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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549


FORM 10-K

FOR ANNUAL AND TRANSITION REPORTSPURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

(Mark One)

|  |  |                                                                                     
|- |  | ------------------------------------------------------------------------------------
|x |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2002

|  |  |                                                                                         
|- |  | ----------------------------------------------------------------------------------------
|o |  | TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to

Commission file number 000-25271

COVAD COMMUNICATIONS GROUP, INC.

(Exact Name of Registrant as Specified in Its Charter)


|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 77-0461529                          
|(State or Other Jurisdiction
of Incorporation or Organization) |  | (I.R.S. Employer
Identification No.)

3420 Central Expressway, Santa Clara, California 95051

Registrants telephone number, including area code:
(408) 616-6500

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  o No  x

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, 2002 as reported on the OTC Bulletin Board, was
approximately $258.8 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 [  ]

APPLICABLE ONLY TO CORPORATE ISSUERS:

As of March 17, 2003, there were 223,511,240 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 I        
|               | ITEM 1. BUSINESS                                                                             
|               | ITEM 2. PROPERTIES                                                                           
|               | ITEM 3. LEGAL PROCEEDINGS                                                                    
|               | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                  
|PART II       
|               | ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                
|               | ITEM 6. SELECTED FINANCIAL DATA                                                              
|               | ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|               | ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                          
|               | ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                          
|               | ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE 
|PART III      
|               | ITEM 11. EXECUTIVE COMPENSATION                                                              
|               | ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                      
|PART IV       
|               | ITEM 14. CONTROLS AND PROCEDURES                                                             
|               | ITEM 15. FINANCIAL STATEMENT SCHEDULES, REPORTS ON FORM 8-K AND EXHIBITS                     
|EXHIBIT INDEX 
|SIGNATURES    
|CERTIFICATIONS
|EXHIBIT 23.1  
|EXHIBIT 99.1  
|EXHIBIT 99.2  



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PART I




ITEM 1. BUSINESS

The following discussion contains forward-looking statements that involve
risks and uncertainties, including statements regarding our growth rates, cash
needs, the adequacy of our cash reserves, relationships with customers and
vendors, market opportunities, legislative and regulatory
proceedings, operating and capital expenditures, expense
reductions and operating results. Actual results could differ materially from
those anticipated in the forward-looking statements as a result of certain
factors including, but not limited to, those discussed in Part I. Item 1.
BusinessRisk Factors and elsewhere in this Report.

We disclaim any obligation to update information contained in any
forward-looking statement. See Part II. Item 7. Managements Discussion and
Analysis of Financial Condition and Results of OperationsForward Looking
Statements.

Overview

We are a leading provider of high-speed Internet connectivity and related
communications services. Our services include a range of high-speed,
high-capacity, or broadband, Internet access connectivity and related services
using digital subscriber line (DSL), T-1, Virtual Private Network (VPN) and
firewall technologies. With over 1,800 collocation facilities, we believe we
have the largest contiguous national broadband network. We provide services
throughout the United States in 94 metropolitan statistical areas (MSA). As
of December 31, 2002, we had approximately 381,000 DSL and other high-speed
lines in service. We sell services indirectly through resellers, as well as
directly through Covad.net.

The
majority of our sales are generated by more than 150 resellers, including AT&T Corporation (AT&T), America Online, Inc. (AOL),
XO Communications, Inc. (XO Communications), EarthLink, Inc. (EarthLink),
Sprint Corporation (Sprint), Megapath Networks, and Speakeasy.net. Although
wholesale line growth in 2002 was slowed by the financial difficulties faced by
some of our partners and churn (which represents end user disconnections), we
installed more than 168,000 lines and ended the year with approximately 339,000
lines in service in the reseller channel. Future wholesale growth will be
supported by marketing contracts we signed in 2002 with key Internet service
providers (ISP) and telecommunications carriers, including AOL, AT&T and
Sprint.

Covad.net, our direct channel, ended 2002 with approximately 42,600 lines
in service, up from 14,600 lines at the end of the previous year. Covad.net
sells products through multiple channels including telesales, field sales,
affinity partner programs, and our website. Covad.net focuses on the small
business market and also sells to enterprise customers that purchase our
services for distribution across their enterprise. Covad.net also provides
dial-up Internet access services to approximately 49,000 subscribers as of
December 31, 2002, primarily as a private label offering to affinity groups as
well as a complimentary service to Covad broadband customers.

We were originally incorporated in California as Covad Communications
Company in October 1996. In July 1997, we were incorporated in Delaware as
Covad Communications Group, Inc., a holding company that conducts substantially
all of its business through its subsidiaries. We introduced our services
commercially in the San Francisco Bay Area in December 1997.

On August 15, 2001, Covad Communications Group, Inc. filed a voluntary
petition under Chapter 11 of the United States Bankruptcy Code, for the purpose
of confirming a pre-negotiated plan of reorganization with the majority holders
of our debt. The petition was filed with the United States Bankruptcy Court for
the District of Delaware. On December 13, 2001, the Bankruptcy Court entered
its order confirming the plan of reorganization. On December 20, 2001, the
plan of reorganization was consummated. Under the plan of reorganization, we
were able to retire approximately $1.4 billion in aggregate face amount of
outstanding notes. For additional information see Part II Item 8. Notes to
Consolidated Financial Statements, Note 3, Reorganization Under Bankruptcy
Proceedings.

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Recent Developments

On February 20, 2003, the Federal Communications Commission (FCC) issued
a press release announcing the results of its Triennial Review. Based on our
understanding of such press release, the FCCs Triennial Review
is a significant
development for us for the following reasons:



| |  |  | The FCC announced that it is phasing out its rule requiring
line-sharing over a three-year period. Line-sharing currently allows
us to provision services using asymmetric DSL (ADSL) technology over
the same telephone line that the local telephone company is using to
provide voice services. The federal rules requiring line-sharing will
be phased out over a three-year period, during which we will be
required to transition our existing line-sharing customers to new
arrangements. New line-sharing customers may be acquired at regulated
rates only during the first year of the transition. During each year
of the transition, the FCC-mandated maximum price for the
high-frequency portion of the phone line will increase incrementally
towards the cost of a separate phone line. This means that, unless we
reach agreements with the local telephone companies that will provide us
with continued access to line-sharing, we will be required to purchase
a separate telephone line in order to provide services to an end-user.
The cost of a separate phone line is significantly higher than the cost
of a shared line. As of December 31, 2002, we had approximately
169,000 subscriber lines using line-sharing arrangements.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The FCC also announced that the local telephone companies would not
be required to allow us to access the packet-switching functions of
fiber-fed telephone lines to provision DSL services. This means that,
unless we reach agreements with the local telephone companies, we will
be unable to provide our most commonly-used services to end-users
served by fiber-fed lines. This is significant for our business
because it preserves a substantial limit on the addressable market for
our services, thereby limiting our growth. In addition, the local
telephone companies are increasing their deployment of fiber-fed remote
terminal architectures, which could decrease our addressable market. We currently have no lines in service using
packet-switching capabilities of fiber-fed telephone lines.                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| |  |  | The FCC announced that, if the state public utilities commissions
deem it appropriate, companies that compete with the local telephone
companies would continue to have access to the local telephone
companies networks in order to provide their services under an
arrangement known as the Unbundled Network Element platform (UNE-P). Under this arrangement
these competitive telecommunications companies purchase phone lines in
order to provide voice and data services. The continued existence of
the UNE-P provides us with the opportunity to potentially bundle our
data services with the voice services of these companies.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

The FCC has not yet issued its order in the Triennial Review and it is
uncertain when that order will be released. Without that order, it is
difficult for us to evaluate the full impact of the FCCs decision on our
business. However, based on the FCCs announcement, it appears that at some
point we will be required to purchase a separate telephone line in order to
provide services to an end-user, unless we reach agreements with the local
telephone companies that provide us with continued access to line-sharing. The
cost of a separate phone line is significantly higher than the cost of a shared
line. If we are unable to obtain from the traditional telephone companies
reasonable line-sharing rates substantially below the cost of a separate
telephone line, we may stop selling stand-alone consumer grade services,
which would slow the growth of our revenue and require us to significantly
change our business plan.

On September 23, 2002, we announced that we signed a three-year agreement
with AT&T that provides it with the ability to purchase our wholesale
consumer-grade broadband Internet access services. AT&T began placing orders
for these services in the fourth quarter of 2002. On January 1, 2003, we
announced that we amended this agreement to add additional services and grant
AT&T three warrants to purchase an aggregate of 3,000,000 shares of our common
stock at prices ranging from $0.94 to $5.00 per share.

Beginning in January 2003, we realigned our business into two distinct
segments to better focus on differences in product and services requirements
and marketing channels. These business units are Covad Strategic Partnerships
(CSP) and Covad Broadband Solutions (CBS). Prior to 2003, our business
segments were wholesale and direct based on whether the end-user was serviced
and billed through a wholesale customer relationship or directly through
Covad.net.

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CSP focuses on delivering services to small business, small office/home
office (SoHo), and consumer customers. CSP sells its services entirely
through wholesale relationships with larger ISPs, telecommunications carriers
and other large resellers. We believe the customer requirements of these
larger strategic partners require more individualized attention. These larger
resellers include AT&T Corporation, SBC, EarthLink, Inc., AOL, Megapath
Networks, Speakeasy.net, XO Communications, WorldCom and Sprint.

CBS focuses
on the small business and SoHo markets. CBS sells services directly to
end-users as well as through independent authorized sales agents, smaller wholesale resale relationships, consisting
primarily of small regional ISPs.

We believe the establishment of CSP and CBS with separate general
management will better serve these markets and will increase financial
accountability. Andrew S. Lockwood, previously senior vice president of
marketing, was appointed EVP and General Manager, Covad Strategic Partnerships.
Patrick Bennett, EVP and General Manager, Covad Broadband Solutions, leads
CBS. Mr. Bennett was previously EVP and General Manager for our direct
segment.

Industry Background

DSL technology first emerged in the 1990s and is commercially available
today to address performance bottlenecks of the public switched telephone
network. DSL equipment, when deployed at each end of standard copper telephone
lines, increases the data carrying capacity of copper telephone lines from
analog modem speeds of up to 56.6 kilobits per second (for the fastest consumer
modems) and ISDN speeds of up to 128 kilobits per second to DSL speeds of up to
8 megabits per second downstream and up to 1.5 megabits per second upstream,
depending on the length and condition of the copper line.

The passage of the 1996 Telecommunications Act created a legal framework
for competitive telecommunications companies to provide local, analog and
digital communications services in competition with the traditional telephone
companies. The 1996 Telecommunications Act eliminated a substantial barrier to
entry for competitive telecommunications companies by enabling them to use the
existing infrastructure built by the traditional telephone companies rather
than constructing a competing infrastructure at significant cost. The FCC
develops and implements rules under the 1996 Telecommunications Act. The 1996
Telecommunications Act, as interpreted by the FCC, requires traditional
telephone companies, among other things, to:



| |  |  | allow competitive telecommunications companies to lease telephone
lines on a line-by-line basis;                                                                                      
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | provide central office space for the competitive telecommunications
companies DSL and other equipment required to connect to leased
telephone lines;                                 
|
| |  |  | lease access on traditional telephone companies inter-central office
backbone to link the competitive telecommunications companies
equipment; and                                   
|
| |  |  | allow competitive telecommunications companies to electronically
connect into traditional telephone companies operational support
systems to place orders and access their databases.

Our Service Offerings

We offer ten business-grade services, three consumer grade services and
two managed security services. Our business grade services are offered under
the TeleSpeed (six services), TeleSoho (two services) and TeleXtend (three
services) brands and our consumer-grade services are offered under the
TeleSurfer brand (two services). CBS offers Managed security services and VPN services under
the TeleDefend brand, in addition to email and hosting services. In
addition, resellers may purchase high-capacity network backhaul services from us to connect
their facilities to our network or to the Internet and direct technical support
for their end-users.

We believe that substantially all, if not all, of the potential end-users
in our service areas generally can be served with one of our services. The
specific number of potential end-users who qualify for service will vary by
central office, by region and will be affected by line quality. Prices for our
end-user services vary depending upon the performance level of the service and
the underlying technology used to deliver the service. Our prices also vary for

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high volume customers that are eligible for volume discounts. See Item 1.
BusinessRisk FactorsWe may experience decreasing margins on the sale of our
services, which may impair our ability to achieve profitability or positive
cash flow for a discussion of some of the risks associated with our ability to
sustain current price levels in the future.

TeleSpeed

We launched service in December 1997 with our TeleSpeed services. These
services are intended to connect individual end-users on previously unused
conventional telephone lines to our DSL equipment in their serving central
office and from there to our network serving that metropolitan statistical
area. The particular TeleSpeed service available to an end-user depends in
large part on the end-users distance to their respective central office.

TeleSoho

TeleSoho.Our TeleSoho service was introduced in September 2001. We
designed this service for the Small Office/Home Office
(SoHo) customer segment, with merged features from
our consumer and business services. The service is asymmetric, offering speeds
up to 3.0 megabits per second downstream and up to 384 kilobits per second
upstream, and can be delivered to customers using a self or professional
installation. TeleSoho is provisioned with an ADSL router capable of supporting
up to four end-users and can support one fixed IP address.

TeleXtend

Our TeleXtend services were introduced in November 2001. These services
allow end-users to connect to our network equipment in their local central
office and from there to our network serving that metropolitan statistical
area. The TeleXtend services available to end-users are not limited by distance
from the servicing central office. As of December 31, 2002, TeleXtend services
were available in 839 central offices.

TeleSurfer

Our TeleSurfer service was introduced in April 1999 and is designed for
consumers. This service is asymmetric, offering speeds up to 1.5 megabits per
second downstream and up to 128 kilobits per second upstream. We generally
deliver this service to customers using a self installation over a line-shared
loop. Line-sharing and self installation reduce the monthly recurring cost and
the up-front cost for installation of the service.

Asynchronous Transfer Mode (ATM) Services

We also provide DS3 and OC3 circuit backhaul services from our regional
network to a resellers site. This service aggregates individual end-users in a
metropolitan statistical area and transmits the packet information to the
customer on a single high-speed line. The service utilizes ATM protocol that
operates at up to 45 megabits per second for DS3 circuits and up to 155
megabits per second for OC3 circuits.

Broadband Internet Access Service

This service currently bundles Internet protocol services with our
high-speed connectivity services to provide a complete connection to the public
Internet. The additional Internet protocol services include end-user
authentication, authorization and accounting, Internet protocol address
assignment and management, domain name service and Internet protocol routing
and connectivity.

Value-Added Services

In addition to access services, we offer three suites of value-added
services to end-users that purchase our service directly from us. These
services include:

TeleDefendThis service is designed to meet the security and private
networking needs of small to medium-size businesses. TeleDefend is a managed
and monitored service. We currently offer two versions of TeleDefend 

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TeleDefend Firewall, which protects businesses with only one site, and
TeleDefend VPN/Firewall, which allows businesses with multiple sites to
communicate securely.

TeleXchangeIn December 2002, we introduced our first voice service in
the San Francisco Bay Area. TeleXchange service combines business class DSL
service with telephone voice service, including unlimited local usage, free
long-distance minutes, and free calling features. It is currently available in
a 4-line and 8-line option.

Email and Web HostingIn March 2003, we introduced our first suite of
stand alone email and web hosting services. These services will target small
to medium-size businesses. These services will allow such companies to have a
custom domain name (e.g. www.mybusiness.com) as well as business-class email
and web hosting. All services will come with anti-spam and anti-virus
protection and easy-to-use website building tools and templates.

Wholesale

We sell our wholesale services to Internet services providers,
telecommunications carriers and other resellers. These resellers purchase our
services on a wholesale basis and sell these services under their own brand.
We had over 150 resellers as of December 31, 2002. For the year
ended December 31, 2002, our 30 largest resellers collectively
comprised 93.3% of our total wholesale net revenues and 79.5% of the Companys
total net revenues. For the year ended December 31, 2002, EarthLink, one of
our resellers accounted for 20.0% of our total net revenues. As of
December 31, 2002, we had approximately 339,000 end-users purchasing services
through our resellers.

Our agreements with our resellers generally have terms of one year and are
nonexclusive. We generally do not require these resellers to generate a minimum
number of end-users, but we grant volume discounts based on subscriber volume.

Direct

We also sell our services directly to end-users. We sell a suite of
enhanced services directly to end-users in certain markets by using a direct
field sales force, telephone sales, websales and a variety of third parties as
referral resources. Our approach to this market is to combine our high quality
national network with other features to deliver value added services to small
offices, home offices and small and medium size businesses. As of December 31,
2002, we had approximately 42,600 end-users purchasing services directly from
us.

Sales and Marketing

Wholesale Strategy

Our wholesale strategy is to enter into relationships with leading
Internet service providers and telecommunications companies, including
competitive telecommunications carriers and interexchange carriers. We offer
our partners a range of DSL and T1 services that they in turn offer their business and
consumer end-users. They can either combine our DSL and T1 lines with their own
Internet access services under their own brand or purchase our lines and
Internet access services and resell the combination to their customers.

We believe that strategic partners like EarthLink, SBC Communications,
AOL, AT&T and Sprint will increase the revenues we derive from the broadband
market in the enterprise, small and medium-size businesses, SoHo and consumer
segments more rapidly and profitably. Given the cost of customer acquisition
in the DSL market, leveraging the brand of our partners, their customer bases,
and embedded direct and indirect sales channels offer us an attractive
opportunity.

We
provide these strategic partners with a dedicated sales and marketing
organization. We work jointly with our partners to develop and fund marketing
programs that are specific to their target markets, product offerings and sales
objectives. We work to improve the cost of acquisition by assisting these
partners with direct marketing, promotions, and incentive programs.

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Direct Strategy

Our direct sales efforts focus on providing broadband services to very
small to medium sized businesses. We sell to our target customers through
multiple sales channels: telesales, web sales, field sales, and Alliance
Network sales (e.g., sales through agents and authorized resellers).

Our marketing programs and communications to small businesses are designed
to increase brand awareness and encourage potential customers to contact our
telesales center or visit our web site. Our marketing campaigns are national
in scope, are supported by offers that encourage potential customers to
purchase our services, and employ a wide variety of media, including on-line
advertisements, direct mail, radio and TV. In addition, we employ outbound
telesales to follow up on leads generated from the marketing campaigns.

Our telesales and field sales channels sell our services via outbound
calling and prospecting in the field. Our telesales groups make outbound calls
to people who have visited our web site and to lists of pre-qualified
businesses that match the profile of customers who have purchased DSL from
Covad in the past. The field sales organization targets larger companies with
many branch offices that have small business like broadband needs, such as
connecting remote offices back to the corporate center. Typical companies that
field sales have sold to in the past include restaurant chains and franchise
organizations.

In 2002, we expanded our agent sales channel. Agents are typically VARs
and telecom specialists that have existing relationships with businesses and
receive commissions in exchange for referring a customer to us. Sales from
agents increased in 2002, and we plan to further expand this channel.

Service Deployment and Operations

ISPs, telecommunications carriers and corporate information technology
managers typically have had to assemble their digital communications
connections using multiple services and equipment suppliers, leading to
additional work, cost and coordination problems. With our services, we
emphasize a one-stop service solution for our customers. This service
solution includes:



| |  |  | end-user premises wiring and modem configuration;                                              
| | - |  | -----------------------------------------------------------------------------------------------
|
| |  |  | ongoing network monitoring and customer reporting;                                             
|
| |  |  | customer service and technical support; and                                                    
|
| |  |  | operational support systems that reduce costs and improve performance for us and our customers.

Network Architecture and Technology

We designed our network to provide the following attributes, which we
believe are important requirements for our existing and potential customers:

Consistent and Scalable Performance.We believe that eventually public
packet networks will evolve to replace the analog modems currently deployed in
the United States. As such, we designed our network for scalability and
consistent performance to all users as the network grows. We have designed a
nation-wide network that is organized around our regional metropolitan areas
and interconnected across the country.

Intelligent End-to-End Network Management.Because customers and
end-users lines are continuously connected, they can also always be monitored.
We have visibility from the Internet service provider or enterprise site across
the network and to the end-users premises equipment. Because our network is
centrally managed, we can identify and dynamically enhance network quality,
service and performance and address network problems promptly.

Flexibility.We have designed our network to be flexible in handling
various types of network traffic, starting with data, but extending to
real-time voice and video information in the future. This flexibility will
allow us to carry not only value-added services such as voice over DSL, but
will also allow us to control the prioritization of content

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delivery over our national network. We accomplish the prioritization and
quality of service control using ATM technology which allows us to support both
non-real time and real time applications and provides fair allocation of
bandwidth among customers.

Network Operations Centers.Our entire network is managed from a
network operations center located in the San Francisco Bay Area. We provide
end-to-end network management using advanced network management tools on a 24x7
basis, which enhances our ability to address performance or connectivity issues
before they affect the end-user experience. From the network operations center,
we can monitor the equipment and circuits in our Internet access points,
national backbone network, each metropolitan network, each central office
(including DSLAMs) and potentially individual end-user lines (including the DSL
modems).

Nationwide Broadband Access and Internet Connectivity. We link each of
our metropolitan areas together with our leased high-speed private backbone
network connections. Our Internet access points are strategically located at
high-speed interconnection facilities across the country in order to increase
the performance and decrease the latency of connections to the Internet for our
customers. Many of our customers choose to use our network rather than
developing their own national backbone.

Private Metropolitan Network.We operate our own private metropolitan
network in each region that we enter. The network consists of high-speed
communications circuits that we lease to connect our hubs, our equipment in
individual central offices, our Internet access points, and our resellers and
direct customers with multiple locations. We have deployed leased fiber optic
networks using SONET technology in two of our major metropolitan areas. These
metropolitan networks operate at speeds of 45 megabits per second to 4.8
gigabits per second.

Central Office Spaces.Through our interconnection agreements with the
traditional telephone companies, we have secured space in every central office
where we offer service. These central office spaces are designed to offer the
same high reliability and availability as the traditional telephone companys
other central office space. We require access to these spaces for our equipment
and for persons employed by or under contract with us. We place DSLAMs in our
central office spaces to provide the high-speed DSL signals on each copper line
to our end-users. As of December 31, 2002, we had more than 1,800 operational
central offices.

Telephone Lines.We lease the telephone lines running to end-users from
the traditional telephone companies under terms specified in our
interconnection agreements. We lease lines that, in numerous cases, must be
specially conditioned by the traditional telephone companies to carry digital
signals, usually at an additional charge relative to that for voice grade
telephone wires. We also provide some of our services over telephone lines that
already carry the voice service of a traditional telephone company. Based on
the FCCs recent announcement in the Triennial Review, our continuing ability
to use these line-shared telephone lines is dependent on our ability to enter
into agreements with the traditional telephone companies.

DSL Modems and On-Site Connection.We buy DSL modems from our suppliers
for resale to our customers. We configure and install these modems along with
any required on-site wiring needed to connect the modem to the copper line
leased from the traditional telephone company. DSL modems are also included in
self-installation kits provided by us or our resellers and are shipped to
end-users to perform their own installation.

Ongoing Network Development. Our ongoing service development and
engineering efforts focus on the design and development of new technologies and
services to increase the speed, efficiency, reliability and security of our
network and to facilitate the development of network applications by ourselves
and third parties that will increase the use of our network.

Competition

The markets for business and consumer Internet access and network access
services are intensely competitive, and we expect these markets will become
increasingly competitive in the future. The principal bases of competition in
our markets include (in no particular order):



| |  |  | price/performance;
| | - |  | ------------------

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| |  |  | discounted rates for bundles of services;
| | - |  | -----------------------------------------
|
| |  |  | breadth of service availability;         
|
| |  |  | reliability of service;                  
|
| |  |  | network security; and                    
|
| |  |  | ease of access and use.                  

We face competition from traditional telephone companies, cable modem
service providers, competitive telecommunications companies, traditional and
new national long distance carriers, Internet service providers, on-line
service providers and wireless and satellite service providers.

Traditional Telephone Companies.All of the largest traditional
telephone companies in our target markets offer DSL services. As a result, the
traditional telephone companies represent strong competition in all of our
target service areas and we expect this competition to intensify. The
traditional telephone companies have an established brand name and reputation
for quality in their service areas, possess sufficient capital to deploy DSL
equipment rapidly, own the telephone lines themselves and can bundle digital
data services with their existing voice services to achieve economies of scale
in serving their customers. Certain of the traditional telephone companies are
aggressively pricing their consumer DSL services as low as $34.95 per month,
placing pricing pressure on our consumer grade services. The traditional
telephone companies are also able to offer consumer services through remote
terminals, and the FCC announced in its Triennial Review that the telephone
companies would not be required to provide us with access to remote terminals.

Cable Modem Service Providers.Cable modem service providers such as
Comcast Corp, Cox Communications, AOL Time Warner and Charter Communications
are deploying high-speed Internet access services over hybrid fiber-coaxial
cable networks. Hybrid fiber-coaxial cable is a combination of fiber optic and
coaxial cable and has become the primary architecture utilized by cable
operators in recent and ongoing upgrades of their systems. Where deployed,
these networks provide similar and in some cases higher-speed Internet access
than we provide.

Competitive Telecommunications Companies.Many competitive
telecommunications companies, such as DSL.net, Inc., Mpower Communications
Corporation and New Edge Networks, Inc., offer high-speed digital services
using a business strategy similar to ours. Some of these competitors offer
DSL-based access services, and others are likely to do so in the future.
Companies such as XO Communications and Allegiance Telecom have extensive fiber
networks in many metropolitan areas, primarily providing high-speed digital and
voice circuits to large corporations and have deployed DSL equipment and
provide DSL-based services. They also have interconnection agreements with the
traditional telephone companies pursuant to which they have acquired central
office space in many markets targeted by us.

National Interexchange Carriers.Interexchange carriers, such as AT&T,
Sprint, WorldCom, Qwest and Level 3 Communications, have deployed large-scale
Internet access networks or ATM networks, sell connectivity to businesses and
residential customers and have high brand recognition. In early 2001, AT&T and
WorldCom purchased the DSL networks of two of our former competitors. They also
have interconnection agreements with many of the traditional telephone
companies and a number of spaces in central offices from which they are
currently offering or could begin to offer competitive DSL services. Many of
these companies provide DSL-based services in competition with us. In addition,
some of these companies, such as AT&T and UUNET Technologies (a WorldCom
company) are our resellers.

Internet Service Providers.Internet service providers such as Genuity,
UUNET Technologies (a WorldCom company), EarthLink, XO Communications and
Speakeasy.net provide Internet access to residential and business customers,
generally using a variety of telecommunications services such as T1, satellite,
wireless, dial-up, ISDN and DSL services. These Internet service providers can
and do compete with us in certain instances at the retail level and at the
wholesale level. To the extent we are not able to recruit Internet service
providers as customers for our

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service, Internet service providers resell our competitors services and
could even become competitive DSL service providers themselves.

On-Line Service Providers.On-line service providers include companies
such as AOL Time Warner and MSN (a subsidiary of Microsoft Corp.) that provide,
over the Internet and through proprietary on-line services, content and
applications ranging from news and sports to consumer video conferencing. These
services are designed for broad consumer access which enables the provision of
digital services to a significant number of consumers. In addition, they
provide Internet connectivity, ease-of-use and consistency of environment. Many
of these on-line service providers have developed their own access networks for
modem connections. AOL Time Warner owns certain cable systems throughout the
United States. Some of these systems offer cable modem service and AOL has
begun the deployment of its Internet services over these networks.

Wireless and Satellite Data Service Providers.Wireless and satellite
data service providers continue to develop wireless and satellite-based
Internet connectivity. We face competition from terrestrial wireless services
including: third-generation wireless networks, two Gigahertz (Ghz) and 28 Ghz
wireless cable systems (Multi-channel Microwave Distribution System (MMDS)
and Local Multi-channel Distribution System (LMDS)), and 18 Ghz, 39 Ghz and
50 Ghz point-to-point and point-to-multi-point microwave systems. Some of our
resellers, such as WorldCom and XO Communications hold many of these microwave
licenses and are offering broadband data services over this spectrum. Companies
such as Teligent Inc. and WinStar Communications, Inc., hold point-to-point
microwave licenses to provide fixed wireless services such as voice, data and
videoconferencing. Many of the companies that have historically offered these
alternative connectivity solutions have scaled back their operations, suspended
service, or sold their operations. Winstar Communications sold substantially
all of its operating assets in its bankruptcy proceedings to IDT Corporation
and Aerie Networks recently acquired the Ricochet Network from the bankruptcy
proceedings of Metricom, Inc. Many of these wireless providers are having some
difficulty with these newer technologies as they are relatively immature. Third
generation cellular (3G) or augmented second generation cellular (2.5G) systems
are being deployed or are expected to be deployed in the near future by
providers such as AT&T Wireless, Cingular, Sprint, Verizon and Voice Stream.
These wireless services tend to have equal or slower speeds than DSL and are
generally more expensive to deploy.

We also may face competition from satellite-based systems. StarBand
Communications Inc., Hughes Communications (a subsidiary of General Motors
Corporation and provider of DirecTV and DirecPC), EchoStar Communications
Corporation, Globalstar, Lockheed, Teledesic and others have either deployed or
are planning to deploy satellite networks to provide broadband voice and data
services. Such services could offer a competitive alternative to our DSL
services and these providers may be able to sell services in areas where our
DSL network does not currently reach.

From time to time, our competitors have used the difficulties faced by
competitive telecom companies to attempt to dissuade potential customers from
purchasing our services. These efforts may continue in the near future, which
may lead to reduced demand for our services and higher disconnection rates.

Interconnection Agreements with Traditional Telephone Companies

A critical aspect of our business is our interconnection agreements with
the traditional telephone companies. These agreements cover a number of aspects
including:



| |  |  | the price we pay to lease access (both for stand-alone lines and
line-shared lines) to the traditional telephone companys telephone
lines; 
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the special conditioning the traditional telephone company provides
on certain of these lines to enable the transmission of digital signals;
|
| |  |  | the price and terms of central office space for our equipment in the
traditional telephone companys central offices;                       
|
| |  |  | the price we pay and access we have to the traditional telephone
companys voice and data transport facilities;                             

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| |  |  | the interfaces that we can use to place orders, report network
problems and monitor the traditional telephone companys response to our
requests;                              
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the dispute resolution process we use to resolve disagreements; and                                                                                                            
|
| |  |  | the term of the interconnection agreement, its transferability to
successors, its liability limits and other general aspects of the
traditional telephone company relationship.

We have entered into interconnection agreements with or otherwise obtained
interconnection rights from the different major traditional telephone companies
in all the states covering our metropolitan statistical areas. Traditional
telephone companies often do not agree to our requested provisions in
interconnection agreements. When we cannot agree, the 1996 Telecommunications
Act provides for arbitration of interconnection agreement terms before state
commissions. We have not consistently prevailed in obtaining all of our
desired provisions in such agreements.

Many of our interconnection agreements have a term of three years. A party
can request renegotiation of these agreements prior to the agreements
expiration date if there is a change in law. It is possible that one or more
of the telephone companies will claim that the Triennial Review order is a
change in law that gives them the right to renegotiate these agreements and
remove those provisions that allow us to purchase line-sharing. We will also
have to renew these agreements when they expire. Although we expect to renew
the interconnection agreements that require renewal and believe the 1996
Telecommunications Act limits the ability of traditional telephone
companies not to renew such agreements, we may not succeed in extending or
renegotiating our interconnection agreements on favorable terms. Additionally,
disputes have arisen and will likely arise in the future as a result of
differences in interpretations of the interconnection agreements. In the past,
these disputes have delayed our deployment of our network. Such disputes have
also adversely affected our service to our customers and our ability to enter
into additional interconnection agreements with the traditional telephone
companies in other states. Finally, the interconnection agreements are subject
to state commission, FCC and judicial oversight. These government authorities
may modify the terms of the interconnection agreements in a way that hurts our
business.

Government Regulation

Overview.Our services are subject to a variety of federal regulations.
With respect to certain activities and for certain purposes, we have submitted
our operations to the jurisdiction of state and local authorities who may also
assert more extensive jurisdiction over our facilities and services. The FCC
has jurisdiction over all of our services and facilities to the extent that we
provide interstate and international services. To the extent we provide
identifiable intrastate services, our services and facilities are subject to
state regulations. Rates for the services and network elements we purchase from
the traditional local telephone companies are, in many cases, determined by the
states, consistent with federal law. In addition, local municipal governments
assert jurisdiction over our facilities and operations. The jurisdictional
reach of the various federal, state and local authorities is uncertain because
it is subject to ongoing controversy and judicial review.

Federal Regulation.We must comply with the requirements of the
Communications Act of 1934, as amended by the 1996 Telecommunications Act, as
well as the FCCs regulations under the statute. The 1996 Telecommunications
Act eliminates many of the pre-existing legal barriers to competition in the
telecommunications and video programming communications businesses, preempts
many of the state barriers to local telecommunications service competition that
previously existed in state and local laws and regulations and sets basic
standards for relationships between telecommunications providers. The law
delegates to the FCC and the states broad regulatory and administrative
authority to implement the 1996 Telecommunications Act.

Among other things, the 1996 Telecommunications Act removes barriers to
entry in the local telecommunications market. It also requires that traditional
telephone companies provide nondiscriminatory access and interconnection to
potential competitors. Regulations promulgated by the FCC under the 1996
Telecommunications Act specify in greater detail the requirements imposed on
the traditional telephone companies to open their networks to competition by
providing competitors interconnection, central office and remote terminal
space, access to unbundled network elements, retail services at wholesale rates
and nondiscriminatory access to

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telephone poles, ducts, conduits and rights-of-way. The requirements allow
companies like us to interconnect with the traditional telephone companies in
order to provide local telephone exchange services and to offer our TeleSpeed,
TeleSurfer and TeleXtend services.

As discussed above in Recent Developments, the FCCs recently announced
decision in the Triennial Review is a significant regulatory development for
our business.

In February 2002, the FCC opened an inquiry into how its existing
regulations impact the retail deployment of broadband services by the nations
phone companies. Although we do not believe that the outcome of this proceeding
should impair our ability to purchase unbundled network elements, we anticipate
that phone companies may argue that it does advance such an argument. While we
do not believe such an argument should prevail, we cannot provide any assurance
at this point.

Aside from rulemaking proceedings, other actions by the FCC impact our
business. The 1996 Telecommunications Act also allows the Regional Bell
Operating Companies or RBOCs (now BellSouth, Verizon, SBC and Qwest) to
provide interLATA long distance services in their own local service regions
upon a showing that the RBOC makes its own facilities available for
interconnection and access to companies like us in accordance with the Act.
Where appropriate, we are active in the RBOC long distance entry process before
the state commissions, the FCC and the Department of Justice, all of which have
a role in ensuring that the RBOC provides access and interconnection as
required by the Act. The FCC has approved thirty-five RBOC applications to
date. There are several other RBOC applications for long distance authority
currently pending at the FCC, and more filings are anticipated in the immediate
future. Given the FCCs grant of numerous applications, the FCC is likely to
thereafter grant similar applications by RBOCs in other states. We have opposed
such applications where we believe we have not received access and
interconnection as required by the Act. We expect that grants of long-distance
authority to RBOCs will reduce the level of cooperation we receive from each of
the RBOCs.

In addition, the 1996 Telecommunications Act provides relief from the
earnings restrictions and price controls that have governed the local telephone
business for many years. Since passage of the 1996 Act, traditional telephone
company tariff filings at the FCC, including filings for DSL services, have
been subjected to increasingly less regulatory review. In particular, without
substantive review of the cost support for traditional telephone company DSL
services, rates for those services may be below cost and may facilitate price
squeezes, predatory pricing or other exclusionary strategies by traditional
telephone companies that harm our business. In addition, the FCC is considering
whether it should eliminate regulations that apply to the traditional telephone
companies provision of services that are competitive with ours. We expect that
any regulatory freedom granted to the traditional telephone companies will
increase the competition we face from the traditional telephone companies
services. In December 2001, the FCC sought comments on whether it should treat
the DSL retail services of traditional telephone companies as non-dominant
services. If the FCC declares such services non-dominant, the FCC might
eliminate the tariff filings for DSL services, including the requirement that
the telephone companies provide cost support for their pricing determinations.
The elimination of the tariffing and cost imputation requirements would
facilitate telephone company price squeezes and similar predatory conduct,
which could raise the prices we pay for crucial inputs to our business.
Although the FCC has not publicly signaled its intent in this proceeding, the
chance that the FCC will lift some or all of these safeguards is a risk to our
ability to secure timely access to network elements at a sustainable price.

Further, the 1996 Telecommunications Act provides the FCC with the
authority to forbear from regulating entities such as us who are classified as
non-dominant carriers. The FCC has exercised its forbearance authority. As a
result, we are not obligated to obtain prior approval from the FCC for our
interstate services or file tariffs for such services. We have generally
determined not to file tariffs for our interstate services. We provide our
interstate services to our customers on the basis of contracts rather than
tariffs. We believe that it is unlikely that the FCC will require us to file
tariffs for our interstate services in the future. We are, however, required to
submit to certain obligations that attach to all telecommunications carriers.
For example, we are required to make quarterly payments into the federal
universal service fund (FUSF). The FUSF is a federal fund to support various
programs that ensure the availability of telecommunications services to, for
example, schools, libraries, hospitals, and in high-cost regions of the
country. We are required to pay a percentage of our interstate and
international telecommunications revenue to the FUSF, and we generally pass
that percentage through to our customers pursuant to FCC rules. The amount we
are required to pay into the FUSF varies depending on the breakdown between,
for example, our

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telecommunications revenue and non-telecommunications (such as equipment
sales and installation services) revenue. In addition, we are not required to
pay into the FUSF for any information services revenue. The FCC has a
proceeding underway to reexamine its FUSF contribution rules, and the FCC and
its FUSF collection agent periodically change the rules related to those
contributions, including the percentage and time period of interstate
telecommunications revenue that a carrier must contribute to the FUSF. To the
extent those rules are changed, or interpretation of those rules results in an
increase in the FUSF contributions that we must make, we may be subject to
increased liability for payments beyond what we have already contributed.

State Regulation.To the extent we provide identifiable intrastate
services or have otherwise submitted ourselves to the jurisdiction of the
relevant state telecommunications regulatory commissions, we are subject to
state jurisdiction. In addition, certain states have required prior state
certification as a prerequisite for processing and deciding an arbitration
petition for interconnection under the 1996 Telecommunications Act. We are
authorized to operate as a competitive local exchange carrier in all of our
targeted metropolitan statistical areas. We file tariffs in certain states for
intrastate services as required by state law or regulation. We are also subject
to periodic financial and other reporting requirements of these states with
respect to our intrastate services. Jurisdictional determinations that some or
all of our services are intrastate services could harm our business. In
particular, we could be deemed liable for payments into state universal service
funds, which require telecommunications carriers providing intrastate services
to pay a percentage of their intrastate revenues to support state programs that
ensure universal availability of telecommunications and related services. We do
not believe that the services we offer on an interstate basis are subject to
such state assessments, but a state commission or judicial decision to the
contrary could subject us to liability for such payments.

Each state commission has proceedings to determine the rates, charges and
terms and conditions for collocation and unbundled network elements. Unbundled
network elements are the various portions of a traditional telephone companys
network that a competitive telecommunications company can lease for purposes of
building a facilities-based competitive network, including telephone lines,
central office collocation space, inter-office transport, operational support
systems, local switching and rights of way. The rates in many of our
interconnection agreements are interim rates and will be prospectively, and, in
some cases, retroactively, affected by the permanent rates set by the various
state commissions. We have participated in unbundled network element rate
proceedings in several states in an effort to reduce these rates. If any state
commission decides to increase unbundled network element rates our operating
results would suffer.

Local Government Regulation.We may be required to obtain various
permits and authorizations from municipalities in which we operate our own
facilities. The issue of whether actions of local governments over the
activities of telecommunications carriers, including requiring payment of
franchise fees or other surcharges, pose barriers to entry for competitive
telecommunications companies which may be preempted by the FCC is the subject
of litigation. Although we rely primarily on the unbundled network elements of
the traditional telephone companies, in certain instances we deploy our own
facilities and, therefore, may need to obtain certain municipal permits or
other authorizations. The actions of municipal governments in imposing
conditions on the grant of permits or other authorizations or their failure to
act in granting such permits or other authorizations could harm our business.

The foregoing does not purport to describe all present and proposed
federal, state and local regulations and legislation affecting the
telecommunications industry. Other existing federal regulations are currently
the subject of judicial proceedings, legislative hearings and administrative
proposals which could change, in varying degrees, the manner in which
communications companies operate in the United States. In particular, in the
107th Congress the United States House of Representatives approved H.R. 1542,
principally sponsored by Congressmen Tauzin (R-LA) and Dingell (D-MI). This
bill contained several provisions that, if enacted into law, would have posed
an obstacle to the expansion of our business. Specifically, H.R. 1542 would
have permitted the Bell Operating Companies to enter the long distance data
market without first satisfying the market-opening provisions of the 1996 Act,
including the obligations to provide nondiscriminatory access to unbundled
network elements. In addition, the proposed legislation would have eliminated
the legal requirement that telephone companies provide access to local lines
that consist of a combination of fiber and copper, rather than just copper. If
our ability to lease such lines were eliminated, it would severely impact our
addressable market and our ability to compete effectively with the telephone
companies retail DSL offerings. The 107th Congress adjourned in 2002 without
any Senate action on the bill, and at this time no similar bill has been
introduced in the 108th Congress. The traditional telephone companies have
also proposed similar legislation in several state legislatures and some states
legislatures have approved these

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proposals. It would be reasonable to expect that the phone companies will
introduce additional state and/or federal legislation that, if enacted into
law, would adversely affect our business.

The ultimate outcome of these proceedings and the ultimate impact of the
1996 Telecommunications Act or any final regulations adopted pursuant to the
1996 Telecommunications Act on our business cannot be determined at this time
but may well be adverse to our interests. We cannot predict the impact, if any,
that future regulation or regulatory changes may have on our business and we
can give you no assurance that such future regulation or regulatory changes
will not harm our business. See Part I. Item 1. BusinessRisk FactorsOur
services are subject to government regulation, and changes in current or future
laws or regulations could adversely affect our business and Part I. Item 1.
BusinessRisk FactorsChallenges in obtaining space for our equipment on
premises owned by the traditional local telephone companies harms our
business.

Intellectual Property

We regard certain aspects of our products, services and technology as
proprietary and attempt to protect them with patents, copyrights, trademarks,
trade secret laws, restrictions on disclosure and other methods. These methods
may not be sufficient to protect our technology. We also generally enter into
confidentiality or license agreements with our employees and consultants, and
generally control access to and distribution of our documentation and other
proprietary information. Despite these precautions, it may be possible for a
third party to copy or otherwise obtain and use our products, services or
technology without authorization, or to develop similar technology
independently.

Currently we have six patents granted and a number of patent applications
pending. We intend to seek additional patent protection for our systems and
services to the extent possible. These patents may not be issued to us. Even if
they are issued, they may not protect our intellectual property from
competition. Competitors may design around or seek to invalidate these
patents.

Further, effective patent, copyright, trademark and trade secret
protection may be unavailable or limited in certain foreign countries. The
global nature of the Internet makes it virtually impossible to control the
ultimate destination of our proprietary information. Steps taken by us may not
prevent misappropriation or infringement of our technology. Litigation may be
necessary in the future to enforce our intellectual property rights to protect
our trade secrets or to determine the validity and scope of the proprietary
rights of others. Such litigation could result in substantial costs and
diversion of resources. In addition, others may sue us alleging infringement of
their intellectual property rights.

A manufacturer of telecommunications hardware named COVID has filed an
opposition to our trademark application for the mark COVAD and design. Covid
has also filed a complaint in the United States District Court for the District
of Arizona, alleging claims for false designation of origin, infringement and
unfair competition. Covid is also seeking to cancel our trademark registration
for the Covad name. We do not believe that this lawsuit, or the opposition to
our trademark application and granted trademark, has merit. However, these
legal proceedings are unpredictable and there is no guarantee we will prevail.
If we do not succeed, it could limit our ability to provide our services under
the COVAD name.

Employees

As of December 31, 2002, we had approximately 1,300 employees. None of our
employees are represented by a labor union, and we consider our relations with
our employees to be good. Our ability to achieve our financial and operational
objectives depends in large part upon the continued service of our senior
management and key technical, sales, marketing, legal and managerial personnel,
and our continuing ability to attract and retain highly qualified technical,
sales, marketing, legal and managerial personnel. Competition for such
qualified personnel is intense, particularly in software development, network
engineering and product management. In addition, in the event that our
employees unionize, we could incur higher ongoing labor costs and disruptions
in our operations in the event of a strike or other work stoppage.

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Risk Factors

Our services are subject to government regulation, and changes in current or
future laws or regulations and the methods of enforcing the law and
regulations could adversely affect our business

Our services are subject to federal, state and local government
regulations. In particular, we are dependent on certain provisions of the 1996
Telecommunications Act to procure certain facilities and services from the
traditional telephone companies that are necessary for us to provide our
services. As a result, our business is highly dependent on rules and rulings
from the FCC, legislative actions at both the state and federal level, and
rulings from state public utility commissions.

In February 2003, the FCC announced that it would be adopting new rules
that could adversely affect our business. While the FCC has not issued a final
Order codifying the proposed changes, the FCCs announcement in the Triennial
Review creates several risks to our business:



| |  |  | The FCC announced that it is phasing out its rule requiring
line-sharing as an unbundled network element over a three-year period.
This means that, unless we reach agreements with the local telephone
companies that provide us with continued access to line-sharing, we
will be required to purchase a separate telephone line in order to
provide services to an end-user. The cost of a separate phone line is
significantly higher than the cost of a shared line. If we are unable
obtain reasonable rates from the traditional telephone companies for
line-sharing, we may be forced to stop selling stand-alone consumer
grade services, which would slow the growth of our revenue and force us
to significantly change our business plan.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The FCC also announced that we would not be allowed access to
packet-based functions of hybrid fiber and copper networks to provision
DSL services. This means that, unless we reach an agreement with the
local telephone companies, we will be unable to provide packet-based
services to end-users if any portion of their voice service is
delivered over a fiber line. This is significant for our business
because it preserves a substantial limit on the addressable market for
our services and limits our potential growth.                                                                                                                                                                                                                 

For further information about the regulatory, legislative and court
challenges we face, please see Part I Item 1. Business-Government Regulation.

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

Traditional telephone companies provide the unbundled DSL-capable
telephone lines that connect each end-user to our equipment located in the
central offices. The 1996 Telecommunications Act generally requires that
charges for these unbundled network elements be cost-based and
nondiscriminatory. The nonrecurring and recurring monthly charges for
DSL-capable lines (telephone wires) that we require vary greatly. These rates
are subject to negotiations between us and the traditional telephone companies
and to the approval of the state regulatory commissions. The rate approval
processes for DSL-capable lines and other unbundled network elements typically
involve a lengthy review of the rates proposed by the traditional telephone
companies in each state. These rate approval proceedings are time-consuming and
expensive. Consequently, we are subject to the risk that the non-recurring and
recurring charges for DSL-capable lines and other unbundled network elements
will increase based on higher rates proposed by the traditional telephone
companies and approved by state regulatory commissions from time to time, which
would increase our operating expenses.

The impact of judicial and regulatory decisions on the prices we pay to
the traditional telephone companies for collocation and unbundled network
elements is highly uncertain. There is a risk that any new prices set by the
regulators could be materially higher than current prices. In addition, the
FCC indicated at the Triennial Review that line-sharing will be phased out over
the next three years. If we are required to pay higher prices to the local
telephone companies for collocation and network components, it could materially
increase our operating expenses.

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Our business will suffer if our interconnection agreements are not renewed or
if they are modified on unfavorable terms

We are required to enter into and implement interconnection agreements in
each of our targeted metropolitan statistical areas with the appropriate
traditional telephone companies in order to provide service in those regions.
Many of our existing interconnection agreements have a maximum term of three
years. Therefore, we will have to renegotiate these agreements with the
traditional telephone companies when they expire. We may not succeed in
extending or renegotiating them on favorable terms or at all.

As the FCC modifies, changes and implements rules related to unbundling
and collocation, we generally have to renegotiate our interconnection
agreements to implement those new or modified rules. For example, it is likely
that we will have to renegotiate our interconnection agreements to reflect the
changes made by the FCC in the Triennial Review. We may be unable to
renegotiate these agreements in a timely manner, or we may be forced to
arbitrate and litigate with the traditional telephone companies in order to
obtain agreement terms that fully comply with FCC rules.

Additionally, disputes have arisen and will continue to arise in the
future as a result of differences in interpretations of the interconnection
agreements. These disputes have delayed the deployment of our network, and
resolution of the litigated matters will require ongoing expenditures and
management time. In addition, the interconnection agreements are subject to
state commission, FCC and judicial oversight. These government authorities may
modify the terms of the interconnection agreements in a way that reduces our
access to, or increases the cost of, the network components that we purchase
from the traditional telephone companies.

We may need to raise additional capital under difficult financial market
conditions in order to maintain our operations

We believe our current cash, cash equivalents, and short-term investments
should be sufficient to meet our anticipated cash needs for working capital and
capital expenditures until we become cash flow positive. We have a business
plan that we believe will take us to the point where our operations will yield
a positive cash flow without raising additional capital. This business plan is
based upon several assumptions, including growth of our subscriber base with a
reasonable per subscriber profit margin and improvements in productivity. If
actual events differ from these assumptions, we may be required to alter our
business plan to reflect these changes. We will continue to monitor events to
determine if such adjustments to our business plan are appropriate. The FCCs
impending order in the Triennial Review may impact our cash flow from
operations and the manner in which we progress towards cash flow sufficiency.
In particular, our ability to continue to sell stand-alone consumer-grade
services will likely depend on our ability to negotiate with the telephone
companies fair and reasonable prices for line-sharing that are substantially
lower than the cost of a separate telephone line. If we cannot reach
reasonable terms with the phone companies, we would be unable to sell
stand-alone consumer-grade services. In that event we would be required to, and
we believe we can, adjust our business plan so that we can still reach cash
flow sufficiency without raising additional capital. However, in this event
our growth could be impaired because of our reduced access to the consumer
market.

In addition to the Triennial Review announcement, we are currently facing
a variety of challenges that may affect the assumptions contained in our
business plan, including, among others:



| |  |  | customer disconnection rates that reduce our revenues;                                                                                                
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | our ability to maintain pricing levels of our services;                                                                                               
|
| |  |  | the level of marketing dollars required to acquire and retain both
CSP and CBS end-users and to attain a competitive position in each
region we enter;
|
| |  |  | our need to invest in engineering and development and intellectual
property with respect to existing and future technology;                           
|
| |  |  | investment opportunities in complementary businesses, acquisitions or other opportunities;                                                            

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| |  |  | the possibility of an adverse resolution of the lawsuits against us; and
| | - |  | ------------------------------------------------------------------------
|
| |  |  | the additional risk factors
mentioned throughout this section.          

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, especially
under the current capital market conditions. If we are unable to acquire
additional capital or are required to raise it on terms that are less
satisfactory than we desire, it will have a material adverse effect on our
financial condition which could require a sale or liquidation of our company.

As of December 31, 2002, we had approximately $66.5 million of total
indebtedness (including capital lease obligations and the future minimum
payments under our operating leases). If we were unable to generate sufficient
cash flow or are otherwise unable to obtain funds necessary to meet required
payments of principal and interest on our indebtedness, we would be in default
under the terms of the agreements governing such indebtedness. In that case,
SBC Communications could elect to declare all of the funds borrowed to be due
and payable together with accrued and unpaid interest. In the event of any
distribution or payment of our assets in any foreclosure, dissolution,
winding-up, liquidation or reorganization, SBC Communications will have a
secured claim to our assets, prior to the satisfaction of any unsecured claim
from such assets. As a result, holders of our equity will only be entitled to
payment from the remaining assets, if any, after payment of, or provision for,
all indebtedness.

In order to become cash flow positive and to achieve profitability, we must
add end-users to our network while minimizing the cost to expand our network
infrastructure.

Our current strategy is to significantly increase the number of end-users
on our network within our existing metropolitan statistical areas. To
accomplish this strategy, we must, among other things:



| |  |  | market to and acquire a substantial number of end-users;                                                                                                                                                                                                                                                                                                          
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | enter into agreements with the traditional telephone companies that
provide us with access to line-sharing on terms and conditions that
allow us to profitably sell our consumer services;                                                                                                                                                                        
|
| |  |  | expand our direct sales capability and infrastructure in a
cost-effective manner; and                                                                                                                                                                                                                                                                             
|
| |  |  | continue to implement and improve our operational, financial and
management information systems, including our client ordering,
provisioning, dispatch, trouble ticketing and other operational systems,
as well as our billing, accounts receivable and payable tracking,
collection, fixed assets, transaction-based tax and other financial
management systems.

If we are unable to add a significant number of new end-users to our
network, while controlling network infrastructure costs and costs of end-user
acquisition, we may not become cash flow positive.

Our growth has placed, and will continue to place, significant demands on
our management and operations. We expect to implement system upgrades, new
software releases and other enhancements which could cause disruption and
dislocation in our business. If we are successful in implementing our marketing
strategy, we may have difficulty responding to demand for our services and
technical support in a timely manner and in accordance with our customers
expectations. We expect these demands to require the addition of new management
personnel and the increased outsourcing of Covad functions to third parties. We
may be unable to do this successfully, in which case we could experience a
reduction in the growth of our orders and therefore our revenues.

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If we do not reduce our end-user disconnection rate our revenue and end-user
growth will decline.

We experience high disconnection or churn rates. Our high end-user
disconnection rate continues to impair the growth we need to cover the cost of
maintaining our network. These disconnections have occurred as a result of
several factors, including:



| |  |  | the need to disconnect end-users
who move to a new location;                                           
| | - |  | -------------------------------------------------------------------------------------------------------
|
| |  |  | our need to disconnect end-users served by resellers that are not paying for our services;             
|
| |  |  | end-users who disconnect because of better offers in the market; and                                   
|
| |  |  | end-users who disconnect because they do not like our service or the service provided by our resellers.

While we
are working to address problems with the end user experience,
many of these factors are beyond our control. As a result, we may see
additional increases in our disconnection rates even if we improve on the
customer experience.

In addition, since our promotions and rebates that we offer to our
resellers and end-users are based on an assumption that a given end-user will
maintain our service for a period of time, if our disconnection rate increases
for more recently added end-users, we may not recoup the money we spend on
these promotions and rebates.

We may experience decreasing margins on the sale of our services, which may
impair our ability to achieve profitability or positive cash flow

Prices for our services have steadily decreased since we first began
operations. We may continue to experience an overall price decrease for our
services due to competition, volume-based pricing, an increase in the
proportion of our revenues generated by our consumer services and other
factors. Currently, we charge higher prices for some of our services than some
of our competitors do for their similar services. As a result, we cannot assure
you that our customers will select our services over those of our competitors.
In addition, prices for digital communications services in general have fallen
historically, and we expect this trend to continue.

Our consumer-grade services have lower prices and significantly lower
profit margins than our business-grade services. In recent months, the number
of orders that we have received for consumer-grade services have been greater
than the number of orders we have received for business-grade services.
Subject to the terms and impact of the FCCs Triennial Review order, we expect
that the percentage of our revenues which we derive from our consumer services
will continue to increase and will likely reduce our overall profit margins. We
also may need to reduce prices periodically in the future to respond to
competition and to generate increased sales volume. In addition, the FCCs
Triennial Review order may increase the cost of obtaining and maintaining a
line-shared loop from the incumbent local exchange carrier. If our costs for
obtaining such network elements increase, we may need to raise our
prices for
line-shared services, or we may need to exit the consumer portion of our
business. As a result of these factors, we cannot predict whether demand for
our services will exist at prices that enable us to achieve profitability or
positive cash flow.

Our internal controls need to be improved

In the course of preparing our financial statements for the year ended
December 31, 2000, internal control weaknesses were discovered, some of which
continued into 2001 and 2002. During 2001 and 2002, we have taken corrective
action, including the hiring of key personnel, the use of outside consultants,
and documenting key policies and procedures that we believe improved our
internal controls. We are continuing our efforts to improve such controls. For
example, in connection with its audit of our 2002 financial statements, our
independent auditors identified a reportable condition and had other comments
regarding our controls and procedures in its management letter. We have
reviewed these and similar matters and have modified our controls and
procedures to address them. However, these procedures and modifications are
relatively new and may still need to be improved. Our growth continues to
stress these internal controls, and we cannot assure you that our current
control procedures will be adequate. See Item 14, Controls and Procedures for
further discussion.

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We depend on a limited number of customers for the preponderance of our
revenues, and we are highly dependent on sales through our resellers

We primarily market our Internet access services through Internet service
providers, telecommunications carriers and other customers for resale to their
business and consumer end-users. Our agreements with our resellers are
generally non-exclusive, and many of our customers also resell services offered
by our competitors. Also, our agreements with our resellers generally do not
contain purchase commitments. In addition, a limited number of resellers
account for a significant portion of our revenues. Our top 30 resellers
accounted for 79.5% of our net revenue for the year ended December 31, 2002. As a
result, if we were to lose one or more of our key resellers or if one or more
of our key resellers stopped providing us with orders or removed end-users from
our network, our revenue and line-growth would be materially adversely
affected. We expect that our reseller customers will account for the majority
of our future market penetration and revenue growth.

Some of our resellers are facing financial difficulties, which makes it more
difficult to predict our revenues.

During 2002, several of our reseller customers, including XO
Communications, Genuity and WorldCom, were facing financial difficulties,
including bankruptcy. If a customer cannot provide us with reasonable
assurance of payment, then we only recognize revenue when we collect
cash for
our services, assuming all other criteria for revenue recognition have been
met, and only after we have collected all previous accounts receivable
balances. As of December 31, 2002, the percentage of our lines that remain in
service with customers for which we only recognize revenue when the customer
pays for our services was 2.6%, excluding lines that are in the process of
being disconnected. Although we will continue to try to obtain payments from
these customers, it is unlikely that we will obtain payment in full from one or
more of these customers.

With respect to resellers that are in bankruptcy proceedings, we may not
be able to collect sums owed to us by these customers and we may be required to
refund pre-petition amounts paid to us for the 90 days prior to the bankruptcy
filing. In addition, we would not know what consequence a bankruptcy
proceeding would have on the end-user lines that such reseller has on our
network. Such uncertainty makes it difficult for us to predict current and
future revenues for such resellers.

We expect that some additional resellers will face financial difficulties
in the future, which means that we may not receive payments from these
resellers. As a result, we may need to terminate our contracts with some of
these resellers, and we may have to disconnect end-users that are purchasing
our services from such delinquent resellers. Such disconnected end-users may
not purchase our services from us or from another one of our other resellers.
Even if we are able to transition these end-users to another reseller or to
Covad.net, such migrations will require a significant amount of our resources
and may cause disruptions in our processes and operations, which may impair our
ability to timely install new lines from other resellers or from CBS.

Our development of CBS poses operational challenges and may cause our
resellers to place fewer orders with us or may cause us to lose resellers

Sales of services directly to end-user customers through CBS are becoming
a larger portion of our business strategy, and we intend to increase our direct
sales efforts significantly in 2003. This will require significant management
and operational resources and may cause disruption to our business. It is also
uncertain whether we will be able to profitably expand our direct sales
capability.

In light of the expansion of CBS, some of our existing resellers may
perceive us as a potential or actual competitor instead of as a supplier. As a
result, these resellers may reduce the volume or the rate of growth of the
sales of our services, or may cease to resell our services entirely.

The markets in which we operate are highly competitive, and we may not be able
to compete effectively, especially against established industry competitors
with significantly greater financial resources

The markets in which we compete for business and consumer Internet access
and remote network access are intensely competitive. We expect that these
markets will become increasingly competitive in the future. In addition,

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the traditional telephone companies dominate the current market and have a
monopoly on telephone lines. We pose a competitive risk to the traditional
telephone companies and, as both our competitors and our suppliers, they have
the ability and the motivation to harm our business. We also face competition
from cable modem service providers, competitive telecommunications companies,
traditional and new national long distance carriers, Internet service
providers, on-line service providers and wireless and satellite service
providers. Many of these competitors have longer operating histories, greater
name recognition, better strategic relationships and significantly greater
financial, technical or marketing resources than we do. As a result, these
competitors:



| |  |  | may be able to develop and adopt new or emerging technologies and
respond to changes in customer requirements or devote greater resources
to the development, promotion and sale of their products and services
more effectively than we can;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | may form new alliances and rapidly acquire significant market share;
and                                                                                                                                                                     
|
| |  |  | may be able to undertake more extensive marketing campaigns, adopt
more aggressive pricing policies and devote substantially more resources
to developing high-speed digital services.                                                       

The intense competition from our competitors, including the traditional
telephone companies, the cable modem service providers and the competitive
telecommunications companies could harm our business.

The traditional telephone companies represent the dominant competition in
all of our target service areas, and we expect this competition to intensify.
These competitors have an established brand name and reputation for high
quality in their service areas, possess sufficient capital to deploy DSL
equipment rapidly, have their own telephone lines and can bundle digital data
services with their existing analog voice services to achieve economies of
scale in serving customers. Certain of the traditional telephone companies are
aggressively pricing their DSL services as low as $34.95 per month, placing
pricing pressure on our services. If we are unable to reach agreements with
the traditional telephone companies that provide us with access to line-sharing
at reasonable rates, we will be unable to price our consumer services at a
price that is competitive with the traditional telephone companies. Further,
they can offer service to end-users from certain central offices and remote
terminals from which we are unable to offer service. In addition,
consolidations involving the traditional telephone companies may further the
traditional telephone companies efforts to compete with us since the combined
entities will benefit from the resources of the traditional telephone company.

Cable modem service providers, such as Cox Communications, and their
respective cable company customers, are deploying high-speed Internet access
services over coaxial cable networks. Where deployed, these networks provide
similar, and in some cases, higher-speed Internet access and RLAN access than
we provide. They also offer these services at lower price points than our
TeleSurfer services. As a result, competition with the cable modem service
providers may have a significant negative effect on our ability to secure
customers and may create downward pressure on the prices we can charge for our
services.

The broadband communications industry is undergoing rapid technological
changes, and new technologies may be superior to the technology we use

The broadband communications industry is subject to rapid and significant
technological change, including continuing developments in DSL technology and
alternative technologies for providing broadband communications, such as cable
modem, satellite and wireless technology. As a consequence:



| |  |  | we will rely on third parties, including some of our competitors and
potential competitors, to develop and provide us with access to
communications and networking technology;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | our success will depend on our ability to anticipate or adapt to new
technology on a timely basis; and                                                                        
|
| |  |  | we expect that new products and technologies will emerge that may be
superior to, or may not be compatible with, our products and
technologies.                               

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If we fail to adapt successfully to technological changes or fail to
obtain access to important technologies, our business will suffer.

A system failure could delay or interrupt service to our customers, which
could reduce demand for our services

Our operations depend upon our ability to support our highly complex
network infrastructure and avoid damage from fires, earthquakes, terrorist
attacks, floods, power losses, excessive sustained or peak user demand,
telecommunications failures, network software flaws, transmission cable cuts
and similar events. In connection with our cost-cutting efforts, we also closed
our second network operations center in Virginia. The occurrence of a natural
disaster or other unanticipated problem at our network operations center or any
of our regional data centers could cause interruptions in our services.
Additionally, failure of a traditional telephone company or other service
provider to provide communications capacity as a result of a natural disaster,
operational disruption, labor dispute or any other reason could cause
interruptions in our services. We have previously had difficulties obtaining
service from the traditional telephone companies due to their labor disputes.
Any damage or failure that interrupts our operations could harm our business.

A breach of network security could delay or interrupt service to our
customers, which could reduce demand for our services

Our network may be vulnerable to unauthorized access, computer viruses,
worms and Trojan horses and other disruptions. Internet service provider,
telecommunications carrier and corporate networks have in the past experienced,
and may in the future experience, interruptions in service as a result of
accidental or intentional actions of Internet users, current and former
employees and others. Unauthorized access could also potentially jeopardize
the security of confidential information stored in our computer systems, our
end-users and our resellers end-users. This might result in liability to us
and also might deter potential customers from purchasing or reselling our
services. We continue to implement security measures and develop additional
security measures. We have not yet developed and implemented many of these
security measures, and we may not implement such measures in a timely manner.
Moreover, these measures, if and when implemented, may be circumvented, and
eliminating computer viruses and alleviating other security problems may
require interruptions, delays or cessation of service to our end-users and our
resellers end-users, which could harm our business.

If we are not able to electronically interface with the traditional phone
companies to order services, our costs will increase

To date, we have electronically linked our own ordering systems to the
ordering and provisioning systems of our traditional telephone company
suppliers for most of the components we purchase. Such electronic linkage is
essential for us to successfully place a large volume of orders for access to
telephone lines. We may not be able to successfully link our systems to those
of all of the traditional telephone companies on whom we rely for access to
their telephone lines. Even if we have such electronic links, we may not be
able to process all of our orders through such electronic links, which would
require additional human intervention. Our failure to electronically link our
systems with the major traditional telephone companies would severely harm our
ability to provide our services in large volume to our customers.

Our success depends on our retention of certain key personnel, our ability to
hire additional key personnel and the maintenance of good labor relations

We depend on the performance of our executive officers and key employees.
In particular, our senior management has significant experience in the data
communications, telecommunications and personal computer industries, and the
loss of any of them could negatively affect our ability to execute our business
strategy. Additionally, we do not have key person life insurance policies on
any of our employees.

Our future success also depends on our continuing ability to identify,
hire, train and retain other highly qualified technical, operations, sales,
marketing, financial, legal, human resource, and managerial personnel as we add
end-users to our network. Despite the down turn in the economy, competition
for qualified personnel is intense. The significant drop in our stock price
has greatly reduced or eliminated the value of stock options held by our
employees, making it more difficult to retain employees in a competitive
market. In addition, in the event that our

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employees unionize, we could incur higher ongoing labor costs and
disruptions in our operations in the event of a strike or other work stoppage.

We depend on a limited number of third parties for equipment supply, service
and installation

We rely on outside parties to manufacture our network equipment and
provide certain network services. These services and equipment include:



| |  |  | digital subscriber line access multiplexers;            
| | - |  | --------------------------------------------------------
|
| |  |  | customer premises equipment modems, routers and bridges;
|
| |  |  | network routing and switching hardware;                 
|
| |  |  | customer support;                                       
|
| |  |  | network management software;                            
|
| |  |  | systems management software;                            
|
| |  |  | database management software;                           
|
| |  |  | collocation space; and                                  
|
| |  |  | Internet connectivity and Internet protocol services.   

We have in the past experienced supply problems with certain of our
vendors. These vendors may not be able to meet our needs in a satisfactory and
timely manner in the future, which may cause us to lose revenue. In addition,
we may not be able to obtain additional vendors when needed.

Our reliance on third-party vendors involves additional risks, including:



| |  |  | the possibility that some manufacturers will leave the DSL equipment
business because of the financial uncertainties facing many DSL
companies;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the absence of guaranteed capacity; and                                                                                                        
|
| |  |  | reduced control over delivery schedules, quality assurance, production yields and costs.                                                       

Any of these events could have a material adverse impact on our business
and operating results.

Our business is difficult to evaluate because we have a limited operating
history

We were incorporated in October 1996 and introduced our services
commercially in the San Francisco Bay Area in December 1997. Because of our
limited operating history, we have limited operating and financial data upon
which to evaluate our business. We, in essence, have the risks of an early
stage company in a new and rapidly evolving market. To overcome these risks,
we must:



| |  |  | negotiate reasonable prices with the traditional telephone companies
that provide us with access to line-sharing;                        
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | attract and retain end-users in an economical manner;                                                                                    
|
| |  |  | preserve and, if possible, expand our rights with respect to the
network components we purchase from the traditional telephone companies;

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| |  |  | maintain and expand our
relationships with our key resellers;
| | - |  | -------------------------------------------------------------
|
| |  |  | expand CBS; and                                              
|
| |  |  | deliver additional value added services to our customers.    

We have made and may make acquisitions of complementary technologies or
businesses in the future, which may disrupt our business and be dilutive to
our existing stockholders

We intend to consider acquisitions of businesses and technologies in the
future on an opportunistic basis. Acquisitions of businesses and technologies
involve numerous risks, including the diversion of management attention,
difficulties in assimilating the acquired operations, loss of key employees
from the acquired company, and difficulties in transitioning key customer
relationships. In addition, these acquisitions may result in dilutive
issuances of equity securities, the incurrence of additional debt and large
one-time expenditures. Any such acquisition may not provide the benefits
originally anticipated, and there may be difficulty in integrating the service
offerings and networks gained through acquisitions and strategic investments
with our own. In a strategic investment where we acquire a minority interest
in a company, we may lack control over the operations and strategy of the
business, and we cannot guarantee that such lack of control will not interfere
with the integration of services and distribution channels of the business with
our own. Although we attempt to minimize the risk of unexpected liabilities
and contingencies associated with acquired businesses through planning,
investigation and negotiation, such unexpected liabilities nevertheless may
accompany such strategic investments and acquisitions.

The unpredictability of our revenues, along with other factors, may cause the
price of our common stock to fluctuate and could cause it to decline.

The market price for our common stock has been and is likely to continue
to be highly volatile. We believe that a number of factors contribute to this
fluctuation, and may cause our stock price to decline in the future. While it
is not possible to foresee all of the events that could adversely affect the
price of our common stock or cause such price to remain volatile, a few of the
factors include:



| |  |  | the content of the FCCs order in the Triennial Review and other
state and federal regulatory and legislative actions;                                                                                                      
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | general economic conditions and the condition of the
telecommunications industry;                                                                                                                                           
|
| |  |  | our ability to maintain existing customers and add new customers and
recognize revenue from distressed resellers;                                                                                                           
|
| |  |  | our ability to reach profitability and cash flow positive operations;                                                                                                                                                       
|
| |  |  | adverse litigation results;                                                                                                                                                                                                 
|
| |  |  | announcements of new products, services or pricing by our competitors
or the emergence of new competing technologies;                                                                                                       
|
| |  |  | our failure to meet the expectations of investors or of analysts;                                                                                                                                                           
|
| |  |  | the adoption of new, or changes in existing, accounting rules,
guidelines and practices, which may materially impact our financial
statements and may materially alter the expectations of securities
analysts or investors;
|
| |  |  | the level of demand for broadband internet access services; and                                                                                                                                                             
|
| |  |  | departures of key personnel.                                                                                                                                                                                                

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In addition, we were delisted from the Nasdaq National Market on July 20, 2001
and our common stock currently trades on Nasdaqs OTC Bulletin Board. This
contributes to our volatility and may affect the liquidity of our common stock.

Future sales or issuances of our common stock may depress our stock price

Sales of a substantial number of shares of our common stock in the public
market, or the appearance that such shares are available for sale, could
adversely affect the market price for our common stock. As of March 17, 2003,
we had 223,511,240 shares of common stock outstanding. As of January 1, 2003,
we also had 15,957,768 shares of our common stock reserved for issuance
pursuant to options under our 1997 Stock Plan. As of January 1, 2003, we had
25,675,014 shares that are subject to outstanding options issued pursuant to
our 1997 Stock Plan and the stock option plans we assumed in connection with
our acquisitions of BlueStar and Laser Link.net. We have also reserved
approximately 6,450,827 shares of common stock for issuance under our 1998
Employee Stock Purchase Plan as of January 1, 2003. Shares underlying vested
options and shares sold to employees through the 1998 Employee Stock Purchase
Plan are generally eligible for immediate resale in the public market.

Pursuant to the Memorandum of Understanding (MOU) we signed with the
plaintiffs in the securities class action in the United States District Court
for the Northern District of California, we will distribute 6,495,844 shares to
the class action plaintiffs and their attorneys (see Part I. Item 3. Legal
Proceedings for a more detailed discussion of this matter). On December 18,
2002, the District Court issued its final judgment and dismissal order in this
matter. However, one class member has filed an appeal pertaining to the final
judgment. This appeal only relates to the allocation of the settlement
proceeds between the plaintiffs and their attorneys. When these shares are
distributed to these individuals, which we anticipate will happen later this
year, they will be eligible for immediate resale in the public markets.

We sold 9,373,169 shares of our common stock to SBC Communications, Inc.
SBC agreed to offer us the first opportunity to purchase shares that it intends
to sell. Sales of such shares by SBC could adversely affect the price of our
stock.

In September 2002, we granted three warrants to a reseller, AOL. These
warrants provide AOL with the right to purchase 1,500,000 shares of our common
stock for $1.06 per share, 1,000,000 shares of our common stock for $3.00 per
share and 1,000,000 shares of our common stock for $5.00 per share. These
warrants have a seven-year term and are immediately exercisable, fully vested
and non-forfeitable at the time of grant. In January 2003, we granted three
warrants to another reseller, AT&T. These warrants provide AT&T with the right
to purchase 1,000,000 shares of our common stock for $0.94 per share, 1,000,000
shares of our common stock for $3.00 per share and 1,000,000 shares of our
common stock for $5.00 per share. These warrants have a seven-year term and
are immediately exercisable, fully vested and non-forfeitable at the time of
grant. Both the AOL and AT&T warrants include registration rights. Purchases
of our common stock pursuant to these warrants, and subsequent resale of our
common stock by AOL and AT&T could cause the price of our stock to decline. In
the future, we may issue additional warrants to other resellers.

We may issue additional shares of capital stock, or warrants or other
convertible securities in connection with future financings, which, given our
current stock price, will have a dilutive effect on existing stockholders and
may adversely affect our stock price.

Anti-takeover effects of certain charter and bylaw provisions, Delaware law,
our indebtedness, our Stockholder Protection Rights Plan and our change in
control severance arrangements could prevent a change in our control, which
could inhibit your ability to receive a premium for your shares.

Our Board of Directors has the authority to issue up to 5,000,000 shares
of preferred stock and to determine the price, rights, preferences, privileges
and restrictions, including voting rights, of those shares without any further
vote or action by the stockholders. The issuance of preferred stock, while
providing desirable flexibility in connection with possible acquisitions and
other corporate purposes, could have the effect of making it more difficult for
a third party to acquire a majority of our outstanding voting stock. In
addition, our charter and bylaws provide for a number of other measures that
may make it more difficult for a third party to acquire a majority of our
outstanding voting stock, including: a classified board of directors,
limitations on the ability of stockholders to call special meetings and

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act by written consent, the lack of cumulative voting for directors and
procedures for advance notification of stockholder nominations and proposals.
These provisions, as well as Section 203 of the Delaware General Corporation
Law to which we are subject, could discourage potential acquisition proposals,
could delay or prevent a change of control and may prevent changes in our Board
of Directors and management. As a result, these measures may inhibit your
ability to receive a premium for your shares.

Our agreements with SBC Communications provide that, in the event of
certain changes in control, SBC could require us to repay its $50 million loan
and the unused portion of its $75 million prepayment. In addition, our
Stockholder Protection Rights Plan contains provisions that make a hostile
takeover prohibitively expensive and, in effect, requires interested acquirers
to cooperate with the Board of Directors prior to acquiring more than 15% of
our capital stock. The SBC agreements and the Stockholder Protection Plan may
discourage takeover attempts, which would otherwise result in a premium to our
stockholders.

We must comply with federal, state and local tax and other surcharges on our
service, the levels of which are uncertain

Telecommunications providers pay a variety of surcharges and fees on their
gross revenues from interstate services and intrastate services. Interstate
surcharges include Federal Universal Service Fees and Common Carrier Regulatory
Fees. In addition, state regulators impose similar surcharges and fees on
intrastate services and the interpretation of these surcharges and fees is
uncertain in many cases. The division of our services between interstate
services and intrastate services is a matter of interpretation and may in the
future be contested by the FCC or state authorities. The FCC is currently
considering the jurisdictional nature of Internet service provider-bound
traffic. A change in the characterization of their jurisdictions could cause
our payment obligations, pursuant to the relevant surcharges, to increase. In
addition, periodic revisions by state and federal regulators of the applicable
surcharges may increase the surcharges and fees we currently pay. Also, a
determination of the jurisdictional nature of our DSL services may require us
to commit additional resources to regulatory compliance, such as tariff
filings. In addition, we may be required to pay certain state taxes, including
sales taxes, depending on the jurisdictional treatment of the services we
offer. The amount of those taxes could be significant depending on the extent
to which the various states choose to tax our services.

The
Federal government and many states apply transaction-based taxes to
(i) sales of our products and
services and (ii) purchases of telecommunications circuits from
various carriers. We are in discussions with Federal and state tax authorities regarding the
extent of our transaction-based tax liabilities. It is reasonably possible
that our estimates of our transaction-based tax liabilities could materially
change in the near term. We may or may not be able to recover some of those taxes from
our customers.

We are a party to litigation and adverse results of such litigation matters
could negatively impact our financial condition and results of operations

On June 11, 2001, Verizon Communications filed a lawsuit against us in the
United States District Court for the Northern District of California. Verizon
is a supplier of telephone lines that we use to provide services to our
customers. Verizons amended complaint claims that we falsified trouble ticket
reports with respect to the phone lines that we ordered and seeks unspecified
monetary damages (characterized as being in the millions) and injunctive
relief. The current complaint asserts causes of action for negligent and
intentional misrepresentation and violations of Californias unfair competition
statute. On November 13, 2002, the District Court entered summary judgment in
our favor and dismissed Verizons claims against us in their entirety. It is
unclear whether Verizon will appeal this dismissal. We believe we have strong
defenses to this lawsuit, but litigation is inherently unpredictable and there
is no guarantee we will prevail.

In addition, we are a defendant in other litigation described in Part I,
Item 3. Legal Proceedings. While we are vigorously defending these lawsuits,
the total outcome of these litigation matters is inherently unpredictable, and
there is no guarantee we will prevail. Adverse results in any of these actions
could negatively impact our financial condition and results of operations and,
in some circumstances, result in a material adverse effect on us. In addition,
defending such actions could result in substantial costs and diversion of
resources that could adversely affect our financial condition, results of
operations and cash flows.

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Our intellectual property protection may be inadequate to protect our
proprietary rights

We regard certain aspects of our products, services and technology as
proprietary. We attempt to protect them with patents, copyrights, trademarks,
trade secret laws, restrictions on disclosure and other methods. These methods
may not be sufficient to protect our technology. We also generally enter into
confidentiality or license agreements with our employees and consultants, and
generally control access to and distribution of our documentation and other
proprietary information. Despite these precautions, it may be possible for a
third party to copy or otherwise obtain and use our products, services or
technology without authorization, or to develop similar technology
independently.

Currently, we have been issued six patents and we have a number of
additional patent applications pending. We intend to prepare additional
applications and to seek patent protection for our systems and services. These
patents may not be issued to us. If issued, they may not protect our
intellectual property from competition. Competitors could design around or seek
to invalidate these patents.

Effective patent, copyright, trademark and trade secret protection may be
unavailable or limited in certain foreign countries. The global nature of the
Internet makes it virtually impossible to control the ultimate destination of
our proprietary information. The steps that we have taken may not prevent
misappropriation or infringement of our technology. Litigation may be necessary
in the future to enforce our intellectual property rights, to protect our trade
secrets or to determine the validity and scope of the proprietary rights of
others. Such litigation could result in substantial costs and diversion of
resources and could harm our business.




ITEM 2. PROPERTIES

We are headquartered in Santa Clara, California in a facility under lease
that will expire on March 31, 2004. We also lease office space in many of the
metropolitan statistical areas in which we conduct operations. In June 2002, we
completed the sale of our property (consisting of land, a building and certain
improvements) in Manassas, Virginia, and recognized a gain of $133,000 which
represents the net proceeds of $13,334,000 less the aggregate carrying value of
$13,201,000.

We have completed the process of consolidating our office space in Santa
Clara as well as our office spaces in Denver and Virginia. In connection with
our restructuring, we closed a facility in Alpharetta, Georgia. We also lease
central office space from the traditional telephone company in each region that
we operate or plan to operate under the terms of our interconnection agreements
and obligations imposed by state public utilities commissions and the FCC. The
productive use of our central office space is subject to the terms of our
interconnection agreements. We will increase our central office space if we
choose to expand our network geographically.




ITEM 3. LEGAL PROCEEDINGS

(All dollar amounts are presented in thousands)

On December 13, 2001, the United States Bankruptcy Court for the District
of Delaware (the Bankruptcy Court) entered an order confirming our
pre-negotiated First Amended Plan of Reorganization, as modified on November
26, 2001 (the Plan). On December 20, 2001 (the Effective Date), the Plan
was consummated and we emerged from bankruptcy. Under our Plan, we settled
several claims against us. These claims include:



| |  |  | The class action lawsuits filed in the United States District Court
for the Northern District of California, provided that this settlement
will not be final unless it is approved by that court. This settlement
is described in more detail below.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The lawsuits filed in the Superior Court of the State of California
for the County of Santa Clara by six purchasers of the convertible notes
that we issued in September 2000.                                                                      
|
| |  |  | Disputed claims made by former shareholders of Laser Link.net.                                                                                                                                                                                      
|
| |  |  | Disputed claims made by GE Capital and its subsidiary, Heller Financial Group.                                                                                                                                                                      

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As of December 31, 2002, there were approximately $8,344 in unresolved
claims related to our Chapter 11 bankruptcy proceedings. As of December 31,
2002, we have recorded $7,381 for these unresolved claims in our condensed
consolidated balance sheet. However, it is reasonably possible that our
unresolved Chapter 11 bankruptcy claims could ultimately be settled for amounts
that differ from the amounts recorded in our condensed consolidated balance
sheet.

Purchasers of our common stock and purchasers of the convertible notes we
issued in September 2000 have filed complaints on behalf of themselves and
alleged classes of stockholders and holders of convertible notes against us and
certain of our present and former officers and directors. These complaints were
filed in the United States District Court for the Northern District of
California (District Court) in the fourth quarter of 2000. The complaints
have been consolidated and the lead plaintiff has filed its amended
consolidated complaint. The amended consolidated complaint alleges violations
of federal securities laws on behalf of persons who purchased or otherwise
acquired our securities, including common stock and notes, during the period
from April 19, 2000 to May 24, 2001. The relief sought includes monetary
damages and equitable relief. We and the officer and director defendants
entered into a Memorandum of Understanding (MOU) with counsel for the lead
plaintiffs in this litigation that tentatively resolves the litigation. The MOU
sets forth the terms upon which we, the officer and director defendants and the
plaintiffs agree to settle the litigation. Pursuant to the MOU, the plaintiffs
agreed to support and vote in favor of our bankruptcy plan if it provided for
the distribution of $16,500 in cash to be funded by our insurance carriers and
6,495,844 shares of our common stock. The plaintiffs voted in favor of the
Plan. The settlement provided for in the MOU 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 has filed an appeal pertaining
to the final judgment, but this appeal only relates to the allocation of the
settlement proceeds between the plaintiffs and their attorneys.

In April 1999, we filed a lawsuit against Bell Atlantic (now Verizon) and
its affiliates in the United States District Court for the District of
Columbia. We are pursuing antitrust and other claims in this lawsuit arising
out of Verizons conduct as a supplier of network facilities, including central
office space, transmission facilities and telephone lines. In December 2000, we
also filed a lawsuit against BellSouth Telecommunications and its subsidiaries
in the United States District Court for the Northern District of Georgia. We
are pursuing claims in this lawsuit that are similar to our claims against
Verizon. Both courts dismissed some of our claims based on the ruling of the
Seventh Circuit in Goldwasser v. Ameritech. The court in the Verizon case also
dismissed our remaining claims on other grounds. We voluntarily dismissed our
remaining claims in the BellSouth case so we could pursue certain issues on
appeal. We have appealed these decisions to the United States Court of Appeals
for the Eleventh Circuit and the United States Court of Appeals for the
District of Columbia. On August 2, 2002, the Eleventh Circuit Court of Appeals
reversed the lower courts decision in the BellSouth case and remanded the case
for further proceedings. BellSouth has requested a rehearing before the
Eleventh Circuit. On or about December 20, 2002, the Eleventh Circuit denied
BellSouths request for a rehearing. The matter was subsequently remanded to
the District Court, where it remains pending. In addition, the United States
Supreme Court has agreed to review a decision from the United States Court of
Appeals for the Second Circuit entitled Verizon Communications v. Law Offices
of Curtis Trinko, which rejected the Goldwasser decision. The Eleventh Circuit
relied in part on the Trinko decision when it reversed the lower courts
dismissal of our claims against BellSouth. We cannot predict the outcome of
these matters.

On June 11, 2001, Verizon Communications filed a lawsuit against us in the
United States District Court for the Northern District of California. Verizon
is a supplier of telephone lines that we use to provide services to our
customers. In its amended complaint, Verizon claims that we falsified trouble
ticket reports with respect to the phone lines that we ordered and seeks
unspecified monetary damages (characterized as being in the millions) and
injunctive relief. The current complaint asserts causes of action for negligent
and intentional misrepresentation and violations of Californias unfair
competition statute. On November 13, 2002, the District Court entered summary
judgment in favor of the Company and dismissed Verizons claims against the
Company in their entirety. Verizon has appealed the dismissal of its lawsuit.
We believe we have strong defenses to this lawsuit, but litigation is
inherently unpredictable and there is no guarantee we will prevail.

Several stockholders have filed complaints in the United States District
Court for the Southern District of New York, on behalf of themselves and
purported classes of stockholders, against us and several former and current
officers and directors in addition to some of the underwriters in our stock
offerings. These lawsuits are so-called IPO

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allocation cases, challenging practices allegedly used by certain
underwriters of public equity offerings during the late 1990s and 2000. On
April 19, 2002 the plaintiffs amended their complaint and removed us as a
defendant. Certain directors and officers are still named in the complaint. The
plaintiffs claim that we failed to disclose the arrangements that some of these
underwriters purportedly made with certain investors. We believe we have strong
defenses to these lawsuits and we intend to contest them vigorously. However,
because these lawsuits are at an early stage, we are unable to provide an
evaluation of the ultimate outcome of the litigation.

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

In June 2002, Dhruv Khanna was relieved of his duties as our General
Counsel and Secretary. Shortly thereafter, Mr. Khanna alleged that, over a
period of years, certain current and former directors and officers had breached
their fiduciary duties to the Company by engaging in or approving actions that
constituted waste and self-dealing, that certain current and former
directors and officers had provided false representations to our auditors and
that he had been relieved of his duties in retaliation for his being a
purported whistleblower and because of racial or national origin
discrimination. He has threatened to file a shareholder derivative action
against those current and former directors and officers, as well as a wrongful
termination lawsuit. Mr. Khanna was placed on paid leave while his allegations
were being investigated.

Our Board of Directors appointed a special investigative committee, which
initially consisted of Mr. Crandall and Ms. Runtagh, to investigate the
allegations made by Mr. Khanna. Mr. Jalkut was appointed to this committee
shortly after he joined our Board of Directors. This committee retained an
independent law firm to assist in its investigation. Based on this
investigation, the committee concluded that Mr. Khannas allegations were
without merit and that it would not be in the best interests of the Company to
commence litigation based on these allegations. The committee considered,
among other things, that many of Mr. Khannas allegations were not accurate,
that certain allegations challenged business decisions lawfully made by
management or the Board, that the transactions challenged by Mr. Khanna in
which any director had an interest were approved by a majority of disinterested
directors in accordance with Delaware law, that the challenged director and
officer representations to the auditors were true and accurate, and that Mr. Khanna was not
relieved of his duties as a result of retaliation for alleged whistleblowing or
racial or national origin discrimination. Mr. Khanna has disputed the
committees work and the outcome of its investigation.

After the committees findings had been presented and analyzed, 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. While the Company believes the contentions of
Mr. Khanna referred to above are without
merit, and will be vigorously defended if brought, it is unable to predict the
outcome of any potential lawsuit.

We are also a party to a variety of pending or threatened legal
proceedings as either plaintiff or defendant, or are engaged in business
disputes that arise in the ordinary course of business. Failure to resolve
these various legal disputes and controversies without excessive delay and cost
and in a manner that is favorable to us could significantly harm our business.
We do not believe the ultimate outcome of these matters will have a material
impact on our consolidated financial position and results of operations.
However, litigation is inherently unpredictable and there is no guarantee we
will prevail or otherwise not be adversely affected.

We are subject to state public utility commission, FCC and other court
decisions as they relate to the interpretation and implementation of the 1996
Telecommunications Act, the interpretation of competitive telecommunications
company interconnection agreements in general, and our interconnection
agreements in

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particular. In some cases we may be bound by or may otherwise be
significantly impacted by the results of ongoing proceedings of these bodies or
the legal outcomes of other contested interconnection agreements that are
similar to our agreements. The results of any of these proceedings could harm
our business.

In addition, we are engaged in a variety of legal proceedings with several
traditional telephone companies. These proceedings concern the traditional
telephone companies denial of central office space to use in central offices,
the cost and delivery of transmission facilities and telephone lines and
central office spaces, billing issues and other operational issues. Other than
the payment of legal fees and expenses, which are not quantifiable but are
expected to be material, we do not believe that these matters will result in
material liability to us and the potential gains are not quantifiable at this
time. An unfavorable result in any of these proceedings, however, could have a
material adverse effect on our consolidated financial position and results of
operations if we are denied or charged higher rates for transmission lines or
central office spaces.




ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

During the quarter ended December 31, 2002, we did not submit any matters
to the vote of our security holders.

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PART II




ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Market Price Information and Dividend Policy for Our Common Stock

Our common stock traded on the Nasdaq National Market under the symbol
COVD from January 22, 1999, the date of our initial public offering, to July
20, 2001. On July 20, 2001, our common stock was delisted from the NASDAQ
National Market. Since July 20, 2001, our common stock has traded on Nasdaqs
OTC Bulletin Board. Prior to January 22, 1999, there was no public market for
our common stock. The following table sets forth, for the periods indicated,
the high and low closing sales prices for our common stock as reported by the
Nasdaq National Market. These prices have been adjusted to account for stock
splits in May 1999 and April 2000.

|                                     |  |      |      |     |  |   |      | 
|------------------------------------ |  | ---- | ---- | --- |  | - | ---- | 
|                                     |  | High |      | Low
|                                     |  |      |      |    
|Fiscal Year Ending December 31, 2001 |  |      |      |     |  |   |      | 
|First Quarter                        |  | $    | 4.72 |     |  | $ | 1.16 | 
|Second Quarter                       |  | $    | 1.52 |     |  | $ | 0.66 | 
|Third Quarter                        |  | $    | 0.91 |     |  | $ | 0.35 | 
|Fourth Quarter                       |  | $    | 3.07 |     |  | $ | 0.35 | 
|Fiscal Year Ending December 31, 2002 |  |      |      |     |  |   |      | 
|First Quarter                        |  | $    | 2.98 |     |  | $ | 1.32 | 
|Second Quarter                       |  | $    | 2.31 |     |  | $ | 1.08 | 
|Third Quarter                        |  | $    | 1.72 |     |  | $ | 0.88 | 
|Fourth Quarter                       |  | $    | 1.57 |     |  | $ | 0.93 | 

On December 30, 2002, the last reported sale price for our common stock on
the OTC Bulletin Board was $0.96 per share. As of March 17, 2003, there were
1,262 holders of record of our common stock, and there were no holders of
record of our Class B common stock.

We have never declared or paid any dividends on our common stock. We
currently anticipate that we will retain all of our future earnings for use in
the expansion and operation of our business. Thus, we do not anticipate paying
any cash dividends on our common stock in the foreseeable future. Our Board of
Directors will determine our future dividend policy.

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ITEM 6. SELECTED FINANCIAL DATA

|                                                                                                    |                   |   |                                 |          |      |   |                                                  |         |      |   |             |            |   |   |             |          |   |   |            |         |  
|--------------------------------------------------------------------------------------------------- | ----------------- | - | ------------------------------- | -------- | ---- | - | ------------------------------------------------ | ------- | ---- | - | ----------- | ---------- | - | - | ----------- | -------- | - | - | ---------- | ------- | -
|                                                                                                    |                   |   | For the Year Ended December 31,
|                                                                                                    |                   |   |                                
|                                                                                                    |                   |   | 2002                            |          | 2001 |   | 2000                                             |         | 1999 |   | 1998       
|                                                                                                    |                   |   |                                 |          |      |   |                                                  |         |      |   |            
|                                                                                                    |                   |   |                                 |          |      |   | (dollars in thousands, except per share amounts) |         |      |   |            
|Consolidated Statement of
Operations Data:                                                          |                   |   |                                 |          |      |   |                                                  |         |      |   |             |            |   |   |             |          |   |   |            |        
|Revenues, net                                                                                       |                   | $ | 383,496                         |          |      | $ | 332,596                                          |         |      | $ | 158,736     |            |   | $ | 66,488      |          |   | $ | 5,326      |        
|Depreciation and amortization                                                                       |                   |   | 127,088                         |          |      |   | 150,839                                          |         |      |   | 178,425     |            |   |   | 37,602      |          |   |   | 3,406      |        
|Provision for restructuring
expenses                                                                |                   |   |                                |          |      |   | 14,364                                           |         |      |   | 4,988       |            |   |   |            |          |   |   |           |        
|Provision for long-lived
asset impairment                                                           |                   |   |                                |          |      |   | 11,988                                           |         |      |   | 589,388     |            |   |   |            |          |   |   |           |        
|Loss from operations                                                                                |                   |   | (180,992                        | )        |      |   | (536,880                                         | )       |      |   | (1,354,192  | )          |   |   | (171,601    | )        |   |   | (37,682    | )      
|Interest expense                                                                                    |                   |   | (5,581                          | )        |      |   | (92,782                                          | )       |      |   | (109,863    | )          |   |   | (44,472     | )        |   |   | (15,217    | )      
|Reorganization expenses, net                                                                        |                   |   |                                |          |      |   | (62,620                                          | )       |      |   |            |            |   |   |            |          |   |   |           |        
|Loss before extraordinary
item and cumulative effect
of change in accounting
principle              |                   |   | (184,828                        | )        |      |   | (688,969                                         | )       |      |   | (1,433,887  | )          |   |   | (195,397    | )        |   |   | (48,121    | )      
|Extraordinary item                                                                                  |                   |   |                                |          |      |   | 1,033,727                                        |         |      |   |            |            |   |   |            |          |   |   |           |        
|Cumulative effect of change
in accounting
principle                                                 |                   |   |                                |          |      |   |                                                 |         |      |   | (9,249      | )          |   |   |            |          |   |   |           |        
|                                                                                                    |                   |   |                                 |          |      |   |                                                  |         |      |   |             |            |   |   |             |          |   |   |            |        
|Net income (loss)                                                                                   |                   | $ | (184,828                        | )        |      | $ | 344,758                                          |         |      | $ | (1,443,136  | )          |   | $ | (195,397    | )        |   | $ | (48,121    | )      
|Basic and diluted per share
amounts:                                                                |                   |   |                                 |          |      |   |                                                  |         |      |   |             |            |   |   |             |          |   |   |            |        
|Net income (loss) before
extraordinary item and
cumulative effect of change
in accounting principle |                   | $ | (0.84                           | )        |      | $ | (3.89                                            | )       |      | $ | (9.41       | )          |   | $ | (1.83       | )        |   | $ | (3.75      | )      
|Extraordinary item                                                                                  |                   | $ |                                |          |      | $ | 5.83                                             |         |      | $ |            |            |   | $ |            |          |   | $ |           |        
|Cumulative effect of
accounting change                                                              |                   | $ |                                |          |      | $ |                                                 |         |      | $ | (0.06       | )          |   | $ |            |          |   | $ |           |        
|Net income (loss)                                                                                   |                   | $ | (0.84                           | )        |      | $ | 1.94                                             |         |      | $ | (9.47       | )          |   | $ | (1.83       | )        |   | $ | (3.75      | )      
|Weighted average common
shares used in computing
basic and diluted per share
amounts                |                   |   | 219,743,662                     |          |      |   | 177,347,193                                      |         |      |   | 152,358,589 |            |   |   | 107,647,812 |          |   |   | 12,844,203 |        
|Pro forma amounts assuming
the accounting change is
applied retroactively:                          |                   |   |                                 |          |      |   |                                                  |         |      |   |             |            |   |   |             |          |   |   |            |        
|                                                                                                    | Net income (loss) |   | $                               | (184,828 | )    |   | $                                                | 344,758 |      |   | $           | (1,433,887 | ) |   | $           | (204,646 | ) |   | $          | (48,121 | )
|Net income (loss)
attributable to common
Stockholders                                               |                   | $ | (184,828                        | )        |      | $ | 344,758                                          |         |      | $ | (1,433,887  | )          |   | $ | (205,792    | )        |   | $ | (48,121    | )      
|Basic and diluted net income
(loss) per common share                                                |                   | $ | (0.84                           | )        |      | $ | 1.94                                             |         |      | $ | (9.41       | )          |   | $ | (1.91       | )        |   | $ | (3.75      | )      

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|                                                  |  |                                           |            |      |  |      |            |      |  |      |            |   |  |   |            |  |  |   |           |  
|------------------------------------------------- |  | ----------------------------------------- | ---------- | ---- |  | ---- | ---------- | ---- |  | ---- | ---------- | - |  | - | ---------- |  |  | - | --------- | -
|                                                  |  | As of December 31,                       
|                                                  |  |                                          
|                                                  |  | 2002                                      |            | 2001 |  | 2000 |            | 1999 |  | 1998
|                                                  |  |                                           |            |      |  |      |            |      |  |     
|Consolidated Balance Sheet
Data:                  |  |                                           |            |      |  |      |            |      |  |      |            |   |  |   |            |  |  |   |           |  
|Cash, cash equivalents and
short-term investments |  | $                                         | 204,567    |      |  | $    | 283,863    |      |  | $    | 869,834    |   |  | $ | 767,357    |  |  | $ | 64,450    |  
|Net property and equipment                        |  |                                           | 108,737    |      |  |      | 215,804    |      |  |      | 338,409    |   |  |   | 186,059    |  |  |   | 59,145    |  
|Total assets                                      |  |                                           | 442,161    |      |  |      | 675,168    |      |  |      | 1,511,485  |   |  |   | 1,147,606  |  |  |   | 139,419   |  
|Long-term obligations,
including current portion  |  |                                           | 50,165     |      |  |      | 50,011     |      |  |      | 1,374,673  |   |  |   | 375,050    |  |  |   | 142,879   |  
|Total stockholders equity
(deficit)              |  |                                           | 82,299     |      |  |      | 259,829    |      |  |      | (182,663   | ) |  |   | 690,291    |  |  |   | (24,706   | )
|                                                 
|                                                  |  | As of and for the Year Ended December 31,
|                                                  |  |                                          
|                                                  |  | 2002                                      |            | 2001 |  | 2000 |            | 1999 |  | 1998
|                                                  |  |                                           |            |      |  |      |            |      |  |     
|Other Operating and
Financial Data:               |  |                                           |            |      |  |      |            |      |  |      |            |   |  |   |            |  |  |   |           |  
|Homes and businesses passed                       |  |                                           | 46,000,000 |      |  |      | 40,000,000 |      |  |      | 40,000,000 |   |  |   | 29,000,000 |  |  |   | 6,000,000 |  
|Lines installed                                   |  |                                           | 381,000    |      |  |      | 351,000    |      |  |      | 274,000    |   |  |   | 57,000     |  |  |   | 4,000     |  
|Capital expenditures for
property and equipment   |  | $                                         | 22,782     |      |  | $    | 15,732     |      |  | $    | 319,234    |   |  | $ | 174,054    |  |  | $ | 41,177    |  

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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 consolidated financial
statements and the related notes thereto included elsewhere in this Annual
Report on Form 10-K. 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 and elsewhere in this Annual Report on Form 10-K. We
disclaim any obligation to update information contained in any forward-looking
statement. See  Forward Looking Statements.

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

Overview

We are a leading provider of high-speed Internet connectivity and related
communications services, which we sell to businesses and consumers indirectly
through Internet service providers (ISP), 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 website. Our services include a range of high-speed, high-capacity, or
broadband, Internet access connectivity and related services using digital
subscriber line (DSL), T-1, Virtual Private Network (VPN) and firewall
technologies.

We have a relatively short operating history. We introduced our services
commercially in the San Francisco Bay Area in December 1997. As of December 31,
2002, we believe we have one of the largest nationally deployed DSL networks
based on approximately 1,800 operational central offices that pass more than 46
million homes and businesses in the United States. As of December 31, 2002, we
had approximately 381,000 high-speed Internet access lines in service using DSL
technology (approximately 2.6% of these lines are associated with wholesale
customers for which we recognize revenue when cash for services rendered is
received due to their financial condition, primarily concentrated among two
such customers). We also provide dial-up Internet access service to over 49,000
customers through our direct sales channel. We are also developing a variety of
services that are enhanced or enabled by our high-speed network.

Since our inception, we have generated significant net and operating
losses and we continue to experience negative operating cash flow. As of
December 31, 2002, we had an accumulated deficit of $1,529,336. We expect
losses and negative cash flow to continue at least into 2004. Although we
currently have a plan in place that we believe will ultimately allow us to
achieve positive cash flows from our operating activities without raising
additional capital, our cash reserves are limited and our plan is based on
assumptions, some of which are out of our control. If actual events differ from
our assumptions, we may need to raise additional capital on terms that are less
favorable than we desire, which may have a material adverse effect on our
financial condition and could cause significant dilution to our stockholders.
The inability to raise additional capital could also result in a liquidation or
sale of our company.

In the course of preparing our financial statements for the year ended
December 31, 2000, internal control weaknesses were discovered, some of which
continued into 2001 and 2002. The improvements we have made over the last
several quarters to our internal policies and procedures and systems
capabilities have significantly improved controls. However, during our
2002 year end financial statement close process, we identified some additional control
weaknesses which are discussed in Part IV Item 14 Controls and
Procedures. Based on controls that have been recently developed and implemented, as
well as other planned enhancements, we do not expect any material adjustments
in subsequent periods related to these control weaknesses.

Recent Developments

On February 20, 2003, the Federal Communications Commission (FCC) issued
a press release announcing the results of its Triennial Review. Based on our
understanding of such press release, the FCCs Triennial Review is a
significant development for us for the following reasons:

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| |  |  | The FCC announced that it is phasing out its rule requiring
line-sharing over a three-year period. Line-sharing currently allows
us to provision services using asymmetric DSL (ADSL) technology over
the same telephone line that the local telephone company is using to
provide voice services. The federal rules requiring line-sharing will
be phased out over a three-year period, during which we will be
required to transition our existing line-sharing customers to new
arrangements. New line-sharing customers may be acquired at regulated
rates only during the first year of the transition. During each year
of the transition, the FCC-mandated maximum price for the
high-frequency portion of the phone line will increase incrementally
towards the cost of a separate phone line. This means that, unless we
reach agreements with the local telephone companies that provide us
with continued access to line-sharing, we will be required to purchase
a separate telephone line in order to provide services to an end-user.
The cost of a separate phone line is significantly higher than the cost
of a shared line. As of December 31, 2002, we had approximately
169,000 subscriber lines using line-sharing agreements.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The FCC also announced that the local telephone companies would not
be required to allow us to access the packet-switching functions of
fiber-fed telephone lines to provision DSL services. This means that,
unless we reach agreements with the local telephone companies, we will
be unable to provide our most commonly-used services to end-users
served by fiber-fed lines. This is significant for our business
because it preserves a substantial limit on the addressable market for
our services, thereby limiting our growth. In addition, the local
telephone companies are increasing their deployment of fiber-fed remote
terminal architectures. We currently have no lines in service using
packet-switching capabilities of fiber-fed telephone lines.                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|
| |  |  | The FCC announced that, if the state public utilities commissions
deem it appropriate, companies that compete with the local telephone
companies would continue to have access to the local telephone
companies networks in order to provide their services under an
arrangement known as the Unbundled Network Element platform (UNE-P). Under this arrangement
these competitive telecommunications companies purchase phone lines in
order to provide voice and data services. The continued existence of
the UNE-P provides us with the opportunity to potentially bundle our
data services with the voice services of these companies.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

The FCC has not yet issued its order in the Triennial Review and it is
uncertain when that order will be released. Without that order, it is
difficult for us to evaluate the full impact of the FCCs decision on our
business. However, based on the FCCs announcement, it appears that at some
point we will be required to purchase a separate telephone line in order to
provide services to an end-user, unless we reach agreements with the local
telephone companies that provide us with continued access to line-sharing. The
cost of a separate phone line is significantly higher than the cost of a shared
line. If we are unable to obtain from the traditional telephone companies
reasonable line-sharing rates substantially below the cost of a separate
telephone line, we may stop selling stand-alone consumer grade services,
which would slow the growth of our revenue and require us to significantly
change our business plan.

On September 23, 2002, we announced that we signed a three-year agreement
with AT&T Corporation (AT&T) that provides it with the ability to purchase
certain of our wholesale consumer-grade broadband Internet access services.
AT&T began placing orders for these services in the fourth quarter of 2002. On
January 1, 2003, we announced that we amended this agreement and granted AT&T
three warrants to purchase an aggregate of 3,000,000 shares of our common stock
at prices ranging from $0.94 to $5.00 per share. Such warrants were immediately
exercisable, fully vested and non-forfeitable at the date of grant.
Accordingly, the measurement date for accounting purposes for the warrants was
the date of grant. The aggregate fair value of such warrants of approximately
$2,640 was recorded as a deferred customer incentive in 2003 and is being
recognized as a reduction of revenues on a straight-line basis over the
three-year term of the agreement because we believe that future revenues from
AT&T will exceed the fair value of the warrants.

Revenue Recognition and Change in Accounting Principle

See Note 2 to our consolidated financial statements for a discussion of
our revenue recognition policy.

During the fourth quarter of 2000, we changed our method of accounting for
up-front fees associated with service activation and the related incremental
direct costs in accordance with SEC Staff Accounting Bulletin
33Table of Contents

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

The cumulative effect of the change in accounting principle resulted in a
charge to operations of $9,249, which is included in net loss for the year
ended December 31, 2000. The effect of the change in accounting principle on
the year ended December 31, 2000 was to increase loss before cumulative effect
of change in accounting principle by $51,550 ($0.33 per share). For the years
ended December 31, 2001 and 2000, we recognized approximately $11,661 and
$18,661, respectively, in revenue that was included in the cumulative effect
adjustment as of January 1, 2000 (none during the year ended December 31,
2002). The effect of that revenue during 2001 and 2000 was to decrease net loss
by $ 3,067 and $4,624, respectively. Although SAB No. 101 substantially alters
the timing of recognition of certain revenues and treatment of certain costs in
our consolidated financial statements, it does not affect our consolidated cash
flows.

Reseller Financial Difficulties

Some of our resellers are experiencing financial difficulties. During
the years ended December 31, 2002, 2001 and 2000, certain of these customers
either (i) were not current in their payments for our services or (ii) 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 (i) the collectibility of revenues from these customers was not
reasonably assured or (ii) 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.
Revenues from financially distressed customers are recognized when cash for
services provided 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 legally defined period prior to their filing of
petitions for bankruptcy protection are recorded in our consolidated balance
sheet caption Unearned revenues if our ability to retain these payments is
not reasonably assured. Although WorldCom, Inc (WorldCom) filed for
bankruptcy protection during the year ended December 31, 2002, we have not
classified it as a financially distressed customer based on WorldCom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 WorldCom on an accrual basis during 2002.

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

Even though we are making progress in reducing the number of financially
distressed customers for which we are not currently recognizing revenue on an
accrual basis, we may be unable to completely restore the remaining lines to
normal revenue producing status and we may encounter future payment problems
with our customers. In addition, in light of the financial position of many of
our resellers, should a particular reseller become subject to
34Table of Contents

reorganization or bankruptcy proceedings, we may be unable to collect
payments owed to us or retain payments or other consideration (including
subscriber lines) already received by us.

Restructuring  and
Reorganization Activities

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

On June 25, 2001, our former subsidiary, BlueStar Communications Group,
Inc. (BlueStar), made an irrevocable assignment for the benefit of its
creditors (ABC) of all its assets to an independent trustee (the Assignee)
in the state of Tennessee. Immediately thereafter, the Assignee began an
orderly liquidation of BlueStar that was initially expected to be completed in
the fourth quarter of 2002. However, the Assignee has informed us that it is
still in the process of resolving some matters among BlueStars creditors and
that the process may extend into the second half of 2003. An ABC under
Tennessee law is a non-judicial alternative to a plan of liquidation under
Chapter 7 of the United States Bankruptcy Code. As a result of the ABC,
BlueStars former assets are no longer controlled by us or BlueStar and cannot
be used by either BlueStars or our board of directors to satisfy the
liabilities of BlueStar. Consequently, the liquidation of BlueStars assets and
the discharging of its liabilities are currently under the sole control of the
Assignee. Therefore, 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. Subsequently, we reduced the deferred gain by $1,228 because certain
BlueStar assets, which inadvertently had not been deconsolidated on June 25,
2001, were identified during the fourth quarter of 2002 and deconsolidated at that time. The deconsolidation of
these assets was charged against the deferred gain during the fourth quarter of
2002, resulting in a deferred gain balance of $53,972 in our consolidated
balance sheet as of December 31, 2002. We will recognize such deferred gain in
our consolidated statement of operations when the liquidation of BlueStar is
complete and its liabilities have been discharged.

During the year ended December 31, 2000, in response to changes in the
economy and the capital markets, we implemented a business plan that helped to
lower our cost structure in an effort to reach profitability earlier than
previously planned. We took the following steps: the BlueStar subsidiary ABC;
elimination of our high yield bond debt through a reorganization under the
Bankruptcy Code; reduction of our workforce by as many as 2,600 employees from
a peak of approximately 4,000 employees in 2000; reduction of the size of our
network
35Table of Contents

through the closing of approximately 200 underproductive or not fully
built-out central offices within the Covad network and approximately 250
central offices related to BlueStar; reevaluating the amount and quantity of
rebates and other incentives that we provide to our customers; consolidation
and/or closing of administrative offices throughout the United States;
enhancement of productivity in our operations to increase customer satisfaction
while reducing costs; streamlining our direct sales and marketing channel and
supplementing it with telephone sales and sales through our Website; and
evaluation and implementation of other cost reduction strategies, including
reductions in travel and facilities expenditures.

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. We recognized revenues of $5,601 and $7,189
related to this customer during the years ended December 31, 2001 and 2000,
respectively (none during the year ended December 31, 2002). Gross accounts
receivable from this customer amounted to $1,375 as of December 31, 2000 (none
at December 31, 2002 or 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. The purchase
price for the assets of InternetConnect was $5,470 in cash. Under the terms of
the asset purchase agreement, we may be required to pay additional cash of up
to $1,880 for the assets of InternetConnect, depending upon the outcome of a
previous post-petition bankruptcy claim filed by us against InternetConnect.
That claim is still unresolved. We did not assume any liabilities or
obligations of InternetConnect or hire any of InternetConnects employees. The
tangible assets purchased from InternetConnect consisted of accounts
receivable, refundable deposits and property and equipment. We also purchased
the right, but not the obligation, to assume InternetConnects customer
contracts. However, we did not exercise this right. Instead, we solicited
approximately 9,250 DSL, T-1, VPN and dial-up customers of InternetConnect, and
approximately 6,200 of these customers executed new contracts with us or our
resellers.

We acquired an equity interest in a supplier during 1999 and disposed of
this interest in 2001. Purchases from this supplier totaled $5,774, $13,928 and
$53,156 for the years ended December 31, 2002, 2001 and 2000, respectively. We
also purchased certain products from a company in which Mr. Marshall serves as
a director. Purchases from this vendor totaled $258 and $140 during the years
ended December 31, 2002 and 2001, respectively (none during the year ended
December 31, 2000).

A member of our Board of Directors, Richard Jalkut, is the President and
CEO of TelePacific, one of our wholesale customers. We recognized revenues of
$1,311, $1,822 and $1,317 from TelePacific during the years ended December 31,
2002, 2001 and 2000, respectively.

Results of Operations

During the year ended December 31, 2002, our business operated in two
distinct segments based upon differences in services and marketing channels
even though the cash flows from these segments were not independent of each
other. Our wholesale division (Wholesale) provided high-speed connectivity
services to ISP, enterprise and telecommunications carrier customers. Our
direct division (Direct) provided Internet access services to individuals,
corporations, small businesses and other organizations. We evaluate performance
of the segments based on segment operating results.

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 (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 year ended December 31, 2002, we recorded
additional (i) depreciation expense of $6,989, (ii) network and product costs
of $2,635, (iii) loss on the disposition of property and equipment of $635 and
(iv) 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
36Table of Contentscompensation was overstated in prior periods by $3,213. Therefore, for
the year ended December 31, 2002, we recorded reductions of (i) network and
products costs of $320 and (ii) 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
(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). The
impact on prior financial reporting periods would have been as follows if these
amounts had been recorded in the correct financial reporting periods: (i) net
income for the year ended December 31, 2001 would have been decreased by $3,433
($0.02 per share) and (ii) net loss for the year ended December 31, 2000 would
have been decreased by $1,139 ($0.01 per share).ReclassificationsCertain balances in the Companys 2001 and 2000 consolidated financial
statements, including certain operating expenses, have been reclassified to
conform to the presentation in 2002.Three Years Ended December 31, 2002Revenues, netWe recorded net revenues of $383,496 for the year ended December 31, 2002,
an increase of $50,900, or 15.3%, over net revenues of $332,596 for the year
ended December 31, 2001. Net revenues increased by $224,760, or 141.6%, over
net revenues of $158,736 for the year ended December 31, 2000. The increases in
net revenues are primarily attributable to growth in the number of subscribers
resulting from our sales and marketing efforts. During the year ended December
31, 2002, we recognized revenues of $1,010 from one of our wholesale partners
that was not the result of services provided by us, but was instead a
result of a shortfall in the wholesale partners contractual revenue commitment
to us. In addition, as a result of the developments in the bankruptcy
proceedings of certain of our wholesale customers, as discussed further below,
we recognized revenues of $4,427 during the year ended December 31, 2002 that
were for services provided prior to January 1, 2002. Although we expect our
subscriber base to grow as we introduce new services and increase our sales and
marketing efforts, our revenue growth may be impaired by lower selling prices
and customer incentives and rebates that we record as reductions of revenues.Included in net revenues are FUSF charges billed to our customers
aggregating $9,229, $13,277 and $10,647 for the years ended December 31, 2002,
2001 and 2000, respectively.We recorded net revenues of $326,659 from our Wholesale channel and
$56,837 from our Direct channel for the year ended December 31, 2002, an
increase of $40,952, or 14.3%, and $9,948, or 21.2%, over net revenues of
$285,707 and $46,889 from our Wholesale and Direct channels, respectively, for
the year ended December 31, 2001. Net revenues for the year ended December 31,
2000 were comprised of $133,535 from our Wholesale channel and $25,201 from our
Direct Channel. Net revenues from our Wholesale channel represented 85.2%,
85.9% and 84.1% of total net revenues for the years ended December 31, 2002,
2001 and 2000, respectively. Net revenues from our Direct Channel represented
14.8%, 14.1% and 15.9% of total net revenues for the years ended December 31,
2002, 2001 and 2000, respectively.We had over 150 wholesale customers as of December 31, 2002 compared to
approximately 150 and 250 as of December 31, 2001 and 2000, respectively. The
decrease in 2001 from 2000 was primarily attributable to industry consolidation
and certain wholesalers having exited the business. For the years ended
December 31, 2002 and 2001, our 30 largest wholesale customers collectively
comprised 93.3% and 88.5% of our total wholesale net revenues, respectively,
and 79.5% and 76.0% of our total net revenues, respectively. As of December 31,
2002 and 2001, receivables from these customers collectively comprised 75.3%
and 79.9%, respectively, of our gross accounts receivable balance.37Table of ContentsFor the
year ended December 31, 2002 and 2001, EarthLink, Inc., one of our
wholesale customers, accounted for 20.0% and 17.5%, respectively, of our total
net revenues. As of December 31, 2002 and 2001, receivables from this customer comprised
25.9% and 26.0%, respectively, of our gross accounts receivable balance. No other individual customer
accounted for more than 10% of our total revenues in 2002, 2001 and 2000.A number of our customers are currently in bankruptcy proceedings.
Revenues from these customers accounted for approximately 5.6%, 7.1% and 8.3%
of our total net revenues for the years ended December 31, 2002, 2001 and 2000,
respectively. As described above, although WorldCom filed for bankruptcy
protection on July 21, 2002, we continued to recognize revenues from WorldCom
on an accrual basis during 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 WorldCom because we have not presently
classified it as a financially distressed customer for revenue recognition
purposes. We continue to attempt to migrate end-users from some financially
distressed customers to the extent it is legally and operationally feasible.During the years ended December 31, 2002, 2001 and 2000, we issued
billings to our financially distressed customers aggregating $42,881, $74,928
and $45,278, respectively, that were not recognized as revenues or accounts
receivable in our consolidated financial statements. However, we ultimately
recognized net revenues from certain of these customers when cash was collected
aggregating $47,609, $29,003 and $2,814 during the years ended December 31,
2002, 2001 and 2000, respectively, some of which relate to services provided in
prior periods. Revenues recognized during the year ended December 31, 2002
include payments totaling $4,427 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, 2002. Consequently, we recognized
these payments as revenues during 2002. No such payments were recognized as
revenues during the years ended December 31, 2001 or 2000. We had contractual
receivables from our financially distressed customers totaling $6,031 as of
December 31, 2002 that are not reflected in our consolidated financial
statements.Some of our customers, including WorldCom, who were essentially current in
their payments for our services prior to December 31, 2002, or have
subsequently paid all or significant portions of the respective amounts that we
recorded as accounts receivable as of December 31, 2002, have a high risk of
becoming financially distressed. Revenues from these customers accounted for
approximately 34.6%, 14.2% and 13.9% of our total net revenues for the years
ended December 31, 2002, 2001 and 2000, respectively. As of December 31, 2002,
receivables from these customers comprised 31.8% 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, 2002, revenue from such customers will be recognized when cash is
collected, as described above.We have obtained persuasive evidence indicating that the financial
condition of one of our wholesale 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, we concluded that collection of our billings to this
customer was now reasonably assured. Therefore, we resumed the recognition of
revenues from this customer on an accrual basis during 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, we
resumed the recognition of revenue on an accrual basis for another wholesale
customer during 2002. However, we did not recognize additional revenue from
services rendered in prior periods because such customer was current in its
payments. No similar amounts were recognized during the other periods reported
in the accompanying consolidated financial statements.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. Accordingly, we maintain an allowance, through
charges to revenues based on our estimate of the ultimate resolution of these
disputes. These charges to revenues amounted to $2,322, $11,178 and $13,838
during the years ended December 31, 2002, 2001 and 2000, respectively.38Table of ContentsDuring the years ended December 31, 2002, 2001 and 2000, we wrote-off
certain accounts receivable balances aggregating $3,748, $6,701 and $13,468,
respectively, against the allowance for customer disputes. During the year
ended December 31, 2002, we recovered $2,145 of accounts
receivable balances previously written-off against such allowance.
There were no similar recoveries of
accounts receivable balances for the years ended December 31,
2001 and 2000.Network and Product CostWe recorded network and product costs of $298,336, $461,875 and $432,153
for the years ended December 31, 2002, 2001 and 2000, respectively. For the
year ended December 31, 2002, network and product costs were 77.8% of revenues,
a significant improvement from the years ended December 31, 2001 and 2000, when
network and product costs were 138.9% and 272.3% of revenues, respectively. The
decrease in network and product costs during the year ended December 31, 2002
is primarily attributable to cost reduction initiatives to lower network costs
related to data transport and a reduction in our workforce within the
operations and engineering groups. In addition, the decrease in network and
product costs during the year ended December 31, 2002 is attributable to the
deconsolidation of our BlueStar subsidiary, which was effective June 25, 2001.
Network and product costs related to BlueStar were none for the year ended
December 31, 2002 as compared to $34,768 for the year ended December 31, 2001.
The increase in network and product costs during the year ended December 31,
2001 is primarily attributable to the expansion of our network. 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 acquisition costs of $3,674 associated with certain
of InternetConnects former customers, as described above. 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. We expect network
and product costs to increase in future periods if we can add subscribers and
services to our network, but to decrease as a percentage of revenue as we
increase revenue and leverage the economies of scale that we expect.As discussed in the Overview  Recent Developments and in Part I, Item
3 Legal Proceedings sections of this document, there is uncertainty concerning
our ability to purchase line-shared services from the traditional telephone
companies as a result of the FCCs decision in its Triennial Review of the
Telecommunications Act of 1996. 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 ExpensesWe recorded sales, marketing, general and administrative expenses of
$150,373, $199,908 and $292,991 for the years ended December 31, 2002, 2001 and
2000, respectively. For the year ended December 31, 2002, sales, marketing,
general and administrative expenses were 39.2% of net revenues, a significant
improvement from the years ended December 31, 2001 and 2000, when these
expenses were 60.1% and 184.6% of net revenues, respectively. Sales, marketing,
general and administrative expenses consist primarily of salaries and related
expenses and our promotional and advertising expenses.The decrease in sales, marketing, general and administrative expenses in
all periods is primarily attributable to a reduction in our workforce and a
reduction in office facilities throughout the United States. For the year ended
December 31, 2002, the decrease in sales, marketing, general and administrative
expenses was offset by an increase of $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
was launched on September 23, 2002. For the year ended December 31, 2001,
advertising expenses decreased by $29,044, which contributed to the overall
decrease in sales, marketing, general and administrative for the year then
ended, as compared to 2000. In addition, the decrease in sales, marketing,
general and administrative expenses for the year ended December 31, 2002, is
attributable to the deconsolidation of our BlueStar subsidiary, which was
effective June 25, 2001. Sales, marketing, general and administrative expenses
related to BlueStar were none 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, as discussed in more detail
above.39Table of ContentsWe expect sales, marketing, general and administrative expense levels to
increase in the near future as we continue our marketing efforts. However, as
discussed in the Overview  Recent Developments and in Part I, Item 3 Legal
Proceedings sections of this document, there is uncertainty concerning our
ability to purchase line-shared services from the traditional telephone
companies as a result of the FCCs decision in its Triennial Review of the
Telecommunications Act of 1996. 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 stand-alone consumer grade services for new and
existing customers. If this occurs, our sales, marketing, general and
administrative expense levels may be curtailed to respond to a new business
structure.Operating ExpensesTotal operating expenses, which include network and product costs, sales,
marketing, general and administrative expenses, provision for bad debts (bad
debt recoveries), depreciation and amortization expenses, restructuring
expenses, impairment of long-lived assets, litigation-related expenses and the
write-off of in-process research and development costs, were $564,488, $869,476
and $1,512,928 for the years ended December 31, 2002, 2001 and 2000,
respectively. These expenses were comprised of $434,560, $630,934 and $705,425,
respectively, from our wholesale channel, $79,795, $93,044 and $48,784,
respectively, from our direct channel and $50,133, $145,498 and $758,719,
respectively, from our corporate operations.Provision for Bad Debts (Bad Debt Recoveries)We recorded net bad debt expenses (recoveries) of $319, $(658) and $11,257
for the years ended December 31, 2002, 2001 and 2000, respectively. Bad debt
expenses (recoveries) were 0.1%, (0.2)%, and 7.1% of net revenues for the years
ended December 31, 2002, 2001 and 2000, respectively. The increase in bad debt
expense from 2001 to 2002 is primarily attributable to pre-petition accounts
receivable balances from WorldCom and certain collection issues in our Direct
segment. The decrease in bad debt expense from 2000 to 2001 is the result of
improved collections in our Wholesale segment.Depreciation and AmortizationDepreciation and amortization of property and equipment was $112,438,
$137,920 and $91,205 for the years ended December 31, 2002, 2001 and 2000,
respectively. The decrease from 2001 to 2002 was due principally to asset
retirements and certain assets becoming fully depreciated during 2002, offset
by additional depreciation expense of $6,989 recognized during 2002, as
discussed in more detail above. The increase from 2000 to 2001 was due to the
addition of equipment and facilities placed in service throughout the years
ended December 31, 2000 and 2001. We expect depreciation and amortization to
decrease in the future because we anticipate that our capital expenditures in
the near term will be less than historical amounts and additional assets will
become fully depreciated. We believe that the geographic footprint of our
network will remain relatively unchanged and that near term capital
expenditures will be mostly limited to adding capacity to our network to
support new users.Amortization of intangible assets for the years ended December 31, 2002,
2001 and 2000 was $14,650, $12,919 and $87,220, respectively. The increase from
2001 to 2002 resulted from the resumption of our network build for selected
markets during 2002, which increased collocation fee expenditures and related
amortization expenses. We do not expect to incur significant capital
expenditures for property and equipment in connection with this expansion. The
decrease in amortization expense from 2000 to 2001 is a result of the
impairment and corresponding write-down of certain intangible assets during the
fourth quarter of 2000, as discussed below.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 increased our loss before
extraordinary item by $14,006, or $0.08 per share, and decreased our net income
by $14,006, or $0.08 per share, in 2001.40Table of ContentsDepreciation and amortization expenses for the years ended December 31,
2002, 2001 and 2000 were comprised of $121,553, $140,827 and $79,421,
respectively, from our wholesale channel and $2,257, $2,393 and $7,770,
respectively, from our direct channel, and $3,278, $7,619 and $91,234,
respectively, from our corporate operations.Provision for Restructuring ExpensesIn the fourth quarter of 2000, we announced our decision to adopt a new
business plan to help lower our cost structure in an effort to reach cash flow
positive earlier than previously planned. These decisions were driven by
changes in the overall economy and the capital markets, and based upon a
comprehensive review of our internal operations. Specific steps that were
taken:
    
    raising revenue by reducing rebates and other incentives that
we provide 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 our network to
approximately 1,700 central offices;
    
    reducing our workforce by 638 employees, which represented
approximately 21% of our workforce;
    
    closing a facility in Alpharetta, Georgia and consolidating
offices in Manassas, Virginia, Santa Clara, CA and Denver, Colorado;
    
    continued downsizing of our international operations and
discontinuing plans to fund additional international expansion while
continuing to manage existing investments;
    
    enhancing productivity in our operations to increase customer satisfaction while reducing costs;
    
    restructuring our 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 our restructuring efforts, we 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, we made further workforce
reductions, and we paid $3,849 in severance benefits, which were charged
against the restructuring liability recorded as of December 31, 2000.We 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, we paid collocation and building lease
termination costs of $12,355, which were charged against the restructuring
liabilities recorded during 2001. No restructuring expenses were recorded
during the year ended December 31, 2002. However, we continue to consider
whether additional restructuring is necessary, and additional charges to
operations related to any further restructuring activities may be incurred by
in future periods. For example, we may take steps to reduce our expenses in
response to the February 20, 2003 announcement from the FCC on its Triennial
Review of the Telecommunication Act of 1996.Provision for Long-Lived Asset ImpairmentDuring the year ended December 31, 2001, we recorded an expense in the
amount of $11,988 for the impairment of certain long-lived assets. In the
fourth quarter of 2001, we determined that certain communication equipment was
obsolete, based on its discontinued use in our network. We also made the
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
the current book value. Accordingly, we recorded a41Table of Contentswrite-down of this property and equipment for $9,999 during the fourth
quarter of 2001. We completed the sale of this property in June 2002. We also
recorded a write-down of goodwill in the amount of $1,989 during 2001
associated with our BlueStar subsidiary.At the end of 2000, various indicators pointed to a possible impairment of
our long-lived assets. These indicators included deterioration in the business
climate for Internet and DSL service companies, the reduced availability of
private or public funding for such businesses, significant declines in the
market values of our competitors in the DSL service industry and changes in our
strategic plans. We performed asset impairment tests by comparing the expected
aggregate undiscounted cash flows to the carrying amounts of the long-lived
assets. Based on the results of these tests, we determined that our long-lived
assets were impaired. With the assistance of independent valuation experts, we
then determined the fair value of our long-lived assets. Fair value was
determined using the discounted cash flow method and the market comparison
method. A write-down of $589,388 was recorded as of the fourth quarter of 2000,
reflecting the amount by which the carrying amount of certain long-lived assets
exceeded their respective fair values. The write-down consisted of $390,600 for
goodwill, $92,400 for other intangible assets and $106,388 for certain property
and equipment. In connection with this write-down, all of the goodwill recorded
as part of the Laser Link and BlueStar acquisitions has been eliminated.Litigation-related ExpensesWe 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
(MOU) 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 for the year ended
December 31, 2000.Write-off of In-process Research & Development CostsDuring the year ended December 31, 2000, we recorded an expense in the
amount of $3,726 for the write-off of in-process research and development
(IPRD) costs that we obtained through the acquisition of Laser Link.net, Inc.
There were no write-offs of IPRD for the years ended December 31, 2002 and
2001.Net Interest ExpenseNet interest expense was $459, $68,189 and $56,962 for the years ended
December 31, 2002, 2001 and 2000, respectively. Net interest expense during the
year ended December 31, 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 years ended December 31, 2001 and
2000 consisted primarily of interest expense on our 13.5% senior discount notes
due 2008 issued in March 1998, our 12.5% senior notes due 2009 issued in
February 1999, our 12% senior notes due 2010, our 6% convertible senior notes
due 2005 and capital lease obligations, less interest income earned on our
cash, cash equivalent and short-term investment balances on hand during the
years. For the year ended December 31, 2001, our contractual interest
obligation on the above-identified 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 is42Table of Contentspayable 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.We expect future net interest expense to be limited to accrued interest on
our 11.0% note payable to SBC offset by interest earned on cash balances. We
may, however, seek additional debt financing in the future if it is available
on terms that we believe are favorable. If we seek additional debt financing,
our interest expense would increase.Reorganization ItemsDuring the year ended December 31, 2001, we recognized expenses directly
associated with our Chapter 11 bankruptcy proceeding in the amount of $63,229.
These reorganization expenses consisted of non-cash adjustments to unamortized
debt issuance costs and discounts and professional fees for legal and financial
advisory services. For the year ended December 31, 2001, we recognized interest
income in the amount of $609 on accumulated cash that we did not disburse as a
result of our Chapter 11 bankruptcy proceeding. This interest income has been
offset against the reorganization expenses in our consolidated statement of
operations for the year ended December 31, 2001.Investment LossesWe 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. We recorded losses and write-downs on
investments for the year ended December 31, 2000 in the amount of $22,391. This
included impairment write-downs of equity investments of $17,826, our equity in
the losses of unconsolidated affiliates of $6,452, the recognition of other
than temporary losses on short-term investments of $11,579 and a net realized
gain on short-term investments of $13,466.Extraordinary ItemGain on the Extinguishment of DebtWe recorded a gain on the 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.Income TaxesWe 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 extraordinary gain resulting from the extinguishment of debt in
2001 (Note 3) due to the relevant tax regulations governing the treatment of
debt extinguishment income in Chapter 11 bankruptcy proceedings. As of December
31, 2002, we had net operating loss carryforwards for federal tax purposes of
approximately $646,421, which will begin to expire in 2021, if not utilized.
The federal operating loss carryforwards have been reduced by approximately
$994,768 as a result of the bankruptcy. We also had aggregate net operating
loss carryforwards for state income tax purposes of approximately $1,164,682,
which begin to expire in 2004, if not utilized. In addition, we had capital
loss carryforwards for federal and state income tax purposes of approximately
$27,008, which will begin to expire in 2006.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 $129,529, $(145,941) and $411,672
during the years ended December 31, 2002, 2001 and 2000, respectively.43Table of ContentsCritical Accounting Policies and EstimatesOur 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. The preparation of our financial statements requires us to
make estimates that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosures of contingent assets and
liabilities. We base our accounting estimates on historical experience and
other factors that are believed to be reasonable under the circumstances.
However, actual results may vary from these estimates under different
assumptions or conditions. 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, which
are more fully described in the referenced notes to our consolidated financial
statements:
    
    As more fully described in Note 2, we recognize revenues when (i)
persuasive evidence of an arrangement between the customer and us
exists, (ii) service has been provided to the customer, (iii) the price
to the customer is fixed or determinable and (iv) 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.
    
    As more fully described in Notes 1 and 2, we have concentrations of
credit risk with several customers, some of which were experiencing
financial difficulties as of December 31, 2002 and 2001 and were not
current in their payments for our services as of those dates.
Accordingly, we recognize revenues from some of these customers in the
period in which cash is collected, but only after the collection of all
previous outstanding accounts receivable balances. We perform ongoing
credit evaluations of our customers financial condition and maintain an
allowance for estimated credit losses. In addition, we have billing
disputes with some of our customers. These disputes arise in the
ordinary course of business in the telecommunications industry and their
impact on our accounts receivable and revenues can be reasonably
estimated based on historical experience. We maintain an allowance,
through charges to revenues, based on our estimate of the ultimate
resolution of these disputes, and our reported revenue in any period
could be different than what is reported if we employed different
assumptions in estimating the outcomes of these disputes.
    
    As more fully described in Note 1, 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.
    
    As more fully described in Notes 3 and 4, 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, 2002, 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, 2002.
    
    As more fully described in Notes 1 and 5, property and equipment and
intangible assets are recorded at cost, subject to adjustments for
impairment. Property and equipment and intangible assets are depreciated
or amortized using the straight-line method over their estimated useful
lives, certain of which were significantly revised in 2001, as more
fully described in Note 1. 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.44Table of Contents
    
    As more fully described in Notes 3, 4 and 10, we are a party to a
variety of legal proceedings, as either plaintiff or defendant, and are
engaged in other disputes that arise in the ordinary course of business.
We are required to assess the likelihood of any adverse judgments or
outcomes to these matters, as well as potential ranges of probable
losses for certain of these matters. The determination of the
liabilities required, if any, for loss contingencies is made after
careful analysis of each individual situation based on the facts and
circumstances. However, it is reasonably possible that the liabilities
reflected in our 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.
    
    As more fully described in Note 10, we are currently analyzing the
applicability of certain transaction-based taxes to (i) sales of our
products and services and (ii) purchases of telecommunications circuits
from various carriers. This analysis includes discussions with
authorities of jurisdictions in which we do business to determine the
extent of our transaction-based tax liabilities. We believe that these
discussions will be concluded without a material adverse effect to our
consolidated financial position and results of operations. However, it
is reasonably possible that our estimates of our transaction-based tax
liabilities could change in the near term, the effects of which could be
material to our consolidated financial position and results of
operations.
    
    As more fully described in Notes 1 and 12, 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.
    
    As more fully described in Notes 1 and 13, 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 PronouncementsIn December 2002, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) number (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, 2002, we have no
immediate plans to adopt the fair value method of accounting for stock-based
employee compensation.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
45Table of Contentscircumstances. We will prospectively adopt EITF Issue No. 00-21 on July 1,
2003, and we do not believe the adoption of EITF Issue No. 00-21 will have a
material effect on our consolidated financial statements.In November 2002, the FASB issued Interpretation (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 are required to adopt the
recognition and measurement provisions of FIN No. 45 on a prospective basis
with respect to guarantees issued or modified after December 31, 2002. We do
not believe the adoption of the recognition and measurement provisions of FIN
No. 45 will have a material effect on our consolidated financial statements.In July 2002, the FASB issued 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 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 will no longer be sufficient to record
a one-time charge for most restructuring activities. Instead, companies will
record exit or disposal costs when they are incurred and can be measured at
fair value. In addition, the resultant liabilities will be subsequently
adjusted for changes in estimated cash flows. SFAS No. 146 is effective
prospectively for exit or disposal activities initiated after December 31,
2002. Companies may not restate previously issued financial statements for the
effect of the provisions of SFAS No. 146, and liabilities that a company
previously recorded under EITF Issue No. 94-3 are grandfathered. We will adopt
SFAS No. 146 on January 1, 2003, and we do not believe the adoption of SFAS No.
146 will have a material effect on our consolidated financial statements.In April 2002, the FASB issued SFAS No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of 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. We are required to adopt the
provisions of SFAS No. 145 on January 1, 2003, and we do not believe the
adoption of SFAS No. 145 will have a material effect on our consolidated
financial statements.On January 1, 2002, we adopted SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, which supersedes SFAS No. 121,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to be Disposed Of, and provides a single accounting model for long-lived
assets to be disposed of. The adoption of SFAS No. 144 had no effect on our
consolidated financial statements.On January 1, 2002, we adopted SFAS No. 141, Business Combinations, and
SFAS No. 142, Goodwill and Other Intangibles Assets. SFAS No. 141 eliminates
the pooling-of-interests method of accounting for business combinations, except
for qualifying business combinations that were initiated prior to July 1, 2001.
Under SFAS No. 142, goodwill and indefinite-lived intangible assets are no
longer amortized, but are reviewed annually for impairment or more frequently
if impairment indicators arise. The adoption of SFAS Nos. 141 and 142 had no
effect on our consolidated financial statements.On January 1, 2002, we adopted the provision in EITF Issue No. 01-9,
Accounting for Consideration Given by a Vendor to a Customer (Including a
Reseller of the Vendors Products), dealing with consideration from a vendor
to a reseller under cooperative advertising and other arrangements. This
provision of EITF Issue No. 01-9 states that consideration from a vendor to a
reseller of the vendors products or services is presumed to be a reduction of
the selling price of the vendors products or services, unless the vendor (i)
receives an identifiable benefit in return for the consideration and (ii) can
reasonably estimate the fair value of the benefit received. If the amount of
consideration paid by the vendor exceeds the estimated fair value of the
benefit received, the excess amount is to be recorded by the vendor as a
reduction of revenues. The adoption of this new guidance did not have a
material effect on our consolidated financial statements.46Table of ContentsIn August 2001, the FASB issued SFAS No. 143, Accounting for Asset
Retirement Obligations. SFAS No. 143 requires that the fair value of a
liability for an asset retirement obligation be recognized in the period in
which it is incurred if a reasonable estimate of fair value can be made. The
associated asset retirement costs are capitalized as part of the carrying
amount of the long-lived asset. We are required to adopt SFAS No. 143 on
January 1, 2003, and we do not believe the adoption of SFAS No. 143 will have a
material effect on our consolidated financial statements.On January 1, 2001, we adopted SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, as amended. SFAS No. 133 standardizes the
accounting for derivatives and hedging activities and requires that all
derivatives be recognized in the statement of financial position as either
assets or liabilities at fair value. Changes in the fair value of derivatives
that do not meet the hedge accounting criteria are required to be reported in
operations. The adoption of SFAS No. 133 had no effect on our consolidated
financial statements.During the fourth quarter of 2000, retroactive to January 1, 2000, we
changed our method of accounting for up-front fees associated with service
activation and the related incremental direct costs in accordance with the SAB
No. 101. The cumulative effect of the change in accounting principle resulted
in a charge to operations of $9,249, which is included in net loss for the year
ended December 31, 2000. For the years ended December 31, 2001 and 2000, we
recognized $11,661 and $18,661, respectively, in revenue that was included in
the cumulative effect adjustment as of January 1, 2000 (none during the year
ended December 31, 2002). The effect of that revenue during 2001 and 2000 was
to decrease our net loss by $3,067 and $4,624, respectively.Quarterly Financial Information (Unaudited)Certain operating expenses for periods ended prior to December 31, 2002
have been reclassified to conform to the presentation in the fourth
quarter of 2002.The Companys 2002 and 2001 unaudited condensed consolidated quarterly
financial information is as follows:

|                                             |                                |   |                    |       |         |   |              |       |             |   |          |       |   |   |           |       |  
|-------------------------------------------- | ------------------------------ | - | ------------------ | ----- | ------- | - | ------------ | ----- | ----------- | - | -------- | ----- | - | - | --------- | ----- | -
|                                             |                                |   | Three months ended
|                                             |                                |   |                   
|                                             |                                |   | March 31           |       | June 30 |   | September 30 |       | December 31
|                                             |                                |   |                    |       |         |   |              |       |            
|2002:                                        |                                |   |                    |       |         |   |              |       |             |   |          |       |   |   |           |      
|Revenues, net                                |                                | $ | 101,666            |       |         | $ | 97,733       |       |             | $ | 96,206   |       |   | $ | 87,891    |      
|Network and product costs                    |                                | $ | 90,194             |       |         | $ | 76,262       |       |             | $ | 69,546   |       |   | $ | 62,334    |      
|Sales, marketing, general and administrative |                                | $ | 37,204             |       |         | $ | 33,833       |       |             | $ | 41,173   |       |   | $ | 38,163    |      
|Loss 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     | )    
|2001:                                        |                                |   |                    |       |         |   |              |       |             |   |          |       |   |   |           |      
|Revenues, net                                |                                | $ | 71,245             |       |         | $ | 87,099       |       |             | $ | 84,784   |       |   | $ | 89,468    |      
|Network and product costs                    |                                | $ | 135,950            |       |         | $ | 122,420      |       |             | $ | 104,273  |       |   | $ | 99,232    |      
|Sales, marketing, general and administrative |                                | $ | 62,039             |       |         | $ | 58,292       |       |             | $ | 45,618   |       |   | $ | 33,959    |      
|Provision for restructuring expenses         |                                | $ | 14,805             |       |         | $ | 2,942        |       |             | $ | (130     | )     |   | $ | (3,253    | )    
|Provision for long-lived asset impairment    |                                |   |                   |       |         | $ | 2,230        |       |             | $ | (241     | )     |   | $ | 9,999     |      
|Loss from operations                         |                                | $ | (174,712           | )     |         | $ | (141,847     | )     |             | $ | (108,070 | )     |   | $ | (112,251  | )    
|Loss before extraordinary item               |                                | $ | (198,535           | )     |         | $ | (175,462     | )     |             | $ | (139,749 | )     |   | $ | (175,223  | )    
|Extraordinary item                           |                                |   |                   |       |         |   |             |       |             |   |         |       |   | $ | 1,033,727 |      
|Net income (loss)                            |                                | $ | (198,535           | )     |         | $ | (175,462     | )     |             | $ | (139,749 | )     |   | $ | 858,504   |      
|Basic and diluted per share amounts:         |                                |   |                    |       |         |   |              |       |             |   |          |       |   |   |           |      
|                                             | Loss before extraordinary item |   | $                  | (1.15 | )       |   | $            | (1.01 | )           |   | $        | (0.79 | ) |   | $         | (0.96 | )
|                                             | Extraordinary item             |   |                    |      |         |   |              |      |             |   |          |      |   |   | $         | 5.65  |  
|                                             | Net income (loss)              |   | $                  | (1.15 | )       |   | $            | (1.01 | )           |   | $        | (0.79 | ) |   | $         | 4.69  |  

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Our net revenues decreased in the second, third and fourth quarters of
2002 primarily due to the timing of cash collections related to financially
distressed partners and the impact of various promotional rebates and customer
incentives programs. Cash collected from our financially distressed partners
that is included in net revenues was $16,862, $15,300, $12,077 and $3,370
for the first, second, third and fourth quarters of 2002, respectively.

Revenues recognized during the three months ended March 31, 2002 include
payments totaling $3,307 from certain bankrupt customers that we received prior
to January 1, 2002 and recorded as unearned revenues in our consolidated
balance sheet as of December 31, 2001 because our ability to retain these
payments was not reasonably assured as of that date. However, as a result of
subsequent developments in the bankruptcy proceedings of such customers, we
determined that our ability to retain these payments was reasonably assured
prior to March 31, 2002. Consequently, we recognized these payments as revenues
during the three months then ended. During the three months ended September 30,
2002, due to the developments in the bankruptcy proceeding of another customer,
we determined our ability to retain certain payments received from this
bankrupt customer prior to January 1, 2002 was now reasonably assured.
Accordingly, we recognized revenues of $1,120 that were deferred as of December
31, 2001. In addition we recognized revenues of $1,010 during the three months
ended September 30, 2002 from one of our wholesale partners that was not as a
result of services provided by us, but was instead  a
result of a shortfall in the wholesale partners contractual revenue commitment to us.

During the fourth quarter of 2000, retroactive to January 1, 2000, we
adopted SAB No. 101, which requires up-front revenues to be deferred. Also, as
a result of the adoption of SAB No. 101 retroactive to January 1, 2000, we now
treat the incremental direct costs of service activation as deferred charges in
amounts that are no greater than the up-front fees that are deferred. For the
three-month periods ended March 31, June 30, September 30 and December 31 of
2001, we recognized approximately $4,264, $3,679, $2,697, and $1,021 of
revenues, respectively, that were included in the SAB No. 101 cumulative effect
adjustment as of January 1, 2000. The effect of that revenue during those
periods was to decrease net loss by approximately $1,140, $949, $688 and $290,
respectively.

Our network and product costs have decreased in every quarter during the
years ended December 31, 2002 and 2001, reflecting the impact of cost reduction
measures and efforts to maximize the efficiency of our network. Included in
network and product costs for the three months ended March 31, 2002
are acquisition costs of $3,674 associated with our solicitation
of InternetConnects former customers. Included in network and
product costs for the three months ended June 30, 2002 is a recovery of $5,550 from the
settlement of certain disputed network service obligations. Included in
network and product costs for the three months ended December 31, 2001 is a
recovery of $5,570 from the settlement of certain disputed collocation claims.

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

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operating results for such year. The impact on prior financial reporting
periods in 2002, 2001 and 2000 would have been as follows if these amounts had
been recorded in the proper financial reporting periods:

|                                                                                                                                                      |  |                    |         |          |  |               |         |          |  |   |         |   |  |   |         |   |  |  |  | 
|----------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ------- | -------- |  | ------------- | ------- | -------- |  | - | ------- | - |  | - | ------- | - |  |  |  | 
|                                                                                                                                                      |  | Three Months Ended
|                                                                                                                                                      |  |                   
|                                                                                                                                                      |  | March 31,          |         | June 30, |  | September 30, |         | December
|                                                                                                                                                      |  | 2002               |         | 2002     |  | 2002          |         | 31, 2002 |  |  
|                                                                                                                                                      |  |                    |         |          |  |               |         |         
|Net loss, as reported                                                                                                                                 |  | $                  | (56,839 | )        |  | $             | (40,793 | )        |  | $ | (51,707 | ) |  | $ | (35,489 | )
|Effect of prospectively correcting
certain differences relating to prior
periods, which is included in net
loss, as reported                          |  |                    |        |          |  |               |        |          |  |   | 10,799  |   |  |   | (7,474  | )
|Effect of unadjusted differences                                                                                                                      |  |                    | (1,186  | )        |  |               | (1,231  | )        |  |   | 1,386   |   |  |   |        |  
|                                                                                                                                                      |  |                    |         |          |  |               |         |          |  |   |         |   |  |   |         |  
|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 | )
|                                                                                                                                                      |  |                    |         |          |  |               |         |          |  |   |         |   |  |   |         |  
|Net loss per share, as reported                                                                                                                       |  |                    | (0.26   | )        |  |               | (0.19   | )        |  |   | (0.23   | ) |  |   | (0.16   | )
|Effect of prospectively correcting certain differences relating to prior
periods, which is included in net loss per share, as reported                |  |                    |        |          |  |               |        |          |  |   | 0.04    |   |  |   | (0.03   | )
|Effect of unadjusted differences                                                                                                                      |  |                    | (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   | )
|                                                                                                                                                      |  |                    |         |          |  |               |         |          |  |   |         |   |  |   |         |  

|                                                                                                                                                     |  |                    |          |            |  |               |          |          |  |          |          |   |  |   |         |   |  |   |         |  
|---------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | -------- | ---------- |  | ------------- | -------- | -------- |  | -------- | -------- | - |  | - | ------- | - |  | - | ------- | -
|                                                                                                                                                     |  | Three Months Ended |          |            |  |              
|                                                                                                                                                     |  |                    |          | Year Ended
|                                                                                                                                                     |  | March 31,          |          | June 30,   |  | September 30, |          | December |  | December
|                                                                                                                                                     |  | 2001               |          | 2001       |  | 2001          |          | 31, 2001 |  | 31, 2001
|                                                                                                                                                     |  |                    |          |            |  |               |          |          |  |         
|Net income (loss), as reported                                                                                                                       |  | $                  | (198,535 | )          |  | $             | (175,462 | )        |  | $        | (139,749 | ) |  | $ | 858,504 |   |  | $ | 344,758 |  
|Effect of prospectively correcting certain differences relating to prior
periods, which is included in net
income (loss), as reported                |  |                    |         |            |  |               |         |          |  |          |         |   |  |   |        |   |  |   |        |  
|Effect of unadjusted differences                                                                                                                     |  |                    | 5,198    |            |  |               | 12       |          |  |          | (4,841   | ) |  |   | (3,802  | ) |  |   | (3,433  | )
|                                                                                                                                                     |  |                    |          |            |  |               |          |          |  |          |          |   |  |   |         |   |  |   |         |  
|Net income (loss), had unadjusted
differences been recorded, net of
effect of prospectively correcting
certain differences relating to prior
periods |  |                    | (193,337 | )          |  |               | (175,450 | )        |  |          | (144,590 | ) |  |   | 854,702 |   |  |   | 341,325 |  
|                                                                                                                                                     |  |                    |          |            |  |               |          |          |  |          |          |   |  |   |         |   |  |   |         |  

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|                                                                                                                                                               |  |                    |       |            |  |               |       |              |  |              |       |   |  |  |       |   |  |  |       |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ----- | ---------- |  | ------------- | ----- | ------------ |  | ------------ | ----- | - |  |  | ----- | - |  |  | ----- | -
|                                                                                                                                                               |  | Three Months Ended |       |            |  |              
|                                                                                                                                                               |  |                    |       | Year Ended
|                                                                                                                                                               |  | March 31,          |       | June 30,   |  | September 30, |       | December 31, |  | December 31,
|                                                                                                                                                               |  | 2001               |       | 2001       |  | 2001          |       | 2001         |  | 2001        
|                                                                                                                                                               |  |                    |       |            |  |               |       |              |  |             
|Net income (loss) per share, as reported                                                                                                                       |  |                    | (1.15 | )          |  |               | (1.01 | )            |  |              | (0.79 | ) |  |  | 4.69  |   |  |  | 1.94  |  
|Effect of prospectively correcting certain differences relating to prior
periods, which is included in net
income (loss) per share, as reported                |  |                    |      |            |  |               |      |              |  |              |      |   |  |  |      |   |  |  |      |  
|Effect of unadjusted differences                                                                                                                               |  |                    | 0.03  |            |  |               |      |              |  |              | (0.03 | ) |  |  | (0.02 | ) |  |  | (0.02 | )
|                                                                                                                                                               |  |                    |       |            |  |               |       |              |  |              |       |   |  |  |       |   |  |  |       |  
|Net income (loss) per share, had
unadjusted differences been recorded,
net of effect of prospectively
correcting certain differences
relating to prior periods |  |                    | (1.12 | )          |  |               | (1.01 | )            |  |              | (0.82 | ) |  |  | 4.67  |   |  |  | 1.92  |  
|                                                                                                                                                               |  |                    |       |            |  |               |       |              |  |              |       |   |  |  |       |   |  |  |       |  

|                                                                                                                                            |  |                    |          |            |  |               |          |              |  |              |          |   |  |   |          |   |  |   |            |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | -------- | ---------- |  | ------------- | -------- | ------------ |  | ------------ | -------- | - |  | - | -------- | - |  | - | ---------- | -
|                                                                                                                                            |  | Three Months Ended |          |            |  |              
|                                                                                                                                            |  |                    |          | Year Ended
|                                                                                                                                            |  | March 31,          |          | June 30,   |  | September 30, |          | December 31, |  | December 31,
|                                                                                                                                            |  | 2000               |          | 2000       |  | 2000          |          | 2000         |  | 2000        
|                                                                                                                                            |  |                    |          |            |  |               |          |              |  |             
|Net loss, as reported                                                                                                                       |  | $                  | (136,259 | )          |  | $             | (153,021 | )            |  | $            | (246,344 | ) |  | $ | (907,512 | ) |  | $ | (1,443,136 | )
|Effect of
prospectively
correcting certain
differences relating
to prior periods,
which is included in
net loss, as
reported                |  |                    |         |            |  |               |         |              |  |              |         |   |  |   |         |   |  |   |           |  
|Effect of unadjusted
differences                                                                                                            |  |                    | (692     | )          |  |               | 211      |              |  |              | 216      |   |  |   | 1,404    |   |  |   | 1,139      |  
|                                                                                                                                            |  |                    |          |            |  |               |          |              |  |              |          |   |  |   |          |   |  |   |            |  
|Net loss, had
unadjusted
differences been
recorded, net of
effect of
prospectively
correcting certain
differences relating
to prior periods |  |                    | (136,951 | )          |  |               | (152,810 | )            |  |              | (246,128 | ) |  |   | (906,108 | ) |  |   | (1,441,997 | )
|                                                                                                                                            |  |                    |          |            |  |               |          |              |  |              |          |   |  |   |          |   |  |   |            |  
|Net loss per share,
as reported                                                                                                             |  |                    | (0.93    | )          |  |               | (1.00    | )            |  |              | (1.58    | ) |  |   | (5.40    | ) |  |   | (9.47      | )
|Effect of
prospectively
correcting certain
differences relating
to prior periods,
which is included in
net loss per share,
as reported      |  |                    |         |            |  |               |         |              |  |              |         |   |  |   |         |   |  |   |           |  
|Effect of unadjusted
differences                                                                                                            |  |                    |         |            |  |               |         |              |  |              |         |   |  |   | 0.01     |   |  |   | 0.01       |  
|                                                                                                                                            |  |                    |          |            |  |               |          |              |  |              |          |   |  |   |          |   |  |   |            |  

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|                                                                                                                                                      |  |                    |       |            |  |               |       |              |  |              |       |   |  |  |       |   |  |  |       |  
|----------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ----- | ---------- |  | ------------- | ----- | ------------ |  | ------------ | ----- | - |  |  | ----- | - |  |  | ----- | -
|                                                                                                                                                      |  | Three Months Ended |       |            |  |              
|                                                                                                                                                      |  |                    |       | Year Ended
|                                                                                                                                                      |  | March 31,          |       | June 30,   |  | September 30, |       | December 31, |  | December 31,
|                                                                                                                                                      |  | 2000               |       | 2000       |  | 2000          |       | 2000         |  | 2000        
|                                                                                                                                                      |  |                    |       |            |  |               |       |              |  |             
|Net loss per share,
had unadjusted
differences been
recorded, net of
effect of
prospectively
correcting certain
differences relating
to prior periods |  |                    | (0.93 | )          |  |               | (1.00 | )            |  |              | (1.58 | ) |  |  | (5.39 | ) |  |  | (9.46 | )
|                                                                                                                                                      |  |                    |       |            |  |               |       |              |  |              |       |   |  |  |       |   |  |  |       |  

Our selling, marketing, general and administrative expenses have decreased
on a relative basis in most quarters during the years ended December 31, 2002
and 2001, which reflects the impact of our restructuring efforts and cost
reduction measures. Our sales, marketing, general and administrative expenses
increased in the third and fourth quarter of 2002 primarily due to advertising
expenses attributable to our radio, television and other various media
marketing and advertising programs related to our Popularizing Broadband
campaign, which we launched during the third quarter of 2002.

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 MOU described in Note 10 to our
consolidated financial statements and in Part I. Item 3 Legal Proceedings.
Charges (credits) pertaining to litigation-related expenses were $(3,767),
$(7,146), $1,884 and $(2,599), for the three months ended March 31, June 30,
September 30 and December 31 of 2002, respectively. 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 recognized $4,000 (non-cash)
of these charges in the second quarter ended June 30, 2001, $1,907 ($2,767 in
cash and $(860) non-cash) in the third quarter ended September 30, 2001 and
$25,253 ($2,592 in cash and $22,661) in the fourth quarter ended December 31,
2001.

During the three months ended December 31, 2001, we determined that
certain communications equipment was obsolete based on its discontinued use in
our network. We also made the 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 current book value. Accordingly, we recorded a
write-down of this property and equipment for $9,999 during the three months
ended December 31, 2001. We completed the sale of this property in June 2002.

We have experienced decreasing losses from operations on a quarterly basis
during the years ended December 31, 2002 and 2001 as a result of reduced
operating expenses levels. Depreciation and amortization have been trending
downwards as a result of decreased capital expenditures and certain assets
becoming fully depreciated. We expect to sustain quarterly net losses for at
least the next two years. See Part I. Item 1. BusinessRisk
FactorsWe have a history
of losses and expect losses in the future. Our annual and quarterly operating
results may fluctuate significantly in the future as a result of numerous
factors, including the factors described in Part I.
Item 1. BusinessRisk
Factors. Factors that may affect our operating results include:



| |  |  | the effect of the FCCs Triennial Review and its announcements that
it would phase out its prior rules on line-sharing and not require that
the phone companies provide us with access to remote terminals;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the impact of other regulatory developments;                                                                                                                                                               
|
| |  |  | financial difficulties experienced by our customers;                                                                                                                                                       
|
| |  |  | our ability to attract and retain Internet service provider,
enterprise and telecommunications carrier customers and limit end-user
churn rates;                                                           
|
| |  |  | the rate at which customers subscribe to our services;                                                                                                                                                     
|
| |  |  | our access to facilities of the traditional telephone companies that we need to sell our service;                                                                                                          

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| |  |  | the ability to order or deploy our services on a timely basis to adequately satisfy end-user demand;                                                                                                                                               
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | our ability to successfully operate our network;                                                                                                                                                                                                   
|
| |  |  | reductions in the prices for our services due to competition, volume-based pricing and other factors;                                                                                                                                              
|
| |  |  | the success of our relationships with strategic partners and other
potential third parties in generating significant subscriber demand;                                                                                                            
|
| |  |  | the mix of line orders between consumer end-users and business
end-users (which typically have higher margins) as well as the mix
between end-users that purchase our services directly from us as opposed
to purchasing from one of our resellers;
|
| |  |  | the ability to develop and commercialize new services by us or our
competitors;                                                                                                                                                                    
|
| |  |  | the amount and timing of capital expenditures and other costs
relating to the expansion of our network, our network capacity and new
service offerings;                                                                                            
|
| |  |  | our ability to raise additional capital as may be required in the future; and                                                                                                                                                                      
|
| |  |  | the absence of an adverse result in litigation against us.                                                                                                                                                                                         

Many of these factors are outside of our control. See Item 1.
Business-Risk Factors-Our operating results are likely to fluctuate in future
periods and may fail to meet the expectations of securities analysts and
investors.

Liquidity and Capital Resources

Our operations have required substantial capital investment for the
procurement, design and construction of our central office collocation
facilities, the design, creation, implementation and maintenance of our
software, the purchase of telecommunications equipment and the design,
development and maintenance of our networks. Capital expenditures were $26,564
for the year ended December 31, 2002. We expect that our capital expenditures
related to the purchase of infrastructure equipment necessary for the
development and expansion of our networks and the development of new regions
will be lower in future periods while incremental, or success-based, capital
expenditures related to the addition of subscribers in existing regions will
increase proportionately in relation to the number of new subscribers that we
add to our network.

From our inception through December 31, 2002, we financed our operations
primarily through private placements of $220,600 of equity securities,
$1,282,000 in net proceeds raised from the issuance of notes (including our
agreement with SBC for a $50,000 note payable), a $75,000 collateralized
deposit and $719,000 in net proceeds raised from public equity offerings. As of
December 31, 2002, we had an accumulated deficit of $1,529,336, and
unrestricted cash, cash equivalents, and short-term investments of $204,567. In
addition, we had stockholders equity as of December 31, 2002 of $82,299.

Net cash used in our operating activities was $73,967 for the year ended
December 31, 2002. The net cash used in our operating activities during this
period was primarily due to the net loss of $184,828, a decrease in accounts
payable of $4,927, a decrease in collateralized customer deposits of $6,809, a
decrease in unearned revenues of $24,882 and a reduction of non-cash
litigation-related expenses of $11,628, offset by depreciation and amortization
charges of $127,088, a decrease in deferred costs of service activation of
$17,676, a decrease in restricted cash of $8,702 and a net decrease in other
operating assets and liabilities of $4,259.

Net cash used in our investing activities was $40,113 for the year ended
December 31, 2002. The net cash used in our investing activities during this
period was primarily due to purchases of short-term investments of $237,088 and
capital expenditures of $26,564, offset by maturities of short-term investments
of $165,526, sales of short-term

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investments of $40,017, proceeds from the sale
of property and equipment of $13,451 and proceeds from the sale of investments
in unconsolidated affiliates of $3,360.

Net cash provided by our financing activities was $2,761 for the year
ended December 31, 2002. The net cash provided by our financing activities
during this period was due to proceeds from the issuance of common stock of
$3,089, offset by principal payments under capital lease obligations of $328.

As of December 31, 2002, we had $96,491 in unrestricted cash and cash
equivalents and $108,076 in unrestricted short-term investments. We expect to
experience negative cash flow from operating and investing activities into 2004
due to continued development of new services and the addition of new end-users
to our network. 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 decision in the Triennial Review, our
continuing ability to access line-shared telephone wires and our ability
to obtain access to the traditional telephone companies remote
terminals;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the rate at which resellers and end-users purchase and pay for our
services and the pricing of such services;                                                                                                    
|
| |  |  | the financial condition of our customers;                                                                                                                                                                        
|
| |  |  | the level of marketing required to acquire and retain customers and
to attain a competitive position in the marketplace;                                                                                         
|
| |  |  | the rate at which we invest in engineering, development and
intellectual property with respect to existing and future technology;                                                                                
|
| |  |  | the operational costs that we incur to install, maintain and repair
end-user lines and our network as a whole;                                                                                                   
|
| |  |  | pending litigation;                                                                                                                                                                                              
|
| |  |  | existing and future technology;                                                                                                                                                                                  
|
| |  |  | unanticipated opportunities;                                                                                                                                                                                     
|
| |  |  | network development schedules and associated costs; and                                                                                                                                                          
|
| |  |  | the number of regions entered, the timing of entry and services offered.                                                                                                                                         

In addition, we may wish to selectively pursue possible acquisitions of,
or investments in businesses, technologies or products complementary to ours in
order to expand our geographic presence, broaden our product and service
offerings and achieve operating efficiencies. We may not have sufficient
liquidity, or we may be unable to obtain additional financing on favorable
terms or at all, in order to finance such an acquisition or investment.

Our contractual debt and lease obligations as of December 31, 2002 for the
next five years, and thereafter, were as follows:

|                       |  |      |       |           |  |           |        |            |  |       |       |  |  |   |     |  |  |   |        | 
|---------------------- |  | ---- | ----- | --------- |  | --------- | ------ | ---------- |  | ----- | ----- |  |  | - | --- |  |  | - | ------ | 
|                       |  | 2003 |       | 2004-2005 |  | 2006-2007 |        | Thereafter |  | Total
|                       |  |      |       |           |  |           |        |            |  |      
|Note payable to SBC    |  | $    |      |           |  | $         | 50,000 |            |  | $     |      |  |  | $ |    |  |  | $ | 50,000 | 
|Capital leases         |  |      | 165   |           |  |           |       |            |  |       |      |  |  |   |    |  |  |   | 165    | 
|Office leases          |  |      | 5,424 |           |  |           | 6,112  |            |  |       | 2,450 |  |  |   | 720 |  |  |   | 14,706 | 
|Other operating leases |  |      | 1,451 |           |  |           | 209    |            |  |       | 4     |  |  |   |    |  |  |   | 1,664  | 
|                       |  |      |       |           |  |           |        |            |  |       |       |  |  |   |     |  |  |   |        | 
|                       |  | $    | 7,040 |           |  | $         | 56,321 |            |  | $     | 2,454 |  |  | $ | 720 |  |  | $ | 66,535 | 
|                       |  |      |       |           |  |           |        |            |  |       |       |  |  |   |     |  |  |   |        | 

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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. We are also obligated under a capital equipment lease,
which expires in 2003.

Our 2003
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 necessary, we will curtail this discretionary
spending so that we can continue as a going concern at least through
December 31, 2003 using only our unrestricted cash,
cash equivalent and short-term investment balances in existence as of
December 31, 2002. Additionally, on February 20, 2003, the
FCC announced the results of the
Triennial Review of its rules for network unbundling obligations of
Incumbent Local Exchange Carriers. Among other things,
the FCC announced that it will phase-out its rule requiring
line-sharing over a three-year period. While the FCC has not yet
issued its order pursuant to the Triennial Review, the ultimate
impact of the FCCs February 20, 2003 announcement on our
business, which relies on line-sharing to serve certain consumer
end-users, will depend on our ability to negotiate fair and
reasonable prices substantially lower than the whole loop cost that
will ultimately be permitted under the FCCs rules. We do not
believe the FCCs revised unbundling rules will have a material
adverse effect on our ability to continue as a going concern at least
through December 31, 2003.

We have in the past described our expectation of attaining cash flow
sufficiency from our operating activities in mid-2004. Subsequent to our
announcement of these expectations, the FCC announced the results of its
Triennial Review, although it has not yet issued its final order. The order,
when issued, may impact our cash flow from operations and the manner in which
we progress towards cash flow sufficiency. In particular, our ability to
continue to sell stand-alone consumer-grade services will likely depend on our
ability to negotiate with the telephone companies fair and reasonable prices
for line-shared services that are substantially lower than the cost of a separate line. If we cannot
reach reasonable terms with the telephone companies, we may be unable to sell
stand-alone consumer-grade services. In that event, we would be required to,
and we believe we can, adjust our business plan so that we can still reach cash
flow sufficiency in the second half of 2004. However, in this event, our growth could
be impaired because of our reduced access to the consumer market.

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, especially under the current capital market conditions. If we are
unable to acquire additional capital on favorable terms or are required to
raise it on terms that are less satisfactory than we desire, it will have a
material adverse effect on our financial condition which could require a sale
or liquidation of our company.

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-K that are not historical facts
are forward-looking statements (as such term is defined in Section 27A of the
Securities Act and Section 21E of the Exchange Act), which can be identified by
the use of forward-looking terminology such as estimates, projects,
anticipates, expects, intends, believes, or the negative thereof or
other variations thereon or comparable terminology, or by discussions of
strategy that involve risks and uncertainties. Examples of such forward-looking
statements include but are not limited to:



| |  |  | the impact of the FCCs decision in the Triennial Review and our
ability to obtain access to line-sharing at rates that allow us to sell
consumer-grade services;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | expectations regarding our ability to become cash-flow positive;                                                                                                 
|
| |  |  | expectations regarding the extent to which customers purchase our services;                                                                                      
|
| |  |  | expectations regarding our relationships with our strategic partners and other potential third parties;                                                          
|
| |  |  | expectations as to pricing for our services in the future;                                                                                                       

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| |  |  | expectations as to the impact of our service offerings on our margins;                                                                                                                                                                          
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the possibility that we will increase our revenues;                                                                                                                                                                                             
|
| |  |  | the impact of advertising on brand recognition and operating results;                                                                                                                                                                           
|
| |  |  | plans to make strategic investments and acquisitions and the affect of such investments and acquisitions;                                                                                                                                       
|
| |  |  | estimates and expectations of future operating results, including
expectations regarding when we anticipate operating on a cash flow
positive basis, the adequacy of our cash reserves, our monthly burn rate
and the number of installed lines;
|
| |  |  | plans to develop and commercialize value-added services;                                                                                                                                                                                        
|
| |  |  | our anticipated capital expenditures;                                                                                                                                                                                                           
|
| |  |  | plans to enter into business arrangements with broadband-related service providers;                                                                                                                                                             
|
| |  |  | the effect of regulatory changes;                                                                                                                                                                                                               
|
| |  |  | the effect of litigation currently pending; and                                                                                                                                                                                                 
|
| |  |  | other statements contained in this Report on Form 10-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 announcement and future 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                                                                                                

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| |  |  | access regions and negotiate suitable interconnection agreements with
the traditional telephone companies, all in a timely manner, at
reasonable costs and on satisfactory terms.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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.




ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to financial market risk, including changes in interest and
marketable equity security prices, relates primarily to our investment
portfolio and outstanding debt obligations. We typically do not attempt to
reduce or eliminate our market exposure on our investment securities because a
substantial majority of our investments are in fixed-rate, short-term
securities. We do not have any derivative instruments. The fair value of our
investment portfolio or related income would not be significantly impacted by
either a 100 basis point increase or decrease in interest rates due mainly to
the fixed-rate, short-term nature of the substantial majority of our investment
portfolio. In addition, all of our outstanding indebtedness as of December 31,
2002 is fixed-rate debt.

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

FINANCIAL STATEMENTS

INDEX

(a)  The following documents are filed as part of this Form 10-K:



| |                                                                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (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

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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, 2002 and 2001, 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, 2002. 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, 2002 and 2001, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 2002, in conformity with accounting principles
generally accepted in the United States.

As discussed in Note 2 to the consolidated financial statements, in 2000
the Company changed its method of accounting for revenue recognition and
related incremental direct costs in accordance with guidance contained in SEC
Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements.

| |  |                      
| |  | ---------------------
| |  | /s/ Ernst & Young LLP

Walnut Creek, California
March 5, 2003

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COVAD COMMUNICATIONS GROUP, INC.

CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share and per share amounts)

|                                                                                                                 |                           |   |         |         |              |   |         |         |  |  | 
|---------------------------------------------------------------------------------------------------------------- | ------------------------- | - | ------- | ------- | ------------ | - | ------- | ------- |  |  | 
|                                                                                                                 |                           |   |         |         | December 31,
|                                                                                                                 |                           |   |         |         |             
|                                                                                                                 |                           |   |         |         | 2002         |   | 2001   
|                                                                                                                 |                           |   |         |         |              |   |        
|ASSETS                                                                                                           |                           |   |         |         |             
|Current assets:                                                                                                  |                           |   |         |         |              |   |         |        
|Cash and cash equivalents                                                                                        |                           | $ | 96,491  |         |              | $ | 207,810 |        
|Short-term investments                                                                                           |                           |   | 108,076 |         |              |   | 76,053  |        
|Restricted cash and investments                                                                                  |                           |   | 501     |         |              |   | 9,203   |        
|Accounts receivable, net of allowances of $5,388 at
December 31, 2002 ($8,483 at December 31, 2001)              |                           |   | 21,746  |         |              |   | 23,245  |        
|Unbilled revenues                                                                                                |                           |   | 3,921   |         |              |   | 4,964   |        
|Other receivables                                                                                                |                           |   | 1,385   |         |              |   | 3,885   |        
|Inventories                                                                                                      |                           |   | 5,096   |         |              |   | 7,249   |        
|Prepaid expenses and other current assets                                                                        |                           |   | 5,524   |         |              |   | 6,689   |        
|                                                                                                                 |                           |   |         |         |              |   |         |        
|                                                                                                                 | Total current assets      |   |         | 242,740 |              |   |         | 339,098 | 
|Property and equipment, net                                                                                      |                           |   | 108,737 |         |              |   | 215,804 |        
|Collocation fees, net of accumulated amortization of
$32,372 at December 31, 2002 ($17,716 at December 31,
2001) |                           |   | 43,284  |         |              |   | 53,464  |        
|Investments in unconsolidated affiliates                                                                         |                           |   | 1,026   |         |              |   | 4,874   |        
|Deferred costs of service activation                                                                             |                           |   | 40,286  |         |              |   | 57,962  |        
|Deferred customer incentives                                                                                     |                           |   | 3,540   |         |              |   |        |        
|Other long-term assets                                                                                           |                           |   | 2,548   |         |              |   | 3,966   |        
|                                                                                                                 |                           |   |         |         |              |   |         |        
|                                                                                                                 | Total assets              |   | $       | 442,161 |              |   | $       | 675,168 | 
|                                                                                                                 |                           |   |         |         |              |   |         |        
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                             |                           |   |         |         |             
|Current Liabilities:                                                                                             |                           |   |         |         |              |   |         |        
|Accounts payable                                                                                                 |                           | $ | 10,915  |         |              | $ | 15,842  |        
|Accrued compensation                                                                                             |                           |   | 12,774  |         |              |   | 16,268  |        
|Current portion of capital lease obligations                                                                     |                           |   | 165     |         |              |   | 11      |        
|Accrued collocation and network service fees                                                                     |                           |   | 16,537  |         |              |   | 31,454  |        
|Accrued transaction-based taxes                                                                                  |                           |   | 45,426  |         |              |   | 40,648  |        
|Accrued interest                                                                                                 |                           |   | 5,683   |         |              |   | 183     |        
|Accrued market development funds and customer incentives                                                         |                           |   | 6,422   |         |              |   | 1,733   |        
|Unresolved claims related to bankruptcy proceedings                                                              |                           |   | 7,381   |         |              |   | 22,200  |        
|Other accrued liabilities                                                                                        |                           |   | 8,581   |         |              |   | 8,103   |        
|                                                                                                                 |                           |   |         |         |              |   |         |        
|                                                                                                                 | Total current liabilities |   |         | 113,884 |              |   |         | 136,442 | 
|Long-term debt                                                                                                   |                           |   | 50,000  |         |              |   | 50,000  |        
|Collateralized customer deposit                                                                                  |                           |   | 68,191  |         |              |   | 75,000  |        
|Deferred gain resulting from deconsolidation of subsidiary                                                       |                           |   | 53,972  |         |              |   | 55,200  |        
|Unearned revenues                                                                                                |                           |   | 73,815  |         |              |   | 98,697  |        
|                                                                                                                 |                           |   |         |         |              |   |         |        
|                                                                                                                 | Total liabilities         |   |         | 359,862 |              |   |         | 415,339 | 
|Commitments and contingencies                                                                                    |                           |   |         |         |              |   |         |        

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COVAD COMMUNICATIONS GROUP, INC.

CONSOLIDATED BALANCE SHEETS (continued)
(Amounts in thousands, except share and per share amounts)

|                                                                                                                                                                                               |                                            |  |              |         |      |  |            |         | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ |  | ------------ | ------- | ---- |  | ---------- | ------- | 
|                                                                                                                                                                                               |                                            |  | December 31,
|                                                                                                                                                                                               |                                            |  |             
|                                                                                                                                                                                               |                                            |  | 2002         |         | 2001
|                                                                                                                                                                                               |                                            |  |              |         |     
|Stockholders Equity:                                                                                                                                                                          |                                            |  |              |         |      |  |            |        
|Preferred stock, $0.001 par value; 5,000,000 shares
authorized; no shares issued and outstanding at December
31, 2002 and 2001                                                                 |                                            |  |             |         |      |  |           |        
|Common stock, $0.001 par value; 590,000,000 shares
authorized; 223,182,511 shares issued and outstanding at
December 31, 2002 (216,542,212 shares issued and
outstanding at December 31, 2001) |                                            |  | 223          |         |      |  | 216        |        
|Common stock  Class B, $0.001 par value; 10,000,000
shares authorized; no shares issued and outstanding at
December 31, 2002 and 2001                                                         |                                            |  |             |         |      |  |           |        
|Additional paid-in capital                                                                                                                                                                     |                                            |  | 1,612,319    |         |      |  | 1,606,737  |        
|Deferred stock-based compensation                                                                                                                                                              |                                            |  | (160         | )       |      |  | (257       | )      
|Accumulated other comprehensive loss                                                                                                                                                           |                                            |  | (747         | )       |      |  | (2,359     | )      
|Accumulated deficit                                                                                                                                                                            |                                            |  | (1,529,336   | )       |      |  | (1,344,508 | )      
|                                                                                                                                                                                               |                                            |  |              |         |      |  |            |        
|                                                                                                                                                                                               | Total stockholders equity                 |  |              | 82,299  |      |  |            | 259,829 | 
|                                                                                                                                                                                               |                                            |  |              |         |      |  |            |        
|                                                                                                                                                                                               | Total liabilities and stockholders equity |  | $            | 442,161 |      |  | $          | 675,168 | 
|                                                                                                                                                                                               |                                            |  |              |         |      |  |            |        

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except share and per share amounts)

|                                                                                       |                                                                                                      |                          |          |                         |         |      |           |          |         |   |            |          |           | 
|-------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------- | ------------------------ | -------- | ----------------------- | ------- | ---- | --------- | -------- | ------- | - | ---------- | -------- | --------- | 
|                                                                                       |                                                                                                      |                          |          | Year ended December 31,
|                                                                                       |                                                                                                      |                          |          |                        
|                                                                                       |                                                                                                      |                          |          | 2002                    |         | 2001 |           | 2000    
|                                                                                       |                                                                                                      |                          |          |                         |         |      |           |         
|Revenues, net                                                                          |                                                                                                      | $                        | 383,496  |                         |         | $    | 332,596   |          |         | $ | 158,736    |         
|Operating expenses:                                                                    |                                                                                                      |                          |          |                         |         |      |           |          |         |   |            |         
|                                                                                       | Network and product costs                                                                            |                          |          | 298,336                 |         |      |           | 461,875  |         |   |            | 432,153  |          
|                                                                                       | Sales, marketing, general and administrative                                                         |                          |          | 150,373                 |         |      |           | 199,908  |         |   |            | 292,991  |          
|                                                                                       | Provision for bad debts (bad debt recoveries)                                                        |                          |          | 319                     |         |      |           | (658     | )       |   |            | 11,257   |          
|                                                                                       | Depreciation and amortization of property and equipment                                              |                          |          | 112,438                 |         |      |           | 137,920  |         |   |            | 91,205   |          
|                                                                                       | Amortization of intangible assets                                                                    |                          |          | 14,650                  |         |      |           | 12,919   |         |   |            | 87,220   |          
|                                                                                       | Provision for restructuring expenses                                                                 |                          |          |                        |         |      |           | 14,364   |         |   |            | 4,988    |          
|                                                                                       | Provision for long-lived asset impairment                                                            |                          |          |                        |         |      |           | 11,988   |         |   |            | 589,388  |          
|                                                                                       | Litigation-related expenses, net                                                                     |                          |          | (11,628                 | )       |      |           | 31,160   |         |   |            |         |          
|                                                                                       | Write-off of in-process research and developments costs                                              |                          |          |                        |         |      |           |         |         |   |            | 3,726    |          
|                                                                                       |                                                                                                      |                          |          |                         |         |      |           |          |         |   |            |         
|                                                                                       |                                                                                                      | Total operating expenses |          |                         | 564,488 |      |           |          | 869,476 |   |            |          | 1,512,928 | 
|                                                                                       |                                                                                                      |                          |          |                         |         |      |           |          |         |   |            |         
|Loss from operations                                                                   |                                                                                                      |                          | (180,992 | )                       |         |      | (536,880  | )        |         |   | (1,354,192 | )       
|Other income (expense):                                                                |                                                                                                      |                          |          |                         |         |      |           |          |         |   |            |         
|                                                                                       | Interest income                                                                                      |                          |          | 5,122                   |         |      |           | 24,593   |         |   |            | 52,901   |          
|                                                                                       | Realized gain (loss) on short-term investments                                                       |                          |          | (17                     | )       |      |           | 5,909    |         |   |            | 13,466   |          
|                                                                                       | Other than temporary losses on short-term investments                                                |                          |          |                        |         |      |           | (1,311   | )       |   |            | (11,579  | )        
|                                                                                       | Provision for impairment of investments in
unconsolidated affiliates                                 |                          |          | (388                    | )       |      |           | (10,069  | )       |   |            | (17,826  | )        
|                                                                                       | Equity in losses of unconsolidated affiliates                                                        |                          |          | (806                    | )       |      |           | (13,769  | )       |   |            | (6,452   | )        
|                                                                                       | Gain (loss) on disposal of investments in
unconsolidated affiliate                                   |                          |          | (636                    | )       |      |           | 178      |         |   |            |         |          
|                                                                                       | Interest expense (contractual interest expense was
$142,356 during the year ended December 31, 2001) |                          |          | (5,581                  | )       |      |           | (92,782  | )       |   |            | (109,863 | )        
|                                                                                       | Miscellaneous expense, net                                                                           |                          |          | (1,530                  | )       |      |           | (2,218   | )       |   |            | (342     | )        
|                                                                                       | Reorganization expenses, net                                                                         |                          |          |                        |         |      |           | (62,620  | )       |   |            |         |          
|                                                                                       |                                                                                                      |                          |          |                         |         |      |           |          |         |   |            |         
|                                                                                       | Other income (expense), net                                                                          |                          |          | (3,836                  | )       |      |           | (152,089 | )       |   |            | (79,695  | )        
|                                                                                       |                                                                                                      |                          |          |                         |         |      |           |          |         |   |            |         
|Loss before extraordinary item and cumulative effect of
change in accounting principle |                                                                                                      |                          | (184,828 | )                       |         |      | (688,969  | )        |         |   | (1,433,887 | )       
|Extraordinary item-gain on extinguishment of debt                                      |                                                                                                      |                          |         |                         |         |      | 1,033,727 |          |         |   |           |         
|Cumulative effect of change in accounting principle                                    |                                                                                                      |                          |         |                         |         |      |          |          |         |   | (9,249     | )       
|                                                                                       |                                                                                                      |                          |          |                         |         |      |           |          |         |   |            |         
|Net income (loss)                                                                      |                                                                                                      | $                        | (184,828 | )                       |         | $    | 344,758   |          |         | $ | (1,443,136 | )       
|                                                                                       |                                                                                                      |                          |          |                         |         |      |           |          |         |   |            |         

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COVAD COMMUNICATIONS GROUP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS (continued)
(Amounts in thousands, except share and per share amounts)

|                                                                           |                                                                                        |  |                         |             |      |  |      |             |   |  |   |             |  
|-------------------------------------------------------------------------- | -------------------------------------------------------------------------------------- |  | ----------------------- | ----------- | ---- |  | ---- | ----------- | - |  | - | ----------- | -
|                                                                           |                                                                                        |  | Year ended December 31,
|                                                                           |                                                                                        |  |                        
|                                                                           |                                                                                        |  | 2002                    |             | 2001 |  | 2000
|                                                                           |                                                                                        |  |                         |             |      |  |     
|Basic and diluted per share amounts:                                       |                                                                                        |  |                         |             |      |  |      |             |   |  |   |            
|                                                                           | Loss before extraordinary item and cumulative effect
of change in accounting principle |  | $                       | (0.84       | )    |  | $    | (3.89       | ) |  | $ | (9.41       | )
|                                                                           |                                                                                        |  |                         |             |      |  |      |             |   |  |   |             |  
|                                                                           | Extraordinary item                                                                     |  | $                       |            |      |  | $    | 5.83        |   |  | $ |            |  
|                                                                           |                                                                                        |  |                         |             |      |  |      |             |   |  |   |             |  
|                                                                           | Cumulative effect of accounting change                                                 |  | $                       |            |      |  | $    |            |   |  | $ | (0.06       | )
|                                                                           |                                                                                        |  |                         |             |      |  |      |             |   |  |   |             |  
|                                                                           | Net income (loss)                                                                      |  | $                       | (0.84       | )    |  | $    | 1.94        |   |  | $ | (9.47       | )
|                                                                           |                                                                                        |  |                         |             |      |  |      |             |   |  |   |             |  
|                                                                           | Weighted average common shares used in computing basic
and diluted per share amounts   |  |                         | 219,743,662 |      |  |      | 177,347,193 |   |  |   | 152,358,589 |  
|                                                                           |                                                                                        |  |                         |             |      |  |      |             |   |  |   |             |  
|Pro forma amounts assuming the accounting change is applied
retroactively: |                                                                                        |  |                         |             |      |  |      |             |   |  |   |            
|                                                                           | Net income (loss)                                                                      |  | $                       | (184,828    | )    |  | $    | 344,758     |   |  | $ | (1,433,887  | )
|                                                                           |                                                                                        |  |                         |             |      |  |      |             |   |  |   |             |  
|                                                                           | Basic and diluted net income (loss) per common share                                   |  | $                       | (0.84       | )    |  | $    | 1.94        |   |  | $ | (9.41       | )
|                                                                           |                                                                                        |  |                         |             |      |  |      |             |   |  |   |             |  

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT)
(Amounts in thousands, except share amounts)

|                                                                                          |  |                 |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           |           |  |             |        |   |  |   |      |       |  |   |         |   |  |   |            |   |  |   |            |  
|----------------------------------------------------------------------------------------- |  | --------------- | - | ------------ |  | ---------- | - | ----------- |  | ---------- | ----------- | ------------- |  | ------------ | --- | ------------- |  | ------------- | --------- | --------- |  | ----------- | ------ | - |  | - | ---- | ----- |  | - | ------- | - |  | - | ---------- | - |  | - | ---------- | -
|                                                                                          |  | Convertible     |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           | Notes     |  | Accumulated |        |   |  |   |      | Total
|                                                                                          |  | Preferred Stock |   | Common Stock |  | Additional |   | Deferred    |  | Receivable |             | Other         |  |              |     |               |  | Stockholders'
|                                                                                          |  |                 |   |              |  | Paid-In    |   | Stock-Based |  | From       |             | Comprehensive |  | Accumulated  |     | Equity       
|                                                                                          |  | Shares          |   | Amount       |  | Shares     |   | Amount      |  | Capital    |             | Compensation  |  | Stockholders |     | Income (Loss) |  | Deficit       |           | (Deficit)
|                                                                                          |  |                 |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           |          
|Balances at
December 31, 1999                                                             |  |                 |  |              |  | $          |  |             |  |            | 138,710,493 |               |  | $            | 139 |               |  | $             | 851,538   |           |  | $           | (6,513 | ) |  | $ |     |       |  | $ | 91,257  |   |  | $ | (246,130   | ) |  | $ | 690,291    |  
|Issuance of common
stock                                                                  |  |                 |  |              |  |            |  |             |  |            | 18,101,646  |               |  |              | 18  |               |  |               | 155,385   |           |  |             |       |   |  |   |     |       |  |   |        |   |  |   |           |   |  |   | 155,403    |  
|Issuance of common
stock upon exercise
of options                                         |  |                 |  |              |  |            |  |             |  |            | 5,461,935   |               |  |              | 5   |               |  |               | 12,080    |           |  |             |       |   |  |   |     |       |  |   |        |   |  |   |           |   |  |   | 12,085     |  
|Issuance of common
stock for
acquisitions of
businesses                                   |  |                 |  |              |  |            |  |             |  |            | 11,097,753  |               |  |              | 11  |               |  |               | 480,645   |           |  |             | (407   | ) |  |   |     |       |  |   |        |   |  |   |           |   |  |   | 480,249    |  
|Repurchase of
common stock                                                                |  |                 |  |              |  |            |  |             |  |            | (1,434,375  | )             |  |              | (1  | )             |  |               |          |           |  |             |       |   |  |   |     |       |  |   |        |   |  |   |            |   |  |   | (1         | )
|Recognition of
warrants                                                                   |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               | 9,089     |           |  |             |       |   |  |   |     |       |  |   |        |   |  |   |           |   |  |   | 9,089      |  
|Assumption of notes
receivable from
stockholders in
connection with
business
acquisitions |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               |          |           |  |             |       |   |  |   | (423 | )     |  |   |        |   |  |   |           |   |  |   | (423       | )
|Deferred
stock-based
compensation                                                         |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               | 628       |           |  |             | (628   | ) |  |   |     |       |  |   |        |   |  |   |           |   |  |   |           |  
|Amortization of
deferred
stock-based
compensation                                         |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               |          |           |  |             | 4,481  |   |  |   |     |       |  |   |        |   |  |   |           |   |  |   | 4,481      |  
|Unrealized losses
on
available-for-sale
securities                                        |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               |          |           |  |             |       |   |  |   |     |       |  |   | (88,985 | ) |  |   |           |   |  |   | (88,985    | )
|Foreign currency
translation                                                              |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               |          |           |  |             |       |   |  |   |     |       |  |   | (1,716  | ) |  |   |           |   |  |   | (1,716     | )
|Net loss                                                                                  |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               |          |           |  |             |       |   |  |   |     |       |  |   |        |   |  |   | (1,443,136 | ) |  |   | (1,443,136 | )
|                                                                                          |  |                 |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           |           |  |             |        |   |  |   |      |       |  |   |         |   |  |   |            |   |  |   |            |  
|Balances at
December 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       |           |  |             |       |   |  |   |     |       |  |   |        |   |  |   |           |   |  |   | 580        |  
|Issuance of common
stock upon exercise
of options                                         |  |                 |  |              |  |            |  |             |  |            | 4,100,979   |               |  |              | 4   |               |  |               | 2,109     |           |  |             |       |   |  |   |     |       |  |   |        |   |  |   |           |   |  |   | 2,113      |  
|Repurchase of
common stock                                                                |  |                 |  |              |  |            |  |             |  |            | (67,500     | )             |  |              |    |               |  |               | (172      | )         |  |             |       |   |  |   |     |       |  |   |        |   |  |   |           |   |  |   | (172       | )

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COVAD COMMUNICATIONS GROUP, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT) (continued)
(Amounts in thousands, except share amounts)

|                                                                        |  |                 |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           |           |  |             |       |   |  |  |     |       |  |  |        |   |  |  |            |   |  |  |         |  
|----------------------------------------------------------------------- |  | --------------- | - | ------------ |  | ---------- | - | ----------- |  | ---------- | ----------- | ------------- |  | ------------ | --- | ------------- |  | ------------- | --------- | --------- |  | ----------- | ----- | - |  |  | --- | ----- |  |  | ------ | - |  |  | ---------- | - |  |  | ------- | -
|                                                                        |  | Convertible     |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           | Notes     |  | Accumulated |       |   |  |  |     | Total
|                                                                        |  | Preferred Stock |   | Common Stock |  | Additional |   | Deferred    |  | Receivable |             | Other         |  |              |     |               |  | Stockholders'
|                                                                        |  |                 |   |              |  | Paid-In    |   | Stock-Based |  | From       |             | Comprehensive |  | Accumulated  |     | Equity       
|                                                                        |  | Shares          |   | Amount       |  | Shares     |   | Amount      |  | Capital    |             | Compensation  |  | Stockholders |     | Income (Loss) |  | Deficit       |           | (Deficit)
|                                                                        |  |                 |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           |          
|Issuance of common
stock upon
emergence from
Chapter 11
bankruptcy      |  |                 |  |              |  |            |  |             |  |            | 37,292,800  |               |  |              | 37  |               |  |               | 93,568    |           |  |             |      |   |  |  |    |       |  |  |       |   |  |  |           |   |  |  | 93,605  |  
|Deconsolidation of
subsidiary                                           |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               |          |           |  |             |      |   |  |  | 423 |       |  |  |       |   |  |  |           |   |  |  | 423     |  
|Stock-based
compensation                                                |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               | 439       |           |  |             |      |   |  |  |    |       |  |  |       |   |  |  |           |   |  |  | 439     |  
|Issuance of common
stock for business
acquisition                       |  |                 |  |              |  |            |  |             |  |            | 2,268,481   |               |  |              | 2   |               |  |               | 2,062     |           |  |             |      |   |  |  |    |       |  |  |       |   |  |  |           |   |  |  | 2,064   |  
|Reversal of
deferred
stock-based
compensation                           |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               | (1,213    | )         |  |             | 1,213 |   |  |  |    |       |  |  |       |   |  |  |           |   |  |  |        |  
|Amortization of
deferred
stock-based
compensation                       |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               |          |           |  |             | 1,597 |   |  |  |    |       |  |  |       |   |  |  |           |   |  |  | 1,597   |  
|Unrealized losses
on
available-for-sale
securities                      |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               |          |           |  |             |      |   |  |  |    |       |  |  | (2,327 | ) |  |  |           |   |  |  | (2,327  | )
|Foreign currency
translation                                            |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               |          |           |  |             |      |   |  |  |    |       |  |  | (588   | ) |  |  |           |   |  |  | (588    | )
|Net income                                                              |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               |          |           |  |             |      |   |  |  |    |       |  |  |       |   |  |  | 344,758    |   |  |  | 344,758 |  
|                                                                        |  |                 |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           |           |  |             |       |   |  |  |     |       |  |  |        |   |  |  |            |   |  |  |         |  
|Balances at
December 31, 2001                                           |  |                 |  |              |  |            |  |             |  |            | 216,542,212 |               |  |              | 216 |               |  |               | 1,606,737 |           |  |             | (257  | ) |  |  |    |       |  |  | (2,359 | ) |  |  | (1,344,508 | ) |  |  | 259,829 |  
|Issuance of common
stock                                                |  |                 |  |              |  |            |  |             |  |            | 5,417,251   |               |  |              | 6   |               |  |               | 4,303     |           |  |             |      |   |  |  |    |       |  |  |       |   |  |  |           |   |  |  | 4,309   |  
|Issuance of common
stock upon exercise
of options                       |  |                 |  |              |  |            |  |             |  |            | 1,005,937   |               |  |              | 1   |               |  |               | 398       |           |  |             |      |   |  |  |    |       |  |  |       |   |  |  |           |   |  |  | 399     |  
|Issuance of common
stock following
emergence from
Chapter 11
bankruptcy |  |                 |  |              |  |            |  |             |  |            | 217,111     |               |  |              |    |               |  |               | 261       |           |  |             |      |   |  |  |    |       |  |  |       |   |  |  |           |   |  |  | 261     |  
|Issuance of warrants                                                    |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               | 3,790     |           |  |             |      |   |  |  |    |       |  |  |       |   |  |  |           |   |  |  | 3,790   |  
|Stock-based
compensation                                                |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               | 285       |           |  |             |      |   |  |  |    |       |  |  |       |   |  |  |           |   |  |  | 285     |  

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COVAD COMMUNICATIONS GROUP, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT) (continued)
(Amounts in thousands, except share amounts)

|                                                             |  |                 |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           |           |  |             |      |   |  |   |   |       |  |   |       |   |  |   |            |   |  |   |          |  
|------------------------------------------------------------ |  | --------------- | - | ------------ |  | ---------- | - | ----------- |  | ---------- | ----------- | ------------- |  | ------------ | --- | ------------- |  | ------------- | --------- | --------- |  | ----------- | ---- | - |  | - | - | ----- |  | - | ----- | - |  | - | ---------- | - |  | - | -------- | -
|                                                             |  | Convertible     |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           | Notes     |  | Accumulated |      |   |  |   |   | Total
|                                                             |  | Preferred Stock |   | Common Stock |  | Additional |   | Deferred    |  | Receivable |             | Other         |  |              |     |               |  | Stockholders'
|                                                             |  |                 |   |              |  | Paid-In    |   | Stock-Based |  | From       |             | Comprehensive |  | Accumulated  |     | Equity       
|                                                             |  | Shares          |   | Amount       |  | Shares     |   | Amount      |  | Capital    |             | Compensation  |  | Stockholders |     | Income (Loss) |  | Deficit       |           | (Deficit)
|                                                             |  |                 |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           |          
|Deferred
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   |   |  |   |           |   |  |   | 270      |  
|Foreign currency
translation                                 |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               |          |           |  |             |     |   |  |   |  |       |  |   | 1,342 |   |  |   |           |   |  |   | 1,342    |  
|Net loss                                                     |  |                 |  |              |  |            |  |             |  |            |            |               |  |              |    |               |  |               |          |           |  |             |     |   |  |   |  |       |  |   |      |   |  |   | (184,828   | ) |  |   | (184,828 | )
|                                                             |  |                 |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           |           |  |             |      |   |  |   |   |       |  |   |       |   |  |   |            |   |  |   |          |  
|Balances at
December 31, 2002                                |  |                 |  |              |  | $          |  |             |  |            | 223,182,511 |               |  | $            | 223 |               |  | $             | 1,612,319 |           |  | $           | (160 | ) |  | $ |  |       |  | $ | (747  | ) |  | $ | (1,529,336 | ) |  | $ | 82,299   |  
|                                                             |  |                 |   |              |  |            |   |             |  |            |             |               |  |              |     |               |  |               |           |           |  |             |      |   |  |   |   |       |  |   |       |   |  |   |            |   |  |   |          |  

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)

|                                                                                     |                                                                             |                                                     |                                       |         |                         |         |         |            |         |          |            |         |         |          |  
|------------------------------------------------------------------------------------ | --------------------------------------------------------------------------- | --------------------------------------------------- | ------------------------------------- | ------- | ----------------------- | ------- | ------- | ---------- | ------- | -------- | ---------- | ------- | ------- | -------- | -
|                                                                                     |                                                                             |                                                     |                                       |         | Year ended December 31,
|                                                                                     |                                                                             |                                                     |                                       |         |                        
|                                                                                     |                                                                             |                                                     |                                       |         | 2002                    |         | 2001    |            | 2000   
|                                                                                     |                                                                             |                                                     |                                       |         |                         |         |         |            |        
|Operating Activities:                                                                |                                                                             |                                                     |                                       |         |                         |         |         |            |         |          |            |        
|Net income (loss)                                                                    |                                                                             | $                                                   | (184,828                              | )       |                         | $       | 344,758 |            |         | $        | (1,443,136 | )      
|Adjustments to reconcile net income (loss) to net cash
used in operating activities: |                                                                             |                                                     |                                       |         |                         |         |         |            |         |          |            |        
|                                                                                     | Provision for bad debts (bad debt recoveries)                               |                                                     |                                       | 319     |                         |         |         | (658       | )       |          |            | 11,257  |        
|                                                                                     | Depreciation and amortization                                               |                                                     |                                       | 127,088 |                         |         |         | 150,839    |         |          |            | 178,425 |        
|                                                                                     | Loss on disposition of property and equipment                               |                                                     |                                       | 1,712   |                         |         |         | 2,679      |         |          |            | 524     |        
|                                                                                     | Non-cash reorganization expenses                                            |                                                     |                                       |        |                         |         |         | 42,856     |         |          |            |        |        
|                                                                                     | Non-cash litigation-related expenses                                        |                                                     |                                       | (11,628 | )                       |         |         | 25,801     |         |          |            |        |        
|                                                                                     | Provision for long-lived asset impairment                                   |                                                     |                                       |        |                         |         |         | 11,988     |         |          |            | 589,388 |        
|                                                                                     | Write-off of in-process research and development
costs                      |                                                     |                                       |        |                         |         |         |           |         |          |            | 3,726   |        
|                                                                                     | Amortization (reversal) of deferred stock-based
compensation, net           |                                                     |                                       | (3,358  | )                       |         |         | 1,597      |         |          |            | 4,481   |        
|                                                                                     | Other stock-based compensation                                              |                                                     |                                       | 285     |                         |         |         | 439        |         |          |            | 9,089   |        
|                                                                                     | Other non-cash charges                                                      |                                                     |                                       | 803     |                         |         |         |           |         |          |            |        |        
|                                                                                     | Accretion of interest on investments                                        |                                                     |                                       | (209    | )                       |         |         | (7,136     | )       |          |            | (25,093 | )      
|                                                                                     | Accretion of debt discount and amortization of
deferred debt issuance costs |                                                     |                                       |        |                         |         |         | 20,845     |         |          |            | 27,826  |        
|                                                                                     | Other than temporary losses on short-term investments                       |                                                     |                                       |        |                         |         |         | 1,311      |         |          |            | 11,579  |        
|                                                                                     | Provision for impairment of investments in
unconsolidated affiliates        |                                                     |                                       | 388     |                         |         |         | 10,069     |         |          |            | 17,826  |        
|                                                                                     | Equity in losses of unconsolidated affiliates                               |                                                     |                                       | 806     |                         |         |         | 13,769     |         |          |            | 6,452   |        
|                                                                                     | (Gain) loss on disposal of investment in
unconsolidated affiliates          |                                                     |                                       | 636     |                         |         |         | (178       | )       |          |            |        |        
|                                                                                     | Extraordinary item                                                          |                                                     |                                       |        |                         |         |         | (1,033,727 | )       |          |            |        |        
|                                                                                     | Cumulative effect of change in accounting principle                         |                                                     |                                       |        |                         |         |         |           |         |          |            | 9,249   |        
|                                                                                     | Net changes in operating assets and liabilities:                            |                                                     |                                       |         |                         |         |         |            |         |          |            |         |        
|                                                                                     |                                                                             | Restricted cash                                     |                                       |         | 8,702                   |         |         |            | (9,103  | )        |            |         | (635    | )       
|                                                                                     |                                                                             | Accounts receivable                                 |                                       |         | 1,180                   |         |         |            | 532     |          |            |         | (18,932 | )       
|                                                                                     |                                                                             | Unbilled revenue                                    |                                       |         | 1,043                   |         |         |            | 2,282   |          |            |         | (1,827  | )       
|                                                                                     |                                                                             | Inventories                                         |                                       |         | 2,153                   |         |         |            | 6,748   |          |            |         | (5,662  | )       
|                                                                                     |                                                                             | Prepaid expenses and other current assets           |                                       |         | 4,159                   |         |         |            | 3,163   |          |            |         | 3,534   |         
|                                                                                     |                                                                             | Deferred costs of service activation                |                                       |         | 17,676                  |         |         |            | (5,131  | )        |            |         | (52,831 | )       
|                                                                                     |                                                                             | Accounts payable                                    |                                       |         | (4,927                  | )       |         |            | (53,652 | )        |            |         | 41,047  |         
|                                                                                     |                                                                             | Unresolved claims related to bankruptcy
proceedings |                                       |         | (2,930                  | )       |         |            | 22,200  |          |            |         |        |         
|                                                                                     |                                                                             | Collateralized customer deposit                     |                                       |         | (6,809                  | )       |         |            |        |          |            |         |        |         
|                                                                                     |                                                                             | Accrued restructuring expenses                      |                                       |         |                        |         |         |            | 2,024   |          |            |         | 4,988   |         
|                                                                                     |                                                                             | Other current liabilities                           |                                       |         | (1,346                  | )       |         |            | (22,291 | )        |            |         | 51,773  |         
|                                                                                     |                                                                             | Unearned revenues                                   |                                       |         | (24,882                 | )       |         |            | 12,777  |          |            |         | 80,459  |         
|                                                                                     |                                                                             |                                                     |                                       |         |                         |         |         |            |         |          |            |        
|                                                                                     |                                                                             |                                                     | Net cash used in operating activities |         |                         | (73,967 | )       |            |         | (455,199 | )          |         |         | (496,493 | )

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COVAD COMMUNICATIONS GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(Amounts in thousands)

|                                                                               |                                                     |  |                         |         |      |  |          |          |   |  |          |           |  
|------------------------------------------------------------------------------ | --------------------------------------------------- |  | ----------------------- | ------- | ---- |  | -------- | -------- | - |  | -------- | --------- | -
|                                                                               |                                                     |  | Year ended December 31,
|                                                                               |                                                     |  |                        
|                                                                               |                                                     |  | 2002                    |         | 2001 |  | 2000    
|                                                                               |                                                     |  |                         |         |      |  |         
|Investing Activities:                                                          |                                                     |  |                         |         |      |  |          |          |   |  |          |          
|Cash acquired through business acquisitions                                    |                                                     |  |                        |         |      |  |         |          |   |  | 4,330    |          
|Cash relinquished as a result of deconsolidating a
subsidiary                  |                                                     |  |                        |         |      |  | (1,599   | )        |   |  |         |          
|Purchase of short-term investments                                             |                                                     |  | (237,088                | )       |      |  | (638,096 | )        |   |  | (613,307 | )        
|Maturities of short-term investments                                           |                                                     |  | 165,526                 |         |      |  | 547,477  |          |   |  | 679,615  |          
|Sale of short-term investments                                                 |                                                     |  | 40,017                  |         |      |  | 329,458  |          |   |  | 92,917   |          
|Redemption of restricted investments                                           |                                                     |  |                        |         |      |  | 26,875   |          |   |  | 26,875   |          
|Purchase of restricted investments in connection with
bankruptcy proceedings   |                                                     |  |                        |         |      |  | (257,202 | )        |   |  |         |          
|Redemption of restricted investments in connection with
bankruptcy proceedings |                                                     |  |                        |         |      |  | 270,698  |          |   |  |         |          
|Purchase of property and equipment                                             |                                                     |  | (22,782                 | )       |      |  | (15,732  | )        |   |  | (319,234 | )        
|Proceeds from sale of property and equipment                                   |                                                     |  | 13,451                  |         |      |  | 1,280    |          |   |  |         |          
|Recovery of internal-use software costs                                        |                                                     |  | 814                     |         |      |  | 2,000    |          |   |  | 21,500   |          
|Payment of collocation fees                                                    |                                                     |  | (3,782                  | )       |      |  | (7,940   | )        |   |  | (25,038  | )        
|Acquisition of equity investments in unconsolidated
affiliates                 |                                                     |  |                        |         |      |  |         |          |   |  | (51,341  | )        
|Proceeds from sale of investments in unconsolidated
affiliates                 |                                                     |  | 3,360                   |         |      |  | 1,225    |          |   |  |         |          
|Decrease (increase) in other long-term assets                                  |                                                     |  | 371                     |         |      |  | (206     | )        |   |  | (2,053   | )        
|                                                                               |                                                     |  |                         |         |      |  |          |          |   |  |          |          
|                                                                               | Net cash provided by (used in) investing
activities |  |                         | (40,113 | )    |  |          | 258,238  |   |  |          | (185,736  | )
|Financing Activities:                                                          |                                                     |  |                         |         |      |  |          |          |   |  |          |          
|Proceeds from collateralized customer deposit                                  |                                                     |  |                        |         |      |  | 75,000   |          |   |  |         |          
|Proceeds from issuance of long-term debt                                       |                                                     |  |                        |         |      |  | 50,000   |          |   |  | 897,619  |          
|Principal payments of long-term debt in connection with
bankruptcy proceedings |                                                     |  |                        |         |      |  | (271,708 | )        |   |  |         |          
|Other principal payments of long-term debt                                     |                                                     |  |                        |         |      |  | (8,393   | )        |   |  | (5,457   | )        
|Principal payments under capital lease obligations                             |                                                     |  | (328                    | )       |      |  | (1,089   | )        |   |  | (2,347   | )        
|Proceeds from common stock issuance, net of repurchase                         |                                                     |  | 3,089                   |         |      |  | 2,521    |          |   |  | 167,487  |          
|Principal payments on short-term borrowings                                    |                                                     |  |                        |         |      |  |         |          |   |  | (32,900  | )        
|                                                                               |                                                     |  |                         |         |      |  |          |          |   |  |          |          
|                                                                               | Net cash provided by (used in) financing
activities |  |                         | 2,761   |      |  |          | (153,669 | ) |  |          | 1,024,402 |  
|Effect of foreign currency translation on cash and cash
equivalents            |                                                     |  |                        |         |      |  |         |          |   |  | 229      |          
|                                                                               |                                                     |  |                         |         |      |  |          |          |   |  |          |          
|Net increase (decrease) in cash and cash equivalents                           |                                                     |  | (111,319                | )       |      |  | (350,630 | )        |   |  | 342,402  |          
|Cash and cash equivalents at beginning of year                                 |                                                     |  | 207,810                 |         |      |  | 558,440  |          |   |  | 216,038  |          
|                                                                               |                                                     |  |                         |         |      |  |          |          |   |  |          |          
|                                                                               | Cash and cash equivalents at end of year            |  | $                       | 96,491  |      |  | $        | 207,810  |   |  | $        | 558,440   |  
|                                                                               |                                                     |  |                         |         |      |  |          |          |   |  |          |          

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COVAD COMMUNICATIONS GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(Amounts in thousands)

|                                                                                                           |  |                         |     |      |  |      |        |  |  |   |        | 
|---------------------------------------------------------------------------------------------------------- |  | ----------------------- | --- | ---- |  | ---- | ------ |  |  | - | ------ | 
|                                                                                                           |  | Year ended December 31,
|                                                                                                           |  |                        
|                                                                                                           |  | 2002                    |     | 2001 |  | 2000
|                                                                                                           |  |                         |     |      |  |     
|Supplemental Disclosures of Cash Flow Information:                                                         |  |                         |     |      |  |      |        |  |  |   |        | 
|Cash paid during the year for interest, net of amounts
capitalized (none in 2002 and 2001, $2,490 in 2000) |  | $                       | 80  |      |  | $    | 68,051 |  |  | $ | 77,816 | 
|                                                                                                           |  |                         |     |      |  |      |        |  |  |   |        | 
|Supplemental Schedule of Non-Cash Investing and Financing
Activities:                                      |  |                         |     |      |  |      |        |  |  |   |        | 
|Equipment purchased through capital leases                                                                 |  | $                       | 482 |      |  | $    |       |  |  | $ | 955    | 
|                                                                                                           |  |                         |     |      |  |      |        |  |  |   |        | 

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2002, 2001 and 2000
(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 Website. ISPs purchase
Covads services in order to provide high-speed Internet access to their
business and consumer end-users. Branded virtual service providers purchase
turnkey broadband or dial-up services from Covad and sell these services to
their existing customers or affiliate groups. 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 subsidiaries
(collectively, BlueStar), which have been excluded from the Companys
consolidated financial statements effective June 25, 2001 (Note 3). All
significant intercompany accounts and transactions have been eliminated in
consolidation.

The
Companys 2003 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, 2003
using only the Companys unrestricted cash, cash equivalent and
short-term investment balances in existence as of December 31,
2002. Additionally, on February 20, 2003, the Federal
Communications Commission (FCC) announced the results of
the Triennial Review of its rules for network unbundling obligations
of Incumbent Local Exchange Carriers (Note 15). Among other
things, the FCC announced that it will phase-out its rule requiring
line-sharing over a three-year period. While the FCC has not yet
issued its order pursuant to the Triennial Review, the ultimate
impact of the FCCs February 20, 2003 announcement on the
Companys business, which relies on line-sharing to serve certain
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.
Management 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, 2003.

As part of managements continuing evaluation of the Companys 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 has 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, management discovered that the Company 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. 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

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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). The impact on prior
financial reporting periods would have been as follows if these amounts had
been recorded in the correct financial reporting periods: (i) net income for
the year ended December 31, 2001 would have been decreased by $3,433 ($0.02 per
share) and (ii) net loss for the year ended December 31, 2000 would have been
decreased by $1,139 ($0.01 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 management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results may differ
materially from 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
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, 2002 and 2001, cash equivalents consisted principally of
money market mutual funds. All of the Companys investments are classified as
available-for-sale and stated at 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. Management 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, 2002 |     |            |   |  
|                                  |                                     |   |           |         |            |   |                   |     |            |   |  
|                                  |                                     |   |           |         |            |   | Gross             |     | Gross      |   |   |   | 
|                                  |                                     |   | Amortized |         | Unrealized |   | Unrealized        |     |            |   |  
|                                  |                                     |   | Cost      |         | Gains      |   | Losses            |     | Fair Value
|                                  |                                     |   |           |         |            |   |                   |     |           
|U.S. Government agency
securities |                                     | $ | 107,867   |         |            | $ | 209               |     |            | $ |  |   |  | $ | 108,076 |        
|                                  |                                     |   |           |         |            |   |                   |     |            |   |   |   |  |   |         |        
|                                  | Total available-for-sale
securities |   | $         | 107,867 |            |   | $                 | 209 |            |   | $ |  |  |   | $       | 108,076 | 
|                                  |                                     |   |           |         |            |   |                   |     |            |   |   |   |  |   |         |        

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|                                  |                                     |   |           |        |            |   |                   |   |            |   |     |     |   |   |        |        | 
|--------------------------------- | ----------------------------------- | - | --------- | ------ | ---------- | - | ----------------- | - | ---------- | - | --- | --- | - | - | ------ | ------ | 
|                                  |                                     |   |           |        |            |   | December 31, 2001 |   |            |   |    
|                                  |                                     |   |           |        |            |   |                   |   |            |   |    
|                                  |                                     |   |           |        |            |   | Gross             |   | Gross      |   |     |     |  
|                                  |                                     |   | Amortized |        | Unrealized |   | Unrealized        |   |            |   |    
|                                  |                                     |   | Cost      |        | Gains      |   | Losses            |   | Fair Value
|                                  |                                     |   |           |        |            |   |                   |   |           
|U.S. Government agency
securities |                                     | $ | 30,019    |        |            | $ | 1                 |   |            | $ | (23 | )   |   | $ | 29,997 |       
|Certificates of deposit           |                                     |   | 46,089    |        |            |   |                  |   |            |   | (33 | )   |   |   | 46,056 |       
|                                  |                                     |   |           |        |            |   |                   |   |            |   |     |     |   |   |        |       
|                                  | Total available-for-sale
securities |   | $         | 76,108 |            |   | $                 | 1 |            |   | $   | (56 | ) |   | $      | 76,053 | 
|                                  |                                     |   |           |        |            |   |                   |   |            |   |     |     |   |   |        |       

Realized gains and losses resulting from the sale of available-for-sale
securities were as follows:

|       |  |                         |     |      |  |      |       |   |  |   |        | 
|------ |  | ----------------------- | --- | ---- |  | ---- | ----- | - |  | - | ------ | 
|       |  | Year ended December 31,
|       |  |                        
|       |  | 2002                    |     | 2001 |  | 2000
|       |  |                         |     |      |  |     
|Gains  |  | $                       |    |      |  | $    | 6,373 |   |  | $ | 13,466 | 
|Losses |  |                         | (17 | )    |  |      | (464  | ) |  |   |       | 
|       |  |                         |     |      |  |      |       |   |  |   |        | 
|       |  | $                       | (17 | )    |  | $    | 5,909 |   |  | $ | 13,466 | 
|       |  |                         |     |      |  |      |       |   |  |   |        | 

Restricted Cash and Investments

As of December 31, 2002 and 2001, the Company held $501 and $9,203,
respectively, in money market mutual funds principally for the payment of
unresolved bankruptcy claims (Note 2).

Other Investments

Other investments consist primarily of strategic investments in publicly
held and private entities. Investments representing equity interests of less
than 20% in publicly held companies are accounted for as available-for-sale
securities at fair value as measured by quoted market prices. 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 both publicly and
privately held investments and the Company does not record subsequent increases
in fair value in excess of the new carrying value for privately held
investments accounted for under the cost or equity methods. The Company
recorded write-downs of $388, $10,069 and $17,826 during the years ended
December 31, 2002, 2001 and 2000, respectively, related to impairments of its
privately held investments.

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 investments. The Companys cash and
investment policies limit cash equivalents, short-term investments and
restricted investments to short-term, investment grade instruments. Cash and
cash equivalents, short-term investments and restricted cash and investments
are held with various domestic and Canadian financial institutions with high
credit standing. The Company has not experienced
any significant losses on its cash, cash equivalents or restricted
investments. However, during the years ended December 31, 2001 and 2000, the
Company recognized other than temporary losses on certain available-for-sale
securities aggregating $1,311 and $11,579, respectively (none during the year
ended December 31, 2002).

The Company conducts business primarily with ISP, enterprise 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

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

of customers, and certain of the Companys customers were experiencing
financial difficulties as of December 31, 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, 2002, 2001 and 2000, the Company
wrote-off certain accounts receivable balances aggregating $2,652, $10,371 and
$175, respectively, against the allowance for credit losses. During the years
ended December 31, 2002 and 2001, the Company recovered $684 and $2,037,
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, 2000.

The Companys former vice-chairman and interim chief executive officer,
who was also a member of the Companys board of directors from October 1997 to
December 2002, is 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 recognized
revenues of $5,601 and $7,189 related to this customer during the years ended
December 31, 2001 and 2000, respectively (none during the year ended December
31, 2002). The Company also purchased certain products from a company in which
its former vice-chairman and interim chief executive officer serves as a
director. Purchases from this vendor totaled $258 and $140 in 2002 and 2001,
respectively. Purchases were not made from this vendor in 2000.

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 acquired an equity interest in a supplier during 1999 and
disposed of this interest in 2001. Purchases from this supplier totaled $5,774,
$13,928 and $53,156 for the years ended December 31, 2002, 2001 and 2000,
respectively.

A member of the Companys Board of Directors is the President of one of
the Companys wholesale customers. The Company recognized revenues from this customer of
$1,311, $1,822 and $1,317 during the years ended December
31, 2002, 2001 and 2000, respectively. As of December 31, 2002 and 2001,
gross accounts receivable from this customer were $68 and $226, respectively.

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.

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:

|                                     |  |                                                    
|------------------------------------ |  | ---------------------------------------------------
|Building                             |  | 10 years                                           
|Leasehold improvements               |  | 5 years or the term of the lease, whichever is less
|Computer equipment                   |  | 2 to 5 years                                       
|Computer software                    |  | 3 to 5 years                                       
|Furniture and fixtures               |  | 2 to 5 years                                       
|Networks and
communication
equipment |  | 2 to 5 years                                       

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

The Company incurs significant costs associated with internal use
software, which consists principally of the Companys operational support
systems (OSS) software and Website. 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 Website development costs, which include
direct costs such as labor and contractors, are capitalized when it is probable
that the project will be completed and the software or Website will be used as
intended. Costs incurred for upgrades and enhancements to the Companys
software or Website are capitalized when it is probable that such efforts will
result in additional and significant functionality. Capitalized software and
Website costs are amortized to expense over the estimated useful life of the
software or Website. Amortization of internal use software costs was $5,814,
$9,207 and $6,394 during the years ended December 31, 2002, 2001 and 2000,
respectively. The Company accounts for incidental sales of licenses to its OSS
software on a cost recovery basis (Note 6).

The Company leases 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

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.

As of December 31, 2002, the Companys estimated annual amortization
expenses associated with collocation fees for the next five years were as
follows:

|     |  |   |        | 
|---- |  | - | ------ | 
|2003 |  | $ | 11,828 | 
|2004 |  | $ | 11,828 | 
|2005 |  | $ | 11,828 | 
|2006 |  | $ | 7,343  | 
|2007 |  | $ | 457    | 

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 building
and leasehold improvements, that previously had estimated useful lives in
excess of five years such that the residual balances and any subsequent
additions are now depreciated or amortized over five years using the
straight-line method. This change in accounting estimate increased the
Companys loss before extraordinary item by $14,006 ($.08 per share) and
decreased net income by $14,006 ($.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

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 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, 2002, 2001 and 2000 had the Company
applied the fair value method to account for stock-based awards to employees:

|                                                                                                                                                                          |             |   |          |       |      |   |         |      |  |   |            |        |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------- | - | -------- | ----- | ---- | - | ------- | ---- |  | - | ---------- | ------ | -
|                                                                                                                                                                          |             |   | 2002     |       | 2001 |   | 2000   
|                                                                                                                                                                          |             |   |          |       |      |   |        
|Net income (loss), as reported                                                                                                                                            |             | $ | (184,828 | )     |      | $ | 344,758 |      |  | $ | (1,443,136 | )     
|Stock-based employee
compensation expense
(reversal) included in the
determination of net income
(loss), as reported                                                      |             |   | (3,112   | )     |      |   | 1,849   |      |  |   | 4,481      |       
|Stock-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 |             |   | (28,001  | )     |      |   | (13,051 | )    |  |   | (206,900   | )     
|                                                                                                                                                                          |             |   |          |       |      |   |         |      |  |   |            |       
|Pro forma net income (loss)                                                                                                                                               |             | $ | (215,941 | )     |      | $ | 333,556 |      |  | $ | (1,645,555 | )     
|                                                                                                                                                                          |             |   |          |       |      |   |         |      |  |   |            |       
|Basic and diluted net income
(loss) per common share:                                                                                                                     |             |   |          |       |      |   |         |      |  |   |            |       
|                                                                                                                                                                          | As reported |   | $        | (0.84 | )    |   | $       | 1.94 |  |   | $          | (9.41  | )
|                                                                                                                                                                          |             |   |          |       |      |   |         |      |  |   |            |       
|                                                                                                                                                                          | Pro forma   |   | $        | (0.98 | )    |   | $       | 1.88 |  |   | $          | (10.80 | )
|                                                                                                                                                                          |             |   |          |       |      |   |         |      |  |   |            |       

The weighted-average grant date fair value of stock-based awards to
employees was $1.50, $1.45 and $29.02 per share during the years ended December 31, 2002,
2001 and 2000, respectively. Such weighted-average grant 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, 2002, 2001 and 2000 was
$27,083, $16,467 and $45,511, 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
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.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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.

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 Investments.
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 and capital lease obligations was $59,140 as of
December 31, 2002, as compared to the aggregate carrying amount of $50,147 as
of such date. The aggregate fair value of the Companys long-term debt and
capital lease obligations was $50,011 as of December 31, 2001, as compared to
the aggregate carrying amount of $50,011 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.

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 senior notes was
not dilutive to loss from operations.

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:

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|                                                                         |  |                         |             |      |  |      |             |  |  |  |             | 
|------------------------------------------------------------------------ |  | ----------------------- | ----------- | ---- |  | ---- | ----------- |  |  |  | ----------- | 
|                                                                         |  | Year ended December 31,
|                                                                         |  |                        
|                                                                         |  | 2002                    |             | 2001 |  | 2000
|                                                                         |  |                         |             |      |  |     
|Weighted average shares of common stock
outstanding                      |  |                         | 219,750,287 |      |  |      | 177,489,090 |  |  |  | 155,944,344 | 
|Less weighted average shares of common
stock subject to repurchase       |  |                         | 6,625       |      |  |      | 141,897     |  |  |  | 3,585,755   | 
|                                                                         |  |                         |             |      |  |      |             |  |  |  |             | 
|Weighted average common shares used in
computing basic per share amounts |  |                         | 219,743,662 |      |  |      | 177,347,193 |  |  |  | 152,358,589 | 
|                                                                         |  |                         |             |      |  |      |             |  |  |  |             | 

Comprehensive Income (Loss)

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

|                                                           |  |            |            |      |  |                         |          |      |  |   |         |   |  |   |            |  
|---------------------------------------------------------- |  | ---------- | ---------- | ---- |  | ----------------------- | -------- | ---- |  | - | ------- | - |  | - | ---------- | -
|                                                           |  |            |            |      |  | Year ended December 31,
|                                                           |  |            |            |      |  |                        
|                                                           |  | Cumulative |            |      |  |                         |          |      |  |   |         |   |  |  
|                                                           |  | Amounts    |            | 2002 |  | 2001                    |          | 2000
|                                                           |  |            |            |      |  |                         |          |     
|Net income (loss)                                          |  | $          | (1,529,336 | )    |  | $                       | (184,828 | )    |  | $ | 344,758 |   |  | $ | (1,443,136 | )
|Unrealized gains (losses)
on available-for-sale
securities |  |            | 215        |      |  |                         | 270      |      |  |   | (2,327  | ) |  |   | (88,985    | )
|Foreign currency
translation adjustment                    |  |            | (962       | )    |  |                         | 1,342    |      |  |   | (588    | ) |  |   | (1,716     | )
|                                                           |  |            |            |      |  |                         |          |      |  |   |         |   |  |   |            |  
|Comprehensive income (loss)                                |  | $          | (1,530,083 | )    |  | $                       | (183,216 | )    |  | $ | 341,843 |   |  | $ | (1,533,837 | )
|                                                           |  |            |            |      |  |                         |          |      |  |   |         |   |  |   |            |  

Recent Accounting Pronouncements

In December 2002, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) number (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, 2002, the Company has no
immediate plans to adopt the fair value method of accounting for stock-based
employee compensation.

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 will prospectively adopt EITF Issue No. 00-21 on
July 1, 2003, and it does not believe the adoption of EITF Issue No. 00-21 will
have a material effect on its consolidated financial statements.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

In November 2002, the FASB issued interpretation (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 is required to adopt 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 Company does not
believe the adoption of the recognition and measurement provisions of FIN No.
45 will have a material effect on its consolidated financial statements.

In July 2002, the FASB issued 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 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 will no longer be sufficient to record
a one-time charge for most restructuring activities. Instead, companies will
record exit or disposal costs when they are incurred and can be measured at
fair value. In addition, the resultant liabilities will be subsequently
adjusted for changes in estimated cash flows. SFAS No. 146 is effective
prospectively for exit or disposal activities initiated after December 31,
2002. Companies may not restate previously issued financial statements for the
effect of the provisions of SFAS No. 146, and liabilities that a company
previously recorded under EITF Issue No. 94-3 are grandfathered. The Company
will adopt SFAS No. 146 on January 1, 2003, and it does not believe the
adoption of SFAS No. 146 will have a material effect on its consolidated
financial statements.

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

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

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

On January 1, 2002, the Company adopted the provision in EITF Issue No.
01-9, Accounting for Consideration Given by a Vendor to a Customer (Including
a Reseller of the Vendors Products), dealing with consideration from a vendor
to a reseller under cooperative advertising and other arrangements. This
provision of EITF Issue No. 01-9
states that consideration from a vendor to a reseller of the vendors
products or services is presumed to be a reduction of the selling price of the
vendors products or services, unless the vendor (i) receives an identifiable
benefit in return for the consideration and (ii) can reasonably estimate the
fair value of the benefit received. If the amount of consideration paid by the
vendor exceeds the estimated fair value of the benefit received, the excess

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

amount is to be recorded by the vendor as a reduction of revenues. The adoption
of this new guidance did not have a material effect on the Companys
consolidated financial statements.

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

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

Reclassifications

Certain balances in the Companys 2001 and 2000 consolidated financial
statements, including certain operating expenses, have been reclassified to
conform to the presentation in 2002.

2. Revenue Recognition and Change in Accounting Principle

Revenues from recurring service are recognized when (i) persuasive
evidence of an arrangement between the Company and the customer exists, (ii)
service has been provided to the customer, (iii) the price to the customer is
fixed 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 sheet caption Unearned revenues. Included in
revenues are Federal Universal Service Fund (FUSF) charges billed to
customers aggregating $9,229, $13,277, and $10,647 for the years ended December
31, 2002, 2001 and 2000, respectively.

The Company had over 150 wholesale customers as of December 31, 2002.
However, for the years ended December 31, 2002 and 2001, the Companys 30
largest wholesale customers collectively comprised 93.3% and 88.5% of the
Companys total wholesale net revenues, respectively, and 79.5% and 76.0% of
the Companys total net revenues, respectively. As of December 31, 2002 and
2001, receivables from these customers collectively comprised 75.3% and 79.9%,
respectively, of the Companys gross accounts receivable balance.

For the
years ended December 31, 2002 and 2001, EarthLink, Inc., one of the
Companys wholesale customers, accounted for 20.0% and 17.5%,
respectively, of the Companys total net
revenues. As of December 31, 2002 and 2001, receivables from this customer comprised
25.9% and 26.0%, 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
2002, 2001 and 2000.

Some of the Companys ISP and telecommunications carrier customers are
experiencing financial difficulties. During the years ended December 31, 2002,
2001 and 2000, 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 (i) the collectibility of revenues from these customers
was not reasonably assured or (ii) its ability to retain some or all of the
payments

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 5.6%,
7.1% and 8.3% of the Companys total net revenues for the years ended December
31, 2002, 2001 and 2000, respectively. Although WorldCom, Inc. (WorldCom)
filed for bankruptcy protection on July 21, 2002, the Company continued to
recognize revenues from WorldCom on an accrual basis during 2002 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 WorldCom 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.

During the years ended December 31, 2002, 2001 and 2000, the Company
issued billings to its financially distressed customers aggregating $42,881,
$74,928 and $45,278, respectively, that were not recognized as revenues or
accounts receivable in the accompanying consolidated financial statements.
However, the Company ultimately recognized revenues from certain of these
customers when cash was collected (as described above) aggregating $47,609,
$29,003 and $2,814 during the years ended December 31, 2002, 2001 and 2000,
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, 2002 include
payments totaling $4,427 and $2,809, respectively, from certain bankrupt customers that the Company
received prior to January 1, 2002 and recorded as unearned revenues in the
accompanying consolidated balance sheet as of December 31, 2001 because the
Companys 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, the Company determined that its ability to
retain these payments was reasonably assured prior to December 31, 2002.
Consequently, the Company recognized these payments as revenues and
bad debt recoveries, respectively, during 2002. No such payments were recognized as revenues or bad debt recoveries during the years ended
December 31, 2001 or 2000. The Company had contractual receivables from its
financially distressed customers totaling $6,031 as of December 31, 2002 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 WorldCom, who (i) were essentially current in their
payments for the Companys services prior to December 31, 2002, or (ii) have
subsequently paid all or significant portions of the respective amounts
recorded as accounts receivable as of December 31, 2002, may become financially
distressed. Revenues from these customers accounted for approximately 34.6%,
14.2% and 13.9% of the Companys total net revenues for the years ended
December 31, 2002, 2001 and 2000, respectively. As of December 31, 2002,
receivables from these customers comprised 31.8% of the Companys gross
accounts receivable balance. If these customers are unable to demonstrate their
ability to pay for the Companys services in a timely manner in periods ending
subsequent to December 31, 2002, revenue from such customers will be recognized
when cash is collected (as described above).

The Company has obtained persuasive evidence indicating that the financial
condition of one of its customers, which was designated as financially
distressed in 2000, improved significantly during the 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

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 certain of its customers. These
disputes arise in the ordinary course of business in the telecommunications
industry and their impact on the Companys accounts receivable and revenues can
be reasonably estimated based on historical experience. Accordingly, the
Company maintains an allowance, through charges to revenues based on the
Companys estimate of the ultimate resolution of the disputes. These charges to
revenues amounted to $2,322, $11,178 and $13,838 during the years ended
December 31, 2002, 2001 and 2000, respectively. During the years ended December 31, 2002, 2001 and 2000, the Company
wrote-off certain accounts receivable balances aggregating $3,748, $6,701 and
$13,468, respectively, against the allowance for customer disputes. During the
year ended December 31, 2002, the Company recovered
$2,145 of accounts receivable balances previously written-off against
such allowance.
There were no similar recoveries of accounts receivable balances for
the years
ended December 31, 2001 and 2000.

During the fourth quarter of 2000, retroactive to January 1, 2000, the
Company changed its method of accounting for up-front fees associated with
service activation and the related incremental direct costs in accordance with
SEC Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in
Financial Statements. Previously, the Company had recognized up-front fees as
revenues upon activation of service. Under the new accounting method, which was
adopted retroactive to January 1, 2000, the Company now recognizes up-front
fees associated with service activation over the expected term of the customer
relationship, which is presently estimated to be 24 months, using the
straight-line method. Also as a result of the adoption of SAB No. 101,
retroactive to January 1, 2000, the Company now treats the incremental direct
costs of service activation (which consist principally of customer 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
cumulative effect of the change in accounting principle resulted in a charge to
operations of $9,249, which is included in net loss for the year ended December
31, 2000. The effect of the change in accounting principle on the year ended
December 31, 2000 was to increase loss before cumulative effect of change in
accounting principle by $51,550 ($0.33 per share). The pro forma amounts
presented in the consolidated statements of operations were calculated assuming
the accounting change was made retroactively to all prior periods presented.

For the years ended December 31, 2001 and 2000, the Company recognized
$11,661 and $18,661, respectively, in revenue that was included in the
cumulative effect adjustment as of January 1, 2000 (none during the year ended
December 31, 2002). The effect of that revenue during 2001 and 2000 was to
increase net income/decrease net loss by $3,067 and $4,624, respectively.

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 note. 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.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

On the Effective Date, the Company made the following distributions of
cash and shares of its common stock to certain claimants:

|                                   |  |              |         |        |  |              |            |                     |  |                |        |  |  |   |         | 
|---------------------------------- |  | ------------ | ------- | ------ |  | ------------ | ---------- | ------------------- |  | -------------- | ------ |  |  | - | ------- | 
|                                   |  | Common Stock
|                                   |  |             
|                                   |  |              |         |        |  |              |            |                     |  | Aggregate Fair |        |  |  |  
|Claimant                           |  | Cash         |         | Shares |  | Market Value |            | Total Consideration
|                                   |  |              |         |        |  |              |            |                    
|Noteholders                        |  | $            | 271,708 |        |  |              | 35,292,800 |                     |  | $              | 88,585 |  |  | $ | 360,293 | 
|Plaintiffs in
litigation (Note 10) |  |              | 5,793   |        |  |              | 2,000,000  |                     |  |                | 5,020  |  |  |   | 10,813  | 
|Other 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 an extraordinary gain 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                                      |                                                           | $         | 1,351,488 |          
|                                    | Accrued interest                                  |                                                           |           | 42,532    |          
|                                    |                                                   |                                                           |           |           |          
|                                    |                                                   |                                                           | 1,394,020 |          
|                                    | Less consideration distributed to the Noteholders |                                                           |           | 360,293   |          
|                                    |                                                   |                                                           |           |           |          
|                                    |                                                   | Extraordinary gain recognized                             |           | $         | 1,033,727 | 
|                                    |                                                   |                                                           |           |           |          
|Settlement of litigation (Note 10): |                                                   |                                                           |           |          
|                                    | Consideration distributed to the plaintiffs       |                                                           | $         | 10,813    |          
|                                    | Less amounts accrued prior to the Effective Date  |                                                           |           | 6,820     |          
|                                    |                                                   |                                                           |           |           |          
|                                    |                                                   | Additional litigation-related expenses recognized         |           | $         | 3,993     | 
|                                    |                                                   |                                                           |           |           |          
|Other:                              |                                                   |                                                           |           |          
|                                    | Consideration distributed to the claimants        |                                                           | $         | 1,900     |          
|                                    | Less 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 $8,344 and $31,608 as of December 31, 2002 and 2001. As
of December 31, 2002 and 2001, 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

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

Unresolved claims related to bankruptcy proceedings reflected in the accompanying consolidated balance
sheets as of December 31, 2002 and 2001.

As of December 31, 2002 and 2001, the Company had (i) placed $501 and
$8,000, respectively, of cash in a reserve fund (this balance is classified as
Restricted Cash and Investments in the accompanying consolidated balance
sheets) and (ii) reserved 7,078,733 and 7,295,844 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 year ended
December 31, 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 year ended December 31, 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      |                          | $ | 2,650   |        
|                    |                        |                          |   |         |        
|                    |                        | Total cash receipts      |   | $       | 2,650   | 
|                    |                        |                          |   |        
|Cash disbursements: |                        |                          |   |        
|                    | Interest paid          |                          | $ | 1,509   |        
|                    | Professional fees paid |                          |   | 16,003  |        
|                    | Claims paid            |                          |   | 277,892 |        
|                    |                        |                          |   |         |        
|                    |                        | Total 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

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 2002) under the PA and has
no additional liabilities under the PA as of December 31, 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 during the year ended December 31,
2002). Of this amount, $1,300 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
2003. An ABC under Tennessee law is a non-judicial alternative to a plan of
liquidation under Chapter 7 of the Bankruptcy Code. As a result of the ABC,
BlueStars former assets are no longer controlled by BlueStar or the Company
and cannot be used by either BlueStars or the Companys boards of directors to
satisfy the liabilities of BlueStar. Consequently, the liquidation of
BlueStars assets and the discharging of its liabilities are currently under
the sole control of the Assignee and the control of BlueStars assets no longer
rests with the Company. Therefore, the Company deconsolidated BlueStar
effective June 25, 2001, which resulted in the recognition of a deferred gain
in the amount of $55,200 in the Companys 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. Subsequently,
the deferred gain was reduced by $1,228 because certain BlueStar assets, which
inadvertently had not been deconsolidated on June 25, 2001, were
identified during the fourth quarter of 2002 and
deconsolidated at that time. The deconsolidation of these assets was charged
against the deferred gain during the fourth quarter of 2002, resulting in a
deferred gain balance of $53,972 in the Companys consolidated balance sheet as
of December 31, 2002. The Company will recognize such deferred gain as an
extraordinary item 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, 2000 and does not purport to be indicative
of the results of operations that would have occurred had the deconsolidation
occurred on January 1, 2000, or the results that may occur in the future:

|                                                                          |  |                         |          |      |  |   |            |  
|------------------------------------------------------------------------- |  | ----------------------- | -------- | ---- |  | - | ---------- | -
|                                                                          |  | Year ended December 31,
|                                                                          |  |                        
|                                                                          |  | 2001                    |          | 2000
|                                                                          |  |                         |          |     
|Revenues                                                                  |  | $                       | 320,619  |      |  | $ | 152,948    |  
|Loss before extraordinary item and
cumulative effect of accounting charge |  | $                       | (646,647 | )    |  | $ | (1,406,527 | )
|Net income (loss)                                                         |  | $                       | 387,080  |      |  | $ | (1,415,776 | )
|Basic and diluted net income (loss) per share                             |  | $                       | 2.18     |      |  | $ | (9.29      | )

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 (Note 5), 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 (Note 6);          
|
| |  |  | enhancing productivity in the Companys operations to increase
customer satisfaction while reducing costs;                                                                                           
|
| |  |  | restructuring the Companys direct sales and marketing channel; and                                                                                                                                  
|
| |  |  | evaluating and implementing other cost reduction strategies,
including salary freezes and reductions in travel, facilities and
advertising expenses.                                                 

In connection with this restructuring plan, the Company recorded a charge
to operations of $4,988 in the fourth quarter of 2000 relating to employee
severance benefits that met the requirements for accrual as of December 31,
2000. During the 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. However, 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. Impairment of Long-Lived Assets

In connection with the 2000 financial statement closing process, the
Company identified indicators of possible impairment of its long-lived assets.
Such indicators included deterioration in the business climate for Internet and
DSL service companies, reduced levels of venture capital and other funding
activity for such businesses and changes in the Companys strategic plans.

The Company performed asset impairment tests at the enterprise-level, the
lowest level for which there are identifiable cash flows that are largely
independent of the cash flows of other groups of assets. The tests were

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

performed by comparing the expected aggregate undiscounted cash flows to the
carrying amounts of long-lived assets. Based on the results of these tests, the
Company determined that its long-lived assets were impaired.

With the assistance of independent valuation experts, the Company then
determined the fair value of its long-lived assets. Fair value was determined
using the discounted cash flow method and the market comparison method. A
write-down of $589,388 was recorded in the fourth quarter of 2000, reflecting
the amount by which the carrying amount of certain long-lived assets exceeded
their respective fair values. The write-down consisted of $390,641 for
goodwill, $92,395 for other intangible assets and $106,352 for certain property
and equipment. As described in Note 6, the Company recorded an additional
write-down of goodwill in the amount of $1,989 during 2001.

Furthermore, 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 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 2002.

Property and equipment consisted of the following:

|                                               |                             |   |              |         |      |   |         |         | 
|---------------------------------------------- | --------------------------- | - | ------------ | ------- | ---- | - | ------- | ------- | 
|                                               |                             |   | December 31,
|                                               |                             |   |             
|                                               |                             |   | 2002         |         | 2001
|                                               |                             |   |              |         |     
|Land                                           |                             | $ |             |         |      | $ | 891     |        
|Building                                       |                             |   |             |         |      |   | 17,257  |        
|Leasehold improvements                         |                             |   | 9,276        |         |      |   | 8,433   |        
|Computer equipment                             |                             |   | 46,724       |         |      |   | 46,440  |        
|Computer software                              |                             |   | 30,486       |         |      |   | 34,751  |        
|Furniture and fixtures                         |                             |   | 17,785       |         |      |   | 20,337  |        
|Networks and communication equipment           |                             |   | 334,483      |         |      |   | 332,668 |        
|                                               |                             |   |              |         |      |   |         |        
|                                               |                             |   | 438,754      |         |      |   | 460,777 |        
|Less accumulated depreciation and amortization |                             |   | 330,017      |         |      |   | 244,973 |        
|                                               |                             |   |              |         |      |   |         |        
|                                               | Property and equipment, net |   | $            | 108,737 |      |   | $       | 215,804 | 
|                                               |                             |   |              |         |      |   |         |        

6. Business Acquisitions, Asset Acquisitions and Equity Investments

Acquisition of Laser Link.net, Inc.

On March 20, 2000, the Company acquired Laser Link.net, Inc. (Laser
Link) by issuing approximately 5,000,000 common shares in exchange for all of
the outstanding common shares of Laser Link. This transaction was accounted for
as a purchase. Accordingly, the Companys consolidated financial statements
include the results of operations of Laser Link for periods ending after the
date of acquisition. The common shares issued were valued for accounting
purposes using the average market price of $61.52 per share, which is based on
the average closing price around the announcement date (March 9, 2000) of the
transaction. The outstanding Laser Link stock options were
converted into options to purchase approximately 1,400,000 shares of the
Companys common stock at a fair value of $58.66 per share. In addition, the
outstanding Laser Link warrants were converted into warrants to purchase 15

85Table of ContentsCOVAD COMMUNICATIONS GROUP, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)shares of the Companys common stock at a fair value of $61.52 per share. The
value of the options and warrants, as well as direct transaction costs, were
included as elements of the total purchase cost.The total purchase cost of the Laser Link acquisition has been allocated
to the assets and liabilities of Laser Link based upon estimates of their fair
values. The following tables depict the total purchase cost and the allocation
thereof:

|                           |                                     |                                     |                              |         |         |         | 
|-------------------------- | ----------------------------------- | ----------------------------------- | ---------------------------- | ------- | ------- | ------- | 
|Total purchase cost:       |                                     |                                     |                              |        
|                           | Value of common shares issued       |                                     | $                            | 308,429 |        
|                           | Value of assumed Laser Link options |                                     |                              | 84,176  |        
|                           |                                     |                                     |                              |         |        
|                           |                                     |                                     | 392,605                      |        
|                           | Acquisition costs                   |                                     |                              | 10,566  |        
|                           |                                     |                                     |                              |         |        
|                           |                                     |                                     | Total purchase cost          |         | $       | 403,171 | 
|                           |                                     |                                     |                              |        
|Purchase price allocation: |                                     |                                     |                              |        
|                           | Tangible net assets acquired        |                                     | $                            | 691     |        
|                           | Intangible assets acquired:         |                                     |                              |         |        
|                           |                                     | Developed and core technology       |                              |         | 13,023  |        
|                           |                                     | Customer base                       |                              |         | 28,552  |        
|                           |                                     | Assembled workforce                 |                              |         | 1,140   |        
|                           |                                     | In-process research and development |                              |         | 3,726   |        
|                           |                                     | Goodwill                            |                              |         | 356,039 |        
|                           |                                     |                                     |                              |         |        
|                           |                                     |                                     | Total purchase consideration |         | $       | 403,171 | 
|                           |                                     |                                     |                              |        

The tangible assets of Laser Link acquired by the Company aggregating
$9,078 consisted principally of cash, accounts receivable and property and
equipment. The liabilities of Laser Link assumed by the Company aggregating
$8,387 consisted principally of a note payable (which was repaid prior to
December 31, 2000), accounts payable and accrued expenses.

The customer base was valued using an income approach, which projects the
associated revenue, expenses and cash flows attributable to the customer base
over its estimated life of five years. These cash flows are discounted to their
present value. Through December 31, 2000, this intangible asset was being
amortized on a straight-line basis over its estimated useful life of five years
(Note 5).

The value of the assembled workforce was derived by estimating the costs
to replace the existing employees, including recruiting, hiring and training
costs for each category of employee. Through December 31, 2000, this intangible
asset was being amortized on a straight-line basis over its estimated useful
life of three years (Note 5).

A portion of the purchase price was allocated to developed and core
technology and in-process research and development (IPRD). Developed and core
technology and IPRD were identified and valued through extensive interviews,
analysis of data provided by Laser Link concerning developmental products,
their stage of development, the time and resources needed to complete them, if
applicable, their expected income generating ability, target markets and
associated risks. The relief from royalty method, which assumes that the value
of an asset equals the amount a third party would pay to use the asset and
capitalize on the related benefits of the assets, was the primary technique
utilized in valuing the developed and core technology and IPRD.

Where developmental projects had reached technological feasibility, they
were classified as developed and core technology and the value assigned to
developed technology was capitalized. Through December 31, 2000, the

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

elements of this intangible asset were being amortized on a straight-line basis over
their estimated useful lives, which ranged from one to four years (Note 5).
Where the developmental projects had not reached technological feasibility and
had no future alternative uses, they were classified as IPRD. The value
allocated to projects identified as IPRD was charged to expense in 2000.

The nature of the efforts required to develop the purchased IPRD into
commercially viable products principally relate to the completion of all
planning, designing, prototyping, verification and testing activities that are
necessary to establish that the products can be produced to meet their design
specifications, including functions, features and technical performance
requirements.

In valuing the IPRD, the Company considered, among other factors, the
importance of each project to the overall development plan, the projected
incremental cash flows from the projects when completed and any associated
risks. The projected incremental cash flows were discounted back to their
present value using a discount rate of 30%. This discount rate was determined
after consideration of the Companys weighted average cost of capital and the
weighted average return on assets. Associated risks include the inherent
difficulties and uncertainties in completing each project and thereby achieving
technological feasibility, anticipated levels of market acceptance and
penetration, market growth rates and risks related to the impact of potential
changes in future target markets.

The IPRD relates to internally developed proprietary software used in
Laser Links virtual ISP business. This software has been designed with
enhancements and upgrades continually underway. With respect to the acquired
in-process technologies, the calculations of value were adjusted to reflect the
value creation efforts of Laser Link prior to the closing date. The percent
complete for the in-process technology was estimated to be 75% as of March 20,
2000.

Goodwill was determined based on the residual difference between the
amount paid and the values assigned to identified tangible and intangible
assets and liabilities. Through December 31, 2000, this intangible asset was
being amortized on a straight-line basis over its estimated useful life of five
years (Note 5).

The following unaudited pro forma financial information presents the
consolidated results of operations of the Company, excluding the charges for
IPRD and long-lived asset impairment, as if the acquisition of Laser Link had
occurred on January 1, 1999 and does not purport to be indicative of the
results of the operations that would have occurred had the acquisition been
made on January 1, 1999, or the results that may occur in the future:

|                                                                          |  |                         |          |      |  |   |          |  
|------------------------------------------------------------------------- |  | ----------------------- | -------- | ---- |  | - | -------- | -
|                                                                          |  | Year ended December 31,
|                                                                          |  |                        
|                                                                          |  | 2000                    |          | 1999
|                                                                          |  |                         |          |     
|Revenues                                                                  |  | $                       | 164,176  |      |  | $ | 66,502   |  
|Loss before extraordinary item and
cumulative effect of accounting
change |  | $                       | (858,011 | )    |  | $ | (276,177 | )
|Net loss                                                                  |  | $                       | (867,260 | )    |  | $ | (276,177 | )
|Basic and diluted net loss per share                                      |  | $                       | (5.65    | )    |  | $ | (2.54    | )

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.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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.

The common shares issued by the Company to BlueStars stockholders were
valued for accounting purposes using the average market price of $14.23 per
share, which is based on the average closing price around the closing date of
the transaction. In addition, the outstanding BlueStar stock options and
warrants were converted into options to purchase approximately 225,000 shares
of the Companys common stock at a fair value of $6.55 per share. The value of
the options, as well as direct transaction costs, have been included as
elements of the total purchase cost.

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.

The total purchase cost of the BlueStar acquisition was allocated to the
assets and liabilities of BlueStar based upon estimates of their fair value.
The following tables depict the total purchase cost and the allocation thereof:

|                           |                                                     |        |        |        |  
|-------------------------- | --------------------------------------------------- | ------ | ------ | ------ | -
|Total purchase cost:      
|                           | Value of common shares issued                       |        | $      | 86,579 |  
|                           | Fair Value of assumed BlueStar options and warrants |        |        | 1,471  |  
|                           |                                                     |        |        |        |  
|                           |                                                     | 88,050 |       
|                           | Acquisition costs                                   |        |        | 5,724  |  
|                           |                                                     |        |        |        |  
|                           | Total purchase cost                                 |        | $      | 93,774 |  
|                           |                                                     |        |        |        |  
|Purchase price allocation:
|                           | Tangible net assets acquired                        |        | $(     | 55,833 | )
|                           | Intangible assets acquired:                        
|                           | Customer base                                       |        |        | 17,332 |  
|                           | Assembled workforce                                 |        | 11,491 |       
|                           | Deferred stock-based compensation                   |        |        | 407    |  
|                           | Collocation agreements                              |        |        | 24,013 |  
|                           | Goodwill                                            |        |        | 96,364 |  
|                           |                                                     |        |        |        |  
|                           |                                                     |        | $      | 93,774 |  
|                           |                                                     |        |        |        |  

The tangible assets of BlueStar acquired by the Company aggregating
$64,753 consisted principally of accounts receivable, prepaid expenses and
property and equipment. The liabilities of BlueStar assumed by the Company

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

aggregating $120,586 consisted principally of accounts payable, accrued
expenses, a short-term bridge loan (which was retired prior to December 31,
2000) and equipment financing arrangements.

The customer base was valued using an income approach, which projects the
associated revenue, expenses and cash flows attributable to the customer base
over its estimated life. These cash flows are discounted to their present value
using a rate of return that reflects the appropriate level of risk. Through
December 31, 2000, this intangible asset was being amortized on a straight-line
basis over its estimated useful life of three years (Note 5).

The value of the assembled workforce was derived by estimating the costs
to replace the existing employees, including recruiting, hiring and training
costs for each category of employee. Through December 31, 2000, this intangible
asset was being amortized on a straight-line basis over its estimated useful
life of three years (Note 5).

The value of the collocation agreements was calculated using the
replacement cost approach which estimates the value of the asset at replacement
cost. Through December 31, 2000, this intangible asset was being amortized to
expense over its estimated useful life of three years (Note 5).

Deferred stock-based compensation associated with unvested BlueStar stock
options at the date of acquisition was being amortized to expense over the
remainder of the vesting period (Note 5).

Goodwill was determined based on the residual difference between the
amount paid and the values assigned to identified tangible and intangible
assets and liabilities. Through December 31, 2000, this intangible asset was
being amortized on a straight-line basis over its estimated useful life of five
years (Note 5).

The following unaudited pro forma financial information presents the
consolidated results of operations of the Company, excluding the charge for
long-lived asset impairment, as if the acquisition of BlueStar had occurred on
January 1, 1999 and does not purport to be indicative of the results of
operations that would have occurred had the acquisition been made on January 1,
1999, or the results that may occur in the future:

|                                                                          |  |                         |          |      |  |   |          |  
|------------------------------------------------------------------------- |  | ----------------------- | -------- | ---- |  | - | -------- | -
|                                                                          |  | Year ended December 31,
|                                                                          |  |                        
|                                                                          |  | 2000                    |          | 1999
|                                                                          |  |                         |          |     
|Revenues                                                                  |  | $                       | 164,635  |      |  | $ | 67,258   |  
|Loss before extraordinary item and
cumulative effect of accounting change |  | $                       | (924,242 | )    |  | $ | (251,636 | )
|Net loss                                                                  |  | $                       | (933,491 | )    |  | $ | (251,636 | )
|Basic and diluted net loss per share                                      |  | $                       | (5.95    | )    |  | $ | (2.21    | )

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

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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.

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

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

The customer acquisition costs of $3,674 described above were charged to
network and product costs for the year ended December 31, 2002 (i) because the
Companys relationship with InternetConnects former customers did not exist as
of January 3, 2002 and (ii) based on the Companys accounting policy for costs
of this nature that are not accompanied by up-front fees (Note 4).

Unconsolidated Investments in Affiliates

The following table lists the Companys unconsolidated investments in
affiliates as of December 31, 2002 and 2001:

|                         |  |                         |  |      |    |                      |  |            |    |                           |  |        |  |   |       |  |  |   |       |  |  |   |       | 
|------------------------ |  | ----------------------- |  | ---- | -- | -------------------- |  | ---------- | -- | ------------------------- |  | ------ |  | - | ----- |  |  | - | ----- |  |  | - | ----- | 
|                         |  |                         |  |      |    | Ownership
Percentage |  | Method of  |    | Investment
Carrying Value
|Entity Name              |  | Date of Investment(s)   |  | 2002 |    | 2001                 |  | Accounting |    | 2002                      |  | 2001  
|                         |  |                         |  |      |    |                      |  |            |    |                           |  |       
|DishnetDSL Limited       |  | February 2000           |  |      |   | %                    |  |            | 6  | %                         |  | Equity |  | $ |      |  |  | $ | 3,000 | 
|ACCA Networks Co., Ltd.  |  | August 2000             |  |      | 10 | %                    |  |            | 18 | %                         |  | Equity |  |   |      |  |  |   |      | 
|Certive Corporation      |  | November 1999; May 2000 |  |      | 5  | %                    |  |            | 5  | %                         |  | Equity |  |   | 1,026 |  |  |   | 1,874 | 
|Sequoia Capital X        |  | May-November 2000       |  |      |   | %                    |  |            |   | %                         |  | Equity |  |   |      |  |  |   |      | 
|Loop Holdings Europe ApS |  | September 2000          |  |      |   | %                    |  |            | 21 | %                         |  | Equity |  |   |      |  |  |   |      | 
|                         |  |                         |  |      |    |                      |  |            |    |                           |  |        |  |   |       |  |  |   |       |  |  |   |       | 
|                         |  |                         |  |      |    |                      |  |            |    |                           |  |        |  |   |       |  |  | $ | 1,026 |  |  | $ | 4,874 | 
|                         |  |                         |  |      |    |                      |  |            |    |                           |  |        |  |   |       |  |  |   |       |  |  |   |       | 

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 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

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 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 is due in December 2005. The
Company may also receive certain royalty payments from ACCA in the future under
terms of the OSS license agreement. 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 for ACCA. Any additional proceeds will
be recorded under the cost recovery method when received as a reduction of the
Companys capitalized internal use software costs. Such proceeds amounted to
$814 during the year ended December 31, 2002 (none during the year ended
December 31, 2001 and 2000).

Certive Corporation

As of December 31, 2002 and 2001, 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 chairman
and a principal stockholder of Certive.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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, 2002 and 2001, 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, as defined in the Credit Agreement, of
the Company, 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.

During the year ended December 31, 2000, the Company recorded in its
consolidated balance sheet, as part of the BlueStar acquisition (Note 6),
various other financing arrangements, principally to finance the acquisition,
build-out and maintenance of BlueStars networks and communication equipment.
These financing arrangements bear interest rates ranging from 7.75% to 12.0%
and mature between August 2001 and July 2003. These financing arrangements were
classified as current liabilities in the Companys consolidated balance sheet
as of December 31, 2000. However, as described in Note 3, the Company
deconsolidated BlueStar effective June 25, 2001.

Aggregate scheduled future principal payments, absent any optional or
mandatory prepayments, of long-term debt are as follows:

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|                         |           |       |   |        |        | 
|------------------------ | --------- | ----- | - | ------ | ------ | 
|Year
ending December 31, |           |       |   |       
|                         | 2003-2004 |       | $ |       |       
|                         | 2005      |       |   | 50,000 |       
|                         |           |       |   |       
|                         |           | Total |   | $      | 50,000 | 
|                         |           |       |   |       

As of December 31, 2002, the Company had a $3,000 revolving line of credit
with a bank that is available through April 2003 and collateralized by cash
equivalents and short-term investments with an aggregate carrying value of
$5,087 as of December 31, 2002. At the Companys option, borrowings under this
credit facility bear interest at certain fixed or variable rates. As of
December 31, 2002, the Company has issued letters of credits aggregating $2,075
under this line of credit in favor of lessors of equipment and facilities.

8. Capital Leases

The Company has a capital lease arrangement related to its acquisition of
equipment that expires in 2003.

The capitalized costs and accumulated amortization related to assets under
capital leases were $482 and $344, respectively, as of December 31, 2002 (the
corresponding amounts were $133 and $133, respectively, as of December 31,
2001).

The Company did not have significant minimum lease payments under these
capital leases as of December 31, 2002.

9. 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 Lease
|                         |            |       |   | Payments    |        | Payments      |   | Payments 
|                         |            |       |   |             |        |               |   |          
|Year
ending December 31, |            |       |   |             |        |               |   |           |     |  |   |      
|                         | 2003       |       | $ | 6,875       |        |               | $ | 381       |     |  | $ | 6,494 |       
|                         | 2004       |       |   | 3,985       |        |               |   | 317       |     |  |   | 3,668 |       
|                         | 2005       |       |   | 2,336       |        |               |   |          |     |  |   | 2,336 |       
|                         | 2006       |       |   | 1,653       |        |               |   |          |     |  |   | 1,653 |       
|                         | 2007       |       |   | 801         |        |               |   |          |     |  |   | 801   |       
|                         | Thereafter |       |   | 720         |        |               |   |          |     |  |   | 720   |       
|                         |            |       |   |             |        |               |   |           |     |  |   |      
|                         |            | Total |   | $           | 16,370 |               |   | $         | 698 |  |   | $     | 15,672 | 
|                         |            |       |   |             |        |               |   |           |     |  |   |      

Rent expense, which is net of sublease income of $402 and $152 in 2002 and
2001, respectively, (none in 2000) totaled $8,710, $15,421 and $19,584 for the
years ended December 31, 2002, 2001 and 2000, respectively.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

10. Contingencies

Litigation

Purchasers of the Companys common stock and purchasers of the convertible
notes the Company issued in September 2000 have filed complaints on behalf of
themselves and alleged classes of stockholders and holders of convertible notes
against the Company and certain of its present and former officers and
directors. These complaints were filed in the United States District Court for
the Northern District of California (District Court) in the fourth quarter of
2000. The complaints have been consolidated and the lead plaintiff has filed
its amended consolidated complaint. The amended consolidated complaint alleges
violations of federal securities laws on behalf of persons who purchased or
otherwise acquired the Companys securities, including common stock and notes,
during the period from April 19, 2000 to May 24, 2001. The relief sought
includes monetary damages and equitable relief. In 2001, the Company and the
officer and director defendants entered into a Memorandum of Understanding
(MOU) with counsel for the lead plaintiffs in this litigation that
tentatively resolves the litigation. The MOU sets forth the terms upon which
the Company, the officer and director defendants and the plaintiffs agree to
settle the litigation. Pursuant to the MOU, the plaintiffs agreed to support
and vote in favor of the Companys bankruptcy plan if it provided for the
distribution of $16,500 in cash to be funded by the Companys insurance
carriers and 6,495,844 shares of the Companys common stock. Consequently, the
Company recorded a liability of $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 in the amount of $11,628 for the year then ended.
One class member has filed an appeal to the District Courts final judgment and
dismissal order, but this 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 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 has requested a
rehearing before the Eleventh Circuit. On or about December 20, 2002, the
Eleventh Circuit denied BellSouths request for a rehearing. The matter was
subsequently remanded to the District Court where it is pending. In addition,
the United States Supreme Court has agreed to review a decision from the United
States Court of Appeals for the Second Circuit entitled Verizon Communications
v. Law Offices of Curtis Trinko, which rejected the Goldwasser decision. The
Eleventh Circuit relied in part on the Trinko decision when it reversed the
lower courts dismissal of the Companys claims against BellSouth. 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 that the Company ordered and seeks unspecified monetary damages
(characterized as being in the millions) and injunctive relief. The current
complaint asserts causes of action for negligent and intentional
misrepresentation and violations of Californias unfair competition statute. On
November 13, 2002, the District Court entered summary judgment in favor of the
Company and dismissed Verizons claims
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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

against the Company in their entirety.
Verizon has appealed the dismissal of its lawsuit. The Company believes it has
strong defenses to this lawsuit, but litigation is inherently unpredictable and
there is no guarantee it will prevail.

Several stockholders have filed complaints in the United States District
Court for the Southern District of New York, on behalf of themselves and
purported classes of stockholders, against the Company and several former and
current officers and directors in addition to some of the underwriters in 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 failed to disclose the arrangements that some of these
underwriters purportedly made with certain investors. The Company believes it
has strong defenses to these lawsuits and intends to contest them vigorously.
However, because these lawsuits are at an early stage, the Company is unable to
provide an evaluation of the ultimate outcome of the litigation.

A manufacturer of telecommunications hardware named COVID has filed an
opposition to the Companys trademark application for the mark COVAD and
design and is seeking to cancel the Companys registration of the COVAD
trademark. The Company does not believe that this opposition has merit, but
trademark proceedings are unpredictable and there is no guarantee it will
prevail. If it does not succeed, it could limit the Companys ability to
provide its services under the COVAD name. In September 2000, COVID also
filed a complaint in the United States District Court for the District of
Arizona, alleging claims for false designation of origin, infringement and
unfair competition. COVID is seeking an injunction to stop the Company from
using the COVAD trademark, as well as an award of monetary damages. The Company
does not believe that these claims have any merit, but the outcome of
litigation is unpredictable and it cannot guarantee that it 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 has 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. While the Company believes Mr. Khannas
contentions referred to above are without
merit, and will be vigorously defended if brought, it is unable to predict the
outcome of any potential lawsuit.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

The Company is also a party to a variety of other pending or threatened
legal proceedings as either plaintiff or defendant, or is engaged in business
disputes that arise in the ordinary course of business. Failure to resolve
these various legal disputes and controversies without excessive delay and cost
and in a manner that is favorable to the Company could significantly harm its
business. The Company does not believe the ultimate outcome of these matters
will have a material impact on its consolidated financial position and results
of operations. However, litigation is inherently unpredictable and there is no
guarantee the Company will prevail or otherwise not be adversely affected.

The Company is subject to state public utility commission, FCC and other
court decisions as they relate to the interpretation and implementation of the
1996 Telecommunications Act, the interpretation of competitive
telecommunications company interconnection agreements in general, and the
Companys interconnection agreements in particular. In some cases the Company
may be bound by or may otherwise be significantly impacted by the results of
ongoing proceedings of these bodies or the legal outcomes of other contested
interconnection agreements that are similar to the Companys agreements. The
results of any of these proceedings could harm the Companys business.

In addition, the Company is engaged in a variety of legal proceedings with
several traditional telephone companies. These proceedings concern the
traditional telephone companies denial of central office space to the Company,
the cost and delivery of transmission facilities and telephone lines and
central office spaces, billing issues and other operational issues. Other than
the payment of legal fees and expenses, which are not quantifiable but are
expected to be material, the Company does not believe that these matters will
result in material liability to us and the potential gains are not quantifiable
at this time. An unfavorable result in any of these proceedings, however,
could have a material adverse effect on the Companys consolidated financial
position and results of operations if the Company is denied access or charged
higher rates for transmission lines or central office spaces.

Other Contingencies

As of December 31, 2002, 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. 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.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

As of December 31, 2002, the Company was analyzing the applicability of
certain transaction-based taxes to (i) sales of the Companys products and
services and (ii) purchases of telecommunications circuits from various
carriers. This analysis includes discussions with authorities of significant
jurisdictions in which the Company does business to determine the extent of 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 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.

11. Stockholders Equity (Deficit)

Strategic Investors

In January 1999, the Company entered into strategic relationships with
AT&T Corp., NEXTLINK Communications, Inc. (now XO Communications) and Qwest
Communications Corporation. As part of these strategic relationships, the
Company received equity investments totaling approximately $60,000. The Company
recorded intangible assets of $28,700 associated with these transactions that
were being amortized over periods of three to six years using the straight-line
method. For the year ended December 31, 2000, such amortization expense totaled
$8,300 (none in 2002 or 2001-Note 5).

On September 20, 2000, the Company entered into various agreements (the
September 2000 Agreements) with SBC Communications, Inc. (SBC), including
(i) a six-year resale and marketing agreement under which SBC was to market and
resell the Companys DSL services (through December 31, 2000, the Company had
not provided any DSL services to SBC or recognized any revenues under this
arrangement), (ii) a stock purchase agreement whereby SBC acquired, on November
6, 2000, a minority ownership position of approximately 6% of the Companys
outstanding common stock in exchange for $150,000, and (iii) a settlement
agreement of the Companys pending legal matters with SBC and its affiliates
including performance standards and line-sharing arrangements governing the
future commercial relationship between the two entities in all 13 SBC states.

Effective December 20, 2001, immediately prior to Covads emergence from
Chapter 11 bankruptcy (Note 3), the Company entered into a series of new
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 the September 2000 Agreements, 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.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

Common Stock

6,625 and 141,897 shares of the Companys common stock outstanding at
December 31, 2002 and 2001, respectively, 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, 2002 was as
follows:

|                             |       |  |            |            | 
|---------------------------- | ----- |  | ---------- | ---------- | 
|Bankruptcy claims (Note 3)   |       |  | 7,078,733  |           
|Outstanding options          |       |  | 25,675,014 |           
|Options available for grant  |       |  | 15,957,768 |           
|Employee stock purchase plan |       |  | 6,450,827  |           
|Outstanding warrants         |       |  | 3,736,574  |           
|                             |       |  |            |           
|                             | Total |  |            | 58,898,916 | 
|                             |       |  |            |           

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, 2002 and
2001, none of these rights were exercisable.

Warrants

On September 4, 2002, in conjunction with the execution of a five-year
Broadband Internet Access Service Agreement (the Broadband Agreement) with
America Online, Inc. (AOL), a wholesale customer, the Company granted AOL
three warrants to purchase 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 non-forfeitable at
the date of grant. Accordingly, the measurement date for these warrants was the
date of grant. The aggregate fair value of such warrants of $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 ($250 for the year ended
December 31, 2002) on a straight-line basis over the five-year term of the
Broadband Agreement because management believes that future revenues from AOL
will exceed the fair value of the warrants described above. However, because
the Broadband Agreement contains no minimum purchase commitment and is
cancelable under certain circumstances by AOL, the Company will continue to
monitor the recoverability of the deferred customer incentive balance described
above in periods ending subsequent to December 31, 2002.

Warrants for the purchase of 236,574 shares of the Companys common stock
were outstanding as of December 31, 2002. Such warrants are exercisable at
prices ranging from $0.0015 to $48.44 per share during periods ending between
February 2003 and March 2008. All such warrants were vested as of December 31,
2002.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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.

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,
|                                              |                              |   |                        
|                                              |                              |   | 2002                    |   | 2001 |   | 2000    
|                                              |                              |   |                         |   |      |   |         
|Federal benefit at statutory rate             |                              | $ | (64,690                 | ) |      | $ | (241,139 | ) |  | $ | (505,098 | )
|Nondeductible interest expense                |                              |   |                        |   |      |   | 878      |   |  |   | 1,189    |  
|Net operating losses with no current
benefits |                              |   | 65,704                  |   |      |   | 206,948  |   |  |   | 342,863  |  
|Goodwill                                      |                              |   |                        |   |      |   |         |   |  |   | 158,257  |  
|Deconsolidation of BlueStar                   |                              |   |                        |   |      |   | 23,915   |   |  |   |         |  
|Other                                         |                              |   | (1,014                  | ) |      |   | 9,398    |   |  |   | 2,789    |  
|                                              |                              |   |                         |   |      |   |          |   |  |   |          |  
|                                              | Income 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,
|                                         |                           |   |             
|                                         |                           |   | 2002         |         | 2001
|                                         |                           |   |              |         |     
|Deferred tax assets:                     |                           |   |              |         |      |   |          |        
|Net operating loss carryforwards         |                           | $ | 284,482      |         |      | $ | 149,756  |        
|Capital loss carryforwards               |                           |   | 10,803       |         |      |   |         |        
|Deferred and unearned revenue            |                           |   | 45,600       |         |      |   | 69,132   |        
|Deconsolidation of BlueStar              |                           |   | 21,589       |         |      |   |         |        
|Unconsolidated investments in affiliates |                           |   | 12,424       |         |      |   | 25,454   |        
|Depreciation and amortization            |                           |   | 36,037       |         |      |   | 36,437   |        
|Other                                    |                           |   | 11,107       |         |      |   | 11,734   |        
|                                         |                           |   |              |         |      |   |          |        
|                                         | Total deferred tax assets |   |              | 422,042 |      |   |          | 292,513 | 
|Valuation allowance                      |                           |   | (422,042     | )       |      |   | (292,513 | )      
|                                         |                           |   |              |         |      |   |          |        
|                                         | Net deferred tax assets   |   |              |        |      |   |          |        | 
|Deferred tax liabilities                 |                           |   |             |         |      |   |         |        
|                                         |                           |   |              |         |      |   |          |        
|                                         | Net deferred taxes        |   | $            |        |      |   | $        |        | 
|                                         |                           |   |              |         |      |   |          |        

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 $129,529,
$(145,941) and $411,672 during 2002, 2001 and 2000, respectively.

As of December 31, 2002, the Company had net operating loss carryforwards
for federal income tax purposes of $646,000, which will expire beginning in the
year 2021, if not utilized. The Companys federal net operating loss
carryforwards were reduced by approximately $995,000 as a result of the
Companys Chapter 11 bankruptcy proceedings (Note 3). The Company also had net
operating loss carryforwards for state income tax purposes of approximately
$1,165,000, which begin to expire in 2004, if not utilized. In addition, the
Company had capital loss carryforwards for both federal and state income tax
purposes of approximately $27,000, which begin to expire in 2006, if not
utilized.

The tax benefits associated with employee stock options provided
cumulative deferred tax benefits of approximately $2,300 at December 31, 2002.
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 losses may be subject to a
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.

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 (Note 6) 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. The Company has reserved a total of 6,450,827 shares of common stock for
issuance under the plan. Eligible employees may 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.

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, 2002, the Company has reserved 41,632,782 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
100Table of ContentsCOVAD COMMUNICATIONS GROUP, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)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.The following table summarizes stock option activity for the years ended
December 31, 2002, 2001 and 2000:

|                                |                     |  |                     |             |                  |   |               |               | 
|------------------------------- | ------------------- |  | ------------------- | ----------- | ---------------- | - | ------------- | ------------- | 
|                                |                     |  | Number of Shares of |             | Option Price Per
|                                |                     |  | Common Stock        |             | Share           
|                                |                     |  |                     |             |                 
|Balance as of December 31, 1999 |                     |  | 24,522,633          |             |                  | $ | 0.007-$44.67  |              
|                                | Granted and assumed |  |                     | 16,604,003  |                  |   | $             | 0.001-$149.79 | 
|                                | Exercised           |  |                     | (5,461,935  | )                |   | $             | 0.001-$66.58  | 
|                                | Cancelled           |  |                     | (7,930,326  | )                |   | $             | 0.001-$64.75  | 
|                                |                     |  |                     |             |                  |   |               |              
|Balance as of December 31, 2000 |                     |  | 27,734,375          |             |                  | $ | 0.001-$149.79 |              
|                                | Granted             |  |                     | 24,726,003  |                  |   | $             | 0.350-$39.00  | 
|                                | Exercised           |  |                     | (4,100,977  | )                |   | $             | 0.001-$2.56   | 
|                                | Cancelled           |  |                     | (16,759,071 | )                |   | $             | 0.001-$149.79 | 
|                                |                     |  |                     |             |                  |   |               |              
|Balance as of December 31, 2001 |                     |  | 31,600,330          |             |                  | $ | 0.001-$149.79 |              
|                                | Granted             |  |                     | 2,231,048   |                  |   | $             | 0.940-$2.30   | 
|                                | Exercised           |  |                     | (1,005,937  | )                |   | $             | 0.001-$2.56   | 
|                                | Cancelled           |  |                     | (7,150,427  | )                |   | $             | 0.001-$149.79 | 
|                                |                     |  |                     |             |                  |   |               |              
|Balance as of December 31, 2002 |                     |  | 25,675,014          |             |                  | $ | 0.001-$149.79 |              
|                                |                     |  |                     |             |                  |   |               |              

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

The following is a summary of the status of stock options outstanding at
December 31, 2002:

|                     |  |                     |            |                     |  |                  |     |                  |  |                |       |                  |  |  |            |  |  |   |       | 
|-------------------- |  | ------------------- | ---------- | ------------------- |  | ---------------- | --- | ---------------- |  | -------------- | ----- | ---------------- |  |  | ---------- |  |  | - | ----- | 
|                     |  | Options Outstanding |            | Options Exercisable
|                     |  |                     |            |                    
|                     |  |                     |            |                     |  | Weighted-Average |     | Weighted-Average |  | Number of      |       | Weighted-Average
|Exercise Price Range |  | Number of Shares    |            | Life Remaining      |  | Exercise Price   |     | Shares           |  | Exercise Price
|                     |  |                     |            |                     |  |                  |     |                  |  |               
|$0.001-$0.49         |  |                     | 1,352,912  |                     |  |                  | 4.9 |                  |  | $              | 0.28  |                  |  |  | 872,479    |  |  | $ | 0.20  | 
|$0.49-$0.56          |  |                     | 5,233,664  |                     |  |                  | 6.7 |                  |  | $              | 0.56  |                  |  |  | 1,565,584  |  |  | $ | 0.56  | 
|$0.60-$0.84          |  |                     | 3,046,423  |                     |  |                  | 6.3 |                  |  | $              | 0.81  |                  |  |  | 1,260,415  |  |  | $ | 0.80  | 
|$0.86-$1.43          |  |                     | 2,758,181  |                     |  |                  | 7.1 |                  |  | $              | 1.23  |                  |  |  | 1,097,319  |  |  | $ | 1.30  | 
|$1.44-$2.55          |  |                     | 2,623,164  |                     |  |                  | 6.2 |                  |  | $              | 1.94  |                  |  |  | 1,048,901  |  |  | $ | 2.07  | 
|$2.56-$2.56          |  |                     | 4,606,939  |                     |  |                  | 6.2 |                  |  | $              | 2.56  |                  |  |  | 2,754,640  |  |  | $ | 2.56  | 
|$2.59-$26.69         |  |                     | 2,753,480  |                     |  |                  | 5.3 |                  |  | $              | 10.76 |                  |  |  | 1,915,725  |  |  | $ | 10.36 | 
|$27.11-$58.25        |  |                     | 2,598,061  |                     |  |                  | 4.8 |                  |  | $              | 38.53 |                  |  |  | 2,070,757  |  |  | $ | 38.11 | 
|$58.58-$149.79       |  |                     | 702,190    |                     |  |                  | 5.2 |                  |  | $              | 63.51 |                  |  |  | 483,128    |  |  | $ | 63.53 | 
|                     |  |                     |            |                     |  |                  |     |                  |  |                |       |                  |  |  |            |  |  |   |       | 
|$0.001-$149.79       |  |                     | 25,675,014 |                     |  |                  | 6.1 |                  |  | $              | 7.80  |                  |  |  | 13,068,948 |  |  | $ | 10.89 | 

In addition to the reversal of stock-based compensation described in Note
1 under Basis of Presentation, during the years ended December 31, 2002 and
2001, the Company reversed approximately $136 and $1,213, respectively, of
stock-based compensation recorded in prior years due to the termination of
certain employees. During the year ended December 31, 2002 and 2000, the
Company recorded deferred stock-based compensation of approximately $426 and
$628, respectively, 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 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, 2002, 2001 and 2000 was
approximately $(3,358), $1,597 and $4,481, respectively. Included in the
amortization of deferred stock-based compensation for the years ended December
31, 2001 and 2000 are amounts aggregating $302 and $724, respectively, 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 and 2000. No similar
amounts are included in the amortization of deferred stock-based compensation
in 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 2000.

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 2002 and 2000. The fair value of these options is being
amortized to expenses over the vesting term of the options. The Company
recorded expenses of $64 and $186 for the fair value of these options in 2002
and 2001, respectively (none in 2000). As of December 31, 2002 and 2001 the
fair value of the remaining unvested options granted to consultants was $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.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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, 2002, 2001 and 2000, the fair value of
the Companys stock-based awards to employees was estimated using the following
weighted average assumptions:

|                                  |  |      |       |      |  |      |       |   |  |  |       |  
|--------------------------------- |  | ---- | ----- | ---- |  | ---- | ----- | - |  |  | ----- | -
|                                  |  | 2002 |       | 2001 |  | 2000
|                                  |  |      |       |      |  |     
|Expected life of options in years |  |      | 4.0   |      |  |      | 4.0   |   |  |  | 4.0   |  
|Volatility                        |  |      | 152.1 | %    |  |      | 169.2 | % |  |  | 171.0 | %
|Risk-free interest rate           |  |      | 3.1   | %    |  |      | 3.5   | % |  |  | 5.1   | %
|Expected dividend yield           |  |      | 0.0   | %    |  |      | 0.0   | % |  |  | 0.0   | %

14. Business Segments

The Company disaggregates its business operations based upon differences
in services and marketing channels, even though the cash flows from these
operations are not largely independent of each other. The Companys wholesale
division (Wholesale) is a provider of high-speed connectivity services, which
utilize DSL technology, to ISP, enterprise and telecommunications carrier
customers. The Companys direct division (Direct) is a provider of high-speed
connectivity, Internet access and other services to individuals, small and
medium-sized businesses, corporations and other organizations. As described in
Note 4, on June 25, 2001, BlueStar, which was a component of Direct, made an
irrevocable assignment for the benefit of creditors of all its assets to an
independent trustee in the State of Tennessee and, accordingly, was not part of
the Companys operations during periods beginning after June 25, 2001.
Corporate operations represent general corporate expenses, headquarters
facilities and equipment, investments, and other nonrecurring and unusual items
not allocated to the segments.

The accounting policies used in measuring segment assets and operating
results are the same as those described in Notes 1 and 2. The items discussed
in Notes 3, 4, 5 and 6 are not allocated to the segments and are included in
corporate operations. Networks and communication equipment and related computer
software and collocation fees (Note 1 and 5), and the associated depreciation
and amortization expense, are allocated to Wholesale. The Company evaluates
performance of the segments based on segment operating results, excluding
nonrecurring and unusual items.

Information about the Companys current business segments was as follows
as of and for the years ended December 31, 2002, 2001 and 2000 (the Companys
2000 segment information has been restated to conform to the Companys
organizational structure in 2002 and 2001):

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|                                                                               |  |                                   |          |           |          |        |         |          |         |            |          |              |          |           |         |              |         |              |   |   |   |   |          |   |          |  
|------------------------------------------------------------------------------ |  | --------------------------------- | -------- | --------- | -------- | ------ | ------- | -------- | ------- | ---------- | -------- | ------------ | -------- | --------- | ------- | ------------ | ------- | ------------ | - | - | - | - | -------- | - | -------- | -
|                                                                               |  |                                   |          |           |          |        |         |          |         |            |          | Total        |          | Corporate |         | Intercompany |         | Consolidated
|                                                                               |  |                                   |          | Wholesale |          | Direct |         | Segments |         | Operations |          | Eliminations |          | Total    
|                                                                               |  |                                   |          |           |          |        |         |          |         |            |          |              |          |          
|As of and for the year ended
December 31, 2002:                                |  |                                   |          |           |          |        |         |          |         |            |          |              |          |           |         |              |         |              |   |   |   |   |          |  
|Domestic Internet and network
access revenues from
unaffiliated customers, net |  | $                                 | 326,659  |           |          | $      | 56,837  |          |         | $          | 383,496  |              |          | $         |        |              |         | $            |  |   |   | $ | 383,496  |  
|Intersegment revenues                                                          |  |                                   |         |           |          |        |        |          |         |            |         |              |          |           |        |              |         |              |  |   |   |   |         |  
|                                                                               |  |                                   |          |           |          |        |         |          |         |            |          |              |          |           |         |              |         |              |   |   |   |   |          |  
|                                                                               |  | Total revenues, net               |          |           | 326,659  |        |         |          | 56,837  |            |          |              | 383,496  |           |         |              |        |              |   |   |  |   |          |   | 383,496  |  
|Operating expenses                                                             |  |                                   | 313,007  |           |          |        | 77,538  |          |         |            | 390,545  |              |          |           | 58,483  |              |         |              |  |   |   |   | 449,028  |  
|Depreciation and amortization                                                  |  |                                   | 106,903  |           |          |        | 2,257   |          |         |            | 109,160  |              |          |           | 3,278   |              |         |              |  |   |   |   | 112,438  |   |          |  
|Amortization of intangible assets                                              |  |                                   | 14,650   |           |          |        |        |          |         |            | 14,650   |              |          |           |        |              |         |              |  |   |   |   | 14,650   |  
|Non-cash litigation-related
expenses                                           |  |                                   |         |           |          |        |        |          |         |            |         |              |          |           | (11,628 | )            |         |              |  |   |   |   | (11,628  | )
|                                                                               |  |                                   |          |           |          |        |         |          |         |            |          |              |          |           |         |              |         |              |   |   |   |   |          |  
|                                                                               |  | Total operating expenses          |          |           | 434,560  |        |         |          | 79,795  |            |          |              | 514,355  |           |         |              | 50,133  |              |   |   |  |   |          |   | 564,488  |  
|                                                                               |  |                                   |          |           |          |        |         |          |         |            |          |              |          |           |         |              |         |              |   |   |   |   |          |  
|Loss from operations                                                           |  |                                   | (107,901 | )         |          |        | (22,958 | )        |         |            | (130,859 | )            |          |           | (50,133 | )            |         |              |  |   |   |   | (180,992 | )
|                                                                               |  |                                   |          |           |          |        |         |          |         |            |          |              |          |           |         |              |         |              |   |   |   |   |          |  
|Interest income                                                                |  |                                   | 5,122    |           |          |        |        |          |         |            | 5,122    |              |          |           |        |              |         |              |  |   |   |   | 5,122    |  
|Equity in losses of
unconsolidated affiliates                                  |  |                                   |         |           |          |        |        |          |         |            |         |              |          |           | (806    | )            |         |              |  |   |   |   | (806     | )
|Interest expense                                                               |  |                                   | (5,581   | )         |          |        |        |          |         |            | (5,581   | )            |          |           |        |              |         |              |  |   |   |   | (5,581   | )
|Other income (expense), net                                                    |  |                                   |         |           |          |        |        |          |         |            |         |              |          |           | (2,571  | )            |         |              |  |   |   |   | (2,571   | )
|                                                                               |  |                                   |          |           |          |        |         |          |         |            |          |              |          |           |         |              |         |              |   |   |   |   |          |  
|                                                                               |  | Total other income
(expense), net |          |           | (459     | )      |         |          |        |            |          |              | (459     | )         |         |              | (3,377  | )            |   |   |  |   |          |   | (3,836   | )
|                                                                               |  |                                   |          |           |          |        |         |          |         |            |          |              |          |           |         |              |         |              |   |   |   |   |          |  
|                                                                               |  | Net loss                          |          | $         | (108,360 | )      |         | $        | (22,958 | )          |          | $            | (131,318 | )         |         | $            | (53,510 | )            |   | $ |  |   |          | $ | (184,828 | )
|                                                                               |  |                                   |          |           |          |        |         |          |         |            |          |              |          |           |         |              |         |              |   |   |   |   |          |  
|Assets                                                                         |  | $                                 | 430,163  |           |          | $      | 5,473   |          |         | $          | 435,636  |              |          | $         | 6,525   |              |         | $            |  |   |   | $ | 442,161  |  
|Investments in unconsolidated
affiliates:                                      |  |                                   |          |           |          |        |         |          |         |            |          |              |          |           |         |              |         |              |   |   |   |   |          |  
|                                                                               |  | Domestic                          |          | $         |         |        |         | $        |        |            |          | $            |         |           |         | $            | 1,026   |              |   | $ |  |   |          | $ | 1,026    |  
|Capital expenditures for
property and equipment                                |  | $                                 | 21,115   |           |          | $      | 1,100   |          |         | $          | 22,215   |              |          | $         | 567     |              |         | $            |  |   |   | $ | 22,782   |  

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |         |              |   |   |   |  |   |           |          |  
|------------------------------------------------------------------------------ | --------------------------------- | - | --------- | -------- | ------ | - | -------- | ------- | ---------- | - | ------------ | -------- | --------- | - | ------------ | ------- | ------------ | - | - | - |  | - | --------- | -------- | -
|                                                                               |                                   |   |           |          |        |   |          |         |            |   | Total        |          | Corporate |   | Intercompany |         | Consolidated
|                                                                               |                                   |   | Wholesale |          | Direct |   | Segments |         | Operations |   | Eliminations |          | Total    
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |          
|As of and for the year ended
December 31, 2001:                                |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |         |              |   |   |   |  |   |           |         
|Domestic Internet and network
access revenues from
unaffiliated customers, net |                                   | $ | 285,707   |          |        | $ | 46,889   |         |            | $ | 332,596      |          |           | $ |             |         |              | $ |  |   |  | $ | 332,596   |         
|Intersegment revenues                                                          |                                   |   |          |          |        |   |         |         |            |   |             |          |           |   |             |         |              |   |  |   |  |   |          |         
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |         |              |   |   |   |  |   |           |         
|                                                                               | Total revenues, net               |   |           | 285,707  |        |   |          | 46,889  |            |   |              | 332,596  |           |   |              |        |              |   |   |  |  |   |           | 332,596  |  
|Operating expenses                                                             |                                   |   | 490,107   |          |        |   | 90,651   |         |            |   | 580,758      |          |           |   | 85,726       |         |              |   |  |   |  |   | 666,484   |         
|Depreciation and amortization                                                  |                                   |   | 127,908   |          |        |   | 2,393    |         |            |   | 130,301      |          |           |   | 7,619        |         |              |   |  |   |  |   | 137,920   |         
|Amortization of intangible
assets                                              |                                   |   | 12,919    |          |        |   |         |         |            |   | 12,919       |          |           |   |             |         |              |   |  |   |  |   | 12,919    |         
|Provision for restructuring
expenses                                           |                                   |   |          |          |        |   |         |         |            |   |             |          |           |   | 14,364       |         |              |   |  |   |  |   | 14,364    |         
|Provision for long-lived
asset impairment                                      |                                   |   |          |          |        |   |         |         |            |   |             |          |           |   | 11,988       |         |              |   |  |   |  |   | 11,988    |         
|Non-cash litigation-related
expenses                                           |                                   |   |          |          |        |   |         |         |            |   |             |          |           |   | 25,801       |         |              |   |  |   |  |   | 25,801    |         
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |         |              |   |   |   |  |   |           |         
|                                                                               | Total operating expenses          |   |           | 630,934  |        |   |          | 93,044  |            |   |              | 723,978  |           |   |              | 145,498 |              |   |   |  |  |   |           | 869,476  |  
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |         |              |   |   |   |  |   |           |         
|Loss from operations                                                           |                                   |   | (345,227  | )        |        |   | (46,155  | )       |            |   | (391,382     | )        |           |   | (145,498     | )       |              |   |  |   |  |   | (536,880  | )       
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |         |              |   |   |   |  |   |           |         
|Interest income                                                                |                                   |   | 23,907    |          |        |   | 77       |         |            |   | 23,984       |          |           |   | 609          |         |              |   |  |   |  |   | 24,593    |         
|Equity in losses of
unconsolidated affiliates                                  |                                   |   |          |          |        |   |         |         |            |   |             |          |           |   | (13,769      | )       |              |   |  |   |  |   | (13,769   | )       
|Interest expense                                                               |                                   |   | (90,048   | )        |        |   | (2,734   | )       |            |   | (92,782      | )        |           |   |             |         |              |   |  |   |  |   | (92,782   | )       
|Other income (expense), net                                                    |                                   |   | (6,644    | )        |        |   | (266     | )       |            |   | (6,910       | )        |           |   | (63,221      | )       |              |   |  |   |  |   | (70,131   | )       
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |         |              |   |   |   |  |   |           |         
|                                                                               | Total other income
(expense), net |   |           | (72,785  | )      |   |          | (2,923  | )          |   |              | (75,708  | )         |   |              | (76,381 | )            |   |   |  |  |   |           | (152,089 | )
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |         |              |   |   |   |  |   |           |         
|Loss before extraordinary item                                                 |                                   |   | (418,012  | )        |        |   | (49,078  | )       |            |   | (467,090     | )        |           |   | (221,879     | )       |              |   |  |   |  |   | (688,969  | )       
|Extraordinary item                                                             |                                   |   |          |          |        |   |         |         |            |   |             |          |           |   | 1,033,727    |         |              |   |  |   |  |   | 1,033,727 |         
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |         |              |   |   |   |  |   |           |         
|                                                                               | Net income (loss)                 |   | $         | (418,012 | )      |   | $        | (49,078 | )          |   | $            | (467,090 | )         |   | $            | 811,848 |              |   | $ |   |  |   | $         | 344,758  |  
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |         |              |   |   |   |  |   |           |         
|Assets                                                                         |                                   | $ | 656,200   |          |        | $ | 801      |         |            | $ | 657,001      |          |           | $ | 18,167       |         |              | $ |  |   |  | $ | 675,168   |         
|Investments in unconsolidated
affiliates:                                      |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |         |              |   |   |   |  |   |           |         
|                                                                               | Domestic                          |   | $         |         |        |   | $        |        |            |   | $            |         |           |   | $            | 1,874   |              |   | $ |  |  |   | $         | 1,874    |  
|                                                                               | International                     |   | $         |         |        |   | $        |        |            |   | $            |         |           |   | $            | 3,000   |              |   | $ |  |  |   | $         | 3,000    |  
|Capital expenditures for
property and equipment                                |                                   | $ | 10,454    |          |        | $ | 614      |         |            | $ | 11,068       |          |           | $ | 4,664        |         |              | $ |  |   |  | $ | 15,732    |         

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |          |              |   |   |   |  |   |            |            |  
|------------------------------------------------------------------------------ | --------------------------------- | - | --------- | -------- | ------ | - | -------- | ------- | ---------- | - | ------------ | -------- | --------- | - | ------------ | -------- | ------------ | - | - | - |  | - | ---------- | ---------- | -
|                                                                               |                                   |   |           |          |        |   |          |         |            |   | Total        |          | Corporate |   | Intercompany |          | Consolidated
|                                                                               |                                   |   | Wholesale |          | Direct |   | Segments |         | Operations |   | Eliminations |          | Total    
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |          
|For the year ended December 31,
2000:                                          |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |          |              |   |   |   |  |   |            |           
|Domestic Internet and network
access revenues from
unaffiliated customers, net |                                   | $ | 133,535   |          |        | $ | 25,201   |         |            | $ | 158,736      |          |           | $ |             |          |              | $ |  |   |  | $ | 158,736    |           
|Intersegment revenues                                                          |                                   |   |          |          |        |   |         |         |            |   |             |          |           |   |             |          |              |   |  |   |  |   |           |           
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |          |              |   |   |   |  |   |            |           
|                                                                               | Total revenues, net               |   |           | 133,535  |        |   |          | 25,201  |            |   |              | 158,736  |           |   |              |         |              |   |   |  |  |   |            | 158,736    |  
|Operating expenses                                                             |                                   |   | 626,004   |          |        |   | 41,014   |         |            |   | 667,018      |          |           |   | 69,383       |          |              |   |  |   |  |   | 736,401    |           
|Depreciation and amortization                                                  |                                   |   | 79,421    |          |        |   | 7,770    |         |            |   | 87,191       |          |           |   | 4,014        |          |              |   |  |   |  |   | 91,205     |           
|Amortization of intangible assets                                              |                                   |   |          |          |        |   |         |         |            |   |             |          |           |   | 87,220       |          |              |   |  |   |  |   | 87,220     |           
|Provision for restructuring
expenses                                           |                                   |   |          |          |        |   |         |         |            |   |             |          |           |   | 4,988        |          |              |   |  |   |  |   | 4,988      |           
|Provision for long-lived asset
impairment                                      |                                   |   |          |          |        |   |         |         |            |   |             |          |           |   | 589,388      |          |              |   |  |   |  |   | 589,388    |           
|Write-off of in-process research
and development costs                         |                                   |   |          |          |        |   |         |         |            |   |             |          |           |   | 3,726        |          |              |   |  |   |  |   | 3,726      |           
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |          |              |   |   |   |  |   |            |           
|                                                                               | Total operating expenses          |   |           | 705,425  |        |   |          | 48,784  |            |   |              | 754,209  |           |   |              | 758,719  |              |   |   |  |  |   |            | 1,512,928  |  
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |          |              |   |   |   |  |   |            |           
|Loss from operations                                                           |                                   |   | (571,890  | )        |        |   | (23,583  | )       |            |   | (595,473     | )        |           |   | (758,719     | )        |              |   |  |   |  |   | (1,354,192 | )         
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |          |              |   |   |   |  |   |            |           
|Interest income                                                                |                                   |   | 52,837    |          |        |   | 64       |         |            |   | 52,901       |          |           |   |             |          |              |   |  |   |  |   | 52,901     |           
|Equity in losses of
unconsolidated affiliates                                  |                                   |   |          |          |        |   |         |         |            |   |             |          |           |   | (6,452       | )        |              |   |  |   |  |   | (6,452     | )         
|Interest expense                                                               |                                   |   | (108,289  | )        |        |   | (1,574   | )       |            |   | (109,863     | )        |           |   |             |          |              |   |  |   |  |   | (109,863   | )         
|Other income (expense), net                                                    |                                   |   | (16,294   | )        |        |   | 13       |         |            |   | (16,281      | )        |           |   |             |          |              |   |  |   |  |   | (16,281    | )         
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |          |              |   |   |   |  |   |            |           
|                                                                               | Total other income
(expense), net |   |           | (71,746  | )      |   |          | (1,497  | )          |   |              | (73,243  | )         |   |              | (6,452   | )            |   |   |  |  |   |            | (79,695    | )
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |          |              |   |   |   |  |   |            |           
|Loss before cumulative effect of
change in accounting principle                |                                   |   | (643,636  | )        |        |   | (25,080  | )       |            |   | (668,716     | )        |           |   | (765,171     | )        |              |   |  |   |  |   | (1,433,887 | )         
|Cumulative effect of change in
accounting principle                            |                                   |   | (9,249    | )        |        |   |         |         |            |   | (9,249       | )        |           |   |             |          |              |   |  |   |  |   | (9,249     | )         
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |          |              |   |   |   |  |   |            |           
|                                                                               | Net loss                          |   | $         | (652,885 | )      |   | $        | (25,080 | )          |   | $            | (677,965 | )         |   | $            | (765,171 | )            |   | $ |  |  |   | $          | (1,443,136 | )
|                                                                               |                                   |   |           |          |        |   |          |         |            |   |              |          |           |   |              |          |              |   |   |   |  |   |            |           
|Capital expenditures for
property and equipment                                |                                   | $ | 289,874   |          |        | $ | 6,485    |         |            | $ | 296,359      |          |           | $ | 22,875       |          |              | $ |  |   |  | $ | 319,234    |           

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

15. Subsequent Events

On February 20, 2003, the FCC issued a press release announcing the
results of its Triennial Review. Based on the Companys understanding of such
press release, the FCCs Triennial Review is a significant development for the
Company for the following reasons:



| |  |  | The FCC announced that it is phasing out its rule requiring
line-sharing over a three-year period. Line-sharing currently allows
the Company to provision services using asymmetric DSL (ADSL)
technology over the same telephone line that the local telephone
company is using to provide voice services. The federal rules
requiring line-sharing will be phased out over a three-year period,
during which the Company will be required to transition its existing
line-sharing customers to new arrangements. New line-sharing customers
may be acquired at regulated rates only during the first year of the
transition. During each year of the transition, the FCC-mandated
maximum price for the high-frequency portion of the phone line will
increase incrementally towards the cost of a separate phone line. This
means that, unless the Company reaches agreements with the local
telephone companies that provide the Company with continued access to
line-sharing, it will be required to purchase a separate telephone line
in order to provide services to an end- user. The cost of a separate
phone line is significantly higher than the cost of a shared line. As
of December 31, 2002, the Company had approximately 169,000 subscriber
lines using line-sharing agreements.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The FCC also announced that the local telephone companies would not
be required to allow the Company to access the packet-switching
functions of fiber-fed telephone lines to provision DSL services. This
means that, unless the Company reaches agreements with the local
telephone companies, the Company will be unable to provide its most
commonly-used services to end-users served by fiber-fed lines. This is
significant for the Companys business because it preserves a
substantial limit on the addressable market for its services, thereby
limiting its growth. In addition, the local telephone companies are
increasing their deployment of fiber-fed remote terminal architectures.
The Company currently has no lines in service using packet-switching
capabilities of fiber-fed telephone lines.                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|
| |  |  | The FCC announced that, if the state public utilities commissions
deem it appropriate, companies that compete with the local telephone
companies would continue to have access to the local telephone
companies networks in order to provide their services under an
arrangement known as the Unbundled Network Element platform (UNE-P). Under this arrangement
these competitive telecommunications companies purchase phone lines in
order to provide voice and data services. The continued existence of
the UNE-P provides the Company with the opportunity to potentially
bundle its data services with the voice services of these companies.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

The FCC has not yet issued its order in the Triennial Review and it is
uncertain when that order will be released. Without that order, it is
difficult for the Company to evaluate the full impact of the FCCs decision on
its business. However, based on the FCCs announcement, it appears that at some
point the Company will be required to purchase a separate telephone line in
order to provide services to an end-user, unless it reaches agreements with the
local telephone companies that provide the Company with continued access to
line-sharing. The cost of a separate phone line is significantly higher than
the cost of a shared line. If the Company is unable to obtain from the
traditional telephone companies reasonable line-sharing rates substantially
below the cost of a separate telephone line, it may stop selling stand-alone
consumer grade services, which would slow the growth of its revenue and require
it to significantly change its business plan.

On January 1, 2003, in conjunction with an amendment to an Agreement for
Broadband Internet Access Services with AT&T Corp., a wholesale customer, the
Company granted AT&T Corp. three warrants to purchase 1,000,000 shares of the
Companys common stock for $0.94 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

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

date for these warrants was the date of grant. The aggregate fair value of
such warrants of $2,640, which 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%, was recorded
as a deferred customer incentive in 2003 and is being recognized as a reduction
of revenues on a straight-line basis over the three-year term of the agreement
because management believes that future revenues from AT&T Corp. will exceed
the fair value of the warrants described above.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

Supplemental Data

The 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.

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PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The current executive officers and directors of the Company, and their
respective ages as of January 1, 2003, are as follows:

|                   |  |     |    |          |  |                                                                           
|------------------ |  | --- | -- | -------- |  | --------------------------------------------------------------------------
|Name               |  | Age |    | Position
|                   |  |     |    |         
|Charles E. Hoffman |  |     | 53 |          |  | President and Chief Executive Officer                                     
|Patrick J. Bennett |  |     | 55 |          |  | Executive Vice
President and General Manager, Covad Broadband Solutions   
|Andrew Lockwood    |  |     | 46 |          |  | Executive Vice
President and General Manager, Covad Strategic Partnerships
|P. Michael Hanley  |  |     | 45 |          |  | Senior Vice
President, Organizational Transformation                      
|Anjali Joshi       |  |     | 42 |          |  | Executive Vice President, Engineering                                     
|Brad Sonnenberg    |  |     | 47 |          |  | Senior Vice President, Secretary and General Counsel                      
|Mark A. Richman    |  |     | 42 |          |  | Executive Vice President and Chief Financial Officer                      
|Charles McMinn     |  |     | 51 |          |  | Chairman, Board of Directors                                              
|Hellene Runtagh    |  |     | 54 |          |  | Director                                                                  
|Daniel Lynch       |  |     | 61 |          |  | Director                                                                  
|Larry Irving       |  |     | 47 |          |  | Director                                                                  
|Robert Hawk        |  |     | 63 |          |  | Director                                                                  
|L. Dale Crandall   |  |     | 61 |          |  | Director                                                                  
|Richard Jalkut     |  |     | 58 |          |  | Director                                                                  

Charles E. Hoffmanhas served as the Companys President and Chief
Executive Officer since June 2001. Mr. Hoffman previously served as President
and Chief Executive Officer of Rogers Wireless, Inc. from 1998 to 2001. From
1996 to 1998 he served as President, Northeast Region for Sprint PCS. Prior to
that, he spent 16 years at Southwestern Bell from 1980 to 1996 in various
senior positions, including regional manager, general manager and vice
president and general manager.

Patrick J. Bennettjoined the Company in October 2001 as our Executive
Vice President and General Manager, Covad Broadband Solutions. Prior to joining
Covad, Mr. Bennett served as Senior Vice President with TESSCO Technologies
from March 2001 to October 2001. Before that, Mr. Bennett was with Rogers
Wireless where he served as its Executive Vice President and Chief Operating
Officer from December 1999 to March 2001 and as its Senior Vice President,
Sales, from April 1998 to December 1999. From 1996 to 1998, Mr. Bennett was an
area vice president for Sprint PCS.

Andrew Lockwoodjoined the Company in July 2002 as the Companys Senior
Vice President of Marketing and in January 2003 was appointed as Executive Vice
President, Covad Strategic Partnerships. Mr. Lockwood brings to Covad 21 years
of experience in telecommunications, sales and marketing. Prioir to joining
Covad, he was Senior Vice President and General Manager of Inktomis Wireless
Division from December 2000 to June 2002 where he was responsible for software
engineering, product management, marketing, sales, finance, human resources and
strategy. Prior to his position at Inktomi, Mr. Lockwood spent eight years at
British Telecommunications (BT) in a variety of senior management positions.
Most recently he was vice president of the Advance Alliance where he led the
relationship between BT and AT&T Wireless, identifying and implementing joint
global product developments and other business initiatives. He was also deputy
COO at Telfort Mobil Netherlands, general manager of the Retail and Logistics
Sector and held senior positions in Cable Television Services, BT Mobile and BT
Cellular.

P. Michael Hanleyhas served as the Companys Senior Vice President,
Organizational Transformation, since February 2002. Mr. Hanley came to the
Company from Rogers Wireless, Inc. where he served as its Vice President,
Organizational Transformation from 1999 to 2001 and as its Vice President,
Credit Operations from 1996 to 1999. Prior to joining, Rogers Wireless, Mr.
Hanley held increasingly senior roles with Canadian Imperial Bank of Commerce
from 1994 to 1996.

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Anjali Joshijoined the Company in 1998 and has served as the Companys
Executive Vice President, Engineering since May 2001. She previously served as
the Companys Vice President, Network Engineering and Director, Network
Engineering. From 1994 to 1998, she served as a Technical Program Manager,
ATM/IP Network Implementation and Service Development for AT&T Interspan High
Speed Services. From 1990 to 1994, she was a Signaling Network
Technology/Architecture Planner for AT&T Bell Laboratories.

Brad Sonnenbergjoined the Company in January 1999 and became General
Counsel in June 2002. Prior to joining Covad, Mr. Sonnenberg was an assistant
U.S. attorney at the U.S. Attorneys Office in Los
Angeles from October 1990 to January 1999 where he focused on prosecuting
white-collar and organized crimes. He started his legal career as an associate at Debevoise &
Plimpton in New York. He also served as an assistant state attorney in Miami,
Florida.

Mark A. Richmanjoined the Company in September 2001 as its Senior Vice
President and Chief Financial Officer and was made Executive Vice
President and Chief Financial Officer in May 2002. Prior to joining the Company, Mr.
Richman served as Vice President and Chief Financial Officer of MainStreet
Networks from June 2000 to August 2001. From October 1996 to June 2000 Mr.
Richman served as vice president and corporate treasurer of Adecco S.A. and as
vice president of finance and administration for its subsidiary, Adecco U.S.
From February 1994 to October 1996, he was European finance director for
Merisel.

Charles McMinnis a founder of the Company and has been the Chairman of
the Board of Directors since October 2000. Mr. McMinn previously served as the
Companys Chairman of the Board of Directors from July 1998 to September 1999.
He served as the Companys President, Chief Executive Officer and as a member
of its Board of Directors from October 1996 to July 1998. Mr. McMinn has over
20 years of experience in creating, financing, operating and advising high
technology companies. From November of 1999 to October 2000, Mr. McMinn served
as Chief Executive Officer and is a founder of Certive Corporation and he is
still chairman of Certives board of directors. From July 1995 to October 1996,
and from August 1993 to June 1994, Mr. McMinn managed his own consulting firm,
Cefac Consulting, which focused on strategic consulting for information
technology and communications businesses. From June 1994 to November 1995, he
served as Principal, Strategy Discipline, at Gemini Consulting. From August
1992 to June 1993, he served as President and Chief Executive Officer of
Visioneer Communications, Inc. and from October 1985 to June 1992 was a general
partner at InterWest Partners, a venture capital firm. Mr. McMinn began his
Silicon Valley career as the product manager for the 8086 microprocessor at
Intel.

L.  Dale Crandallhas served as a member of the Companys Board of
Directors since June 2002. Mr. Crandall also chairs the Audit Committee of the
Companys Board of Directors. Mr. Crandall has 32 years of previous experience
with Price Waterhouse. He was President and Chief Operating Officer of Kaiser
Foundation Health Plan, Inc. and Kaiser Foundation Hospitals until June 2002,
and retired at that time. He joined Kaiser in June 1998 as Senior Vice
President and Chief Financial Officer. Prior to joining Kaiser, he served as
Executive Vice President, Chief Financial Officer and Treasurer of APL Limited
from April 1995 until February 1998. He is also a member of the boards of
directors of Union Bank of California, Ansell Limited and BEA Systems and a
Trustee of Dodge and Cox mutual funds.

Richard Jalkuthas served as a member of the Companys Board of Directors
since July 2002. Mr. Jalkut has more than 35 years of experience in the
telecommunications industry, including extensive senior executive and start-up
experience. He is currently the President and CEO of TelePacific, a Los
Angeles-based competitive local exchange carrier. Prior to joining TelePacific,
he was President and CEO of Pathnet Telecom. Mr. Jalkut spent 32 years with
NYNEX where he served as the President, CEO and Chairman. He is also a member
of the boards of directors of HSBC-USA, Birch Telecom and serves as the lead
independent director of IKON Office Solutions.

Robert Hawkhas served as a member of the Companys Board of Directors
since April 1998. Mr. Hawk is President of Hawk Communications and recently
retired as President and Chief Executive Officer of U S WEST Multimedia
Communications, a regional telecommunications service provider, where he headed
the cable, data and telephony communications business from May 1996 to April
1997. He was president of the Carrier Division of US West Communications, Inc.,
from September 1990 to May 1996. Prior to that time, Mr. Hawk was Vice
President of Marketing and Strategic Planning for CXC Corporation. Prior to
joining CXC Corporation, Mr. Hawk was director of Advanced Systems Development
for AT&T/American Bell. He currently serves on the board of Centillium
Communications.

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Larry Irvinghas served as a member of the Companys Board of Directors
since April 2000. Mr. Irving has served as the President and CEO of the Irving
Information Group, a strategic consulting firm since October 1999. Prior to
founding the Irving Information Group, Mr. Irving served for almost seven years
as Assistant Secretary of Commerce for Communications and Information, where he
was a principal advisor to the President, Vice President and Secretary of
Commerce on domestic and international communications and information policy
issues, including the development of policies related to the Internet and
Electronic Commerce. He was a point person in the Clinton-Gore Administrations successful
efforts to reform the United States telecommunications law, which resulted in
the passage of the Telecommunications Act of 1996. Mr. Irving is widely
credited with popularizing the term Digital Divide and was the principal
author of the landmark Federal survey, Falling Through The Net, which tracked
access to telecommunications and information technologies, including computers
and the Internet, across racial, economic, and geographic lines. In recognition
of his work to promote policies and develop programs to ensure equitable access
to advanced telecommunication and information technologies, Irving was named
one of the fifty most influential persons in the Year of the Internet by
Newsweek Magazine. Prior to joining the Clinton-Gore Administration, Mr. Irving
served ten years on Capitol Hill, most recently as Senior Counsel to the U.S.
House of Representatives Subcommittee on Telecommunications and Finance. He
also served as Legislative Director, Counsel and Chief of Staff (acting) to the
late Congressman Mickey Leland (D-Texas). During the previous four years, Mr.
Irving was associated with the Washington, D.C. law firm of Hogan & Hartson,
specializing in communications law, antitrust law and commercial litigation.

Daniel Lynchhas served as a member of the Companys Board of Directors
since April 1997. From December 1990 to December 1995, he served as chairman of
the board of directors of Softbank Forums, a provider of education and
conference services for the information technology industry. Mr. Lynch founded
Interop Company in 1986, which is now a division of the successor to Softbank
Forums, Key3Media. Mr. Lynch is a member of the Association for Computing
Machinery and the Internet Society. He is also a member of the Board of
Trustees of the Santa Fe Institute and the Bionomics Institute. He previously
served as Director of the Information Processing Division for the Information
Sciences Institute in Marina del Rey, where he led the Arpanet team that made
the transition from the original NCP protocols to the current TCP/IP based
protocols.

Hellene Runtaghhas served as a member of the Companys Board of Directors
since November 1999. Ms. Runtagh served as Executive Vice President of
Universal Studios from January 1999 until January 2001. In this capacity, she
was responsible for overseeing the activities of the Universal Studios
Operations Group, Universal Studios Consumer Products Group, Universal Studios
Corporate Marketing and Sponsorships, and the Spencer Gift retail operations,
Universal Studios worldwide information technology, and Seagrams global
sourcing and real estate operations. From February 1997 to January 1999, she
held the position of senior vice president of reengineering effort at
Universal. Previously, Ms. Runtagh spent 25 years at General Electric, where
she served as President and Chief Executive Officer of GE Information Services
from 1989 to 1996 and held general management roles with GEs capital and
software businesses.

See Part I. Item 3 Legal Proceedings for information relating to our
Chapter 11 proceeding in 2001.

Classified Board

The Board of Directors is divided into three classes. The term of office
and directors in each class is as follows:

|          |  |                                          |  |  |   |                                                                                                             
|--------- |  | ---------------------------------------- |  |  | - | ------------------------------------------------------------------------------------------------------------
|Class     |  | Directors                                |  |  |   | Term of Office                                                                                              
|          |  |                                          |  |  |   |                                                                                                             
|Class I   |  | Daniel Lynch
Richard Jalkut
Larry Irving |  |  |  | expires at the annual meeting of
stockholders in 2003 and at each
third succeeding annual meeting
thereafter
|Class II  |  | L. Dale Crandall
Hellene Runtagh         |  |  |  | expires at the annual meeting of
stockholders in 2004 and at each
third succeeding annual meeting
thereafter
|Class III |  | Charles McMinn
Robert Hawk               |  |  |  | expires at the annual meeting of
stockholders in 2005 and at each
third succeeding annual meeting
thereafter

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The classification of directors has the effect of making it more difficult
to change the composition of the Board of Directors.

Board Committees

In April 1998, the Board of Directors established an Audit Committee and a
Compensation Committee.

The Audit Committee currently consists of four of the Companys outside
directors, Messrs. Crandall, Lynch, Hawk and Ms. Runtagh, with Mr. Crandall
serving as the chairperson. The Audit Committee is responsible for providing
oversight and monitoring of management and the independent auditors and their
activities with respect to our financial reporting process and the system of
internal controls.

The Compensation Committee currently consists of three of the Companys
outside directors, Mr. Irving, Mr. Lynch and Ms. Runtagh. The primary
responsibilities of the Compensation Committee include:



| |  |  | reviewing and determining the compensation policy for the Companys
executive officers and directors, and other employees as directed by the
Board of Directors;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | reviewing and determining all forms of compensation to be provided to
the Companys executive officers; and                                                     
|
| |  |  | unless otherwise directed by the Board, administering equity-based
compensation plans adopted by the Company.                                                   

In September 2002, the Board of Directors established a Nominating and
Corporate Governance Committee that consists of Messrs. Hawk, Irving and
Jalkut. The primary responsibilities of the Nominating and Corporate
Governance Committee include:



| |  |  | proposing nominees for election as directors;  
| | - |  | -----------------------------------------------
|
| |  |  | Board appraisals and performance standards; and
|
| |  |  | Oversight of corporate governance matters.     

The Company also has a Pricing Committee and Management Compensation
Committee. The Pricing Committee currently consists of one outside director,
Mr. Irving and two inside directors, Messrs. McMinn and Hoffman. The function
of the Pricing Committee is to set the price for the sale of the Companys
common stock to third-parties. The function of the Management Compensation
Committee, which consists solely of one inside director, Mr. Hoffman, is to
review and determine the compensation policy for employees other than the
Companys executive officers and directors and to review and determine all
forms of compensation for such employees.

Director Compensation

Prior to 2003, the only compensation provided to directors for services
provided as a director or committee member were grants of stock options subject
to vesting and restricted stock subject to repurchase. Periodic stock options
and restricted stock were granted as follows:



| |  |  | All newly installed directors received a stock option grant to
purchase 60,000 shares of common stock and ongoing directors received
annual grants of options to purchase 15,000 shares of our common stock;                                                                               
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Members of our Audit Committee, other than the Chairperson, received
a one time grant of options to purchase 10,000 shares of our common
stock when they were appointed to the Audit Committee and then received
annual grants of options to purchase 5,000 shares of our common stock;
and

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| |  |  | The Chairperson of our Audit Committee received an option to purchase
10,000 shares of our common stock when appointed to the Audit Committee
and then received annual grants of options to purchase 10,000 shares of
our common stock.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

All of these grants of stock options or restricted stock subject to
repurchase were at the market price on the grant date and vest over a period of
four years.

In February 2003, the Board adopted new policies regarding Director
compensation. The new compensation plan provides for a continuation of the
compensation benefits listed above. In addition, the new plan provides:



| |  |  | An annual retainer of $18,000 to be paid to each Director. A
Director may elect to receive either (1) the retainer paid in two equal
payments every six months or (2) a grant of an option to purchase 5,000
shares, vesting 1/12 per month.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The above-referenced annual grants of options to purchase 15,000
shares will vest 1/12 per month rather than 1/48 per month.                                                                                                                
|
| |  |  | The above referenced annual grants of options to Audit Committee
members and the Chairperson of the Audit Committee will vest 1/12 per
month rather than 1/48 per month.                                                                    
|
| |  |  | A fee of $1,000 to be paid to a Director for each Board meeting
that he or she attends.                                                                                                                                                     
|
| |  |  | A fee of $1,000 to be paid to a Director for each Committee meeting
that he or she attends on a different day from a Board meeting.                                                                                                         

Each Director also received a special one time grant of an option to
purchase 45,000 shares at an exercise price equal to the market price on the
date of grant, vesting over three years.

In January 2001, each of the members of the Board of Directors, other than
Mr. McMinn (who received a stock option grant to purchase 60,000 shares at the
market price on the grant date as a newly installed director), received a
one-time stock option grant to purchase 50,000 shares at the market price on
the grant date, vesting over four years.

In April 2001, we provided Mr. McMinn and Frank Marshall, our then interim
Chief Executive Officer, with stock option grants to purchase 200,000 shares
each. These options were priced at the closing price of our stock on the NASDAQ
National Market on the grant date. One-half of these options were immediately
vested and the remaining one-half were scheduled to vest over the following six
months. As a result of Mr. Marshalls resignation as our Interim Chief
Executive Officer in June 2001, the option to purchase 50,000 of these 200,000
shares did not vest. In November 2001, Mr. Marshall was granted an additional
option to purchase 50,000 shares at the market price on the grant date. These
options fully vested in December 2001. Mr. Marshall resigned from our Board of
Directors in December 2002.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16 of the Exchange Act requires our directors and certain of our
officers, and persons who own more than 10% of our common stock, to file
initial reports of ownership and reports of changes in ownership with the
Securities and Exchange Commission and the Nasdaq National Market. Such persons
are required by Securities and Exchange Commission regulation to furnish us
with copies of all Section 16(a) forms they file. Based solely on our review of
the copies of such forms furnished to us and written representations from these
officers and directors, we believe that except for Daniel Lynch (Form 4
covering two transactions due December 4, 2002 filed on December 9, 2002) all
Section 16(a) filing requirements were met during fiscal 2002.

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ITEM 11. EXECUTIVE COMPENSATION

The following table sets forth certain information with respect to
compensation awarded to, earned by or paid to each person who served as the
Companys Chief Executive Officer or was one of the Companys four other most
highly compensated executive officers (collectively, the Named Executive
Officers) during the fiscal year ended December 31, 2002.

115



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SUMMARY COMPENSATION TABLE

|                            |                            |                         |      |        |      |       |         |                             |         |                  |         |              |   |                       |   |                        |   |  |           |        |        |   |         |     |     |    
|--------------------------- | -------------------------- | ----------------------- | ---- | ------ | ---- | ----- | ------- | --------------------------- | ------- | ---------------- | ------- | ------------ | - | --------------------- | - | ---------------------- | - |  | --------- | ------ | ------ | - | ------- | --- | --- | ---
|                            |                            |                         |      |        |      |       |         |                             |         |                  |         |              |   |                       |   | Long-Term Compensation |   |  |           |       
|                            |                            |                         |      |        |      |       |         |                             |         |                  |         |              |   |                       |   |                        |   |  |           |       
|                            |                            |                         |      |        |      |       |         |                             |         |                  |         |              |   |                       |   |                        |   |  |           |        |        |   |         |    
|                            |                            |                         |      |        |      |       |         | Annual
Compensation         |         |                  |         |              |   | Securities
Underlying |   | All Other             
|Name and principal position |                            | Fiscal Year             |      | Salary |      | Bonus |         | Restricted Stock Awards ($) |         | Options/SARs (#) |         | Compensation
|                            |                            |                         |      |        |      |       |         |                             |         |                  |         |             
|Charles E. Hoffman (1)      |                            |                         | 2002 |        |      | $     | 500,004 |                             |         | $                | 542,483 |              |   |                       |  |                        |   |  |          |        |        | $ | 414     | (2)
|President and Chief         |                            |                         | 2001 |        |      | $     | 259,617 |                             |         | $                | 207,621 |              |   |                       |  |                        |   |  | 2,500,000 |        |        | $ | 100,207 | (3)
|                            | Executive Officer          |                         |      | 2000   |      |       | $       |                            |         |                  | $       |             |   |                       |   |                       |   |  |           |       |        |   | $       |    |    
|Patrick J. Bennett (4)      |                            |                         | 2002 |        |      | $     | 285,000 |                             |         | $                | 126,343 |              |   |                       |  |                        |   |  |          |        |        | $ | 774     | (2)
|Executive Vice President    |                            |                         | 2001 |        |      | $     | 60,288  |                             |         | $                | 29,704  |              |   |                       |  |                        |   |  | 200,000   |        |        | $ | 25,093  | (5)
|                            | and General Manager, Covad |                         |      | 2000   |      |       | $       |                            |         |                  | $       |             |   |                       |   |                       |   |  |           |       |        |   | $       |    |    
|                            | Broadband Solutions        |                         |      |        |      |       |         |                             |         |                  |         |              |   |                       |   |                        |   |  |           |        |        |   |         |     |    
|Dhruv Khanna (6)            |                            |                         | 2002 |        |      | $     | 275,000 |                             |         | $                | 87,535  |              |   |                       |  |                        |   |  |          |        |        | $ | 180     | (2)
|Executive Vice President    |                            |                         | 2001 |        |      | $     | 275,000 |                             |         | $                | 153,450 |              |   |                       |  |                        |   |  | 327,000   |        |        | $ | 152     | (2)
|                            | and General Counsel        |                         |      | 2000   |      |       | $       | 263,462                     |         |                  |         |             |   |                       |   |                       |   |  |           | 52,501 |        |   | $       | 270 | (2)
|Anjali Joshi                |                            |                         | 2002 |        |      | $     | 250,000 |                             |         | $                | 110,827 |              |   |                       |  |                        |   |  |          |        |        | $ | 180     | (2)
|Executive Vice President,   |                            |                         | 2001 |        |      | $     | 232,692 |                             |         | $                | 125,308 |              |   |                       |  |                        |   |  | 325,000   |        |        | $ | 145     | (2)
|                            |                            | Engineering             |      |        | 2000 |       |         | $                           | 175,942 |                  |         |              |  |                       |   |                        |  |  |           |        | 80,001 |   |         | $   | 180 | (2)
|Mark A. Richman (7)         |                            |                         | 2002 |        |      | $     | 228,077 |                             |         | $                | 100,723 |              |   |                       |  |                        |   |  |          |        |        | $ | 180     | (2)
|Executive Vice President,   |                            |                         | 2001 |        |      | $     | 64,904  |                             |         | $                | 32,923  |              |   |                       |  |                        |   |  | 250,000   |        |        | $ | 55      | (2)
|                            |                            | Chief Financial Officer |      |        | 2000 |       |         |                             |        |                  |         |              |  |                       |   |                        |  |  |           |        |       |   |         | $   |    |    
|Brad Sonnenberg             |                            |                         | 2002 |        |      | $     | 202,500 |                             |         | $                | 80,128  |              |   |                       |  |                        |   |  |          |        |        | $ | 270     | (2)
|Senior Vice President       |                            |                         | 2001 |        |      | $     | 183,654 |                             |         | $                | 184,415 |              |   |                       |  |                        |   |  | 371,000   |        |        | $ | 228     | (2)
|                            | and General Counsel        |                         |      | 2000   |      |       | $       | 145,385                     |         |                  | $       | 37,661       |   |                       |   |                       |   |  |           | 58,750 |        |   | $       | 180 | (2)



---

|(1) |  | Mr. Hoffman joined Covad in June 2001.                                                                                                                                               
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | The dollar amount represents premium payments the Company made for these executives term life insurance.                                                                            
|   
|(3) |  | Includes a payment of $100,000 as a sign on bonus, as well as $207 for term life insurance.                                                                                          
|   
|(4) |  | Mr. Bennett joined Covad in October 2001.                                                                                                                                            
|   
|(5) |  | Includes a payment of $25,000 as a sign on bonus, as well as $93 for term life insurance.                                                                                            
|   
|(6) |  | Mr. Khanna was no longer
serving as an executive officer as of June 2002 but if he had been
serving as of December 31, 2002, would have been one of Covads Named
Executive Officers.
|   
|(7) |  | Mr. Richman joined Covad in September 2001.                                                                                                                                          

Option/SAR Grants In Last Fiscal Year

There were no stock options grants or SAR grants to Named Executive
Officers during the fiscal year ended December 31, 2002.

Aggregated Option/SAR Exercises In Last Fiscal Year And Year-End Option/SAR Values

The following table sets forth information with respect to the exercise of
stock options during the year ended December 31, 2002 and the number and
year-end value of shares of the Companys common stock underlying the
unexercised options held by the Named Executive Officers.

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|                   |  |                    |        |                 |  |                              |        |                          |  |                        |         |                         |  |  |           |  |  |   |        |  |  |   |         | 
|------------------ |  | ------------------ | ------ | --------------- |  | ---------------------------- | ------ | ------------------------ |  | ---------------------- | ------- | ----------------------- |  |  | --------- |  |  | - | ------ |  |  | - | ------- | 
|                   |  |                    |        |                 |  |                              |        |                          |  | Number Of Securities   |         | Value Of Unexercised   
|                   |  |                    |        |                 |  |                              |        |                          |  | Underlying Unexercised |         | In-The-Money Options At
|                   |  | Shares Acquired On |        | Value           |  | Options
At December 31, 2002 |        | December
31, 2002 ($)(2)
|Name               |  | Exercise (#)       |        | Realized ($)(1) |  | Exercisable                  |        | Unexercisable            |  | Exercisable            |         | Unexercisable          
|                   |  |                    |        |                 |  |                              |        |                          |  |                        |         |                        
|Charles E. Hoffman |  |                    | 0      |                 |  |                              | 0      |                          |  |                        | 937,500 |                         |  |  | 1,562,500 |  |  | $ | 93,750 |  |  | $ | 156,250 | 
|Patrick J. Bennett |  |                    | 0      |                 |  |                              | 0      |                          |  |                        | 58,333  |                         |  |  | 141,667   |  |  | $ | 26,833 |  |  | $ | 65,167  | 
|Dhruv Khanna       |  |                    | 0      |                 |  |                              | 0      |                          |  |                        | 206,875 |                         |  |  | 172,626   |  |  | $ | 11,875 |  |  | $ | 26,125  | 
|Brad Sonnenberg    |  |                    | 0      |                 |  |                              | 0      |                          |  |                        | 267,215 |                         |  |  | 230,036   |  |  | $ | 18,458 |  |  | $ | 38,342  | 
|Anjali Joshi       |  |                    | 56,219 |                 |  | $                            | 93,532 |                          |  |                        | 213,019 |                         |  |  | 394,482   |  |  | $ | 11,875 |  |  | $ | 156,474 | 
|Mark A. Richman    |  |                    | 0      |                 |  |                              | 0      |                          |  |                        | 78,125  |                         |  |  | 171,875   |  |  | $ | 35,547 |  |  | $ | 78,203  | 



---

|(1) |  | Value represents the fair market value at exercise minus the exercise price.                                                                                                                                                                        
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | Value represents the difference
between the exercise price and the market value (i.e., closing price) of common stock of $0.94 on December 31, 2002. An option is in-the-money if the market value of the common stock exceeds the exercise price.

Employment Agreements and Change in Control Arrangements

In May 2001, we entered into a written employment agreement with Charles
Hoffman, our President and Chief Executive Officer. Mr. Hoffman receives
compensation in the form of a $500,000 annual base salary and a bonus of
$375,000 if he attains certain performance goals. Mr. Hoffman also received (i)
a signing bonus of $100,000, and (ii) stock options to purchase 2,500,000
shares of our common stock at an exercise price of $0.84 per share. Mr. Hoffman
has agreed to be bound by customary confidentiality provisions. In the event
that Mr. Hoffman is terminated without cause, we have agreed to pay his salary
for an additional year from his termination date, provided that he does not
become employed by one of our competitors.

In December 2000, we entered into a written employment agreement with
Catherine Hemmer, our former Executive Vice President and Chief Operating
Officer, which had an 18 month term. In connection with her departure from the
Company, Ms. Hemmer received a lump sum payment of $120,000 in lieu of any
benefits under her written employment agreement. We forgave the remaining
$87,500 that she owed the Company as a result of a loan that was provided to
her. We also extended the exercise period for a portion of Ms. Hemmers stock
options until July 31, 2002.

In May 2001, we entered into an employment agreement with Anjali Joshi,
our Executive Vice President, Engineering, which had a 12-month term
that expired in May 2002. If we
terminated Ms. Joshi without cause (as that term is defined in the agreement),
or if she resigned for good reason (as that term is defined in the agreement),
we would have continued to pay her annual salary through the term of the
agreement, plus a pro rated portion of her bonus. In the event of a change of
control (as that term is defined in the agreement), her employment
agreement would have been null and void.

Mark Perry, our former Chief Financial Officer, had his salary continued
for nine months after his departure and, in exchange for these payments, Mr.
Perry agreed to forego any rights under his employment agreement and agreed to
provide us with consulting services for three months after his resignation.

With respect to all options granted under the Companys 1997 Stock Plan,
in the event that the Company merges with or into another corporation resulting
in a change of control involving a shift in 50% or more of the voting power of
the Companys capital stock, or the sale of all or substantially all of the
Companys assets, the options will fully vest and become exercisable one year
after the change of control or earlier in the event the individual is
constructively terminated or terminated without cause or in the event the
successor corporation refuses to assume the options.

We have also entered into restricted stock purchase agreements with
certain of the Companys directors. The shares of the Companys common stock
issued pursuant to these restricted stock purchase agreements are subject to
the Companys right of repurchase which lapses in accordance with the vesting
schedule of the agreements. The
agreements also include similar provisions to the stock options, providing
for accelerated vesting in the event of a change of control.

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Securities Authorized for Issuance Under Equity Compensation Plans

The following table provides information about our common stock that may
be issued upon the exercise of options, warrants and rights under our existing
equity compensation plans as of December 31, 2002.

|                                                               |  |                   |            |                   |  |                     |       |                     |  |                     |            | 
|-------------------------------------------------------------- |  | ----------------- | ---------- | ----------------- |  | ------------------- | ----- | ------------------- |  | ------------------- | ---------- | 
|                                                               |  |                   |            |                   |  |                     |       |                     |  | Number of          
|                                                               |  |                   |            |                   |  |                     |       |                     |  | securities         
|                                                               |  |                   |            |                   |  |                     |       |                     |  | remaining available
|                                                               |  | Number of         |            |                   |  |                     |       | for future issuance
|                                                               |  | securities to be  |            |                   |  |                     |       | under equity       
|                                                               |  | issued upon       |            | Weighted-average  |  | compensation plans 
|                                                               |  | exercise of       |            | exercise price of |  | (excluding         
|                                                               |  | outstanding       |            | outstanding       |  | securities         
|                                                               |  | options, warrants |            | options, warrants |  | reflected in column
|Plan Category                                                  |  | and rights        |            | and rights        |  | (a))               
|                                                               |  |                   |            |                   |  |                    
|                                                               |  | (a)               |            | (b)               |  | (c)                
|                                                               |  |                   |            |                   |  |                    
|Equity compensation
plans approved by
security holders
(1)     |  |                   | 25,407,665 |                   |  | $                   | 7.80  |                     |  |                     | 22,408,595 | 
|Equity compensation
plans not approved
by security holders
(2) |  |                   | 267,349    |                   |  | $                   | 11.19 |                     |  |                     | 2,686,139  | 
|Total                                                          |  |                   | 25,675,014 |                   |  | $                   | 7.80  |                     |  |                     | 25,094,734 | 

(1)  Securities available for future issuance under Covads 1998 Employee Stock
Purchase Plan are included in column (c) but are not included in columns (a)
and (b) because amount and price of securities purchased in an offering period
are determined at the end of such offering period. Covads next offering
period ends in April 2003.

(2)  These plans consist of the LaserLink.Net, Inc. 1997 Stock Plan and the
BlueStar Communications Group, Inc. 2000 Stock Incentive Plan, both of which
were assumed by Covad in connection with the acquisitions of each company and
are described in Note 13 of the Financial Statements.

Compensation Committee Interlocks and Insider Participation

Mr. Irving, Mr. Lynch and Ms. Runtagh currently serve on the Compensation
Committee. No interlocking relationship exists between the Board of Directors
or the Compensation Committee and the Board of Directors or compensation
committee of any other company, nor has any such interlocking relationship
existed in the past.

Limitation on Liability and Indemnification Matters

The Companys Amended and Restated Certificate of Incorporation limits the
liability of the Companys directors to the maximum extent permitted by
Delaware law, and the Companys Bylaws provide that the Company will indemnify
the Companys directors and officers and may indemnify the Companys other
employees and agents to the fullest extent permitted by law. We also entered
into agreements to indemnify the Companys directors and executive officers, in
addition to the indemnification provided for in the Companys Bylaws. The
Companys Board of Directors believes that these provisions and agreements are
necessary to attract and retain qualified directors and executive officers.




ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth certain information regarding ownership of
the Companys common stock as of February 1, 2003 by:



| |  |  | each Named Executive Officer;   
| | - |  | --------------------------------
|
| |  |  | each of the Companys directors;

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| |  |  | all of the Companys executive officers and directors as a group; and                         
| | - |  | ----------------------------------------------------------------------------------------------
|
| |  |  | all persons known to the Company to beneficially own 5% or more of the Companys common stock.

Share ownership in each case includes shares issuable upon exercise of
outstanding options and warrants that are exercisable within 60 days of
February 1, 2003 as described in the footnotes below. Percentage ownership is
calculated pursuant to SEC Rule 13d-3(d)(1) and based on 232,794,757 shares of
our common stock outstanding as of February 1, 2003. Except as otherwise
indicated, the address of each of the persons in this table is as follows: c/o Covad Communications Group, Inc., 3420
Central Expressway, Santa Clara, California 95051.

|                                                                     |  |                           |           |            |  |  |      |  
|-------------------------------------------------------------------- |  | ------------------------- | --------- | ---------- |  |  | ---- | -
|                                                                     |  | Shares Beneficially Owned
|                                                                     |  |                          
|Beneficial Owner                                                     |  | Number                    |           | Percentage
|                                                                     |  |                           |           |           
|Dhruv Khanna(1)                                                      |  |                           | 5,537,543 |            |  |  | 2.38 | %
|Charles McMinn(2)                                                    |  |                           | 3,615,247 |            |  |  | 1.55 | %
|Charles E. Hoffman(3)                                                |  |                           | 1,102,940 |            |  |  | *    |  
|Robert Hawk(4)                                                       |  |                           | 561,410   |            |  |  | *    |  
|Anjali Joshi(5)                                                      |  |                           | 360,842   |            |  |  | *    |  
|Daniel Lynch(6)                                                      |  |                           | 344,023   |            |  |  | *    |  
|Brad Sonnenberg(7)                                                   |  |                           | 305,573   |            |  |  | *    |  
|Hellene Runtagh(8)                                                   |  |                           | 110,499   |            |  |  | *    |  
|Mark A. Richman(9)                                                   |  |                           | 102,886   |            |  |  | *    |  
|P. Michael Hanley(10)                                                |  |                           | 81,833    |            |  |  | *    |  
|Patrick J. Bennett(11)                                               |  |                           | 79,688    |            |  |  | *    |  
|Larry Irving(12)                                                     |  |                           | 76,895    |            |  |  | *    |  
|L. Dale Crandall, Richard Jalkut, Andrew Lockwood                    |  |                           | 0         |            |  |  | *    |  
|All current executive officers and directors as a group (14 persons) |  |                           | 6,741,836 |            |  |  | 2.90 | %



---

|*    |  | Represents beneficial ownership of less than 1% of the Companys outstanding
stock.                                                                                      
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    
|(1)  |  | Includes 53,874 shares of common stock subject to options exercisable
within 60 days of February 1, 2003. Mr. Khanna ceased serving as an
executive officer in June 2002.
|    
|(2)  |  | Includes 887 shares of common stock subject to options exercisable
within 60 days of February 1, 2003.                                                                   
|    
|(3)  |  | Includes 104,167 shares of common stock subject to options exercisable
within 60 days of February 1, 2003.                                                               
|    
|(4)  |  | Includes 4,583 shares of common stock subject to options exercisable
within 60 days of February 1, 2003.                                                                 
|    
|(5)  |  | Includes 16,874 shares of common stock subject to options exercisable
within 60 days of February 1, 2003                                                                 
|    
|(6)  |  | Includes 4,791 shares of common stock subject to options exercisable
within 60 days of February 1, 2003.                                                                 
|    
|(7)  |  | Includes 17,906 shares of common stock subject to options exercisable
within 60 days of February 1, 2003.                                                                
|    
|(8)  |  | Includes 6,666 shares of common stock subject to options exercisable
within 60 days of February 1, 2003.                                                                 
|    
|(9)  |  | Includes 10,417 shares of common stock subject to options exercisable
within 60 days of February 1, 2003.                                                                
|    
|(10) |  | Includes 8,333 shares of common stock subject to options exercisable
within 60 days of February 1, 2003.                                                                 
|    
|(11) |  | Includes 8,333 shares of common stock subject to options exercisable
within 60 days of February 1, 2003.                                                                 
|    
|(12) |  | Includes 5,208 shares of common stock subject to options exercisable
within 60 days of February 1, 2003.                                                                 
|    
|(13) |  | Includes 188,165 shares of common stock subject to options
exercisable within 60 days of February 1, 2003.                                                               

Strategic Investments and Relationships

On September 11, 2000, we entered into an agreement with SBC
Communications, Inc. in which SBC purchased 9,373,169 shares of our common
stock for $150 million. SBC has agreed not to transfer any of our common stock
until September 11, 2001, and, after that period, SBC agreed to offer us the
first opportunity to purchase shares that it intends to sell. We are not aware
of any sales of these shares by SBC. SBC also agreed for a
119Table of Contents

period of five years
to vote its shares for the nominees to our Board of Directors either as
recommended by the Board of Directors or in the proportion to the votes cast by
our other shareholders, at SBCs choice. SBC also agreed that it would not
acquire any material number of additional shares of our common stock for a
period of five years without our prior consent.

Concurrently with this equity investment, we entered into the following
other agreements with SBC:



| |  |  | A commercial agreement in which SBC will provide $600 million in
resale revenue to us over six years starting October 1, 2000, with
approximately $23 million of revenue in the first year and increasing
revenue commitments each year during the life of the contract. Upon a
change of control as defined in the contract, SBCs aggregate revenue
commitment is reduced to $100 million during an initial period of the
contract, and is terminated after the initial period.                 
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | A settlement of pending legal matters, our antitrust suit against SBC
and Pacific Bell and our arbitrations against SBC affiliates,
Southwestern Bell and Pacific Bell, including Pacific Bells claim for
alleged past due service fees. The settlement also resolves of several
critical issues in line sharing disputes in Texas, Kansas, Illinois,
Michigan, Ohio, Wisconsin, Indiana, Connecticut and California, plus key
issues in pending interconnection arbitration in Texas and Kansas.
|
| |  |  | An agreement to continue joint OSS development to support SBCs
resale of our products, including the fully automatic line ordering
provisioning process pioneered by us.                                                                                                                                                                                                                                                                                                                         
|
| |  |  | In region agreements that include continued access to neighborhood
gateways utilized in SBCs recently announced Project Pronto,
competitively neutral terms and conditions for spectrum management and
agreements regarding the collocation of equipment in SBC central
offices.                                                                                                                                                                                                               

On November 13, 2001, we signed a loan agreement and restructured our
resale and marketing agreement with SBC Communications Inc. The new agreements
include four elements: a one-time $75 million prepayment, secured by all of our
assets, that SBC can use toward the purchase of our services during the next 10
years; a $50 million four-year loan secured by all of our assets; a payment to
Covad of a $10 million restructuring fee in exchange for Covad eliminating
SBCs revenue commitments under the original resale and marketing agreement and
the elimination of a $15 million co-op-marketing fee we owed to SBC, which was
required in the previous resale and marketing agreement. These agreements with
SBC contain customary change of control provisions that would require us to
repay (1) any outstanding principal and interest on the loan; and (2) any
unused portion of the prepayment, if a change of control occurred.

In September 2002, we granted three warrants to a customer, America
Online, Inc. (AOL). These warrants provide AOL with the right to purchase
1,500,000 shares of our common stock for $1.06 per share, 1,000,000 shares of
our common stock for $3.00 per share, and 1,000,000 shares of our common stock
for $5.00 per share. These warrants have a seven-year term and are immediately
exercisable, fully vested and non-forfeitable at the time of grant. In January
2003, we granted three warrants to another customer, AT&T Corp. (AT&T).
These warrants
provide AT&T with the right to purchase 1,000,000 shares of our common
stock for $0.94 per share, 1,000,000 shares of our common stock for $3.00 per
share, and 1,000,000 shares of our common stock for $5.00 per share. These
warrants have a seven-year term and are immediately exercisable, fully vested
and non-forfeitable at the time of grant.

Employee Loans

In October 1998, we loaned Catherine Hemmer, our former Executive Vice
President and Chief Operating Officer, and her husband, one of the Companys
former employees, the principal amount of $600,000 pursuant to a Note Secured
By Deed of Trust, which was secured by the primary residence of the Hemmers.
The outstanding principal balance of this note was due in four equal annual
installments commencing August 10, 1999, with the last installment due on
August 10, 2002. No interest was charged on the note. $506,250 was forgiven
during the terms of employment of the Hemmers and the balance of this note of
$93,750 was forgiven in connection with Mr. and Ms. Hemmers departures in
March 2002.

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In April 2000, we loaned Jane Marvin, one of our former officers, the
principal amount of $500,000 for the purchase of a primary residence. The loan
is secured by that residence. The remaining balance on the loan was due within
120 days of Ms. Marvins resignation. In addition, in December 1999, we loaned
Ms. Marvin $80,705 pursuant to a note secured by a pledge of shares of our
common stock. The entire principal balance of this note becomes due and payable
in one lump sum on the earlier to occur of December 2004 or the sale of the
pledged shares. Interest is payable on the note at a rate of 5.89% per annum,
compounded semiannually.

In May 1999, we loaned Robert Davenport, one of our former officers, the
principal amount of $600,000 for the purchase of a primary residence. The loan
is secured by that residence. No interest was charged on the note while Mr.
Davenport was our employee. The remaining balance on this loan is $300,000,
plus interest.

121



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PART IV




ITEM 14. CONTROLS AND PROCEDURES

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

The Securities and Exchange Commission defines the term disclosure
controls and procedures to mean a companys controls and other procedures that
are designed to ensure that information required to be disclosed in the reports
that it files or submits under the Securities Exchange Act of 1934 is recorded,
processed, summarized and reported within the time periods specified in the
Commissions rules and forms. Our chief executive officer and our chief
financial officer, based on their evaluation of the effectiveness of our
disclosure controls and procedures within 90 days before the filing date of
this annual report, have concluded that our disclosure controls and procedures
were effective for this purpose, with the exception of the items described
below.

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 (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 year ended December 31, 2002, we recorded
additional (i) depreciation expense of $6,989, (ii) network
and product costs of $2,635, (iii) loss on the disposition of
property and equipment of $635 and (iv) interest expense of $51. To address these matters, we have implemented additional
operational controls and system capabilities to track network assets as they
are added to or removed from our network. Additionally, we have made
improvements to the process for tracking network assets that have not yet been
deployed in, or have been removed from, the network. Lastly, we have added new
processes intended to prevent the capitalization of operating expenses.

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 (i) network and product costs of $320 and (ii) sales,
marketing, general and administrative expense of $2,893. To address this
matter, we have implemented additional procedures intended to track employment
status events for employees to ensure that stock-based
compensation is properly adjusted when these events occur.

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 year ended December 31,
2002. The adjustment was primarily driven by various complex rules surrounding
our estimated liability to the Federal Universal Service Fund (FUSF). As a
result, we are evaluating
our tax accruals more frequently. We also consulted with outside experts throughout 2002
and continue to do so to help us identify and implement changes in applicable rules and regulations,
particularly as they relate to our methodology of estimating our liability for
FUSF and other transaction-based taxes.

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). The
impact on prior financial reporting periods would have been as follows if these
amounts had been recorded in the correct financial reporting periods: (i) net
income for the year ended December 31, 2001 would have been decreased by $3,433
($0.02 per share) and (ii) net loss for the year ended December 31, 2000 would
have been decreased by $1,139 ($0.01 per share).

We believe we have put in place operational and administrative procedures
that will adequately address the control matters discussed above, and we do not
anticipate additional material adjustments in subsequent periods
related to the above described items. However, these procedures are relatively
new and may still need to be improved. We intend to continue to monitor their
effectiveness.

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




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:



| |                                                                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (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

122



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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.




EXHIBIT INDEX

|               |  |                                                                                                                                                                                                               |  |  |  | 
|-------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  | 
|Exhibit Number |  | Description                                                                                                                                                                                                   |  |  |  | 
|               |  |                                                                                                                                                                                                               |  |  |  | 
|2.1(14)        |  | Plan: First Amended Plan of Reorganization, as Modified, of Covad Communications Group, Inc.
dated November 26, 2001.                                                                                        
|2.2(15)        |  | Order Pursuant to § 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.                                                         

123



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|               |  |                                                                                                                                      |  |  |  | 
|-------------- |  | ------------------------------------------------------------------------------------------------------------------------------------ |  |  |  | 
|Exhibit Number |  | Description                                                                                                                          |  |  |  | 
|               |  |                                                                                                                                      |  |  |  | 
|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                                          
|4.15(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, as currently in effect.                                                   
|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                                          

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|               |  |                                                                                                                                                                                                                                                                 |  |  |  | 
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  | 
|Exhibit Number |  | Description                                                                                                                                                                                                                                                     |  |  |  | 
|               |  |                                                                                                                                                                                                                                                                 |  |  |  | 
|               |  | 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.                                                                                                                                                 
|10.37 (32)     |  | Form of Warrant to Purchase Common Stock Issued by the Registrant on January 1, 2003 to AT&T Corp.                                                                                                                                                             
|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).                                                                                                                                                                                                 
|99.1           |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.                                                                                                                                        
|99.2           |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.                                                                                                                                        

125



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---

|(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.                                                     
|    
|(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.                                                                                 

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|(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.

(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, 2002.

On December 27, 2002, the Company filed a current report on Form 8-K,
pursuant to Item 5 thereof, reporting the retirement of Frank Marshall from its
Board of Directors.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized, on March 20, 2003.

| |  |                                  |  |                             
| |  | -------------------------------- |  | ----------------------------
| |  | COVAD COMMUNICATIONS GROUP, INC.
| |  |                                  |  |                             
| |  | By:                              |  | /s/ MARK A. RICHMAN         
| |  |                                  |  |                             
| |  |                                  |  | Mark A. Richman             
| |  |                                  |  | Executive Vice President and
| |  |                                  |  | Chief Financial Officer     

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities indicated on March 20, 2003.

|                                              |  |                                                                                                  
|--------------------------------------------- |  | -------------------------------------------------------------------------------------------------
|Signature                                     |  | Title                                                                                            
|                                              |  |                                                                                                  
|/s/    CHARLES E. HOFFMAN(Charles E. Hoffman) |  | Chief Executive Officer and Director (Principal
Executive Officer)                               
|                                             
|/s/    MARK A. RICHMAN(Mark A. Richman)       |  | Executive Vice President and Chief Financial
Officer (Principal Financial and Accounting Officer)
|                                             
|/s/    CHARLES MCMINN(Charles McMinn)         |  | Chairman of the Board of Directors                                                               
|                                             
|/s/    L. DALE CRANDALL(L. Dale Crandall)     |  | Director                                                                                         
|                                             
|/s/    ROBERT HAWK(Robert Hawk)               |  | Director                                                                                         
|                                             
|/s/    HELLENE RUNTAGH(Hellene Runtagh)       |  | Director                                                                                         
|                                             
|/s/    LARRY IRVING(Larry Irving)             |  | Director                                                                                         
|                                             
|/s/    DANIEL LYNCH(Daniel Lynch)             |  | Director                                                                                         
|                                             
|/s/    RICHARD JALKUT(Richard Jalkut)         |  | Director                                                                                         

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CERTIFICATIONS

I, Charles E. Hoffman, certify that:



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



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



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



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



| | 6. |  | The registrants other certifying officers and I have indicated in
this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
| | -- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                     |  |                                  |  |                                                
|-------------------- |  | -------------------------------- |  | -----------------------------------------------
|                     |  | COVAD COMMUNICATIONS GROUP, INC.
|                     |  |                                  |  |                                                
|                     |  | By:                              |  | /s/ CHARLES E. HOFFMAN                         
|                     |  |                                  |  |                                                
|                     |  |                                  |  | Charles E. Hoffman                             
|                     |  |                                  |  | President, Chief Executive Officer and
Director
|                     |  |                                  |  |                                                
|Date: March 20, 2003 |  |                                  |  |                                                

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CERTIFICATIONS

I, Mark A. Richman, certify that:



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



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



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



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



| | 6. |  | The registrants other certifying officers and I have indicated in
this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
| | -- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                     |  |                                  |  |                             
|-------------------- |  | -------------------------------- |  | ----------------------------
|                     |  | COVAD COMMUNICATIONS GROUP, INC.
|                     |  |                                  |  |                             
|                     |  | By:                              |  | /s/ MARK A. RICHMAN         
|                     |  |                                  |  |                             
|                     |  |                                  |  | Mark A. Richman             
|                     |  |                                  |  | Executive Vice President and
|                     |  |                                  |  | Chief Financial Officer     
|                     |  |                                  |  |                             
|Date: March 20, 2003 |  |                                  |  |                             

130



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EXHIBIT INDEX

|               |  |                                                                                                                                                                                                              
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                  
|               |  |                                                                                                                                                                                                              
|2.1(14)        |  | Plan: First Amended Plan of Reorganization, as Modified, of Covad Communications Group, Inc.
dated November 26, 2001.                                                                                        
|2.2(15)        |  | Order Pursuant to § 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.                                                         





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##### Table of Contents



|               |  |                                                                                                                                     
|-------------- |  | ------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                         
|               |  |                                                                                                                                     
|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                                          
|4.15(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, as currently in effect.                                                   
|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                                          





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##### Table of Contents



|               |  |                                                                                                                                                                                                                                                                
|-------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                                                    
|               |  |                                                                                                                                                                                                                                                                
|               |  | 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.                                                                                                                                                 
|10.37 (32)     |  | Form of Warrant to Purchase Common Stock Issued by the Registrant on January 1, 2003 to AT&T Corp.                                                                                                                                                             
|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).                                                                                                                                                                                                 
|99.1           |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.                                                                                                                                        
|99.2           |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.                                                                                                                                        





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##### Table of Contents





---

|(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.                                                     
|    
|(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.                                                                                 





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##### Table of Contents



|(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.