.06
    )
    
    $
    Net income (loss)
    
    $
    (0.50
    )(1)
    
    $
    (0.84
    )
    
    $
    1.94
    
    
    $
    (9.47
    )
    
    $
    (1.83
    )Weighted average common shares used in computing
basic and diluted per share amounts
    
    
    224,949,891
    
    
    
    219,743,662
    
    
    
    177,347,193
    
    
    
    152,358,589
    
    
    
    107,647,812Pro forma amounts assuming the
accounting change is applied
retroactively:Net income (loss)
    
    $
    (112,302
    )(1)
    
    $
    (184,828
    )
    
    $
    344,758
    
    
    $
    (1,433,887
    )
    
    $
    (204,646
    )Net income (loss) attributable to common
Stockholders
    
    $
    (112,302
    )(1)
    
    $
    (184,828
    )
    
    $
    344,758
    
    
    $
    (1,433,887
    )
    
    $
    (205,792
    )Basic and diluted net income (loss) per common
share
    
    $
    (0.50
    )(1)
    
    $
    (0.84
    )
    
    $
    1.94
    
    
    $
    (9.41
    )
    
    $
    (1.91
    )
   (1)
    
    See Note 15 of Notes to Consolidated Financial Statements As of December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999Consolidated Balance Sheet Data:Cash, cash equivalents and short-term investment
    
    $
    114,345
    
    
    $
    202,492
    
    
    $
    283,863
    
    
    $
    869,834
    
    
    $
    767,357Net property and equipment
    
    
    94,279
    
    
    
    108,737
    
    
    
    215,804
    
    
    
    338,409
    
    
    
    186,059Total assets
    
    
    334,711
    
    
    
    442,161
    
    
    
    675,168
    
    
    
    1,511,485
    
    
    
    1,147,606Long-term obligations, including current portion
    
    
    50,000
    
    
    
    50,165
    
    
    
    50,011
    
    
    
    1,374,673
    
    
    
    375,050Total stockholders equity (deficit)
    
    
    (5,553
    )
    
    
    82,299
    
    
    
    259,829
    
    
    
    (182,663
    )
    
    
    690,291
 As of and for the Year Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999Other Operating and
Financial Data:Homes and businesses passed (approximately)
    
    
    46,000,000
    
    
    
    46,000,000
    
    
    
    40,000,000
    
    
    
    40,000,000
    
    
    
    29,000,000Lines in service
    
    
    517,000
    
    
    
    381,000
    
    
    
    351,000
    
    
    
    274,000
    
    
    
    57,000Capital expenditures for property and equipment
    
    $
    44,142
    
    
    $
    22,782
    
    
    $
    15,732
    
    
    $
    319,234
    
    
    $
    174,054
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Item 7.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 restated consolidated
financial statements and the related notes thereto included elsewhere in this
amended Annual Report onForm 10-K/A. This discussion contains forward-looking
statements, the accuracy of which involves risks and uncertainties. Our actual
results could differ materially from those anticipated in the forward-looking
statements for many reasons including, but not limited to, those discussed in
Part I. Item 1. Business-Risk Factors in the Annual Report onForm 10-Kfiled
February 27, 2004 and elsewhere therein and in this amended Annual Report on
Form 10-K/A. We disclaim any obligation to update information contained in any
forward-looking statement. See  Forward Looking Statements. (All dollar amounts are presented in thousands, except per share amounts) Overview Background We are a leading provider of high-speed Internet connectivity and related
communications services, which we sell to businesses and consumers indirectly
through Internet service providers, or ISPs, telecommunications carriers and
other resellers. We also sell our services directly to business and consumer
end-users through our field sales force, telephone sales, referral agents and
our Web site. We managed the Company in 2003 in two strategic business units. Covad
Strategic Partnerships, or CSP, focused on delivering services to enterprise,
corporate, small business, small office/home office, or SoHo, and consumer
customers primarily through wholesale relationships with large ISPs,
telecommunications carriers and other large resellers. Covad Broadband
Solutions, or CBS, focused on small business and SoHo markets by selling
services directly to end-users as well as through independent authorized sales
agents, small ISPs and resellers. Beginning in January 2004, we realigned our business and no longer
maintain CSP and CBS as separate business units. We believe this realignment
will lead to more efficient product development, sales and marketing because we
will no longer have two separate groups providing these functions. In
connection with this realignment, David McMorrow, previously our Senior Vice
President, Corporate Development, was appointed Executive Vice President,
Sales, Andy Lockwood, previously our Executive Vice President and General
Manager for CSP, was appointed Executive Vice President, Market Development and
Patrick Bennett, previously our Executive Vice President and General Manager
for CBS, was appointed Executive Vice President and will oversee our product
development and management, including our deployment of voice over Internet
Protocol. Since our inception, we have generated significant net and operating
losses and we continue to experience negative operating cash flow. We currently
have a plan in place that we believe will ultimately allow us to achieve
positive cash flows from our operating activities in mid-2004. Our cash
reserves are limited and our plan is based on assumptions that we believe are
reasonable, but some of which are out of our control. If actual events differ
from our assumptions, we may need to raise additional capital on terms that are
less favorable than we desire. Triennial Review The FCCs decision in the Triennial Review is described in this Annual
Report in Item 1, Business  Recent Developments. As a result of this ruling,
in October of 2004 the traditional telephone companies will no longer be
required by law to provide us with line-shared telephone lines under Section
251 of the 1996 Telecommunications Act, although existing customers as of
October 2, 2003 are grandfathered at current rates, terms and conditions.
Consequently, our future ability to offer stand alone Internet access over a
telephone line that is being used by a traditional telephone company to provide
voice service, which is the primary service that we and our resellers have
historically used to provide services to consumers, will depend on whether we
are able to enter into new agreements with the traditional telephone companies
to share access to the high frequency portion of their telephone lines on terms
that are acceptable to us, or whether we are able to obtain favorable
regulatory rulings. Pursuant to the Triennial Review, companies that compete with the
traditional telephone companies will continue to have the ability to access the
local telephone networks to provide bundled voice and data services, so long as
these arrangements are deemed appropriate by the state public utility
commissions, subject to federal guidelines. This situation affords us the
opportunity to continue to partner with voice providers, such as AT&T, to
provide our data services in line-splitting relationships. Investors should review the above-referenced discussion of the Triennial
Review carefully to understand other potentially significant effects that this
ruling will have on our ability to continue to engage in our business as we
have in the past, as the FCCs ruling creates a number of other uncertainties,
challenges and opportunities for us. The final effect of many of these
components of the FCCs ruling will be subject to the reactions of the various
participants in the telecommunications industry, and many of these 3




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components are, or likely will be, the subject of litigation that could
influence their ultimate impact. As such, it is very difficult for us to
predict with a high level of certainty the final effects of the Triennial
Review. Our Opportunities and Challenges Given the highly competitive, dynamic and heavily regulated nature of our
business environment, we face a complex array of factors that create challenges
and opportunities for us. Key matters upon which we are focused at this time
include the following: Achieve cash flow sufficiency.Since we exited our voluntary bankruptcy
proceedings at the end of 2001, we have been able to decrease the amount of
cash flow used in our operations, and concluded 2003 with working capital of
approximately $46.3 million. We have a critical strategic goal of achieving
cash flow sufficiency in mid-2004, and our ability to continue to pursue our
business plan is dependent on our doing so. We have reduced our expenses over
the past two years and continue to manage expenses closely, so our ability to
attain our cash flow goal will largely depend on the rate at which we can grow
our revenues. Manage through a transition in the delivery of broadband Internet access
services to consumers.The delivery of stand-alone broadband internet access
services by our ISP customers is facing intense competition, particularly from
the incumbent telephone carriers, who are aggressively pricing their consumer
DSL services and placing pricing pressure on us, but also from cable providers,
like Comcast, Adelphia and Cox Communications, and wireless service providers.
We believe these market conditions have reduced the number of orders for our
services and are also causing a higher-than-historical level of churn among our
ultimate end users, and we expect this situation to continue. One of our
wholesale customers, AOL, has indicated it will stop taking orders for our
services and is moving to a bring your own access model where it will refer
customers to access providers like us. Anticipating these conditions, we have
entered into line-splitting arrangements with voice providers, particularly
AT&T, which are bundling our data services with their voice services. Our
success in 2004 and beyond will be significantly dependent on whether we can
achieve growth in the sales of our services under these line-splitting
relationships that more than offsets the decline in sales of our stand-alone
consumer-grade data services. Obtain acceptable line-sharing terms from the incumbent telephone
companies.While we expect that the revenues we generate from line-sharing with
the incumbent telephone companies will constitute a smaller portion of our
business in future periods, we think this market will continue to be important
to us. Our ability to remain viable in this market will depend on whether we
are able to reach agreements for new customers with the telephone companies or
obtain favorable regulatory rulings that will allow us to share phone lines on
reasonable terms. Expand and Diversify our Sources of Revenue.We are taking steps to
improve our prospects for revenue growth. First, we have announced our plan to
expand our network by adding 200 central office locations, which will allow us
offer our services to more end-users. Second, we will continue our efforts to
diversify our revenue sources by adding new resellers like Broadwing, a
wholly-owned subsidiary of Corvis Corporation, and Global Crossing, that
primarily resell our higher-priced business-grade services. New Market Opportunities.We recently announced our plan to offer voice
over Internet protocol, or VoIP, services by the end of 2004. We believe that
VoIP services have the potential to be a significant contributor to our revenue
growth in 2005 and beyond. Therefore, we are in the process of developing this
capability, and our success in providing this new service will depend on our
ability to offer a service that operates as a replacement for the voice
services provided by other phone companies. Restructuring and Reorganization Activities On August 15, 2001, the Petition Date, we filed a voluntary petition under
Chapter 11 of the United States Bankruptcy Code to implement, the agreements we
entered into with the majority holders of our then-outstanding debt securities,
which we refer to as the Noteholders, and to restructure various financial
obligations. The Petition was filed with the United States Bankruptcy Court for
the District of Delaware. Our operating subsidiaries did not commence
bankruptcy proceedings and continued to operate in the ordinary course of
business. On December 13, 2001, the Bankruptcy Court entered an order
confirming our First Amended Plan of Reorganization and, on December 20, 2001,
the Effective Date, this Plan was consummated and we emerged from bankruptcy.
However, the Bankruptcy Court still maintains jurisdiction over certain
administrative matters related to the implementation of this Plan, including
certain unresolved claims. Under the Plan, we extinguished approximately
$1,394,020 in aggregate face amount of outstanding debt securities, in exchange
for a combination of approximately $271,708 in cash and 35,292,800 of our
common shares, or 15% of the reorganized company. We also recorded a gain on
the extinguishment of debt in the amount of $1,033,727 in the fourth quarter of
2001. As part of our Chapter 11 proceeding, we signed a loan agreement and
restructured our resale and marketing agreement with SBC Communications, or
SBC. The agreements included four financial 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 4




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cooperative marketing fee owed by us to SBC under the 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, SBC may accelerate any unpaid portion of the prepayment and the loan
in the event that we default. On June 25, 2001, our former subsidiary, BlueStar Communications Group,
Inc., or BlueStar, made an irrevocable assignment for the benefit of its
creditors, or ABC, of all its assets to an independent trustee, or 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 us that it is still
in the process of resolving some matters among BlueStar creditors and the
process may extend into the second half of 2004. 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,
due to this loss of control, 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 consolidated balance sheet as of December 31,
2001. Such deferred gain represented 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. During 2003 and 2002,
we reduced the deferred gain by $9 and $1,228, respectively, because certain
BlueStar assets were inadvertently not deconsolidated on June 25, 2001.
Therefore, the deconsolidation of BlueStar resulted in a deferred gain balance
of $53,963 and $53,972 in our consolidated balance sheets as of December 31,
2003 and 2002, respectively. We will recognize such deferred gain as an element
of other income in our consolidated statements of operations when the
liquidation of BlueStar is complete and its liabilities have been discharged. Critical Accounting Policies and Estimates Our discussion and analysis of financial condition and results of
operations are based upon our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in
the United States. For additional information regarding our critical accounting
policies, please see Note 1 to our Consolidated Financial Statements in Item 8.
The application of these policies 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 we believe to be
reasonable under the circumstances. However, actual results may vary from these
estimates under different assumptions or conditions. We have discussed the
development and selection of critical accounting policies and estimates with
our audit committee. The following is a summary of our critical accounting
policies and estimates we make in preparing our consolidated financial
statements:  
    
    We recognize revenues when persuasive evidence of an arrangement
between the customer and us exists, service has been provided to the
customer, the price to the customer is fixed or determinable and
collectibility of the sales price is reasonably assured. We recognize
up-front fees associated with service activation over the expected term
of the customer relationship, which is presently estimated to be 24
months, using the straight-line method. Similarly, we treat the
incremental direct costs of service activation, which consist
principally of customer premises equipment, service activation fees paid
to other telecommunications companies and sales commissions, as deferred
charges in amounts no greater than the up-front fees that are deferred,
and such incremental direct costs are amortized to expense using the
straight-line method over 24 months.
    
    We have concentrations of credit risk with several customers, some of
which were experiencing financial difficulties as of December 31, 2003
and 2002 and were not current in their payments for our services as of
those dates. We classify this group of customers as financially
distressed for revenue recognition purposes. Accordingly, we recognize
revenues from these customers in the period in which cash is collected,
but only after the collection of all previous outstanding accounts
receivable balances. We record payments received from financially
distressed customers during a defined period prior to their filing of
petitions for bankruptcy protection in the consolidated balance sheet
caption unearned revenues if our ability to retain these payments is not
reasonably assured. We perform ongoing credit evaluations of our
customers financial condition and maintain an allowance for estimated
credit losses. In addition, we have billing disputes with some of our
customers. These disputes arise in the ordinary course of business in
the telecommunications industry and their impact on our accounts
receivable and revenues can be reasonably estimated based on historical
experience. In addition, certain customer revenues are subject to refund
if the end-user terminates service within thirty days of service
activation. Accordingly, we maintain allowances, through charges to
revenues, based on our estimate of the ultimate resolution of these
disputes and future service cancellations, and our reported revenue in
any period could be different than what is reported if we employed
different assumptions in estimating the outcomes of these items. See
Results of OperationsRevenues, net for a further discussion of the
impact of these billing matters on our reported revenue.
    
    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. 5




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
    
    We implemented significant reorganization and restructuring plans in
2001 and 2000. We also consummated a plan of reorganization under
Chapter 11 of the United States Bankruptcy Code on December 20, 2001. As
of December 31, 2003, we had certain unresolved claims relating to our
Chapter 11 bankruptcy proceedings that remain in dispute. Therefore, it
is reasonably possible that such disputed bankruptcy claims could
ultimately be settled for amounts that differ from the aggregate
liability for such claims reflected in our consolidated balance sheet as
of December 31, 2003.
    
    We record property and equipment and intangible assets at cost,
subject to adjustments for impairment. We depreciate or amortize
property and equipment and intangible assets using the straight-line
method over their estimated useful lives, 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.
    
    We are a party to a variety of legal proceedings, as either plaintiff
or defendant, and are engaged in other disputes that arise in the
ordinary course of business. We are required to assess the likelihood of
any adverse judgments or outcomes to these matters, as well as potential
ranges of probable losses for certain of these matters. The
determination of the liabilities to be recognized, if any, for loss
contingencies is made after careful analysis of each individual
situation based on the facts and circumstances. However, it is
reasonably possible that the liabilities reflected in our consolidated
balance sheets for loss contingencies and business disputes could change
in the near term due to new facts and circumstances, the effects of
which could be material to our consolidated financial position and
results of operations.
    
    We are currently analyzing the applicability of certain
transaction-based taxes to sales of our products and services and
purchases of telecommunications circuits from various carriers. This
analysis includes discussions with authorities of jurisdictions in which
we do business and various transaction-based tax experts to determine
the extent of our transaction-based tax liabilities. We believe that
these discussions will be concluded without a material adverse effect on
our consolidated financial position and results of operations. In
addition, we are currently analyzing the probable applicability of
employment-related taxes for certain stock-based compensation provided
to employees in prior periods. We believe that the analysis of the
probable applicability of these taxes will be concluded without a
material adverse effect to our consolidated financial position and
results of operations. However, it is reasonably possible that our
estimates of our transaction-based and employment-related tax
liabilities could change in the near term, the effects of which could be
material to our consolidated financial position and results of
operations.
    
    We account for income taxes using the liability method, under which
deferred tax assets and liabilities are determined based on differences
between the financial reporting and tax bases of our assets and
liabilities. We record a valuation allowance on our deferred tax assets
to arrive at an amount that is more likely than not to be realized. In
the future, should we determine that we are able to realize all or part
of our deferred tax assets, which presently are fully reserved, an
adjustment to our deferred tax assets would increase income in the
period in which the determination was made.
    
    We account for stock-based awards to employees using the intrinsic
value method, and non-employees using the fair value method. Under the
intrinsic value method, when the exercise price of our employee stock
options equals or exceeds the market price of the underlying stock on
the date of grant, we do not record compensation expense in our
consolidated statement of operations. We use the intrinsic value method
in accounting for employee stock options because the alternative fair
value accounting requires us to use option valuation models that were
not developed for use in valuing employee stock options. Rather, such
option valuation models were developed for use in estimating the fair
value of traded options that have no vesting restrictions and are fully
transferable. Because our employee stock options have characteristics
significantly different from those of traded options and because changes
in the subjective input assumptions can materially affect the fair value
estimates of these valuation models, we believe such existing models do
not necessarily provide a reliable single measure of the fair value of
our employee stock options. Recent Accounting Pronouncements On May 15, 2003, the Financial Accounting Standards Board, or FASB, issued
Statement of Financial Accounting Standards, or SFAS, No. 150, Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and
Equity. SFAS No. 150 establishes standards for classifying and measuring as
liabilities certain financial instruments that embody obligations of the issuer
and have characteristics of both liabilities and equity, such as mandatorily
redeemable equity instruments. SFAS No. 150 must be applied immediately to
instruments entered into or modified after May 31, 2003 and to all other
instruments that exist as of the beginning of the first interim financial
reporting period beginning after June 15, 2003, except for mandatorily
redeemable instruments of non-public companies, to which the provisions of SFAS
No. 150 must be applied in fiscal periods beginning after December 15, 2003.
The application of SFAS No. 150 to pre-existing instruments should be
recognized as the cumulative effect of a change in accounting principle. The
adoption of SFAS No. 150 had no effect on our consolidated financial
statements. 6




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In January 2003, the FASB issued Interpretation, or FIN, No. 46,
Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulleting No. 51, Consolidated Financial Statements. FIN 46 applies
to any business enterprise that has a controlling interest, contractual
relationship or other business relationship with a variable interest entity, or
VIE, and establishes guidance for the consolidation of VIEs that function to
support the activities of the primary beneficiary. FIN 46 was effective
immediately for enterprises with VIEs created after January 31, 2003, and it
will be effective March 31, 2004 for enterprises with VIEs created before
February 1, 2003. We do not expect the adoption of FIN 46 to have a significant
effect on our consolidated financial statements. On January 1, 2003, we adopted 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 the FASBs Emerging Issues
Task Force, or EITF, Issue No. 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 is no longer
sufficient to record a one-time charge for most restructuring activities.
Instead, companies record exit or disposal costs when they are incurred and can
be measured at fair value. In addition, the resultant liabilities are
subsequently adjusted for changes in estimated cash flows. SFAS No. 146 was
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 No. 94-3 are grandfathered.
The adoption of SFAS No. 146 had no effect on our consolidated financial
statements. On January 1, 2003, we adopted SFAS No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of SFAS 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. Upon adoption of SFAS No. 145 in
2003, we reclassified the gain on extinguishment of debt that we recognized in
2001, which was previously classified as an extraordinary item, as an element
of other income (expense) in our 2001 consolidated statement of operations. On January 1, 2003, we adopted 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. The adoption of SFAS No. 143 had no effect on
our consolidated financial statements. In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure. SFAS No. 148 amends SFAS
No. 123, Accounting for Stock-Based Compensation, to provide alternative
methods of transition for an entity that voluntarily changes to the fair value
method of accounting for stock-based employee compensation. In addition, SFAS
No. 148 amends the disclosure provisions of SFAS No. 123 to require prominent
disclosure of the effects of an entitys accounting policy with respect to
stock-based employee compensation on reported results of operations, including
per share amounts, in annual and interim financial statements. The disclosure
provisions of SFAS No. 148 were effective immediately upon issuance in 2002. As
of December 31, 2003, we have no immediate plans to adopt the fair value method
of accounting for stock-based employee compensation. In November 2002, the EITF reached a final consensus on Issue No. 00-21,
Accounting for Revenue Arrangements with Multiple Deliverables, which is
effective for revenue arrangements entered into in fiscal periods beginning
after June 15, 2003. Under EITF Issue No.00-21, revenue arrangements with
multiple deliverables are required to be divided into separate units of
accounting under certain circumstances. We adopted EITF Issue No. 00-21 on July
1, 2003, and such adoption did not have a material effect on our consolidated
financial statements. In November 2002, the FASB issued FIN No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others. FIN No. 45 requires certain guarantees to be recorded
at fair value, which is different from current practice, which is generally to
record a liability only when a loss is probable and reasonably estimable. FIN
No. 45 also requires a guarantor to make significant new disclosures, even when
the likelihood of making any payments under the guarantee is remote. The
disclosure provisions of FIN No. 45 were effective immediately upon issuance in
2002. We adopted the recognition and measurement provisions of FIN No. 45 on a
prospective basis with respect to guarantees issued or modified after December
31, 2002. The adoption of the recognition and measurement provisions of FIN No.
45 had no effect on our consolidated financial statements. However, some of our
contracts with our customers have provisions that would require us to indemnify
them in the event that our services infringe upon a third partys intellectual
property rights. Reclassifications and Adjustments Certain balances in the Companys 2002 and 2001 consolidated financial
statements have been reclassified to conform to the presentation in 2003. 7




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During the year ended December 31, 2003, a matter was identified related
to prior financial reporting periods that necessitated the recording of
additional expense. Such matter was related to the modification of stock
options granted to certain employees in prior years. These modifications
occurred upon the separation of such employees from our Company, principally
during 2000. Accordingly, for the year ended December 31, 2003, we recorded
additional stock-based compensation expense in the amount of $1,236 ($0.01 per
share). Such amount is reflected in our sales, marketing, general and
administrative expenses for the year ended December 31, 2003. We do not believe
this amount is material to the periods in which it should have been recorded,
nor do we believe it is material to our consolidated operating results for the
year ended December 31, 2003. This adjustment is principally related to 2000,
the impact of which would have been to increase sales, marketing, general and
administrative expenses and net loss by $1,236 or $0.01 per share for such
year. As explained below, certain other adjustments were recorded during 2002
that related to prior periods. $1,139 of such amounts pertained to 2000, the
effect of which would have been to decrease the Companys 2000 net loss by
$0.01 per share. The aggregate effect of the adjustments recorded during the
years ended December 31, 2003 and 2002 to the previously reported results of
operations for the year ended December 31, 2000 would be to increase net loss
by $97, or $0.00 per share, for such year if these adjustments had been
recorded in 2000. As part of the continuing evaluation of our network assets during the year
ended December 31, 2002, certain matters were identified related to prior
financial reporting periods that necessitated the recording of adjustments to
certain expenses. Such matters were related principally to changes in our
network configuration, which necessitated reductions of the remaining estimated
useful lives of certain network equipment, the capitalization of certain
network and product costs that should have been charged to operating expenses
when they were incurred and various restructuring activities that resulted in
the abandonment of certain network equipment and leasehold improvements.
Accordingly, for the year ended December 31, 2002, we recorded additional
depreciation expense of $6,989, network and product costs of $2,635, loss on
the disposition of property and equipment of $635 and interest expense of $51.
In addition, as part of our financial statement close process for the year
ended December 31, 2002, we discovered that amortization expense related to
non-cash deferred stock-based compensation was overstated in prior periods by
$3,213. Therefore, for the year ended December 31, 2002, we recorded reductions
of network and products costs of $320 and sales, marketing, general and
administrative expense of $2,893. Furthermore, as part of the review of our
December 31, 2002 tax accruals, we determined that we had overstated our
transaction-based tax and other tax accruals in prior periods by $4,804, which
we adjusted during the three months ended December 31, 2002 through a reduction
of network and product costs. The adjustment was primarily driven by various
complex rules surrounding our estimated liability to the Federal Universal
Service Fund, or FUSF. We do not believe any of the aforementioned amounts are
material to the periods in which they should have been recorded, nor do we
believe the prospective correction of such amounts during the year ended
December 31, 2002 is material to our consolidated operating results for such
year. The prospective correction of the aforementioned amounts relating to
prior periods increased our 2002 consolidated net loss by $2,294, or $0.01 per
share, and decreased our 2001 net loss by $3,433 or $0.02 per share. Results of Operations Revenues, net The primary component of our net revenues is earned monthly broadband
subscription billings for DSL products. We also earn revenues from monthly
billings for high-capacity circuits sold to our wholesale customers and to a
lesser degree for dial-up services. Because we do not recognize revenue from
sales to financially distressed customers until we receive payment and until
our ability to keep the payment is reasonably assured, our reported revenues in
each of the last three years have been impacted by whether we receive, and the
timing of receipt of, payments from these customers. Our revenues also include
billings for installation services and equipment, which are recognized as
revenue over the expected life of the relationship with the end-user, and FUSF
charges billed to our customers. Customer incentives and rebates that we offer
to attract and retain customers are recorded as reductions to revenue. Our net revenues in 2003 increased by $5,355, or 1.4%, over 2002 and
$56,255, or 16.9%, over 2001. This growth in 2003 was due to the addition of
approximately 136,000 DSL end-users to our network, which led to an increase in
broadband subscription billings. We expect our revenues and broadband
subscription billings to continue to grow as we execute on our current sales
and marketing programs. In addition, we plan to introduce new sales and
marketing programs and create new services for our customers to lead to higher
revenues and broadband subscription billings. The increase in our revenues and
broadband subscription billings in 2003 was offset by several factors. Our
high-capacity circuit revenues and billings in 2003 decreased, primarily driven
by customer network configuration changes and consolidation in our customer
transport circuits. We do not expect a significant increase or decrease in
high-capacity circuit billings in 2004. In addition, our dial-up revenues and
billings continued to decrease in 2003, primarily driven by the decrease in
demand for this service. We expect that demand for this service will continue
to decrease in 2004. Furthermore, revenue recognized from our financially
distressed customers decreased during 2003. The amount of revenue recognized in
2002 from payments received from financially distressed customers was higher
than the corresponding amount in 2003 because we received several large
payments from financially distressed customers for billings that were not
initially included in revenue. As a result of the reduction in billings issued
to financially distressed customers in 2002 and 2003, we received fewer
payments from financially distressed customers in 2003. Due to the reduction in
broadband subscription billings to distressed customers, we currently do not
expect that a significant amount of revenue in 2004 will come from these
customers. In 2003, we also increased our customer rebates 8




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and incentives, which resulted in reductions to our revenues. We expect
customer rebates and incentives to continue to be an element of our sales and
marketing programs due to competitive market conditions. Revenue from
installation services and equipment billings, which we recognize over the
expected life of the end user, decreased in 2003, primarily driven by lower net
selling prices, some of which is attributable to lower prices from our vendors
and competitive pricing in the marketplace. We expect prices for these services
and equipment to continue to decline in the future. FUSF charges billed to our
customers, which we recognize as revenue, decreased in 2003, primarily driven
by changes in the applicability of FUSF to some of our wholesale customers. We regularly have billing disputes with our customers. These disputes
arise in the ordinary course of business in the telecommunications industry and
we believe their impact on our accounts receivable and revenues can be
reasonably estimated based on historical experience. In addition, certain
revenues are subject to refund if the end-user terminates service within thirty
days of service activation. Accordingly, we maintain allowances, through
charges to revenues, based on our estimate of the ultimate resolution of these
disputes and future service cancellations. These charges to revenues were
$2,886, $2,322 and $11,178 during the years ended December 31, 2003, 2002 and
2001, respectively. During the years ended December 31, 2003 and 2002,
respectively, we recovered $1,282 and $2,145 of accounts receivable balances
previously written-off against such allowance. There were no similar recoveries
of accounts receivable balances for the year ended December 31, 2001. Segment Revenues and Significant Customers Our segment net revenues were as follows: Year ended December 31,2003
    
    2002
    
    2001CSP
    
    $
    236,928
    
    
    $
    231,721
    
    
    $
    162,054Percent of total net revenues
    
    
    60.9
    %
    
    
    60.4
    %
    
    
    48.7
    %CBS
    
    $
    151,923
    
    
    $
    151,775
    
    
    $
    170,542Percent of total net revenues
    
    
    39.1
    %
    
    
    39.6
    %
    
    
    51.3
    %
 We had over 300 wholesale customers as of December 31, 2003 compared to
approximately 150 as of December 31, 2002 and 2001. The increase in 2003 from
2002 resulted primarily from the addition of smaller resellers to our CBS
segment. For the years ended December 31, 2003, 2002 and 2001, our 30 largest
wholesale customers in each such year collectively comprised 93.3%, 93.3% and
88.5% of our total wholesale net revenues, respectively, and 71.6%, 79.5% and
76.0% of our total net revenues, respectively. As of December 31, 2003 and
2002, receivables from these customers collectively comprised 70.3% and 75.3%,
respectively, of our gross accounts receivable balance. For the year ended December 31, 2003, EarthLink, Inc. and AT&T, two
wholesale customers in our CSP business segment, accounted for 21.5% and 12.5%,
respectively, of our total net revenues. For the year ended December 31, 2002,
these customers accounted for 20.0% and 10.4%, respectively, of our total net
revenues. For the year ended December 31, 2001, these customers accounted for
17.5% and 6.4%, respectively, of our total net revenues. As of December 31,
2003, receivables from these customers comprised 20.9% and 17.1%, respectively,
of our gross accounts receivable balance. As of December 31, 2002, receivables
from these customers comprised 25.9% and 11.7%, respectively, of our gross
accounts receivable balance. No other individual customer accounted for more
than 10% of our total revenues in 2003, 2002 and 2001. Beginning in January 2004 we realigned our business and no longer maintain
CSP and CBS as separate business units. We believe this realignment will lead
to more efficient product development, sales and marketing because we will no
longer have two separate groups providing these functions. We expect most of
our revenue growth in 2004 to come from our wholesale customers because we
expect increased sales of business-grade services by these resellers and
increased sales through line-splitting agreements with wholesale customers like
AT&T. Wholesaler Financial Difficulties Some of our resellers are experiencing financial difficulties. During the
years ended December 31, 2003, 2002 and 2001, certain of these customers either
were not current in their payments for our services or were essentially current
in their payments but, subsequent to the end of the reporting period, their
financial condition deteriorated significantly and some of them filed for
bankruptcy protection. Based on this information, we determined that the
collectibility of revenues from these customers was not reasonably assured or
our ability to retain some or all of the payments received from some of these
customers that filed for bankruptcy protection was not reasonably assured.
Accordingly, we have classified this group of customers as financially
distressed for revenue recognition purposes. Although MCI, formerly known as
WorldCom, Inc., filed for bankruptcy protection during the year ended December
31, 2002, we have not classified it as a financially distressed customer based
on MCIs specific facts and circumstances in relation to the revenue
recognition criteria described in Note 2 to our consolidated financial
statements. Therefore, we continued to recognize revenues from MCI on an
accrual basis during 2003 and 2002. 9




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A number of our customers are currently in bankruptcy proceedings.
Revenues from these customers accounted for approximately 1.3%, 5.6% and 7.1%
of our total net revenues for the years ended December 31, 2003, 2002 and 2001,
respectively. As described above, although MCI filed for bankruptcy protection
on July 21, 2002, we continued to recognize revenues from MCI on an accrual
basis during 2003 and 2002 based on the revenue recognition criteria described
in Note 2 to our consolidated financial statements. Consequently, the
disclosures in the following paragraph related to financially distressed
customers exclude amounts pertaining to MCI because we have not presently
classified it as a financially distressed customer for revenue recognition
purposes. During the years ended December 31, 2003, 2002 and 2001, we issued
billings to our financially distressed customers aggregating $5,139, $42,881
and $74,928, respectively, that were not recognized as revenues or accounts
receivable in our consolidated financial statements. However, we recognized net
revenues from certain of these customers when cash was collected aggregating
$4,367, $47,609 and $29,003 during the years ended December 31, 2003, 2002 and
2001, respectively. Revenues recognized during the year ended December 31, 2003
and 2002, respectively, include payments totaling $827 and $4,427,
respectively, 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
December 31, 2003. Consequently, we recognized these payments as revenues
during 2003 and 2002. No such payments were recognized as revenues during the
year ended December 31, 2001. We had contractual receivables from our
financially distressed customers totaling $1,093 and $6,031, respectively, as
of December 31, 2003 and 2002 that are not reflected in our consolidated
financial statements. We have identified certain of our customers, including MCI, who were
essentially current in their payments for our services prior to December 31,
2003, or have subsequently paid all or significant portions of the respective
amounts that we recorded as accounts receivable as of December 31, 2003, that
we believe may have a high risk of becoming financially distressed. Revenues
from these customers accounted for approximately 11.6%, 34.6% and 14.2% of our
total net revenues for the years ended December 31, 2003, 2002 and 2001,
respectively. As of December 31, 2003, receivables from these customers
comprised 14.7% 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 December 31, 2003, revenue from such
customers will only be recognized when cash is collected, as described above. Operating Expenses Operating expenses include network and product costs, sales, marketing,
general and administrative expenses, provision for and recoveries of bad debts,
depreciation and amortization expenses, restructuring expenses, provisions for
impairment of long-lived assets and litigation-related expenses. Our total operating expenses were as follows: Year ended December 31,2003
    
    2002
    
    2001(Restated)Amount
    
    $
    503,421
    (1)
    
    $
    564,488
    
    
    $
    869,476Percent of net revenues
    
    
    129.5
    %
    
    
    147.2
    %
    
    
    261.4
    %
   (1)
    
    See Note 15 of Notes to Consolidated Financial Statements. Network and Product Costs Network and product costs consist primarily of the costs of provisioning
and maintaining telecommunications circuits and central office space, equipment
sold to our customers, and labor related expenses and other non-labor items to
operate and maintain our network and related system infrastructure. Our network and product costs were as follows: Year ended December 31,2003
    
    2002
    
    2001(Restated)Amount
    
    $
    288,122
    (1)
    
    $
    298,336
    
    
    $
    461,875Percent of net revenue
    
    
    74.1
    %
    
    
    77.8
    %
    
    
    138.9
    %
   (1)
    
    See Note 15 of Notes to Consolidated Financial Statements. 10




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Our network and product costs during the year ended December 31, 2003 were
lower because we managed our network capacity more efficiently and obtained
lower prices for the copper loops we purchase from the traditional telephone
companies. These reductions in network and product costs were partially offset
by the additional network and product costs associated with the addition of
subscribers to our network. In addition, during the year ended December 31,
2003, we changed our estimates of certain liabilities for transaction-based
taxes and property taxes based on settlements reached with various states and
local jurisdictions on our transaction-based taxes and additional compilation
of data on the valuation of our taxable property and equipment. These changes
in accounting estimate decreased our network and product costs by $8,439 during
the year ended December 31, 2003. Also during 2003, we changed our estimates of
certain liabilities for collocation and network services as a result of the
resolution of various billing disputes with our vendors and on our receipt of
an invoice in December 2003 from a vendor for certain services provided by such
vendor primarily in 2000 and 2001, which we are currently disputing. These
changes in accounting estimate increased our network and product costs by
$3,414 during the year ended 2003. Network and product costs for the year ended
December 31, 2003 include $6,018 of migration expenses from the Qwest customer
list acquisition, $2,135 for the probable applicability of employment-related
taxes related to certain stock-based compensation provided to employees in
prior periods, and $4,721 from amortization of deferred variable stock-based
compensation expenses related to our 2003 Employee Stock Purchase Plan. Network
and product costs for the year ended December 31, 2002 include a credit of
$5,550 from the settlement of certain disputed network service obligations
during the year and customer acquisition costs of $3,674 associated with the
acquisition of InternetConnect assets. Included in network and product costs
for the year ended December 31, 2001 is a credit of $5,570 from the settlement
of certain disputed collocation claims costs of approximately $34,768 from our
BlueStar subsidiary, which we deconsolidated effective June 25, 2001. We expect network and product costs to increase in future periods as we
add subscribers and services like line-splitting to our network. To offset
these increased costs, we plan to continue cost-saving programs, like
outsourcing portions of our customer support to India and improving the
technology we use to deliver our services. We expect that network and product
costs as a percentage of revenue will decline as we transition more of our
customer lines to line-splitting arrangements rather than line-sharing
arrangements because we generally do not pay a fee to our partners for access
to the high-frequency portion of the phone line used to provide our services in
our line-splitting arrangements. As discussed in the Overview  Recent Developments and in Part I, Item
3 Legal Proceedings, there is uncertainty concerning our ability to purchase
line-shared services from the traditional telephone companies as a result of
the FCCs Triennial Review decision. As a result of those legal and regulatory
proceedings, it is possible that the traditional telephone companies could
substantially increase the cost or reduce the availability of line-shared
services, which would substantially increase our overall network cost structure
and might cause us to discontinue our consumer grade services for new and
existing customers. Sales, Marketing, General and Administrative Expenses Sales, marketing, general and administrative expenses consist primarily of
salaries and related expenses and our promotional and advertising expenses. Our sales, marketing, general and administrative expenses were as follows: Year ended December 31,2003
    
    2002
    
    2001(Restated)Amount
    
    $
    140,081
    (1)
    
    $
    150,373
    
    
    $
    199,908Percent of net revenue
    
    
    36.0
    %
    
    
    39.2
    %
    
    
    60.1
    %
   (1)
    
    See Note 15 of Notes to Consolidated Financial Statements. We reduced our sales, marketing, general and administrative workforce in
all periods, which contributed to a reduction in our expenses. In addition, for
the year ended December 31, 2003, we reduced our advertising expense by
$19,433. The decrease in sales, marketing, general and administrative expenses
for the year ended December 31, 2003 was partially offset by charges of $1,236
for additional stock-based compensation and $3,796 for the potential
applicability of employment-related taxes related to certain stock-based
compensation provided to employees in prior periods and $7,650 from
amortization of deferred variable stock-based compensation expenses related to our 2003
Employee Stock Purchase Plan. The decrease in sales, marketing, general and administrative expenses for
the year ended December 31, 2002 is also partially attributable to the
deconsolidation of our BlueStar subsidiary, which was effective June 25, 2001.
We incurred no sales, marketing, general and administrative expenses related to
BlueStar for the year ended December 31, 2002 as compared to $11,510 for the
year ended December 31, 2001. Sales, marketing, general and administrative
expenses for the year ended December 31, 2002 include a reduction of
amortization expense related to non-cash deferred stock-based compensation in
the amount of $3,074. For the year ended December 31, 2002, the decrease in
sales, marketing, general and administrative expenses was offset by an increase
of approximately $10,616 in advertising expenses attributable to our radio,
television and other various media marketing and advertising programs related
to our Popularizing Broadband campaign, which we launched on September of
2002. 11




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We expect sales, marketing, general and administrative expense levels to
remain relatively unchanged. We plan to incur additional advertising expenses
to support sales of business-grade services and our anticipated deployment of
VoIP services in the second half of 2004. We plan that these increased
advertising expenses will be offset by other cost-saving measures. Depreciation and Amortization Depreciation and amortization of property and equipment was $56,559,
$112,438 and $137,920 for the years ended December 31, 2003, 2002 and 2001,
respectively. The decrease in 2003 and 2002 was due principally to asset
retirements and certain assets becoming fully depreciated during 2002 and 2003.
As a result of increased capital expenditures in 2003 to support additional end
users, and anticipated expenditures in 2004 to add capabilities to our network
and expand coverage to an additional 200 central office locations, we expect
depreciation and amortization to increase. Amortization of intangible assets was $17,325, $14,650 and $12,919 for the
years ended December 31, 2003, 2002 and 2001, respectively. The increase in
amortization of intangible assets in 2003 and 2002 resulted from the resumption
of our network build for selected markets during 2003 and 2002, which increased
collocation fee expenditures and related amortization expenses. We expect
amortization of intangible assets to continue to increase as a result of adding
200 central offices to our network in 2004. Following the completion of our long-lived asset impairment analysis as of
December 31, 2000, as discussed below, we also re-evaluated the remaining
estimated useful lives of our long-lived assets, including intangibles. As a
result, effective January 1, 2001, we reduced the remaining estimated useful
lives of all long-lived assets, excluding buildings and leasehold improvements,
that previously had estimated useful lives in excess of five years so that the
residual balances and any subsequent additions are now depreciated or amortized
over five years. This change in accounting estimate decreased our net income by
$14,006, or $0.08 per share, in 2001. We do not allocate depreciation and amortization expense to our business
segments. Provision for Restructuring Expenses During the year ended December 31, 2003, we reduced our workforce by
approximately 113 employees, which represented approximately 10.3% of our
workforce. The reductions covered employees in the areas of sales and
marketing, operations and corporate functions. In connection with the
reductions, we recorded restructuring expenses, consisting primarily of
employee severance benefits, of $1,235 during the year ended December 31, 2003.
While we do not currently plan to make any additional material reductions in
force, business conditions may require additional reductions in future periods. We recorded restructuring expenses aggregating $14,364 during the year
ended December 31, 2001. These expenses consist principally of collocation and
building lease termination costs that met the requirements for accrual in 2001.
Of these expenses, $2,140 related to the BlueStar shutdown. We did not record
any restructuring expenses during 2002. We continuously evaluate and consider
whether additional restructuring is necessary, consequently, additional charges
to operations related to any further restructuring activities may be incurred
in future periods. Provision for Long-Lived Asset Impairment During the year ended December 31, 2001, we recorded a charge in the
amount of $11,988 for the impairment of certain long-lived assets. In the
fourth quarter of 2001, we made a decision to sell our Manassas, Virginia
facility, including land, a building and certain furniture and fixtures. In
March 2002, we entered into a non-binding agreement with a third party to sell
this property for less than its book value. The sale of our Manassas facility
resulted in a write-down of this property in the amount of $9,999. We also
recorded a write-down of goodwill in the amount of $1,989 during 2001
associated with our BlueStar subsidiary. Litigation-related Expenses We recorded a credit to litigation-related expenses of $11,628 for the
year ended December 31, 2002. The credit represents the non-cash valuation
adjustment for the change in value of the 6,495,844 shares of common stock that
will ultimately be distributed pursuant to the Memorandum of Understanding
described in Note 10 to our consolidated financial statements and in Part I.
Item 3 Legal Proceedings. We recorded litigation-related expenses of $31,160
for the year ended December 31, 2001, including a cash payment of $5,359 and a
non-cash charge of $25,801 for the value of 9,328,334 shares of common stock
that either were issued in 2001 or will ultimately be issued, as described
above. We did not recognize similar charges or credits for the year ended
December 31, 2003. 12




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##### Table of Contents



Other Income (Expense) Net Interest Expense Our net interest expense was $3,421, $459 and $68,189 for the years ended
December 31, 2003, 2002 and 2001, respectively. Net interest expense during the
years ended December 31, 2003 and 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 expense during the year ended December 31,
2001 consisted primarily of interest expense on notes that were extinguished
upon our emergence from our voluntary bankruptcy proceeding and capital lease
obligations, less interest income earned on our cash, cash equivalents and
short-term investments balances on hand during the years. For the year ended
December 31, 2001, our contractual interest obligation on our notes was
$142,356. During the year ended December 31, 2001, we completed a
reorganization under Chapter 11 of the United States Bankruptcy Code. Under our
Plan, we were able to extinguish approximately $1,394,020 in aggregate face
amount of outstanding notes, 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. As a result of the extinguishment, we did not
recognize contractual interest expense of $49,574 for the year ended December
31, 2001 on these notes. As described above, upon our emergence from Chapter 11 bankruptcy on
December 20, 2001 (see Note 3 to our consolidated financial
statementsReorganization Under Bankruptcy Protectionfor additional
information), we entered into a series of new agreements with SBC (see Note 11
to our consolidated financial statementsStockholders Equity (Deficit)for
additional information). One such agreement, the Credit Agreement, involves a
term note that is collateralized by substantially all of our domestic assets.
This note bears interest at 11%, which is payable quarterly beginning in
December 2003. The entire unpaid principal balance is payable in December 2005.
We have the right to prepay the principal amount of the note, in whole or in
part, at any time without penalty. Our current net interest expense is limited to accrued interest on our 11%
note payable to SBC offset by interest earned on cash balances. We may,
however, seek additional debt financing if it is available on terms that we
believe are favorable. If we seek additional debt financing our interest
expense may increase. Reorganization Items During the year ended December 31, 2001, we recognized expenses directly
associated with our Chapter 11 bankruptcy proceeding in the amount of $62,620. These reorganization expenses consisted of non-cash adjustments to
unamortized debt issuance costs and discounts and professional fees for legal
and financial advisory services. Investment Losses We recorded losses and write-downs on investments for the year ended
December 31, 2003 in the amount of $1,026. This included impairment write-downs
of equity investments of $747 and our equity in the losses of unconsolidated
affiliates of $279. We recorded losses and write-downs on investments for the
year ended December 31, 2002 in the amount of $1,847. This included a net
realized loss on short-term investments of $17, an impairment write-down of an
equity investment of $388, our equity in the losses of unconsolidated
affiliates of $806 and a net realized loss on the sale of certain investments
in unconsolidated affiliates of $636. We recorded losses and write-downs on
investments for the year ended December 31, 2001 in the amount of $19,062. This
included impairment write downs of equity investments of $10,069, our equity in
the losses of unconsolidated affiliates of $13,769, the recognition of other
than temporary losses on short-term investments of $1,311, a net realized gain
on short-term investments of $5,909 and a net realized gain on the sale of an
investment in an unconsolidated affiliate of $178. Miscellaneous Income and Expenses We recorded miscellaneous income for the year ended December 31, 2003 in
the amount of $6,715. Included in this amount are $5,606 of royalty payments
received from a license agreement on our OSS software, $5,000 of which was
received as a result of an amendment to the license agreement that resulted in
the acceleration of a payment that was originally scheduled to be received in
2005. The remaining balance included in miscellaneous income is primarily
comprised of trade purchase discounts. We recorded miscellaneous expenses for
the years ended December 31, 2002 and 2001 in the amount of $1,530 and $2,218,
respectively. These amounts are primarily comprised of losses on the
disposition of certain of our fixed assets. Gain on Extinguishment of Debt We recorded a gain on extinguishment of debt in the amount of $1,033,727
for the year ended December 31, 2001. See Note 3 to our consolidated financial
statementsReorganization Under Bankruptcy Proceedingsfor additional
information. 13




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##### Table of Contents



Income Taxes We made no provision for income taxes in any period presented in the
accompanying consolidated financial statements because we incurred operating
losses in each of these periods. In addition, we made no provision for income
taxes on the gain resulting from the extinguishment of debt in 2001 due to the
relevant tax regulations governing the treatment of debt extinguishment income
in Chapter 11 bankruptcy proceedings. As of December 31, 2003, we had net
operating loss carryforwards for federal tax purposes of approximately
$761,000, which will begin to expire in 2022, if not utilized. As a result of
the Company emerging from bankruptcy, the federal operating loss carryforwards
have been reduced by approximately $995,000 in 2001. We also had aggregate net
operating loss carryforwards for state income tax purposes of approximately
$1,221,000, of which $14,856 will expire in 2004, $122,832 will expire in 2005,
and $1,083,312 will expire through 2022, if not utilized. In addition, we had
capital loss carryforwards for federal and state income tax purposes of
approximately $42,000, which will begin to expire in 2006. The utilization of the Companys net operating loss may be subject to
substantial annual limitation due to the change in ownership provisions of
the Internal Revenue Code of 1986, as amended, and similar state provisions.
The annual limitation may result in the expiration of net operating losses and
tax credits before utilization. Realization of our deferred tax assets relating to net operating loss
carryforwards and other temporary differences is dependent upon future
earnings, the timing and amount of which are uncertain. Accordingly, our net
deferred tax assets have been fully offset by a valuation allowance. The
valuation allowance increased (decreased) by $39,071, $129,529 and $(145,941)
during the years ended December 31, 2003, 2002 and 2001, respectively. 14




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##### Table of Contents



Quarterly Financial Information (Unaudited) The Companys 2003 and 2002 unaudited condensed consolidated quarterly
financial information is as follows: Three months endedMarch 31
    
    June 30
    
    September 30
    
    December 31(Restated)
    
    (Restated)2003:Revenues, net
    
    $
    90,860
    
    
    $
    92,445
    
    
    $
    100,507
    
    
    $
    105,039Network and product costs
    
    $
    68,877
    
    
    $
    68,632
    
    
    $
    77,215
    (1)
    
    $
    73,398
    (1)Sales, marketing, general and administrative
    
    $
    36,895
    
    
    $
    31,791
    
    
    $
    37,635
    (1)
    
    $
    33,760
    (1)Loss from operations
    
    $
    (34,330
    )
    
    $
    (26,194
    )
    
    $
    (32,164
    )(1)
    
    $
    (21,882
    )(1)Net loss
    
    $
    (34,722
    )
    
    $
    (27,287
    )
    
    $
    (33,431
    )(1)
    
    $
    (16,862
    )(1)Basic and diluted net loss per share
    
    $
    (0.16
    )
    
    $
    (0.12
    )
    
    $
    (0.15
    )(1)
    
    $
    (0.07
    )(1)2002:Revenues, net
    
    $
    101,666
    
    
    $
    97,733
    
    
    $
    96,206
    
    
    $
    87,891Network and product costs
    
    $
    90,194
    
    
    $
    76,262
    
    
    $
    69,546
    
    
    $
    62,334Sales, marketing, general and administrative
    
    $
    37,204
    
    
    $
    33,833
    
    
    $
    41,173
    
    
    $
    38,163Loss from operations
    
    $
    (56,374
    )
    
    $
    (39,524
    )
    
    $
    (51,864
    )
    
    $
    (33,230
    )Net loss
    
    $
    (56,839
    )
    
    $
    (40,793
    )
    
    $
    (51,707
    )
    
    $
    (35,489
    )Basic and diluted net loss per share
    
    $
    (0.26
    )
    
    $
    (0.19
    )
    
    $
    (0.23
    )
    
    $
    (0.16
    )
   (1)
    
    During the review process for our condensed
consolidated financial statements as
of March 31, 2004 and for the three months then ended, we
determined that certain stock options granted pursuant to the 2003
Employee Stock Purchase Plan were subject to variable accounting and
that our unaudited condensed consolidated financial statements for
the quarters ended September 30, 2003 and December 31,
2003, as well as the audited financial statements for the year ended
December 31, 2003, need to be restated to account for this
compensation. The
restatement involves non-cash charges, which reflect the
stock-based compensation expense for those options granted in 2003
that are subject to variable accounting. See Note 1 of Notes to
Consolidated Financial Statements for further discussion of
stock-based compensation. The effect of the restatement (a) increases
our net loss for the third quarter of 2003 by $8,288 from $25,143 to
$33,431, which increases our third quarter 2003 loss per basic and
diluted share by $0.04, and (b) increases our net loss for the
fourth quarter of 2003 by $4,083, from $12,779 to $16,862, which
increases our fourth quarter 2003 loss per basic and diluted share by
$0.01. For the year ended December 31, 2003, the restatement
increases our net loss by $12,371, from $99,931 to $112,302, which
increases our 2003 net loss per basic and diluted share by $0.06,
from $0.44 to $0.50. During the year ended December 31, 2003, a matter was identified related
to prior financial reporting periods that necessitated the recording of
additional expense. Such matter was related to the modification of stock
options granted to certain employees in prior years. These modifications
occurred upon the separation of such employees from our Company, principally
during 2000. Accordingly, for the year ended December 31, 2003, we recorded
additional stock-based compensation expense in the amount of $1,236 ($0.01 per
share). Such amount is reflected in our sales, marketing, general and
administrative expenses for the year ended December 31, 2003. We do not believe
this amount is material to the periods in which it should have been recorded,
nor do we believe it is material to our consolidated operating results for the
year ended December 31, 2003. This adjustment is principally related to 2000,
the impact of which would have been to increase sales, marketing, general and
administrative expenses and net loss by $1,236 ($0.01 per share) for such year.
As explained below, certain other adjustments were recorded during 2002 that
related to prior periods. $1,139 of such amounts pertained to 2000, the effect
of which would have been to decrease our 2000 net loss by $0.01 per share. The
aggregate effect of the adjustments recorded during the years ended December
31, 2003 and 2002 to the previously reported results of operations for the year
ended December 31, 2000 would be to increase net loss by $97, or $0.00 per
share, for such year if these adjustments had been recorded in 2000. As part of the continuing evaluation of our network assets during the
third and fourth quarters of 2002, certain matters were identified related to
prior financial reporting periods that necessitated the recording of
adjustments to certain expenses. Such matters were related principally to (i)
changes in our network configuration, which necessitated reductions of the
remaining estimated useful lives of certain network equipment, (ii) the
capitalization of certain network and product costs that should have been
charged to operating expenses when they were incurred and (iii) various
restructuring activities that resulted in the abandonment of certain network
equipment and leasehold improvements. Accordingly, for the three months ended
September 30, 2002, we recorded additional (i) depreciation expense of $9,584
and (ii) network and product costs of $1,215. During the three months ended
December 31, 2002, we reduced depreciation expense by $1,306 and recorded
additional (i) network and product costs of $1,930, (ii) loss on the
disposition of property and equipment of $863 and (iii) interest expense of $75
as a result of this continuing evaluation. In addition, as part of our
financial statement close process for the fourth quarter of 2002, we discovered
that we had overstated our non-cash amortization expense relating to deferred
stock-based compensation in prior periods by $3,745. Therefore, we recorded
reductions of (i) network and product costs of $671 and (ii) sales, marketing,
general and administrative expense of $3,074 during the three months ended
December 31, 2002. Furthermore, as part of the review of our December 31, 2002
tax accruals, we determined that we had overstated our transaction-based tax
and other tax accruals in prior periods by $5,291, which we adjusted during the
three months ended December 31, 2002 through a reduction of network and product
costs of $5,122 and a reduction of sales, marketing, general and administrative
expenses of $169. The adjustment was primarily driven by various complex rules
surrounding our estimated liability to the Federal Universal Service Fund. We
do not believe any of the aforementioned amounts are material to the periods in
which they should have been recorded, nor do we believe the prospective
correction of such amounts during the year ended December 31, 2002 is
material to our consolidated operating results for such year. The impact on
prior financial reporting periods in 2003 and 2002 would have been as follows
if the amounts described above had been recorded in the proper financial
reporting periods: 15




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##### Table of Contents



Three Months Ended
    
    Year EndedMarch 31,
    
    June 30,
    
    September 30,
    
    December 31,
    
    December 31,2003
    
    2003
    
    2003
    
    2003
    
    2003(Restated)
    
    (Restated)
    
    (Restated)Net loss, as reported
    
    $
    (34,722
    )
    
    $
    (27,287
    )
    
    $
    (33,431
    )(1)
    
    $
    (16,862
    )(1)
    
    $
    (112,302
    )(1)Effect of prospectively correcting certain differences
relating to prior periods, which is included in net loss, as
reported
    
    
    
    
    
    
    1,236
    
    
    
    
    
    
    
    
    
    
    
    1,236Net loss, net of effect of prospectively correcting certain
differences relating to prior periods
    
    
    (34,722
    )
    
    
    (26,051
    )
    
    
    (33,431
    )(1)
    
    
    (16,862
    )(1)
    
    
    (111,066
    )(1)Net loss per share, as reported
    
    
    (0.16
    )
    
    
    (0.12
    )
    
    
    (0.15
    )(1)
    
    
    (0.07
    )(1)
    
    
    (0.50
    )(1)Effect of prospectively correcting certain differences
relating to prior periods, which is included in net loss per
share, as reported
    
    
    
    
    
    
    0.01
    
    
    
    
    
    
    
    
    
    
    
    0.01
    (1)Net loss per share, net of effect of prospectively correcting
certain differences relating to prior periods
    
    
    (0.16
    )
    
    
    (0.11
    )
    
    
    (0.15
    )(1)
    
    
    (0.07
    )(1)
    
    
    (0.49
    )(1)
   (1)
    
    During the review process for our condensed
consolidated financial statements as
of March 31, 2004 and for the three months then ended, we
determined that certain stock options granted pursuant to the 2003
Employee Stock Purchase Plan were subject to variable accounting and
that our unaudited condensed consolidated financial statements for
the quarters ended September 30, 2003 and December 31,
2003, as well as the audited financial statements for the year ended
December 31, 2003, need to be restated to account for this
compensation. The
restatement involves non-cash charges, which reflect the
stock-based compensation expense for those options granted in 2003
that are subject to variable accounting. See Note 1 of Notes to
Consolidated Financial Statements for further discussion of
stock-based compensation. The effect of the restatement (a) increases
our net loss for the third quarter of 2003 by $8,288 from $25,143 to
$33,431, which increases our third quarter 2003 loss per basic and
diluted share by $0.04, and (b) increases our net loss for the
fourth quarter of 2003 by $4,083, from $12,779 to $16,862, which
increases our fourth quarter 2003 loss per basic and diluted share by
$0.01. For the year ended December 31, 2003, the restatement
increases our net loss by $12,371, from $99,931 to $112,302, which
increases our 2003 net loss per basic and diluted share by $0.06,
from $0.44 to $0.50. Three Months Ended
    
    Year EndedMarch 31,
    
    June 30,
    
    September 30,
    
    December 31,
    
    December 31,2002
    
    2002
    
    2002
    
    2002
    
    2002Net loss, as reported
    
    $
    (56,839
    )
    
    $
    (40,793
    )
    
    $
    (51,707
    )
    
    $
    (35,489
    )
    
    $
    (184,828
    )Effect of prospectively correcting
certain differences relating to prior
periods, which is included in net loss,
as reported
    
    
    
    
    
    
    
    
    
    
    10,799
    
    
    
    (7,474
    )
    
    
    3,325Effect of unadjusted differences
    
    
    (1,186
    )
    
    
    (1,231
    )
    
    
    1,386
    
    
    
    
    
    
    
    (1,031
    )Net loss, had unadjusted differences
been recorded, net of effect of
prospectively correcting certain
differences relating to prior periods
    
    
    (58,025
    )
    
    
    (42,024
    )
    
    
    (39,522
    )
    
    
    (42,963
    )
    
    
    (182,534
    )Net loss per share, as reported
    
    
    (0.26
    )
    
    
    (0.19
    )
    
    
    (0.23
    )
    
    
    (0.16
    )
    
    
    (0.84
    )Effect of prospectively correcting
certain differences relating to prior
periods, which is included in net loss
per share, as reported
    
    
    
    
    
    
    
    
    
    
    0.04
    
    
    
    (0.03
    )
    
    
    0.01Effect of unadjusted differences
    
    
    (0.01
    )
    
    
    (0.01
    )
    
    
    0.01
    
    
    
    
    
    
    
    (0.01
    )Net loss per share, had unadjusted
differences been recorded, net of
effect of prospectively correcting
certain differences relating to prior
periods
    
    
    (0.27
    )
    
    
    (0.20
    )
    
    
    (0.18
    )
    
    
    (0.19
    )
    
    
    (0.84
    )
 Related Party Transactions Our former vice-chairman and former interim chief executive officer, Frank
Marshall, who was also a member of our board of directors from October 1997 to
December 2002, 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. 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 for $5,470 in
cash, and 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. That claim
is still unresolved. We did not assume any liabilities or obligations of
InternetConnect or hire any of InternetConnects employees. We acquired an equity interest in a supplier during 1999 and disposed of
this interest in 2001. Purchases from this supplier totaled $8,346, $5,774 and
$13,928 for the years ended December 31, 2003, 2002 and 2001, respectively. We
also purchased certain products from a company in which Mr. Marshall serves as
a director. Purchases from this vendor totaled $269, $258 and $140 during the years ended
December 31, 2003, 2002 and 2001, respectively. A member of our Board of Directors, Richard Jalkut, is the President and
CEO of TelePacific, one of our resellers. We recognized revenues from
TelePacific of $611, $1,311 and $1,822 for the years ended December 31, 2003,
2002 and 2001, respectively. L. Dale Crandall, one of our directors, is also a director of BEA Systems,
one of our vendors. We paid $2,232, $121 and $214 to BEA Systems during the
years ended December 31, 2003, 2002 and 2001, respectively. We believe the terms of these transactions are comparable to transactions
that would likely be negotiated with clearly independent parties. 16




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##### Table of Contents



Liquidity and Capital Resources Our operations have required substantial capital investment for the
procurement, design and construction of our central office collocation
facilities, the design, creation, implementation and maintenance of our
internal support system infrastructure, the purchase of telecommunications
equipment and the design, development and maintenance of our networks. Capital
expenditures were $59,031 for the year ended December 31, 2003. This included
$3,750 of expenditures in connection with our acquisition of a customer list
from Qwest. We expect to incur $7,833 in capital expenditures for the purchase of
additional equipment for the 200 central offices we plan to add to our network
in 2004. Even with these expenditures, we do not anticipate a significant
change in our capital expenditures for 2004. However, if we do not add
end-users to our network at the rate that we anticipate capital expenditures
will be lower in comparison to 2003. If we add more end-users than we
anticipate, our capital expenditures related to the new end-users will increase
in comparison with 2004. From our inception through December 31, 2003, we have 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 agreement with SBC for a $50,000 note payable, a $75,000
collateralized deposit from SBC and $719,000 in net proceeds raised from public
equity offerings. As of December 31, 2003, we had an accumulated deficit of
$1,641,638, and unrestricted cash, cash equivalents, and short-term investments
of $114,345. In addition, we had a stockholders deficit as of December 31,
2003 of $5,553 and current liabilities of $114,317. Net cash used in our operating activities was $45,553 for the year ended
December 31, 2003, in comparison with $76,042 in net cash used in our operating
activities for the year ended December 31, 2002. The net cash used in our
operating activities during 2003 was primarily due to the net loss of $112,302,
a decrease in collateralized customer deposits of $7,933, and a decrease in
unearned revenues of $12,089, offset by depreciation and amortization charges
of $73,884, stock-based compensation and other non-cash charges
aggregating $15,595, a decrease in deferred costs of service activation of $8,800, an
increase in accounts payable of $2,067, and miscellaneous income from the
recovery of certain internal-use licensed software costs of $5,606. Net cash provided by our investing activities was $8,508 for the year
ended December 31, 2003. The net cash provided by our investing activities
during this period was primarily due to purchases of short-term investments of
$131,903 and capital expenditures of $59,031, offset by maturities of
short-term investments of $191,894 and the recovery of internal-use software
costs of $7,345. Net cash provided by our financing activities was $8,005 for the year
ended December 31, 2003. The net cash provided by our financing activities
during this period resulted from purchases of our common stock by our employees
under our stock purchase plan and stock option plan totaling $8,170, offset by
principal payments under capital lease obligations of $165. As of December 31, 2003, we had $65,376 in unrestricted cash and cash
equivalents and $48,969 in unrestricted short-term investments. We expect to
experience negative cash flow from operating and investing activities into 2004
until we add enough end-users to our network to cover the fixed cost of
maintaining our network and pay for our sales, marketing, general and
administrative expenses. Our future cash requirements for developing, deploying
and enhancing our network and operating our business, as well as our revenues,
will depend on a number of factors including:  
    
    the effect of the FCCs Triennial Review order, our continuing
ability to access line-shared telephone wires and other traditional
telephone company facilities at reasonable prices;
    
    the deployment of local voice services by providers other than the
traditional telephone companies and our ability to bundle our data
services with the voice services of these alternative providers;
    
    the rate at which wholesalers 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 continue 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 and any future litigation; 17




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##### Table of Contents




    
    network development schedules and associated costs; and
    
    the number of regions entered, the timing of entry and services offered. In addition, we may wish to selectively pursue possible acquisitions of,
or investments in businesses, technologies or products complementary to ours in
order to expand our geographic presence, broaden our product and service
offerings and achieve operating efficiencies. We may not have sufficient
liquidity, or we may be unable to obtain additional financing on favorable
terms or at all, in order to finance such an acquisition or investment. Our contractual debt, lease and purchase obligations as of December 31,
2003 for the next five years, and thereafter, were as follows: 2004
    
    2005-2006
    
    2007-2008
    
    Thereafter
    
    TotalNote payable to SBC
    
    $
    
    
    
    $
    50,000
    
    
    $
    
    
    
    $
    
    
    
    $
    50,000Office leases
    
    
    4,696
    
    
    
    6,087
    
    
    
    3,355
    
    
    
    269
    
    
    
    14,407Other operating leases
    
    
    303
    
    
    
    209
    
    
    
    
    
    
    
    
    
    
    
    512Purchase obligations
    
    
    20,665
    
    
    
    4,475
    
    
    
    
    
    
    
    
    
    
    
    25,140$
    25,664
    
    
    $
    60,771
    
    
    $
    3,355
    
    
    $
    269
    
    
    $
    90,059
 We lease certain vehicles, equipment and office facilities under various
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. In 2002, we entered into a three-year, non-exclusive agreement with MCI,
for the right to provide certain network services to us. We have a monthly
minimum usage requirement which began in June 2002. The agreement expires in
May 2005 has a minimum remaining aggregate purchase obligation of $11,390 as of
December 31, 2003. Similarly, in 2002 and we entered into a three-year,
non-exclusive agreement with AT&T for the right to provide certain data
services to us. We have an annual minimum usage requirement which began in
January 2002. The agreement expires in December 2004 and we have a minimum
remaining aggregate purchase obligation of approximately $11,500 as of December
31, 2003. In addition, in 2002, we entered into a four-year, non-exclusive
agreement with AT&T for the right to provide long distance services to us. We
have an annual minimum usage requirement which began in April 2002. The
agreement expires in March 2006 and has a minimum remaining aggregate usage
commitment of approximately $2,250 as of December 31, 2003. We have in the past described our expectation of attaining cash flow
sufficiency in mid-2004. Nonetheless, adverse business, legal, regulatory or
legislative developments, such as the inability to continue line-sharing, may
require us to raise additional financing, raise our prices or substantially
decrease our cost structure. We also recognize that we may not be able to raise
additional capital. If we are unable to acquire additional capital on favorable
terms if needed, or are required to raise it on terms that are less
satisfactory than we desire, our financial condition will be adversely
affected. Our 2004 business plan includes certain discretionary spending that is
based on several assumptions, including growth of our subscriber base with a
reasonable per subscriber profit margin and improvements in productivity. If
necessarily, we will curtail this discretionary spending so that we can
continue as a going concern at least through December 31, 2004 using only our
unrestricted cash, cash equivalent and short term investment balances in
existence as of December 31, 2003. Forward-Looking Statements We include certain estimates, projections, and other forward-looking
statements in our reports, in presentations to analysts and others, and in
other publicly available material. Future performance cannot be ensured. Actual
results may differ materially from those in forward-looking statements. The
statements contained in this Report on Form 10-Q that are not historical facts
are forward-looking statements (as such term is defined in Section 27A of the
Securities Act and Section 21E of the Exchange Act), which can be identified by
the use of forward-looking terminology such as estimates, projects,
anticipates, expects, intends, believes, or the negative thereof or
other variations thereon or comparable terminology, or by discussions of
strategy that involve risks and uncertainties. Examples of such forward-looking
statements include but are not limited to:  
    
    the impact of the FCCs decision in the Triennial Review and our
ability to obtain access to line-sharing at rates that allow us to sell
consumer-grade services to new customers;
    
    expectations regarding the continuing deployment of local voice
services by providers other than the traditional telephone companies and
our ability to bundle our data services with the voice services of these
alternative providers;
    
    expectations regarding our ability to become cash-flow positive; 18




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##### Table of Contents




    
    expectations regarding the extent to which customers purchase our services;
    
    expectations regarding our relationships with our strategic partners and other potential third parties;
    
    expectations as to pricing for our services in the future;
    
    expectations regarding our margins on our service offerings;
    
    the possibility that we will increase our revenues;
    
    plans to make strategic investments and acquisitions and the effect of such investments and acquisitions;
    
    estimates and expectations of future operating results, including
expectations regarding when we anticipate operating on a cash flow
positive basis, the adequacy of our cash reserves, our monthly cash burn
rate and the number of installed lines;
    
    plans to develop and commercialize value-added services, like Voice over Internet Protocol;
    
    our anticipated capital expenditures;
    
    plans to enter into business arrangements with broadband-related service providers;
    
    the effect of regulatory changes;
    
    the effect of litigation currently pending; and
    
    other statements contained in this Report on Form 10-K regarding matters that are not historical facts. These statements are only estimates or predictions and cannot be relied
upon. We can give you no assurance that future results will be achieved. Actual
events or results may differ materially as a result of risks facing us or
actual results differing from the assumptions underlying such statements. Such
risks and assumptions that could cause actual results to vary materially from
the future results indicated, expressed or implied in such forward-looking
statements include our ability to:  
    
    adapt our business plan in response to further developments resulting from the FCCs Triennial Review order;
    
    collect receivables from customers;
    
    retain end-users that are served by customers facing financial difficulties;
    
    successfully market our services to customers;
    
    generate customer demand for our services;
    
    successfully defend our company against litigation;
    
    successfully reduce our operating costs and overhead while continuing to provide good customer service;
    
    successfully continue to increase the number of business-grade lines;
    
    achieve favorable pricing for our services;
    
    respond to increasing competition;
    
    manage growth of our operations; and
    
    access regions and negotiate suitable interconnection agreements with
the traditional telephone companies in the areas where we provide
service, all in a timely manner, at reasonable costs and on satisfactory
terms that provide us with access to line-sharing and remote terminals. All written and oral forward-looking statements made in connection with
this Report on Form 10-K which are attributable to us or persons acting on our
behalf are expressly qualified in their entirety by the Part I. Item 1.
BusinessRisk Factors and other cautionary statements included in this Report
on Form 10-K. We disclaim any obligation to update information contained in any
forward-looking statement. 19




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##### Table of Contents



Item 8.Financial Statements and Supplementary Data FINANCIAL STATEMENTS INDEX (a) The
following documents are filed as part of this Form 10-K/A:  (1)
    
    Financial Statements.The following Financial Statements of Covad
Communications Group, Inc. and Report of Independent Auditors are filed
as part of this report. Report of Ernst & Young LLP, Independent AuditorsConsolidated Balance SheetsConsolidated Statements of OperationsConsolidated Statements of Stockholders Equity (Deficit)Consolidated Statements of Cash FlowsNotes to Consolidated Financial Statements
 20




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##### Table of Contents



REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS The Board of Directors and Stockholders
Covad Communications Group, Inc. We have audited the accompanying consolidated balance sheets of Covad
Communications Group, Inc. as of December 31, 2003 and 2002, and the related
consolidated statements of operations, stockholders equity (deficit), and cash
flows for each of the three years in the period ended December 31, 2003. These
financial statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Covad
Communications Group, Inc. at December 31, 2003 and 2002, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 2003, in conformity with accounting principles
generally accepted in the United States. As
discussed in Note 15, the consolidated financial statements for the
year ended December 31, 2003 have been restated. /s/ Ernst & Young LLP Walnut Creek, California
February 12, 2004,
except for Note 15,
as to which the date is May 11, 2004 21




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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC. CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share and per share amounts) December 31,2003
    
    2002(Restated, see Note 15)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    65,376
    
    
    $
    94,416Short-term investments
    
    
    48,969
    
    
    
    108,076Restricted cash and cash equivalents
    
    
    2,892
    
    
    
    2,576Accounts receivable, net of allowances of $4,951 at
December 31, 2003 ($5,388 at December 31, 2002)
    
    
    28,528
    
    
    
    21,746Unbilled revenues
    
    
    5,127
    
    
    
    3,921Other receivables
    
    
    637
    
    
    
    1,385Inventories
    
    
    5,335
    
    
    
    5,096Prepaid expenses and other current assets
    
    
    3,761
    
    
    
    5,524Total current assets
    
    
    160,625
    
    
    
    242,740Property and equipment, net
    
    
    94,279
    
    
    
    108,737Collocation fees and other intangible assets, net of
accumulated amortization of $49,698 at December 31, 2003
($32,372 at December 31, 2002)
    
    
    40,848
    
    
    
    43,284Investments in unconsolidated affiliates
    
    
    
    
    
    
    1,026Deferred costs of service activation
    
    
    31,486
    
    
    
    40,286Deferred customer incentives
    
    
    4,431
    
    
    
    3,540Other long-term assets
    
    
    3,042
    
    
    
    2,548Total assets
    
    $
    334,711
    
    
    $
    442,161LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)Current Liabilities:Accounts payable
    
    $
    12,982
    
    
    $
    10,915Accrued compensation
    
    
    21,661
    
    
    
    12,774Current portion of capital lease obligations
    
    
    
    
    
    
    165Accrued collocation and network service fees
    
    
    18,714
    
    
    
    16,537Accrued transaction-based taxes
    
    
    35,268
    
    
    
    45,426Accrued interest
    
    
    5,683
    
    
    
    5,683Accrued market development funds and customer incentives
    
    
    7,024
    
    
    
    6,422Unresolved claims related to bankruptcy proceedings
    
    
    7,378
    
    
    
    7,381Other accrued liabilities
    
    
    5,607
    
    
    
    8,581Total current liabilities
    
    
    114,317
    
    
    
    113,884Long-term debt
    
    
    50,000
    
    
    
    50,000Collateralized customer deposit
    
    
    60,258
    
    
    
    68,191Deferred gain resulting from deconsolidation of subsidiary
    
    
    53,963
    
    
    
    53,972Unearned revenues
    
    
    61,726
    
    
    
    73,815Total liabilities
    
    
    340,264
    
    
    
    359,862Commitments and contingenciesStockholders Equity (Deficit):Preferred stock, $0.001 par value; 5,000,000 shares
authorized; no shares issued and outstanding at December
31, 2003 and 2002
    
    
    
    
    
    
    Common stock, $0.001 par value; 590,000,000 shares
authorized; 230,163,012 shares issued and outstanding at
December 31, 2003 (223,182,511 shares issued and
outstanding at December 31, 2002)
    
    
    230
    
    
    
    223Common stock  Class B, $0.001 par value; 10,000,000
shares authorized; no shares issued and outstanding at
December 31, 2003 and 2002
    
    
    
    
    
    
    Additional paid-in capital
    
    
    1,651,267
    
    
    
    1,612,319Deferred stock-based compensation
    
    
    (14,459
    )
    
    
    (160
    )Accumulated other comprehensive loss
    
    
    (953
    )
    
    
    (747
    )Accumulated deficit
    
    
    (1,641,638
    )
    
    
    (1,529,336
    )Total stockholders equity (deficit)
    
    
    (5,553
    )
    
    
    82,299Total liabilities and stockholders equity (deficit)
    
    $
    334,711
    
    
    $
    442,161
 See accompanying notes. 22




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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except share and per share amounts) Year ended December 31,2003
    
    2002
    
    2001(Restated, see Note 15)Revenues, net
    
    $
    388,851
    
    
    $
    383,496
    
    
    $
    332,596Operating expenses:Network and product costs
    
    
    288,122
    
    
    
    298,336
    
    
    
    461,875Sales, marketing, general and administrative
    
    
    140,081
    
    
    
    150,373
    
    
    
    199,908Provision for bad debts (bad debt recoveries)
    
    
    99
    
    
    
    319
    
    
    
    (658
    )Depreciation and amortization of property and equipment
    
    
    56,559
    
    
    
    112,438
    
    
    
    137,920Amortization of intangible assets
    
    
    17,325
    
    
    
    14,650
    
    
    
    12,919Provision for restructuring expenses
    
    
    1,235
    
    
    
    
    
    
    
    14,364Provision for long-lived asset impairment
    
    
    
    
    
    
    
    
    
    
    11,988Litigation-related expenses, net
    
    
    
    
    
    
    (11,628
    )
    
    
    31,160Total operating expenses
    
    
    503,421
    
    
    
    564,488
    
    
    
    869,476Loss from operations
    
    
    (114,570
    )
    
    
    (180,992
    )
    
    
    (536,880
    )Other income (expense):Interest income
    
    
    2,105
    
    
    
    5,122
    
    
    
    24,593Realized gain (loss) on short-term investments
    
    
    
    
    
    
    (17
    )
    
    
    5,909Other than temporary losses on short-term investments
    
    
    
    
    
    
    
    
    
    
    (1,311
    )Provision for impairment of investments in unconsolidated
affiliates
    
    
    (747
    )
    
    
    (388
    )
    
    
    (10,069
    )Equity in losses of unconsolidated affiliates
    
    
    (279
    )
    
    
    (806
    )
    
    
    (13,769
    )Gain (loss) on disposal of investments in unconsolidated
affiliate
    
    
    
    
    
    
    (636
    )
    
    
    178Interest expense (contractual interest expense was
$142,356 during the year ended December 31, 2001)
    
    
    (5,526
    )
    
    
    (5,581
    )
    
    
    (92,782
    )Miscellaneous income (expense), net
    
    
    6,715
    
    
    
    (1,530
    )
    
    
    (2,218
    )Reorganization expenses, net
    
    
    
    
    
    
    
    
    
    
    (62,620
    )Gain on extinguishment of debt
    
    
    
    
    
    
    
    
    
    
    1,033,727Other income (expense), net
    
    
    2,268
    
    
    
    (3,836
    )
    
    
    881,638Net income (loss)
    
    $
    (112,302
    )
    
    $
    (184,828
    )
    
    $
    344,758Basic and diluted per share amounts:Net income (loss)
    
    $
    (0.50
    )
    
    $
    (0.84
    )
    
    $
    1.94Weighted average common shares used in computing basic
and diluted per share amounts
    
    
    224,949,891
    
    
    
    219,743,662
    
    
    
    177,347,193
 See accompanying notes. 23




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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT)
(Amounts in thousands, except share amounts) Notes
    
    Accumulated
    
    
    
    
    
    TotalPreferred Stock
    
    Common Stock
    
    Additional
    
    Deferred
    
    Receivable
    
    Other
    
    
    
    
    
    StockholdersPaid-In
    
    Stock-Based
    
    From
    
    Comprehensive
    
    Accumulated
    
    EquityShares
    
    Amount
    
    Shares
    
    Amount
    
    Capital
    
    Compensation
    
    Stockholders
    
    Income (Loss)
    
    Deficit
    
    (Deficit)Balances
atDecember 31, 2000
    
    
    
    
    
    
    
    
    
    
    171,937,452
    
    
    $
    172
    
    
    $
    1,509,365
    
    
    $
    (3,067
    )
    
    $
    (423
    )
    
    $
    556
    
    
    $
    (1,689,266
    )
    
    $
    (182,663
    )Issuance of common stock
    
    
    
    
    
    
    
    
    
    
    1,010,000
    
    
    
    1
    
    
    
    579
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    580Issuance of common
stock upon exercise
of options
    
    
    
    
    
    
    
    
    
    
    4,100,979
    
    
    
    4
    
    
    
    2,109
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,113Repurchase of
common stock
    
    
    
    
    
    
    
    
    
    
    (67,500
    )
    
    
    
    
    
    
    (172
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (172
    )Issuance of common stock
upon emergence from Chapter
11 bankruptcy
    
    
    
    
    
    
    
    
    
    
    37,292,800
    
    
    
    37
    
    
    
    93,568
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    93,605Deconsolidation of
subsidiary
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    423
    
    
    
    
    
    
    
    
    
    
    
    423Stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    439
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    439Issuance of common stock
for business acquisition
    
    
    
    
    
    
    
    
    
    
    2,268,481
    
    
    
    2
    
    
    
    2,062
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,064Reversal of deferred
stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,213
    )
    
    
    1,213
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Amortization of deferred
stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,597
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,597Unrealized losses on
available-for-sale
securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,327
    )
    
    
    
    
    
    
    (2,327
    )Foreign currency translation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (588
    )
    
    
    
    
    
    
    (588
    )Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    344,758
    
    
    
    344,758
 See accompanying notes. 24




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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT)  (Continued)
(Amounts in thousands, except share amounts) Notes
    
    Accumulated
    
    
    
    
    
    TotalPreferred Stock
    
    Common Stock
    
    Additional
    
    Deferred
    
    Receivable
    
    Other
    
    
    
    
    
    StockholdersPaid-In
    
    Stock-Based
    
    From
    
    Comprehensive
    
    Accumulated
    
    EquityShares
    
    Amount
    
    Shares
    
    Amount
    
    Capital
    
    Compensation
    
    Stockholders
    
    Income (Loss)
    
    Deficit
    
    (Deficit)Balances at
December 31, 2001
    
    
    
    
    
    
    
    
    
    
    216,542,212
    
    
    
    216
    
    
    
    1,606,737
    
    
    
    (257
    )
    
    
    
    
    
    
    (2,359
    )
    
    
    (1,344,508
    )
    
    
    259,829Issuance of common stock
    
    
    
    
    
    
    
    
    
    
    5,417,251
    
    
    
    6
    
    
    
    4,303
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,309Issuance of common stock upon
exercise of options
    
    
    
    
    
    
    
    
    
    
    1,005,937
    
    
    
    1
    
    
    
    398
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    399Issuance of common stock
following emergence from
Chapter 11 bankruptcy
    
    
    
    
    
    
    
    
    
    
    217,111
    
    
    
    
    
    
    
    261
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    261Issuance of warrants
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,790
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,790Stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    285
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    285Deferred stock-based
compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    290
    
    
    
    (290
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Amortization (reversal) of
deferred stock-based
compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,745
    )
    
    
    387
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,358
    )Unrealized losses on available-for-sale securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    270
    
    
    
    
    
    
    
    270Foreign currency translation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,342
    
    
    
    
    
    
    
    1,342Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (184,828
    )
    
    
    (184,828
    )Balances at December 31,
2002
    
    
    
    
    
    
    
    
    
    
    223,182,511
    
    
    
    223
    
    
    
    1,612,319
    
    
    
    (160
    )
    
    
    
    
    
    
    (747
    )
    
    
    (1,529,336
    )
    
    
    82,299Issuance of common stock
    
    
    
    
    
    
    
    
    
    
    1,996,222
    
    
    
    2
    
    
    
    1,721
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,723Issuance of common stock upon
exercise of options
    
    
    
    
    
    
    
    
    
    
    4,984,279
    
    
    
    5
    
    
    
    6,453
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,458Issuance of warrants
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,640
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,640Stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,356
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,356Deferred
variable stock-based
compensation (restated, see
Note 15)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    26,778
    
    
    
    (26,778
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Amortization of
deferred variable stock-based
compensation (restated, see Note 15)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12,371
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12,371Amortization
of deferred stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    108
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    108Unrealized losses on available-for-sale securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (206
    )
    
    
    
    
    
    
    (206
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (112,302
    )
    
    
    (112,302
    )Balances at
December 31, 2003(restated,
see Note 15)
    
    
    
    
    
    $
    
    
    
    
    230,163,012
    
    
    $
    230
    
    
    $
    1,651,267
    
    
    $
    (14,459
    )
    
    $
    
    
    
    $
    (953
    )
    
    $
    (1,641,638
    )
    
    $
    (5,553
    )
 See accompanying notes. 25




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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands) Year ended December 31,2003
    
    2002
    
    2001(Restated, see Note 15)Operating Activities:Net income (loss)
    
    $
    (112,302
    )
    
    $
    (184,828
    )
    
    $
    344,758Adjustments to reconcile net income (loss) to net cash used
in operating activities:Provision for bad debts (bad debt recoveries)
    
    
    99
    
    
    
    319
    
    
    
    (658
    )Depreciation and amortization
    
    
    73,884
    
    
    
    127,088
    
    
    
    150,839Loss on disposition of property and equipment
    
    
    112
    
    
    
    1,712
    
    
    
    2,679Non-cash reorganization expenses
    
    
    
    
    
    
    
    
    
    
    42,856Non-cash litigation-related expenses
    
    
    
    
    
    
    (11,628
    )
    
    
    25,801Provision for long-lived asset impairment
    
    
    
    
    
    
    
    
    
    
    11,988Amortization (reversal) of deferred stock-based compensation, net
    
    
    12,479
    
    
    
    (3,358
    )
    
    
    1,597Other stock-based compensation
    
    
    1,367
    
    
    
    305
    
    
    
    439Other non-cash charges
    
    
    1,749
    
    
    
    803
    
    
    
    Accretion of interest on investments
    
    
    (1,090
    )
    
    
    (209
    )
    
    
    (7,136
    )Accretion of debt discount and amortization of deferred debt
issuance costs
    
    
    
    
    
    
    
    
    
    
    20,845Other than temporary losses on short-term investments
    
    
    
    
    
    
    
    
    
    
    1,311Provision for impairment of investments in unconsolidated affiliates
    
    
    747
    
    
    
    388
    
    
    
    10,069Equity in losses of unconsolidated affiliates
    
    
    279
    
    
    
    806
    
    
    
    13,769Miscellaneous income from internal-use software license royalties
    
    
    (5,606
    )
    
    
    
    
    
    
    (Gain) loss on disposal of investment in unconsolidated affiliates.
    
    
    
    
    
    
    636
    
    
    
    (178
    )Gain on extinguishment of debt
    
    
    
    
    
    
    
    
    
    
    (1,033,727
    )Net changes in operating assets and liabilities:Restricted cash and cash equivalents
    
    
    (316
    )
    
    
    6,627
    
    
    
    (9,103
    )Accounts receivable
    
    
    (6,881
    )
    
    
    1,180
    
    
    
    532Unbilled revenues
    
    
    (1,206
    )
    
    
    1,043
    
    
    
    2,282Inventories
    
    
    (239
    )
    
    
    2,153
    
    
    
    6,748Prepaid expenses and other assets
    
    
    1,995
    
    
    
    4,159
    
    
    
    3,163Deferred costs of service activation
    
    
    8,800
    
    
    
    17,676
    
    
    
    (5,131
    )Accounts payable
    
    
    2,067
    
    
    
    (4,927
    )
    
    
    (53,652
    )Unresolved claims related to bankruptcy proceedings
    
    
    (3
    )
    
    
    (2,930
    )
    
    
    22,200Collateralized customer deposit
    
    
    (7,933
    )
    
    
    (6,809
    )
    
    
    Accrued restructuring expenses
    
    
    
    
    
    
    
    
    
    
    2,024Other current liabilities
    
    
    (1,466
    )
    
    
    (1,366
    )
    
    
    (22,291
    )Unearned revenues
    
    
    (12,089
    )
    
    
    (24,882
    )
    
    
    12,777Net cash used in operating activities
    
    
    (45,553
    )
    
    
    (76,042
    )
    
    
    (455,199
    )
 See accompanying notes. 26




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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS  (Continued)
(Amounts in thousands) Year ended December 31,2003
    
    2002
    
    2001(Restated, see Note 15)Investing Activities:Cash relinquished as a result of deconsolidating a subsidiary
    
    
    
    
    
    
    
    
    
    
    (1,599
    )Purchase of short-term investments
    
    
    (131,903
    )
    
    
    (237,088
    )
    
    
    (638,096
    )Maturities of short-term investments
    
    
    191,894
    
    
    
    165,526
    
    
    
    547,477Sale of short-term investments
    
    
    
    
    
    
    40,017
    
    
    
    329,458Redemption of restricted investments
    
    
    
    
    
    
    
    
    
    
    26,875Purchase of restricted investments in connection with bankruptcy
proceedings
    
    
    
    
    
    
    
    
    
    
    (257,202
    )Redemption of restricted investments in connection with bankruptcy
proceedings
    
    
    
    
    
    
    
    
    
    
    270,698Purchase of property and equipment
    
    
    (44,142
    )
    
    
    (22,782
    )
    
    
    (15,732
    )Proceeds from sale of property and equipment
    
    
    181
    
    
    
    13,451
    
    
    
    1,280Recovery of internal-use software costs
    
    
    7,345
    
    
    
    814
    
    
    
    2,000Payment of collocation fees and purchase of other intangible assets
    
    
    (14,889
    )
    
    
    (3,782
    )
    
    
    (7,940
    )Proceeds from sale of investments in unconsolidated affiliates
    
    
    
    
    
    
    3,360
    
    
    
    1,225Decrease (increase) in other long-term assets
    
    
    22
    
    
    
    371
    
    
    
    (206
    )Net cash provided by (used in) investing activities
    
    
    8,508
    
    
    
    (40,113
    )
    
    
    258,238Financing Activities:Proceeds from collateralized customer deposit
    
    
    
    
    
    
    
    
    
    
    75,000Proceeds from issuance of long-term debt
    
    
    
    
    
    
    
    
    
    
    50,000Principal payments of long-term debt in connection with bankruptcy
proceedings
    
    
    
    
    
    
    
    
    
    
    (271,708
    )Other principal payments of long-term debt
    
    
    
    
    
    
    
    
    
    
    (8,393
    )Principal payments under capital lease obligations
    
    
    (165
    )
    
    
    (328
    )
    
    
    (1,089
    )Proceeds from common stock issuance, net of repurchase
    
    
    8,170
    
    
    
    3,089
    
    
    
    2,521Net cash provided by (used in) financing activities
    
    
    8,005
    
    
    
    2,761
    
    
    
    (153,669
    )Net decrease in cash and cash equivalents
    
    
    (29,040
    )
    
    
    (113,394
    )
    
    
    (350,630
    )Cash and cash equivalents at beginning of year
    
    
    94,416
    
    
    
    207,810
    
    
    
    558,440Cash and cash equivalents at end of year
    
    $
    65,376
    
    
    $
    94,416
    
    
    $
    207,810Supplemental Disclosures of Cash Flow Information:Cash paid during the year for interest
    
    $
    5,510
    
    
    $
    80
    
    
    $
    68,051Supplemental Schedule of Non-Cash Investing and Financing Activities:Equipment purchased through capital leases
    
    $
    
    
    
    $
    482
    
    
    $
    
 See accompanying notes. 27




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##### Table of Contents



COVAD COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003, 2002 and 2001
(Amounts in thousands, except share and per share amounts) 1. Nature of Operations and Summary of Significant Accounting Policies Organization, Business and Basis of Presentation Organization and Business Covad Communications Group, Inc. (Covad) is a provider of high-speed
connectivity services. These services include a range of high-speed,
high-capacity Internet and network access services utilizing digital subscriber
line (DSL) technology and related value-added services. Covads high-speed
connectivity services are sold to businesses and consumers directly and
indirectly through Internet service providers (ISPs), enterprises,
telecommunications carriers and other customers. These services are sold
directly to business and consumer end-users through Covads field sales force,
telephone sales, third party referrals and Covads Web site. ISPs purchase
Covads services in order to provide high-speed Internet access to their
business and consumer end-users. Enterprise customers purchase services
directly or indirectly from Covad to provide their employees with high-speed
remote access to the enterprises local area network. Other telecommunications
carriers purchase Covads services for resale to their ISP affiliates, Internet
users and enterprise customers. Basis of Presentation The consolidated financial statements include the accounts of Covad and
its wholly owned subsidiaries (collectively, the Company), except for the
accounts of BlueStar Communications Group, Inc. and its wholly owned
subsidiaries (collectively, BlueStar), which have been excluded from the
Companys consolidated financial statements effective June 25, 2001 (Note 4).
All significant intercompany accounts and transactions have been eliminated in
consolidation. The Companys 2004 business plan includes certain discretionary spending
that is based on several assumptions, including growth of the Companys
subscriber base with a reasonable per subscriber profit margin and improvements
in productivity. If necessary, the Company will curtail this discretionary
spending so that it can continue as a going concern at least through December
31, 2004 using only the Companys unrestricted cash, cash equivalent and
short-term investment balances in existence as of December 31, 2003.
Additionally, on August 21, 2003, the Federal Communications Commission (FCC)
issued its order in the Triennial Review of its rules for network unbundling
obligations of Incumbent Local Exchange Carriers (ILECs). Among other things,
that order will phase-out the FCC rule requiring line-sharing over a three-year
period. The ultimate impact of the Triennial Review order on the Companys
business, which currently relies to a large-extent on line-sharing to serve the
Companys consumer end-users, will depend on the Companys ability to negotiate
fair and reasonable prices substantially lower than the whole loop cost that
will ultimately be permitted under the FCCs rules. The Company does not
believe the FCCs revised unbundling rules will have a material adverse effect
on the Companys ability to continue as a going concern at least through
December 31, 2004, but the Companys operating results and financial condition
may be adversely affected over time if the new rules result in substantially
higher prices for access to the ILECs telephone lines. During the year ended December 31, 2003, a matter was identified related
to prior financial reporting periods that necessitated the recording of
additional expense. Such matter was related to the modification of stock
options granted to certain employees in prior years. These modifications
occurred upon the separation of such employees from the Company, principally
during 2000. Accordingly, for the year ended December 31, 2003, the Company
recorded additional stock-based compensation expense in the amount of $1,236
($0.01 per share). Such amount is reflected in the Companys sales, marketing,
general and administrative expenses for the year ended December 31, 2003. The
Company does not believe this amount is material to the periods in which it
should have been recorded, 28




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##### Table of Contents



nor does it believe it is material to its consolidated operating results
for the year ended December 31, 2003. This adjustment is principally related to
2000, the impact of which would have been to increase sales, marketing, general
and administrative expenses and net loss by $1,236 ($0.01 per share) for such
year. As explained below, certain other adjustments were recorded during 2002
that related to prior periods. $1,139 of such amounts pertained to 2000, the
effect of which would have been to decrease the Companys 2000 net loss by
$0.01 per share. The aggregate effect of the adjustments recorded during the
year ended December 31, 2003 and 2002 to the previously reported results of
operations for the year ended December 31, 2000 would be to increase net loss
by $97, or $0.00 per share, for such year if these adjustments had been
recorded in 2000. As part of the Companys continuing evaluation of its network assets
during the year ended December 31, 2002, certain matters were identified
related to prior financial reporting periods that necessitated the recording of
adjustments to certain expenses. Such matters were related principally to (i)
changes in the Companys network configuration, which necessitated reductions
of the remaining estimated useful lives of certain network equipment, (ii) the
capitalization of certain network and product costs that should have been
charged to operating expenses when they were incurred and (iii) various
restructuring activities that resulted in the abandonment of certain network
equipment and leasehold improvements. Accordingly, for the year ended December
31, 2002, the Company recorded additional (i) depreciation expense of $6,989
($1,306 of which was recorded during the fourth quarter of 2002), (ii) network
and product costs of $2,635 ($1,930 of which was recorded during the fourth
quarter of 2002), (iii) loss on the disposition of property and equipment of
$635 (all of which was recorded during the fourth quarter of 2002), and (iv)
interest expense of $51 (all of which was recorded during the fourth quarter of
2002). In addition, as part of the Companys financial statement close process
for the year ended December 31, 2002, the Company discovered that it had
overstated its amortization expense relating to non-cash deferred stock-based
compensation in prior periods by $3,213. Therefore, for the year ended December
31, 2002, the Company recorded reductions of (i) network and products costs of
$320 (all of which was recorded during the fourth quarter of 2002) and (ii)
sales, marketing, general and administrative expense of $2,893 (all of which
was recorded during the fourth quarter of 2002). Furthermore, as part of the
Companys review of its December 31, 2002 tax accruals, it determined that it
had overstated its transaction-based tax and other tax accruals in prior
periods by $4,804, which the Company adjusted during the year ended December
31, 2002 (all of which was recorded during the fourth quarter of 2002). The
adjustment was primarily driven by various complex rules surrounding the
Companys estimated liability to the Federal Universal Service Fund (FUSF).
The Company does not believe any of the aforementioned amounts are material to
the periods in which they should have been recorded, nor does it believe the
prospective correction of such amounts during the year ended December 31, 2002
is material to its consolidated operating results for such year (the
prospective correction of the aforementioned amounts relating to prior periods
increased the Companys 2002 consolidated net loss by $2,294, or $0.01 per
share, and decreased the Companys 2001 net loss by $3,433 or $0.02 per share). Summary of Significant Accounting Policies Use of Estimates The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires the Company 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 those estimates. The Companys critical accounting estimates
include (i) revenue recognition and the establishment of accounts receivable
allowances (Notes 1 and 2), (ii) inventory valuation (Note 1), (iii)
reorganization and restructuring liabilities (Notes 3 and 4), (iv) useful life
assignments and impairment evaluations associated with property and equipment
and intangible assets (Notes 1 and 5), (v) anticipated outcomes of legal
proceedings and other disputes (Notes 3, 4 and 10), (vi) transaction-based tax
and employment-related tax liabilities (Note 10) and (vii) valuation allowances
associated with deferred tax assets (Note 12). Cash Equivalents and Short-Term Investments The Company considers all highly liquid investments with a maturity of
three months or less from the date of original issuance to be cash equivalents.
As of December 31, 2003 and 2002, cash equivalents consisted principally of
money market mutual funds. All of the Companys investments are classified as
available-for-sale and stated at 29




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##### Table of Contents



their fair market values, which are determined based on quoted market prices.
The Companys short-term investments had original maturities greater than three
months, but less than one year, from the balance sheet dates. The Company
determines the appropriate classification of investments at the time of
purchase and reevaluates such designation at the end of each period. Unrealized
gains and losses on available-for-sale securities are included as a separate
component of stockholders equity. Realized gains and losses on
available-for-sale securities are determined based on the specific
identification of the cost of securities sold. Short-term investments consisted of the following: December 31, 2003Gross
    
    GrossAmortized
    
    Unrealized
    
    UnrealizedCost
    
    Gains
    
    Losses
    
    Fair ValueU.S. Government agency securities
    
    $
    38,961
    
    
    $
    7
    
    
    $
    
    
    
    $
    38,968Certificates of deposit
    
    
    10,000
    
    
    
    1
    
    
    
    
    
    
    
    10,001Total available-for-sale securities
    
    $
    48,961
    
    
    $
    8
    
    
    $
    
    
    
    $
    48,969
 December 31, 2002Gross
    
    GrossAmortized
    
    Unrealized
    
    UnrealizedCost
    
    Gains
    
    Losses
    
    Fair ValueU.S. Government agency securities
    
    $
    107,867
    
    
    $
    209
    
    
    $
    
    
    
    $
    108,076Total available-for-sale securities
    
    $
    107,867
    
    
    $
    209
    
    
    $
    
    
    
    $
    108,076
 As of December 31, 2003, the contractual maturities of all
available-for-sale securities are between January 2004 and September 2004. Realized gains and losses resulting from the sale of available-for-sale
securities were as follows: Year ended December 31,2003
    
    2002
    
    2001Gains
    
    $
    
    
    
    $
    
    
    
    $
    6,373Losses
    
    
    
    
    
    
    (17
    )
    
    
    (464
    )$
    
    
    
    $
    (17
    )
    
    $
    5,909
 Restricted Cash and Cash Equivalents As of December 31, 2003 and 2002, the Company held $2,892 and $2,576,
respectively, in money market mutual funds, which (i) collateralize irrevocable
letters of credit pertaining to certain operating lease commitments (Note 7) or
(ii) are restricted for the payment of unresolved bankruptcy claims (Note 2). Other Investments Other investments consist primarily of strategic investments in privately
held entities. These investments in privately held companies are accounted for
under either the cost or equity methods of accounting, depending on the
Companys ability to significantly influence these entities. The Company performs periodic reviews of its investments for impairment.
Impairment write-downs create a new carrying value for the investment and the
Company does not record subsequent increases in fair value in excess of the new
carrying value for these types of privately held investments accounted for
under the cost or equity methods. The Company recorded write-downs of $747,
$388 and $10,069 during the years ended December 31, 2003, 2002 and 2001,
respectively, related to impairments of its privately held investments. 30




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Concentrations of Credit Risk, Significant Customers, Key Suppliers and Related Parties Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash and cash equivalents,
short-term investments and restricted cash and cash equivalents. The Companys
cash and investment policies limit cash equivalents, short-term investments and
restricted cash and cash equivalents to short-term, investment grade
instruments. Cash and cash equivalents, short-term investments and restricted
cash and cash equivalents are held primarily with various domestic and Canadian
financial institutions with high credit standings. The Company has not
experienced any significant losses on its cash, cash equivalents or restricted
cash and cash equivalents. However, during the year ended December 31, 2001,
the Company recognized other than temporary losses on certain
available-for-sale securities aggregating $1,311. No similar losses were
recognized during the years ended December 31, 2003 and 2002. The Company conducts business primarily with ISPs, enterprise customers
and telecommunications carrier customers in the United States. As more fully
described in Note 2, the Company has concentrations of credit risk with a small
number of customers, and certain of the Companys customers were experiencing
financial difficulties as of December 31, 2003, 2002 and 2001 and were not
current in their payments for the Companys services at those dates. The
Company performs ongoing credit evaluations of its customers financial
condition and generally does not require collateral. An allowance is maintained
for estimated credit losses. During the years ended December 31, 2003, 2002 and
2001, the Company wrote-off certain accounts receivable balances aggregating
$385, $2,652 and $10,371, respectively, against the allowance for credit
losses. During the years ended December 31, 2003, 2002 and 2001, the Company
recovered $374, $684 and $2,037, respectively, of accounts receivable balances
previously written-off against such allowance. The Company is dependent on a limited number of suppliers for certain
equipment used to provide its services. The Company has generally been able to
obtain an adequate supply of such equipment. However, an extended interruption
in the supply of equipment currently obtained from its suppliers could
adversely affect the Companys business and results of operations. The Companys former vice-chairman and former interim chief executive
officer, Frank Marshall, who was also a member of the Companys board of
directors from October 1997 to December 2002, was a minority stockholder and
former member of the board of directors of one of the Companys former ISP
customers, InternetConnect, which filed for bankruptcy protection in 2001 (Note
6). The Company acquired an equity interest in a supplier during 1999 and
disposed of this interest in 2001. Purchases from this supplier totaled $8,346,
$5,774 and $13,928 for the years ended December 31, 2003, 2002 and 2001,
respectively. The Company also purchased certain products from a company in
which Mr. Marshall serves as a director. Purchases from this vendor totaled
$269, $258 and $140 during the years ended December 31, 2003, 2002 and 2001,
respectively. A member of the Companys Board of Directors, Richard Jalkut, is the
President and CEO of TelePacific, one of the Companys resellers. The Company
recognized revenues from TelePacific of $611, $1,311 and $1,822 for the years
ended December 31, 2003, 2002 and 2001, respectively. Another member of the
Companys Board of Directors, L. Dale Crandall, is also a director of BEA
Systems, one of the Companys vendors. The Company paid $2,232, $121 and $214
to BEA Systems during the years ended December 31, 2003, 2002 and 2001,
respectively. The Company believes the terms of these transactions are comparable to
transactions that would likely be negotiated with clearly independent parties. Inventories Inventories, consisting primarily of customer premises equipment, are
stated at the lower of cost, determined using the first-in, first-out method,
or market. 31




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Property and Equipment Property and equipment are recorded at cost, subject to adjustments for
impairment, and depreciated or amortized using the straight-line method over
the following estimated useful lives: Leasehold improvements
    
    5 years or the term of the lease, whichever is lessComputer equipment
    
    2 to 5 yearsComputer software
    
    3 to 5 yearsFurniture and fixtures
    
    2 to 5 yearsNetworks and communication equipment
    
    2 to 5 years
 The Company incurs significant costs associated with internal-use
software, which consists principally of the Companys operational support
systems (OSS) software and Web site. The Company charges the costs of
research to expense as they are incurred, including pre-development efforts
related to determining technological or product alternatives, and costs
incurred for training and maintenance. Software and Web site development costs,
which include direct costs such as labor and contractors, are capitalized when
they can be segregated from other non-capitalizable labor activities and when
it is probable that the project will be completed and the software or Web site
will be used as intended. Costs incurred for upgrades and enhancements to the
Companys software or Web site are capitalized when it is probable that such
efforts will result in additional and significant functionality. Capitalized
software and Web site costs are amortized to expense over the estimated useful
life of the software or Web site. Amortization of internal-use software costs
was $3,336, $6,030 and $9,433 during the years ended December 31, 2003, 2002
and 2001, respectively. The Company accounts for incidental sales of licenses
to its OSS software on a cost recovery basis (Note 6). The Company leased certain equipment under capital lease agreements.
Assets and liabilities under capital leases are recorded at the lesser of the
present value of the aggregate future minimum lease payments, including
estimated bargain purchase options, or the fair value of the assets under
lease. Assets under capital leases are amortized over the lesser of the lease
term or useful life of the assets. Amortization of assets under capital leases
is included in depreciation and amortization expense. Collocation Fees and Other Intangible Assets Collocation fees represent nonrecurring fees paid to other
telecommunications carriers for the right to use central office space to house
equipment owned or leased by the Company. Such nonrecurring fees are
capitalized as intangible assets and amortized over five years using the
straight-line method. The Companys collocation agreements also require
periodic recurring payments, which are charged to expense as incurred. All such
collocation agreements are cancelable by the Company at any time. Other intangible assets consist of a customer list acquired from a third
party (Note 6). Such customer list is being amortized over twenty-four months
using the straight-line method. As of December 31, 2003, the Companys estimated annual amortization
expenses associated with collocation fees and other intangible assets for the
next five years were as follows: 2004
    
    $
    17,2362005
    
    $
    14,7692006
    
    $
    5,0672007
    
    $
    2,3322008
    
    $
    1,444
 32




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Change in Accounting Estimate In addition to the changes in accounting estimate described above under
Basis of Presentation, effective January 1, 2001, the Company reduced the
remaining estimated useful lives of all long-lived assets, excluding a 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 decreased the
companys net income by $14,006 ($0.08 per share) for the year ended December
31, 2001. Impairment of Long-lived Assets The Company periodically evaluates potential impairments of its long-lived
assets, including intangibles. When the Company determines that the carrying
value of long-lived assets may not be recoverable based upon the existence of
one or more indicators of impairment, the Company evaluates the projected
undiscounted cash flows related to the assets. If these cash flows are less
than the carrying value of the assets, the Company measures the impairment
using discounted cash flows or other methods of determining fair value. Long-lived assets to be disposed of are carried at the lower of cost or
fair value less estimated costs of disposal. Stock-Based Compensation The Company accounts for stock-based awards to (i) employees (including
non-employee directors) using the intrinsic value method and (ii) non-employees
using the fair value method. Under the intrinsic value method, when the exercise price of the Companys
employee stock options equals the market price of the underlying stock on the
date of grant, no compensation expense is recognized. The following table
illustrates the pro forma effect on net income (loss) and earnings (loss) per
share for the years ended December 31, 2003, 2002 and 2001 had the Company
applied the fair value method to account for stock-based awards to employees: 2003
    
    2002
    
    2001(Restated, see Note 15)Net income (loss), as reported
    
    $
    (112,302
    )
    
    $
    (184,828
    )
    
    $
    344,758Stock-based employee compensation expense (reversal)
included in the determination of net income (loss),
as reported
    
    
    13,715
    
    
    
    (3,112
    )
    
    
    1,849Stock-based employee compensation expense that would
have been included in the determination of net
income (loss) if the fair value method had been
applied to all awards
    
    
    (20,507
    )
    
    
    (28,471
    )
    
    
    (66,751
    )Pro forma net income (loss)
    
    $
    (119,094
    )
    
    $
    (216,411
    )
    
    $
    279,856Basic and diluted net income (loss) per common share:As reported
    
    $
    (0.50
    )
    
    $
    (0.84
    )
    
    $
    1.94Pro forma
    
    $
    (0.53
    )
    
    $
    (0.98
    )
    
    $
    1.58
 The weighted-average grant date fair value of stock-based awards to
employees was $1.76, $0.83 and $1.38 per share during the years ended December
31, 2003, 2002 and 2001, respectively. Such weighted-average grant date fair
values were estimated using the Black-Scholes option valuation model and the
assumptions listed in Note 13 under the caption Pro Forma Stock-Based
Compensation Information. Advertising Costs The Company charges the costs of advertising to expense as incurred.
Advertising expense for the years ended December 31, 2003, 2002 and 2001 was
$7,650, $27,083 and $16,467, respectively. The Company makes market development funds (MDF) available to certain
customers for the reimbursement of co-branded advertising expenses and other
purposes. To the extent that MDF is used by the Companys customers for
co-branded advertising, and (i) the customers provide the Company with
third-party evidence of such co-branded 33




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##### Table of Contents



advertising as required by Company policy and (ii) the Company can
reasonably estimate the fair value of its portion of the advertising, such
amounts are charged to advertising expense as incurred. Other amounts payable
to customers relating to rebates, customer incentives and nonqualified MDF
activities are recorded as reductions of revenues as incurred. Income Taxes The Company uses the liability method to account for income taxes. Under
this method, deferred tax assets and liabilities are determined based on
differences between financial reporting and tax bases of assets and
liabilities. Deferred tax assets and liabilities are measured using enacted tax
rates and laws that will be in effect when the differences are expected to
reverse. Valuation allowances are established when necessary to reduce deferred
tax assets to the amount expected to be realized. Fair Values of Financial Instruments The following methods and assumptions were used to estimate the fair
values of the Companys financial instruments: Cash, Cash Equivalents, Short Term Investments and Restricted Cash and
Cash Equivalents.The carrying amounts of these assets approximate their
respective fair values, which were determined based on quoted market prices. Borrowings.The fair values of borrowings, including long-term debt and
capital lease obligations, are estimated based on quoted market prices, where
available, or by discounting the future cash flows using estimated borrowing
rates at which similar types of borrowing arrangements with the same remaining
maturities could be obtained by the Company. The aggregate fair value of the
Companys long-term debt was $58,646 as of December 31, 2003, as compared to
the aggregate carrying amount of $50,000 as of such date. The aggregate fair
value of the Companys long-term debt and capital lease obligations was $59,140
as of December 31, 2002, as compared to the aggregate carrying amount of
$50,165 as of such date. Foreign Currency The functional currency of the Companys unconsolidated affiliates is the
local currency. The investments in these unconsolidated affiliates are
translated into U.S. dollars at year-end exchange rates, and the Companys
equity in the income or losses of these affiliates is translated at average
exchange rates prevailing during the year. Translation adjustments are included
in Accumulated other comprehensive loss, a separate component of
stockholders equity (deficit). Per Share Amounts Basic per share amounts are computed by using the weighted average number
of shares of the Companys common stock, less the weighted average number of
common shares subject to repurchase, outstanding during the period. 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 income (loss) per share is the same as
basic net income (loss) per share in the periods presented in the accompanying
consolidated statements of operations because loss from operations is the
control number in determining whether potential common shares are included in
the calculation. Consequently, the impact of (i) including common shares
subject to repurchase, (ii) the assumed exercise of outstanding stock options
and warrants and (iii) the assumed conversion of convertible debt instruments
was not dilutive to loss from operations. 34




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The following table presents the calculation of weighted average common
shares used in the computations of basic and diluted per share amounts
presented in the accompanying consolidated statements of operations: Year ended December 31,2003
    
    2002
    
    2001Weighted average shares of common stock outstanding
    
    
    224,949,891
    
    
    
    219,750,287
    
    
    
    177,489,090Less weighted average shares of common stock
subject to repurchase
    
    
    
    
    
    
    6,625
    
    
    
    141,897Weighted average common shares used in computing
basic per share amounts
    
    
    224,949,891
    
    
    
    219,743,662
    
    
    
    177,347,193
 Comprehensive Income (Loss) Significant components of the Companys comprehensive income (loss) are as
follows: Year ended December 31,CumulativeAmounts
    
    2003
    
    2002
    
    2001(Restated, see
    
    (Restated, seeNote 15)
    
    Note 15)Net income (loss)
    
    $
    (1,641,638
    )
    
    $
    (112,302
    )
    
    $
    (184,828
    )
    
    $
    344,758Unrealized gains (losses) on available-for-sale
securities
    
    
    9
    
    
    
    (206
    )
    
    
    270
    
    
    
    (2,327
    )Foreign currency translation adjustment
    
    
    (962
    )
    
    
    
    
    
    
    1,342
    
    
    
    (588
    )Comprehensive income (loss)
    
    $
    (1,642,591
    )
    
    $
    (112,508
    )
    
    $
    (183,216
    )
    
    $
    341,843
 Recent Accounting Pronouncements On May 15, 2003, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 150, Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and
Equity". SFAS No. 150 establishes standards for classifying and measuring as
liabilities certain financial instruments that embody obligations of the issuer
and have characteristics of both liabilities and equity, such as mandatorily
redeemable equity instruments. SFAS No. 150 must be applied immediately to
instruments entered into or modified after May 31, 2003 and to all other
instruments that exist as of the beginning of the first interim financial
reporting period beginning after June 15, 2003, except for mandatorily
redeemable instruments of non-public companies, to which the provisions of SFAS
No. 150 must be applied in fiscal periods beginning after December 15, 2003.
The application of SFAS No. 150 to pre-existing instruments should be
recognized as the cumulative effect of a change in accounting principle. The
adoption of SFAS No. 150 had no effect on the Companys consolidated financial
statements. In January 2003, the FASB issued Interpretation (FIN) No. 46,
Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulleting No. 51, Consolidated Financial Statements. FIN 46 applies
to any business enterprise that has a controlling interest, contractual
relationship or other business relationship with a variable interest entity
(VIE) and establishes guidance for the consolidation of VIEs that function to
support the activities of the primary beneficiary. FIN 46 was effective March
31, 2004 for enterprises with VIEs created after January 31, 2003, and will be
effective March 31, 2004 for enterprises with VIEs created before February 1,
2003. The Company does not expect the adoption of FIN 46 will have an effect on
its consolidated financial statements. In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure. SFAS No. 148 amends SFAS
No. 123, Accounting for Stock-Based Compensation, to provide alternative
methods of transition for an entity that voluntarily changes to the fair value
method of accounting for stock-based employee compensation. In addition, SFAS
No. 148 amends the disclosure provisions of SFAS No. 123 to require prominent
disclosure of the effects of an entitys accounting policy with respect to
stock-based employee compensation on reported operating results, including per
share amounts, in annual and interim financial statements. The disclosure
provisions of SFAS No. 148 were effective immediately upon issuance in 2002. As
of December 31, 2003, the Company has no immediate plans to adopt the fair
value method of accounting for stock-based employee compensation. 35




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In November 2002, the FASBs Emerging Issues Task Force (EITF) reached a
final consensus on Issue No. 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables, which is effective for revenue arrangements entered
into in fiscal periods beginning after June 15, 2003. Under EITF Issue No.
00-21, revenue arrangements with multiple deliverables are required to be
divided into separate units of accounting under certain circumstances. The
Company adopted EITF Issue No. 00-21 on July 1, 2003, and such adoption did not
have a material effect on its consolidated financial statements. In November 2002, the FASB issued FIN No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others. FIN No. 45 requires certain guarantees to be recorded
at fair value, which is different from current practice, which is generally to
record a liability only when a loss is probable and reasonably estimable. FIN
No. 45 also requires a guarantor to make significant new disclosures, even when
the likelihood of making any payments under the guarantee is remote. The
disclosure provisions of FIN No. 45 were effective immediately in 2002. The
Company adopted the recognition and measurement provisions of FIN No. 45 on a
prospective basis with respect to guarantees issued or modified after December
31, 2002. The adoption of the recognition and measurement provisions of FIN No.
45 had no effect on the Companys consolidated financial statements. However,
some of the Companys contracts with customers have provisions that would
require the Company to indemnify them in the event that the Companys services
infringe upon a third partys intellectual property rights (Note 10). On January 1, 2003, the Company adopted SFAS No. 146, Accounting for
Costs Associated with an Exit or Disposal Activity. SFAS No. 146 revised the
accounting for exit and disposal activities under EITF Issue No. 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 is no longer sufficient to record a
one-time charge for most restructuring activities. Instead, companies record
exit or disposal costs when they are incurred and can be measured at fair
value. In addition, the resultant liabilities are 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 No. 94-3 are grandfathered. The adoption of SFAS No. 146 had
no effect on the Companys consolidated financial statements. On January 1, 2003, the Company adopted 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 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. Upon adoption of
SFAS No. 145 in 2003, the Company reclassified the gain on extinguishment of
debt that it recognized in 2001, which was previously classified as an
extraordinary item, as an element of other income (expense) in the accompanying
2001 consolidated statement of operations. On January 1, 2003, the Company adopted 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. The adoption of SFAS No. 143 had no effect on
the Companys consolidated financial statements. Reclassifications Certain balances in the Companys 2002 and 2001 consolidated financial
statements have been reclassified to conform to the presentation in 2003. 36




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2. Revenue Recognition Revenues from recurring service are recognized when (i) persuasive
evidence of an arrangement between the Company and the customer exists, (ii)
service has been provided to the customer, (iii) the price to the customer is
fixed or determinable and (iv) collectibility of the sales prices is reasonably
assured. Revenues earned for which the customer has not been billed are
recorded as Unbilled revenues in the consolidated balance sheets. Amounts
billed in advance of providing service are deferred and recorded as an element
of the consolidated balance sheets caption Unearned revenues. Included in
revenues are FUSF charges billed to customers aggregating $4,993, $8,233 and
$13,277 for the years ended December 31, 2003, 2002 and 2001, respectively. The Company recognizes up-front fees associated with service activation
over the expected term of the customer relationship, which is presently
estimated to be 24 months, using the straight-line method. The Company treats
the incremental direct costs of service activation (which consist principally
of customer premises equipment, service activation fees paid to other
telecommunications companies and sales commissions) as deferred charges in
amounts that are no greater than the up-front fees that are deferred, and such
deferred incremental direct costs are amortized to expense using the
straight-line method over 24 months. The Company had over 300 wholesale customers as of December 31, 2003.
However, for the years ended December 31, 2003, 2002 and 2001, the Companys 30
largest wholesale customers in each such year collectively comprised 93.3%,
93.3% and 88.5% of the Companys total wholesale net revenues, respectively,
and 71.6%, 79.5% and 76.0% of the Companys total net revenues, respectively.
As of December 31, 2003 and 2002, receivables from these customers collectively
comprised 70.3% and 75.3%, respectively, of the Companys gross accounts
receivable balance. For the year ended December 31, 2003, EarthLink, Inc. and AT&T, two of the
Companys wholesale customers that are included in the Companys Covad
Strategic Partnerships (CSP, business segment (Note 14), accounted for 21.5%
and 12.5%, respectively, of the Companys total net revenues. For the years
ended December 31, 2002 and 2001, EarthLink, Inc. accounted for 20.0% and
17.5%, respectively, of the Companys total net revenues. As of December 31,
2003 and 2002, receivables from these customers comprised 20.9% and 17.1%, and
25.9% and 11.7%, respectively, of the Companys gross accounts receivable
balance. No other individual customer accounted for more than 10% of the
Companys total net revenues in 2003, 2002 and 2001. Some of the Companys ISP and telecommunications carrier customers are
experiencing financial difficulties. During the years ended December 31, 2003,
2002 and 2001, certain of these customers either (i) were not current in their
payments for the Companys services or (ii) were essentially current in their
payments but, subsequent to the end of the reporting period, the financial
condition of such customers deteriorated significantly and certain of them have
filed for bankruptcy protection. Based on this information, the Company
determined that the collectibility of revenues from these customers was not
reasonably assured or its ability to retain some or all of the payments
received from certain of these customers that have filed for bankruptcy
protection was not reasonably assured. Accordingly, the Company classified this
group of customers as financially distressed for revenue recognition
purposes. Revenues from financially distressed customers that have not filed
for bankruptcy protection are recognized when cash for those services is
collected, assuming all other criteria for revenue recognition have been met,
but only 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. A number of the Companys customers are currently in bankruptcy
proceedings. Revenues from these customers accounted for approximately 1.3%,
5.6% and 7.1% of the Companys total net revenues for the years ended December
31, 2003, 2002 and 2001, respectively. Although MCI filed for bankruptcy
protection on July 21, 2002, the Company continued to recognize revenues from
MCI on an accrual basis during 2002 and 2003 based on its specific facts and
circumstances in relation to the revenue recognition criteria described above.
Consequently, the disclosures in the following paragraph related to financially
distressed customers exclude amounts pertaining to MCI because the Company has
not presently classified it as a financially distressed customer for revenue
recognition purposes. The Company continues to attempt to migrate end-users
from some of its financially distressed customers to the extent it is legally
and operationally feasible. 37




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##### Table of Contents



During the years ended December 31, 2003, 2002 and 2001, the Company
issued billings to its financially distressed customers aggregating $5,139,
$42,881 and $74,928, respectively, that were not recognized as revenues or
accounts receivable in the accompanying consolidated financial statements at
the time of such billings. However, in accordance with the revenue recognition
policy described above, the Company recognized revenues from certain of these
customers when cash was collected aggregating $4,367, $47,609 and $29,003
during the years ended December 31, 2003, 2002 and 2001, respectively, some of
which relates to services provided in prior periods. In addition, revenues and
the provision for bad debts (bad debt recoveries) recognized during the year
ended December 31, 2003 and 2002 include cash collected totaling $827 and
$4,427, respectively, from certain bankrupt customers that the Company received
prior to the periods in which they were ultimately recognized. The Company
recorded these payments as unearned revenues in the accompanying consolidated
balance sheet as of those dates because its ability to retain the payments was
not reasonably assured at such dates. However, as a result of subsequent
developments in the bankruptcy proceedings of such customers, the Company
determined that its ability to retain these payments was reasonably assured
prior to December 31,
2003. Consequently, the Company recognized these payments as revenues and
bad debt recoveries, respectively, during 2003 and 2002. No such payments were
recognized as revenues or bad debt recoveries during the year ended December
31, 2001. The Company had contractual receivables from its financially
distressed customers totaling $1,093 and $6,031 as of December 31, 2003 and
2002, respectively, that are not reflected in the accompanying consolidated
balance sheet as of such date. The Company has obtained information indicating that some of its
customers, including MCI, who (i) were essentially current in their payments
for the Companys services prior to December 31, 2003, or (ii) have
subsequently paid all or significant portions of the respective amounts
recorded as accounts receivable as of December 31, 2003, may become financially
distressed. Revenues from these customers accounted for approximately 11.6%,
34.6% and 14.2% of the Companys total net revenues for the years ended
December 31, 2003, 2002 and 2001, respectively. As of December 31, 2003 and
2002, receivables from these customers comprised 14.7% and 31.8% of the
Companys gross accounts receivable balance, respectively. If these customers
are unable to demonstrate their ability to pay for the Companys services in a
timely manner in periods ending subsequent to December 31, 2003, the Company,
based on its revenue recognition policy described above, will recognize revenue
when cash is collected. 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 year ended December 31,
2002, principally as a result of a capital infusion during this period.
Consequently, the Company concluded that collection of its billings to this
customer was now reasonably assured. Therefore, the Company resumed the
recognition of revenues from this customer on an accrual basis during 2002,
which resulted in the recognition of revenues in the amount of approximately
$1,542 that relate to services rendered in periods ended prior to January 1,
2002. Similarly, the Company resumed the recognition of revenue on an accrual
basis for another wholesale customer during 2002. The Company did not, however,
recognize additional revenue from services rendered in prior periods because
this customer was current in its payments. No similar amounts were recognized
during the other periods reported in the accompanying consolidated financial
statements. The Company has billing disputes with some of its customers. These
disputes arise in the ordinary course of business in the telecommunications
industry and their impact on the Companys accounts receivable and revenues can
be reasonably estimated based on historical experience. In addition, certain
revenues are subject to refund if the end-user terminates service within thirty
days of service activation. Accordingly, the Company maintains allowances,
through charges to revenues, based on the Companys estimates of (i) the
ultimate resolution of the disputes (ii) future service cancellations. These
charges to revenues amounted to $2,886, $2,322 and $11,178 during the years
ended December 31, 2003, 2002 and 2001, respectively. During the years ended
December 31, 2003, 2002 and 2001, the Company wrote-off certain accounts
receivable balances aggregating $1,557, $3,748 and $6,701, respectively,
against the allowance for customer disputes and service cancellations. During
the years ended December 31, 2003 and 2002, the Company recovered $1,282 and
$2,145, respectively, of accounts receivable balances previously written-off
against such allowance. There were no similar recoveries of accounts receivable
balances for the year ended December 31, 2001. During the year ended December 31, 2001, the Company recognized $11,661 in
revenue that was included in the cumulative effect adjustment as of January 1,
2000, which resulted from the Companys adoption of Securities and 38




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##### Table of Contents



Exchange
Commission Staff Accounting Bulletin No. 101, Revenue Recognition in Financial
Statements (no similar revenues were recognized during the years ended
December 31, 2003 and 2002). The effect of that revenue during 2001 was to
increase net income by $3,067. 3. 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 (the
Noteholders) of its senior notes. 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). 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 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. On the Effective Date, the Company made the following distributions of
cash and shares of its common stock to certain claimants: Common StockAggregate Fair
    
    TotalClaimant
    
    Cash
    
    Shares
    
    Market Value
    
    ConsiderationNoteholders
    
    $
    271,708
    
    
    
    35,292,800
    
    
    $
    88,585
    
    
    $
    360,293Plaintiffs in litigation (Note 10)
    
    
    5,793
    
    
    
    2,000,000
    
    
    
    5,020
    
    
    
    10,813Other claimants
    
    
    1,900
    
    
    
    
    
    
    
    
    
    
    
    1,900$
    279,401
    
    
    
    37,292,800
    
    
    $
    93,605
    
    
    $
    373,006
 The aforementioned distributions of cash and shares of the Companys
common stock resulted in the extinguishment of certain liabilities of Covad as
of the Effective Date and the recognition of a gain on extinguishment of debt
and certain litigation-related and other general and administrative expenses in
the accompanying consolidated statement of operations for the year ended
December 31, 2001, as follows: Extinguishment of senior notes:Senior notes
    
    $
    1,351,488Accrued interest
    
    
    42,5321,394,020Less consideration distributed to the Noteholders
    
    
    360,293Gain on extinguishment of debt
    
    $
    1,033,727Settlement of litigation (Note 10):Consideration distributed to the plaintiffs
    
    $
    10,813Less amounts accrued prior to the Effective Date
    
    
    6,820Additional litigation-related expenses recognized
    
    $
    3,993Other:Consideration distributed to the claimants
    
    $
    1,900Less amounts accrued prior to the Effective Date
    
    
    Additional general and administrative expenses recognized
    
    $
    1,900
 There were unresolved claims related to Covads Chapter 11 bankruptcy
proceedings aggregating $8,341 and $8,344 as of December 31, 2003 and 2002,
respectively. As of December 31, 2003 and 2002, the Company recorded these
unresolved claims in its 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
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 consolidated
balance sheets as of December 31, 2003 and 2002. 39




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As of December 31, 2003 and 2002, the Company had (i) placed $309 and
$501, respectively, of cash in a reserve fund (this balance is classified as
Restricted Cash and Cash Equivalents in the accompanying consolidated balance
sheets) and (ii) reserved 7,078,733 and 7,078,733 shares, respectively, of
common stock pending the resolution of the aforementioned disputed claims. The holders of the Companys common stock issued prior to the Effective
Date of the Plan retained their existing equity interests, but were diluted
through the issuance of common stock to the claimants described above. As of
the Effective Date, and after the issuance of 37,292,800 shares of the
Companys common stock pursuant to the Plan as described above, there were
216,445,276 shares of the Companys common stock issued and outstanding. The
holders of the Companys common stock immediately before the Effective Date of
the Plan held more than 50% of the Companys voting shares (including shares
reserved for future issuance under the Plan) immediately after the
Effective Date of the Plan. Therefore, under AICPA Statement of Position
(SOP) 90-7, Financial Reporting by Entities in Reorganization Under the
Bankruptcy Code, the Company did not qualify for fresh-start reporting. In accordance with SOP 90-7, expenses resulting from the restructuring are
reported separately as reorganization items. For the year ended December 31,
2001, the Company recognized expenses directly associated with Covads Chapter
11 bankruptcy proceedings in the amount of $63,229 (none for the years ended
December 31, 2003 and 2002). These reorganization expenses consisted of (i)
non-cash adjustments to unamortized debt issuance costs and discounts and (ii)
professional fees for legal and financial advisory services. For the year ended
December 31, 2001, the Company recognized interest income in the amount of $609
on accumulated cash that Covad did not disburse as a result of its Chapter 11
bankruptcy proceedings (none for the years ended December 31, 2003 and 2002).
Such interest income has been offset against the aforementioned reorganization
expenses in the Companys 2001 consolidated statement of operations. Operating cash receipts and payments made by Covad resulting from the Plan
were as follows for the period from August 15, 2001 through December 20, 2001: Cash receipts:Interest received
    
    $
    2,650Total cash receipts
    
    $
    2,650Cash disbursements:Interest paid
    
    $
    1,509Professional fees paid
    
    
    16,003Claims paid
    
    
    277,892Total cash disbursements
    
    $
    295,404
 4. Other Restructuring Activities BlueStar, which was acquired by the Company on September 22, 2000 in a
transaction accounted for as a purchase (Note 6), 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, on June 22, 2001, to cease the Companys funding of
BlueStars operations. Subsequently, on June 25, 2001, BlueStar terminated all
of its 365 employees. However, 59 of 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 subsequent to June 25, 2001. On June 24, 2001, the Company and BlueStar entered into a Purchase
Agreement (PA) under which the Company 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 (none in 2003 and 2002) under the PA
and had no additional liabilities under the PA as of December 31, 2003 and
2002. To facilitate this migration, 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 $5,100 in
connection with BlueStars cessation of operations during the year ended
December 31, 2001 (none in 2003 and 2002). Of this amount, $1,300 40




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represents employee severance benefits, $2,000 represents customer acquisition costs under
the PA and $1,800 represents legal and other professional fees. Such (i)
severance benefits and professional fees and (ii) customer acquisition costs
have been charged to restructuring expenses and network and product costs,
respectively, in the Companys consolidated statement of operations for the
year ended December 31, 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
2004. 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 boards of directors to satisfy the liabilities
of BlueStar. Consequently, the liquidation of BlueStars assets and the
settlement 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 consolidated balance sheet as of December 31, 2001. Such deferred
gain represented the difference between the carrying values of BlueStars
assets (aggregating $7,900) and liabilities (aggregating $63,100) as of June
25, 2001. During 2003 and 2002, the deferred gain was reduced by $9 and $1,228,
respectively, because certain BlueStar assets were inadvertently not
deconsolidated on June 25, 2001. Therefore, the deconsolidation of BlueStar,
resulted in a deferred gain balance of $53,963 and $53,972 in the Companys
consolidated balance sheets as of December 31, 2003 and 2002, respectively. The
Company will recognize such deferred gain as an element of other income
(expense) when the liquidation of BlueStar is complete and its liabilities have
been discharged. The following unaudited pro forma financial information presents the
consolidated results of operations of the Company as if the deconsolidation of
BlueStar had occurred on January 1, 2001 and does not purport to be indicative
of the results of operations that would have occurred had the deconsolidation
occurred on January 1, 2001, or the results that may occur in the future: Year ending December 31, 2001Revenues
    
    $
    320,619Loss before gain on extinguishment of debt and cumulative effect of accounting charge
    
    $
    (646,647
    )Net income (loss)
    
    $
    387,080Basic and diluted net income (loss) per share
    
    $
    2.18
 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; 41




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
    
    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 year ended December 31, 2001, the total workforce was reduced
by 638 employees and the Company paid $3,849 in severance benefits, which were
charged against the restructuring liability recorded as of December 31, 2000. The Company recorded additional restructuring expenses aggregating $14,364
during the year ended December 31, 2001, of which $2,140 related to the
BlueStar shutdown. These expenses consist principally of collocation and
building lease termination costs that met the requirements for accrual in 2001.
During the year ended December 31, 2001, the Company paid collocation and
building lease termination costs of $12,355, which were charged against the
restructuring liabilities recorded during 2001. During the year ended December
31, 2001, the restructuring liability was also reduced by $131 based on revised
estimates of the Companys restructuring expenses. No restructuring expenses
were recorded during the year ended December 31, 2002. During the year ended December 31, 2003, the Company reduced its workforce
by approximately 113 employees, which represented approximately 10.2% of the
Companys workforce. The reductions covered employees in the areas of sales and
marketing, operations and corporate functions. In connection with the
reductions in force, the Company recorded a charge to operations for the year
ended December 31, 2003 of $1,235 relating to employee severance benefits, all
of which was paid during the year ended December 31, 2003. The expenses
associated with these reductions in force were $103 related to the Companys
CSP business segment (Note 14), and $349 related to the Companys Covad
Broadband Solutions (or CBS) business segment (Note 14). The remaining $783
in expenses associated with these reductions in force were related to the
Companys Corporate Operations (Note 14). Management continues to consider whether additional restructuring is
necessary, and the Company may incur additional charges to operations related
to any further restructuring activities in future periods. 5. Property and Equipment Property and equipment consisted of the following: December 31,2003
    
    2002Leasehold improvements
    
    $
    10,339
    
    
    $
    9,276Computer equipment
    
    
    48,801
    
    
    
    47,206Computer software
    
    
    33,912
    
    
    
    30,486Furniture and fixtures
    
    
    17,515
    
    
    
    17,785Networks and communication equipment
    
    
    362,910
    
    
    
    334,001473,477
    
    
    
    438,754Less accumulated depreciation and amortization
    
    
    379,198
    
    
    
    330,017Property and equipment, net
    
    $
    94,279
    
    
    $
    108,737
 During the fourth quarter of 2001, the Company determined that (i) certain
of its communication equipment was obsolete based on its discontinued use in
the Companys network and (ii) it would sell (subject to the approval of the
Companys board of directors) its land, building and certain furniture and
fixtures located in Manassas, Virginia. In March 2002, the Company entered into
a non-binding letter of intent with a third party to sell the aforementioned
Manassas, Virginia property for $14,000. Accordingly, the Company recognized a
write-down of this property and equipment in the amount of $9,999 during the
fourth quarter of 2001. 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, which 42




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represents the net proceeds of $13,334 less the aggregate
carrying value of the property, as described above, in the accompanying
consolidated statement of operations for the year ended December 31, 2002. The
Company recorded no impairment write-downs of long-lived assets during 2003 and
2002. 6. Business Acquisition, Asset Acquisitions and Equity Investments Acquisition of BlueStar On September 22, 2000, the Company acquired BlueStar by issuing
approximately 6,100,000 shares of common stock (including 800,000 shares to be
held in escrow for a one year period pending the Companys verification of
certain representations and warranties made to it by BlueStar at the date of
the acquisition) in exchange for all of the
outstanding preferred and common shares of BlueStar. Two of the Companys
stockholders and members of its board of directors when the acquisition
occurred were also stockholders of BlueStar, and one was a member of the board
of directors of BlueStar. This transaction was accounted for as a purchase. Accordingly, the
Companys consolidated financial statements include the results of operations
of BlueStar for periods ending after the date of acquisition. However, as
described in Note 3, the Company deconsolidated BlueStar effective June 25,
2001. Up to 5,000,000 additional common shares of the Companys common stock
were to be issued 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 800,000 of the Companys common shares to be held in escrow as of
December 31, 2000, by providing the BlueStar stockholders with 2,532,850 (which
include 264,369 options and warrants which are held by the Company in the event
such options and warrants are exercised after the distribution date) of the
5,000,000 shares, in exchange for a release of all claims against the Company.
The 800,000 common shares held in escrow were ultimately returned to the
Company under this agreement. BlueStars former stockholders received the
additional shares of the Companys common stock during 2001. Consequently, the
Company recorded additional goodwill of $1,989 in 2001. However, the Company
determined that such goodwill was impaired based on BlueStars continued
operating losses, as described in Note 3. Therefore, such goodwill balance was
written-off through a charge to the provision for long-lived asset impairment
during the year ended December 31, 2001. Acquisition of InternetConnect Assets On January 3, 2002, the Company purchased substantially all of the assets
of InternetConnect, a related party (Note 1), 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 January 1, 2002. 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, integrated set of activities and
assets that would constitute a 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 approximately 9,250 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
or its resellers subsequent to January 3, 2002. 43




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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
    
    $
    1,386Refundable deposits
    
    
    349Property and equipment
    
    
    61Customer acquisition costs
    
    
    3,674$
    5,470
 The customer acquisition costs of $3,674 described above were charged to
network and product costs for the year ended December 31, 2002 based on the
Companys accounting policy for costs of this nature that are not accompanied
by up-front fees (Note 2). Acquisition of Qwest Customer List On June 5, 2003, the Company purchased a customer list from Qwest
Communications Corporation and Qwest Interprise America, Inc. (collectively,
Qwest) pertaining to approximately 23,000 DSL subscribers who were not
located in the states where Qwest provides local telephone services
(substantially all of whom were not, indirectly, end-user customers of the
Company as of June 5, 2003 under the then-existing wholesale DSL services
agreement with Qwest). In exchange for the customer list, the Company paid
$3,750 in cash and released Qwest from its obligations under the wholesale DSL
services agreement. In addition, the Company agreed to pay Qwest an additional
amount of up to $1,250 if certain numbers of these customers migrate to the
Companys network within a defined period, which has now elapsed. The
additional level of successful migrations was not achieved and, consequently,
the Company was not required to pay such additional amount to Qwest. The
Company did not assume any liabilities or obligations of Qwest or hire any of
Qwests employees. In addition, the Company does not believe the customer list
acquired from Qwest constitutes a self-sustaining, integrated set of activities
and assets that would constitute a business. Approximately 13,000 of these
customers were migrated to the Companys network as of December 31, 2003. The Company recorded the $3,750 cash payment to Qwest for the customer
list as an intangible asset, and such intangible asset is being amortized on a
straight-line basis to operations over a twenty-four month period, which is the
Companys estimate of the aggregate expected term of its customer
relationships. Unconsolidated Investments in Affiliates The following table lists the Companys unconsolidated investments in
affiliates as of December 31, 2003 and 2002: Date of
    
    Ownership Percentage
    
    Method of
    
    Investment Carrying ValueEntity Name
    
    Investment(s)
    
    2003
    
    2002
    
    Accounting
    
    2003
    
    2002DishnetDSL Limited
    
    February 2000
    
    
    
    %
    
    
    
    %
    
    Equity
    
    $
    
    
    
    $
    ACCA Networks Co., Ltd.
    
    August 2000
    
    
    10
    %
    
    
    10
    %
    
    Equity
    
    
    
    
    
    
    Certive Corporation
    
    November 1999; May 2000
    
    
    5
    %
    
    
    5
    %
    
    Equity
    
    
    
    
    
    
    1,026Sequoia Capital X
    
    May-November 2000
    
    
    
    %
    
    
    
    %
    
    Equity
    
    
    
    
    
    
    Loop Holdings Europe ApS
    
    September 2000
    
    
    
    %
    
    
    
    %
    
    Equity
    
    
    
    
    
    
    $
    
    
    
    $
    1,026
 DishnetDSL Limited In February 2000, the Company acquired a 6% American Depository Receipt
(ADR) equity interest in DishnetDSL Limited (Dishnet), a privately held,
Indian telecommunications company, in exchange for cash payments totaling
approximately $23,000, which the Company believed was representative of the
fair value of such investment based on significant concurrent investments in
Dishnet made by new, non-strategic investors. The difference between the cost
of the Companys equity investment in Dishnet and its proportional share of
Dishnets net assets ($11,963 as of December 31, 2001) was being amortized
using the straight-line method over a period of five years. Concurrent with its
purchase of the Dishnet ADRs, the Company also acquired, without further
consideration, (i) contingent warrants for the purchase of up to 3,700,000
Dishnet ADRs at a price that is presently 44




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indeterminate and (ii) a put option
(the Put Option) from a Dishnet shareholder and another entity that entitles
the Company to require these entities to purchase the Dishnet ADRs owned by the
Company at their original purchase price for a specified period beginning in
February 2002. Because of the contingent nature of the Dishnet warrants and
uncertainties concerning the financial capacity of the makers of the Put
Option, the Company ascribed no separate value to these elements of the
transaction. As a result of this strategic investment, one employee of the
Company became a member of the board of directors of Dishnet. (The Companys
chairman holds options to purchase shares of Dishnet and is a member of the
board of directors of Dishnet). In February 2002, the Companys board of directors approved an offer
involving (i) the sale of the Companys 6% ADR interest in Dishnet for $3,000
in cash, (ii) settlement of a claim alleging breach of contract by the Company
relating to the OSS license described below and (iii) relinquishment of the Put
Option by the Company. Consequently, during 2001, the Company wrote-down the
carrying value of its Dishnet equity investment to its estimated net realizable
value through a charge to the provision for impairment of unconsolidated equity
investments in the amount of $10,069. This transaction was completed in May
2002, which resulted in the recognition of an additional loss in the amount of
$996. Such loss included a cumulative foreign currency translation loss in the
amount of $1,342, which was included in (i) the carrying value of the
Companys Dishnet equity investment and (ii) the Companys accumulated other
comprehensive income (loss) balance as of the date of sale of such investment. In February 2000, the Company also licensed its OSS software to Dishnet
and another entity for $28,000, $24,000 of which was received in cash on such
date. The Company also agreed to provide certain software support,
customization and training services to Dishnet and another entity relating to
the OSS license up to an aggregate cost of $2,500. Accordingly, the Company
recorded $2,500 of the OSS license proceeds received from Dishnet as a
liability in February 2000, all of which has been offset by expenses incurred
in 2000 and 2001 by the Company to customize the OSS for Dishnet. The remaining
proceeds of $21,500 have been offset against the Companys capitalized
internal-use software costs. ACCA Networks Co., Ltd. In August 2000, the Company acquired a 42% preferred equity interest in
ACCA Networks Co., Ltd. (ACCA), a privately held, Japanese telecommunications
company, in exchange for cash payments aggregating approximately $11,700, which
the Company believes is representative of the fair value of such investment
based on significant concurrent investments in ACCA made by new, non-strategic
investors. The difference between the cost of the Company equity investment in
ACCA and its proportional share of ACCAs net assets had been fully amortized
as of December 31, 2001. As of December 31, 2003, the Companys equity interest
in ACCA was diluted to 10% due to ACCAs financings in 2002 and 2001. As a
result of this strategic investment, one employee of the Company is a member of
the board of directors of ACCA. In addition, in August 2000, the Company also licensed its OSS software to
ACCA for $9,000, of which $2,000 and $2,000 was received in cash during 2001
and 2000, respectively. The remainder of $5,000, which was scheduled to be
received in 2005, was received in December 2003 in accordance with an amendment
to the August 2000 OSS software license agreement. The Company recorded the
$5,000 payment received in December 2003 as miscellaneous income, because the
carrying value of the OSS software licensed to ACCA was fully recovered at that
time. The Company may also receive certain on-going royalty payments from ACCA
under terms of the amended OSS license agreement. Such payments amounted to
$2,345 and $814 during the years ended December 31, 2003 and 2002 (none during
the year ended December 31, 2001). As stated above, the OSS software licensed
to ACCA had a net book value of zero at December 31, 2003. Consequently, any
additional royalty payments will be recorded as miscellaneous income in future
periods. The Company also agreed to provide certain software support,
customization and training services to ACCA relating to the OSS license up to
an aggregate cost of $2,000. Accordingly, the Company recorded $2,000 of the
OSS license proceeds received from ACCA as a liability in August 2000, all of
which has been offset by expenses incurred in 2000 and 2001 by the Company to
customize the OSS software for ACCA. Certive Corporation As of December 31, 2003 and 2002, the Company held a 5% preferred equity
interest in Certive Corporation (Certive), a privately held, development
stage application service provider. The Companys chairman is also the 45




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chairman and a principal stockholder of Certive. During 2003, the Company determined
that its investment in Certive may impaired due to Certives financial
condition and market prospects. Accordingly, the Company wrote-off the
remaining carrying value of its investment through a charge to operations of
$747 in 2003. Sequoia Capital X As of December 31, 2000, the Company held a 2% limited partnership
interest in Sequoia Capital X, a privately held venture capital partnership.
The Company sold its investment in Sequoia Capital X during 2001 for $1,225 in
cash, which resulted in the recognition of a gain in the amount of $178. Loop Holdings Europe ApS In September 2000, the Company acquired 100% of the capital stock of Loop
Holdings Europe ApS (Loop Holdings), which owns 70% (a 43% voting interest)
of the preferred stock of Loop Telecom, S.A. (Loop Telecom), a privately
held, Spanish telecommunications company. Consideration for the Companys
acquisition of
the capital stock of Loop Holdings consisted of $15,000 in cash and
non-recourse notes payable aggregating $35,000. In March 2001, the Company
declined to make the first scheduled payment of $15,000 under the terms of the
non-recourse notes payable. As a result, the Companys indirect preferred
equity interest in Loop Telecom was diluted to 21% (a 21% voting interest) and
its obligations under the non-recourse notes payable were released.
Accordingly, in the Companys consolidated balance sheet as of December 31,
2000, the Company netted the non-recourse notes payable aggregating $35,000
against the equity investment balance and wrote-off its initial $15,000
investment balance in Loop Holdings through a charge to operations in 2000 due
to uncertainties concerning the recoverability of such investment. On February 5, 2002, the Company, via Loop Holdings, sold its equity
interest in Loop Telecom to certain other shareholders of Loop Telecom for $360
in cash, which resulted in the recognition of a gain in the amount of $360. 7. Credit Arrangements As of December 31, 2003 and 2002, the Companys long-term debt consisted
of a $50,000 term note payable to SBC (Note 11), as described below. Immediately prior to Covads emergence from Chapter 11 bankruptcy on
December 20, 2001 (Note 3), the Companys new agreements with SBC became
effective (Note 11). One such agreement (the Credit Agreement) involves a
term note payable that is collateralized by substantially all of the Companys
domestic assets. This note bears interest at 11%, which is payable quarterly
beginning in December 2003. The entire unpaid principal balance is payable in
December 2005. However, the Company has the right to prepay the principal
amount of the note, in whole or in part, at any time without penalty. In
addition, upon a Change of Control of the Company, as defined in the Credit
Agreement, SBC has the option to require all amounts due under the terms of the
Credit Agreement to be paid by the Company within 30 days of the Change of
Control. The Credit Agreement contains various restrictive covenants, which,
among other things, restrict the Companys ability to incur additional
indebtedness or permit liens to be placed on its assets. As of December 31, 2003, the Company had a $3,000 revolving line of credit
with a bank that is available through April 2004. At the Companys option,
borrowings under this credit facility bear interest at certain fixed or
variable rates. As of December 31, 2003 and 2002, the Company had issued
irrevocable letters of credit aggregating $2,583 and $2,075, respectively,
under this line of credit in favor of lessors of equipment and facilities. 8. Capital Leases The capitalized costs and accumulated amortization related to assets under
capital leases were $165 and $165, respectively, as of December 31, 2003 (the
corresponding amounts were $482 and $344, respectively, as of December 31,
2002). All of the Companys capital leases were retired at maturity in 2003. 46




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9. Operating Leases and Purchase Obligations Operating Leases The Company leases vehicles, equipment and office space under various
noncancelable operating leases. The facility leases generally require the
Company to pay operating costs, including property taxes, insurance and
maintenance, and contain scheduled rent increases and certain other rent
escalation clauses. The Company recognizes rent expense on a straight-line
basis over the terms of the respective leases. Future minimum lease payments by
year under operating leases with noncancelable terms in excess of one year,
along with future minimum payments to be received under noncancelable
subleases, are as follows: Gross Lease
    
    Less Sublease
    
    Net LeasePayments
    
    Payments
    
    PaymentsYear ending December 31,2004
    
    $
    4,999
    
    
    $
    544
    
    
    $
    4,4552005
    
    
    3,482
    
    
    
    
    
    
    
    3,4822006
    
    
    2,814
    
    
    
    
    
    
    
    2,8142007
    
    
    1,926
    
    
    
    
    
    
    
    1,9262008
    
    
    1,429
    
    
    
    
    
    
    
    1,429Thereafter
    
    
    269
    
    
    
    
    
    
    
    269Total
    
    $
    14,919
    
    
    $
    544
    
    
    $
    14,375
 Rent expense, which is net of sublease income of $533, $402 and $152 in
2003, 2002 and 2001, respectively, totaled $7,874, $8,710 and $15,421 for the
years ended December 31, 2003, 2002 and 2001, respectively. Purchase Obligations In 2002, the Company entered into a three-year, non-exclusive agreement
with MCI, for the right to provide certain network services to the Company. The
Company has a monthly minimum usage requirement which began in June 2002. The
agreement expires in May 2005 and the Company has a minimum remaining aggregate
purchase obligation of approximately $11,390 as of December 31, 2003.
Similarly, in 2002, the Company entered into a three-year, non-exclusive
agreement with AT&T for the right to provide certain data services to the
Company. The Company has an annual minimum usage requirement which began in
January 2002. The agreement expires in December 2004 and the Company has a
minimum remaining aggregate purchase obligation of approximately $11,500 as of
December 31, 2003. In addition, in 2002, the Company entered into a four-year,
non-exclusive agreement with AT&T for the right to provide long distance
services to the Company. The Company has an annual minimum usage requirement
which began in April 2002. The agreement expires in March 2006 and the Company
has a minimum remaining aggregate usage commitment of approximately $2,250 as
of December 31, 2003. Aggregate payments by year for the Companys purchase obligations are as
follows: Year ending December 31,2004
    
    $
    20,6652005
    
    
    4,475Total
    
    $
    25,140
 Network and product costs, recognized pursuant to the aforementioned purchase
obligations totaled $1,292 for the year ended December 31, 2003. No similar
amounts for these purchase obligations were recorded during 2002 and 2001. 47




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10. Contingencies Litigation Purchasers of the Companys common stock and purchasers of the convertible
senior notes the Company issued in September 2000 filed complaints 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 were consolidated and the lead plaintiff filed its
amended consolidated complaint. The amended consolidated complaint alleges
violations of federal securities laws on behalf of persons who purchased or
otherwise acquired the Companys securities, including common stock and notes,
during the period from April 19, 2000 to May 24, 2001. The relief sought
includes monetary damages and equitable relief. In 2001, the Company and the
officer and director defendants entered into a Memorandum of Understanding
(MOU) with counsel for the lead plaintiffs in this litigation that
tentatively resolves the litigation, providing for the distribution of $16,500
in cash to be funded by the Companys insurance carriers and 6,495,844 shares
of the Companys common stock. The plaintiffs voted in favor of the plan.
Consequently, the Company recorded a liability of approximately $18,578 in its
consolidated balance sheet as of December 31, 2001 through a charge to
litigation-related expenses for the year then ended in connection with this
anticipated settlement. As a result of changes in the fair market value of the
Companys common stock, the Company decreased this liability to $6,950 as of
December 31, 2002 through a credit to litigation-related expenses of $11,628
for the year ended December 31, 2002. The settlement provided for in the MOU
was subject to the approval of the District Court and, on December 18, 2002,
the District Court issued its final judgment and dismissal order. One class
member subsequently filed an appeal pertaining to the final judgment, but his
appeal only relates to the allocation of the settlement proceeds between the
plaintiffs and their attorneys. In April 1999, the Company filed a lawsuit against Bell Atlantic (now
Verizon) and its affiliates in the United States District Court for the
District of Columbia. The Company is pursuing antitrust and other claims in
this lawsuit arising out of Verizons conduct as a supplier of network
facilities, including central office space, transmission facilities and
telephone lines. In December 2000, the Company also filed a lawsuit against
BellSouth Telecommunications and its subsidiaries in the United States District
Court for the Northern District of Georgia. The Company is pursuing claims in
this lawsuit that are similar to its claims against Verizon. Both courts
dismissed some of the Companys claims based on the ruling of the United States
Court of Appeals for the Seventh Circuit in Goldwasser v. Ameritech. The court
in the Verizon case also dismissed the Companys remaining claims on other
grounds. The Company voluntarily dismissed its remaining claims in the
BellSouth case so it could pursue certain issues on appeal. The Company
appealed these decisions to the United States Court of Appeals for the Eleventh
Circuit and the United States Court of Appeals for the District of Columbia. On
August 2, 2002, the Eleventh Circuit Court of Appeals reversed the lower
courts decision in the BellSouth case and remanded the case for further
proceedings. BellSouth appealed this decision to the United States Supreme
Court. On January 20, 2004, the United States Supreme Court reversed a decision
entitled Verizon Communications v. Law Offices of Curtis Trinko, which rejected
the Goldwasser decision. The Eleventh Circuit also relied in part on the Trinko
decision when it reversed the lower courts dismissal of our claims against
BellSouth. The Supreme Court also vacated the Eleventh Circuits decision in
the Companys case against BellSouth and remanded the case to the Eleventh
Circuit for review in light of the Trinko decision. The Company believes the
Trinko decision does not impact its cases, but both BellSouth and Verizon claim
that Trinko supports the dismissal of the Companys lawsuits. 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 services to its customers. In its amended complaint, Verizon claims
that the Company falsified trouble ticket reports with respect to the phone
lines the Company ordered and seeks unspecified monetary damages (characterized
as being in the millions) and injunctive relief. The current complaint
asserts causes of action for negligent and intentional misrepresentation and
violations of Californias unfair competition statute. On November 13, 2002,
the District Court entered summary judgment in favor of the Company and
dismissed Verizons claims against the Company in their entirety. Verizon has
appealed the dismissal of its lawsuit. The Company believes it has strong
defenses to this lawsuit, but litigation is inherently unpredictable and there
is no guarantee it will prevail. 48




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Several stockholders filed complaints in the United States District Court
for the Southern District of New York, on behalf of themselves and purported
classes of stockholders, against the Company and several former and current
officers and directors in addition to some of the underwriters who handled the
Companys stock offerings. These lawsuits are so-called IPO allocation cases,
challenging practices allegedly used by certain underwriters of public equity
offerings during the late 1990s and 2000. On April 19, 2002, the plaintiffs
amended their complaint and removed the Company as a defendant. Certain
directors and officers are still named in the complaint. The plaintiffs claim
that the Company and others failed to disclose the arrangements that some of
these underwriters purportedly made with certain investors. The plaintiffs and
the issuer defendants have reached a tentative agreement to settle the matter,
and the Company believes the tentative settlement will not have a material
adverse effect on its consolidated financial position or results of operations.
That settlement, however, has not been finalized. If the settlement is not
finalized, the Company believes it has strong defenses to these lawsuits and
intends to contest them vigorously. However, litigation is inherently
unpredictable and there is no guarantee that the Company will prevail. In June 2002, Dhruv Khanna was relieved of his duties as the Companys
General Counsel and Secretary. Shortly thereafter, Mr. Khanna alleged that,
over a period of years, certain current and former directors and officers
breached their fiduciary duties to the Company by engaging in or approving
actions that constituted waste and self-dealing, that certain current and
former directors and officers had provided false representations to the
Companys auditors and that he had been relieved of his duties in retaliation
for his being a purported whistleblower and because of racial or national
origin discrimination. He had threatened to file a shareholder derivative
action against those current and former directors and officers, as well as a
wrongful termination lawsuit. Mr. Khanna was placed on paid leave while his
allegations were being investigated. The Companys Board of Directors appointed a special investigative
committee, which initially consisted of Dale Crandall and Hellene Runtagh, to
investigate the allegations made by Mr. Khanna. Richard Jalkut was appointed to
this committee shortly after he joined the Companys Board of Directors. This
committee retained an independent law firm to assist in its investigation.
Based on this investigation, the committee concluded that Mr. Khannas
allegations were without merit and that it would not be in the best interests
of the Company to commence litigation based on these allegations. The committee
considered, among other things, that many of Mr. Khannas allegations were not
accurate, that certain allegations challenged business decisions lawfully made
by management or the board of directors, that the transactions challenged by
Mr. Khanna in which any director had an interest were approved by a majority of
disinterested directors in accordance with Delaware law, that the challenged
director and officer representations to the Companys auditors were true and
accurate, and that Mr. Khanna was not relieved of his duties as a result of
retaliation for alleged whistleblowing or racial or national origin
discrimination. Mr. Khanna has disputed the committees work and the outcome of
its investigation. After the committees findings had been presented and analyzed, the
Company concluded in January 2003 that it would not be appropriate to continue
Mr. Khanna on paid leave status, and determined that there was no suitable role
for him at the Company. Accordingly, he was terminated as an employee of the
Company. Based on the events mentioned above, in September 2003, Mr. Khanna filed a
purported class action and a derivative action against the Companys current
and former directors in the Court of Chancery of the State of Delaware in and
for New Castle County. In this action Mr. Khanna seeks recovery on behalf of
the Company from the individual defendants for their purported breach of
fiduciary duty. Mr. Khanna also seeks to invalidate the Companys election of
directors in 2002 and 2003 because he claims that the Companys proxy
statements were misleading. While the Company believes Mr. Khannas contentions
referred to above are without merit, and the Company and its directors will
vigorously defend against them, it is unable to predict the outcome of this
lawsuit. The Company is also a party to a variety of other pending or threatened
legal proceedings as either plaintiff or defendant, or is engaged in business
disputes that arise in the ordinary course of business. Failure to resolve
these various legal disputes and controversies without excessive delay and cost
and in a manner that is favorable to the Company could significantly harm its
business. The Company does not believe the ultimate outcome of these matters
will have a material impact on its consolidated financial position and results
of operations. However, litigation is inherently unpredictable and there is no
guarantee the Company will prevail or otherwise not be adversely affected. 49




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The Company is subject to state public utility commission, FCC and other
regulatory and court decisions as they relate to the interpretation and
implementation of the 1996 Telecommunications Act, the interpretation of
competitive telecommunications company interconnection agreements in general,
and the Companys interconnection agreements in particular. In some cases the
Company may be bound by or may otherwise be significantly impacted by the
results of ongoing proceedings of these bodies or the legal outcomes of other
contested interconnection agreements that are similar to the Companys
agreements. The results of any of these proceedings could harm the Companys
business. Other Contingencies As of December 31, 2003, the Company had disputes with a number of
telecommunications companies concerning the balances owed to such
telecommunications carriers for collocation fees and certain network services.
The Company believes 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 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, on February 26, 2002, the Company
executed a settlement agreement with Verizon involving certain disputed
collocation fee and network service obligations. Under the terms of this
settlement agreement, (i) the Company was relieved of an accrued collocation
fee and network service obligation with a balance of $5,570, which was recorded
as a reduction of network and product costs during the fourth quarter of 2001
and (ii) Verizons ultimate damage award or settlement, if any, pursuant to the
Companys antitrust lawsuit against Verizon will be reduced by approximately
$6,600. Furthermore, in May 2002, the Company executed a settlement agreement
with another 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 year ended December 31, 2002. During 2003,
the Company changed its estimates of certain liabilities for collocation and
network services as a result of (i) the resolution of various billing disputes
with its vendors and (ii) the receipt of an invoice in December 2003 from a
vendor for certain services provided by such vendor primarily in 2000 and 2001,
which the Company is currently disputing. In addition, the Company is engaged
in a variety of legal proceedings with multiple telephone companies. These
negotiations, arbitrations and regulatory 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 space, billing issues and other operational
issues. 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 space. The Company is analyzing the applicability of certain transaction-based
taxes to (i) sales of its products and services and (ii) purchases of
telecommunications circuits from various carriers. This analysis includes
discussions with authorities of significant jurisdictions in which the Company
does business and various transaction-based tax experts to determine the extent
of the Companys respective transaction-based tax liabilities. It is the
Companys opinion that such analysis will be concluded without a material
adverse effect on its consolidated financial position and results of
operations. However, it is reasonably possible that the Companys estimates of
its transaction-based tax liabilities, as reflected in the accompanying
condensed consolidated balance sheets, could change in the near term, and the
effects could be material to the Companys consolidated financial position and
results of operations. During the year ended December 31, 2003, the Company
changed its estimates of certain accrued liabilities for transaction-based and
property taxes based on settlement agreements reached with various states and
local jurisdictions where the Company does business. These changes in
accounting estimate reduced the Companys net loss by $8,439 ($0.04 per share).
No such changes in estimate were recognized during the years ended December 31,
2002 and 2001. The Company is analyzing the applicability of employment-related taxes for
certain stock-based compensation provided to employees in prior periods. Due to
the probable applicability of these taxes, the Company recorded an estimated
liability through a charge to operations in the amount of $5,931 during the
year ended December 31, 2003. 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 50




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estimates of these tax liabilities, as reflected in the accompanying
consolidated balance sheets as of December 31, 2003, could change in the near
term, and the effects could be material to the Companys consolidated financial
position and results of operations. Guarantees From time to time, the Company enters into certain types of contracts that
contingently require it to indemnify various parties against claims from third
parties. These contracts primarily relate to: (i) certain real estate leases,
under which the Company may be required to indemnify property owners for
environmental and other liabilities, and other claims arising from the
Companys use of the applicable premises, (ii) certain agreements with the
Companys officers, directors and employees, under which the Company may be
required to indemnify such persons for liabilities arising out of their
employment relationship, (iii) contracts under which the Company may be
required to indemnify customers against third-party claims that a Company
product infringes a patent, copyright or other intellectual property right and
(iv) procurement or license agreements under which the Company may be required
to indemnify licensors or vendors for certain claims that may be brought
against them arising from the Companys acts or omissions with respect to the
supplied products or technology. Generally, a maximum obligation under these contracts is not explicitly
stated. Because the obligated amounts associated with these types of agreements
are not explicitly stated, the overall maximum amount of the obligation cannot
be reasonably estimated. Historically, the Company has not been required to
make payments under these obligations, and no liabilities have, therefore, been
recorded for these obligations in the Companys consolidated balance sheets. 11. Stockholders Equity (Deficit) Strategic Investors Effective December 20, 2001, immediately prior to Covads emergence from
Chapter 11 bankruptcy (Note 3), the Company entered into a series of agreements
with SBC, including (i) a $50,000 Credit Agreement (Note 7), (ii) a 10-year
resale agreement (the Resale Agreement) under which SBC, its affiliates or
special agents will resell the Companys DSL services (SBC made a $75,000
noninterest-bearing prepayment, which is collateralized by substantially of the
Companys domestic assets, to the Company on December 20, 2001 under the terms
of the Resale Agreement) and (iii) a termination and mutual general release
agreement (the Termination Agreement) that resulted in the cancellation of
various agreements entered into in September 2000, except for the stock
purchase agreement and an interconnection and line-sharing agreement that
remains in effect. The Company received a payment of $10,000 from SBC on
December 20, 2001 under the terms of the Termination Agreement, which was
deferred and is being recognized as revenue on a straight-line basis over the
10-year term of the Resale Agreement. Common Stock 6,625 shares of the Companys common stock outstanding at December 31,
2002 (none in 2003) were subject to repurchase provisions, which generally
lapse over a four-year period from the date of issuance. Common stock reserved for future issuance as of December 31, 2003 was as
follows: Bankruptcy claims (Note 3)
    
    
    7,078,733Outstanding options (Note 13)
    
    
    21,676,765Options available for grant (Note 13)
    
    
    14,895,194Employee stock purchase plan (Note 13)
    
    
    3,005,809Outstanding warrants (Note 11)
    
    
    6,511,574Total
    
    
    53,168,075
 51




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Stockholder Protection Rights Plan On February 15, 2000, the Companys board of directors adopted a
Stockholder Protection Rights Plan under which stockholders received one right
for each share of the Companys common stock or Class B common stock owned by
them. The rights become exercisable, in most circumstances, upon the
accumulation by a person or group of 15% or more of the Companys outstanding
shares of common stock. Each right entitles the holder to purchase from the
Company, as provided by the Stockholder Protection Rights Agreement, one
one-thousandth of a share of participating preferred stock, par value $.001 per
share, for $400 per share, subject to adjustment. As of December 31, 2003 and
2002, none of these rights were exercisable. Warrants On January 1, 2003, in conjunction with an amendment to an agreement with
AT&T, the Company granted AT&T three warrants to purchase shares of the
Companys common stock as follows: 1,000,000 shares for $0.94 per share;
1,000,000 shares for $3.00 per share; and 1,000,000 shares for $5.00 per share.
Such warrants were immediately exercisable, fully vested and nonforfeitable at
the date of grant. Accordingly, the measurement date for these warrants was the
date of grant. The aggregate fair value of such warrants of $2,640 was recorded
as a deferred customer incentive during the first quarter of 2003 and is being
recognized as a reduction of revenues on a straight-line basis over the
three-year term of the agreement because the Company believes that future
revenues from AT&T will exceed the fair value of the warrants described above.
This value was determined using the Black-Scholes option valuation model and
the following assumptions: closing price of the Companys common stock on
December 31, 2002 of $0.94 per share; expected life of seven years (which is
also the contractual life of the warrants); dividend yield of zero; volatility
of 1.52; and a risk-free interest rate of 3.36%. None of these warrants were
exercised during 2003 or had expired as of December 31, 2003. On September 4, 2002, in conjunction with the execution of a five-year
agreement with America Online, Inc. (AOL), a wholesale customer, the Company
granted AOL three warrants to purchase 1,500,000 shares of the Companys common
stock for $1.06 per share, 1,000,000 shares of the Companys common stock for
$3.00 per share and 1,000,000 shares of the Companys common stock for $5.00
per share. Such warrants were immediately exercisable, fully vested and
nonforfeitable at the date of grant. Accordingly, the measurement date for
these warrants was the date of grant. The aggregate fair value of such warrants
of $3,790, which was determined using the Black-Scholes option valuation model
and the following assumptions: closing price of the Companys common stock on
September 4, 2002 of $1.14 per share; expected life of seven years (which is
also the contractual life of the warrants); dividend yield of zero; volatility
of 1.56; and a risk-free interest rate of 3.63%, was recorded as a deferred
customer incentive and is being recognized as a reduction of revenues on a
straight-line basis over the five-year term of the agreement. None of these
warrants were exercised during 2003 or had expired as of December 31, 2003. Other warrants for the purchase of 11,574 shares of the Companys common
stock were outstanding as of December 31, 2003. Such warrants are exercisable
at a purchase price of $0.01 per share and fully vested as of December 31,
2003. Unless exercised, all such warrants will expire on March 15, 2008.
Warrants for the purchase of 225,000 shares of the Companys common stock
expired in February 2003. 12. Income Taxes The Company has made no provision for income taxes in any period presented
in the accompanying consolidated financial statements because it incurred
operating losses in each of these periods. In addition, the Company made no
provision for income taxes on the extraordinary gain resulting from the
extinguishment of debt in 2001 (Note 3) due to the relevant Federal and state
tax regulations governing the treatment of debt extinguishment income in
Chapter 11 bankruptcy proceedings. 52




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A reconciliation of income taxes computed at the federal statutory rate
(35%) to income tax expense (benefit) recorded in the Companys consolidated
statements of operations is as follows: Year ended December 31,2003
    
    2002
    
    2001(Restated, seeNote 15)Federal benefit at statutory rate (restated, see Note 15)
    
    $
    (39,306
    )
    
    $
    (64,690
    )
    
    $
    (241,139
    )Nondeductible interest expense
    
    
    
    
    
    
    
    
    
    
    878Net operating losses with no current benefits
    
    
    33,807
    
    
    
    65,704
    
    
    
    206,948Deferred
variable stock-based compensation (restated, see Note 15)
    
    
    4,330
    
    
    
    
    
    
    
    Deconsolidation of BlueStar
    
    
    
    
    
    
    
    
    
    
    23,915Other
    
    
    1,169
    
    
    
    (1,014
    )
    
    
    9,398Income tax expense (benefit)
    
    $
    
    
    
    $
    
    
    
    $
    
 Deferred income taxes reflect the net tax effect of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and amounts used for income tax purposes. Significant components of
the Companys deferred tax assets and liabilities for federal and state income
taxes are as follows: December 31,2003
    
    2002Deferred tax assets:Net operating loss carryforwards
    
    $
    327,574
    
    
    $
    284,482Capital loss carryforwards
    
    
    16,919
    
    
    
    10,803Deferred and unearned revenue
    
    
    37,921
    
    
    
    45,600Deconsolidation of BlueStar
    
    
    21,585
    
    
    
    21,589Unconsolidated investments in affiliates
    
    
    6,725
    
    
    
    12,424Depreciation and amortization
    
    
    38,158
    
    
    
    36,037Other
    
    
    12,231
    
    
    
    11,107Total deferred tax assets
    
    
    461,113
    
    
    
    422,042Valuation allowance
    
    
    (461,113
    )
    
    
    (422,042
    )Net deferred tax assets
    
    
    
    
    
    
    Deferred tax liabilities
    
    
    
    
    
    
    Net deferred taxes
    
    $
    
    
    
    $
    
 Realization of the Companys deferred tax assets relating to net operating
loss carryforwards and other temporary differences is dependent upon future
earnings, the timing and amount of which are uncertain. Accordingly, the
Companys net deferred tax assets have been fully offset by a valuation
allowance. The valuation allowance increased (decreased) by $39,071, $129,529
and $(145,941) during 2003, 2002 and 2001, respectively. As of December 31, 2003, the Company had net operating loss carryforwards
for federal income tax purposes of $762,000, which will expire beginning in
2022, if not utilized. As a result of the Company emerging from the bankruptcy
(Note 3), the Companys federal net operating loss carryforwards were reduced
by approximately $995,000 in 2001. The Company also had aggregate net operating
loss carryforwards for state income tax of approximately $1,221,000, of which
$14,856 will expire in 2004, $122,832 will expire in 2005, and $1,083,312 will
expire thereafter, if not utilized. In addition, the Company had capital loss
carryforwards for both federal and state income tax purposes of approximately
$42,000, which begin to expire in 2006, if not utilized The tax benefits associated with employee stock options provided
cumulative deferred tax benefits of approximately $6,938 and $2,300 for the
years ended December 31, 2003 and 2002, respectively. Such deferred tax
benefits have been offset by a valuation allowance and will be credited to
additional paid-in capital when realized. The utilization of the Companys net operating loss may be subject to
substantial annual limitation due to the change in ownership provisions of
the Internal Revenue Code of 1986, as amended, and similar state provisions.
The annual limitation may result in the expiration of net operating losses and
tax credits before utilization. 53




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13. Employee Benefit Plans Defined Contribution Plan The Company has a defined contribution retirement plan under Section
401(k) of the Internal Revenue Code that covers substantially all employees.
Eligible employees may contribute amounts to the plan, via payroll withholding,
subject to certain limitations. The Company does not match contributions by
plan participants. In connection with the Companys acquisition of Laser Link.net, Inc.
(Laser Link) on March 20, 2000 and BlueStar (Notes 4 and 6), the Company
merged Laser Links and BlueStars defined contribution retirement plan under
Section 401(k) of the Internal Revenue Code into the Companys defined
contribution retirement plan. 1998 Employee Stock Purchase Plan In January 1999, the Company adopted the 1998 Employee Stock Purchase
Plan. Under this plan, eligible employees could purchase common stock at 85% of
the lesser of the fair market value of the Companys common stock on the first
day of the applicable twenty-four month offering period or the last day of the
applicable six month purchase period. The 1998 Employee Stock Purchase Plan was
terminated on April 28, 2003. 2003 Employee Stock Purchase Plan In June 2003, following the termination of the 1998 Employee Stock
Purchase Plan, the Company adopted the 2003 Employee Stock Purchase Plan. Under
this plan, eligible employees may purchase common stock at 85% of: (i) the fair
market value of the Companys common stock on the first day of the applicable
twenty-four month offering period; or (ii) the fair market value on the last
day of the applicable six-month purchase period. Stock Option Plans The 1997 Stock Plan (the Plan) provides for the grant of stock purchase
rights and options to purchase shares of common stock to employees and
consultants from time to time as determined by the Companys board of
directors. The options expire from two to eight years after the date of grant.
As of December 31, 2003, the Company has reserved 14,895,194 shares of the
Companys common stock under the Plan for sale and issuance at prices to be
determined by the Companys board of directors. In connection with the Companys acquisition of Laser Link, the Company
assumed Laser Links stock option plan. Laser Links stock option plan provides
for the grant of options to purchase shares of common stock to employees and
consultants from time to time. The options expire up to ten years after the
date of grant. The Company assumed the Laser Link stock option plan at the time
it acquired Laser Link and it is no longer issuing options under the Laser Link
stock option plan. A maximum of 1,434,957 shares of the Companys common stock
will be available for issuance under the Laser Link Plan. The options granted
under the Laser Link plan are included in the data set forth below. In connection with the Companys acquisition of BlueStar, the Company
assumed BlueStars stock option plan. BlueStars stock option plan provides for
the grant of options to purchase shares of common stock to employees and
consultants from time to time. The options expire up to ten years after the
date of grant. The Company assumed the BlueStar stock option plan at the time
it acquired BlueStar and it is no longer issuing options under the BlueStar
stock option plan. A maximum of 1,251,182 shares of the Companys common stock
will be available for issuance under the BlueStar stock option plan. The
options granted under the BlueStar stock option plan are included in the data
set forth below. 54




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The following table summarizes stock option activity for the years ended
December 31, 2003, 2002 and 2001: Number of Shares of
    
    Option Price PerCommon Stock
    
    ShareBalance as of December 31, 2000
    
    
    27,734,375
    
    
    $
    0.001$149.79Granted
    
    
    24,726,003
    
    
    $
    0.350$39.00Exercised
    
    
    (4,100,977
    )
    
    $
    0.001$2.56Cancelled
    
    
    (16,759,071
    )
    
    $
    0.001$149.79Balance as of December 31, 2001
    
    
    31,600,330
    
    
    $
    0.001$149.79Granted
    
    
    2,231,048
    
    
    $
    0.940$2.30Exercised
    
    
    (1,005,937
    )
    
    $
    0.001$2.56Cancelled
    
    
    (7,150,427
    )
    
    $
    0.001$149.79Balance as of December 31, 2002
    
    
    25,675,014
    
    
    $
    0.001$149.79Granted
    
    
    7,195,875
    
    
    $
    0.570$5.53Exercised
    
    
    (4,984,279
    )
    
    $
    0.001$5.44Cancelled
    
    
    (6,209,845
    )
    
    $
    0.296$149.79Balance as of December 31, 2003
    
    
    21,676,765
    
    
    $
    0.001$149.79
 The following is a summary of the status of stock options outstanding at
December 31, 2003: Options Outstanding
    
    Options ExercisableExercise
    
    
    
    
    
    Weighted-Average
    
    Weighted-Average
    
    Number of
    
    Weighted-AveragePrice Range
    
    Number of Shares
    
    Life Remaining
    
    Exercise Price
    
    Shares
    
    Exercise Price$0.001$0.48
    
    
    594,439
    
    
    
    4.06
    
    
    $
    0.28
    
    
    
    429,847
    
    
    $
    0.23$0.49$0.56
    
    
    2,987,310
    
    
    
    5.70
    
    
    $
    0.55
    
    
    
    1,269,337
    
    
    $
    0.55$0.57$0.72
    
    
    451,965
    
    
    
    6.21
    
    
    $
    0.68
    
    
    
    199,946
    
    
    $
    0.69$0.78$0.84
    
    
    2,356,825
    
    
    
    5.48
    
    
    $
    0.84
    
    
    
    1,415,761
    
    
    $
    0.84$0.86$1.17
    
    
    948,540
    
    
    
    6.53
    
    
    $
    1.05
    
    
    
    309,610
    
    
    $
    1.05$1.18$1.28
    
    
    4,954,980
    
    
    
    7.57
    
    
    $
    1.28
    
    
    
    1,428,203
    
    
    $
    1.28$1.29$2.56
    
    
    2,081,123
    
    
    
    5.60
    
    
    $
    1.80
    
    
    
    1,211,408
    
    
    $
    1.86$2.56$2.56
    
    
    2,499,601
    
    
    
    5.22
    
    
    $
    2.56
    
    
    
    2,031,856
    
    
    $
    2.56$2.59$27.75
    
    
    2,357,460
    
    
    
    5.05
    
    
    $
    10.77
    
    
    
    1,608,614
    
    
    $
    12.73$27.83$149.79
    
    
    2,444,522
    
    
    
    3.84
    
    
    $
    43.62
    
    
    
    2,384,705
    
    
    $
    43.29$0.001$149.79
    
    
    21,676,765
    
    
    
    5.76
    
    
    $
    7.09
    
    
    
    12,289,287
    
    
    $
    11.02
 In addition to the recognition and reversal of stock-based compensation
described in Note 1 under Basis of Presentation, during the years ended
December 31, 2003 and 2002, the Company reversed approximately $136 and $1,213,
respectively, of stock-based compensation recorded in prior years due to the
termination of certain employees (none in 2003). During the year ended December
31, 2003, the Company recorded deferred stock-based compensation of $26,778 as
a result of stock options subject to variable accounting that were
granted under the Companys 2003 Employee Stock Purchase Plan. During the year ended December 31,
2002, the Company recorded deferred stock-based compensation of approximately
$426, as a result of employment status changes, stock option grants and
restricted stock issuances with exercise or purchase prices that were less than
the fair value of the Companys common stock at the date of grant or issuance
(none in 2003 or 2001). These amounts are being amortized to operations over
the respective vesting periods of the underlying options using a graded vesting
method. Amortization (reversal) of deferred stock-based compensation for the
years ended December 31, 2003, 2002 and 2001 was approximately
$12,479,
$(3,358) and $1,597, respectively. Included in the amortization of deferred
stock-based compensation for the year ended December 31, 2001 is $302 relating
to accelerated vesting provisions included in stock options granted to certain
employees in previous years. These accelerated vesting provisions were
triggered by the resignation of such employees during 2001. No similar amounts
are included in the amortization of deferred stock-based compensation in 2003
and 2002. During the years ended December 31, 2002 and 2001, the Company extended
the exercise period of options granted to certain former employees for the
purchase of 272,184 and 244,550 shares, respectively, of the Companys common
stock. Consequently, for the years ended December 31, 2002 and 2001, the
Company recognized stock-based compensation expense of $221 and $253,
respectively, which represents the difference between the exercise price of
these options and the fair value of the Companys common stock on the
respective dates of the option award modifications. The Company did not modify
any stock-based awards in 2003. The Company grants options to consultants from time to time in exchange
for services. In general, these options vest over the contractual period of the
consulting arrangement. The Company granted options to consultants to purchase
347,000 shares of the Companys common stock in 2001. No options were granted
to consultants in 2003 or 2002. The fair value of these options is being
amortized to expenses over the vesting term of the options. The 55




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##### Table of Contents



Company recorded expenses of $120, $64 and $186 for the fair value of
these options in 2003, 2002 and 2001, respectively. As of December 31, 2003,
2002 and 2001 the fair value of the remaining unvested options granted to
consultants was $22, $3 and $643, respectively. These charges are subject to
adjustment based on the fair value of the Companys common stock on the date
the options vest. Pro forma Stock-Based Compensation Information Pro forma information regarding the results of operations and net income
(loss) per share (Note 1) is determined as if the Company had accounted for its
employee stock options using the fair value method. Under this method, the fair
value of each option granted is estimated on the date of grant using the
Black-Scholes option valuation model. The Company uses the intrinsic value method in accounting for its employee
stock options because, as discussed below, the alternative fair value
accounting requires the use of option valuation models that were not developed
for use in valuing employee stock options. Under the intrinsic value method,
when the exercise price of the Companys employee stock options equals or
exceeds the market price of the underlying stock on the date of grant, no
compensation expense is recognized. Option valuation models were developed for use in estimating the fair
value of traded options that have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions, including the expected life of the option. Because the
Companys employee stock options have characteristics significantly different
from those of traded options and because changes in the subjective input
assumptions can materially affect the fair value estimates, in managements
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options. For the years ended December 31, 2003, 2002 and 2001, the fair value of
the Companys stock-based awards to employees was estimated using the following
weighted average assumptions: Stock Options
    
    Employee Stock Purchase Plan2003
    
    2002
    
    2001
    
    2003
    
    2002
    
    2001Expected life of options in years
    
    
    4.0
    
    
    
    4.0
    
    
    
    4.0
    
    
    
    0.5
    
    
    
    0.5
    
    
    
    0.5Volatility
    
    
    131.70
    %
    
    
    152.10
    %
    
    
    169.20
    %
    
    
    131.70
    %
    
    
    152.10
    %
    
    
    169.20
    %Risk-free interest rate
    
    
    2.10
    %
    
    
    3.10
    %
    
    
    4.09
    %
    
    
    1.08
    %
    
    
    1.72
    %
    
    
    3.45
    %Expected dividend yield
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
 14. Business Segments The Companys business segments are strategic business units that are
managed based upon differences in customers, services and marketing channels,
even though the assets and cash flows from these operations are not independent
of each other. CSP focuses on delivering services to enterprise, corporate,
small business, small office/home office (SoHo) and consumer customers
primarily through wholesale relationships with large ISPs, telecommunications
carriers and other large resellers. CBS focuses on small business and SoHo
markets by selling services directly to end-users as well as through
independent authorized sales agents, small ISPs and resellers. All other
business operations and activities of the Company are aggregated and reported
as Corporate Operations. These operations and activities are primarily
comprised of general corporate functions to support the Companys revenue
producing segments as well as costs and expenses for headquarters facilities
and equipment, depreciation and amortization, network capacity and other
non-recurring or unusual items not directly attributable or allocated to the
segments, gains and losses on the Companys investments, and income and
expenses from the Companys treasury and financing activities. The accounting policies used in measuring segment assets and operating
results are the same as those described in Notes 1 and 2. The Company evaluates
the performance of, and allocates resources to, the segments based on segment
net income or loss, which excludes certain operating expenses, including
depreciation and amortization, and all other income and expense items, all of
which are allocated to Corporate Operations. The Company does not allocate such
operating expenses and other income and expense items to its business segments
because it believes that these expenses and other income items are not directly
controlled by the business segments. 56




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##### Table of Contents



Segment information, including a reconciliation to the respective balances
in the Companys consolidated financial statements, as of December 31, 2003,
2002 and 2001, are as follows (the Companys 2002 and 2001 segment information
have been restated to conform to the Companys organizational structure in
2003): Total
    
    Corporate
    
    Intercompany
    
    ConsolidatedCSP
    
    CBS
    
    Segments
    
    Operations
    
    Eliminations
    
    Total(Restated, see
    
    (Restated, see
    
    (Restated, see
    
    (Restated, see
    
    
    
    
    
    (Restated, seeNote 15)
    
    Note 15)
    
    Note 15)
    
    Note 15)
    
    
    
    
    
    Note 15)As of and for the year ended December 31, 2003:Domestic revenues from unaffiliated customers, net
    
    $
    236,928
    
    
    $
    151,923
    
    
    $
    388,851
    
    
    $
    
    
    
    $
    
    
    
    $
    388,851Intersegment revenues
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total revenues, net
    
    
    236,928
    
    
    
    151,923
    
    
    
    388,851
    
    
    
    
    
    
    
    
    
    
    
    388,851Operating expenses
    
    
    191,422
    
    
    
    107,621
    
    
    
    299,043
    
    
    
    129,259
    
    
    
    
    
    
    
    428,302Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    56,559
    
    
    
    
    
    
    
    56,559Amortization of intangible assets
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17,325
    
    
    
    
    
    
    
    17,325Provision for restructuring expenses
    
    
    103
    
    
    
    349
    
    
    
    452
    
    
    
    783
    
    
    
    
    
    
    
    1,235Total operating expenses
    
    
    191,525
    
    
    
    107,970
    
    
    
    299,495
    
    
    
    203,926
    
    
    
    
    
    
    
    503,421Income (loss) from operations
    
    
    45,403
    
    
    
    43,953
    
    
    
    89,356
    
    
    
    (203,926
    )
    
    
    
    
    
    
    (114,570
    )Interest income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,105
    
    
    
    
    
    
    
    2,105Equity in losses of unconsolidated affiliates
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (279
    )
    
    
    
    
    
    
    (279
    )Interest expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,526
    )
    
    
    
    
    
    
    (5,526
    )Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,968
    
    
    
    
    
    
    
    5,968Total other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,268
    
    
    
    
    
    
    
    2,268Net income (loss)
    
    $
    45,403
    
    
    $
    43,953
    
    
    $
    89,356
    
    
    $
    (201,658
    )
    
    
    
    
    
    $
    (112,302
    )Assets
    
    $
    46,140
    
    
    $
    23,432
    
    
    $
    69,572
    
    
    $
    265,139
    
    
    
    
    
    
    $
    334,711Capital expenditures for property and equipment
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    44,142
    
    
    
    
    
    
    $
    44,142Payment of collocation fees and purchase of other
intangible assets
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    14,889
    
    
    
    
    
    
    $
    14,889As of and for the year ended December 31, 2002:Domestic revenues from unaffiliated customers, net
    
    $
    231,721
    
    
    $
    151,775
    
    
    $
    383,496
    
    
    $
    
    
    
    
    
    
    
    $
    383,496Intersegment revenues
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total revenues, net
    
    
    231,721
    
    
    
    151,775
    
    
    
    383,496
    
    
    
    
    
    
    
    
    
    
    
    383,496Operating expenses
    
    
    183,384
    
    
    
    113,260
    
    
    
    296,644
    
    
    
    152,384
    
    
    
    
    
    
    
    449,028Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    112,438
    
    
    
    
    
    
    
    112,438Amortization of intangible assets
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    14,650
    
    
    
    
    
    
    
    14,650Non-cash litigation-related expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (11,628
    )
    
    
    
    
    
    
    (11,628
    )Total operating expenses
    
    
    183,384
    
    
    
    113,260
    
    
    
    296,644
    
    
    
    267,844
    
    
    
    
    
    
    
    564,488Income (loss) from operations
    
    
    48,337
    
    
    
    38,515
    
    
    
    86,852
    
    
    
    (267,844
    )
    
    
    
    
    
    
    (180,992
    )Interest income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,122
    
    
    
    
    
    
    
    5,122Equity in losses of unconsolidated affiliates
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (806
    )
    
    
    
    
    
    
    (806
    )Interest expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,581
    )
    
    
    
    
    
    
    (5,581
    )Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,571
    )
    
    
    
    
    
    
    (2,571
    )Total other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,836
    )
    
    
    
    
    
    
    (3,836
    )Net income (loss)
    
    $
    48,337
    
    
    $
    38,515
    
    
    $
    86,852
    
    
    $
    (271,680
    )
    
    
    
    
    
    $
    (184,828
    )Assets
    
    $
    52,173
    
    
    $
    17,319
    
    
    $
    69,492
    
    
    $
    372,669
    
    
    
    
    
    
    $
    442,161Investments in unconsolidated affiliates:Domestic
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    1,026
    
    
    
    
    
    
    $
    1,026Capital expenditures for property and equipment
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    22,782
    
    
    
    
    
    
    $
    22,782Payment of collocation fees
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    3,782
    
    
    
    
    
    
    $
    3,782As of and for the year ended December 31, 2001:Domestic revenues from unaffiliated customers, net
    
    $
    162,054
    
    
    
    170,542
    
    
    $
    332,596
    
    
    $
    
    
    
    
    
    
    
    
    332,596Intersegment revenues
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total revenues, net
    
    
    162,054
    
    
    
    170,542
    
    
    
    332,596
    
    
    
    
    
    
    
    
    
    
    
    332,596Operating expenses
    
    
    206,807
    
    
    
    210,586
    
    
    
    417,393
    
    
    
    243,732
    
    
    
    
    
    
    
    661,125Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    137,920
    
    
    
    
    
    
    
    137,920Amortization of intangible assets
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12,919
    
    
    
    
    
    
    
    12,919Provision for restructuring expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    14,364
    
    
    
    
    
    
    
    14,364Provision for long-lived asset impairment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,988
    
    
    
    
    
    
    
    11,988Non-cash litigation-related expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    31,160
    
    
    
    
    
    
    
    31,160Total operating expenses
    
    
    206,807
    
    
    
    210,586
    
    
    
    417,393
    
    
    
    452,083
    
    
    
    
    
    
    
    869,476Loss from operations
    
    
    (44,753
    )
    
    
    (40,044
    )
    
    
    (84,797
    )
    
    
    (452,083
    )
    
    
    
    
    
    
    (536,880
    )Interest income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    24,593
    
    
    
    
    
    
    
    24,593Equity in losses of unconsolidated affiliates
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (13,769
    )
    
    
    
    
    
    
    (13,769
    )Interest expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (92,782
    )
    
    
    
    
    
    
    (92,782
    )Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (70,131
    )
    
    
    
    
    
    
    (70,131
    )Gain on extinguishment of debt
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,033,727
    
    
    
    
    
    
    
    1,033,727Total other income (expense), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    881,638
    
    
    
    
    
    
    
    881,638Net income (loss)
    
    $
    (44,753
    )
    
    $
    (40,044
    )
    
    $
    (84,797
    )
    
    $
    429,555
    
    
    
    
    
    
    $
    344,758Capital expenditures for property and equipment
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    15,732
    
    
    
    
    
    
    $
    15,732Payment of collocation fees
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    7,940
    
    
    
    
    
    
    $
    7,940
 57




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##### Table of Contents



15. Restatement of Financial Statements During
the review process for the Companys condensed consolidated financial statements as of
March 31, 2004 and for the three
months then ended, the Company determined that certain
employee stock options granted under the 2003 Employee Stock Purchase
Plan were subject to variable accounting and that
the Companys consolidated financial statements for the year
ended December 31, 2003 need to be restated to
correct the misstatement. The restatement involves a non-cash charge, which
reflects the stock-based
compensation expense for those options granted in 2003 that are subject to variable accounting. See Note 1 for further
discussion of stock-based compensation. The
following tables summarize certain of the effects of the restatement on the
Companys consolidated financial statements as of and for the year
ended December 31, 2003: Year ended December 31, 2003As reported
    
    As restatedConsolidated statement of operations:Network and
product costs
    
    $
    283,401
    
    
    $
    288,122Sales,
marketing, general and administrative expenses
    
    $
    132,431
    
    
    $
    140,081Total
operating expenses
    
    $
    491,050
    
    
    $
    503,421Loss from
operation
    
    $
    (102,199
    )
    
    $
    (114,570
    )Net loss
    
    $
    (99,931
    )
    
    $
    (112,302
    )Basic and diluted net loss per share
    
    $
    (0.44
    )
    
    $
    (0.50
    )
 As of December 31, 2003As reported
    
    As restatedConsolidated balance sheet:Additional paid-in capital
    
    $
    1,624,489
    
    
    $
    1,651,267Deferred stock-based compensation
    
    $
    (52
    )
    
    $
    (14,459
    )Accumulated deficit
    
    $
    (1,629,267
    )
    
    $
    (1,641,638
    )
 Furthermore,
certain additional information in Note 1 and Notes 12-14
has been restated to reflect the effects of the restatement. 58




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##### Table of Contents



Supplementary Data The
unaudited supplementary information required by Item 302 of Regulation S-K is in
Part II. Item 7. Managements Discussion and Analysis of Financial Condition
and Results of Operations. 
 Item 9.Changes In and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. 
 Item 9A.Controls and Procedures Evaluation of Disclosure Controls and Procedures.The Securities and
Exchange Commission defines the term disclosure controls and procedures to
mean a companys controls and other procedures that are designed to ensure that
information required to be disclosed in the reports that it files or submits
under the Securities Exchange Act of 1934 is recorded, processed, summarized
and reported, within the time periods specified in the Commissions rules and
forms. Our chief executive officer and chief financial officer have concluded,
based on the evaluation of the effectiveness of the disclosure controls and procedures by our
management, with the participation of our chief executive officer and chief
financial officer, as of the end of the period covered by this report, that our
disclosure controls and procedures were effective for this purpose,
with the exception of the items described below. During
the review process for our condensed consolidated financial
statements as of March 31, 2004 and for the three months then ended,
we determined that certain stock-based compensation that we began
offering to employees in the third quarter of 2003 should have been
subject to variable accounting and that the financial statements for
the quarters ended September 30, 2003 and December 31,
2003, as well as for the year ended December 31, 2003, need to
be restated to correct this misstatement. The restatement involves a
non-cash compensation charge which reflects the impact of stock-based
compensation expense for options subject to variable accounting that
were issued under our 2003 Employee Stock Purchase Plan. See
Note 15 to the financial statements included in Item 8 for
further discussion of this restatement. To address these matters, we
have implemented additional procedures to ensure that stock-based
compensation is properly evaluated and recorded when we implement or
make changes to our stock-based compensation plans. During the year ended December 31, 2003 covered by this report, certain
other changes were made to our controls and procedures that improved our internal
controls over financial reporting. We implemented additional operational
controls and procedures related to the tracking, monitoring and proper
capitalization of our network assets. We implemented additional administrative
controls and procedures to track employment status events for employees to
ensure that stock-based compensation is properly adjusted when these events
occur. We implemented additional controls and procedures in the determination
and estimation of our transaction-based tax accruals to identify and implement
changes in applicable rules and regulations and to monitor the accuracy and
resolution of our accruals. Changes in Internal Controls.Except as described above, during the fourth
quarter of fiscal year 2003, there were no changes in our internal control over
financial reporting that have materially affected or are reasonably likely to
materially affect our internal control over financial reporting. 59




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##### Table of Contents



PART IV 
 Item 15.Financial Statement Schedules, Reports on Form 8-K and Exhibits (a) The
following documents are filed as part of this Form 10-K/A:  (1)
    
    Financial Statements.The following Financial Statements of Covad
Communications Group, Inc. and Report of Independent Auditors are filed as
part of this report. Report of Ernst & Young LLP, Independent Auditors
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders Equity (Deficit)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements  (2)
    
    Financial Statement Schedules.Financial statement schedules not filed
herein are omitted because of the absence of conditions under which they
are required or because the information called for is shown in the
consolidated financial statements and notes thereto.(3)
    
    Exhibits.The Exhibits listed below and on the accompanying Index to
Exhibits immediately following the signature page hereto are filed as part
of, or incorporated by reference into, this Report on Form 10-K/A. EXHIBIT INDEX ExhibitNumber
    
    Description2.1(14)
    
    Plan: First Amended Plan of Reorganization, as Modified, of Covad Communications Group, Inc.
dated November 26, 2001.2.2(15)
    
    Order Pursuant toss.1129 of the Bankruptcy Code Confirming the Debtors First Amended Chapter 11
Plan of Reorganization, as Modified (Docket No. 214).2.3(3)
    
    Agreement and Plan of Merger Among Covad Communications Group, Inc., LightSaber Acquisition Co.
and Laser Link.Net, Inc., dated as of March 8, 2000.2.4(8)
    
    Agreement and Plan of Merger and Registration among Covad Communications Group, Inc., Covad
Acquisition Corp. and BlueStar Communications Group, Inc., dated as of June 15, 2000.2.5(10)
    
    Acquisition Agreement, dated as of September 8, 2000, among Covad Communications Group, Inc.,
Greenway Holdings Ltd., Loop Holdings Europe APS, Loop Telecom, S.A. and the shareholders of Loop
Telecom, S.A.2.6(16)
    
    Shareholders Agreement, dated as of September 12, 2000, among Loop Holdings Europe APS, Loop
Telecom, S.A., Covad Communications Group, Inc. and the other shareholders of Loop Telecom, S.A.3.1(12)
    
    Amended and Restated Certificate of Incorporation.3.2(17)
    
    Certificate of Amendment of Certificate of Incorporation of the Registrant filed on July 14, 2000.3.3(33)
    
    Certificate of Amendment of Certificate of Incorporation of the Registrant filed on December 20,
2001.3.4(18)
    
    Bylaws, as currently in effect.4.1(1)
    
    Indenture dated as of March 11, 1998 between the Registrant and The Bank of New York.
 61




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##### Table of Contents



ExhibitNumber
    
    Description4.4(1)
    
    Warrant Registration Rights Agreement dated as of March 11, 1998 among the Registrant and Bear,
Stearns & Co., Inc. and BT Alex. Brown Incorporated.4.5(1)
    
    Specimen 13 1/2% Senior Note Due 2008.4.6(1)
    
    Amended and Restated Stockholders Rights Agreement dated January 19, 1999 among the Registrant
and certain of its stockholders.4.7(2)
    
    Indenture dated as of February 18, 1999 among the Registrant and The Bank of New York.4.8(2)
    
    Registration Rights Agreement dated as of February 18, 1999 among the Registrant and the Initial
Purchasers.4.9(2)
    
    Specimen 12 1/2% Senior Note Due 2009.4.10(7)
    
    Indenture dated as of January 28, 2000, between the Registrant and United States Trust Company of
New York.4.11(7)
    
    Registration Rights Agreement dated as of January 28, 2000, between the Registrant and Bear,
Stearns Co., Inc.4.12(7)
    
    Specimen 12% Senior Note Due 2010.4.13(4)
    
    Stockholder Protection Rights Agreement dated February 15, 2000.4.14(13)
    
    Amended and Restated Stockholder Protection Rights Agreement, dated as of November 1, 20014.15(8)
    
    Stock Restriction Agreement among Covad Communications and certain stockholders of BlueStar.4.16(9)
    
    Indenture, dated as of September 25, 2000, between the Company and United States Trust Company of
New York.4.17(9)
    
    Specimen 6% Convertible Senior Note.10.1(2)
    
    Form of Indemnification Agreement entered into between the Registrant and each of the
Registrants executive officers and directors.10.2(33)
    
    1998 Employee Stock Purchase Plan and related agreements.10.3(33)
    
    1997 Stock Plan and related option agreement, as currently in effect.10.22(11)
    
    Stock Purchase Agreement between SBC Communications Inc. and Covad Communications Group, Inc.,
dated September 10, 2000.10.23(11)
    
    Resale and Marketing Agreement between SBC Communications Inc. and Covad Communications Group,
Inc., dated September 10, 2000.10.24(19)
    
    Credit Agreement dated as of November 12, 2001 by and between Covad Communications Group, Inc.
and SBC Communications Inc.10.25(20)
    
    Resale Agreement dated as of November 12, 2001 by and among SBC Communications Inc., Covad
Communications Group, Inc., Covad Communications Company, DIECA Communications Company and Laser
Link.net, Inc.10.26(21)
    
    Term Loan Note dated December 20, 2001 made by Covad Communications Group, Inc. in favor of SBC
Communications Inc.
 62




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##### Table of Contents



ExhibitNumber
    
    Description10.27(22)
    
    Deed of Trust, Assignment of Leases and Rents, Security Agreement and Financing Statement dated
effective as of December 20, 2001 made by DIECA Communications, Inc. in favor of Title
Associates of Virginia, Inc., for the benefit of SBC Communications Inc.10.28(23)
    
    Pledge Agreement dated as of December 20, 2001 made by Covad Communications Group, Inc. to SBC
Communications Inc.10.29(24)
    
    Pledge Agreement dated as of December 20, 2001 made by Covad Communications Group, Inc. to SBC
Communications Inc.10.30(25)
    
    Security Agreement dated as of December 20, 2001 made by Covad Communications Company in favor of
SBC Communications Inc.10.31(26)
    
    Intellectual Property Security Agreement dated as of December 20, 2001 made by Covad
Communications Company in favor of SBC Communications Inc.10.32(27)
    
    Subsidiary Guaranty dated as of December 20, 2001 made by Covad Communications Company in favor
of and for the benefit of SBC Communications Inc.10.33(28)
    
    Capital Markets Debt Subordination Provisions.10.34(29)
    
    General Unsecured Debt Subordination Agreement.10.35(8)
    
    Stockholders Agreement among Covad Communications and certain stockholders of BlueStar.10.36(31)
    
    Form of Warrant to Purchase Common Stock Issued by the Registrant on September 3, 2002 to America
Online, Inc.10.37(32)
    
    Form of Warrant to Purchase Common Stock Issued by the Registrant on January 1, 2003 to AT&T Corp.10.38(34)
    
    Covad Communications Group, Inc., 2003 Employee Stock Purchase Plan.10.39(34)
    
    Covad Communications Group, Inc. Executive Severance Plan and Summary Plan Description.10.40(35)
    
    General Release of All Claims executed by Anjali Joshi.10.41
    
    Letter Agreement between Covad Communications and Charles Hoffman dated May 29, 2001.10.42
    
    Lease Agreement for 110 Rio Robles, San Jose, California, between Covad Communications and
CarrAmerica Realty Corporation dated August 6, 2003.21.1(30)
    
    Subsidiaries of the Registrant.23.1
    
    Consent of Ernst & Young LLP, Independent Auditors.31.1
    
    Certification Pursuant to Rule 13a-14(a).31.2
    
    Certification Pursuant to Rule 13a-14(a).32.1*
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.32.2*
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
 63




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##### Table of Contents




    
    Filed as an exhibit to the initial annual report on Form 10-K for the
fiscal year ended December 31, 2003 filed on February 27, 2004.*
    
    These certifications accompany the Registrants Annual Report on Form
10-K and are not deemed filed with the SEC.(1)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-4 (No. 333-51097) as originally
filed on April 27, 1998 and as subsequently amended.(2)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-4 (No. 333-75955) as originally
filed on April 4, 1999 and as subsequently amended.(3)
    
    Incorporated by reference to Exhibit 2.1 filed with our current report on
Form 8-K as originally filed on March 23, 2000 and as subsequently
amended.(4)
    
    Incorporated by reference to Exhibit 4.1 filed with our current report on
Form 8-A as originally filed on February 22, 2000 and as subsequently
amended.(5)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-1 (File No. 333-63899) as
originally filed on September 21, 1998 and as subsequently amended.(6)
    
    Intentionally deleted.(7)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-4 (No. 333-30360) as originally
filed on February 14, 2000 and as subsequently amended.(8)
    
    Incorporated by reference to Exhibit 2 filed with our registration
statement on Form S-4 (No. 333-43494) as originally filed on August 10,
2000 and as subsequently amended.(9)
    
    Incorporated by reference to exhibit of corresponding number filed with
our current report on Form 8-K as originally filed on September 27, 2000
and as subsequently amended.(10)
    
    Incorporated by reference to Exhibit 2.3 filed with our current report on
Form 8-K as originally filed on September 27, 2000 and as subsequently
amended.(11)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our current report on Form 8-K as originally filed on September 12,
2000 and as subsequently amended.(12)
    
    Incorporated by reference to Exhibit 3.2 filed with our registration
statement on Form S-1/A (No. 333-38688) as originally filed on July 17,
2000 and as subsequently amended.(13)
    
    Incorporated by reference to Exhibit 4.1 filed with our current report on
Form 8-K as originally filed on December 14, 2001.(14)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our current report on Form 8-K as originally filed on December 28,
2001.(15)
    
    Incorporated by reference to Exhibit 99.12 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(16)
    
    Incorporated by reference to Exhibit 2.4 filed with our current report on
Form 8-K as originally filed on September 27, 2000 and as subsequently
amended. 64




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##### Table of Contents



(17)
    
    Incorporated by reference to Exhibit 3.5 filed with our current report on
Form 8-K as originally filed on July 17, 2000 and as subsequently amended.(18)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-1/A (No. 333-38688) as
originally filed on July 17, 2000 and as subsequently amended.(19)
    
    Incorporated by reference to Exhibit 99.1 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(20)
    
    Incorporated by reference to Exhibit 99.2 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(21)
    
    Incorporated by reference to Exhibit 99.3 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(22)
    
    Incorporated by reference to Exhibit 99.4 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(23)
    
    Incorporated by reference to Exhibit 99.5 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(24)
    
    Incorporated by reference to Exhibit 99.6 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(25)
    
    Incorporated by reference to Exhibit 99.7 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(26)
    
    Incorporated by reference to Exhibit 99.8 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(27)
    
    Incorporated by reference to Exhibit 99.9 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(28)
    
    Incorporated by reference to Exhibit 99.10 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(29)
    
    Incorporated by reference to Exhibit 99.11 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(30)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our report on 10-K as filed on May 24, 2001.(31)
    
    Incorporated by reference to Exhibit 99.1 filed with our current report
on Form 8-K as originally filed September 5, 2002.(32)
    
    Incorporated by reference to Exhibit 99.1 filed with our current report
on Form 8-K as originally filed January 7, 2003.(33)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our Annual Report on Form 10-K as filed on March 29, 2002.(34)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our quarterly report on Form 10-Q as filed on July 31, 2003.(35)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our quarterly report on Form 10-Q as filed on October 24, 2003. 65




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##### Table of Contents



(b) Reports on Form 8-K The following items were reported on Form 8-K by the Company during the
fiscal quarter ended December 31, 2003. On October 22, 2003, we furnished a current report on Form 8-K, pursuant to
Item 12 thereof, furnishing a copy of a press release dated October 22, 2003. 66




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Amendment No. 1 on
Form 10-K/A to be signed on its behalf by the undersigned, thereunto duly
authorized, on May 17, 2004. COVAD COMMUNICATIONS GROUP, INC.By:
    
    /s/ Mark A. RichmanMark A. RichmanExecutive Vice President and
Chief Financial Officer
 67




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##### Table of Contents



EXHIBIT INDEX ExhibitNumber
    
    Description2.1(14)
    
    Plan: First Amended Plan of Reorganization, as Modified, of Covad Communications Group, Inc.
dated November 26, 2001.2.2(15)
    
    Order Pursuant toss.1129 of the Bankruptcy Code Confirming the Debtors First Amended Chapter 11
Plan of Reorganization, as Modified (Docket No. 214).2.3(3)
    
    Agreement and Plan of Merger Among Covad Communications Group, Inc., LightSaber Acquisition Co.
and Laser Link.Net, Inc., dated as of March 8, 2000.2.4(8)
    
    Agreement and Plan of Merger and Registration among Covad Communications Group, Inc., Covad
Acquisition Corp. and BlueStar Communications Group, Inc., dated as of June 15, 2000.2.5(10)
    
    Acquisition Agreement, dated as of September 8, 2000, among Covad Communications Group, Inc.,
Greenway Holdings Ltd., Loop Holdings Europe APS, Loop Telecom, S.A. and the shareholders of Loop
Telecom, S.A.2.6(16)
    
    Shareholders Agreement, dated as of September 12, 2000, among Loop Holdings Europe APS, Loop
Telecom, S.A., Covad Communications Group, Inc. and the other shareholders of Loop Telecom, S.A.3.1(12)
    
    Amended and Restated Certificate of Incorporation.3.2(17)
    
    Certificate of Amendment of Certificate of Incorporation of the Registrant filed on July 14, 2000.3.3(33)
    
    Certificate of Amendment of Certificate of Incorporation of the Registrant filed on December 20,
2001.3.4(18)
    
    Bylaws, as currently in effect.4.1(1)
    
    Indenture dated as of March 11, 1998 between the Registrant and The Bank of New York.4.4(1)
    
    Warrant Registration Rights Agreement dated as of March 11, 1998 among the Registrant and Bear,
Stearns & Co., Inc. and BT Alex.Brown Incorporated.4.5(1)
    
    Specimen 13 1/2% Senior Note Due 2008.4.6(1)
    
    Amended and Restated Stockholders Rights Agreement dated January 19, 1999 among the Registrant
and certain of its stockholders.4.7(2)
    
    Indenture dated as of February 18, 1999 among the Registrant and The Bank of New York.4.8(2)
    
    Registration Rights Agreement dated as of February 18, 1999 among the Registrant and the Initial
Purchasers.4.9(2)
    
    Specimen 12 1/2% Senior Note Due 2009.4.10(7)
    
    Indenture dated as of January 28, 2000, between the Registrant and United States Trust Company of
New York.4.11(7)
    
    Registration Rights Agreement dated as of January 28, 2000, between the Registrant and Bear,
Stearns & Co., Inc.4.12(7)
    
    Specimen 12% Senior Note Due 2010.4.13(4)
    
    Stockholder Protection Rights Agreement dated February 15, 2000.4.14(13)
    
    Amended and Restated Stockholder Protection Rights Agreement, dated as of November 1, 2001
 68




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##### Table of Contents



ExhibitNumber
    
    Description4.15(8)
    
    Stock Restriction Agreement among Covad Communications and certain stockholders of BlueStar.4.16(9)
    
    Indenture, dated as of September 25, 2000, between the Company and United States Trust Company of
New York.4.17(9)
    
    Specimen 6% Convertible Senior Note.10.1(2)
    
    Form of Indemnification Agreement entered into between the Registrant and each of the
Registrants executive officers and directors.10.2(33)
    
    1998 Employee Stock Purchase Plan and related agreements.10.3(33)
    
    1997 Stock Plan and related option agreement, as currently in effect.10.22(11)
    
    Stock Purchase Agreement between SBC Communications Inc. and Covad Communications Group, Inc.,
dated September 10, 2000.10.23(11)
    
    Resale and Marketing Agreement between SBC Communications Inc. and Covad Communications Group,
Inc., dated September 10, 2000.10.24(19)
    
    Credit Agreement dated as of November 12, 2001 by and between Covad Communications Group, Inc.
and SBC Communications Inc.10.25(20)
    
    Resale Agreement dated as of November 12, 2001 by and among SBC Communications Inc., Covad
Communications Group, Inc., Covad Communications Company, DIECA Communications Company and Laser
Link.net, Inc.10.26(21)
    
    Term Loan Note dated December 20, 2001 made by Covad Communications Group, Inc. in favor of SBC
Communications Inc.10.27(22)
    
    Deed of Trust, Assignment of Leases and Rents, Security Agreement and Financing Statement dated
effective as of December 20, 2001 made by DIECA Communications, Inc. in favor of Title Associates
of Virginia, Inc., for the benefit of SBC Communications Inc.10.28(23)
    
    Pledge Agreement dated as of December 20, 2001 made by Covad Communications Group, Inc. to SBC
Communications Inc.10.29(24)
    
    Pledge Agreement dated as of December 20, 2001 made by Covad Communications Group, Inc. to SBC
Communications Inc.10.30(25)
    
    Security Agreement dated as of December 20, 2001 made by Covad Communications Company in favor of
SBC Communications Inc.10.31(26)
    
    Intellectual Property Security Agreement dated as of December 20, 2001 made by Covad
Communications Company in favor of SBC Communications Inc.10.32(27)
    
    Subsidiary Guaranty dated as of December 20, 2001 made by Covad Communications Company in favor
of and for the benefit of SBC Communications Inc.10.33(28)
    
    Capital Markets Debt Subordination Provisions.10.34(29)
    
    General Unsecured Debt Subordination Agreement.10.35(8)
    
    Stockholders Agreement among Covad Communications and certain stockholders of BlueStar.10.36(31)
    
    Form of Warrant to Purchase Common Stock Issued by the Registrant on September 3, 2002 to America
Online, Inc.
 69




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##### Table of Contents



ExhibitNumber
    
    Description10.37(32)
    
    Form of Warrant to Purchase Common Stock Issued by the Registrant on January 1, 2003 to AT&T Corp.10.38(34)
    
    Covad Communications Group, Inc., 2003 Employee Stock Purchase Plan.10.39(34)
    
    Covad Communications Group, Inc. Executive Severance Plan and Summary Plan Description.10.40(35)
    
    General Release of All Claims executed by Anjali Joshi.10.41
    
    Letter Agreement between Covad Communications and Charles Hoffman dated May 29, 2001.10.42
    
    Lease Agreement for 110 Rio Robles, San Jose, California, between Covad Communications and
CarrAmerica Realty Corporation dated August 6, 2003.21.1(30)
    
    Subsidiaries of the Registrant.23.1
    
    Consent of Ernst & Young LLP, Independent Auditors.24.1
    
    Power of Attorney (incorporated in the signature page herein).31.1
    
    Certification Pursuant to Rule 13a-14(a).31.2
    
    Certification Pursuant to Rule 13a-14(a).32.1*
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.32.2*
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
   
    
    Filed as an exhibit to the initial annual report on Form 10-K for the
fiscal year ended December 31, 2003 filed on February 27, 2004.*
    
    These certifications accompany the Registrants Annual Report on Form
10-K and are not deemed filed with the SEC.(1)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-4 (No. 333-51097) as originally
filed on April 27, 1998 and as subsequently amended.(2)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-4 (No. 333-75955) as originally
filed on April 4, 1999 and as subsequently amended.(3)
    
    Incorporated by reference to Exhibit 2.1 filed with our current report on
Form 8-K as originally filed on March 23, 2000 and as subsequently
amended.(4)
    
    Incorporated by reference to Exhibit 4.1 filed with our current report on
Form 8-A as originally filed on February 22, 2000 and as subsequently
amended.(5)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-1 (File No. 333-63899) as
originally filed on September 21, 1998 and as subsequently amended.(6)
    
    Intentionally deleted. 70




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##### Table of Contents



(7)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-4 (No. 333-30360) as originally
filed on February 14, 2000 and as subsequently amended.(8)
    
    Incorporated by reference to Exhibit 2 filed with our registration
statement on Form S-4 (No. 333-43494) as originally filed on August 10,
2000 and as subsequently amended.(9)
    
    Incorporated by reference to exhibit of corresponding number filed with
our current report on Form 8-K as originally filed on September 27, 2000
and as subsequently amended.(10)
    
    Incorporated by reference to Exhibit 2.3 filed with our current report on
Form 8-K as originally filed on September 27, 2000 and as subsequently
amended.(11)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our current report on Form 8-K as originally filed on September 12,
2000 and as subsequently amended.(12)
    
    Incorporated by reference to Exhibit 3.2 filed with our registration
statement on Form S-1/A (No. 333-38688) as originally filed on July 17,
2000 and as subsequently amended.(13)
    
    Incorporated by reference to Exhibit 4.1 filed with our current report on
Form 8-K as originally filed on December 14, 2001.(14)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our current report on Form 8-K as originally filed on December 28,
2001.(15)
    
    Incorporated by reference to Exhibit 99.12 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(16)
    
    Incorporated by reference to Exhibit 2.4 filed with our current report on
Form 8-K as originally filed on September 27, 2000 and as subsequently
amended.(17)
    
    Incorporated by reference to Exhibit 3.5 filed with our current report on
Form 8-K as originally filed on July 17, 2000 and as subsequently amended.(18)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-1/A (No. 333-38688) as
originally filed on July 17, 2000 and as subsequently amended.(19)
    
    Incorporated by reference to Exhibit 99.1 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(20)
    
    Incorporated by reference to Exhibit 99.2 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(21)
    
    Incorporated by reference to Exhibit 99.3 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(22)
    
    Incorporated by reference to Exhibit 99.4 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(23)
    
    Incorporated by reference to Exhibit 99.5 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(24)
    
    Incorporated by reference to Exhibit 99.6 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(25)
    
    Incorporated by reference to Exhibit 99.7 filed with our current report
on Form 8-K as originally filed on December 28, 2001. 71




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##### Table of Contents



(26)
    
    Incorporated by reference to Exhibit 99.8 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(27)
    
    Incorporated by reference to Exhibit 99.9 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(28)
    
    Incorporated by reference to Exhibit 99.10 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(29)
    
    Incorporated by reference to Exhibit 99.11 filed with our current report
on Form 8-K as originally filed on December 28, 2001.(30)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our report on 10-K as filed on May 24, 2001.(31)
    
    Incorporated by reference to Exhibit 99.1 filed with our current report
on Form 8-K as originally filed September 5, 2002.(32)
    
    Incorporated by reference to Exhibit 99.1 filed with our current report
on Form 8-K as originally filed January 7, 2003.(33)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our Annual Report on Form 10-K as filed on March 29, 2002.(34)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our quarterly report on Form 10-Q as filed on July 31, 2003.(35)
    
    Incorporated by reference to the exhibit of corresponding number filed
with our quarterly report on Form 10-Q as filed on October 24, 2003. 72