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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission file number: 000-25271

COVAD COMMUNICATIONS GROUP, INC.

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

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x     No o

     Indicate by check mark whether the registrant is an accelerated filer (as described by Rule 12b-2 of the Exchange Act). Yes x     No o

APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

     Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes x     No o

     As of July 23, 2003 there were 223,922,388 shares outstanding of the Registrant’s Common Stock, including Class B Common Stock.

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COVAD COMMUNICATIONS GROUP, INC.

FORM 10-Q

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PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements (Unaudited)

COVAD COMMUNICATIONS GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except share and per share amounts)

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.

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

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
(Unaudited)

See accompanying notes.

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COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2003 and 2002
(All dollar amounts are presented in thousands, except per share amounts)
(Unaudited)

1.     Basis of Presentation and Summary of Significant Accounting Policies

     The condensed consolidated financial statements include the accounts of Covad Communications Group, Inc. (“Covad”) and its wholly-owned subsidiaries (collectively, the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation.

     The condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the condensed consolidated financial statements have been included. Operating results for the three and six months ended June 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003.

     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 (“ILECs”) (Note 8). 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 prices with the ILECs that allow the Company to maintain acceptable profit levels. 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.

     The condensed consolidated balance sheet as of December 31, 2002 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

     All information included in this report should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

Use of Estimates

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ materially from these estimates. The Company’s critical accounting estimates include (i) revenue recognition and the establishment of accounts receivable allowances, (ii) inventory valuation, (iii) useful life assignments and impairment evaluations associated with property and equipment, collocation fees and other intangible assets, (iv) reorganization and restructuring liabilities, (v) anticipated outcomes of legal proceedings and other disputes, (vi) transaction-based tax liabilities, (vii) employment-related tax liabilities, (viii) liabilities for market development funds and customer incentives and (ix) valuation allowances associated with deferred tax assets.

     During the six months ended June 30, 2003, the Company changed its estimates of certain accrued liabilities for customer incentives based on the compilation of sufficient historical data with which to estimate sales incentives that will not ultimately be claimed by customers. The change in accounting estimate increased the Company’s revenues by $735 and decreased the Company’s

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net loss by $1,449 ($0.01 per share) for the six months ended June 30, 2003. There were no similar changes during the three months ended June 30, 2003.

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 or exceeds the market price of the underlying stock on the date of grant, no compensation expense is recognized. The following table illustrates the pro forma effect on net loss and net loss per share for the three and six months ended June 30, 2003 and 2002 had the Company applied the fair value method to account for stock-based awards to employees:

     During the three months ended June 30, 2003, a matter was identified related to prior financial reporting periods that necessitated the recording of additional expense. Such matter was related to the modification of stock options granted to certain employees in prior years. These modifications occurred upon the separation of such employees from the Company, principally during 2000. Accordingly, for the three months ended June 30, 2003, the Company recorded additional stock-based compensation expense in the amount of $1,237 ($0.01 per share). Such amount is reflected in the Company’s sales, marketing, general and administrative expenses for the three and six months ended June 30, 2003. The Company does not believe this amount is material to the periods in which it should have been recorded, nor does it expect that this expense will be material to its consolidated operating results for the year ending December 31, 2003. However, if this adjustment is ultimately deemed to be material to the Company’s consolidated operating results for the year ending December 31, 2003, the Company will need to restate prior financial reporting periods, including the current period. As noted above, this adjustment is principally related to 2000, the impact of which would have been to increase sales, marketing, general and administrative expenses and net loss by $1,237 ($0.01 per share) for such year. As previously reported in the Company’s 2002 Annual Report on Form 10-K, certain other adjustments were recorded during 2002 that related to prior periods. $1,139 of such amounts pertained to 2000, the effect of which would have been to decrease the Company’s 2000 net loss by $0.01 per share. The aggregate effect of the adjustments recorded during the year ended December 31, 2002 and the three months ended June 30, 2003 to the previously reported results of operations for the year ended December 31, 2000 would be to increase net loss by $98, or $0.00 per share, for such year if these adjustments had been recorded in 2000.

Basic and Diluted Net Loss Per Share

     Basic net loss per share is computed using the weighted-average number of shares of the Company’s common stock outstanding during the period, less the weighted-average number of outstanding common shares subject to repurchase.

     Diluted per share amounts are determined in the same manner as basic per share amounts, except that the number of weighted-average common shares used in the computations includes dilutive common shares subject to repurchase and is increased assuming the (i) exercise of dilutive stock options and warrants using the treasury stock method and (ii) conversion of dilutive convertible debt instruments. However, diluted net loss per share is the same as basic net loss per share in the periods presented in the accompanying condensed consolidated statements of operations because the impact of (i) common shares subject to repurchase and (ii) the assumed exercise of outstanding stock options and warrants is not dilutive.

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

Comprehensive Loss

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

Recent Accounting Pronouncements

     In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation (“FIN”) No. 46, “Consolidation of Variable Interest Entities,” an interpretation of Accounting Research Bulleting No. 51, “Consolidated Financial Statements.” FIN 46 applies to any business enterprise that has a controlling interest, contractual relationship or other business relationship with a variable interest entity (“VIE”) and establishes guidance for the consolidation of VIEs that function to support the activities of the primary beneficiary. FIN 46 was effective immediately for enterprises with VIEs created after January 31, 2003, and it will be effective July 1, 2003 for enterprises with VIEs created before February 1, 2003. The Company believes it has no investments in, or contractual or other business relationships with, VIEs. Therefore, the adoption of FIN 46 had no effect on the Company’s consolidated financial position as of June 30, 2003 or the results of its operations for the three and six months ended June 30, 2003.

     In December 2002, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for an entity that voluntarily changes to the fair value method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure provisions of SFAS No. 123 to require prominent disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported operating results, including per share amounts, in annual and interim financial statements. The disclosure provisions of SFAS No. 148 were effective immediately upon issuance in 2002. As of June 30, 2003, 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 condensed consolidated financial statements.

     In November 2002, the FASB issued FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN No. 45 requires certain guarantees to be recorded at fair value, which is different from current practice, which is generally to record a liability only when a loss is probable and reasonably estimable. FIN No. 45 also requires a guarantor to make significant new disclosures, even when the likelihood of making any payments under the guarantee is remote. The disclosure provisions of FIN No. 45 were effective immediately in 2002. The Company adopted the recognition and measurement provisions of FIN No. 45 on a prospective basis with respect to guarantees issued or

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modified after December 31, 2002. The adoption of the recognition and measurement provisions of FIN No. 45 had no effect on the Company’s condensed consolidated financial statements as of and for the three and six months ended June 30, 2003.

     On January 1, 2003, the Company adopted SFAS No. 146, “Accounting for Costs Associated with an Exit or Disposal Activity.” SFAS No. 146 revised the accounting for exit and disposal activities under EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring),” by extending the period in which expenses related to restructuring activities are reported. A commitment to a plan to exit an activity or dispose of long-lived assets is no longer sufficient to record a one-time charge for most restructuring activities. Instead, companies record exit or disposal costs when they are incurred and can be measured at fair value. In addition, the resultant liabilities are subsequently adjusted for changes in estimated cash flows. SFAS No. 146 is effective prospectively for exit or disposal activities initiated after December 31, 2002. Companies may not restate previously issued financial statements for the effect of the provisions of SFAS No. 146, and liabilities that a company previously recorded under EITF Issue No. 94-3 are grandfathered. The adoption of SFAS No. 146 had no effect on the Company’s condensed consolidated financial statements as of and for the three and six months ended June 30, 2003.

     On January 1, 2003, the Company adopted SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS No. 145 rescinds SFAS No. 4, “Reporting Gains and Losses from Extinguishment of Debt,” which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. SFAS No. 145 requires that gains or losses from extinguishment of debt be classified as extraordinary items only if they meet the criteria of APB Opinion No. 30. The adoption of SFAS No. 145 had no effect on the Company’s condensed consolidated financial statements as of and for the three and six months ended June 30, 2003.

     On January 1, 2003, the Company adopted SFAS No. 143, “Accounting for Asset Retirement Obligations.” SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The adoption of SFAS No. 143 had no effect on the Company’s condensed consolidated financial statements as of and for the three and six months ended June 30, 2003.

Reclassifications

     Certain balances in the Company’s 2002 condensed consolidated financial statements, including certain operating expenses, have been reclassified to conform to the presentation in 2003.

2. Revenue Recognition

     Revenues from recurring service are recognized when (i) persuasive evidence of an arrangement between the Company and the customer exists, (ii) service has been provided to the customer, (iii) the price to the customer is fixed or determinable and (iv) collectibility of the sales prices is reasonably assured. Revenues earned for which the customer has not been billed are recorded as “Unbilled revenues” in the condensed consolidated balance sheets. Amounts billed in advance of providing service are deferred and recorded as an element of the condensed consolidated balance sheet caption “Unearned revenues.” Included in revenues are Federal Universal Service Fund (“FUSF”) charges billed to customers aggregating $1,282 and $2,258 for the three and six months ended June 30, 2003, respectively, and $2,908 and $5,896 for the three and six months ended June 30, 2002, respectively.

     As of June 30, 2003, the Company had over 230 wholesale customers. For the three and six months ended June 30, 2003, the Company’s 30 largest customers collectively comprised 97.4% and 95.7%, respectively, of the Company’s total wholesale revenues and 75.3% and 75.6%, respectively, of the Company’s total revenues. As of June 30, 2003, receivables from these customers collectively comprised 77.8% of the Company’s gross accounts receivable balance. For the three and six months ended June 30, 2002, these customers collectively comprised 92.8% and 93.2%, respectively, of the Company’s total wholesale revenues and 79.3% and 80.4%, respectively, of the Company’s total revenues. As of June 30, 2002, receivables from these customers collectively comprised 85.5% of the Company’s gross accounts receivable balance.

     For the three months ended June 30, 2003, Earthlink, Inc. and AT&T Corp. (“AT&T”), two of the Company’s wholesale customers, accounted for 23.2% and 11.6%, respectively, of the Company’s total net revenues. For the six months ended June 30, 2003, these customers accounted for 22.2% and 11.5%, respectively, of the Company’s total net revenues. As of June 30, 2003, receivables from these customers comprised 25.5% and 12.3% of the Company’s gross accounts receivable balance. No other

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individual customer accounted for more than 10% of the Company’s total net revenues during the three and six months ended June 30, 2003.

     For the three months ended June 30, 2002, Earthlink, Inc. and XO Communications (“XO”), two of the Company’s wholesale customers, accounted for 20.1% and 8.7%, respectively, of the Company’s total net revenues. For the six months ended June 30, 2002, these customers accounted for 20.3% and 9.7%, respectively, of the Company’s total net revenues. As of June 30, 2002, receivables from Earthlink, Inc. comprised 29.9% of the Company’s gross accounts receivable balance. The Company began recognizing revenues from XO on a cash basis (as described below) during the fourth quarter of 2001. Therefore, the Company’s contractual receivable from XO of $2,414 as of June 30, 2002 was not recognized in the Company’s condensed consolidated balance sheet as of such date. However, the Company resumed the recognition of revenues from XO on an accrual basis during the fourth quarter of 2002.

     Some of the Company’s wholesale customers are experiencing financial difficulties. During the three and six months ended June 30, 2003 and 2002, 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 several of them have filed for bankruptcy protection over the past three years. Based on this information, the Company determined that (i) the collectibility of revenues from these customers was not reasonably assured or (ii) its ability to retain some or all of the payments received from 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 are recognized when cash for services rendered 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 condensed consolidated balance sheet caption “Unearned revenues” if the Company’s ability to retain these payments is not reasonably assured.

     Some of the Company’s wholesale customers are currently in bankruptcy proceedings. Revenues from these customers accounted for approximately 1.1% and 2.3% of the Company’s total net revenues for the three and six months ended June 30, 2003, respectively, and 20.1% and 20.0% of the Company’s total revenues for the three and six months ended June 30, 2002, 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 and 2003 based on its specific facts and circumstances in relation to the revenue recognition criteria described above. Consequently, the disclosures in the following paragraph related to financially distressed customers exclude amounts pertaining to WorldCom because the Company does not currently classify 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.

     The Company issued billings to its financially distressed customers aggregating $763 and $3,440 during the three and six months ended June 30, 2003, respectively, which were not recognized as revenues or accounts receivable in the accompanying condensed consolidated financial statements, as compared to the corresponding amounts of $13,557 and $32,332 for the three and six months ended 2002, respectively. However, the Company ultimately recognized revenues from certain of these customers when cash was collected (as described above) aggregating $850 and $3,286 during the three and six months ended June 30, 2003, respectively, and $14,507 and $31,369 during the three and six months ended June 30, 2002, respectively, some of which relates to services provided in prior periods. In addition, revenues during the three and six months ended June 30, 2002 include payments totaling $0 and $3,307, respectively, from bankrupt customers that the Company received prior to January 1, 2002 and recorded as unearned revenues in its condensed 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 recognized these payments as revenues during the three and six months ended June 30, 2002. The Company had contractual receivables from its financially distressed customers totaling $5,857 as of June 30, 2003 that are not reflected in the accompanying condensed consolidated balance sheet as of such date.

     The Company has obtained information indicating that some of its wholesale customers, including WorldCom, who (i) were essentially current in their payments for the Company’s services prior to June 30, 2003, or (ii) have subsequently paid all or significant portions of the respective amounts recorded as accounts receivable as of June 30, 2003, may be at risk of becoming financially distressed. Revenues from these customers accounted for approximately 21.9% and 22.3% of the Company’s total net revenues for the three and six months ended June 30, 2003, respectively. As of June 30, 2003, receivables from these customers comprised 33.8% 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 June 30, 2003, revenues from such customers will be recognized when cash is collected (as described above).

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     The Company has billing disputes with some of its customers. These disputes arise in the ordinary course of business in the telecommunications industry and their impact on the Company’s accounts receivable and revenues can be reasonably estimated based on historical experience. In addition, certain revenues are subject to refund if the end-user terminates service within thirty days of service activation. Accordingly, the Company maintains allowances, through charges to revenues, based on the Company’s estimates of (i) the ultimate resolution of the disputes and (ii) future service cancellations. These charges to revenues amounted to $950 and $1,621 during the three and six months ended June 30, 2003, respectively, and $261 and $1,521 during the three and six months ended June 30, 2002, respectively.

3. Customer Warrants

     On January 1, 2003, in conjunction with an amendment to an Agreement for Broadband Internet Access Services with AT&T, the Company granted AT&T three warrants to purchase shares of the Company’s common stock as follows: 1,000,000 shares for $0.94 per share; 1,000,000 shares for $3.00 per share; and 1,000,000 shares for $5.00 per share. Such warrants were immediately exercisable, fully vested and nonforfeitable at the date of grant. Accordingly, the measurement date for these warrants was the date of grant. The aggregate fair value of such warrants of $2,640 was recorded as a deferred customer incentive during the first quarter of 2003 and is being recognized as a reduction of revenues on a straight-line basis over the three-year term of the agreement because management believes that future revenues from AT&T will exceed the fair value of the warrants described above. This value was determined using the Black-Scholes option valuation model and the following assumptions: closing price of the Company’s common stock on December 31, 2002 of $0.94 per share; expected life of seven years (which is also the contractual life of the warrants); dividend yield of zero; volatility of 1.52; and a risk-free interest rate of 3.36%.

4. Asset Purchases

Qwest

     On June 5, 2003, the Company purchased a customer list from Qwest Communications Corporation and Qwest Interprise America, Inc. (collectively, “Qwest”) pertaining to approximately 23,000 out-of-region digital subscriber line (“DSL”) subscribers (substantially all of whom were not, indirectly, end-user customers of the Company as of June 5, 2003 under the existing wholesale DSL services agreement with Qwest). In exchange for the customer list, the Company paid $3,750 in cash and released Qwest from its obligations under the existing wholesale DSL services agreement. In addition, the Company will pay Qwest an additional amount of up to $1,250 if certain levels of these customers successfully migrate to the Company’s network within a defined period. The Company did not assume any liabilities or obligations of Qwest or hire any of Qwest’s employees. In addition, the Company does not believe the customer list acquired from Qwest constitutes a self-sustaining, integrated set of activities and assets that would constitute a business. The Company is currently soliciting the aforementioned 23,000 DSL customers of Qwest, and over 800 of such customers have been successfully migrated to the Company’s network subsequent to June 5, 2003. In addition, over 8,300 orders have been processed and are pending migration. The solicitation and migration of these customers to the Company’s network is expected to be complete by September 2003.

     The Company recorded the $3,750 cash payment to Qwest for the customer list as an intangible asset, and such intangible asset is being amortized on a straight-line basis to operations over a twenty-four month period, which is the Company’s estimate of the aggregate expected term of the customer relationship.

InternetConnect

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

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contracts. However, the Company did not exercise this right. Instead, the Company solicited the approximate 9,250 DSL, T-1, virtual private network (“VPN”) and dial-up customers of InternetConnect (substantially all of whom were, indirectly, end-user customers of the Company as of January 3, 2002 under the existing wholesale DSL services agreement with InternetConnect), and approximately 6,200 of such customers executed new contracts with the Company and its resellers subsequent to January 3, 2002.

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

     The customer acquisition costs of $3,674 were charged to network and product costs for the three months ended March 31, 2002 based on the Company’s accounting policy for costs of this nature that are not accompanied by up-front fees.

5. Property Sale

     During the three months ended December 31, 2001, the Company tentatively decided to sell land, a building and certain improvements located in Manassas, Virginia. This property was part of the Company’s Corporate Operations. In March 2002, the Company entered into a non-binding letter of intent with a third party to sell such property for $14,000, which was subject to approval by the Company’s board of directors. In April 2002, the Company received the necessary approval from its board of directors to proceed with the sale of this property (at which time the Company suspended depreciation of the building and related improvements when such assets had an aggregate carrying value of $13,201). In June 2002, the Company completed the sale of this property and recognized a gain of $133, which represents the net proceeds of $13,334 less the aggregate carrying value of the property as described above.

6. Reductions in Force

     During the three and six months ended June 30, 2003, the Company reduced its workforce by approximately 43 and 113 employees, respectively, which represented approximately 3.3% and 8.7% of the Company’s workforce, respectively. The reductions covered employees in the areas of sales and marketing, operations and corporate functions.

     In connection with the reductions in force, the Company recorded charges to operations for the three and six months ended June 30, 2003 of $604 and $1,235, respectively, relating to employee severance benefits that met the requirements for accrual. For the three and six months ended June 30, 2003, $95 and $242, respectively, of these expenses were charged to network and product costs and the remaining $509 and $993, respectively, were charged to sales, marketing, general and administrative expenses. During the three and six months ended June 30, 2003, the Company paid severance benefits of approximately $519 and $1,088, respectively. The Company paid the remainder of the severance benefits accrued as of June 30, 2003 in July 2003. The expenses associated with the reductions in force for the three and six months ended June 30, 2003 were $31 and $103, respectively, related to the Company’s Covad Strategic Partnerships business segment and $320 and $349, respectively, related to the Company’s Covad Broadband Solutions business segment. The remaining expenses associated with these reductions in force during the three and six months ended June 30, 2003 of $253 and $783, respectively, were related to the Company’s Corporate Operations.

7. Pro forma Stock-Based Compensation Information

     Pro forma information regarding the results of operations and net 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.

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     Option valuation models such as Black-Scholes 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. In management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of the Company’s employee stock options 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.

     For the three and six months ended June 30, 2003 and 2002, the fair value of the Company’s stock-based awards to employees was estimated using the following weighted-average assumptions:

8. Contingencies

Litigation

     On December 13, 2001, the Unites States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) entered an order confirming the Company’s pre-negotiated First Amended Plan of Reorganization as modified on November 26, 2001 (the “Plan”). On December 20, 2001 (the “Effective Date”), the Plan was consummated and the Company emerged from bankruptcy. Under the Plan, the Company settled several claims against it. These claims include:

	•		The class action lawsuits filed in the United States District Court for the Northern District of California. This settlement is described in more detail below.
	•		The lawsuits filed in the Superior Court of the State of California for the County of Santa Clara by six purchasers of the convertible notes that the Company issued in September 2000.
	•		Disputed claims made by former shareholders of Laser Link.net., Inc.
	•		Disputed claims made by GE Capital and its subsidiary, Heller Financial Group.

     As of June 30, 2003, there were approximately $8,346 in unresolved claims related to the Company’s Chapter 11 bankruptcy proceedings. As of June 30, 2003, the Company had recorded $7,383 for these unresolved claims in its condensed consolidated balance sheet. However, it is reasonably possible that the Company’s unresolved Chapter 11 bankruptcy claims could ultimately be settled for amounts that differ from the amounts recorded in the Company’s condensed consolidated balance sheet.

     Purchasers of the Company’s common stock and purchasers of the convertible senior notes the Company issued in September 2000 filed complaints on behalf of themselves and alleged classes of stockholders and holders of convertible notes against the Company and certain present and former officers of the Company in the United States District Court for the Northern District of California (the “District Court”). The complaints were consolidated and the lead plaintiff filed its amended consolidated complaint. The amended consolidated complaint alleges violations of federal securities laws on behalf of persons who purchased or otherwise acquired the Company’s securities, including common stock and notes, during the period from April 19, 2000 to May 24, 2001. The relief sought includes monetary damages and equitable relief. In 2001, the Company and the officer and director defendants entered into a Memorandum of Understanding (“MOU”) with counsel for the lead plaintiffs in this litigation that tentatively resolves the litigation. The MOU sets forth the terms upon which the Company, the officer and director defendants and the plaintiffs agree to settle the litigation. Pursuant to the MOU, the plaintiffs agreed to support and vote in favor of the Plan if it provided for the distribution of $16,500 in cash to be funded by the Company’s insurance carriers and 6,495,844 shares of the Company’s common stock. The plaintiffs voted in favor of the plan. Consequently, the Company recorded a liability of approximately $18,578 in its condensed 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 $7,665 as of June 30, 2002 through credits to litigation-related expenses of $7,146 and $10,913 for

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the three and six months ended June 30, 2002, respectively. 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, the Company filed a lawsuit against Bell Atlantic (now Verizon) and its affiliates in the United States District Court for the District of Columbia. The Company is pursuing antitrust and other claims in this lawsuit arising out of Verizon’s conduct as a supplier of network facilities, including central office space, transmission facilities and telephone lines. In December 2000, the Company also filed a lawsuit against BellSouth Telecommunications and its subsidiaries in the United States District Court for the Northern District of Georgia. The Company is pursuing claims in this lawsuit that are similar to its claims against Verizon. Both courts dismissed some of the Company’s claims based on the ruling of the United States Court of Appeals for the Seventh Circuit in Goldwasser v. Ameritech. The court in the Verizon case also dismissed the Company’s remaining claims on other grounds. The Company voluntarily dismissed its remaining claims in the BellSouth case so it could pursue certain issues on appeal. The Company appealed these decisions to the United States Court of Appeals for the Eleventh Circuit and the United States Court of Appeals for the District of Columbia. On August 2, 2002, the Eleventh Circuit Court of Appeals reversed the lower court’s decision in the BellSouth case and remanded the case for further proceedings. BellSouth is seeking an appeal of this decision before the United States Supreme Court. 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 Court of Appeals for the District of Columbia has indicated that it will not act on the Company’s appeal in the Verizon case until the Supreme Court decides the Trinko case. The Company cannot predict the outcome of these matters.

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

     Several stockholders filed complaints in the United States District Court for the Southern District of New York, on behalf of themselves and purported classes of stockholders, against the Company and several former and current officers and directors in addition to some of the underwriters who handled the Company’s stock offerings. These lawsuits are so-called IPO allocation cases, challenging practices allegedly used by certain underwriters of public equity offerings during the late 1990s and 2000. On April 19, 2002, the plaintiffs amended their complaint and removed the Company as a defendant. Certain directors and officers are still named in the complaint. The plaintiffs claim that the Company and others failed to disclose the arrangements that some of these underwriters purportedly made with certain investors. The plaintiffs and the issuer defendants have reached a tentative agreement to settle the matter, and the Company believes the tentative settlement will not have a material adverse effect on its consolidated financial position or results of operations. That settlement, however, has not been finalized. If the settlement is not finalized, the Company believes it has strong defenses to these lawsuits and intends to contest them vigorously. However, litigation is inherently unpredictable and there is no guarantee that the Company will prevail.

     In June 2002, Dhruv Khanna was relieved of his duties as the Company’s General Counsel and Secretary. Shortly thereafter, Mr. Khanna alleged that, over a period of years, certain current and former directors and officers breached their fiduciary duties to the Company by engaging in or approving actions that constituted waste and self-dealing, that certain current and former directors and officers had provided false representations to the Company’s auditors and that he had been relieved of his duties in retaliation for his being a purported whistleblower and because of racial or national origin discrimination. He 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

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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.

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

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

Other Contingencies

     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 June 30, 2003, the Company had approximately 222,000 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.

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     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.

     In addition, one of the traditional telephone companies has notified the Company that it claims the decision in the Triennial Review is a “change in law” that triggers a renegotiation of its interconnection agreements with the Company. These agreements contain the prices and other terms for the telephone lines the Company purchases from this traditional telephone company.

     As of June 30, 2003, the Company had disputes with a number of telecommunications companies concerning the balances owed to such carriers for collocation fees and certain network services. The Company believes that such disputes will be resolved without a material adverse effect on its consolidated financial position and results of operations. However, it is reasonably possible that the Company’s estimates of its collocation fee and network service obligations, as reflected in the accompanying condensed consolidated balance sheets, could change in the near term, and the effects could be material to the Company’s consolidated financial position and results of operations.

     In addition, the Company is engaged in a variety of negotiations, arbitrations and regulatory and court proceedings with multiple telephone companies. These negotiations, arbitrations and proceedings concern the 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 proceedings could have a material adverse effect on the Company’s consolidated financial position and results of operations if it is denied access to, or charged higher rates for transmission lines or central office spaces.

     As of June 30, 2003, the Company was analyzing the applicability of certain transaction-based taxes to (i) sales of its products and services and (ii) purchases of telecommunications circuits from various carriers. This analysis includes discussions with authorities of significant jurisdictions in which the Company does business to determine the extent of its respective transaction-based tax liabilities. It is the Company’s opinion that such analysis will be concluded without a material adverse effect on its consolidated financial position and results of operations. However, it is reasonably possible that the Company’s estimates of its transaction-based tax liabilities, as reflected in the accompanying condensed consolidated balance sheets, could change in the near term, and the effects could be material to the Company’s consolidated financial position and results of operations. During the six months ended June 30, 2003, the Company changed its estimates of certain accrued liabilities for transaction-based and property taxes based on settlement agreements reached with the tax authorities of certain jurisdictions in which the Company does business. These changes in accounting estimate reduced the Company’s net loss by $2,506 ($0.01 per share) for the six months ended June 30, 2003. There were no material changes in estimate during the three months ended June 30, 2003.

     The Company is analyzing the applicability of employment-related taxes for certain stock-based compensation provided to employees in prior periods. Due to the probable applicability of these taxes, the Company recorded an estimated liability through a charge to operations in the amount of $5,938 during the three months ended March 31, 2003. However, it is reasonably possible that the Company’s estimates of these tax liabilities, as reflected in the accompanying condensed consolidated balance sheet as of June 30, 2003, could change in the near term, and the effects could be material to the Company’s consolidated financial position and results of operations.

9. Business Segments

     The Company’s business segments are strategic business units that are managed based upon differences in customers, services and marketing channels, even though the assets and cash flows from these operations are not independent of each other. Covad Strategic Partnerships (“CSP”) focuses on delivering services to enterprise, corporate, small business, small office/home office (“SoHo”) and consumer customers primarily through wholesale relationships with large Internet service providers (“ISPs”), telecommunications carriers and other large resellers. Covad Broadband Solutions (“CBS”) focuses on small business and SoHo markets by selling services directly to end-users as well as through independent authorized sales agents and small ISPs and resellers. All other business operations and activities of the Company are aggregated and reported as Corporate Operations. These operations and activities are primarily comprised of general corporate functions to support the Company’s revenue producing segments as well as costs and expenses for headquarters facilities and equipment, depreciation and amortization, network capacity and other non-recurring or

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unusual items not directly attributable or allocated to the segments, gains and losses on the Company’s investments, and income and expenses from the Company’s treasury and financing activities.

     The Company evaluates performance and allocates resources to the segments based on income or loss from operations, excluding certain operating expenses, including depreciation and amortization, and other income and expense items. The Company does not allocate such operating expenses and other income and expense items to its business segments because it believes that these expenses and other income items are not directly controlled by the business segments.

     Segment information, including a reconciliation to the respective balances in the Company’s condensed consolidated financial statements, as of and for the three and six months ended June 30, 2003 and 2002, are as follows (the Company’s 2002 segment information has been restated to conform to the Company’s organizational structure in 2003):