Back to GetFilings.com
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT 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, 2000
OR
[_] 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 4813 77-0461529
(State or other jurisdiction of (Primary Standard Industrial (I.R.S. Employer
incorporation or organization) Classification Code Number) Identification Number)
4250 Burton Drive, Santa Clara, California 95054
(408) 987-1000
(Address and telephone number of principal executive offices)
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 [_] No [X]
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. [_]
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 May 18, 2001 as reported on the Nasdaq National Market, was
approximately $155.4 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 CORPORATE ISSUERS:
As of May 18, 2001, there were 179,958,511 shares outstanding of the
Registrant's Common Stock, including Class B Common Stock.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
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, operating and capital expenses, 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 broadband communications services, which we
sell to businesses and consumers directly and indirectly through Internet
service providers, enterprises, telecommunications carriers and other
customers. These services include a range of high-speed, high-capacity Internet
and network access services using digital subscriber line ("DSL") technology
and related value-added services. We sell these services directly to business
and consumer end-users through our sales force, telephone sales and our
website. Internet service providers purchase our 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
us and sell these services to their existing customers or affiliate groups.
Enterprise customers purchase our services directly or indirectly from us to
provide their employees with high-speed remote access to the enterprise's local
area network ("RLAN access"). Other telecommunications carriers purchase our
services for resale to their Internet service provider affiliates, Internet
users and enterprise customers.
We believe we have the nation's largest DSL network that is not owned by a
traditional telephone company, encompassing more than 1800 operational central
offices and passing more than 40 million homes and businesses in 109
metropolitan statistical areas. As of March 31, 2001, we had 319,000 DSL based
high-speed access lines in service and we had received orders for our services
from more than 250 Internet service provider, enterprise, and
telecommunications carrier customers, including AT&T Corporation,
XO Communications (formerly NEXTLINK Communications, Inc. and Concentric
Network Corporation), EarthLink, Inc., UUNET Technologies (a WorldCom company)
and Speakeasy.net, a privately owned company. We also provide dial-up Internet
access service to over 400,000 subscribers through our Covad Integrated
Services subsidiary.
We are also developing a variety of services that are enhanced or enabled by
our network and we are entering into business arrangements with broadband-
related service providers in order to bring a variety of value-added service
offerings to our customers and their end-users.
Recent Developments
In the course of preparing our financial statements for the year ended
December 31, 2000, internal control weaknesses were discovered which have been
exacerbated by our rapid growth. As a result, we have restated our unaudited
interim financial statements for previously reported quarters in 2000. We also
performed long-lived asset impairment tests and determined that our long-lived
assets were impaired. These events caused us to delay the filing of this Form
10-K until after the time permitted by the SEC's rules. Due to the management
resources devoted to the preparation of this Form 10-K and because we did not
have our year end financial results for 2000, we also did not file our Form 10-
Q for the quarter ended March 31, 2001 within the time permitted by the SEC's
rules. We have received a notice of delisting from Nasdaq because of the late
filing of this Form 10-K. Nasdaq has scheduled a delisting hearing on May 24,
2001 to address this failure to comply with Nasdaq's marketplace
1
rules. Our failure to file timely this Form 10-K, the 2001 first quarter Form
10-Q, or other reasons (such as the failure to satisfy the minimum
stockholders' equity requirement for continued Nasdaq National Market listing)
may result in our stock being delisted from the Nasdaq National Market after
the May 24, 2001 hearing.
As a result of our recurring operating losses, negative cash flows, negative
stockholders' equity, combined with litigation against us by some of our
noteholders which seeks, among other remedies, rescission of their note
purchases, there is substantial doubt about our ability to continue as a going
concern unless we can obtain additional financing.
Please see "Part I. Item 1. Business--Risk Factors", "Part II. Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Part II. Item 8. Financial Statements and Supplementary Data"
for a more detailed discussion of these matters.
Industry Background
Growing Market Demand for Broadband Communications and Bandwidth Services
High-speed connectivity has become important to small- and medium-sized
businesses and consumers due to the dramatic increase in Internet usage. This
has resulted in both the need to improve the efficiency of the time spent on-
line as well as the desire to have quick access to higher quality, graphics-
intensive on-line services and documents. According to industry experts, the
number of digital subscriber lines is expected to expand from 2.3 million lines
at year-end 2000 to over 25.8 million lines by 2004, with the majority of this
growth occurring in the residential sector.
As use of the Internet, intranets and extranets increase, we expect the
market size for both small- and medium-sized business access, consumer
Internet, RLAN access and virtual private networks to continue to grow rapidly
causing the demand for broadband communications services to also grow rapidly.
The full potential of Internet and local area network applications, however,
cannot be realized without removing the performance bottlenecks of the existing
public switched telephone network. Over the last ten years, increases in
telecommunications bandwidth have significantly lagged improvements in
microprocessor performance, and most Internet users can only connect to the
Internet or their corporate local area network by low-speed analog telephone
lines.
Higher speed connections are available, however, including:
. Integrated Services Digital Networks ("ISDN")--An ISDN line transmits
digital signals over ordinary analog lines and is capable of carrying
data at speeds up to 128 kilobits per second.
. T1 and Fractional T1 Lines--T1 and Fractional T1 Lines are telephone
industry terms for specialized digital transmission links with a
capacity of 1.544 megabits per second or portions thereof.
. Frame-Relay Circuits--A frame-relay circuit is a high-speed packet-
switched data communications protocol used across the interface between
user devices (such as hosts and routers) and network equipment (such as
switching nodes) at speeds up to 45 megabits per second in the United
States.
. Cable Modems--Cable modems provide Internet access over hybrid fiber-
coaxial cable at downstream speeds up to 10 megabits per second.
While these services have recently experienced dramatic growth in the United
States, they are frequently expensive, complex to order, install and maintain
and, in some cases, not as widely available as DSL technology.
Emergence of DSL Technology
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
2
speeds of 56.6 kilobits per second (for the fastest consumer modems) and ISDN
speeds of 128 kilobits per second to DSL speeds of up to 8 megabits per second
downstream and 1.5 megabits per second upstream depending on the length and
condition of the copper line. Recent advances in semiconductor technology,
digital signal processing algorithms as well as falling equipment prices have
made the widespread deployment of DSL technology more economical. We anticipate
that equipment prices will continue to fall as a result of continued advances
in semiconductor technologies and increases in equipment production volumes.
Because DSL technology reuses the existing copper plant, it is significantly
less expensive to deploy on a broad scale than alternative technologies, such
as cable modems, wireless data and satellite data. As a result, a significant
portion of the investment in a DSL network is success-based, requiring a
comparatively lower initial fixed investment. Subsequent variable investments
in DSL technology are directly related to the number of paying customers.
Impact of Regulatory Developments
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 leverage
the existing infrastructure built by the traditional telephone companies rather
than constructing a competing infrastructure at significant cost. The 1996
Telecommunications Act requires traditional telephone companies, among other
things, to:
. allow competitive telecommunications companies to lease telephone wires
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
fiber 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.
In particular, the 1996 Telecommunications Act, as interpreted by the
Federal Communications Commissions ("FCC"), emphasizes the need for
competition-driven innovations in the deployment of advanced telecommunications
services, such as DSL services.
Our Competitive Strengths
We were formed to capitalize on the substantial business opportunity created
by the growing demand for broadband Internet and network access, the commercial
availability of low-cost DSL technology and the passage of the 1996
Telecommunications Act. Key aspects of our solution to provide broadband
communications services include:
. an attractive value proposition that provides superior two-way high-
speed business and consumer grade connections at similar or lower prices
than the alternative high-speed technologies currently available to
customers;
. a nationwide network service delivery capability that covers about 45%
of all homes and businesses in the United States with significant line
installations to date;
. a variety of channels such as Internet service providers,
telecommunications resellers and other third party resellers through
direct sales, including telesales, websales and third party referral
services and national brand entities;
. a mix of high-margin business end-users along with lower-margin consumer
end-users;
3
. a widely available, continuously connected, relatively secure network
that facilitates deployment of Internet and intranet applications; and
. a management team experienced in the data communications,
telecommunications and personal computer industries.
Attractive Value Proposition. We offer higher bandwidth digital connections
than some alternative services, our services do not vary with usage and our
services are offered at similar or lower prices than similar alternative
services. For business Internet users, our high-end services offer two-way
bandwidth comparable to that offered by T1 and frame-relay circuits at
approximately 50% of the cost. For the RLAN market, our mid-range services are
three to six times the speed of ISDN lines and up to ten times the speed of the
fastest consumer analog modems at monthly rates similar to or lower than those
for heavily used ISDN lines. We believe that many of our enterprise customers
can justify deploying our lines to their employees if their productivity
improves by only a few hours per month based on increases in the number of
hours worked and decreases in commute time and time spent waiting for
information. For consumer Internet users, our Internet service provider
customers resell our services at prices comparable to current cable modem
services. Unlike cable modems, however, where multiple users share a single
coaxial cable, our service provides a dedicated, robust, two-way connection
from and to each end-user's home or business to and from our network. We
believe our dedicated high-speed, two-way connection provides a superior end-
user experience.
We have leveraged our first-mover advantage to deploy a large nationwide
network and grow our number of lines installed. We were the first to widely
roll out DSL services on a commercial basis, making DSL service available for
purchase in the San Francisco Bay Area in December 1997. We believe that we
have leveraged our first-mover advantage to rapidly expand our network into our
targeted metropolitan regions across the United States. We believe that our
more than 1,800 central offices give us one of the nation's largest DSL
networks, passing over more than 40 million homes and businesses. We have also
developed proprietary operational support systems (OSS) software and procedures
to allow us to rapidly add subscribers to our network. As of March 31, 2001, we
had 319,000 lines in service nationwide and we have demonstrated the capacity
to add over 1,000 subscribers per day to our network using our OSS tools.
A wide-variety of channels to reach end-users. We have leveraged the brands,
sales and marketing and operational capabilities, and existing end-users of
major and startup Internet service providers and telecommunications carriers in
order to quickly generate demand for our services. In addition, we are
increasingly using our own direct sales force, telesales, websales and third
party referral services to generate end-user orders for our services in certain
markets. We are also now seeking to leverage the brand names of significant
companies using our suite of DSL, Internet service providers and credit card
billing services. We believe our broad approach to generate end-user demand for
our services is one of our key competitive strengths.
A mix of high-margin business end-users and lower-margin consumer end-
users. Unlike our cable modem service competitors and our traditional local
telephone company competitors, we have historically targeted and continue to
target small business end-users who are willing to pay significantly higher
prices for our services than consumer end-users. Because our business end-user
base is a very significant proportion of our total end-user base (approximately
50% of our installed lines as of March 31, 2001), we believe our services
obtain a significantly higher average sales price per end-user than our larger
competitors. We have been successful in penetrating a significant portion of
the small business market in many of the cities in which we offer our services.
By also offering lower prices targeted at higher volume, lower-margin consumer
end-users, we also believe that we will obtain the necessary economies of scale
in reducing our average per unit costs of providing our services. We therefore
believe our mix of business and consumer end-users is one of our competitive
strengths.
Widely available, always-connected relatively secure network. Our strategy
of providing comprehensive coverage in each region we serve is designed to
ensure that our services are available to the vast majority of
4
our customers' end-users. Our network provides 24-hour, always-on connectivity,
unlike ISDN lines and analog modems which require customers to dial-up each
time for Internet or RLAN access. Also, because we use dedicated connections
from each end-user to our network, our customers can reduce the risk of
unauthorized access relative to other shared forms of broadband access, such as
cable modems. These factors are important to our customers because any Internet
service they market to their end-users must actually be available for them to
purchase and be secure enough to not risk their own reputation or business with
any security lapses.
Experienced management team. Our management team includes individuals with
extensive experience in the data communications, telecommunications and
personal computer industries, including Frank J. Marshall, Interim Chief
Executive Officer and Director (former Vice President at Cisco Systems);
Charles McMinn, Chairman of the Board of Directors (Covad founder and former
Chief Executive Officer of Certive Corporation); Mark H. Perry, Executive Vice
President and Chief Financial Officer (former Corporate Vice President
Operations, Finance & Administration of U S WEST Communications, Inc.);
Catherine Hemmer, Executive Vice President and Chief Operations Officer (former
Vice President, Network Reliability and Operations at U S WEST Communications,
Inc., former General Manager, Network Provisioning at Ameritech Corporation and
former Vice President, Network Services at MFS); Anjali Joshi, Executive Vice
President, Engineering (former Program Manager at AT&T Corp.); Dhruv Khanna,
Executive Vice President, Human Resources, General Counsel and Secretary (Covad
founder and former in-house counsel for Intel Corporation's communications
products division); John McDevitt, Executive Vice President, Sales and
Marketing (former Vice President of Sales and Marketing at Danly IEM and former
Business Director at Praxair, Inc.); and Terry Moya, Executive Vice President,
External Affairs and Corporate Development (former Vice President & Chief
Financial Officer, Capital Management, Network Operations and Technologies at U
S WEST Communications, Inc.).
Business Strategy
Our objective is to become the leading nationwide provider of broadband
services and a supplier of a critical element in the proliferation of e-
commerce and other applications that are enabled or enhanced by broadband
communications. The key elements of our strategy to achieve this objective are
as follows:
Drive our business toward profitability and positive cash flow. In response
to the significant changes in the financial markets at the end of 2000, we have
adapted our business plan to reduce our costs and drive for earlier
profitability with less capital. Specific steps we have taken in this regard
include:
. raising revenue per line by reducing rebates and other incentives that
we provide to our Internet service provider customers and
correspondingly reducing our new line addition plans for 2001 to
increase margins and reduce subscriber payback times;
. closing approximately 200 underproductive or not fully built out central
offices and holding the size of our network at approximately 1,800
central offices, which will significantly reduce our capital
expenditures and operating expenses;
. reducing our workforce by approximately 800 employees and contractors,
which represents approximately 25% of our workforce;
. closing a facility in Alpharetta, Georgia and consolidating offices in
Manassas, Virginia, Santa Clara, California and Denver, Colorado;
. downsizing our international operations and discontinuing our plans to
fund additional international expansion (but we will continue to manage
our current international investments);
. enhancing productivity in our operations to increase customer
satisfaction while reducing costs;
. restructuring BlueStar Communications Group, our subsidiary, to
streamline our direct sales and marketing channel and supplement it with
telephone sales and sales through our website; and
. evaluating and implementing other cost reduction strategies including
salary freezes and reductions in travel, facilities and advertising
expenses.
5
Roll out service in our targeted metropolitan statistical areas. As of March
31, 2001 our network was operational in 109 of the top metropolitan statistical
areas nationwide, passing 40% of all homes and 45% of all businesses in the
United States. We plan on holding our network size at substantially these
levels in the near term while we focus on adding subscribers in these markets.
Establish and maintain sales and marketing relationships with leading
Internet service providers, telecommunications carriers and other DSL resellers
to drive subscriber additions. We principally target Internet service
providers, telecommunications carriers and other DSL resellers that can offer
their end-users cost and performance advantages for Internet access using our
services. We primarily provide connections to Internet service providers, which
then offer high-speed Internet access using our network. In other cases, we
provide wholesale DSL and Internet access services for resale by our customers.
In this way we:
. carry the traffic of multiple Internet service providers,
telecommunications carriers and other customers in any region,
increasing our volume and reducing our costs;
. leverage our selling efforts through the sales and support staff of
these Internet service providers, telecommunications carriers and other
customers;
. offer Internet service providers, telecommunications carriers and other
customers an alternative, since traditional telephone companies
typically provide their own retail Internet access services in
competition with our customers; and
. provide Internet service providers, telecommunications carriers and
other customers a high-speed service offering to compete with cable-
based Internet access.
Sell directly to selected business and consumer end-users. We also provide
high-speed access, Internet access, web hosting, electronic mail, and remote
private networks directly to business and consumer end-users. We started
selling directly to business end-users upon the closing of the BlueStar
Communications Group, Inc. ("Blue Star") acquisition in September of 2000. Our
strategy is to initially sell in our underutilized markets, utilizing a
combination of direct salespeople, telesales, websales and third-party
referrals. We may expand our direct sales, telesales, and co-branded sales
efforts into other markets over time.
Develop and commercialize value-added services. We intend to introduce
value-added services to our customers and leverage the value of the network
access we offer today. Offering services such as voice over DSL, DSL plus
Internet Protocol (DSL + IP), Private Networking and our Virtual Internet
Service Provider (VISP) and Virtual Broadband Service Provider (VBSP) offerings
will allow us to bundle service offerings to our customers and increase the
number of channels through which we sell our services. We believe this is an
important part of our strategy and will allow us to build upon our success in
adding and retaining subscribers. We have announced agreements to sell a
complete Internet service provider solution through Avon Products, Compaq
Computer Corporation and Sony Electronics.
Acquire and enter into business arrangements with network and broadband-
related service providers. We believe that the pace of deployment of our
network can be increased by acquiring and entering into business arrangements
with other network service providers. We also believe our network deployment
will enable the delivery of a variety of broadband-related services and content
that are desired by our customers. We expect to make these services available
to our customers through acquiring and entering into business arrangements with
leading providers of broadband-related services or content. For example, in
2000 we acquired Laser Link.Net, Inc. ("Laser Link") and BlueStar
Communications Group, Inc. ("BlueStar"). The acquisition of Laser Link allows
us to better provide DSL and IP services on a wholesale and direct basis. It
will also enable us to serve customers with established brand names who do not
wish to run their own Internet access facilities. Likewise, our acquisition of
BlueStar has expanded our selling capabilities in smaller cities and rural
areas, increased our distribution methods and will improve our ability to
deliver enhanced broadband solutions to small businesses.
Take advantage of new regulatory developments. In late 1999, the FCC
required the major local phone companies to provide us, and other competitive
local carriers, with "line sharing." This allows us to provide
6
our services over the same telephone wire used by the traditional telephone
companies to provide analog voice services. In addition, some of the conditions
adopted by the FCC in October 1999 in connection with the SBC Communications,
Inc./Ameritech Corp. merger also contain provisions for line sharing and
provide for reductions in costs for telephone wires in certain circumstances.
Beginning in 2000, we started to provision new orders for our consumer-grade
services over line-shared telephone wires. Asymmetric DSL and standard
telephone service can exist on a single line and most, if not all, of the
traditional telephone companies provision their own asymmetric services on the
same line as existing voice services. Now, almost all of our consumer orders
are provisioned over line shared lines. As of March 31, 2001, we had
provisioned over 48,000 line-shared lines.
We see line sharing as an important opportunity for us for four reasons.
First, line sharing significantly reduces the monthly recurring charges we
incur for telephone loops. Second, line sharing reduces the time it takes
traditional telephone companies to deliver telephone loops because the
telephone loop will already exist. Third, line sharing helps resolve lack of
telephone loop availability problems that we have encountered when ordering
telephone loops in some areas of the country. And fourth, line sharing has
enabled us to offer self-installation, which reduces our costs and should
improve the end-user installation experience.
We have started implementing line sharing in almost all of our serviced
states and we have entered into line sharing agreements with all major
traditional local telephone companies.
Our Service Offerings
We offer six business-grade services under the TeleSpeed brand and two
consumer-grade service offerings called TeleSurfer and TeleSurfer Pro to
connect end-users to our network. In March 2000, we introduced three new
services--DSL+IP, VISP and VBSP. We also offer business consumers private
networking technology over our network. In addition, Internet service provider
and enterprise customers may purchase backhaul services from us to connect
their facilities to our network.
TeleSpeed Services
Our TeleSpeed services connect individual end-users on previously unused
conventional telephone wires 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. We believe
that substantially all, if not all, of our potential end-users in our target
markets generally can be served with one of our services. The specific number
of potential end-users who qualify for the higher speeds will vary by central
office and by region and will be affected by line quality. The chart below
compares the performance and markets for each of our intraregional end-user
services:
Maximum Maximum
Speed To Speed From Range*
Intraregional Services End-User End-User (Feet) Market Usage
---------------------- -------- ---------- ------ ------------
TeleSpeed 144............. 144 Kbps 144 Kbps 35,000 ISDN replacement
TeleSpeed 192............. 192 Kbps 192 Kbps 15,000 Business Internet, RLAN
TeleSpeed 384............. 384 Kbps 384 Kbps 15,000 Business Internet, RLAN
TeleSpeed 768............. 768 Kbps 768 Kbps 13,000 Business Internet
TeleSpeed 1.1............. 1.1 Mbps 1.1 Mbps 12,000 Business Internet
TeleSpeed 1.5S............ 1.5 Mbps 1.5 Mbps 7,000 T-1 Equivalent
- --------
* Estimated maximum distance from the end-user to the central office.
Prices for our end-user services may vary depending upon the performance
level of the service. For example, our TeleSpeed 144 and 192 services are our
lowest priced end-user services and our TeleSpeed 1.1 and 1.5 services are our
highest priced end-user services. Our prices also vary for high volume
customers that
7
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 144. Our TeleSpeed 144 service operates at up to 144 kilobits per
second in each direction, which is similar to the performance of an ISDN line.
This service, which can use existing ISDN equipment at the end-user site, is
targeted at the ISDN replacement market where its per month flat rate can
compare favorably to ISDN services from the traditional telephone company when
per-minute usage charges apply. It is also the service that we offer on
telephone wires that are either too long to carry our higher speed services or
are served by digital loop carrier systems or similar equipment where a
continuous copper connection is not available from the end-user site to a
central office.
TeleSpeed 192. This service provides one-and-a-half to three times the
performance of ISDN lines at similar or lower price points to heavily-used ISDN
lines.
TeleSpeed 384. This service provides three to six times the performance of
ISDN lines at similar price points to heavily-used ISDN lines.
TeleSpeed 768. This service provides one-half the bandwidth of a T1 data
circuit at substantially less than one-half of the monthly price that we
estimate is typical for T1 service. The target market for the TeleSpeed 768
service is small businesses needing moderate speed access to the Internet but
who have previously been unable to afford the price of such a service. The
service also competes favorably from a price/performance standpoint with
traditional fractional T1 and frame-relay services for these same customers.
TeleSpeed 1.1. This service provides over two-thirds the bandwidth of a T1
data circuit at less than one-half of the monthly price that we estimate is
typical for T1 service. The target market for the TeleSpeed 1.1 service is
small businesses needing T1-level access to the Internet but which are unable
to afford the price of such a service. The service also competes favorably from
a price/performance stand point with traditional fractional T1 and frame-relay
services for these same customers.
TeleSpeed 1.5S. This service provides bandwidth comparable to a T1 data
circuit at less than one-half of the monthly price that we estimate is typical
for T1 service. The service also provides the highest performance of any
TeleSpeed service to stream video or other multimedia content to end-user
locations.
TeleSpeed Remote. TeleSpeed Remote provides high-speed network access for
end-users to their corporate networks. This service is targeted at businesses
that want high-speed remote office connections at a lower cost than ISDN or
frame-relay services. For example, this service can provide a corporation's
employees located in Boston with high-speed access to their corporate network
located in San Francisco.
TeleSurfer Services
Maximum Maximum
Speed To Speed From Range*
Intraregional Services End-User End-User (Feet) Market/Usage
---------------------- -------- ---------- ------ ------------
TeleSurfer ADSL...................... 608 Kbps 128 Kbps 15,000 Consumer
TeleSurfer Pro ADSL.................. 1.5 Mbps 384 Kbps 15,000 Consumer
- --------
* Estimated maximum distance from the end-user to the central office.
TeleSurfer ADSL. This consumer-grade service is an asymmetric service,
offering up to 608 kilobits per second downstream and up to 128 kilobits per
second upstream. This service is our base consumer service. The target market
for this service is consumers using either dial-up analog or ISDN connections
for web access.
8
TeleSurfer Pro ADSL. This is a premium consumer-grade asymmetric service,
offering up to 1.5 megabits per second downstream and up to 384 kilobits per
second upstream. The target market for this service is consumers using analog
or ISDN connections for web access.
DSL + IP
This service currently bundles Internet protocol services with our TeleSpeed
and TeleSurfer services. 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.
VISP/VBSP
This service provides a complete dial-up (VISP) and broadband (VBSP)
solution for organizations and businesses that want to offer Internet services
to their customers without having to develop their own Internet capabilities.
We provide Internet services to end-users under the brand name of our customer
or co-branded with COVAD.net. These Internet services are a turnkey solution
that includes dial-up and broadband access, registration, connection and
Internet software, web sites, network authentication, electronic mail, billing
and reporting, news, web-space and end-user service and technical support.
Private Networking Over DSL
We currently offer private networking services, which are primarily sold
through our direct sales channel. This service uses the public Internet
backbone or a private data network, combined with DSL connections, as a channel
for sharing information and applications within a closed circle of users in
different locations.
Other Services
We also provide a DS3 backhaul service from our regional network to an
Internet service provider or enterprise customer site. This service aggregates
all 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 an asynchronous transfer mode (ATM) protocol that efficiently handles
the high data rates involved and operates at up to 45 megabits per second. In
addition to monthly service charges, we impose non-recurring order set-up
charges for Internet service provider and RLAN end-users for our TeleSpeed,
TeleSurfer, and DS3 backhaul services. Customers must also purchase a DSL modem
from us or a third party for each end-user of our services. Certain of our
customers also purchase inside wiring and professional installation services
from us.
Customers
We offer our services to Internet service providers, telecommunications
carriers, branded virtual service providers, enterprises and other DSL
resellers as well as directly to end-users. As of March 31, 2001, we had more
than 319,000 lines in service and we had received orders for our services from
more than 250 Internet service provider, enterprise and telecommunications
carrier customers. The following is a list of selected Internet service
provider, telecommunications carrier, enterprise and other customers:
Selected Internet Service Selected Telecommunications
Provider Customers Selected Branded VSPs Carriers
- ------------------------- --------------------- ---------------------------
EarthLink, Inc. Avon Products AT&T Corporation
UUNET Technologies Sony Corp. Qwest Communications
Speakeasy.net Compaq Computer Corp. International, Inc.
XO Communications SBC Communications, Inc.
Our agreements with Internet service providers and other DSL resellers
generally have terms of one year and are nonexclusive. We do not require
Internet service providers to generate a minimum number of end-users
9
and generally grant volume discounts based on subscribers volume. We serve
Internet service providers who provide their own Internet access service and
have started serving Internet service providers who choose to obtain access to
the Internet through us. In both cases, the Internet service providers purchase
our services on a wholesale basis and sell such services under their own brand.
We also enter into customer agreements with telecommunications carriers,
including competitive telecommunications companies and interexchange carriers.
Under these agreements our telecommunication carrier customers typically resell
our services to their new and existing customers. These carriers currently
market our Internet and RLAN services primarily to small, medium and enterprise
businesses that purchase voice services from them.
Our initial practice with respect to our enterprise customers was to sell
our RLAN service directly to enterprise customers for use by their employees.
Now, our enterprise customers are choosing to purchase our services directly
from us, but also indirectly from our Internet service provider or
telecommunications service provider customers.
In addition, we have begun selling our services directly to end-users in
certain markets also by using a direct sales force, telesales, websales and a
variety of third-parties as referral resources to whom we pay a one-time
commission for the referral.
We have recently started to sign agreements with branded virtual service
providers. In these agreements a company with a recognized brand would utilize
Covad as the underlying Internet service provider by which it may provide
service to an existing base of customers who are potential purchasers of high-
speed Internet service. We expect that the rollout of these services will
require several months of work before they are marketed and sold to the branded
company's incumbent customer base.
During the second half of the calendar year 2000, EarthLink became our
largest customer based on lines ordered. EarthLink primarily sells our
consumer-oriented TeleSurfer and TeleSurfer Pro services, and is also a
significant reseller of our business-oriented TeleSpeed services.
We stopped recognizing revenue for several of our Internet service provider
customers in the third and fourth quarters of 2000 and the first quarter of
2001 because we could no longer be reasonably assured of payment from these
customers. If a customer cannot provide us with reasonable assurance of
payment, then we only recognize revenue when the customer actually pays for our
services and after the collection of all previous accounts receivable balances.
As of April 30, 2001, we estimate that the number of our lines that remain in
service with Internet service provider customers for which we only recognize
revenue when the customer pays for our services is approximately 51,000 lines,
excluding lines that are in the process of being disconnected. Based upon our
experience to this point, we expect that approximately 50% of the lines that
are with these customers will be restored to ordinary revenue recognition
status and the remainder will be disconnected.
Some of these Internet service provider customers, including Flashcom, Inc.,
Fastpoint Communications, Inc., Zyan Communications and Relay Point, Inc., have
filed for bankruptcy protection. It is likely that these bankruptcies will
impair our ability to collect the amounts owed to us and constrain our ability
to migrate these lines to other Internet service provider customers or to our
own network. We have been required to continue to provide services to these
Internet service providers during the pendancy of the bankruptcy proceedings.
The bankruptcy court ordered Zyan Communications to prepay us for our future
services on a weekly basis beginning in January 2001 and Zyan made those
payments until March, 2001. For four of these Internet service providers in
bankruptcy proceedings, we have received bankruptcy court approval to solicit
their end-users and attempt to move them to another one of our Internet service
providers or to our own service.
10
Sales and Marketing
Business and Consumer Internet. For the business and consumer Internet
access markets, we sell our service to Internet service providers,
telecommunications carriers and others. These customers can either combine our
lines with their Internet access services or purchase wholesale Internet access
services from us and resell the combination to their existing and new end-
users. We address these markets through sales and marketing personnel dedicated
to the Internet service provider sales channel. We supplement our sales efforts
to Internet service providers through training programs and marketing programs
that include promotions and sales incentives designed to encourage the Internet
service providers to sell our services instead of those of our competitors.
Third-Party Relationships. A key element of our strategy is to enter into
relationships with leading telecommunications companies, including competitive
telecommunications carriers and interexchange carriers, pursuant to which those
companies resell our TeleSpeed and TeleSurfer services to their customers. For
example, we have entered into a commercial agreement with XO Communications
providing for the purchase and resale of our services, primarily to their small
business and enterprise customers. We believe that these indirect sales
channels will enable us to penetrate our target markets more rapidly and
eventually will generate the majority of sales of our services.
Branding and Marketing Programs. In October 1999 we commenced a branding and
advertising effort to educate the market about our broadband service offerings
and increase recognition of our brand. This program, which uses print and radio
advertising on both a national and regional basis, is intended to inform the
market about the availability of our service, differentiate the products and
services offered by us and simplify the process through which these products
and services are ordered.
We are also pursuing several types of joint marketing arrangements with our
Internet service provider, telecommunications carrier customers and other DSL
resellers. We also support our sales efforts with marketing efforts that
include advertising programs through radio and other popular media, attendance
at trade shows and presentations at industry conferences. See "Item 1.
Business--Risk Factors--Our business will suffer in a variety of ways unless
financial market conditions improve."
Direct Sales. We have historically marketed our RLAN services to businesses
through a direct sales force, augmented by marketing programs with value-added
resellers and interexchange carriers. In addition, we are increasingly using
our own direct sales force, telesales, web sales and third-party referral
resources to generate end-user orders in certain markets. We have augmented our
sales efforts to RLAN customers through partnerships with value-added
resellers, including systems integrators that can offer our TeleSpeed service
as part of a complete work-at-home solution to businesses. We are also now
seeking to leverage the brand names of significant companies using our suite of
DSL, Internet service provider and credit card billing services.
Service Deployment and Operations
Internet service providers, telecommunications carriers and corporate
information technology managers typically have had to assemble their digital
communications connections using multiple service 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:
. extending our network to customers and end-users with various needs and
configuration requirements;
. end-user premise wiring and DSL 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.
11
Extending Our Network to Customers and End-Users. We work with our Internet
service provider, enterprise, telecommunications carrier and other customers to
extend our network to each customer premise and each end-user premise by
ordering circuits from the traditional telephone company or a competitive
telecommunications company, interconnecting the customers and end-users to our
network, testing the circuits, configuring customer routers or switches and
end-user routers and monitoring the circuits from our network operations
center.
End-User Premises Wiring, DSL Modem Configuration and Self-Installs. We use
our own and subcontracted field service crews and trucks to perform any
required inside wiring and to configure DSL modems at each end-user site. We
also provide self-install kits for end-users and permit our resellers to
provide their own self-install kits to end-users.
Network Monitoring. We monitor our network from our network operations
centers in order to identify and correct network problems. We have also
extended some of our network monitoring capabilities to our Internet service
provider, enterprise and telecommunications carrier customers so that they can
directly monitor their end-users for greater operational efficiency.
Customer Reporting. We communicate regularly with our customers about the
status of their end-users. We also operate a toll-free customer care help-line.
Additionally, we provide web-based tools to allow individual Internet service
providers and enterprise information technology managers and telecommunications
carriers to monitor their end-users directly, to place orders for new end-
users, to enter trouble tickets on end-user lines and to communicate with us on
an ongoing basis.
Customer Service and Technical Support. We provide 24x7 on-line support to
our Internet service provider customers and enterprise information technology
managers. The Internet service provider and information technology manager and
telecommunications carriers serve as the initial contact for service and
technical support, and we provide the second level of support. For customers
using our VBSP offering, we provide the first level of support for their end-
users.
Operational Support System. We have developed what we believe to be the
industry-leading operational support system for DSL networks. Our operational
support system is based on web interfaces and is highly automated. These
features are intended to and should allow us to scale our businesses rapidly
because they eliminate many manual processes such as line testing, network path
configuration, equipment configuration, order taking and verification and
billing.
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 over 40 million analog modems
currently connected to circuit switched networks that have been 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 "star
topology" network similar to the most popular local area network architecture
currently used in high-performance enterprise networks. In this model, new
capacity is added automatically as each new user receives a new line.
Intelligent End-to-End Network Management. Because the 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 into the end-user's home or business. Because our network is
centrally managed, we can identify and dynamically enhance network quality,
service and performance and address network problems promptly.
12
Flexibility. We have designed our network to be flexible in handling various
types of network traffic, starting with data, but extending to voice and video
information in the future. This flexibility will allow us to directly offer, or
enter into arrangements with other entities to offer, not only value-added
services such as voice over DSL, but also control the prioritization of content
delivery within our national network.
The primary components of our network are the network operations center, our
high-speed private metropolitan networks, central office spaces, including
digital subscriber line access multiplexers (DSLAMs), copper telephone lines
and DSL modems.
Network Operations Centers. Our entire network is managed from two network
operations centers. 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 centers, we can monitor the equipment and circuits
in each metropolitan network (including the asynchronous transfer mode
equipment), each central office (including DSLAMs) and potentially individual
end-user lines (including the DSL modems). One network operations center is
located in the San Francisco Bay Area and the second network operations center
is in Manassas, Virginia.
Nationwide Broadband Access and Internet Connectivity. We link each of our
metropolitan areas together with our leased high speed private backbone network
connections. We also provide multiple points of presence (POPs) 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
asynchronous transfer mode communications circuits that we lease to connect our
asynchronous transfer mode hubs, our equipment in individual central offices
and our Internet service provider, enterprise and telecommunications carrier
customers. This network operates at a speed of 45 to 155 megabits 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 standards 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 March 31, 2001, we had more than 1,800
operational central offices.
Telephone Wires. We lease the telephone wires 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 wires that already
carry the voice service of a traditional telephone company.
DSL Modems and On-Site Connection. We buy our DSL modems from our suppliers
for resale to our Internet service provider or enterprise customers for use by
their end-users. 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 shipped to end-users to
do 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 third parties that will
increase the use of our network.
13
Competition
The markets for business and consumer Internet access and network access
services are intensely competitive. We expect that these markets will become
increasingly competitive in the future. The principal bases of competition in
our markets include:
. price/performance;
. breadth of service availability;
. reliability of service;
. network security;
. ease of access and use;
. service bundling;
. content bundling;
. customer support;
. brand recognition;
. operating scale and cost efficiency;
. operating experience;
. relationships with Internet service providers and other third parties;
and
. capital resources.
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 high quality in their service areas, possess sufficient capital to deploy
DSL equipment rapidly, own the telephone wires 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 $30
per month, placing pricing pressure on our TeleSurfer services. In recent
months, some of the traditional telephone companies have increased their retail
consumer DSL prices by approximately 25%. They have not, however, increased
their wholesale prices to major Internet service providers and therefore
continue to under-price our services. The traditional telephone companies are
also in a position to offer service from central offices where we are unable to
secure space because of asserted or actual space restrictions.
Cable Modem Service Providers. Cable modem service providers such as AT&T,
Excite@Home, Cox, AOL Time Warner, Road Runner and Charter 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. They
also offer these services at lower price points than our TeleSurfer services.
We believe the cable modem service providers face a number of challenges that
providers of DSL services do not face. For example, different regions within a
metropolitan statistical area may be served by different cable modem service
providers, making it more difficult to offer the blanket coverage required by
potential customers. Also, much of the current cable infrastructure in the
United States must be upgraded to support cable modems, a
14
process which we believe is significantly more expensive and time-consuming
than the deployment of DSL-based networks. Further, unlike DSL networks, cable
networks typically do not serve business areas. Therefore, we do not view cable
modem service providers as significant competition in the business market
segment.
Competitive Telecommunications Companies. Many competitive
telecommunications companies such as Rhythms NetConnections, DSL.net, Inc.,
Mpower.com Inc. and New Edge Networks Inc. offer high-speed digital services
using a business strategy similar to ours. Some of these competitors have begun
offering DSL-based access services and others are likely to do so in the
future. Companies such as XO Communications and Allegiance have extensive fiber
networks in many metropolitan areas, primarily providing high-speed digital and
voice circuits to large corporations and have also begun to deploy 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. Further, some of
our resellers (such as XO Communications and Qwest) have either made
investments in our competitors or are deploying their own DSL capabilities.
In addition, our DSL competitors may be acquired in whole or in part by one
or more of our established customers or another entity on highly favorable
terms because of the currently low market values of companies in this sector or
because they are in bankruptcy. In such instances, we could lose one or more of
our resellers and face more robust competition, any of which would have a
material adverse impact on our business.
National Interexchange Carriers. Interexchange carriers, such as AT&T,
Sprint, WorldCom, Qwest, Level 3 and Global Crossing have deployed large-scale
Internet access networks or ATM networks, sell connectivity to businesses and
residential customers and have high brand recognition. AT&T also recently
purchased the DSL network assets of our former competitor NorthPoint
Communications. 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 have begun to provide DSL-based services in
competition with us. In addition, some of these companies, such as AT&T,
WorldCom (through UUNET) and Qwest, 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 T-1, 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 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, MSN (a subsidiary of Microsoft Corp.) and Web TV (a
subsidiary of Microsoft Corp.) that provide, over the Internet and on
proprietary on-line services, content and applications ranging from news and
sports to consumer video conferencing. These services are designed for broad
consumer access over telecommunications-based transmission media which enable
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. If these on-line service providers were
to extend their access networks to DSL or other high-speed service
technologies, they would become competitors of ours.
Wireless and Satellite Data Service Providers. Wireless and satellite data
service providers are developing wireless and satellite-based Internet
connectivity. We face competition from terrestrial wireless services including
future 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
15
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. Although WinStar and Teligent (which has filed for
bankruptcy protection) are facing severe financial difficulties, other
providers, such as Sprint and Metricom, Inc., are now providing wireless
services that compete with our services.
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.
Many of our competitors have used the difficulties faced by NorthPoint
Communications and Rhythms NetConnections to attempt to dissuade potential
customers from purchasing our services. We expect these efforts to continue in
the near future, which may lead to reduced demand for our services and higher
cancellation 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 entire loops and line-shared
loops) to the traditional telephone company's telephone wires;
. 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 and remote terminals;
. the price we pay and access we have to the traditional telephone
company's transport facilities;
. the operational support systems and 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 that we use to resolve disagreements on
the terms of the interconnection contract; 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 do not, in many cases, agree to our requested provisions in
interconnection agreements and we have not consistently prevailed in obtaining
all of our desired provisions in such agreements either voluntarily or through
the interconnection arbitration process. We cannot be sure that we will be able
to continue to sign interconnection agreements with existing or other
traditional telephone companies. The traditional telephone companies are also
permitting competitive telecommunications companies to adopt previously signed
interconnection agreements. In certain instances, we have adopted the
interconnection agreement of another competitive telecommunications company.
Other competitive telecommunications companies have also adopted the same or
modified versions of our interconnection agreements, and may continue to do so
in the future.
16
Many of our interconnection agreements have a term of three years. We will
have to renegotiate these agreements when they expire. The 1996
Telecommunications Act provides for arbitration of interconnection agreement
terms before state commissions. In many states, we are currently arbitrating
the rates, terms and conditions of such agreements. Although we expect to renew
the interconnection agreements that require renewal and believe the 1996
Telecommunications Act and the agreements themselves limit the ability of
traditional telephone companies not to renew such agreements, we may not
succeed in these arbitrations or 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. For example, we are in
litigation proceedings with certain of the traditional telephone companies. 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 generally determined by the
States, consistent with federal law. In addition, local municipal government
authorities also assert jurisdiction over our facilities and operations. The
jurisdictional reach of the various federal, state and local authorities is
subject to ongoing controversy and judicial review and we cannot predict the
outcome of such 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 does this by preempting
certain state and local laws that are barriers to competition and by requiring
traditional telephone companies to provide nondiscriminatory access and
interconnection to potential competitors, such as cable operators, wireless
telecommunications providers, interexchange carriers and competitive
telecommunications companies.
Regulations promulgated by the FCC under the 1996 Telecommunications Act
specify in greater detail the requirements of the 1996 Telecommunications Act
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 telephone poles, ducts,
conduits and rights-of-way. The requirements enable companies such as us to
interconnect with the traditional telephone companies in order to provide local
telephone exchange services and to use portions of the traditional telephone
companies' existing networks to offer new and innovative services such as our
TeleSpeed and TeleSurfer services.
These FCC requirements have been subject to litigation before several courts
and reconsideration at the FCC. Currently, the FCC's rules for pricing of
unbundled network elements is on appeal before the United
17
States Supreme Court. On July 18, 2000, the United States Court of Appeals for
the Eighth Circuit struck down the FCC's total element long run incremental
cost methodology which the FCC previously required state commissions to use in
setting the prices for collocation and for unbundled network elements that we
purchase from the traditional telephone companies. The court also rejected an
alternative cost methodology based on "historical costs" which was advocated by
the traditional telephone companies. In rejecting the FCC's cost methodology,
the court held that, under the 1996 Telecommunications Act, it is permissible
for the FCC to prescribe a forward-looking incremental cost methodology that is
based on actual incremental costs. The Supreme Court agreed to hear appeals of
the Eighth Circuit decision in January 2001. The outcome of this proceeding and
subsequent FCC and state commissions implementation actions is uncertain.
The FCC's September 1999 rules (issued as a result of a remand from a
January 1999 United States Supreme Court decision) defining unbundled network
elements are on reconsideration before the United States Court of Appeals for
the Eighth Circuit.
The FCC's March 1999 collocation rules are currently on remand to the FCC as
a result of a March 2000 D.C. Circuit Court of Appeals decision. The D.C.
Circuit's decision casts doubt on whether new entrants will be able to locate
certain kinds of equipment in the traditional local telephone companies central
offices. In particular, the appeals court has required the FCC to revise its
rules concerning the types of equipment that we may collocate on the
traditional telephone company premises, the steps that traditional telephone
companies may take to separate their equipment from our equipment and the
ability of one competitive carrier to interconnect with another competitive
carrier on premises owned by a traditional local telephone company. The
traditional telephone companies may implement the court's ruling and any
subsequent FCC rules in a manner that impairs our ability to obtain collocation
space and collocate the equipment of our choice on their premises. Such actions
by the traditional telephone companies could adversely affect our business and
disrupt our existing network design, configuration and services.
The FCC's November 1999 and January 2001 rules regarding line-sharing and
spectrum management policy are currently on appeal before the D.C. Circuit
Court of Appeals. In addition, FCC unbundling and collocation rules often times
must be implemented by state commissions, such as in interconnection
arbitrations. State commission implementation decisions are subject to appeal
in either federal or state court. Since our business plan depends upon the
unbundling and collocation provisions of the 1996 Telecommunications Act, the
results of these proceedings, challenges, and appeals could significantly
impact our ability to provide our services.
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," the traditional telephone companies created by
AT&T's divestiture of its local exchange business (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.
As a result, 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 five RBOC applications to date, for Verizon in
New York and Massachusetts and SBC in Texas, Oklahoma and Kansas. Currently
pending before the FCC is Verizon's application in Connecticut. Given the FCC's
grant of these applications, the FCC is likely to thereafter grant similar
applications by Verizon, SBC and the other RBOCs in other states. Covad has
opposed such applications where it believes it has not received access and
interconnection as required by the Act. Grants of long-distance authority to
RBOCs will likely affect the level of cooperation we receive from each of the
RBOCs. In addition, the approval of such entry will likely adversely affect the
level of cooperation.
The FCC also reviews and approves telecommunications industry mergers. In
approving the merger of SBC and Ameritech in October 1999, the FCC required
SBC/Ameritech to create a structurally-separate advanced services affiliate
throughout the SBC/Ameritech service territory. The FCC required SBC/Ameritech
to provide its own in-region DSL services through this affiliate, as a
requirement for freeing the affiliate from
18
traditional telephone company regulation. The provision of DSL services by such
an affiliate could harm our business. In June 2000, Bell Atlantic and GTE were
ordered by the FCC to create such a similar affiliate in the context of their
merger into Verizon. In January 2001, however, the D.C. Circuit Court of
Appeals reversed and vacated the FCC's SBC/Ameritech Merger Order on the basis
that the separate affiliate requirement was inconsistent with the 1996
Telecommunications Communications Act.
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 may harm our business. In addition, under the 1996
Telecommunications Act, the FCC is considering eliminating certain regulations
that apply to the traditional telephone companies' provision of services that
are competitive with ours. The timing and the extent of regulatory freedom and
pricing flexibility granted to the traditional telephone companies will affect
the competition we face from the traditional telephone companies' competitive
services.
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 certificate approval from the FCC
for our interstate services or file tariffs for such services. We have
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.
The impact of these 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 or currently expected
prices. If we are required to pay higher prices to the local telephone
companies for collocation and unbundled network elements, it could have a
material adverse effect on our business.
Any changes in applicable federal law and regulations, in particular,
changes in its interconnection agreements with traditional telephone companies,
the prospective entry of the RBOCs into the in-region long distance business
and grant of regulatory freedom and pricing flexibility to the traditional
telephone companies could harm our business.
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 such 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. As of March 31, 2001, we
were authorized under state law to operate as a competitive local exchange
carrier in all of our targeted metropolitan statistical areas. We have pending
arbitration proceedings in different states for interconnection arrangements
with the relevant traditional telephone companies. We have concluded
arbitration proceedings in a number of states by entering into interconnection
agreements with the relevant traditional telephone companies. We have filed
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.
The different state commissions have various 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 wires, central office collocation space, inter-office
transport, operational support systems, local switching and rights of way. The
rates set forth in many of our interconnection agreements are interim rates and
will be prospectively, and, in
19
some cases, retroactively, affected by the permanent rates set by the various
state commissions for such unbundled network elements as unbundled loops and
interoffice transport. 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 could suffer. The applicability of the various state regulations on our
business and compliance requirements will be further affected by the extent to
which our services are determined to be intrastate services. Jurisdictional
determinations of our services as intrastate services could harm our business.
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,
including fiber optic cables, 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, several bills introduced in the
106th Congress would have significantly altered or repealed pro-competitive FCC
rules, including unbundled access to line-sharing, and portions of the 1996
Telecommunications Act. Similar legislation has been introduced in the current
107th Congress. Passage of any these bills could 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 or 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 "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 "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 one patent granted and a number of patent applications
pending, and intend to prepare additional applications and to seek additional
patent protection for our systems and services to the extent possible. The
pending and any future patents may not be issued to us, and if issued, they may
not protect our intellectual property from competition which could seek to
design around or 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
20
destination of our proprietary information. Steps taken by us may not prevent
misappropriation or infringement of our intellectual property rights, and
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. We were recently sued by Verizon (formerly Bell Atlantic) for
an alleged infringement of a patent issued to them in September 1998 entitled
"Variable Rate and Variable Mode Transmission System." On February 18, 2000, we
were granted a summary judgment ruling in the Verizon lawsuit. The court ruled
that we had not infringed on Verizon's patent. Verizon's appeal of this
decision is pending before the court, and while we expect that we will prevail
on appeal, the outcome of such an appeal is inherently uncertain. Such
lawsuits, including the appeal in the Verizon lawsuit, could significantly harm
our business.
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 have merit, but 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 March 31, 2001, we had approximately 2,300 employees, excluding
temporary personnel and consultants. 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.
Risk Factors
Our ability to continue as a "going concern" is uncertain
To date, we have funded our operations through both private and public debt
and equity offerings. In addition, as described elsewhere in this report, we
have altered our business plan to scale back our growth to reduce our cash
needs and to achieve profitability at an earlier stage than was possible under
our previous business plan. However, because we have not yet achieved positive
cash flow status for our operations, we will continue to require capital
support until we are cash flow positive. Because of the scale of our existing
network and the long-term commitments associated with central office and
equipment obligations, we do not believe that we can alter our business plan
sufficiently to achieve profitability without raising substantial additional
capital.
Our consolidated financial statements as of December 31, 2000 have been
prepared on the assumption that we will continue as a going concern, which
contemplates the realization of assets and liquidation of liabilities in the
normal course of business. Our independent auditors have issued a report dated
May 23, 2001 stating that our recurring operating losses, negative cash flows,
and stockholders' deficit, combined with the distressed financial condition of
certain of our customers, existence of the litigation against us by some of our
noteholders which seeks, in addition to other remedies, rescission of their
note purchases, a notice of default delivered to us on April 2, 2001, based on
our failure to file our annual report on Form 10-K for our fiscal year 2000 in
a timely fashion, and a notice of default delivered to us on May 17, 2001,
based on our failure to file our
21
quarterly report on Form 10-Q for our first fiscal quarter of 2001 in a timely
fashion, in each case, as required by our 2000 convertible notes indenture,
raise substantial doubt as to our ability to continue as a going concern.
Investors in our securities should review carefully the report of Ernst &
Young LLP. Our ability to continue as a going concern is dependent on several
factors, including our ability to raise additional capital, our ability to
improve our operations, the lack of an adverse outcome in the litigation
pending against us, our ability to hire a permanent Chief Executive Officer
and President, and our ability to maintain our listing on the Nasdaq National
Market. There can be no assurance that any financing will be available through
bank borrowings, debt or equity issuances, vendor lines of credit, or
otherwise, on acceptable terms or at all. If future financing requirements are
satisfied through the issuance of equity securities, investors may experience
significant dilution both in terms of their percentage interest in Covad and
the net book value per share of common stock. While we are actively seeking
strategic solutions to our funding issue, there can be no assurance that we
will be able to continue as a going concern.
We face possible delisting from the Nasdaq National Market which could result
in a limited public market for our common stock
We have received a standard notice of delisting by the Nasdaq Stock Market
because we did not file this Form 10-K by its due date, April 2, 2001, as
required under Nasdaq's marketplace rules. Nasdaq has scheduled a hearing on
May 24, 2001, to address this failure to comply with such marketplace rules.
We are fully cooperating with Nasdaq and expect that the filing of this Form
10-K with the SEC will satisfy Nasdaq with respect to this issue. However, due
to the management resources devoted to preparing this Form 10-K, we did not
file our quarterly report on Form 10-Q for the quarter ended March 31, 2001 in
a timely manner. We expect to file such Form 10-Q as soon as possible, but our
failure to file it within the time period provided by the SEC's rules, or for
other reasons, could result in our being delisted by Nasdaq.
Moreover, there are several requirements for continued listing of our
common stock on the Nasdaq National Market, including, without limitation:
. a minimum closing bid price for our stock of three dollars per share; or
. maintaining at least $10 million in stockholders' equity and a minimum
closing bid price for our stock of one dollar per share.
Our stockholders' deficit as of December 31, 2000 was $182.7 million. As of
May 22, 2001, the closing bid price of our common stock was $1.09. Our stock
may be delisted from the Nasdaq National Market after the hearing on May 24,
2001, unless our stockholders' equity increases to at least $10 million or our
stock price increases to at least three dollars per share. Additionally, if
the closing bid price of our common stock falls below one dollar per share for
30 consecutive business days, we may receive a notification from Nasdaq that
our common stock will be delisted unless the closing bid price of the stock
equals or exceeds one dollar per share for at least ten consecutive business
days during the 90-day period following such notification. If Nasdaq, in its
discretion, decides to delist our common stock we would have the right to
appeal that decision, however, there can be no assurances that such an appeal
would be successful. If our common stock is delisted, then we may apply for
listing on the Nasdaq SmallCap Market, subject to Nasdaq's approval. The
Nasdaq SmallCap Market requires a minimum closing bid price of one dollar per
share, and there can be no assurance that we will be able to meet this
requirement. If not, our common stock may trade only in the secondary markets
in the so-called "pink sheets" or Nasdaq's "OTC Bulletin Board." Delisting
from the Nasdaq National Market could adversely affect the liquidity and price
of our common stock and it could have a long-term adverse impact on our
ability to raise capital in the future.
We have received a notice of default from some of the holders of our
convertible notes relating to the late filing of this report on Form 10-K
On April 2, 2001, we received a notice of default from certain holders of
our convertible notes relating to our failure to file this Form 10-K by its
April 2, 2001 due date. The indenture governing the convertible notes, which
contains a covenant requiring us to file timely reports with the SEC, provides
for a grace period of
22
60 days after notice from the holders of the convertible notes. We believe
that by filing this Form 10-K within the applicable grace period, we have
cured this default.
We have received a notice from some of the holders of our convertible notes
relating to the late filing of our report on Form 10-Q for the first quarter
of 2001
On May 17, 2001, we received a notice of default from certain holders of
our convertible notes relating to our failure to file our quarterly report on
Form 10-Q for the quarter ended March 31, 2001 by its May 15, 2001 due date.
The indenture governing the convertible notes, which contains a covenant
requiring us to file timely reports with the SEC, provides for a grace period
of 60 days after notice from the holders of the convertible notes. Our Form
10-Q for the first quarter of 2001 could not be filed by the prescribed due
date because we have devoted our management resources to the preparation of
this Form 10-K and because our financial statements for the first quarter of
2001 depend on the financial statements published in this Form 10-K. It is
possible that holders of our other notes will send us a notice of default
relating to this failure to file such Form 10-Q on a timely basis. While we
believe that we will be able to prepare and file such Form 10-Q within the
applicable grace periods, no assurance can be given in that regard and the
failure to file could mature into an event of default, which would entitle the
holders of the notes giving such notice to accelerate the maturity of their
notes and result in all of our notes becoming due.
Our rapid growth exacerbated weaknesses in our internal controls
In the course of preparing the financial statements for the year ended
December 31, 2000, internal control weaknesses were discovered. These
weaknesses have been exacerbated by our rapid growth. We are in the process of
implementing new control procedures which we believe will correct such
weaknesses. However, the effectiveness of these new procedures will not be
ultimately known until we have had a chance to establish a history with the
new procedures. We note that these new procedures were only partially in place
during the first quarter of 2001 and therefore we are experiencing some of the
same problems in preparing the financial statements for the first quarter of
2001 that we experienced in preparing the year 2000 financial statements.
We must raise additional capital under very difficult financial market
conditions in order to continue our growth and maintain current operations
Our management has developed a business plan that it believes will make us
profitable. This business plan is based upon several assumptions, including
the growth of our subscriber base with a reasonable per subscriber profit
margin, the raising of additional capital and improvements in productivity.
Under this business plan, we must raise more capital to, among other uses,
fund operating losses, capital expenditures and interest payments before we
become cash flow positive.
We are currently facing a variety of challenges which affect the cash needs
of the Company, including:
. the failure or inability of some of our Internet service provider
customers to pay their bills for our services;
. the letter we received from some of our bondholders requesting that we
meet with them to discuss our operations and our use of our remaining
cash;
. the fact that we have generated significant net losses and that we
continue to experience negative cash flow from our operations;
. the difficulties we face in accessing the capital markets on reasonable
terms or at all; and
. the possibility of an adverse resolution of the shareholder and
noteholder lawsuits against us.
After consideration of these challenges, we believe our current cash, cash-
equivalents and short-term investments, including proceeds received from our
stock sale to SBC, will be sufficient to meet our anticipated
23
cash needs for working capital and capital expenditures into the second quarter
of 2002. An adverse judgment in the securities litigation, noteholder
litigation or other adverse business, legal, regulatory or legislative
development would accelerate the time at which we would need additional
financing. Thereafter, we will be required to raise additional capital through
the issuance of debt or equity securities or other financings. If we have the
opportunity, we may choose to raise additional capital sooner, depending on
market conditions. Further, the actual amount and timing of our future capital
requirements is uncertain and will depend upon a number of factors which we can
not accurately predict today, including:
. the number of geographic areas targeted and entered and the growth of our
revenue and line count in each geographic area;
. our network deployment schedules, closures and associated costs;
. our operational efficiency in each geographic area;
. the rate at which customers and end-users purchase and pay for our
different services and the pricing of such services;
. the level of marketing required to acquire and retain customers and to
attain a competitive position in each region we enter;
. the rate at which we invest in engineering and development and
intellectual property with respect to existing and future technology; and
. investment opportunities in complementary businesses, acquisitions or
other opportunities.
Because of these factors, we may be unsuccessful in raising sufficient
capital at all or on terms that we consider acceptable. Moreover, we believe
that current capital market conditions, particularly for our industry, may
severely restrict our ability to obtain such additional financing. In addition,
we expect that the revenue recognition issues that we reported with our third
quarter results, the legal proceedings against us which followed the
announcement of our earnings results for the third quarter, the potential
delisting of our stock from the Nasdaq Stock Market, and the adjustments we
made to our previously reported results for 2000, will make it particularly
difficult for us to access capital markets. If we are unable to obtain required
additional capital or are required to obtain it on terms less satisfactory than
we desire, there will be a material adverse effect on our financial condition
which would require a restructuring, sale or liquidation of our company, in
whole or in part.
The unavailability of public capital and the perceived lack of private
capital needed to fund our business as well as the demise of NorthPoint
Communications has caused significant press, analyst, investor, customer, end-
user and employee concerns about the viability of our business. These concerns
will be compounded with our auditor's "going concern" opinion. These concerns
are likely also helping fuel our current end-user disconnect rates and, they
have reduced and continue to reduce our booking of orders. Existing customers
may not be placing orders with us and instead may be sending more orders to our
competitors. Also, certain large Internet service providers are not signing up
to book their end-user orders with us because of their concern that we are not
a viable business. Unless we raise a significant amount of capital soon, the
confidence of our customers and employees may continue to erode and may
continue to have at least the following effects:
. greater cancellation of orders placed and disconnects of lines already in
service;
. fewer orders from existing customers;
. loss of existing customers;
. inability to sign up new customers and book new orders;
. reduced revenues and growth; and
. loss of employees and continued erosion of employee morale.
Each of the effects has had, is having, and will continue to have a material
adverse impact on our business.
24
In addition, indentures governing our existing indebtedness contain
covenants that may restrict our business activities and our ability to raise
additional funds. As a result, we may not be able to undertake certain
activities which management believes are in our best interest to develop our
business. We also may be unable to raise as much additional funding through the
issuance of debt securities as we may need in the future. This could require us
to raise funding through the issuance of equity securities or to seek to amend
our indentures, which we may be unable to do on acceptable terms.
We have no commitments for any future financing and there can be no
assurance that we will be able to obtain additional financing in the future
from either debt or equity financings, bank loans, collaborative arrangements
or other sources on terms acceptable to us, or at all. Any additional equity
financing will be dilutive to our stockholders. Collaborative arrangements, if
necessary to raise additional funds, may require us to relinquish rights to,
among other things, market our services in certain territories.
Our business will suffer in a variety of ways unless financial market
conditions improve
The current financial market conditions pose a variety of additional
challenges to our business. First, the financial condition of many of our
Internet service provider customers has deteriorated, and continues to
deteriorate because of their inability to raise additional funds for their
businesses. In the quarter ended December 31, 2000, these financially-
distressed customers accounted for approximately one-third of our installed
base of lines. The ability of these customers to generate additional revenue
for us has been reduced dramatically, if not eliminated. Our inability to
rapidly replace this portion of our distribution channel will have a material
adverse impact on our business.
Second, many of our Internet service provider customers are making and will
continue to make significant cutbacks in their sales and marketing efforts and
capital expenditures, which will in turn adversely affect our financial
results. Since our Internet service provider customers face many of the same
challenges that we face, we may be adversely affected by these reductions since
it is uncertain what effect such reductions will have on their operations,
customer and/or end-user relationships, growth prospects and financial results.
Any significant adverse effect on our Internet service provider customers may
adversely affect us.
Third, the continued decline in the overall economy will also have a
material adverse impact on the demand for our services from our customers and
our own direct sales.
Fourth, in order to fund continued development, deployment and expansion of
our networks and fund operating losses, we will need continued access to the
capital markets on terms we believe are reasonable. If adequate funds are
unavailable or not available on acceptable terms, we may further revise our
business strategies and/or further delay, curtail, reduce the scope of, or
eliminate the expansion of our networks, operations and/or our marketing and
sales efforts. Should we revise our business strategies, we may not achieve
break even on a cash-flow basis or turn profitable as planned, expected or
announced.
The financial uncertainty of the DSL industry is causing us to lose orders
In recent months we have received an increasing number of reports that our
competitors are using the bankruptcy of NorthPoint Communications and the
financial difficulties faced by other DSL companies to discourage end-users
from purchasing DSL services. We have seen and expect that some end-users will
either purchase DSL services from the traditional telephone companies, or
purchase alternative technologies instead of our DSL services.
In addition, as a result of the difficulties faced by DSL companies,
including the bankruptcy of NorthPoint Communications and our own limited cash
reserves, several prospective customers have postponed discussions with us and
we believe that some of our current customers have slowed the numbers of orders
that they have submitted for our services. If we cannot provide our existing
customers and prospective customers with adequate assurances of our continuing
viability, it will inhibit our growth and will have a material adverse effect
on our business.
25
Our failure to manage our growth effectively may hurt our ability to achieve
profitability and positive cash flow from our operations
A. We may not be able to expand as quickly as we need to achieve
profitability
Our 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 customers and end-users;
. 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 and other financial management systems;
. hire and train additional qualified management and technical personnel;
. manage and resolve any disputes which have arisen and may in the future
arise with our traditional telephone company suppliers;
. establish and maintain relationships with third parties to market and
sell our services, install network equipment and provide field service;
and
. continue to expand and upgrade our network infrastructure.
We may be unable to do these things successfully. As a result, we may be
unable to deploy our services in a timely manner or achieve the operational
growth necessary to meet our business strategy.
Our growth has placed, and is expected to continue to place, significant
demands on our management, operational and capital resources. 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 line orders
and therefore our revenues.
In February to March 2000, we deployed new software systems that caused
some disruption to our business while enhancing the productivity and
efficiency of certain operational practices. Future changes in our processes
that we introduce or we are required to introduce as a result of our
arrangements with the traditional telephone companies could cause similar or
more serious disruption to our ability to provide our services and to our
overall business.
Thus far we have electronically linked our own ordering software systems to
the software systems of most of our traditional telephone company suppliers.
Such electronic linkage is essential for us to successfully place a large
volume of orders for access to telephone wires. There is no assurance that we
will be successful in electronically linking our software system to those of
all of the traditional telephone companies on whom we rely for access to their
telephone wires. Even if we have such electronic links, we cannot assure you
that we will 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 those of all major traditional telephone
companies would severely harm our ability to provide our services in large
volume to our customers.
Although we are continuing to grow our business, we are also implementing
strategies intended to reduce our costs. As we implement these strategies, we
may cause disruption to our business if we do not manage this cost cutting
effort properly. For example, we have closed approximately 200 of our central
offices. We expect
26
that these closings will result in significantly reduced service to customers
that have end-users served out of those central offices, and those customers
may choose to seek services from our competitors. We are strategically
selecting central offices for closure that service the fewest end-users or are
otherwise less productive. However, there can be no assurance that closing
these central offices will not result in significant loss of our customers'
confidence, cause additional costs, and otherwise disrupt our business.
B. We have experienced increased cancellations and disconnections
Since our inception, we have cancelled a significant percentage of orders
for our services. The primary reasons for these cancellations are because the
subscriber is too far from our central office, the lack of adequate facilities
or because service is not available at their location. Since the beginning of
2000, we have been provisioning almost all orders for our consumer grade
services over line-shared telephone lines, which is a change from how we
previously provisioned consumer orders. Coincident with this new method of
provisioning our consumer orders, we have seen a significant increase in the
cancellations of its orders. These higher cancellation rates are due to a
number of factors, including the failure of the traditional telephone companies
to timely and properly implement line-sharing, changes in our operational
procedures which allow us to cancel orders at an earlier point in the
provisioning process, cancellation of orders placed by our distressed partners
and the increasing use of line-sharing for our consumer orders. These higher
cancellation rates have had a significant adverse impact on our overall
installations and ongoing bookings, revenues and overall business. Further, the
cancellation rates for consumer line-shared orders are particularly high in the
territories of the two large traditional local telephone companies on the east
coast, BellSouth and Bell Atlantic. Based upon our experiences with other
traditional local telephone companies like Pacific Bell, we believe that our
consumer line-shared order cancellation rates will decline as we work through
various operational issues, as well as regulatory and legal issues relating to
the performance of the traditional local telephone companies. However, our
failure to significantly reduce our current cancellation rates and improve our
operational and other processes with the traditional local telephone companies
will continue to have a material adverse impact on our customer relationships,
bookings, installations, revenues and our ability to acquire new customers. In
addition, this lack of success will impair further cost reduction efforts, such
as our planned implementation of self-installation of line-shared services.
We have also experienced a significant increase in our customer
disconnection rate in recent months. These disconnections have occurred as a
result of several factors, including disconnections of end-users served by
partners that were not paying for our services, disconnection requests that
were not immediately processed, disconnections in regions where we stopped
offering our services as a result of our restructuring, and other reasons. We
may see additional increases in our disconnection rates for various reasons.
Our failure to significantly reduce our disconnection rate would have a
material adverse effect on our business.
We are dependent on a limited number of customers for the preponderance of our
revenues, and we are highly dependent on sales through our resellers
We primarily market our Internet access services through Internet service
providers, telecommunications carriers and other customers for resale to their
business and consumer end-users. To date, a limited number of Internet service
providers have accounted for the significant majority of our revenues. For
example, in the fourth quarter of 2000, one of our Internet service providers,
EarthLink, provided approximately 40% of our orders and a significant percent
of our revenues. As a result, a significant reduction in the number of end-
users or revenues provided by one or more of our key customers could materially
harm our operating results including revenues and line-growth in any given
period. We expect that our Internet service provider customers and
telecommunications carriers will account for the majority of our future market
penetration and revenue growth.
Our agreements with our customers are generally non-exclusive. Many of our
customers also resell services offered by our competitors. In addition, a
number of our customers have committed to provide large numbers of end-users in
exchange for price discounts. If our customers do not meet their volume
commitments
27
or otherwise do not sell our services to as many end-users as we expect, our
business will suffer. In addition, future relationships we may establish with
other third parties may not result in significant line orders or revenues.
We stopped recognizing revenue for several of our Internet service provider
customers in the third and fourth quarters of 2000 and the first quarter of
2001 because we could no longer be reasonably assured of payment from these
customers. If a customer cannot provide us with reasonable assurance of
payment, then we only recognize revenue when the customer actually pays for our
services and after we have collected all previous accounts receivable balances.
As of April 30, 2001, we estimate that the number of our lines that remain in
service with Internet service provider customers for which we only recognize
revenue when the customer pays for our services is approximately 51,000,
excluding lines that are in the process of being disconnected. With respect to
these Internet service provider customers, approximately 55% of their lines are
business lines and approximately 45% are consumer lines. Business lines carry a
higher profit margin than consumer lines. Based upon our experience to this
point, we expect that approximately 50% of the lines that are with these
customers will be restored to ordinary revenue recognition status and the
remainder will be disconnected.
Some of our Internet service provider customers, including Flashcom Inc.,
Zyan Communications, Inc., Relay Point, Inc. and Fastpoint Communications Inc.,
have filed for bankruptcy protection. For these Internet service providers we
have received bankruptcy court approval to solicit their end-users and attempt
to move them to another one of our Internet service provider customers, or to
our own service. Based upon our experience, we expect that a significant number
of these end-users will not continue to purchase our services.
Although we will continue to try to obtain payments from these customers, it
is unlikely that we will obtain payments in full from one or more of these
customers. With respect to the Internet service provider customers that are in
bankruptcy proceedings, as well as any additional Internet service provider
customers that seek bankruptcy protection, there can be no assurance that we
will ultimately collect sums owed to us by these customers and it remains
uncertain what consequence, if any, bankruptcy proceedings would have on lines
installed for such customers. Moreover, to the extent that we receive payments
from customers that subsequently seek bankruptcy protection, we may be required
to return some or all of these payments to the bankruptcy trustee. The
inability of our Internet service provider customers to pay these past due
amounts, and to make timely payments for our services in the future, has
adversely affected our financial condition and results of operations and may
continue to do so in the future.
We expect that some additional Internet service provider customers will be
unable to obtain additional funding and therefore unable to pay for our
service, which means that we will not recognize the revenue associated with
these additional Internet service provider customers. We have terminated our
contracts with some of these Internet service provider customers and we have
and may continue to disconnect end-users that are purchasing our services from
delinquent Internet service providers. There can be no assurance that these
end-users will continue to purchase our services from us or from another one of
our Internet service provider customers. Even if we are able to transition
these end-users to another Internet service provider or to ourselves, such
migrations will require a significant amount of our resources and cause
disruptions in our processes and operations, which may impair our ability to
install new lines as they are ordered. Any of these circumstances could
adversely affect our business.
We are a party to litigation and adverse results of such litigation matters
could negatively impact our financial condition and results of operations
Several of our shareholders have filed class action lawsuits against us, our
former president and Chief Executive Officer, Robert E. Knowling, and our
current executive vice president and Chief Financial Officer, Mark H. Perry.
These lawsuits were filed in the United States District Court for the Northern
District of California. The complaints in these matters allege violations of
federal securities laws on behalf of persons who purchased our securities,
including those who purchased common stock and those who purchased convertible
28
notes, during the periods from September 7, 2000 to October 17, 2000 or
September 7, 2000 to November 14, 2000. The relief sought includes monetary
damages and equitable relief.
Six purchasers of our convertible notes have filed complaints in California
Superior Court for the County of Santa Clara. These complaints allege fraud and
deceit, negligence and violations of state securities laws in connection with
our convertible notes offering. The relief sought includes rescission of their
aggregate purchases of approximately $142 million in aggregate principal amount
of convertible notes and unspecified damages, including punitive damages. Two
of these purchasers holding $48 million in aggregate principal amount of the
convertible notes have dismissed their complaints without prejudice. The others
continue to pursue their claims. Although they have previously failed in their
attempts to attach Covad's cash proceeds from the sale of the notes and to
obtain an early adjudication of their claims, there can be no assurance that
they will not succeed in any future attempts. Any such success in court by
these purchasers will have a material adverse impact on our business.
We also received a letter from a purported bondholder threatening to file a
lawsuit against our board of directors for breach of fiduciary duty if we do
not meet with it to discuss our prospects. This purported bondholder claims
that it would request that the court appoint a receiver or custodian, or grant
an injunction ordering our directors to comply with their fiduciary duties, in
addition to monetary damages. Any of these remedies would have a material
adverse effect on our business.
We have restated our unaudited interim financial statements for previously
reported quarters in 2000. We believe that weaknesses in internal controls
prompted certain of these adjustments to prior periods. Our restated unaudited
financial statements for previously reported quarters in 2000 reflect
adjustments to prior periods principally in the following areas: (i) the
treatment of a start-up fee associated with a customer contract, (ii) customer
billings, (iii) the treatment of certain Market Development Fund payments and
customer or vendor rebates, (iv) the treatment of certain labor and other
costs, (v) inventory valuation adjustments, (vi) the recognition of certain
liabilities, and (vii) business acquisitions and other equity investments.
These prior periods adjustments resulted in (i) decreases in our unaudited
revenues of $21.1 million, $14.9 million and $16.8 million during the three-
month periods ended March 31, June 30 and September 30, 2000, respectively,
(ii) increases in our unaudited net loss of $29.0 million, $21.5 million and
$51.5 million during the three-month periods ended March 31, June 30 and
September 30, 2000, respectively, and (iii) increases in our unaudited basic
and diluted loss before cumulative effect of accounting change and net loss per
share of $0.20, $0.14 and $0.33 during the three-month periods ended March 31,
June 30 and September 30, 2000, respectively.
Verizon has filed suit against us asserting infringement of a patent issued
to them in September 1998 entitled "Variable Rate and Variable Mode
Transmission System." On February 18, 2000 the court issued a summary judgment
ruling holding that we had not infringed Verizon's patent. Verizon's appeal of
that decision is currently pending and, while we expect that we will prevail on
appeal, the outcome of such an appeal is inherently uncertain. An unfavorable
outcome on appeal of this ruling, or in any other lawsuit that may be brought
against us, could limit our ability to provide all our services and require us
to pay damages, which could significantly harm our business.
We anticipate that some or all of the Laser Link shareholders will file
lawsuits against us to seek damages arising out of our alleged failure to
register the Covad shares that they received in exchange for their Laser Link
shares.
In addition, we are party to 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. Moreover, we cannot guarantee the successful
resolution of these actions and an adverse result in these actions, including
settlement 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.
29
Our leverage is substantial and will increase, making it more difficult to
respond to changing business conditions
As of December 31, 2000, we have approximately $1.4 billion of long-term
obligations, which consists primarily of our 13.5 % senior discount notes due
2008 (the "1998 notes"), our 12.5% senior notes due 2009 (the "1999 notes"),
our 12.0 % senior notes due 2010 (the "2000 notes") and our 6.0% convertible
notes due 2005 (the "2000 convertible notes"). Because the 1998 notes accrete
to $260 million through March 2003, we will become increasingly leveraged
until then, whether or not we incur new indebtedness in the future. We may
also incur additional indebtedness in the future, subject to certain
restrictions contained in the indentures governing the 1998 notes, the 1999
notes, the 2000 notes, and the 2000 convertible notes to finance the continued
development, commercial deployment and expansion of our network and for
funding operating losses or to take advantage of unanticipated opportunities.
The degree to which we are leveraged could have important consequences. For
example, it could:
. materially limit or impair our ability to obtain additional financing or
refinancing in the future for working capital, capital expenditures,
acquisitions, general corporate purposes or other purposes;
. require us to dedicate a substantial portion of our cash flow to the
payment of principal and interest on our indebtedness, which reduces the
availability of cash flow to fund working capital, capital expenditures,
acquisitions, general corporate purposes or other purposes;
. limit our ability to redeem the 1998 notes, the 1999 notes, the 2000
notes and the 2000 convertible notes in the event of a change of control;
. increase our vulnerability to economic downturns, limit our ability to
withstand competitive pressures and reduce our flexibility in responding
to changing business and economic conditions; and
. expose us to potential delisting of our stock on the Nasdaq Stock Market.
We will require a significant amount of cash to service our indebtedness; our
ability to generate cash depends on many factors beyond our control
We expect to continue to generate substantial net losses and negative cash
flow for at least the next several years. We will require additional capital
infusions in the future in addition to our cash flow from operations to permit
us to grow our business and pay the principal and interest on our current
indebtedness and any additional indebtedness we may incur.
The 1998 notes accrete to $260 million through March 2003 and we must begin
paying cash interest on those notes in September 2003. We have provided for
the first six payments on the 1999 notes by setting aside approximately $74.1
million in government securities to fund such payments. We began paying cash
interest on the 1999 notes in August 1999, cash interest on the 2000 notes in
August 2000, and cash interest on the 2000 convertible notes on March 15,
2001.
Our ability to make scheduled payments with respect to indebtedness will
depend upon, among other things:
. our ability to achieve significant and sustained growth in cash flow;
. receipt of timely payment from our customers;
. the rate and success of the commercial deployment of our network;
. successful operation of our network;
. the market acceptance, customer demand, rate of utilization and pricing
for our services;
. our ability to successfully complete development, upgrades and
enhancements of our network; and
. our ability to complete additional financings.
30
Each of these factors is affected by economic, financial, competitive and
other factors, many of which are beyond our control. If we are unable to
generate sufficient cash flow to service our indebtedness, we may have to
reduce or delay network deployments, restructure or refinance our indebtedness
or seek additional equity capital, strategies that may not enable us to service
and repay our indebtedness. Any failure to satisfy our obligations with respect
to the 1998 notes, the 1999 notes, the 2000 notes, or the 2000 convertible
notes at or before maturity would be a default under the related indentures and
could cause a default under agreements governing our other indebtedness. If
such defaults occur, the holders of the indebtedness would have enforcement
rights, including the right to accelerate payment of the entire amount of the
debt and the right to commence an involuntary bankruptcy proceeding against us.
We rely upon distributions from our subsidiaries to service our indebtedness
and our indebtedness is effectively subordinated to the indebtedness of our
subsidiaries
We are a holding company. As such, we conduct substantially all of our
operations through our subsidiaries. As of March 31, 2000, we had approximately
$1.4 billion of total indebtedness (including capital lease obligations). Our
indentures permit us and our subsidiaries to incur substantial additional
indebtedness in the future.
Our cash flow and ability to service our indebtedness will depend upon the
cash flow of our subsidiaries and payments of funds by those subsidiaries to us
in the form of repayment of loans, dividends or otherwise. These subsidiaries
are separate and distinct legal entities with no legal obligation to pay any
amounts due on our indebtedness. In addition, our subsidiaries may become
parties to financing arrangements which may contain limitations on the ability
of our subsidiaries to pay dividends or to make loans or advances to us or
otherwise make cash flow available to us.
In addition, if we caused a subsidiary to pay a dividend in order to enable
us to make payments in respect of our indebtedness, and such transfer were
deemed a fraudulent transfer or unlawful distribution, the holders of our
indebtedness could be required to return the payment to (or for the benefit of)
the creditors of our subsidiaries.
If we were unable to generate sufficient cash flow or were otherwise unable
to obtain funds necessary to meet required payments of principal, premium, if
any, and interest on our indebtedness, we would be in default under the terms
of the agreements governing such indebtedness, including the indentures. In
that case, the holders of our indebtedness could elect to declare all of the
funds borrowed to be due and payable together with accrued and unpaid interest.
If an acceleration occurs and we do not have sufficient funds to pay the
accelerated indebtedness, the holders could initiate enforcement action against
us.
In addition, in the event of any distribution or payment of our assets in
any foreclosure, dissolution, winding-up, liquidation or reorganization,
holders of any secured indebtedness will have a secured claim to our assets
that constitute their collateral, prior to the satisfaction of any unsecured
claim from such assets. Our indentures permit the incurrence of indebtedness
secured by our assets and our subsidiaries' assets. In the event of our
bankruptcy, liquidation or reorganization, holders of our equity will be
entitled to payment from the remaining assets only after payment of, or
provision for, all indebtedness, including secured indebtedness. In any of the
foregoing events, we may not have sufficient assets to make any payments with
respect to our equity.
The price of our common stock may fluctuate significantly, which may result in
losses for investors
The market price for our common stock has been and is likely to continue to
be highly volatile. We expect our common stock to be subject to fluctuations as
a result of a variety of factors, including factors beyond our control. These
include:
. changes in market valuations of Internet and telecommunications related
companies;
. our ability to recognize revenue;
31
. any loss of major customers, or inability of major customers to make
payments;
. any deviations in net revenues or in losses from levels expected by
securities analysts;
. actual or anticipated variations in quarterly operating results,
including the pace of the expansion of our business;
. adverse results in shareholder or noteholder litigation;
. announcements of new products or services by us or our competitors or new
competing technologies;
. the addition or loss of Internet service provider or enterprise customers
or subscribers;
. changes in financial estimates or recommendations by securities analysts
including our failure to meet the expectations of our stockholders 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;
. conditions or trends in the telecommunications industry, including
legislative and regulatory developments;
. growth of the Internet and on-line commerce industries;
. announcements by us or our competitors of significant acquisitions,
strategic partnerships, joint ventures or capital commitments;
. additions or departures of key personnel;
. future equity or debt offerings or our announcements of such offerings;
. general market and general economic conditions;
. volume fluctuations, which are particularly common among highly volatile
securities of Internet related companies; and
. other events or factors, many of which are beyond our control.
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 May 18, 2001, we
had 179,958,511 shares of common stock outstanding. A significant number of
these shares are not publicly traded but are available for immediate resale to
the public, subject to certain volume limitations under the securities laws and
lock-up arrangements. As of January 1, 2001, we also have 46,304,128 shares of
our common stock reserved for issuance pursuant to options under our 1997 Stock
Plan. As of January 1, 2001, we have 27,734,375 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 4.0 million shares of common
stock for issuance under our 1998 Employee Stock Purchase Plan as of January 1,
2001. Shares underlying vested options are generally eligible for immediate
resale in the public market. In addition, a significant portion of our
stockholders have certain registration rights with respect to their shares.
In addition, in connection with our acquisition of BlueStar Communications
Group, Inc., we issued 6.1 million shares of our common stock to BlueStar's
shareholders, some of which are freely tradable by the new shareholders. We
also agreed to place approximately 800,000 of these shares in a third-party
escrow account. These escrow shares would be returned to us to the extent that
we discover that representations and warranties that were made to us by
BlueStar at the time of the acquisition were not true. We also agreed to issue
up to an additional 5.0 million shares if BlueStar met certain operating and
financial criteria during 2001. We have reached an agreement with the BlueStar
shareholders' representative to resolve both of these matters
32
by providing the BlueStar shareholders with 3.25 million of the 5.0 million
shares, in exchange for a release of all potential claims against us. The
800,000 escrow shares would be returned to us under this agreement. This
agreement is conditioned upon obtaining approval by 80% of the BlueStar
shareholders, which approval has not yet been obtained. If BlueStar
shareholders were to sell their shares of our common stock, it could adversely
affect our stock price.
In connection with the $500 million of convertible notes due 2005, we may
issue up to 28,129,395 shares of our common stock. If the convertible notes are
converted into shares of our common stock, the sale of these shares could
adversely affect the price of our stock.
We sold 9,373,169 shares of our common stock to SBC Communications, Inc. in
the fourth quarter of 2000. SBC has agreed not to transfer any of these shares
until November 2001, and, after that period, SBC agreed to offer us the first
opportunity to purchase shares that it intends to sell. Sales of shares of our
common stock by SBC after this lock-up period could adversely affect the price
of our stock.
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, may 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 indentures, our Stockholder Protection Rights Plan and our change in
control severance arrangements could prevent a change in our control
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. Our charter
and bylaws provide for a classified board of directors, limitations on the
ability of stockholders to call special meetings and 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 and could delay or
prevent a change of control.
The indentures relating to the 1998 notes, 1999 notes, 2000 notes and 2000
convertible notes provide that, in the event of certain changes in control,
each holder of these notes will have the right to require us to repurchase such
holder's notes at a premium over the aggregate principal amount or the accreted
value, as the case may be, of such debt. In addition, our Stockholder
Protection Rights Plan contains provisions that make a hostile takeover
prohibitively expensive and, in effect, requires interested suitors to
cooperate with the Board of Directors prior to acquiring more than 15% of our
capital stock. There is no guarantee that the Stockholder Protection Rights
Plan will not discourage takeover attempts which would otherwise result in a
premium to our stockholders.
The provisions in the charter, bylaws, indentures and Stockholder Protection
Rights Plan and our change in control severance arrangements with certain key
executives could have the effect of discouraging others from making tender
offers for our shares and, as a consequence, they also may inhibit increases in
the market price of our shares that could result from actual or rumored
takeover attempts. Such provisions also may have the effect of preventing
changes in our management.
We may experience decreasing margins on the sale of our services, which may
impair our ability to achieve profitability or positive cash flow
We may experience decreasing prices 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
33
result, we cannot assure you that our customers and their end-user 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. We have provided and expect in the future to
provide price discounts to customers that commit to sell our services to a
large number of their end-user customers. 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.
December 31, March 31, June 30, September 30, December 31, March 31,
1999 2000 2000 2000 2000 2001
------------ --------- -------- ------------- ------------ ---------
Total Installed
Business-Grade Lines... 45,000 68,000 93,000 118,000 141,000 159,000
Total Installed Consumer
Lines.................. 12,000 25,000 45,000 87,000 133,000 160,000
Total Installed Lines... 57,000 93,000 138,000 205,000 274,000 319,000
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 expect to reduce prices periodically in the future to
respond to competition and to generate increased sales volume. As a result, we
cannot predict whether demand for our services will exist at prices that enable
us to achieve profitability or positive cash flow.
The markets we face are highly competitive and we may not be able to compete
effectively, especially against established industry competitors with
significantly greater financial resources
The markets we face for business and consumer Internet access and remote
network access services are intensely competitive. We expect that these markets
will become increasingly competitive in the future. In addition, the
traditional telephone companies dominate the current market and have a monopoly
on telephone wires. 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. Our ability to stay competitive may be reduced
if our new business plan is not successful, or if we are unable to obtain
additional financing as and when needed. 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.
For example, they 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 wires 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 consumer DSL services as low as $30 per month and
their business DSL services as low as $39 per month, placing pricing pressure
on our services. Recently, some of the traditional local telephone companies
have increased their retail consumer DSL prices by approximately 25%. They have
not, however,
34
increased their wholesale prices to major Internet service providers and
therefore continue to under-price our services. While we are now allowed to
provide our data services over the same telephone wires which provide analog
voice services, we have experienced difficulties in implementing this ability,
and in many instances, final prices for that shared-line access have not been
established. There is no assurance that we can provide our services in this
manner without running into operational, technical or financial obstacles,
including those created by the traditional telephone companies. Further, they
can offer service to end-users from certain central offices where we are unable
to secure central office space and 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.
Accordingly, we may be unable to compete successfully against the traditional
telephone companies.
The risks posed to us by the traditional telephone companies as our key
suppliers and competitors is also compounded by the role some of these
companies, such as SBC and Qwest, play as our resellers. These competitors may
determine not to fulfill their obligations despite their contractual
commitments to us. The failure by these resellers to fulfill their obligations
to us would have a material adverse impact on our business.
Cable modem service providers, such as Excite@Home and Road Runner, 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.
Many competitive telecommunications companies offer high-speed data services
using a business strategy similar to ours. Some of these competitors have been
offering DSL-based access services and others are likely to do so in the
future. These companies may be acquired in whole or in part by one or more of
our established resellers on highly favorable terms because of the currently
low market values of companies in this sector or because they are in
bankruptcy. In such instances, we could lose one or more of our resellers and
face more robust competition, which would have a material adverse impact on our
business. For example, one of our significant resellers, AT&T, recently
acquired the operating assets of NorthPoint Communications. In addition, some
competitive telecommunications companies have extensive fiber networks in many
metropolitan areas primarily providing high-speed digital and voice circuits to
large corporations, and have interconnection agreements with traditional
telephone companies pursuant to which they have acquired central office space
in many of our existing and target markets. Further, certain of our resellers
have made investments in our competitors, and some of our resellers have
deployed their own facilities to provide DSL-based access services. As a result
of these factors, we may be unsuccessful in generating a significant number of
new customers or retaining existing customers.
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, you have limited operating and financial data upon
which to evaluate our business. You should consider that we have the risks of
an early stage company in a new and rapidly evolving market. To overcome these
risks, we must:
. sell our services directly in certain markets;
. attract and retain end-users;
. raise additional capital;
. respond to competitive developments;
. reduce our dependence on financially weak resellers;
. continue to attract, retain and motivate qualified persons;
35
. continue to upgrade our technologies in response to competition and
market factors;
. manage our traditional telephone company suppliers;
. rapidly install high-speed access lines;
. effectively manage the growth of our operations; and
. deliver additional value added services to our customers without causing
existing customers to cease reselling our services or reducing the volume
or rate of growth of sales of our services.
We have a history of losses and expect losses in the future
We have incurred substantial losses and experienced negative cash flow each
fiscal quarter since our inception in 1997. Through the fourth quarter of 2000,
we have increased our capital expenditures and operating expenses each quarter
in order to expand our business. Although we are in the process of reducing our
capital expenditures, we expect to incur substantial additional net losses and
substantial negative cash flow for the next several years due to continued
development, commercial deployment and expansion of our network. We may also
make investments in and acquisitions of businesses that are complementary to
ours to support the growth of our business. 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 number of regions entered, the timing of entry and services offered;
. network development schedules, closures and associated costs;
. the rate at which customers and end-users purchase our services and the
pricing of such services;
. the financial condition of our customers;
. the migration of end-users from financially-unsound customers to
financially sound customers or to our own retail business;
. the level of marketing required to acquire and retain customers and to
attain a competitive position in the marketplace;
. the network integration efforts between our different affiliated
companies and the efficient migration of customers and end-users between
these networks;
. the rate at which we invest in engineering and development and
intellectual property with respect to existing and future technology;
. pending litigation;
. existing and future technology; and
. unanticipated opportunities.
In addition, we expect our net losses to increase in the future due to
interest and debt issuance cost amortization charges related to the 1998 notes,
the 1999 notes, the 2000 notes, and the 2000 convertible notes. For example:
. Interest and debt issuance cost amortization charges relating to the 1998
notes were approximately $25.3 million during the year ending December
31, 2000. These charges will increase each year until the year ending
December 31, 2004, during which period the interest and amortization
charges will be approximately $36.9 million. This increase is due to the
accretion of the 1998 notes to $260 million through March 2003.
. Interest and debt issuance cost amortization charges relating to the 1999
notes were approximately $28.4 million during the year ending December
31, 2000 and will increase slightly each year to approximately $29.3
million during the year ending December 31, 2008.
36
. Interest and debt issuance cost amortization charges relating to the 2000
notes were approximately $48.2 million during the year ending December
31, 2000 and will be $52.2 million each following year through the
maturity of the notes in February 2010.
. Interest and debt issuance cost amortization charges relating to the 2000
convertible notes were approximately $8.7 million during the year ending
December 31, 2000, and will be approximately $33.1 million each following
year until the 2000 convertible notes are converted or, if not converted,
until maturity of the 2000 convertible notes in September 2005.
Any future financing we are able to obtain may be on terms less favorable to
us than the terms of our existing financings, and charges related to any such
future financing may be proportionately greater.
Our operating results are likely to fluctuate in future periods and may fail
to meet the expectations of securities analysts and investors
Our annual and quarterly operating results are likely to fluctuate
significantly in the future as a result of numerous factors, many of which are
outside of our control. These factors include:
. the effect of our revised business plan on our relationships with our
customers;
. the amount and timing of capital expenditures and other costs relating to
the filling of our network and the marketing of our services;
. difficulties we may face in accessing the capital markets to fund such
capital expenditures;
. the bankruptcy or other financial difficulties experienced by our
Internet service provider customers;
. our ability to collect receivables from our customers;
. receipt of timely payment from our Internet service provider and other
customers;
. our ability to migrate end-users from financially-unsound customers to
financially sound customers or to our own retail business;
. delays in the commencement of operations in new regions and the
generation of revenue because certain network elements have lead times
that are controlled by traditional telephone companies and other third
parties;
. the ability to develop and commercialize new services by us or our
competitors;
. 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 and integrate the
networks of our different affiliated companies;
. the rate at which customers subscribe to our services;
. the efficiency with which we operate redundant network and operational
capabilities;
. the necessity of decreasing the prices for our services due to
competition, volume-based pricing and other factors;
. our ability to retain Internet service provider, enterprise and
telecommunications carrier customers and limit end-user churn rates;
. our ability to migrate end-users from the network of one of our
affiliates to another;
. our ability to minimize costs of closing portions of our network,
including central offices and other facilities in particular markets;
. our ability to successfully defend our company against certain pending
litigation;
37
. the mix of line orders between consumer end-users and business end-users
(which typically have higher margins);
. the success of our relationships with AT&T, SBC and other third parties
and distribution channels in generating significant end-user demand;
. our ability to reduce our capital expenditures and other expenses without
jeopardizing our relationships with key customers and suppliers;
. the timing and willingness of traditional telephone companies to provide
us with space on their premises and the prices, terms and conditions on
which they make available the space to us;
. the development and operation of our billing and collection systems and
other operational systems and processes;
. our ability to address control weaknesses identified during our 2000 year
end financial statement closing process and audit;
. our inventory and supply-chain management;
. the rendering of accurate and verifiable bills by our traditional
telephone company suppliers and resolution of billing disputes;
. the incorporation of enhancements, upgrades and new software and hardware
products into our network and operational processes that may cause
unanticipated disruptions;
. the changing interpretation and enforcement of regulatory developments
and court rulings concerning the 1996 Telecommunications Act,
interconnection agreements and the anti-trust laws;
. legislative changes in the 1996 Telecommunications Act;
. our ability to integrate the businesses we acquire into our business
efficiently; and
. the availability of equipment and services from key vendors.
As a result, it is likely that in some future quarters our operating results
will be below the expectations of securities analysts and investors. If this
happens, the trading price of our common stock would likely decline.
We cannot predict whether we will be successful because our business strategy
is largely unproven
We believe that we were the first competitive telecommunications company to
widely provide high-speed Internet and network access using DSL technology. To
date, our business strategy remains significantly unproven. To be successful,
we must develop and market services that achieve broad commercial acceptance by
Internet service provider, enterprise and telecommunications carrier customers
in our targeted metropolitan statistical areas. Because our business and the
demand for high-speed digital communications services are in the early stages
of development, we are uncertain whether our services will achieve broad
commercial acceptance.
It is uncertain whether our strategy of selling and providing our service
through Internet service providers, telecommunication carriers and others will
be successful. This strategy creates marketing, operational and other
challenges and complexities that are less likely to appear in the case of a
single entity providing integrated DSL and Internet service provider services.
For example, cable modem service providers, such as Excite@Home Corporation and
Time Warner, Inc., market, sell and provide high-speed services, Internet
access and content services on an integrated basis. Since we are currently
selling most of our services to end-users through third parties, our ability to
retain these end-users is largely dependent on the performance of these
resellers. If these resellers fail to satisfy their obligations to their end-
users, or if they do not pay us for our services, we may lose end-users or we
may be forced to disconnect end-users. Also, our new DSL + IP and VBSP services
may adversely affect our relationship with our current Internet service
provider customers, since we will be
38
providing some of the services that they provide. We do not anticipate that
this will have a substantial adverse effect on our relationship with our
Internet service provider customers because we will be able to provide our
Internet service provider customers with these additional services at a lower
cost than they would pay if they developed these additional services
internally.
The mergers and acquisitions between America Online, Inc. and Time Warner,
Inc., between NTT and Verio, and between NEXTLINK and Concentric Network
Corporation (now XO Communications)--highlight a growing trend among service
providers and telecommunications carriers to combine the marketing, selling and
provisioning of high-speed data transmission services, Internet access and
content services. While we do not believe that such combined entities providing
integrated services will materially adversely affect our business, no assurance
can be given that such combinations will not ultimately have such a material
adverse effect. Further, no assurance can be given that additional acquisitions
of Internet service providers by traditional and local competitive
telecommunications carriers, and other strategic alliances between such
entities, will not harm our business.
One of our competitors, NorthPoint Communications, has sold its network
assets to AT&T. The acquisition of these assets by AT&T will potentially reduce
the orders we receive from AT&T, introduce a formidable new competitor into our
market, create uncertainty in the financial and business markets, and may
reduce the prices our customers pay us for lines because of increased
competition.
In light of our acquisition of Laser Link.Net, Inc. and other changes we
have made in our business, some of our existing Internet service provider
customers may perceive us as a potential or actual competitor instead of as a
supplier. Similarly, our acquisition of BlueStar, which sells its services
directly to end-users, may cause our existing Internet service provider
customers to view us as a competitor. Such Internet service providers may
therefore reduce the volume or the rate of growth of the sales of our services,
or may cease to resell our services. No assurance can be given that our
provision of additional services will not alienate some or all of our existing
customers and thus harm our business.
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.
The 1996 Telecommunications Act, which became effective in February 1996,
introduced widespread changes in the regulation of the telecommunications
industry, including the digital access services segment in which we operate.
The 1996 Telecommunications Act eliminates many of the pre-existing legal
barriers to competition in the telecommunications services business and sets
basic criteria for relationships between telecommunications providers.
Among other things, the 1996 Telecommunications Act removes barriers to
entry in the local telecommunications markets by preempting state and local
laws that restrict competition by providing competitors interconnection, access
to unbundled network elements, collocation, and retail services at wholesale
rates. The FCC's primary rules interpreting the 1996 Telecommunications Act
were issued on August 8, 1996. These rules have been reviewed by the U.S. Court
of Appeals for the Eighth Circuit, the U.S. Court of Appeals for the District
of Columbia, and the U.S. Supreme Court. The U.S. Supreme Court overruled the
Eighth Circuit in January 1999 and upheld most of the FCC rules. In September
1999, the FCC adopted unbundling rules that responded to the Supreme Court's
January 1999 decision. The FCC is currently considering petitions to reconsider
this decision, and appeals of this decision are also currently pending before
the Eighth Circuit.
Since August 1996, the FCC has proposed and adopted further rules related to
our ability to obtain access to unbundled network elements and other services.
These decisions also have been the subject of litigation and appeals.
In August 1998, the FCC stated that its rules required traditional local
telephone companies to provide us access to copper wires in order to provide
"advanced services," such as our DSL services.
39
In November 1999, the FCC ruled that traditional local telephone companies
must provide access to "line sharing" on an unbundled basis. The FCC reaffirmed
this decision in January 2001. Line sharing permits us to provide a DSL service
on the same telephone wire in which an end-user has analog, local telephone
service. Only certain DSL technologies, such as ADSL, are designed to work on
the same line as analog telephone service. Most traditional telephone companies
provide ADSL service exclusively over line sharing. Without access to line
sharing, we have to have the traditional telephone company install an
additional telephone line to an end-user's premises. Without line sharing, we
may not be able to provide a product that is competitive with the traditional
telephone company's offering. A group of traditional telephone companies has
appealed this decision to the D.C. Circuit Court of Appeals, and an adverse
result in that court proceeding could harm our business.
In January 2001, the FCC reaffirmed its line-sharing rules and also
interpreted those rules as requiring traditional local telephone companies to
facilitate "line-splitting"--the provisioning on a single loop of DSL service
by a company like Covad while another competitive local exchange carrier
provides analog, dial-up telephone service on the lower frequencies of the same
loop. Beginning in 2001, we have generally begun provisioning new orders for
consumer-grade services over line-shared telephone wires. If the traditional
telephone companies fail to deliver line-shared telephone wires in sufficient
quantities or to deliver functioning line-shared telephone wires in an
acceptable period of time, the growth of our consumer business will be
adversely affected. In addition, traditional local telephone companies have
appealed both of these decisions to the D.C. Circuit Court of Appeals. The
outcome of these appeals is uncertain and an unfavorable outcome could have a
material adverse impact on our business.
We have not entered into interconnection agreements that take full advantage
of these new federal rules. We anticipate that traditional telephone companies
will challenge these new rules in regulatory proceedings and court challenges.
In addition, we anticipate that traditional telephone companies will resist
full implementation of these federal and state rules. Any unfavorable decisions
by the courts, the FCC, or state telecommunications regulatory commissions
could harm our business. In addition, a failure to enforce these rules by the
appropriate court, FCC, or state authority in a timely basis could slow down
our deployment of services or could otherwise harm our business.
FCC actions other than rulemaking proceedings can also impact our business.
The 1996 Telecommunications Act also allows the Regional Bell Operating
Companies (RBOCs, now BellSouth, Verizon, SBC and Qwest), which are the
traditional telephone companies created by AT&T's divestiture of its local
exchange business, to provide interLATA long distance services in their own
local service regions upon a showing that the RBOC provides interconnection and
access to companies like Covad as required by the Act. As a result, Covad is
active in the RBOC interLATA 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 five RBOC applications to date, for Verizon in New York and
Massachusetts and SBC in Texas, Oklahoma and Kansas. Currently pending before
the FCC is Verizon's application in Connecticut which we expect will be granted
very shortly. Given the FCC's grant of these applications, the FCC is likely to
thereafter grant similar applications by Verizon, SBC, and the other RBOCs in
other states. Covad has opposed such applications where it believes it has not
received access and interconnection as required by the Act. Grants of long-
distance authority to RBOCs will likely adversely affect the level of
cooperation we receive from each of the RBOCs.
In approving the merger of SBC and Ameritech in October 1999, the FCC
required SBC/Ameritech to create a structurally-separate advanced services
affiliate throughout the SBC/Ameritech service territory. The FCC required
SBC/Ameritech to provide its own in-region DSL services through this affiliate,
and the affiliate would be free from traditional telephone company regulation.
The provision of DSL services by such an affiliate could harm our business. In
June 2000, Bell Atlantic and GTE were ordered by the FCC to create such a
similar affiliate, in the context of their merger into Verizon. However, in
January 2001, the D.C. Circuit Court of Appeals reversed and vacated the FCC's
SBC/Ameritech Merger Order on the basis that the separate affiliate requirement
was inconsistent with the Communications Act.
40
Changes to current regulations, the adoption of new regulations or policies
by the FCC or state regulatory authorities, court decisions, or legislation,
such as changes to the 1996 Telecommunications Act, could harm our business.
In particular, a bill was introduced in the 107th Congress, H.R. 1542, that,
if enacted, would harm our business by taking away access to line-sharing in
certain cases and other legal rights we have to unbundled network elements and
collocation, and by diminishing the incentive the Regional Bell Operating
Companies have to provide us the elements, collocation and services we need to
provide our services. Passage of this bill or similar legislation would
adversely and significantly harm our business, and may cause us to eliminate
or even disconnect certain services to particular end-users. In addition,
passage of any of these bills may cause us to disrupt and change our existing
network design and configuration.
In addition to regulatory proceedings and decisions, we rely significantly
upon private antitrust and other litigation to ensure that traditional local
telephone companies provide us access to their networks as required by federal
and state antitrust law, the Communications Act, and other legal requirements.
We are pursuing antitrust and other remedies in federal district court against
Verizon and BellSouth. In pursuing this litigation, we have incurred
substantial expenses and overhead costs that may or may not lead to
satisfactory results. A recent Seventh Circuit Court of Appeals decision in
Goldwasser v. Ameritech has cast doubt and uncertainty as to our ability to
pursue private antitrust remedies for actions by traditional local telephone
companies that also violate the Communications Act. Some federal district
courts in subsequent rulings have followed the Goldwasser decision, while
others have not. We believe that the Goldwasser decision has already reduced
traditional local telephone company incentives to provide us access to their
networks as required by law. In addition, Verizon and BellSouth have filed
motions to dismiss our pending litigation against them in federal district
court on the basis of the Goldwasser decision. While we are opposing those
motions to dismiss and believe that our position should prevail, we cannot
predict the outcome of these motions.
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 lines or
telephone wires 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. The ultimate rates approved typically depend on the
traditional telephone company's initial rate proposals and the policies of the
state public utility commission. 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 rates proposed by the traditional
telephone companies and approved by state regulatory commissions from time to
time, which would harm our operating results.
On July 18, 2000, the United States Court of Appeals for the Eighth Circuit
struck down the FCC's total element long run incremental cost methodology,
which the FCC previously required state commissions to use in setting the
prices for collocation and for unbundled network elements we purchase from the
traditional telephone companies. The Court also rejected an alternative cost
methodology based on "historical costs," which was advocated by the
traditional telephone companies. In rejecting the FCC's cost methodology, the
Court held that it is permissible for the FCC to prescribe a forward-looking
incremental cost methodology that is based on actual incremental costs under
the 1996 Telecommunications Act. In January 2001, the Supreme Court agreed to
hear the appeal of this Eighth Circuit decision in the coming year.
The Eighth Circuit's decision and the current Supreme Court appeal create
additional uncertainty concerning the prices that we are obligated to pay the
traditional telephone companies for collocation and unbundled network
elements. The FCC may also adopt, or be required to adopt, new rules to
reflect the cost
41
methodology that was approved by the Eighth Circuit. It is uncertain whether
the Eighth Circuit's decision will be affirmed by the United States Supreme
Court. It is also uncertain whether the FCC and the state commissions will
implement a new cost methodology as a result of this decision.
The impact of these 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 or currently expected
prices. If we are required to pay higher prices to the local telephone
companies for collocation and unbundled network elements, it could have a
material adverse effect on our business.
Challenges in obtaining space for our equipment on premises owned by the
traditional local telephone companies harms our business
We must secure physical space from traditional local telephone companies for
our equipment in their central offices in order to provide our intended
services in our targeted metropolitan statistical areas. In the past, we have
experienced rejections of our applications to secure this space in many central
offices, and we are likely to receive rejections when we apply for space in
remote terminals. We must place our equipment in remote terminals in order to
provide higher speed DSL service to a larger number of users. Remote terminals
are used by traditional telephone companies to serve end-users through a
combination of fiber optic technology and copper wires. Traditional telephone
companies are increasing their deployment of fiber-fed remote terminal
architectures (for example, SBC's "Project Pronto"). For us to provide copper
based DSL services to these end-users, we need to access the copper telephone
wires that terminate at these remote terminals.
At least some (if not all) of the rejections of our applications for space
on premises owned by the traditional local telephone companies in the past have
not been based on an actual lack of space. In other instances, there may be
real limitations on the availability of central office space in certain central
offices and remote terminals. We expect that we will face additional rejections
of our applications in many instances. Rejections of our applications for
central office space have in the past resulted, and such applications and
remote terminal applications could in the future result, in delays and
increased expenses in the rollout of our services in our targeted metropolitan
statistical areas, including delays and expenses associated with engaging in
legal proceedings with the traditional telephone companies. This has harmed our
business and is likely to continue to harm our business in the future periods.
The Federal Communications Commission ("FCC") has been reviewing the
policies and practices of the traditional telephone companies with the goal of
facilitating the efforts of competitive telecommunications companies to obtain
central office space and telephone wires more easily and on more favorable
terms. On March 31, 1999, the FCC adopted rules to make it easier and less
expensive for competitive telecommunications companies to obtain central office
space and to require traditional telephone companies to make new alternative
arrangements for obtaining central office space. While the FCC's new rules did
increase our success in obtaining central office space, the FCC's new rules
were not uniformly implemented in a timely manner and have been subject to
litigation.
Moreover, in March 2000, a federal appeals court struck portions of the
FCC's new collocation rules, and has required the FCC to reconsider and review
those rules. In particular, the appeals court has required the FCC to revise
its rules concerning the types of equipment that we may collocate on the
traditional telephone company premises and the steps that traditional telephone
companies may take to separate their equipment from our equipment, and has
impaired our ability to connect to other carriers in the central office. The
remand of these collocation rules is currently pending before the FCC. The
traditional telephone companies may implement the court's ruling and any
subsequent FCC rules in a manner that impairs our ability to obtain collocation
space, increase our costs, collocate the equipment of our choice on their
premises, and connect to other carriers. Such actions by the traditional
telephone companies could adversely affect our business and disrupt our
existing network design, configuration and services.
42
In September 1999, the FCC adopted rules that require traditional telephone
companies to provide access to remote terminal locations and to require them
to provide access to copper wires that terminate at these terminals. These
rules went into effect in May 2000. However, traditional local telephone
companies have filed petitions with the FCC for reconsideration of those rules
and have also filed a court challenge before the Eighth Circuit Court of
Appeals regarding those FCC rules. The outcome of these petitions and appeals
is uncertain, and unfavorable outcome could adversely affect our business.
In February of 2000, SBC sought a waiver from the FCC of certain merger
conditions that it had agreed to as part of its merger with Ameritech.
Specifically, SBC sought permission from the FCC to put ownership of certain
advanced services equipment in the SBC ILECs, rather than in SBC's advanced
services affiliate as required by those merger conditions. SBC sought the
waiver in order to facilitate deployment of a new remote terminal architecture
throughout its network (called "Project Pronto"). On September 7, 2000, the
FCC adopted an order granting SBC's waiver request, subject to numerous
conditions designed to ensure that competitive LEC's, such as us, have
nondiscriminatory access to all of the features, functions and capabilities of
the Pronto architecture. The FCC imposed similar conditions in approving the
Bell Atlantic/GTE (now Verizon) merger. However, in January 2001, the D.C.
Circuit Court of Appeals reversed and vacated the FCC's original order
approving the SBC/Ameritech Merger Order, on the grounds the "separate
advanced services affiliate" was inconsistent with the Communications Act. The
outcome of these legal proceedings upon the method in which SBC and Verizon
provide DSL services and the applicability of the FCC's Project Pronto access
conditions remains uncertain and could adversely affect our business and
disrupt our network design.
The failure of traditional telephone companies to adequately provide
transmission facilities and provision telephone wires is likely to impair our
ability to install lines and adversely affect our growth rate
We interconnect with and use traditional telephone companies' networks to
service our customers. This presents a number of challenges because we depend
on traditional telephone companies:
. to use their technology and capabilities to meet certain
telecommunications needs of our customers and to maintain our service
standards;
. to cooperate with us for the provision and maintenance of transmission
facilities; and
. to provide the services and network components that we order, for which
they depend significantly on unionized labor. Labor issues have in the
past, and may in the future, hurt the telephone companies' performance.
For example, in August 2000, employees of Verizon Communications
conducted a work stoppage that impaired its ability to provision,
maintain and repair the telephone lines that we use to deliver our
services.
Our dependence on the traditional telephone companies has caused and could
continue to cause us to encounter delays in establishing our network and
providing higher speed DSL services. We rely on the traditional telephone
companies to provision telephone wires to our customers and end-users. We must
establish efficient procedures for ordering, provisioning, maintaining and
repairing large volumes of DSL capable lines from the traditional telephone
companies. We must also establish satisfactory electronic billing and payment
arrangements with the traditional telephone companies. We may not be able to
do these things in a manner that will allow us to retain and grow our customer
and end-user base.
It has been and continues to be our experience that, at any given time, one
or more of the traditional telephone companies will fail to deliver the
central office space, transmission facilities, telephone wires or other
elements, features and functions that our business requires. For example, the
traditional telephone companies currently are significantly impairing our
ability to efficiently install our services, and this has adversely affected
the growth in the volume of orders we receive. The failure of the traditional
telephone companies to consistently and adequately deliver operable telephone
wires to us on time has significantly contributed to our backlog of
uninstalled orders. The continued inadequate performance of the traditional
telephone companies could slow the growth in our revenues and reduce the
growth in orders placed by our customers, which could materially harm our
business.
43
On November 18, 1999, the FCC decided that the traditional local telephone
companies must provide us and other competitive local exchange carriers with
access to line sharing. The FCC reaffirmed this decision in January 2001 and
clarified that traditional telephone companies had an obligation to facilitate
the sharing of one copper wire between two competitive local exchange
companies. These rules allow us to provide our services over the same telephone
wire used by the traditional telephone companies to provide analog voice
services. The FCC directed the traditional local telephone companies to enter
into agreements with competitors, such as ourselves, and take the necessary
steps to provide such access by mid-2000. Since early 2001, we have generally
begun provisioning new orders for consumer-grade services over line-shared
telephone wires. The traditional telephone companies have failed to promptly
and properly deliver line-shared telephone wires to us in significant volumes,
and this failure has materially harmed our business. If the traditional
telephone companies continue to fail to deliver line-shared telephone wires in
sufficient quantities and to deliver functioning line-shared telephone wires in
an acceptable period of time, the growth of our consumer business will be
adversely affected.
Although we have entered into line sharing agreements with the major local
telephone carriers, in many instances the permanent rates, terms and conditions
of line sharing access have not yet been mutually agreed to between the
traditional local phone companies and us. Many state commissions are either
currently arbitrating or have not yet arbitrated disputes or set line sharing
rates in connection with failed negotiations between traditional local phone
companies and us. The outcome of these rate proceedings is uncertain and could
adversely impact our business. In addition, traditional local telephone
companies have appealed the FCC's November 1999 and January 2001 rules to the
D.C. Circuit Court of Appeals, and the outcome of those appeals is uncertain
and could adversely impact our business. We are experiencing ongoing
difficulties with the traditional local telephone companies as they attempt to
provide us with line sharing which has resulted in disruption and dislocation
to our ability to provide our services. The performance of the various
traditional telephone companies varies widely. The efforts of the traditional
phone companies have adversely affected our ability to scale our consumer-grade
services and to make those services profitable.
Challenges in obtaining the overall cooperation of the traditional local
telephone companies harms our business
We face a variety of challenges in dealing with the traditional telephone
companies which include the following:
. they frequently claim lack of available facilities when asked by us to
provide connections between central offices, remote terminals, and
telephone wires to end-users;
. they frequently fail to promise delivery of, and fail to deliver,
properly connected telephone wires to our end-users on time;
. they frequently fail to properly configure equipment that supports line-
sharing, cross-connect telephone wires for us at the central offices, and
otherwise fail to properly and timely deliver to us line-shared telephone
wires;
. they frequently do not cooperate in providing us with relevant telephone
wire information, such as the length of the wire;
. they frequently do not cooperate in resolving purported problems in the
orders we submit to them for telephone wires and other facilities;
. they frequently do not deploy interfaces or provide us with integrated
software systems that allow us to seamlessly place large volumes of
orders for telephone lines;
. they frequently do not cooperate in resolving billing disputes and in
assisting us in closing parts of our network in central offices at low or
reasonable costs to us;
44
. they frequently do not cooperate in testing installations, and trouble-
shooting, maintaining and resolving problems relating to delivery of
telephone lines; and
. they frequently do not cooperate in providing relevant information about
the presence and types of remote terminals that may be serving end-users.
We are engaged in a variety of negotiations, regulatory disputes and legal
actions to resolve these situations. We may be unable to resolve these matters
successfully.
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.
We may be unable to timely enter into these agreements, which is prerequisite
for us to provide service in those areas. 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
with the traditional telephone companies in order to implement those new or
modified rules. 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. As a result, although the FCC may implement rules or policies
designed to speed or improve our ability to provide services, we may not be
able to timely implement those rules or policies.
Additionally, disputes have arisen and will continue to arise in the future
as a result of differences in interpretations of the interconnection
agreements. For example, we are in litigation proceedings with certain of the
traditional telephone companies. These disputes have delayed the deployment of
our network, and resolution of the litigated matters will cause us ongoing
expenditure of money and management time. They may have also negatively
affected our service to our customers and our ability to enter into additional
interconnection agreements with the traditional telephone companies in other
states. 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 harms our
business.
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.
Three of our executive officers, Jane Marvin, Rob Davenport and Frank
Thomas, left the Company in May 2001. Ms. Marvin's duties as Executive Vice
President, Human Resources have been assumed by Dhruv Khanna, who is now our
Executive Vice President, Human Resources, General Counsel and Secretary.
Mr. Davenport's duties have been assumed by Terry Moya, our Executive Vice
President, External Affairs and Corporate Development. Mr. Thomas' duties have
been assumed by Anjali Joshi, Executive Vice President of Engineering. These
departures may cause disruption to our business and may lead to the departures
of other 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
45
we add end-users to our network. Competition for such qualified personnel is
intense. The recent 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 this competitive market. This is particularly
the case in software development, network engineering and product management.
We also may be unable to attract, assimilate or retain other highly qualified
technical, operations, sales, marketing, financial, legal, human resource and
managerial personnel. Our business will be harmed if we cannot attract the
necessary technical, operations, sales, marketing, financial, legal, human
resource and managerial personnel. 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.
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 premise equipment modems;
. network routing and switching hardware;
. network management software;
. systems management software;
. database management software;
. collocation space; and
. Internet connectivity and Internet protocol services.
As we sign additional service contracts, we will need to increase
significantly the amount of manufacturing and other services supplied by third
parties in order to meet our contractual commitments. 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. In
addition, we may not be able to obtain additional vendors when needed. We have
identified alternative suppliers for technologies that we consider critical.
However, it could take us a significant period of time to establish
relationships with alternative suppliers for critical technologies and
substitute their technologies into our network.
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.
The loss of any of our relationships with these suppliers could harm our
business.
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
In addition to our acquisitions of Laser Link.Net, Inc. and BlueStar
Communications Group, Inc., 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
46
issuances of equity securities, the incurrence of additional debt, large one-
time expenses and the creation of goodwill or other intangible assets that
result in significant amortization expense. Any acquisition, including the
Laser Link and BlueStar acquisitions, 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. We cannot guarantee that
we successfully will:
. identify attractive acquisition and strategic investment candidates;
. complete and finance additional acquisitions on favorable terms; or
. integrate the acquired businesses or assets into our own.
We cannot guarantee that the integration of our business with any acquired
company's business, including the businesses of Laser Link and BlueStar, will
be accomplished smoothly or successfully, if at all. Any of these factors could
materially harm our business or our operating results in a given period.
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,
which does not presently have widely accepted standards, and alternative
technologies for providing broadband communications, such as cable modem
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.
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
Our operations depend upon our ability to support our highly complex network
infrastructure and avoid damage from fires, earthquakes, floods, power losses,
excessive sustained or peak user demand, telecommunications failures, network
software flaws, transmission cable cuts and similar events. 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, such as competitive telecommunications companies, to provide
communications capacity that we require, as a result of a natural disaster,
operational disruption any other reason, could cause interruptions in our
services. Any damage or failure that causes interruptions in our operations
could harm our business.
A breach of network security could delay or interrupt service to our customers
Our network may be vulnerable to unauthorized access, computer viruses and
other disruptive problems. 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
47
users, current and former employees and others. Unauthorized access could also
potentially jeopardize the security of confidential information stored in the
computer systems of our customers and the customers' end-users. This might
result in liability to our customers and also might deter potential customers.
We intend to implement security measures that are standard within the
telecommunications industry and newly developed security measures. We have not
done so yet and may not implement such measures in a timely manner. Moreover,
if and when implemented, such measures may be circumvented, and eliminating
computer viruses and alleviating other security problems may require
interruptions, delays or cessation of service to our customers and such
customers' end-users, which could harm our business.
Interference in the traditional telephone companies' copper plant could
degrade the performance of our services
Certain tests indicate that some types of DSL technology may cause
interference with, and be interfered with by other signals present in a
traditional telephone company's copper plant, usually with lines in close
proximity. In addition, as we continue to implement line sharing with the
traditional local telephone companies, our deployment of our ADSL data services
could interfere with the voice services of the traditional local telephone
companies carried over the same line or adjacent lines. If it occurs, such
interference could cause degradation of performance of our services or the
services of the traditional local telephone companies and render us unable to
offer our services on selected lines. The amount and extent of such
interference will depend on the condition of the traditional telephone
company's copper plant and the number and distribution of DSL and other signals
in such plant and cannot now be ascertained. When interference occurs, it is
difficult to detect.
In November 1999, the FCC established a loop spectrum policy designed to
facilitate the introduction of new loop technologies (such as new flavors of
xDSL) while at the same time minimizing interference. The FCC also established
a Network Reliability and Interoperability Council V (NRIC V), of which Covad
is a member, to recommend further policies and procedures in this regard. As a
result, the procedures to resolve interference issues between competitive
telecommunications companies and traditional telephone companies are still
being developed and may not be effective ultimately.
In the past we have agreed to and litigated interference resolution
procedures with certain traditional telephone companies. However, we may be
unable to successfully negotiate similar procedures with other traditional
telephone companies in future interconnection agreements or in renewals of
existing interconnection agreements and may be required to litigate these
issues. In addition, the failure of the traditional telephone companies to take
timely action to resolve interference issues could harm the provision of our
services. If our TeleSpeed and TeleSurfer services cause widespread network
degradation or are perceived to cause that type of interference, actions by the
traditional telephone companies or state or federal regulators could harm our
reputation, brand image, service quality, customer satisfaction and retention,
and overall business. Moreover, ostensible interference concerns have in the
past been, continue to currently and may in the future be used by the
traditional telephone companies as a pretext to delay the deployment of our
services and otherwise harm our business.
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.
48
Currently, we have been issued one patent 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 seek to design around or 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.
We must comply with federal and state 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, Common Carrier Regulatory
Fees and TRS Fund 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 relevant state commission
authorities. The FCC is currently considering the jurisdictional nature of
Internet service provider-bound traffic, as a result of a March 24, 2000
decision by the United States Court of Appeals for the D.C. Circuit related to
the jurisdictional nature of analog, dial-up traffic to the Internet. A change
in the characterization of their jurisdictions could cause our payment
obligations, pursuant to the relevant surcharges, to increase. In addition,
pursuant to periodic revisions by state and federal regulators of the
applicable surcharges, we may be subject to increases in the surcharges and
fees currently paid. 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.
ITEM 2. PROPERTIES
We are headquartered in Santa Clara, California in facilities under leases
that will expire beginning on or before January 31, 2005. We also lease office
space in many of the metropolitan statistical areas in which we conduct
operations. We also own our network operations center in Manassas, Virginia.
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 are closing 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. While the terms of these leases are perpetual, 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
We are engaged in a variety of negotiations, arbitrations and regulatory and
court proceedings with multiple traditional telephone companies. These
negotiations, arbitrations and proceedings concern the traditional telephone
companies' denial of physical central office space to us in certain central
offices, the cost and delivery of central office spaces, the delivery of
transmission facilities and telephone lines, billing issues and other
operational issues. In connection with the agreements with SBC Communications,
Inc. that we announced on September 11, 2000, we settled pending litigation
against SBC affiliates. This settlement also resolves our commercial
arbitration proceeding against Pacific Bell. Covad remains involved in certain
regulatory proceedings against SBC affiliates Pacific Bell, Southwestern Bell
and Ameritech.
49
Several of our shareholders have filed class action lawsuits against us, our
former president and Chief Executive Officer, Robert E. Knowling, and our
current executive vice president and Chief Financial Officer, Mark H. Perry.
These lawsuits were filed in the United States District Court for the Northern
District of California during the fourth quarter of 2000. The complaints in
these matters allege violations of federal securities laws on behalf of persons
who purchased our securities, including those who purchased common stock and
those who purchased convertible notes, during the periods from September 7,
2000 to October 17, 2000 or September 7, 2000 to November 14, 2000. The relief
sought includes monetary damages and equitable relief. In addition, during the
fourth quarter of 2000, six purchasers of the convertible notes have filed
complaints in California Superior Court for the County of Santa Clara. These
complaints allege fraud and deceit, negligence and violations of state
securities laws in connection with our convertible notes offering. The relief
sought includes rescission of their purchases of approximately $142 million in
aggregate principal amount of convertible notes and unspecified damages,
including punitive damages. Two of these plaintiffs, holding $48 million in
aggregate principal amount of the convertible notes, have dismissed their
complaints without prejudice. While we do believe that we have strong defenses
in these lawsuits, the ultimate outcome of these litigation matters is
inherently unpredictable and there is no guarantee we will prevail.
We also received a letter from a purported bondholder threatening to file a
lawsuit against our board of directors for breach of fiduciary duty if we do
not meet with them to discuss our prospects. We believe that we have strong
defenses to the threatened lawsuit, but the outcome of litigation is inherently
unpredictable and there is no guarantee we would prevail.
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. We also
recently filed a lawsuit against BellSouth Telecommunications and its
subsidiaries in the United States District Court for the Northern District of
Georgia. We are pursuing antitrust and other claims in this lawsuit arising out
of BellSouth's conduct as a supplier of network facilities, including central
office space, transmission facilities and telephone lines. Both BellSouth and
Verizon have asked the courts to dismiss Covad's cases on the basis of the
ruling of the Seventh Circuit in Goldwasser v. Ameritech, which dismissed a
consumer antitrust class action against Ameritech. Covad is opposing the
BellSouth and Verizon motions, and while we believe our position should
prevail, we cannot predict the outcome of these motions.
In addition, Verizon has separately filed suit against us in the United
States District Court for the Eastern District of Virginia, asserting
infringement of a patent issued to them in September 1998 entitled "Variable
Rate and Variable Mode Transmission System." However, on February 18, 2000 the
court issued a summary judgment ruling holding that we had not infringed
Verizon's patent. Verizon's appeal of that decision is currently pending in the
United States Court of Appeals for the Federal Circuit, and while we expect
that we will prevail on appeal, the outcome of such an appeal is inherently
uncertain.
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. 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 seeking an injunction to stop us from using the COVAD
trademark, as well as an award of monetary damages. We do not believe that
these claims have any merit, but the outcome of litigation is unpredictable and
we cannot guarantee that we will prevail.
We anticipate that some or all of the Laser Link shareholders will file
lawsuits against us seeking damages arising out of our alleged failure to
register the Covad shares that they received in exchange for their Laser Link
shares. We do not believe that these claims have any merit, but we cannot
guarantee we will prevail in these suits.
50
See "Item 1. Business--Customers" for a description of bankruptcy
proceedings of certain of our customers and the disposition of our lines that
remain in service with certain of these customers.
We are also a party to a variety of legal proceedings as either plaintiff or
defendant, or are engaged in business disputes that arise in the ordinary
course of business. We do not believe the ultimate outcome of these matters
will have a material impact on our financial condition or results of
operations.
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 are not currently engaged in any other
legal proceedings that we believe could have a material adverse effect on our
business, prospects, operating results and financial condition. We are,
however, subject to state commission, FCC and court decisions as they relate to
the interpretation and implementation of the 1996 Telecommunications Act, the
interpretation of competitive telecommunications company interconnection
agreements in general and our interconnection agreements in particular. In some
cases, we may be deemed to be bound or we may otherwise be significantly
impacted by the results of ongoing proceedings of these bodies or the legal
outcomes of other contested interconnection agreements that are similar to our
agreements. The results of any of these proceedings could harm our business.
In addition, we are engaged in a variety of negotiations, arbitrations and
regulatory proceedings with multiple traditional telephone companies. These
negotiations, arbitrations and regulatory proceedings concern the traditional
telephone companies' denial of physical central office space to us in certain
central offices, the cost and delivery of central office space, the delivery of
transmission facilities and telephone lines and other operational issues. In
connection with the agreements with SBC Communications, Inc. ("SBC") that were
announced on September 11, 2000, we settled pending litigation against certain
SBC affiliates. This settlement also resolved our commercial arbitration
proceeding against Pacific Bell. We remain involved in certain regulatory
proceedings against SBC affiliates Pacific Bell, Southwestern Bell, and
Ameritech. An unfavorable outcome in any of these negotiations, arbitrations
and regulatory proceedings could have a material adverse effect on our
consolidated financial position, results of operations and cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the quarter ended December 31, 2000, we did not submit any matters to
the vote of our security holders.
51
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 has been traded on the Nasdaq National Market under the
symbol "COVD" since January 22, 1999, the date of our initial public offering.
Prior to that time, there was no public market for our common stock. Due to the
delay in filing our Annual Report on Form 10-K for 2000, our common stock has
traded on the Nasdaq National Market under the symbol "COVDE" since April 23,
2001. The following table sets forth, for the period 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 March, 2000.
Fiscal Year Ended December 31, 1999 High Low
----------------------------------- ------ ------
First Quarter................................................. 31.67 18.00
Second Quarter................................................ 48.25 26.38
Third Quarter................................................. 45.00 24.83
Fourth Quarter................................................ 43.58 25.85
Fiscal Year Ended December 31, 2000 High Low
----------------------------------- ------ ------
First Quarter................................................. $66.25 $38.63
Second Quarter................................................ $45.75 $15.44
Third Quarter................................................. $23.06 $13.38
Fourth Quarter................................................ $12.00 $ 1.34
Fiscal Year Ending December 31, 2001
------------------------------------
First Quarter................................................. $ 4.72 $ 1.16
Second Quarter (through May 23, 2001)......................... $ 1.52 $ 0.75
On May 22, 2001, the last reported sale price for our common stock on the
Nasdaq National Market was $1.09 per share. As of May 18, 2001, there were
1,011 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 future
dividend policy will be determined by our Board of Directors. In addition, the
indentures relating to our outstanding indebtedness restrict our payment of
dividends.
52
ITEM 6. SELECTED FINANCIAL DATA
For the Year Ended December 31,
-----------------------------------------------
2000 1999 1998 1997
----------- ----------- ---------- ---------
(dollars in thousands, except per share
amounts)
Consolidated Statement of
Operations Data:
Revenues, net................ $ 158,736 $ 66,488 $ 5,326 $ 26
Depreciation and
amortization................ 178,425 37,602 3,406 70
Provision for restructuring
expenses.................... 4,988 -- -- --
Provision for long-lived
asset impairment............ 589,388 -- -- --
Loss from operations......... (1,354,192) (171,601) (37,682) (2,767)
Interest expense............. (109,863) (44,472) (15,217) (12)
Loss before cumulative effect
of change in accounting
principle................... (1,433,887) (195,397) (48,121) (2,612)
Cumulative effect of change
in accounting principle..... (9,249) -- -- --
Net loss..................... $(1,443,136) $ (195,397) $ (48,121) $ (2,612)
Basic and diluted loss per
common share before
cumulative effect of change
in accounting principle..... $ (9.41) $ (1.83) $ (3.75) $ (0.35)
Basic and diluted cumulative
effect of accounting change
per common share............ $ (0.06) $ -- $ -- $ --
Basic and diluted net loss
per common share............ $ (9.47) $ (1.83) $ (3.75) $ (0.35)
Weighted average common
shares used in computing
basic and diluted per share
amounts..................... 152,358,589 107,647,812 12,844,203 7,361,000
Pro forma amounts assuming
the accounting change is
applied retroactively:
Net Loss................. $(1,433,887) $ (204,646) $ (48,121) $ (2,612)
Net loss attributable to
common stockholders..... $(1,433,887) $ (205,792) $ (48,121) $ (2,612)
Basic and diluted net
loss per common share... $ (9.41) $ (1.91) $ (3.75) $ (0.35)
As of December 31,
-----------------------------------------------
2000 1999 1998 1997
----------- ----------- ---------- ---------
Consolidated Balance Sheet
Data:
Cash, cash equivalents and
short-term investments...... $ 869,834 $ 767,357 $ 64,450 $ 4,378
Net property and equipment... 338,409 186,059 59,145 3,014
Total assets................. 1,511,485 1,147,606 139,419 8,074
Long-term obligations,
including current portion... 1,374,673 375,050 142,879 783
Total stockholders' equity
(deficit)................... (182,663) 690,291 (24,706) 6,498
As of and for the Year Ended December 31,
-----------------------------------------------
2000 1999 1998 1997
----------- ----------- ---------- ---------
Other Operating and Financial
Data:
Homes and businesses passed.. 40,000,000 29,000,000 6,000,000 278,000
Lines installed.............. 274,000 57,000 4,000 26
Capital expenditures for
property and equipment...... $ 319,234 $ 174,054 $ 41,177 $ 1,617
53
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 involve 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."
Overview
We are a leading provider of high-speed Internet access and related
communications services which we sell to businesses and consumers directly or
indirectly through Internet service providers, telecommunications carriers and
other resellers. These services include a range of high-speed, high-capacity
gateways for connecting end-users to the Internet and corporate networks using
traditional copper telephone wiring. The technology that makes this possible is
commonly referred to as "digital subscriber line" or "DSL."
We sell our services directly to business and consumer end-users through our
direct and telephone sales force and our website. We also sell our services to
Internet service providers and telecommunications carriers, who resell our
services to their business and consumer end-users. Our other customers are
large companies with established brand names or other organizations that resell
our Internet access services.
We have a relatively short operating history because we were incorporated in
October 1996. We introduced our services commercially in the San Francisco Bay
Area in December 1997. As of March 31, 2001, we believe we have one of the
largest nationally deployed digital subscriber line networks based on our
approximately 1,800 operational central offices that pass more than 40 million
homes and businesses. As of March 31, 2001, we had approximately 319,000 high-
speed Internet access lines in service using digital subscriber line
technology. We have received orders for our services from more than 250
Internet service provider and telecommunications carrier customers. We also
provide dial-up Internet access service to over 400,000 customers through Covad
Integrated Services, our private label Internet service provider. We are also
developing a variety of services that are enhanced or enabled by our high-speed
network and we are entering into business arrangements in order to bring a
variety of additional service offerings to our customers and their end-users.
Since our inception, we have generated significant net losses and we
continue to experience negative operating cash flow. As of December 31, 2000,
we had an accumulated deficit of approximately $1.69 billion. We expect these
losses and negative cash flow to continue at least into 2003, requiring us to
raise additional capital. In addition we have limited cash reserves and
uncertainty exists concerning our ability to raise additional capital and
continue as a going concern.
Furthermore, we devoted substantial resources to the various internal
control weaknesses and accounting reviews described hereafter, which (i)
resulted in the restatement of our interim financial statements for each of the
three quarters in the period ended September 30, 2000 and (ii) delayed the
filing of our year-end financial results. As a result, the filing of our first
quarter Report on Form 10-Q for 2001 has been delayed as well.
During the year ending December 31, 2000, we acquired two companies,
LaserLink.net and BlueStar Communications Group, Inc. LaserLink was acquired by
issuing approximately 5 million common shares at an average market price of
$61.52 in exchange for all outstanding common shares of LaserLink. The Laser
Link subsidiary now does business as Covad Integrated Services. BlueStar was
acquired by issuing approximately 6.1 million shares at an average market price
of $14.23 in exchange for all outstanding preferred and common stock of
BlueStar. BlueStar is now a wholly-owned subsidiary that also does business as
Covad Business
54
Solutions ("BlueStar" or "CBS"). Additional information on these acquisitions
is available in Note 5 to the Consolidated Financial Statements.
We disaggregate our 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. Our wholesale division ("Wholesale") is
a provider of broadband communications services, which involve DSL technology,
to ISP, enterprise and telecommunications customers. Our Covad Integrated
Services ("CIS") division, formerly known as Laser Link, is a provider of
Internet access services to corporations and other organizations. Our Covad
Business Services ("CBS") division, formerly known as BlueStar, is a provider
of broadband communications and Internet services to small and medium-sized
businesses in Tier II and Tier III cities. Corporate operations represent
general corporate expenses, headquarters facilities and equipment,
investments, and other items not allocated to the segments.
We evaluate performance of the segments based on segment operating results.
Revenue Recognition and Change in Accounting Principle
See Note 1 to the accompanying financial statements for a discussion of our
revenue recognition policy.
We performed a review of the agreements and contracts between us and our
customers related to services provided in 2000. We confirmed these agreements
with our customers, recalculated the revenues based on the combined terms of
the agreements, and determined the propriety of our application of customer
payments. We also analyzed customer disputes and adjusted the timing of
related customer credits to coincide with the accounting period during which
the related revenue was recorded.
As a result of this review, revenues reported for the nine months ended
September 30, 2000 have been restated. Since the review confirmed that
controls needed to be strengthened, extensive efforts have been made to
provide additional controls. Although implementation is ongoing, we believe
the new control procedures will assure that revenue is recognized in
accordance with accounting principles generally accepted in the United States.
We also reviewed our incentive programs, including market development
funds. We concluded that certain market development funds recorded as
advertising expenses during the first three quarters of 2000 should be
classified as a reduction of revenue. This reclassification did not impact our
previously reported loss from operations or our net loss for the year ended
December 31, 2000.
During the fourth quarter of 2000, retroactive to January 1, 2000, we
changed our method of accounting for up-front fees associated with DSL service
activation and the related incremental direct costs in accordance with SEC
Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in Financial
Statements." Previously, we had recognized up-front fees as revenues upon
activation of DSL service. Under the new accounting method, which was adopted
retroactive to January 1, 2000, we now recognize up-front fees associated with
DSL service activation over the expected term of the customer relationship,
which is presently estimated to be 24 months, using the straight-line method.
Also as a result of the adoption of SAB No. 101, retroactive to January 1,
2000, we now treat the incremental direct costs of DSL 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 $9.2 million 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 $51.5 million ($0.33 per share).
For the year ended December 31, 2000, we
55
recognized approximately $18.7 million in revenue that was included in the
cumulative effect adjustment as of January 1, 2000. The effect of that revenue
during the year was to decrease net loss by $4.6 million. Although SAB 101
substantially alters the timing of recognition of certain revenues and
treatment of certain costs in our consolidated financial statements, it does
not affect our consolidated cash flows.
Internet Service Provider Resale Channel Difficulties
Some of our channel partners became delinquent in their payments to us and
failed to give us reasonable assurances of future payment. In the third and
fourth quarters of 2000, we only recognized revenue for these customers when
cash is received, after the collection of all previous outstanding accounts
receivable balances.
For the quarters ended September 30, 2000 and December 31, 2000, we billed
those customers approximately $21.8 million and $18.2 million, respectively,
which we did not recognize as revenue or accounts receivable.
In order to limit the adverse financial impact to Covad of these customers,
we have taken a series of actions including, but not limited, to the following:
We stopped taking new orders from some of these Internet service provider
customers, but continued to install and maintain previously accepted orders
from certain of them. We have terminated our contracts with some of these
Internet service provider customers who were unresponsive to our efforts to
maintain an on-going business relationship. While our goal is to maintain
consistent high quality service to end-users, we have also decided to
disconnect some end-users that are purchasing our services from delinquent
Internet service provider customers. Although we have successfully migrated
some of their lines to another channel partner or to our own network under the
Covad Safety Net program, there can be no assurance that these end-users will
continue to purchase our services from us or from another one of our Internet
service provider customers. Even if we are able to move these end-users to
other Internet service provider customers or to our network, it will require a
significant amount of our resources, which may impair our ability to install
new lines as they are ordered. Any of these circumstances could adversely
affect our business. We have also worked proactively to collect outstanding
amounts billed to these customers.
Based on our experience to this point, we expect to retain approximately 50%
of the lines that are with these customers and the remainder will be
disconnected.
Even though we are making progress in reducing the number of subscribers for
which we are not currently recognizing revenue, there is no assurance that we
will be able to completely restore the remaining lines to revenue producing
status or that we will not encounter future payment problems from our
customers.
Some of our distressed Internet service provider customers, including
Flashcom, Inc., Fastpoint Communications, Inc., Zyan Communications and Relay
Point, Inc., have filed for bankruptcy protection. It is likely that these
bankruptcies will impair our ability to collect the amounts owed to us and
constrain our ability to migrate these lines to other Internet service provider
customers or to our own network. We have been required to continue to provide
services to these Internet service providers during the pendancy of the
bankruptcy proceedings. The bankruptcy court ordered Zyan Communications to
prepay us for our future services on a weekly basis beginning in January 2001
and Zyan made those payments until March, 2001. For some Internet service
providers in bankruptcy proceedings, we have received bankruptcy court approval
to solicit their end-users and attempt to move them to another one of our
Internet service providers or to our own service.
However, in light of the financial position of many Internet service
providers, should a particular Internet service provider customer become
subject to reorganization or bankruptcy proceedings, no assurance can be given
that we will be able to collect payments owed to us or retain payments or other
consideration (including subscriber lines) already received by us.
56
International Investments
During 2000, Covad made international strategic investments in Dishnet
Limited Partnership ("Dishnet"), ACCA Networks ("ACCA"), and Loop Holdings Inc.
("Loop"), totaling $23 million, $11.7 million and $50 million, respectively.
Dishnet, ACCA and Loop are providers of DSL services in India, Japan and Spain.
All of these investments are accounted for using the equity method of
accounting.
In February 2000, we 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 million. In February 2000, we licensed our OSS software to
Dishnet and another entity for $28 million, $24 million of which was received
in cash on such date. We also agreed to provide support, customization and
training services relating to the OSS license up to an aggregate cost of
$2.5 million. We recorded $2.5 million of the OSS license proceeds received
from Dishnet as a liability and the remaining proceeds of $21.5 million have
been offset against capitalized internal use software costs. Any future
proceeds under the license agreement will be recorded under the cost recovery
method when received as a reduction of the Company's capitalized internal-use
software costs.
In August 2000, we acquired a 42% preferred equity interest in ACCA Networks
Co., Ltd. ("ACCA"), a privately held, development stage Japanese
telecommunications Company, in exchange for cash payments aggregating
approximately $11.7 million. In addition, in August 2000, we sold a license for
our OSS software to ACCA for $9 million, $2 million of which was received in
cash during 2000. The remainder is due in installments of $2 million in April
2001 and $5 million in December 2005. We may also receive certain royalty
payments from ACCA in the future under terms of the OSS license agreement. We
also agreed to provide support, customization and training services to ACCA
relating to the OSS license up to an aggregate cost of $2 million. We recorded
$2 million of the OSS license proceeds received from ACCA as a liability in
August 2000, and the remainder of such proceeds will be recorded under the cost
recovery method when received as a reduction of capitalized internal use
software costs.
In September 2000, we 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,
development stage Spanish telecommunications company. Consideration for the
acquisition of the capital stock of Loop Holdings consisted of $15 million in
cash and nonrecourse notes payable aggregating $35 million. In March 2001, we
declined to make the first scheduled payment of $15 million under the terms of
the nonrecourse notes payable. As a result, our indirect preferred equity
interest in Loop Telecom was diluted to 21% (a 21% voting interest) and its
obligations under the nonrecourse notes payable were released. We have netted
the nonrecourse notes payable aggregating $35 million against the equity
investment balance and we have written-off our initial $15 million investment
balance in Loop Holdings through a charge to operations in the fourth quarter
of 2000 due to uncertainties concerning the recoverability of such investment.
Results of Operations
Three Years Ended December 31, 2000
Revenues, net
We recorded net revenues of $158.7 million for the year ended December 31,
2000, $66.5 million for the year ended December 31, 1999, and $5.3 million for
the year ended December 31, 1998. The increase in revenues in all periods is
mainly attributable to growth in the number of customers and end-users
resulting from our increased sales and marketing efforts and the expansion of
our national network. We expect revenues to increase in future periods as we
add additional end-users, introduce new services and increase our sales and
marketing efforts. Revenues for the year ended December 31, 2000, were
comprised of $133.5 million from our wholesale channel, $19.4 million from
Covad Integrated Services (CIS) and $5.8 million from Covad Business Solutions
(CBS).
57
Network and Product Costs
We recorded network and product costs of $430.3 million for the year ended
December 31, 2000, $101.4 million for the year ended December 31, 1999, and
$15.8 million for the year ended December 31, 1998. The increase in network and
product costs in all periods is attributable to the expansion of our network
and increased orders resulting from sales and marketing efforts. We expect
network and product costs to increase significantly in future periods due to
increased sales activity and expected revenue growth.
Sales, Marketing, General and Administrative Expenses
Sales, marketing, general and administrative expenses were $294.8 million
for the year ended December 31, 2000, $96.1 million for the year ended December
31, 1999, and $23.5 million for the year ended December 31, 1998. Sales,
marketing, general and administrative expenses consist primarily of salaries,
expenses for the development of business, the development of corporate
identification, promotional and advertising materials, expenses for the
establishment of our management team, and sales commissions. The increase in
sales, marketing, general and administrative expense for all years is
attributable to growth in personnel in all areas and the continued expansion of
our sales and marketing efforts, deployment of our network, expansion of our
facilities and building of our operating infrastructure. In addition, in 1999,
sales, marketing, general and administrative expenses increased over 1998
primarily due to increased advertising. Sales, marketing, general and
administrative expenses are expected to increase in absolute terms, but
decrease as a percentage of revenue as we continue to grow our business.
Operating expenses, which include network and product costs and selling,
marketing, general and administrative expenses, for the year ended December 31,
2000, were comprised of $624.1 million from our wholesale channel, $15.5
million from CIS and $25.6 million from BlueStar.
Provision for Bad Debts
We recorded bad debt expenses of $11.3 million for the year ended December
31, 2000, $3.0 million for the year ended December 31, 1999 and $0.2 million
for the year ended December 31, 1998. Bad debt expense was 6.7%, 4.5% and 4.3%
of net revenue for the periods ending December 31, 2000, 1999 and 1998. The
increase in percentage is to account for the increased risk that some of our
resellers face in obtaining additional financing and our experiences from prior
periods.
Depreciation and Amortization of Property and Equipment
Depreciation and amortization include:
. depreciation of network costs and related equipment;
. depreciation of information systems, furniture and fixtures;
. amortization of improvements to central offices, regional data centers
and network operations center facilities and corporate facilities; and
. amortization of capitalized software costs.
Depreciation and amortization of property and equipment was approximately
$91.2 million for the year ended December 31, 2000, $27.9 million for the year
ended December 31, 1999, and $3.4 million for the year ended December 31, 1998.
The increase was due to the addition of equipment and facilities placed in
service throughout the year. We expect depreciation and amortization to
decrease in the short term due to the impairment write-down of long-lived
assets that was recorded in 2000.
Depreciation and amortization expenses for the year ended December 31, 2000,
were comprised of $79.4 million from our wholesale channel, $1.6 million from
CIS and $6.1 million from CBS.
58
Amortization of Intangible Assets
In January 1999, we recorded intangible assets of $28.7 million in
conjunction with the issuance of preferred stock at less than fair market value
to AT&T Ventures, NEXTLINK (now XO Communications) and Qwest Communications.
In connection with the Laser Link acquisition completed in the first quarter
of 2000, we recorded approximately $402.5 million of goodwill and other
intangible assets. In connection with the BlueStar acquisition completed in the
third quarter of 2000, we recorded approximately $149.6 million of goodwill and
other intangible assets. For both acquisitions, goodwill was determined based
on the residual difference between the amount paid for the acquired company and
the values assigned to identified tangible and intangible assets and
liabilities. As described in the "Provision for Long-Lived Asset Impairment"
section below, we have written off all goodwill and the majority of other
intangible assets previously recorded, including the amounts recorded at the
time of the acquisition of Laser Link and BlueStar. For the year ended December
31, 2000, the write-off of the goodwill and intangible assets results in a
charge of $483.0 million, which is included in the provision for long-lived
asset impairment.
Provision for Restructuring Expenses
In the fourth quarter of 2000, we announced our decision to reduce the
number of central offices in service and to take steps to reduce our costs.
These decisions were driven by changes in the external markets and based upon a
comprehensive review of internal operations. The plan includes the following
steps:
. closing approximately 200 under performing or not fully built out central
offices, holding the size of our network at approximately 1800 central
offices;
. reducing our workforce by approximately 638 employees, which represents
approximately 21% of our workforce;
. closing a facility in Alpharetta, Georgia and consolidating offices in
Manassas, Virginia, Santa Clara, California and Denver, Colorado;
. restructuring our BlueStar subsidiary to streamline our direct sales and
marketing channel; and
. evaluating and implementing other cost reduction strategies including
salary freezes and reductions in travel, facilities and advertising.
In connection with this restructuring plan, we recorded a charge to
operations of approximately $5.0 million in the fourth quarter of 2000 relating
to employee severance benefits that met the recording requirements for the year
ended December 31, 2000.
The Company expects to record additional restructuring expenses of
approximately $15 million during the first quarter of 2001. These expenses
consist principally of collocation and building lease termination costs that
did not meet the requirements for accrual as of December 31, 2000. Additional
expenses related to the restructuring may be incurred in future periods.
Provision for Long-Lived Asset Impairment
At the end of 2000, various indicators pointed to a possible impairment of
our long-lived assets. Such 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.
59
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
$589.4 million was recorded as of the fourth quarter of 2000, reflecting the
amount by which the carrying amount of certain long-lived assets exceed their
respective fair values. The write-down consisted of $390.6 million for
goodwill, $92.4 million for other intangible assets and $106.4 million 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. No impairment
write-downs of long-lived assets were recorded during 1999 and 1998.
Following the completion of our long-lived asset impairment analysis as of
December 31, 2000, we also re-evaluated the remaining estimated useful lives of
our long-lived assets, including intangibles. As a result, effective January 1,
2001, we are reducing 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 such that the residual balances
and any subsequent additions will be depreciated or amortized over five years.
Write-off of In-process Research & Development Costs
During the year ended December 31, 2000, we recorded an expense in the
amount of $3.7 million for the write-off of in-process research and development
("IPRD") costs that we obtained through the acquisition of Laser Link. There
were no write-offs of IPRD for the periods ending December 31, 1999 and
December 31, 1998.
Net Interest Expense
Net interest expense for the years ended December 31, 2000, 1999, and 1998
was $57.0 million, $23.8 million, and $10.4 million, respectively. Net interest
expense during these periods 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. Net interest
expense was partially offset by interest income earned on cash balances on hand
during the year.
We expect net interest expense to increase in 2002 due to the interest
expense attributable to our 2000 6% convertible notes due 2005 and to the
decreasing interest income generated by our cash as it is being used to fund
our operations.
Investment Losses
We recorded losses and write downs on investments for the period ending
December 31, 2000, in the amount of $35.9 million. This included impairment
write downs of equity investments of $17.8 million, our equity in the losses of
unconsolidated affiliates of $6.5 million and the recognition of other than
temporary losses on short-term investments of $11.6 million. We did not
recognize similar expenses for the years ending December 31, 1999 or December
31, 1998.
Income Taxes
We made no provision for taxes because we operated at a loss for the years
ended December 31, 2000, 1999, and 1998. As of December 31, 2000, we had net
operating loss carryforwards for federal tax purposes of approximately $785.0
million which will expire in the years 2011 through 2020, if not utilized. We
also had net operating losses carryforwards for state income tax purposes of
approximately $386.0 million which expire in the years 2004 through 2010, if
not utilized.
60
Realization of our deferred tax assets relating to net operating loss
carryforwards 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 by $411.7 million,
$8.3 million and $18.5 million during 2000, 1999 and 1998, respectively.
Preferred Dividends
We did not recognize any preferred dividends for the year ending December
31, 2000. The holders of preferred stock were entitled to receive dividends
payable in preference and priority to any payment of dividends on common stock.
The cumulative dividends at December 31, 1998, for preferred stock were
approximately $1.1 million, all of which were converted into 133,587 shares of
common stock in connection with our IPO in January 1999. For the year ended
December 31, 1999, this was recorded as a preferred dividend.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133. "Accounting for
Derivative Instruments and Hedging Activities." In June 2000, the FASB issued
SFAS No. 138, which amended SFAS No. 133 and postponed its effective date. SFAS
No. 133/138 establishes standards for reporting information about derivative
instruments and hedging activities, require that an entity recognize all
derivative instruments as either assets or liabilities in the statement of
financial position, and require that those instruments be measured at fair
value. We will be required to adopt SFAS No. 133/138 effective January 1, 2001.
We do not expect the adoption of SFAS No. 133/138 to have a material effect on
our consolidated financial position or results of operations.
Quarterly Financial Information (Unaudited)
In connection with our financial statement closing process for the year
ended December 31, 2000, we have restated our unaudited interim consolidated
financial statements for previously reported quarters in 2000. Management
believes that weaknesses in internal controls prompted these adjustments to
prior periods. The restated unaudited quarterly financial information depicted
below reflects prior period adjustments principally in the following areas: (i)
the treatment of a start-up fee associated with a customer contract,
(ii) customer billings, (iii) the treatment of certain Market Development Funds
payments and customer or vendor rebates, (iv) the treatment of certain labor
and other costs, (iv) inventory valuation adjustments (vi) the recognition of
certain liabilities and (vii) business acquisitions and unconsolidated equity
investments. The prior period adjustments resulted in (i) decreases in our
unaudited revenues of $21.1 million, $14.9 million and $16.8 million during the
three-month periods ended March 31, June 30 and September 30, 2000,
respectively, (ii) increases in our unaudited net loss of $29.0 million, $21.5
million and $51.5 million during the three-month periods ended March 31, June
30 and September 30, 2000, respectively, and (iii) increases in our unaudited
basic and diluted net loss per share of $0.20, $0.14 and $0.33 during the
three-month periods ended March 31, June 30 and September 30, 2000,
respectively.
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 DSL 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, 2000, we recognized approximately $4.8 million, $4.7 million, $4.6
million and $4.5 million 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
$1.2 million during each of those periods.
61
The Company's 2000 and 1999 unaudited consolidated quarterly financial
information, as previously reported and restated, is a follows (in thousands):
Three months ended
-----------------------------------------------------------------------------------
Previously Previously Previously
Reported Restated Reported Restated Reported Restated
March 31 March 31 June 30 June 30 September 30 September 30 December 31
---------- --------- ---------- --------- ------------ ------------ -----------
2000:
Revenues, net........... $ 41,807 $ 20,750 $ 58,160 $ 43,244 $ 56,341 $ 39,523 $ 55,219
Network and product
costs.................. $ 31,349 $ 66,008 $ 43,614 $ 88,891 $ 58,122 $ 129,818 $ 145,581
Sales, marketing,
general and
administrative......... $ 89,172 $ 52,757 $ 102,462 $ 64,917 $ 123,538 $ 89,311 $ 87,861
Provision for
restructuring
expenses............... -- -- -- -- -- -- $ 4,988
Provision for long-lived
asset impairment....... -- -- -- -- -- -- $ 589,388
Loss from operations.... $(100,681) $(188,311) $(133,029) $(152,720) $(179,617) $(229,046) $(854,115)
Loss before cumulative
effect of accounting
change................. $(107,225) $(127,010) $(131,478) $(153,021) $(194,836) $(246,344) $(907,512)
Cumulative effect of
accounting change...... -- $ (9,249) -- -- -- -- --
Net loss................ $(107,225) $(136,259) $(131,478) $(153,021) $(194,836) $(246,344) $(907,512)
Basic and diluted loss
per share:
Loss before cumulative
effect of accounting
change............... $ (0.73) $ (0.86) $ (0.86) $ (1.00) $ (1.25) $ (1.58) $ (5.40)
Cumulative effect of
accounting change.... $ -- $ (0.06) $ -- $ -- $ -- $ -- $ --
Net loss.............. $ (0.73) $ (0.93) $ (0.86) $ (1.00) $ (1.25) $ (1.58) $ (5.40)
1999:
Revenues, net........... $ 5,596 N/A $ 10,833 N/A $ 19,141 N/A $ 30,918
Network and product
costs.................. $ 9,729 N/A $ 18,849 N/A $ 30,039 N/A $ 42,827
Sales, marketing,
general and
administrative......... $ 14,342 N/A $ 17,361 N/A $ 24,424 N/A $ 39,961
Loss from operations.... $ (23,777) N/A $ (34,613) N/A $ (46,851) N/A $ (66,360)
Net Loss................ $ (28,904) N/A $ (41,852) N/A $ (54,105) N/A $ (70,536)
Preferred dividends..... $ (1,146) N/A -- N/A -- N/A --
Net loss attributable to
common stockholders.... $ (30,050) N/A $ (41,852) N/A $ (54,105) N/A $ (70,536)
Basic and diluted loss
per share.............. $ (0.37) N/A $ (0.41) N/A $ (0.47) N/A $ (0.53)
62
The following is a reconciliation of the unaudited 2000 quarterly net loss
amounts previously reported by us and the restated 2000 quarterly net loss
amounts depicted above (in thousands):
Three months ended
------------------------------------------------
March 31, June 30, September 30, December 31,
2000 2000 2000 2000
--------- --------- ------------- ------------
Net loss, as previously
reported (except for the
quarter ended December 31,
2000)....................... $(107,225) $(131,478) $(194,836) $(907,512)
Adjustments attributed to
specific quarters:(1)
Prior Period adjustments... (13,762) (4,857) (33,985) N/A
Cumulative effect of
accounting change......... (9,249) N/A N/A N/A
Adoption of SAB No. 101.... (6,023) (16,686) (17,523) N/A
--------- --------- --------- ---------
Net loss, as restated........ $(136,259) $(153,021) $(246,344) $(907,512)
========= ========= ========= =========
- --------
(1) Certain adjustments were allocated to quarters on a reasonable and rational
basis.
Our network and product costs have increased in every quarter, reflecting
costs associated with customer and end-user growth and the deployment of our
network in existing and new regions. Our selling, marketing, general and
administrative expenses have increased in every quarter and reflect sales and
marketing costs associated with the acquisition of customers and end-users,
including sales commissions, and the development of regional and corporate
infrastructure. In addition, certain costs, including certain labor and stock-
based compensation expenses, that do not change our previously reported net
loss have been reclassified to network and product costs from sales, marketing,
general and administrative expenses. Depreciation and amortization has
increased in each quarter, primarily reflecting the purchase of equipment
associated with the deployment of our networks. We have experienced increasing
net losses on a quarterly basis as we increased operating expenses and
increased depreciation as a result of increased capital expenditures, and we
expect to sustain quarterly losses for at least the next several years. See
"Item 1. Business--Risk Factors--We have a history of losses and expect
increasing 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 bankruptcy or other financial difficulties experienced by our
Internet service provider and other customers;
. our ability to collect "past-due" receivables from certain key
customers;
. receipt of timely payment from our Internet service providers and other
customers;
. the financial condition of 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;
. the rate at which traditional telephone companies can provide us
telephone wires over which we sell our service;
. 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;
. our ability to address control weaknesses identified during the year end
audit;
. decreases 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);
63
. the ability to develop and commercialize new services by us or our
competitors;
. the willingness, timing and ability of traditional telephone companies
to provide us with central office space;
. the amount and timing of capital expenditures and other costs relating
to the expansion of our network, our network capacity and new service
offerings;
. the impact of regulatory developments, including interpretations of the
1996 Telecommunications Act;
. delays in the commencement of operations in new regions and the
generation of revenue because certain network elements have lead times
that are controlled by traditional telephone companies and other third
parties;
. our ability to raise additional capital;
. and the absence of an adverse result in the shareholder and noteholder
litigation.
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 cages, the design,
creation, implementation and maintenance of our Operational Support System, the
purchase of telecommunications equipment and the design and development of our
networks. Capital expenditures were approximately $319.2 million for the year
ending December 31, 2000. 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 less in
future periods while capital expenditures related to the addition of
subscribers in existing regions will increase proportionately in relation to
the number of new subscribers that we add.
From our inception through December 31, 2000, we financed our operations
primarily through private placements of $220.6 million of equity securities,
$1,232 million in net proceeds raised from the issuance of the notes, and $719
million in net proceeds raised from public equity offerings. As of December 31,
2000, we had an accumulated deficit of $1.7 billion, and cash, cash
equivalents, and short-term investments of $869.8 million. In addition, we had
a net capital deficiency as of December 31, 2000 of $182.7 million.
Net cash used in our operating activities was $496.5 million for the year
ended December 31, 2000. The net cash used for operating activities during this
period was primarily due to the net losses of $1.4 billion, increases in assets
of $76.4 million, offset by non-cash expenses of $840.6 million that included
$11.3 million provisions for bad debts, $178.4 million for depreciation and
amortization, $594.4 million for restructuring and asset impairment, $9.2
million for the cumulative effect of SAB 101 and $26.2 million of other
expenses. Additionally, accounts payable, other current liabilities and
unearned revenue increased by $173.3 million.
Net cash used in our investing activities was $185.7 million for the year
ended December 31, 2000. The net cash used for investing activities during this
period was primarily due to purchases of property and equipment of $319.2
million, the acquisition of businesses and equity investments of $51.3 million,
payment of collocation fees of $25.0 million, recovery of internal use software
costs of $21.5 million and the net proceeds received from the sale of
investments of $159.2 million.
Net cash provided by financing activities for the year ended December 31,
2000 was $1.0 billion, which primarily related to the net proceeds of $413.3
million from the issuance of the 2000 notes with an aggregate principal amount
of $425.0 million, $484.4 million from the issuance of the convertible notes
with an aggregate principal amount of $500.0 million and $150.0 million in net
proceeds from our agreement with SBC to take a minority ownership position in
us.
64
We expect to experience substantial negative cash flow from operating and
investing activities for at least the next two years due to continued
development, commercial deployment and addition of new end-users to our
networks. We may also make investments in and acquisitions of businesses that
are complementary to ours to support the growth of our business. Our future
cash requirements for developing, deploying and enhancing our networks and
operating our business, as well as our revenues, will depend on a number of
factors including:
. the rate at which customers and end-users purchase and pay for our
services and the pricing of such services;
. the financial condition of our customers;
. the level of marketing required to acquire and retain customers and to
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 debt or equity financing on
favorable terms or at all, in order to finance such an acquisition or
investment.
We believe that our current cash, cash equivalents and short-term
investments, will be sufficient to meet our anticipated cash needs for working
capital and capital expenditures into the second quarter of 2002. An adverse
judgment in the securities litigation, noteholder litigation or other adverse
business, legal, regulatory or legislative development would accelerate the
time at which we would need additional financing. If necessary, we will develop
a contingency plan to address any material adverse developments arising in the
securities litigation. We also recognize that we will be required to raise this
additional capital, at times and in amounts which are uncertain, 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 restructuring, sale or liquidation of
our company.
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:
. expectations regarding the extent to which enterprise customers roll out
our service;
. expectations regarding our relationships with our strategic partners and
other potential third parties;
65
. expectations as to pricing for our services in the future;
. expectations as to the impact of our service offerings on our margins;
. the possibility that we may obtain significantly increased sales volumes;
. the impact of our national advertising campaign 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 our monthly burn rate and the number of installed
lines;
. expectations regarding the time frames, rates, terms and conditions for
implementing "line sharing;"
. plans to develop and commercialize value-added services;
. projections of the amount of additional capital required to fund our
business and the sufficiency of our current cash to meet our future
needs;
. our anticipated capital expenditures;
. plans to enter into business arrangements with broadband-related service
providers;
. expectations regarding the development and commencement of our voice
services;
. our plans to expand our existing networks or to commence service in new
metropolitan statistical areas;
. estimates regarding the timing of launching our service in new
metropolitan statistical areas;
. our ability to manage our relations with our bondholders;
. the effect of regulatory reform and the securities and regulatory
litigation;
. the effect of other 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:
. collect receivables from certain key customers;
. retain end-users that are serviced by delinquent Internet service
provider customers;
. successfully market our services to current and new customers;
. generate customer demand for our services in the particular regions where
we plan to market services;
. successfully defend our company against certain pending litigation;
. successfully reduce our operating costs and overhead in light of the
financial circumstances of many of our Internet service provider
customers while continuing to provide good customer service;
. successfully continue to increase the number of business-grade lines;
. achieve favorable pricing for our services;
. respond to increasing competition;
. manage growth of our operations; and
. access regions and negotiate suitable interconnection agreements with the
traditional telephone companies, all in a timely manner, at reasonable
costs and on satisfactory terms and conditions consistent with
regulatory, legislative and judicial developments.
66
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, substantially all of our outstanding indebtedness as of
March 31, 2001, including our 1998 notes, our 1999 notes, our 2000 notes and
our convertible notes, is fixed-rate debt.
67
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
68
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, 2000 and 1999, and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the three years in the period ended December 31, 2000. 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, 2000 and 1999, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 2000, in conformity with accounting principles
generally accepted in the United States.
The accompanying consolidated financial statements have been prepared
assuming that Covad Communications Group, Inc. will continue as a going
concern. As more fully described in Note 1 to the consolidated financial
statements, the Company has incurred recurring operating losses and negative
cash flows from operating and investing activities and it has a stockholders'
deficit as of December 31, 2000. In addition, a number of the Company's
customers have experienced financial difficulties and certain of them have
filed for bankruptcy protection. Furthermore, several of the Company's
stockholders and purchasers of its convertible notes have filed lawsuits
against the Company and certain of its current and former officers alleging
violations of federal and state securities laws. The relief sought in these
lawsuits includes rescission of certain convertible note sales completed by the
Company in September 2000 and unspecified damages. Additionally, subsequent to
December 31, 2000, the Company has received two notices of default relating to
its lack of compliance with a covenant contained in one of its senior note
indentures. These conditions raise substantial doubt about the Company's
ability to continue as a going concern. Management's plans in regard to these
matters are described in Notes 3, 6 and 9 to the consolidated financial
statements. The consolidated financial statements do not include any
adjustments to reflect the possible future effects on the recoverability and
classification of assets or the amounts and classification of liabilities that
may result from the outcome of this uncertainty.
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
May 23, 2001
69
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share and per share amounts)
December 31,
-----------------------
2000 1999
----------- ----------
ASSETS
Current assets:
Cash and cash equivalents............................ $ 558,440 $ 216,038
Short-term investments............................... 311,394 551,319
Restricted cash and investments...................... 27,748 27,112
Accounts receivable, net of allowances of $13,864 at
December 31, 2000 ($2,057 at December 31, 1999)..... 26,877 15,392
Unbilled revenues.................................... 7,246 5,419
Other receivables.................................... 6,389 1,219
Inventories.......................................... 14,221 8,547
Prepaid expenses and other current assets............ 5,884 6,047
----------- ----------
Total current assets............................... 958,199 831,093
Property and equipment, net........................... 338,409 186,059
Intangible assets, net................................ 74,888 72,152
Restricted investments................................ 12,722 36,512
Investments in unconsolidated affiliates.............. 30,347 --
Deferred costs of service activation.................. 52,831 --
Deferred debt issuance costs.......................... 36,890 12,369
Other long-term assets................................ 7,199 9,421
----------- ----------
Total assets....................................... $ 1,511,485 $1,147,606
=========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current Liabilities:
Current portion of long-term debt.................... $ 43,735 $ --
Current portion of capital lease obligations......... 2,566 268
Accounts payable..................................... 72,896 19,539
Accrued collocation and network service fees......... 39,910 8,898
Accrued interest..................................... 38,706 10,979
Accrued market development funds..................... 13,860 4,442
Accrued restructuring expenses....................... 3,980 --
Other accrued liabilities............................ 64,203 33,170
----------- ----------
Total current liabilities.......................... 279,856 77,296
Long-term debt, net of discount of $10,227 at December
31, 2000 ($11,321 at December 31, 1999).............. 1,324,704 374,738
Long-term portion of capital lease obligations........ 3,668 44
Unearned revenue and other............................ 85,920 5,237
----------- ----------
Total liabilities.................................. 1,694,148 457,315
Commitments and contingencies
Stockholders' Equity (Deficit):
Preferred stock, $0.001 par value; 5,000,000 shares
authorized; no shares issued and outstanding at
December 31, 2000 and 1999.......................... -- --
Common Stock, $0.001 par value; 590,000,000 shares
authorized; 171,937,452 shares issued and
outstanding at December 31, 2000 (132,331,316
shares issued and outstanding at December 31,
1999)............................................... 172 133
Common Stock--Class B, $0.001 par value; 10,000,000
shares authorized; no shares issued and outstanding
at December 31, 2000 (6,379,177 shares issued and
outstanding at December 31, 1999)................... -- 6
Additional paid-in capital........................... 1,509,365 851,538
Deferred stock-based compensation.................... (3,067) (6,513)
Notes receivable from stockholders................... (423) --
Accumulated other comprehensive income............... 556 91,257
Accumulated deficit.................................. (1,689,266) (246,130)
----------- ----------
Total stockholders' equity (deficit)............... (182,663) 690,291
----------- ----------
Total liabilities and stockholders' equity
(deficit)......................................... $ 1,511,485 $1,147,606
=========== ==========
See accompanying notes.
70
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except share and per share amounts)
Year ended December 31,
------------------------------------
2000 1999 1998
----------- ----------- ----------
Revenues, net........................... $ 158,736 $ 66,488 $ 5,326
Operating expenses:
Network and product costs............. 430,298 101,445 15,842
Sales, marketing, general and
administrative....................... 294,846 96,086 23,529
Provision for bad debts............... 11,257 2,956 231
Depreciation and amortization of
property and equipment............... 91,205 27,888 3,342
Amortization of intangible assets..... 87,220 9,714 64
Provision for restructuring expenses.. 4,988 -- --
Provision for long-lived asset
impairment........................... 589,388 -- --
Write-off of in-process research and
developments costs................... 3,726 -- --
----------- ----------- ----------
Total operating expenses............ 1,512,928 238,089 43,008
----------- ----------- ----------
Loss from operations.................... (1,354,192) (171,601) (37,682)
Other income (expense):
Interest income....................... 52,901 20,676 4,778
Realized gain on short-term
investments.......................... 13,466 -- --
Other than temporary losses on short-
term investments..................... (11,579) -- --
Impairment write-down of other equity
investments.......................... (17,826) -- --
Equity in losses of unconsolidated
affiliates........................... (6,452) -- --
Interest expense...................... (109,863) (44,472) (15,217)
Miscellaneous income, net............. (342) -- --
----------- ----------- ----------
Other (expense) income, net........... (79,695) (23,796) (10,439)
----------- ----------- ----------
Loss before cumulative effect of change
in accounting principle................ (1,433,887) (195,397) (48,121)
Cumulative effect of change in
accounting principle................... (9,249) -- --
----------- ----------- ----------
Net loss................................ (1,443,136) (195,397) (48,121)
Preferred dividends..................... -- (1,146) --
----------- ----------- ----------
Net loss attributable to common
stockholders........................... $(1,443,136) $ (196,543) $ (48,121)
=========== =========== ==========
Basic and diluted loss per common share
before cumulative effect of change in
accounting principle................... $ (9.41) $ (1.83) $ (3.75)
=========== =========== ==========
Basic and diluted cumulative effect of
accounting change per common share..... $ (0.06) $ -- $ --
=========== =========== ==========
Basic and diluted net loss per common
share.................................. $ (9.47) $ (1.83) $ (3.75)
=========== =========== ==========
Weighted average common shares used in
computing basic and diluted per share
amounts................................ 152,358,589 107,647,812 12,844,203
=========== =========== ==========
Pro forma amounts assuming the
accounting change is applied
retroactively:
Net Loss............................ $(1,433,887) $ (204,646) $ (48,121)
=========== =========== ==========
Net loss attributable to common
stockholders....................... $(1,433,887) $ (205,792) $ (48,121)
=========== =========== ==========
Basic and diluted net loss per
common share....................... $ (9.41) $ (1.91) $ (3.75)
=========== =========== ==========
See accompanying notes.
71
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(Amounts in thousands, except share amounts)
Convertible Notes Accumulated
Preferred Stock Common Stock Additional Deferred Receivable Other
------------------- ------------------- Paid-In Stock-Based From Comprehensive Accumulated
Shares Amount Shares Amount Capital Compensation Stockholders Income (Loss) Deficit
----------- ------ ----------- ------ ---------- ------------ ------------ ------------- -----------
Balances at
December 31,
1997 ........... 26,625,002 $ 18 25,562,709 $ 26 $ 9,677 $ (611) $ -- $ -- $ (2,612)
Issuance of
common stock ... -- -- 928,785 1 570 -- -- -- --
Issuance of
Series B
preferred stock
................ 150,003 -- -- -- 100 -- -- -- --
Issuance of
Series C
preferred stock
................ 594,238 -- -- -- 1,100 -- -- -- --
Issuance of
common stock
warrants as part
of debt offering
issuance costs
................ -- -- -- -- 2,928 -- -- -- --
Issuance of
common stock
warrants
pursuant to debt
offering ....... -- -- -- -- 8,221 -- -- -- --
Deferred stock-
based
compensation ... -- -- -- -- 8,074 (8,074) -- -- --
Amortization of
deferred stock-
based
compensation ... -- -- -- -- -- 3,997 -- -- --
Net loss ....... -- -- -- -- -- -- -- -- (48,121)
----------- ---- ----------- ---- ---------- ------- ----- ------- -----------
Balances at
December 31,
1998............ 27,369,243 18 26,491,494 27 30,670 (4,688) -- -- (50,733)
Issuance of
common stock.... -- -- 48,999,989 49 725,692 -- -- -- --
Issuance of
common stock
upon exercise of
warrants........ -- -- 15,652,382 16 (11) -- -- -- --
Issuance of
Series C and D
preferred
stock........... 9,568,766 6 -- -- 59,994 -- -- -- --
Deferred charge
related to
issuance of
Series C and D
preferred
stock........... -- -- -- -- 28,700 -- -- -- --
Conversion of
Series A, Series
B and Series C
preferred stock
to common
stock........... (27,369,243) (18) 41,053,864 41 (23) -- -- -- --
Conversion of
Series C1 and D1
preferred
stock........... (9,568,766) (6) 6,379,177 6 -- -- -- -- --
Preferred
dividends....... -- -- 133,587 -- (77) -- -- -- --
Conversion of
convertible
preferred
stock........... -- -- -- -- -- -- -- -- --
Deferred stock-
based
compensation.... -- -- -- -- 6,593 (6,593) -- -- --
Amortization of
deferred stock-
based
compensation.... -- -- -- -- -- 4,768 -- -- --
Unrealized gains
on investments.. -- -- -- -- -- -- -- 91,257 --
Net loss........ -- -- -- -- -- -- -- -- (195,397)
----------- ---- ----------- ---- ---------- ------- ----- ------- -----------
Balances at
December 31,
1999............ -- -- 138,710,493 139 851,538 (6,513) -- 91,257 (246,130)
Issuance of
common stock.... -- -- 18,101,646 18 155,385 -- -- -- --
Issuance of
common stock
upon exercise of
options......... -- -- 5,461,935 5 12,080 -- -- -- --
Issuance of
common stock for
acquisitions of
businesses...... -- -- 11,097,753 11 480,645 (407) -- -- --
Repurchase of
common stock.... -- -- (1,434,375) (1) -- -- -- --
Issuance of
warrants........ -- -- -- -- 9,089 -- -- -- --
Assumption of
notes receivable
from
stockholders in
connection with
business
acquisitions.... -- -- -- -- -- -- (423) -- --
Deferred stock-
based
compensation.... -- -- -- -- 628 (628) -- -- --
Amortization of
deferred stock-
based
compensation.... -- -- -- -- -- 4,481 -- -- --
Unrealized
losses on
available-for-
sale
securities...... -- -- -- -- -- -- -- (88,985) --
Foreign currency
translation..... -- -- -- -- -- -- -- (1,716) --
Net loss........ -- -- -- -- -- -- -- -- (1,443,136)
----------- ---- ----------- ---- ---------- ------- ----- ------- -----------
Balances at
December 31,
2000............ -- -- 171,937,452 $172 $1,509,365 $(3,067) $(423) $ 556 $(1,689,266)
=========== ==== =========== ==== ========== ======= ===== ======= ===========
Total
Stockholders'
Equity
(Deficit)
-------------
Balances at
December 31,
1997 ........... $ 6,498
Issuance of
common stock ... 571
Issuance of
Series B
preferred stock
................ 100
Issuance of
Series C
preferred stock
................ 1,100
Issuance of
common stock
warrants as part
of debt offering
issuance costs
................ 2,928
Issuance of
common stock
warrants
pursuant to debt
offering ....... 8,221
Deferred stock-
based
compensation ... --
Amortization of
deferred stock-
based
compensation ... 3,997
Net loss ....... (48,121)
-------------
Balances at
December 31,
1998............ (24,706)
Issuance of
common stock.... 725,741
Issuance of
common stock
upon exercise of
warrants........ 5
Issuance of
Series C and D
preferred
stock........... 60,000
Deferred charge
related to
issuance of
Series C and D
preferred
stock........... 28,700
Conversion of
Series A, Series
B and Series C
preferred stock
to common
stock........... --
Conversion of
Series C1 and D1
preferred
stock........... --
Preferred
dividends....... (77)
Conversion of
convertible
preferred
stock........... --
Deferred stock-
based
compensation.... --
Amortization of
deferred stock-
based
compensation.... 4,768
Unrealized gains
on investments.. 91,257
Net loss........ (195,397)
-------------
Balances at
December 31,
1999............ 690,291
Issuance of
common stock.... 155,403
Issuance of
common stock
upon exercise of
options......... 12,085
Issuance of
common stock for
acquisitions of
businesses...... 480,249
Repurchase of
common stock.... (1)
Issuance of
warrants........ 9,089
Assumption of
notes receivable
from
stockholders in
connection with
business
acquisitions.... (423)
Deferred stock-
based
compensation.... --
Amortization of
deferred stock-
based
compensation.... 4,481
Unrealized
losses on
available-for-
sale
securities...... (88,985)
Foreign currency
translation..... (1,716)
Net loss........ (1,443,136)
-------------
Balances at
December 31,
2000............ $ (182,663)
=============
See accompanying notes.
72
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
Year ended December 31,
--------------------------------
2000 1999 1998
----------- --------- --------
Operating Activities:
Net loss..................................... $(1,443,136) $(195,397) $(48,121)
Adjustments to reconcile net loss to net cash
used in operating activities:
Provision for bad debts.................... 11,257 2,956 231
Depreciation and amortization.............. 178,425 37,602 3,406
Loss on disposition of equipment........... 524 358 --
Provision for restructuring expenses....... 4,988 -- --
Provision for long-lived asset impairment.. 589,388 -- --
Write-off of in-process research and
development costs......................... 3,726 -- --
Amortization of deferred stock-based
compensation.............................. 4,481 4,768 3,997
Issuance of warrants....................... 9,089 -- --
Accretion of interest on investments....... (25,093) (6,240) --
Accretion of debt discount and amortization
of deferred debt issuance costs........... 27,826 20,269 16,009
Other than temporary losses on short-term
investments............................... 11,579 -- --
Impairment write-down of other equity
investments............................... 17,826 -- --
Equity in losses of unconsolidated
affiliates................................ 6,452 -- --
Cumulative effect of change in accounting
principle................................. 9,249 -- --
Net changes in operating assets and
liabilities:
Restricted cash........................... (635) (565) (225)
Accounts receivable....................... (18,932) (16,416) (2,139)
Unbilled revenue.......................... (1,827) (4,756) (659)
Inventories............................... (5,662) (7,601) (903)
Prepaid expenses and other current
assets................................... 3,534 (5,005) (1,103)
Deferred costs of service activation...... (52,831) -- --
Accounts payable.......................... 41,047 5,815 14,324
Other current liabilities................. 51,773 50,518 5,585
Unearned revenue and other................ 80,459 4,687 544
----------- --------- --------
Net cash used in operating activities... (496,493) (109,007) (9,054)
Investing Activities:
Cash acquired through business acquisitions.. 4,330 -- --
Purchase of short-term investments........... (613,307) (558,212) --
Maturities of short-term investments......... 679,615 104,390 --
Sale of short-term investments............... 92,917 -- --
Purchase of restricted investments........... -- (73,435) (15)
Redemption of restricted investments......... 26,875 13,214 --
Purchase of property and equipment........... (319,234) (174,054) (41,177)
Recovery of internal-use software costs...... 21,500 -- --
Payment of collocation fees.................. (25,038) (34,132) (18,326)
Acquisition of equity investments in
unconsolidated affiliates................... (51,341) -- --
Purchase of other long-term assets........... (2,053) (7,627) (1,734)
----------- --------- --------
Net cash used in investing activities........ (185,736) (729,856) (61,252)
Financing Activities:
Repayment of long-term debt.................. (5,457) -- --
Proceeds from issuance of long-term debt and
warrants, net............................... 897,619 205,049 129,328
Principal payments under capital lease
obligations................................. (2,347) (267) (238)
Proceeds from common stock issuance, net of
repurchase.................................. 167,487 725,746 571
Proceeds from preferred stock issuance....... -- 60,000 1,200
Payment on short-term borrowings and line of
credit...................................... (32,900) -- --
Payment of long-term debt and common stock
offering costs.............................. -- -- (483)
Payment of preferred dividends............... -- (77) --
----------- --------- --------
Net cash provided by financing activities.... 1,024,402 990,451 130,378
Effect of foreign currency translation on
cash and cash equivalents................... 229 -- --
----------- --------- --------
Net increase in cash and cash equivalents.... 342,402 151,588 60,072
Cash and cash equivalents at beginning of
year........................................ 216,038 64,450 4,378
----------- --------- --------
Cash and cash equivalents at end of year..... $ 558,440 $ 216,038 $ 64,450
=========== ========= ========
73
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS--(Continued)
(Amounts in thousands)
Year ended December 31,
-----------------------
2000 1999 1998
-------- ------- ------
Supplemental Disclosures of Cash Flow Information:
Cash paid during the year for interest, net of amounts
capitalized ($2,490, $2,757 and $908 in 2000, 1999
and 1998, respectively).............................. $ 77,816 $13,257 $ 99
======== ======= ======
Supplemental Schedule of Non-Cash Investing and
Financing Activities:
Common stock issued for preferred dividends........... $ -- $ 1,069 $ --
======== ======= ======
Issuance of common stock for acquisitions of
businesses........................................... $480,655 $ -- $ --
======== ======= ======
Equipment purchased through capital leases............ $ 955 $ -- $ 34
======== ======= ======
Warrants issued to purchase common stock.............. $ 9,089 $ -- $2,928
======== ======= ======
See accompanying notes.
74
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2000, 1999 and 1998
1. Nature of Operations and Summary of Significant Accounting Policies
Organization, Business and Basis of Presentation
Organization and Business
Covad Communications Group, Inc. (the "Company") is a provider of broadband
communications services, which involve digital subscriber line ("DSL")
technology, to Internet Service Provider ("ISP"), enterprise and
telecommunications customers. ISPs and telecommunications carriers purchase the
Company's services in order to provide high-speed Internet access to their
business and consumer end-users. Enterprise customers purchase the Company's
services to provide employees with remote access to their Local Area Networks
to improve employee productivity and reduce operating costs. The Company's
services are provided over standard copper telephone lines at considerably
faster speeds than available through a standard modem.
Basis of Presentation
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.
The consolidated financial statements have been prepared assuming that the
Company will continue as a going concern. The Company has incurred recurring
operating losses and negative cash flows from operating and investing
activities and it has a stockholders' deficit as of December 31, 2000. In
addition, as disclosed in Note 2, a number of the Company's ISP customers have
experienced financial difficulties and certain of them have filed for
bankruptcy protection. Furthermore, as disclosed in Note 9, several of the
Company's shareholders and purchasers of its convertible notes have filed
lawsuits against the Company and certain of its current and former officers in
2000 alleging violations of federal and state securities laws. The relief
sought in these lawsuits includes rescission of certain convertible note sales
completed by the Company in September 2000 and unspecified damages.
Furthermore, subsequent to December 31, 2000, the Company has received a notice
of default delivered on April 2, 2001, based on its failure to file its annual
report on Form 10-K for the fiscal year 2000 in a timely fashion, and a notice
of default delivered on May 17, 2001, based on its failure to file its
quarterly report on Form 10-Q for the first fiscal quarter of 2001 in a timely
fashion, in each case, as required by its 2000 convertible notes indenture.
These conditions raise substantial doubt about the Company's ability to
continue as a going concern. Management's plans in regard to these matters are
described in Notes 3, 6 and 9. The consolidated financial statements do not
include any adjustments to reflect the possible future effects on the
recoverability and classification of assets or the amounts and classification
of liabilities that may result from the outcome of this uncertainty.
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.
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, 2000 and 1999, cash equivalents
75
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 have 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 (deficit). 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 consist of the following (in thousands):
December 31, 2000
----------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- --------
U.S. Government agency
securities....................... $283,884 $ 239 $ (2) $284,121
Commercial paper and corporate
notes............................ 14,935 -- (8) 14,927
Marketable equity securities...... 10,303 2,043 -- 12,346
-------- ------- ----- --------
Total available-for-sale
securities..................... $309,122 $ 2,282 $ (10) $311,394
======== ======= ===== ========
December 31, 1999
----------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- --------
Commercial paper and corporate
notes............................ $426,774 $ 125 $(596) $426,303
Marketable equity securities...... 32,200 92,816 -- 125,016
-------- ------- ----- --------
Total available-for-sale
securities..................... $458,974 $92,941 $(596) $551,319
======== ======= ===== ========
Restricted Investments
As of December 31, 2000 and 1999, the Company held $39,036,000 and
$62,832,000, respectively, in U.S. Treasury securities and $1,434,000 and
$792,000 in money market mutual funds, respectively, for the payment of
interest on the Company's 1999 Notes and other purposes.
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 $17,826,000 during the year ended December 31, 2000
related to impairments of its privately held investments. No impairment losses
were recognized in fiscal 1999 or 1998.
76
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 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 year ended December
31, 2000, the Company recognized other than temporary losses on certain
available- for-sale securities aggregating $11,579,000. No such losses were
recognized in fiscal 1999 or 1998.
The Company conducts business primarily with ISP, enterprise and
telecommunications customers in the United States. As more fully described in
Note 2, certain of the Company's ISP customers were experiencing financial
difficulties as of December 31, 2000 and were not current in their payments for
the Company's services at that date. The Company performs ongoing credit
evaluations of its customers' financial condition and generally does not
require collateral. Allowances are maintained for estimated credit losses.
During the years ended December 31, 2000, 1999 and 1998, the Company wrote-off
certain accounts receivable balances aggregating $175,000, $1,138,000, and
$11,000 respectively, against the allowance for credit losses.
For the year ended December 31, 1999, two customers accounted for 14% and
13%, respectively, of the Company's total revenues. As of December 31, 1999,
receivables from such customers comprised 9.2% and 8.9%, respectively, of the
Company's gross accounts receivable balance. The Company had no significant
customers in 2000 and 1998.
The Company's interim chief executive officer, who is also a member of the
Company's board of directors, is a minority stockholder and former member of
the board of directors of one of the Company's ISP customers. The Company
recognized revenues of $7,189,000, $2,135,000 and $29,000 related to this
customer during the years ended December 31, 2000, 1999 and 1998, respectively.
Accounts receivable from this customer amounted to $1,375,000 and $370,000 as
of December 31, 2000 and 1999, respectively.
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. In addition, the Company believes
that there are alternative suppliers for the equipment used to provide its
services. 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 purchased equipment from a supplier that was partially owned by
a stockholder of the Company. Purchases from this supplier totaled $45,695,000
and $5,844,000 for the years ended December 31, 1999 and 1998, respectively.
During 1999, an unrelated party acquired this supplier. In addition, the
Company acquired an equity interest in a new supplier during 1999. Purchases
from this new supplier totaled $54,538,000 and $3,401,000 for the years ended
December 31, 2000 and 1999, respectively.
Inventories
Inventories, consisting primarily of customer premises equipment, are stated
at the lower of cost, determined on the "first-in, first-out" method, or
market.
77
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 (Note 4):
Building.............. 10 years
Leasehold
improvements......... 10 years or the term of the lease, whichever is less
Computer equipment.... 2 to 7 years
Computer software..... 3 to 5 years
Furniture and
fixtures............. 2 to 7 years
Networks and
communication
equipment............ 2 to 15 years
The Company incurs significant costs associated with internal use software,
which consists principally of the Company's operations support system ("OSS")
software and web site. The Company charges to expense as incurred the costs of
research, including pre-development efforts related to determining
technological or product alternatives, and costs incurred for training and
maintenance. Software and web site development costs, which include direct
costs such as labor and contractors, are capitalized when it is probable that
the project will be completed and the software or web site will be used as
intended. Costs incurred for upgrades and enhancements to the Company's
software or web site are capitalized when it is probable that such efforts will
result in additional functionality. Capitalized software and web site costs are
amortized to expense over the estimated useful life of the software or web
site. Amortization of internal use software costs was $6,394,000, $3,253,000
and $440,000 during the years ended December 31, 2000, 1999 and 1998,
respectively. The Company accounts for incidental sales of licenses to its OSS
software on a cost recovery basis (Note 5).
The Company leases certain equipment under capital lease agreements. The
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 perpetual 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 using the straight-line method
over their estimated useful lives, which range from five to 15 years (Note 4).
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.
Impairment of Long-Lived Assets
The Company periodically evaluates potential impairments of its long-lived
assets, including intangibles. When the Company determines that the carrying
value of long-lived assets may not be recoverable based upon the existence of
one or more indicators of impairment, the Company evaluates the projected
undiscounted cash flows related to the assets. If these cash flows are less
than the carrying value of the assets, the Company measures the impairment
using discounted cash flows or other methods of determining fair value.
Long-lived assets to be disposed of are carried at the lower of cost or fair
value less estimated costs of disposal.
78
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Stock-Based Compensation
The Company accounts for stock-based awards to employees using the intrinsic
value method.
Advertising Costs
The Company expenses the costs of advertising as incurred. Advertising
expense for the years ended December 31, 2000, 1999 and 1998 was $45,511,000,
$25,798,000 and $1,500,000, 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 the customers provide the Company with third-party
evidence of such co-branded advertising as prescribed by Company policy, such
amounts are charged to advertising expense as incurred. Other amounts payable
to customers relating to rebates and nonqualified MDF activities are charged to
revenues as incurred.
Income Taxes
The Company uses the liability method to account for income taxes. Under
this method, deferred tax assets and liabilities are determined based on
differences between financial reporting and tax bases of assets and
liabilities. Deferred tax assets and liabilities are measured using enacted tax
rates and laws that will be in effect when the differences are expected to
reverse.
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,
capital lease obligations and notes payable, 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
$972,045,000 as of December 31, 2000, as compared to the aggregate carrying
amount of $1,374,673,000 as of such date. For all borrowings outstanding at
December 31, 1999, the carrying amounts approximate their respective fair
values.
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 income (loss)," a separate component of
stockholders' equity (deficit).
79
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Net Loss Per Share
Basic net loss per share is computed by dividing net loss attributable to
common stockholders by the weighted average number of shares of the Company's
common stock, after giving consideration to shares subject to repurchase,
outstanding during the period.
Diluted net loss per share is determined in the same manner as basic net
loss per share except that the number of shares is increased assuming the
exercise of dilutive stock options and warrants using the treasury stock
method. Diluted net loss per share is the same as basic net loss per share
because the Company had net losses in all periods presented and the impact of
the assumed exercise of outstanding stock options (27,734,375 at December 31,
2000) and warrants (461,574 at December 31, 2000) and the assumed conversion of
the 6% Convertible Senior notes due 2005 (See Note 6) is not dilutive.
The following table presents the calculation of basic and diluted net loss
per share (in thousands, except share and per share amounts):
Year ended December 31,
------------------------------------
2000 1999 1998
----------- ----------- ----------
Cumulative effect of change in
accounting principle.................. $ 9,249 $ -- $ --
=========== =========== ==========
Net loss............................... $(1,443,136) $ (195,397) $ (48,121)
Preferred dividends.................... -- (1,146) --
----------- ----------- ----------
Net loss attributable to common
stockholders.......................... $(1,443,136) $ (196,543) $ (48,121)
=========== =========== ==========
Basic and diluted:
Weighted average shares of common
stock outstanding................... 155,944,344 115,675,656 25,886,940
Less weighted average shares of
common stock subject to repurchase.. 3,585,755 8,027,844 13,042,737
----------- ----------- ----------
Weighted average shares used in
computing basic and diluted net loss
per share............................. 152,358,589 107,647,812 12,844,203
=========== =========== ==========
Basic and diluted loss per common share
before cumulative effect of change in
accounting principle.................. $ (9.41) $ (1.83) $ (3.75)
=========== =========== ==========
Basic and diluted cumulative effect of
change in accounting principle per
common share.......................... $ (0.06) $ -- $ --
=========== =========== ==========
Basic and diluted net loss per common
share................................. $ (9.47) $ (1.83) $ (3.75)
=========== =========== ==========
Comprehensive Loss
Significant components of the Company's comprehensive loss are as follows
(in thousands):
Year ended December 31,
Cumulative --------------------------------
Amounts 2000 1999 1998
----------- ----------- --------- --------
Net loss....................... $(1,689,266) $(1,443,136) $(195,397) $(48,121)
Unrealized gains (losses) on
available-for-sale
securities.................... 2,272 (88,985) 91,257 --
Foreign currency translation
adjustment.................... (1,716) (1,716) -- --
----------- ----------- --------- --------
Comprehensive loss............. $(1,688,710) $(1,533,837) $(104,140) $(48,121)
=========== =========== ========= ========
80
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No.133, "Accounting for
Derivative Instruments and Hedging Activities." In June 2000, the FASB issued
SFAS No.138, which amended SFAS No. 133 and postponed its effective date. SFAS
No. 133/138 establish standards for reporting information about derivative
instruments and hedging activities, require that an entity recognize all
derivative instruments as either assets or liabilities in the statement of
financial position, and require that those instruments be measured at fair
value. The Company will be required to adopt SFAS No. 133/138 effective January
1, 2001. Management of the Company does not expect the adoption of SFAS No.
133/138 will have a material effect on the Company's consolidated financial
position or results of operations.
Reclassifications
Certain balances in the Company's 1999 and 1998 consolidated financial
statements have been reclassified to conform to the presentation in 2000,
including certain labor and stock-based compensation expenses.
2. Revenue Recognition and Change in Accounting Principle
Revenues from recurring DSL service are recognized in the period in which
the service is provided, assuming the collection of such revenues is reasonably
assured and all other criteria for revenue recognition have been met. Revenues
earned for which the customer has not been billed are recorded as "unbilled
revenue." Amounts billed in advance of providing service are recorded as
"unearned revenue." Included in revenues are Federal Universal Service Fund
charges aggregating $10,647,000 and $1,717,000 in 2000 and 1999, respectively
(none in 1998), that have been billed to customers.
As of December 31, 2000, a number of the Company's ISP customers, which
accounted for approximately 13.9%, 25.5%, and 9.7% of the Company's net
revenues in 2000, 1999 and 1998, respectively, were experiencing financial
difficulties and were not current in their payments for the Company's services.
Based on this information, the Company determined that the collectibility of
revenues from those customers was not reasonably assured. Revenue related to
customers that do not demonstrate the ability to pay for services in a timely
manner is recorded when cash for those services is received, after the
collection of all previous outstanding accounts receivable balances.
Some of the Company's financially distressed ISP customers have subsequently
filed for bankruptcy protection. These ISP customers accounted for
approximately 8.3%, 18.3%, and 6.6% of the Company's net revenues in 2000, 1999
and 1998, respectively. One such ISP customer has been ordered by the court to
prepay the Company for services on a weekly basis. The Company may also obtain
similar relief with respect to other ISP customers in bankruptcy proceedings.
In addition, the Company has completed the migration of certain end-users from
certain of the financially distressed ISP customers.
During the year ended December 31, 2000, the Company issued billings to its
financially distressed customers aggregating $40,025,000 that were not
recognized as revenues or accounts receivable in the consolidated financial
statements.
During the fourth quarter of 2000, retroactive to January 1, 2000, the
Company changed its method of accounting for up-front fees associated with DSL
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 DSL service. Under the new accounting method, which
was adopted retroactive to January 1, 2000, the Company
81
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
now recognizes up-front fees associated with DSL 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 DSL 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 $9,249,000 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 $51,550,000
($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 year ended December 31, 2000, the Company recognized approximately
$18,661,000 million in revenue that was included in the cumulative effect
adjustment as of January 1, 2000. The effect of that revenue during the year
was to decrease net loss by $4,624,000 million.
3. Restructuring
During 2000, the Company announced a comprehensive restructuring plan that
involves the following steps:
. Raising revenue per line by reducing rebates and other incentives that
the Company provides to customers and correspondingly reducing new line
addition plans for 2001 to increase margins and reduce subscriber
payback times;
. Closing approximately 200 under-performing or not fully built-out
central offices and holding the size of the Company's network at
approximately 1,800 central offices;
. Reducing the Company's workforce by 638 employees, which represents
approximately 21% of the Company's workforce;
. Closing a facility in Alpharetta, Georgia and consolidating offices in
Manassas, Virginia, Santa Clara, California and Denver, Colorado;
. Downsizing the Company's international operations and discontinuing
plans to fund additional international expansion (the Company will
continue to manage current international investments);
. Enhancing productivity in the Company's operations to increase customer
satisfaction while reducing costs;
. Restructuring the Covad Business Solutions division, formerly BlueStar
(Note 5), to streamline 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 $4,988,000 in the fourth quarter of 2000 relating to employee
severance benefits that met the requirements for accrual as of December 31,
2000.
The Company expects to record additional restructuring expenses aggregating
approximately $15,000,000 during the first quarter of 2001. These restructuring
expenses consist principally of collocation and building
82
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
lease termination costs that did not meet the requirements for accrual as of
December 31, 2000. Additional expenses related to the restructuring may be
incurred in future periods.
4. 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
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 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 $589,388,000 was recorded in the fourth quarter of 2000,
reflecting the amount by which the carrying amount of certain long-lived assets
exceed their respective fair values. The write-down consisted of $390,641,000
for goodwill, $92,395,000 for other intangible assets and $106,352,000 for
certain property and equipment. No write-downs of long-lived assets were
recorded during 1999 and 1998.
Following the completion of its long-lived asset impairment analysis as of
December 31, 2000, the Company reevaluated the remaining estimated useful lives
of its long-lived assets, including intangibles. As a result, effective January
1, 2001, the Company 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 such that the residual
balances and any subsequent additions will be depreciated or amortized over
five years.
Property and equipment consist of the following (in thousands):
December 31,
-----------------
2000 1999
-------- --------
Land...................................................... $ 1,195 $ 1,120
Building ................................................. 18,226 --
Leasehold improvements.................................... 11,360 6,884
Computer equipment........................................ 45,147 15,182
Computer software......................................... 39,727 23,987
Furniture and fixtures.................................... 28,584 6,606
Networks and communication equipment...................... 290,661 162,832
-------- --------
434,900 216,611
Less accumulated depreciation and amortization............ 96,491 30,552
-------- --------
Property and equipment, net............................... $338,409 $186,059
======== ========
83
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Intangible assets consist of the following (in thousands):
December 31,
---------------
2000 1999
------- -------
Collocation fees............................................ $82,759 $53,094
Other intangible assets..................................... -- 28,839
------- -------
82,759 81,933
Less accumulated amortization............................... 7,871 9,781
------- -------
Intangible assets, net...................................... $74,888 $72,152
======= =======
5. Business 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 million common shares in exchange for all of the
outstanding common shares of Laser Link. This transaction has been 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 1.4 million 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 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, have been 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 (in thousands):
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
========
84
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The tangible assets of Laser Link acquired by the Company aggregating
$9,078,000 consisted principally of cash, accounts receivable and property and
equipment. The liabilities of Laser Link assumed by the Company aggregating
$8,387,000 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 4).
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 4).
A portion of the purchase price has been 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 elements
of this intangible asset was being amortized on a straight-line basis over
their estimated useful lives, which ranged from one to four years (Note 4).
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.
85
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 4).
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
--------- ---------
(in thousands,
except per share
data)
Revenues............................................ $ 164,176 $ 66,502
Net loss............................................ $(867,260) $(276,177)
Basic and diluted loss per share.................... $ (5.65) $ (2.45)
Acquisition of BlueStar Communications Group, Inc.
On September 22, 2000, the Company acquired BlueStar Communications Group,
Inc. ("BlueStar") by issuing approximately 6.1 million shares of common stock
(including 800,000 shares to be held in escrow for a one year period pending
the Company's verification of certain representations and warranties made to it
by BlueStar at the date of the acquisition) in exchange for all of the
outstanding preferred and common shares of BlueStar. Two of the Company's
stockholders and members of its board of directors when the acquisition
occurred were also stockholders of BlueStar, and one was a member of the board
of directors of BlueStar.
This transaction has been 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. The common shares
issued by the Company 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 5.0 million additional common shares of the Company's common stock
were to be issued if BlueStar achieved certain specified levels of revenue 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 3.25 million of
the 5.0 million shares, in exchange for a release of all claims against the
Company. The 800,000 common shares held in escrow would be returned to the
Company under this agreement. This agreement is conditioned upon obtaining
approval by 80% of the BlueStar stockholders, which approval has not yet been
obtained. If such approval is obtained and the additional common shares of the
Company are issued to the BlueStar stockholders, the Company will record
additional purchase cost based on the fair market value of the Company's common
shares at the date of issuance.
86
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The total purchase cost of the BlueStar acquisition has been 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 (in thousands):
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
$64,753,000 consisted principally of accounts receivable, prepaid expenses, and
property and equipment. The liabilities of BlueStar assumed by the Company
aggregating $120,586,000 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 4).
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 4).
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 4).
Deferred stock-based compensation associated with unvested BlueStar stock
options at the date of acquisition is being amortized to expense over the
remainder of the vesting period.
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 4).
87
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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
----------- -----------
(in thousands, except
per share data)
Revenues........................................ $ 164,635 $ 67,259
Net loss........................................ $ (933,491) $ (251,636)
Basic and diluted loss per share................ $ (5.95) $ (2.21)
Unconsolidated Investments in Affiliates
The following table lists the Company's unconsolidated investments in
affiliates as of December 31, 2000 (in thousands):
Ownership Method of Investment
Entity Name Date of Investment(s) Percentage Accounting Carrying Value
----------- --------------------- ---------- ---------- --------------
DishnetDSL Limited...... February 2000 6% Equity $17,603
ACCA Networks Co.,
Ltd.................... August 2000 42% Equity 9,195
Certive Corporation..... November 1999; May 2000 5% Equity 2,418
Sequoia Capital X....... May-November 2000 2% Equity 1,131
Loop Holdings Europe
ApS.................... September 2000 21% Equity --
-------
$30,347
=======
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 $23,000,000, which the Company believes is 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 ($15,700,000 as of December 31, 2000) is 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 3.7 million
Dishnet ADRs at a price that is presently indeterminate and (ii) a 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
aforementioned put option, the Company ascribed no separate value to these
elements of the transaction. As a result of this strategic investment, one
employee of the Company became a member of the board of directors of Dishnet.
(The Company's chairman holds options to purchase shares of Dishnet and is a
member of the board of directors of Dishnet).
In February 2000, the Company also licensed its OSS software to Dishnet and
another entity for $28,000,000, $24,000,000 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 $2,500,000. Accordingly, the Company
recorded $2,500,000 of the
88
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
OSS license proceeds received from Dishnet as a liability in February 2000. The
remaining proceeds of $21,500,000 have been offset against the Company's
capitalized internal use software costs. Any future proceeds under the license
agreement will be recorded under the cost recovery method when received as a
reduction of 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, development stage Japanese
telecommunications Company, in exchange for cash payments aggregating
approximately $11,700,000, 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 ($1,350,000 as of December 31, 2000) is being amortized using the
straight-line method over a period of five years. As a result of this strategic
investment, two employees of the Company became members of the board of
directors of ACCA.
In addition, in August 2000, the Company also licensed for its OSS software
to ACCA for $9,000,000, $2,000,000 of which was received in cash during 2000.
The remainder is due in installments of $2,000,000 in April 2001 and $5,000,000
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 $2,000,000.
Accordingly, the Company recorded $2,000,000 of the OSS license proceeds
received from ACCA as a liability in August 2000, and the remainder of such
proceeds will be recorded under the cost recovery method when received as a
reduction of the Company's capitalized internal use software costs.
Certive Corporation
As of December 31, 2000, the Company holds 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. Due to concerns about overall market
conditions, the Company wrote-down its original $5,075,000 investment in
Certive to its estimated fair value of approximately $2,418,000 during the
fourth quarter of 2000.
Sequoia Capital X
As of December 31, 2000, the Company holds a 2% limited partnership interest
in Sequoia Capital X, a privately held venture capital partnership. Under the
terms of a subscription agreement with Sequoia's general partner, the Company
has a remaining capital commitment to Sequoia Capital X of $3,775,000 as of
December 31, 2000. However, under the terms of the subscription agreement, the
Company may decline any capital calls made pursuant to this capital commitment.
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, development stage Spanish telecommunications company. Consideration for
the Company's acquisition of the capital stock of Loop Holdings consisted of
$15,000,000 in cash and nonrecourse notes payable aggregating $35,000,000. In
March 2001, the Company declined to make the first scheduled payment of
$15,000,000 under the terms of the nonrecourse notes payable. As a result, the
89
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Company's indirect preferred equity interest in Loop Telecom was diluted to 21%
(a 21% voting interest) and its obligations under the nonrecourse notes payable
were released. Accordingly, in the accompanying consolidated balance sheet as
of December 31, 2000, the Company has netted the nonrecourse notes payable
aggregating $35,000,000 against the equity investment balance and it has
written-off its initial $15,000,000 investment balance in Loop Holdings through
a charge to operations in 2000 due to uncertainties concerning the
recoverability of such investment.
6. Short-Term Borrowings and Long-Term Debt
As of December 31, 2000, the Company had a $5,000,000 revolving line of
credit with a bank that is available through February 2002 and collateralized
by cash equivalents and short-term investments with an aggregate carrying value
of $263,573,000 as of December 31, 2000. At the Company's option, borrowings
under this credit facility bear interest at certain fixed or variable rates. As
of December 31, 2000, the Company has issued letters of credit aggregating $1.5
million under this line of credit in favor of the lessor in an equipment lease.
On March 11, 1998, the Company completed a private placement (the "1998
Private Offering") through the issuance of 260,000 units (the "Units"),
consisting of $1,000 in principal amount at maturity of 13 1/2% Senior Discount
Notes due 2008 (the "1998 Notes") and one warrant, initially exercisable to
purchase 43.7346 shares of Common Stock, $0.001 par value, of the Company (the
"Unit Warrants"). Net proceeds from the 1998 Private Offering were
approximately $129,600,000, after transaction costs of approximately
$5,500,000.
The principal amount of the 1998 Notes will accrete from the date of
issuance at the rate of 13 1/2% per annum through March 15, 2003, compounded
semi-annually, and thereafter bear interest at the rate of 13 1/2% per annum,
payable semi-annually, in arrears on March 15 and September 15 of each year,
commencing on September 15, 2003. The 1998 Notes are unsecured senior
obligations of the Company that will mature on March 15, 2008. The 1998 Notes
will be redeemable at the option of the Company at any time after March 15,
2003 at stated redemption prices plus accrued and unpaid interest thereon, if
any, to the redemption date.
The 1998 Notes were originally recorded at approximately $126,900,000, which
represents the $135,100,000 in gross proceeds less the approximate $8,200,000
value assigned to the Unit Warrants, which is included in additional paid-in
capital. The value assigned to the Unit Warrants, representing debt discount,
is being amortized over the life of the 1998 Notes. Debt issuance costs were
incurred through the issuance of additional warrants associated with the
commitment of equity by certain investors. The debt issuance costs are also
being amortized over the life of the 1998 Notes.
The Unit Warrants have ten year terms, have exercise prices of $0.0015 per
share (subject to adjustment in certain events), contain net exercise
provisions and are currently exercisable.
On February 18, 1999, the Company completed a private placement of
$215,000,000 aggregate principal amount of senior notes (the "1999 Notes"). Net
proceeds from the 1999 Notes were approximately $205,100,000 after transaction
costs of approximately $9,900,000, which are being amortized over the life of
the notes. The principal amount of the 1999 Notes bears interest at the rate of
12 1/2% per annum through February 15, 2009, compounded semi-annually, and
thereafter bears interest at the rate of 12 1/2% per annum, payable semi-
annually, in arrears on February 15 and August 15 of each year, commencing on
August 15, 1999. The 1999 Notes are unsecured senior obligations of the Company
that will mature on February 15, 2009. The 1999 Notes will be redeemable at the
option of the Company at any time after February 15, 2004 at stated redemption
prices plus accrued and unpaid interest thereon.
90
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The Company purchased approximately $74,100,000 of U.S. Treasury securities
with a portion of the net proceeds from the 1999 Notes, representing funds
sufficient to pay the first six scheduled interest payments on the 1999 Notes.
These U.S. Treasury securities are restricted for repayment of interest on the
1999 Notes.
On June 1, 1999, the Company completed an offer to exchange all outstanding
1999 Notes due for identical senior notes due February 15, 2009, which have
been registered under the Securities Act of 1933.
On January 28, 2000, the Company completed a private placement of
$425,000,000 aggregate principal amount of 12% senior notes (the "2000 Notes")
due 2010, which are redeemable at the option of the Company any time after
February 15, 2005 at stated redemption prices plus accrued and unpaid interest
thereon. Net proceeds from the 2000 Notes were approximately $413,269,000,
after discounts, commissions and other transaction costs of approximately
$11,700,000. The discount and debt issuance costs are being amortized over the
life of the 2000 Notes.
During the second quarter of 2000, the Company completed an offer to
exchange all outstanding 2000 Notes for identical senior notes due February 15,
2005, which have been registered under the Securities Act of 1933.
On September 25, 2000, the Company completed a private placement of
$500,000,000 aggregate principal amount of the Company's 6% convertible senior
notes (the "Convertible Notes"), due September 15, 2005, which are convertible
into shares of the Company's common stock at a conversion price of $17.775,
subject to certain adjustments (28,129,395 shares at December 31, 2000). The
Convertible Notes are redeemable at the option of the Company at any time at
stated redemption prices plus accrued and unpaid interest thereon. Net proceeds
from the Convertible Notes were approximately $484,350,000 after discounts,
commissions, and other transaction costs of approximately $15,650,000. The
discount and debt issuance costs are being amortized over the life of the
Convertible Notes.
As described in Note 9, several purchasers of the Convertible Notes have
filed lawsuits against the Company and certain of its current or former
officers alleging violations of state securities laws in connection with the
Company's sale of the Convertible Notes. The relief sought includes rescission
of their Convertible Notes purchases and unspecified damages. However, the
Company believes the Convertible Notes were legally and validly issued. In
addition, other purchasers of the Convertible Notes have indicated that they
intend to file similar lawsuits. The ultimate outcome of this pending and
threatened litigation cannot presently be determined. However, management,
based on the advice of legal counsel, believes the likelihood that the pending
securities litigation involving the Convertible Notes will result in judgment
before January 1, 2002 is remote.
On April 2, 2001, the Company received a notice of default from certain
holders of its convertible notes relating to its failure to file its Form 10-K
by the April 2, 2001 due date. The indenture governing the convertible notes,
which contains a covenant requiring the Company to file timely reports with the
SEC, provides for a grace period of 60 days after notice of default. The
Company believes that by filing this Form 10-K within the applicable grace
period, it has cured this default.
On May 17, 2001, the Company received a notice of default from certain
holders of its convertible notes relating to its failure to file its quarterly
report on Form 10-Q for the quarter ended March 31, 2001 by the May 15, 2001
due date. The indenture governing the convertible notes, which contains a
covenant requiring the Company to file timely reports with the SEC, provides
for a grace period of 60 days after notice of default. The Company's Form 10-Q
for the first quarter of 2001 could not be filed by the prescribed due date
because the Company has devoted its management resources to the preparation of
the Form 10-K and because its financials for the first quarter of 2001 depend
on the financials published in the Form 10-K. It is possible that holders of
the Company's other notes will send it a notice of default relating to this
failure to file such Form 10-Q on a
91
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
timely basis. While the Company's management believes that it will be able to
prepare and file such Form 10-Q within the applicable grace periods, no
assurance can be given in that regard and the failure to file could mature
into an event of default, which would entitle the holders of the notes giving
such notice to accelerate the maturity of their notes and result in all of the
Company's notes becoming due, which amount to $1,324,704,000 as of December
31, 2000.
The Company assumed, as part of acquisitions, various other financing
arrangements, principally to finance the acquisition, build-out and
maintenance of its networks and communication equipment. These financing
arrangements bear interest rates ranging from 7.75% to 12% and mature between
August 2001 and July 2003. Certain of these financing arrangements are
collateralized by equipment and other assets with an aggregate carrying value
of $33,704,000 as of December 31, 2000. The Company's future principal
payments under such financing arrangements, based on the contractual terms of
the agreements, are included in the table below. Based on current
circumstances, the aggregate principal balances relating to certain of these
financing arrangements are classified as current liabilities in the Company's
consolidated balance sheet as of December 31, 2000.
Aggregate scheduled future principal payments of long-term debt are as
follows (in thousands):
Year ending December 31,
------------------------
2001.......................................................... $ 22,030
2002.......................................................... 20,710
2003.......................................................... 8,219
2004.......................................................... --
2005.......................................................... 500,000
Thereafter.................................................... 900,000
----------
$1,450,959
==========
7. Capital Leases
The Company has entered into capital lease arrangements to finance the
acquisition of certain equipment.
The capitalized costs and accumulated amortization related to assets under
capital leases were $8,214,000 and $2,298,000, respectively, as of December
31, 2000 (the corresponding amounts were $865,000 and $346,000, respectively,
as of December 31, 1999).
Future minimum lease payments under capital leases are as follows (in
thousands):
Year ending December 31,
------------------------
2001............................................................... $3,040
2002............................................................... 2,863
2003............................................................... 864
2004............................................................... 360
2005............................................................... 94
------
7,221
Less amount representing interest.................................. 987
Less current portion............................................... 2,566
------
Total long-term portion.......................................... $3,668
======
92
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The Company consummated a sale-leaseback transaction with an affiliate of a
principal shareholder in 1998 that has been accounted for as a capital lease.
Such capital lease obligation had an outstanding principal balance of $250,000
as of December 31, 1999. This obligation was repaid in 2000.
8. Operating Leases
The Company leases vehicles, equipment, and office space under various
operating leases. Future minimum lease payments by year under operating leases
with noncancelable terms in excess of one year, net of future minimum rentals
to be received under noncancelable subleases, are as follows (in thousands):
Year ending December 31,
------------------------
2001.............................................................. $ 29,446
2002.............................................................. 27,852
2003.............................................................. 23,740
2004.............................................................. 18,967
2005.............................................................. 13,103
Thereafter........................................................ 28,176
--------
Total........................................................... $141,284
========
Rent expense associated with all operating leases totaled $19,584,000,
$4,302,000 and $1,507,000 for the years ended December 31, 2000, 1999, and
1998, respectively.
9. Contingencies
Litigation
Several of the Company's stockholders have filed class action lawsuits
against the Company and certain of its current or former officers. These
lawsuits were filed in the United States District Court for the Northern
District of California. The complaints in these matters allege violations of
federal securities laws on behalf of persons who purchased the Company's
securities, including those who purchased common stock and those who purchased
Convertible Notes, during the periods from September 7, 2000 to October 17,
2000 or September 7, 2000 to November 14, 2000. The relief sought includes
monetary damages and equitable relief. In addition, six purchasers of the
Convertible Notes have filed complaints in the California Superior Court for
the County of Santa Clara. These complaints allege fraud and deceit, negligence
and violations of state securities laws in connection with the Company's
Convertible Notes offering. The relief sought includes rescission of their
purchases of approximately $142 million in aggregate principal amount of
Convertible Notes and unspecified damages, including punitive damages. However,
the Company believes the Convertible Notes were legally and validly issued. Two
of these purchasers holding $48 million in aggregate principal amount of the
Convertible Notes have dismissed their complaints without prejudice. Although
the Company believes it has strong defenses in these pending and threatened
lawsuits, the ultimate outcome of this litigation cannot presently be
determined. However, management, based on the advice of legal counsel, believes
the likelihood that the pending securities litigation involving the Convertible
Notes will result in judgment before January 1, 2002 is remote.
A manufacturer of telecommunications hardware has filed a complaint against
the Company in the United States District Court for the District of Arizona,
alleging claims for false designation of origin, infringement and unfair
competition. The plaintiff is seeking an injunction to stop the Company from
using the COVAD trademark, as well as an award of monetary damages. The Company
does not believe that these claims have any merit, but the outcome of this
litigation cannot presently be determined.
93
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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. The Company also recently filed a lawsuit against BellSouth
Telecommunications and its subsidiaries in the United States District Court for
the Northern District of Georgia. The Company is pursing antitrust and other
claims in this lawsuit arising out of BellSouth's conduct as a supplier of
network facilities, including central office space, transmission facilities and
telephone lines. Both BellSouth and Verizon have asked the courts to dismiss
the Company's cases on the basis of the ruling of the Seventh Circuit in
Goldwasser v. Ameritech, which dismissed a consumer antitrust class action
against Ameritech. The Company is opposing the BellSouth and Verizon motions,
and while the Company believes its position should prevail, the Company cannot
predict the outcome of these motions.
In addition, Verizon has separately filed suit against the Company in the
United States District Court for the Eastern District of Virginia, asserting
infringement of a patent issued to it in September 1998 entitled "Variable Rate
and Variable Mode Transmission System." However, on February 18, 2000, the
court issued a summary judgment ruling holding that the Company had not
infringed Verizon's patent. Verizon's appeal of that decision is currently
pending in the United States Court of Appeals for the Federal Circuit, and
while the Company expects that it will prevail on appeal, the outcome of such
an appeal is inherently uncertain.
The Company anticipates that some or all of the LaserLink shareholders will
file lawsuits against it seeking damages arising out of the Company's alleged
failure to register the common shares that they received in exchange for their
LaserLink shares (Note 5). The Company does not believe that these claims have
any merit, but the ultimate outcome of this matter cannot presently be
determined.
The Company also received a letter from a purported bondholder threatening
to file a lawsuit against its board of directors for breach of fiduciary duty
if they do not meet with it to discuss its prospects. The Company believes that
it has strong defenses to the threatened lawsuit, but the outcome of litigation
is inherently unpredictable.
An unfavorable outcome in any of the legal proceedings described above could
have a material adverse effect on the Company's consolidated financial
position, results of operations and cash flows.
The Company is also a party to a variety of other legal proceedings, as
either plaintiff or defendant, and is engaged in other business disputes that
arise in the ordinary course of its business. The Company's management believes
these matters will be resolved without a material adverse effect on the
Company's consolidated financial position and results of operations.
Other Contingencies
As of December 31, 2000, the Company has disputes with a number of
telecommunications companies concerning the balances owed to them for
collocation fees and certain network services. In the opinion of management,
such disputes will be resolved without a material adverse effect on the
Company's consolidated financial position and results of operations. However,
it is reasonably possible that estimates of the Company's collocation fee and
network service obligations, as recorded in the accompanying consolidated
balance sheets, could change in the near term. In addition, the Company is
engaged in a variety of negotiations, arbitrations and regulatory proceedings
with multiple traditional 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 central office space, the delivery of transmission
facilities and telephone lines and other operational issues. In connection with
the agreements with SBC Communications, Inc. ("SBC") that were announced on
September 11, 2000 (Note 10), the Company settled
94
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
pending litigation against certain SBC affiliates. This settlement also
resolved the Company's commercial arbitration proceeding against Pacific Bell.
The Company remains involved in certain regulatory proceedings against SBC
affiliates Pacific Bell, Southwestern Bell, and Ameritech. 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, results of operations and cash flows.
10. Stockholders' Equity (Deficit)
Strategic Investors
In January 1999, the Company entered into strategic relationships with AT&T
Corp. ("AT&T"), NEXTLINK Communications, Inc. (now XO Communications) and Qwest
Communications Corporation ("Qwest"). As part of these strategic relationships,
the Company received equity investments totaling approximately $60 million. The
Company recorded intangible assets of $28.7 million associated with these
transactions that were being amortized over periods of three to six years using
the straight-line method. For the years ended December 31, 2000 and 1999, such
amortization expense totaled $8.3 million and $8.2 million, respectively.
On September 11, 2000, the Company announced various agreements with SBC
including, (i) a six-year resale and marketing agreement under which SBC will
market and resell the Company's DSL services (through December 31, 2000, the
Company has 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 million, 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.
Initial Public Offering
On January 27, 1999, the Company completed the initial public offering
("IPO") of 20,182,500 shares of the Company's common stock at a price of $8.00
per share. Net proceeds to the Company from the offering were $150.2 million
after deducting underwriting discounts and commissions and offering expenses
payable by the Company. As a result of the offering, 41,053,864 shares of the
common stock and 6,379,177 shares of the Class B common stock were issued upon
the conversion of preferred stock, 133,587 shares of common stock were issued
for cumulative but unpaid dividends on Series A and Series B preferred stock
and 4,049,439 shares of common stock were issued upon the exercise of common
warrants.
Secondary Offerings
On June 23, 1999, the Company completed a public offering of 12,937,500
shares of common stock sold by certain stockholders of the Company. The Company
did not sell any shares in this offering. Accordingly, there were no net
proceeds to the Company from this offering. The Company incurred offering
expenses of approximately $600,000 related to this offering.
On November 3, 1999, the Company completed a public offering of 22,425,000
shares of common stock sold by the Company and certain stockholders of the
Company. The net proceeds to the Company from this offering were $568.8 million
after deducting underwriting discounts and commissions and offering expenses.
95
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Preferred Dividends
The holders of Series A, Series B and Series C preferred stock were entitled
to receive in any fiscal year, dividends at the rate of $0.0111 per share,
$0.0267 per share and $0.1487 per share, respectively, payable in preference
and priority to any payment of dividends on common stock. The rights to such
dividends were cumulative and accrue to the holders to the extent they were not
declared or paid and were payable, in cash or common stock, only in the event
of a liquidation, dissolution or winding up of the Company, or other liquidity
event (as defined in the Certificate of Incorporation). The cumulative
dividends at December 31, 1998, for preferred stock were approximately
$1,146,000, all of which were converted into 133,587 shares of common stock in
connection with the IPO.
Common Stock
1,114,841 and 6,679,313 shares of common stock outstanding at December 31,
2000 and December 31, 1999, respectively, are subject to repurchase provisions
which generally lapse over a four-year period from the date of issuance. Shares
of Class B common stock outstanding at December 31, 1999 were 6,379,177, all of
which were converted into 14,353,148 shares of common stock in 2000, none of
which remain subject to repurchase.
Common stock reserved for future issuance as of December 31, 2000 is as
follows:
Convertible notes............................................... 28,129,395
Outstanding options............................................. 27,734,375
Options available for grant..................................... 4,396,994
Employee stock purchase plan.................................... 3,969,977
Warrants outstanding............................................ 461,574
----------
Total......................................................... 64,692,315
==========
Stock Splits
The consolidated financial statements applicable to the prior periods have
been restated to reflect stock splits, including a three-for-two stock split
effective in May 1999 and a three-for-two stock split effective in April 2000.
Notes Receivable from Stockholders
Notes receivable from stockholders consist of full-recourse notes issued to
the Company by various employees in connection with the exercise of certain
stock options. Such notes are collateralized by shares of the Company's common
stock and bear interest at a fixed rate of 7%. Interest payments are due
annually from January 2001 through January 2004. All principal and accrued
interest on these notes is due at maturity, in January 2005, and management
believes that all such amounts are fully collectible.
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 $400.00,
subject to adjustment. As of December 31, 2000, no rights were exercisable into
no shares of common stock.
96
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
11. Income Taxes
A reconciliation of income taxes computed at the federal statutory rate to
income tax expense (benefit) recorded in the Company's consolidated statements
of operations is as follows (in thousands):
Year ended December 31,
-----------------------------
2000 1999 1998
--------- -------- --------
Federal benefit at statutory rate........... $(505,098) $(66,435) $(16,363)
Nondeductible interest expense.............. 1,189 2,050 911
Net operating losses with no current
benefits................................... 342,863 64,306 15,436
Goodwill.................................... 158,257 -- --
Other....................................... 2,789 79 16
--------- -------- --------
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 (in thousands):
December 31,
-------------------
2000 1999
--------- --------
Deferred tax assets:
Net operating loss carryforwards...................... $ 297,903 $ 45,462
Unearned revenue and other............................ 52,094 --
Accrued interest...................................... 24,376 15,977
Other................................................. 72,797 1,846
--------- --------
Total deferred tax assets........................... 447,170 63,285
Valuation allowance................................... (438,454) (26,782)
--------- --------
Net deferred tax assets............................. 8,716 36,503
Deferred tax liabilities:
Unrealized gain on investments........................ -- (36,503)
Other................................................. (8,716) --
--------- --------
Net deferred taxes.................................. $ -- $ --
========= ========
Realization of our deferred tax assets relating to net operating loss
carryforwards 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 by $411,672,000,
$8,282,000 and $18,500,000 during 2000, 1999 and 1998, respectively.
As of December 31, 2000, the Company had net operating loss carryforwards
for federal tax purposes of approximately $785,000,000 which will expire in the
years 2011 through 2020, if not utilized. The Company also had net operating
losses carryforwards for state income tax purposes of approximately
$386,000,000 million which expire in the years 2004 through 2010, if not
utilized.
The tax benefits associated with employee stock options provided deferred
tax benefits of $8,604,000 and $14,500,000 for the years ended December 31,
2000 and 1999, respectively (none in 1998). Such deferred tax benefits have
been offset by a valuation allowance and will be credited to additional paid-in
capital if realized.
97
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The utilization of the Company's net operating losses is 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.
12. Employee Benefit Plans
Defined Contribution Plan
The Company has a defined contribution retirement plan under Section 401(k)
of the Internal Revenue Code which 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, the Company
merged Laser Link's defined contribution retirement plan under Section 401(k)
of the Internal Revenue Code into the Company's defined contribution plan.
As of December 31, 2000, BlueStar also had a defined contribution retirement
plan under Section 401(k) of the Internal Revenue Code which covers
substantially all employees. Eligible employees may contribute amounts to the
plan, via payroll withholding, subject to certain limitations. BlueStar did not
match contributions by the plan participants. Subsequent to December 31, 2000,
the Company began merging the BlueStar defined contribution plan into the
Company's defined contribution plan, but the Company has not completed that
merger.
1998 Employee Stock Purchase Plan
In January 1999, the Company adopted the 1998 Employee Stock Purchase Plan.
The Company has reserved a total of 6,507,002 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 Board of Directors. The
options expire from two to eight years after the date of grant. As of December
31, 2000, the Company has reserved 30,996,005 shares of the Company's common
stock under the Plan for sale and issuance at prices to be determined by the
Board of Directors.
In connection with the Company's acquisition of Laser Link, the Company
assumed Laser Link's stock option plan. Laser Link's stock option plan provides
for the grant of options to purchase shares of common stock to employees and
consultants from time to time. The options expire up to ten years after the
date of grant. The Company assumed the Laser Link stock option plan at the time
it acquired Laser Link and it is no longer issuing options under the Laser Link
stock option plan. A maximum of 1,434,957 shares of the Company's Common Stock
will be available for issuance under the Laser Link Plan. The options granted
under the Laser Link plan are included in the data set forth below.
In connection with the Company's acquisition of BlueStar, the Company
assumed BlueStar's stock option plan. BlueStar's stock option plan provides for
the grant of options to purchase shares of common stock to
98
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 Plan. The
options granted under the BlueStar plan are included in the data set forth
below.
The following table summarizes stock option activity for the years ended
December 31, 2000, 1999 and 1998:
Number of
Shares of
Common Option Price
Stock Per Share
---------- ---------------
Granted........................................ 21,077,955 $ 0.067-$ 5.44
Exercised...................................... (466,863) $ 0.022-$ 0.45
Cancelled...................................... (1,627,730) $ 0.022-$ 5.29
---------- ---------------
Balance as of December 31, 1998.................. 27,557,550 $ 0.022-$ 5.44
Granted........................................ 8,774,658 $ 0.007-$ 44.67
Exercised...................................... (8,012,683) $ 0.007-$ 38.17
Cancelled...................................... (3,796,892) $ 0.147-$ 43.42
---------- ---------------
Balance as of December 31, 1999.................. 24,522,633 $0.0007-$ 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
========== ===============
The following is a summary of the status of stock options outstanding at
December 31, 2000:
Options Outstanding Options Exercisable
-------------------------------------- ------------------------
Weighted- Weighted- Weighted-
Number of Average life Average Number of Average
Exercise Price Range Shares Remaining Exercise Price Shares Exercise Price
-------------------- ---------- ------------ -------------- --------- --------------
$ .00-$ 6.63.......... 12,852,097 4.3 $ 1.5762 4,768,895 $ 0.9794
$ 6.63-$ 13.25.......... 1,439,502 5.7 $ 8.0205 437,507 $ 7.5769
$13.25-$ 19.88.......... 3,247,605 5.0 $16.2617 129,098 $17.3438
$19.88-$ 26.50.......... 569,584 5.8 $24.1127 65,463 $25.1142
$26.50-$ 33.13.......... 3,069,101 4.6 $28.9300 1,045,805 $29.0094
$33.13-$ 39.75.......... 1,435,324 4.4 $37.1695 464,165 $37.0179
$39.75-$ 46.38.......... 1,019,952 4.7 $41.0022 365,959 $40.9459
$46.38-$ 53.00.......... 1,534,420 4.1 $51.1893 308,604 $51.0831
$53.00-$ 59.63.......... 1,187,033 6.3 $57.0732 244,232 $57.1030
$59.63-$149.79.......... 1,379,757 5.9 $63.3994 277,851 $63.3966
---------- --- -------- --------- --------
27,734,375 4.8 $18.5342 8,107,579 $14.9632
========== === ======== ========= ========
During the years ended December 31, 2000, 1999 and 1998, the Company
recorded deferred stock-based compensation of approximately $628,000,
$6,593,000 and $8,074,000, respectively, as a result of granting stock options
and issuing restricted stock 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. These amounts are being amortized to operations over the vesting
periods using a graded vesting method. Amortization of deferred stock-based
compensation for
99
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
the years ended December 31, 2000, 1999 and 1998 was approximately $4,481,000,
$4,768,000 and $3,997,000, respectively. Included in the amortization of
deferred stock-based compensation for the year ended December 31, 2000 are
amounts aggregating $724,000 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 2000. No similar amounts are included in the amortization of
deferred stock-based compensation in 1999 or 1998.
Pro forma Stock-Based Compensation Information
Pro forma information regarding the results of operations and net loss per
share 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
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 the
market price of the underlying stock on the date of grant, no compensation
expense is recognized.
The 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 of the estimate, 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, 2000, 1999 and 1998, the fair value of the
Company's stock-based awards to employees was estimated using the following
weighted average assumptions:
2000 1999 1998
----- ----- -----
Expected life of options in years...................... 4.0 4.0 4.0
Volatility............................................. 171.0% 123.5% 123.5%
Risk-free interest rate................................ 5.1% 7.0% 7.0%
Expected dividend yield................................ 0.00% 0.00% 0.00%
The weighted average fair value of stock options granted during the years
ended December 31, 2000, 1999 and 1998 was $29.02, $9.79 and $0.91 per share,
respectively. For pro forma purposes, the estimated fair value of the Company's
stock-based awards to employees is amortized over the options' vesting period
which would result in an increase in net loss of approximately $206.9 million,
$35.2 million and $1.7 million for the years ended December 31, 2000, 1999 and
1998, respectively. The result of applying the fair value method to the
Company's option grants would have increased the net loss per share by $1.33
per share, by $0.23 per share and $0.22 per share for the years ended December
31, 2000, 1999 and 1998, respectively.
13. 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 broadband communications services,
which involve DSL technology, to ISP, enterprise and telecommunications
customers. The Covad Integrated Services
100
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
("CIS") subsidiary, formerly known as Laser Link, is a provider of Internet
access services to corporations and other organizations. The BlueStar
subsidiary also does business as Covad Business Solutions ("CBS") and is a
provider of broadband communications and Internet services to small and medium-
sized businesses in Tier II and Tier III cities. 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 2, 3, 4 and 5 are not allocated to the segments and are included in
corporate operations. The Company evaluates performance of the segments based
on segment operating results, excluding nonrecurring and unusual items.
101
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Information about the Company's business segments was as follows as of and
for the year ended December 31, 2000 (in all prior periods, the Company's
business was comprised entirely of wholesale DSL service operations):
Total Corporate Intercompany Consolidated
Wholesale CIS CBS Segments Operations Eliminations Total
---------- ------- -------- ---------- ---------- ------------ ------------
Domestic revenues from
unaffiliated customers,
net.................... $ 133,535 $19,413 $ 5,788 $ 158,736 $ -- $ -- $ 158,736
Intersegment revenues...
---------- ------- -------- ---------- --------- ---- -----------
Total revenues, net.. 133,535 19,413 5,788 158,736 -- -- 158,736
Operating expenses...... 624,149 15,460 25,554 665,163 71,238 -- 736,401
Depreciation and
amortization........... 79,421 1,630 6,140 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............ 703,570 17,090 31,694 752,354 760,574 -- 1,512,928
---------- ------- -------- ---------- --------- ---- -----------
(Loss) income from
operations............. (570,035) 2,323 (25,906) (593,618) (760,574) -- (1,354,192)
Interest income......... 52,837 -- 64 52,901 -- -- 52,901
Equity earnings in
unconsolidated
affiliates............. -- -- -- -- (6,452) -- (6,452)
Interest expense........ (108,289) (43) (1,531) (109,863) -- -- (109,863)
Other income (expense),
net.................... (16,294) -- 13 (16,281) -- -- (16,281)
---------- ------- -------- ---------- --------- ---- -----------
Total other income
(expense), net...... (71,746) (43) (1,454) (73,243) (6,452) -- (79,695)
---------- ------- -------- ---------- --------- ---- -----------
(Loss) income before
cumulative effect of
change in accounting... (641,781) 2,280 (27,360) (666,861) (767,026) -- (1,433,887)
Cumulative effect of
change in accounting
principle.............. (9,249) -- -- (9,249) -- -- (9,249)
---------- ------- -------- ---------- --------- ---- -----------
Net (loss) income.... $ (651,030) $ 2,280 $(27,360) $ (676,110) $(767,026) $ -- $(1,443,136)
========== ======= ======== ========== ========= ==== ===========
Assets.................. $1,402,968 $11,841 $ 39,949 $1,454,758 $ 56,727 $ -- $ 1,511,485
Investments in
unconsolidated
affiliates:
Domestic.............. $ -- $ -- $ -- $ -- $ 3,549 $-- $ 3,549
International......... $ -- $ -- $ -- $ -- $ 16,798 $-- $ 16,798
Capital expenditures.... $ 289,874 $ 2,783 $ 3,702 $ 296,359 $ 22,875 $-- $ 319,234
102
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.
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 March 15, 2001, are as follows:
Name Age Position
---- --- --------
Charles McMinn..... 49 Chairman of the Board
Frank J. Marshall.. 54 Interim Chief Executive Officer and Director
Mark H. Perry...... 50 Executive Vice President and Chief Financial Officer
Catherine Hemmer... 42 Executive Vice President and Chief Operating Officer
Anjali Joshi....... 40 Executive Vice President, Engineering
Dhruv Khanna....... 41 Executive Vice President, Human Resources, General
Counsel and Secretary
Terry Moya......... 43 Executive Vice President, External Affairs and
Corporate Development
John McDevitt...... 48 Executive Vice President, Sales and Marketing
Chuck Haas......... 41 Executive Vice President and General Manager, Covad
Integrated Services
Helene Runtagh..... 52 Director
Daniel Lynch....... 59 Director
Rich Shapero....... 52 Director
Larry Irving....... 44 Director
Robert Hawk........ 61 Director
Charles McMinn is 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.
Frank J. Marshall has served as a member of the Company's Board of Directors
since October 1997 and has served as the Company's Interim Chief Executive
Officer since November 2000. Mr. Marshall currently serves on the board of
directors of PMC-Sierra, Inc., and several private companies. Mr. Marshall also
serves
103
on the technical advisory board of several high technology private companies.
He is a member of the InterWest Partners Advisory Committee. From 1992 to 1997,
Mr. Marshall served as Vice President of Engineering and Vice President and
General Manager, Core Business Unit of Cisco Systems, Inc. From 1982 to 1992,
he served as Senior Vice President, Engineering at Convex Computer Corporation.
Mark H. Perry joined the Company in August 2000 as the Company's Chief
Financial Officer and Executive Vice President, Finance. Prior to joining the
Company, he was with U S WEST Communications. He began in 1996 as its Vice
President, Finance & Administration and subsequently became its Vice President,
Operations and Merger Integration. From 1995 to 1996, he was U S WEST
Communications' Managing Director with Cable Plus, a cable
television/telecommunications joint venture in the Czech Republic. From 1994 to
1995, he was the Vice President, Finance of Comcast International. From 1988 to
1994 he served in a variety of management roles with U S WEST Communications,
including Assistant Corporate Controller and Chief Auditor, Vice President and
Chief Financial Officer of the Cable Communications Division. From 1976 to
1988, he was with RCA Corporation, where he served in several management
positions.
Catherine Hemmer joined the Company in August 1998. She served as the
Company's Vice President, Operations until February 1999 and served as the
Company's President, Network Services from February 1999 to September 1999, and
currently serves as the Company's Executive Vice President and Chief Operating
Officer. From 1996 to August 1998, she was Vice President, Network Reliability
and Operations at U S WEST Communications, Inc. From 1995 to 1996, she served
as General Manager, Network Provisioning at Ameritech Services, Inc., a
telecommunications company. From 1987 to 1995, she served in various
capacities, including Vice President, Network Services, at MFS Telecom, Inc.
From 1981 to 1987, she served in various management roles at MCI Communications
Inc. (now MCI Worldcom, Inc.), providing management information systems support
for the network operations organization.
Anjali Joshi joined 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.
Dhruv Khanna is one of the Company's founders. He served as the Company's
Vice President, General Counsel and Secretary from October 1996 until February
1999 and has served as the Company's Executive Vice President, General Counsel
and Secretary since that date and Executive Vice President, Human Resources,
since May 2001. He was an in-house counsel for Intel Corporation's
communications products division and its Senior Telecommunications Attorney
between 1993 and 1996. Between 1987 and 1993, Mr. Khanna was an associate at
Morrison & Foerster, LLP, where his clients included Teleport Communications
Group (now AT&T Corp.), McCaw Cellular Communications, Inc. (now AT&T
Wireless), and Southern Pacific Telecom (now Qwest Communications
International, Inc.). Mr. Khanna has extensive experience with regulatory
matters, litigation and business transactions involving the RBOCs and other
telecommunications companies. While at Intel, he helped shape the computer
industry's positions on the Telecommunications Act of 1996 and the FCC's rules
implementing the 1996 Act.
Terry Moya joined the Company in July 1999 as the Company's Executive Vice
President, External Affairs. In January 2001, he also started to serve as the
Company's Executive Vice President for Corporate Development. Prior to joining
the Company, from January 1999 to July 1999, Terry served as Vice President,
Capital Management, Network/Operations and Technologies at U S WEST
Communications, Inc. From August 1998 to January 1999, Terry served as Vice
President, Operations for U S WEST Communications, Inc. From February 1997 to
August 1998, Terry served as Vice President, Construction, Operations and
Technologies and led the outside plant construction contracting organization
for U S WEST Communications, Inc. From August 1992 to February 1997, Terry
spent time in over a half dozen foreign countries establishing and improving
several different lines of business for U S WEST Communications, Inc. These
countries include Poland, Russia, the Czech Republic, Hungary, Brazil and the
United Kingdom. Prior to August 1992, Terry was at KPMG Peat Marwick, LLP in
New Orleans.
104
John McDevitt has served as the Company's Executive Vice President, Sales
and Marketing since July 2000. Prior to joining the Company, he was Vice
President of Sales and Marketing for Danly IEM from 1998 to June 2000. From
1996 to 1998, Mr. McDevitt served as Business Director with Praxair, Inc.
Between 1978 and 1996, Mr. McDevitt was with Liquid Carbonic Corporation, where
he served as Vice President of Sales and Marketing, General Manager and as a
National and Regional Manager.
Charles Haas is a founder of the Company and has been serving as the
Company's Executive Vice President and General Manager of Covad Integrated
Services since December 2000. He served as the Company's Vice President, Sales
and Marketing from May 1997 until November 1998 and has served in various other
roles. Mr. Haas has over fourteen years of sales and business development
experience with Intel where he held various positions from July 1982 to April
1997. At Intel Mr. Haas served as manager of corporate business development,
focusing on opportunities in the broadband computer communications area, and
played a principal in the development of the Company's Residential Broadband
strategy for telephone and satellite companies (DSL, Fiber-to-the-Curb and
satellite modems).
Hellene Runtagh has 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.
Daniel Lynch has served as a member of the Company's Board of Directors
since April 1997. Mr. Lynch is also a founder of CyberCash, Inc. and has served
on its board of directors since August 1994. 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
ZD Comdex and Forums. 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, the Bionomics Institute and CommerceNet. 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. He has served as a member of the board of directors of Exodus
Communications since January 1998. Mr. Lynch previously served as a member of
the board of directors at UUNET Technologies, Inc., from April 1994 until
August 1996.
Rich Shapero has served as a member of the Company's Board of Directors
since July 1997. Mr. Shapero is a managing partner of Crosspoint Venture
Partners, L.P., a venture capital investment firm and has been with that firm
since April 1993. From January 1991 to June 1992, he served as Chief Operating
Officer of Shiva Corporation, a computer network company. Previously, he was a
Vice President of Sun Microsystems, Inc., Senior Director of Marketing at AST
Research, Inc., and held marketing and sales positions at Informatics General
Corporation and UNIVAC's Communications Division. Mr. Shapero serves as a
member of the board of directors of several privately held companies.
Larry Irving has served as a member of the Company's Board of Directors
since April 2000. Mr. Irving is the President and CEO of the Irving Information
Group, a strategic consulting firm. 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 Administration's successful efforts to reform the United
States' telecommunications law, which resulted in the
105
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 three years, Mr.
Irving was associated with the Washington, D.C. law firm of Hogan & Hartson,
specializing in communications law, antitrust law and commercial litigation.
Robert Hawk has 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 U S 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 boards of PairGain Technologies,
Inc., COM21, Inc., Concord Communications, Inc., Radcom, Ltd., Efficient
Networks, Inc. and several privately held companies.
Classified Board
The Board of Directors is divided into three classes. The term of office and
directors consisting of each class is as follows:
Class Directors Term of Office
----- --------- --------------
Class I................. Daniel Lynch . expires at the annual meeting of
Rich Shapero stockholders in 2003 and at each
Larry Irving third succeeding annual meeting
thereafter
Class II................ Frank J. Marshall . expires at the annual meeting of
Hellene Runtagh stockholders in 2001 and at each
third succeeding annual meeting
thereafter
Class III............... Charles McMinn . expires at the annual meeting of
Robert Hawk stockholders in 2002 and at each
third succeeding annual meeting
thereafter
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 three of the
Company's outside directors, Messrs. Lynch and Hawk and Ms. Runtagh.
The Audit Committee's primary responsibilities include:
. conducting a post-audit review of the financial statements and audit
findings;
. reviewing the Company's independent auditors' proposed audit scope and
approach; and
. reviewing, on a continuous basis, the adequacy of the Company's system of
internal accounting controls.
106
The Compensation Committee currently consists of two of the Company's
outside directors, Mr. Shapero 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
. reviewing and making recommendations to the Company's Board of Directors
regarding general compensation goals and guidelines for the Company's
employees and the criteria by which bonuses to the Company's employees
are determined.
The Company also has a Pricing Committee and Management Compensation
Committee. The Pricing Committee currently consists of two outside directors,
Messrs. Shapero and Irving. 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. Marshall, 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.
Messrs. Lynch, Shapero and McMinn are also members of the Chief Executive
Officer Search Committee, which was created following the November 1, 2000
departure of Robert K. Knowling, the Company's former Chairman of the Board,
Chief Executive Officer and President. The function of this committee is to
locate a new Chief Executive Officer for the Company.
Compensation Committee Interlocks and Insider Participation
Mr. Shapero and Ms. Runtagh currently serve on the Compensation Committee.
One former director, Debra Dunn, also served on the Compensation Committee
during 2000. 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. Mr. Shapero is affiliated with Crosspoint Venture Partners
L.P., which was a party along with the Company, to a Series C Preferred Stock
and Warrant Subscription Agreement dated February 23, 1998. Mr. Shapero was a
shareholder of BlueStar Communications, which we acquired in 2000 and was also
on BlueStar's Board of Directors. Mr. Shapero did not participate in Board
matters relating to our purchase of BlueStar. See "--Certain Relationships and
Related Transactions." Mr. McMinn is a member of the Board of Directors of
DishnetDSL, a DSL provider in India, and Certive Corporation. We are a minority
investor in both of these companies.
Director Compensation
Except for grants of stock options subject to vesting and restricted stock
subject to repurchase, directors of the Company generally do not receive
compensation for services provided as a director or committee member. However,
newly installed directors receive a stock option grant to purchase 60,000
shares of common stock which vests over four years. In January 2001, each of
the members of the Board of Directors, other than Mr. McMinn (who received a
stock option grant of 60,000 shares as a newly installed director), received a
one-time stock option grant to purchase 50,000 shares, vesting over four years.
The Company does not pay additional amounts for committee participation or
special assignments of the Board of Directors, except for reimbursement of
expenses in attending Board and committee meetings.
In April 2001, we provided Mr. McMinn and Mr. Marshall with stock option
grants for 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 will vest over six
months.
107
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, 2000.
SUMMARY COMPENSATION TABLE
Long-Term Compensation
------------------------------
Annual
Compensation Restricted Securities
Fiscal -------------------- Stock Underlying All Other
Name and principal position Year Salary Bonus Awards ($) Options/SARs (#) Compensation
--------------------------- ------ -------- -------- ---------- ---------------- ------------
Frank J. Marshall................ 2000 $ 1 -- -- 60,000 --
Interim Chief Executive Officer
and Director
Robert E. Knowling, Jr. ......... 2000 $500,000 $250,000 -- 450,000(11) $250,810(12)
Former Chairman, Board 1999 $399,996 $500,000 -- -- $875,420(13)
of Directors, President and 1998 $180,768(3) $250,000 -- 4,725,000 $750,343(14)
Chief Executive Officer(1)
Robert Davenport, III(24)........ 2000 $303,846 -- -- 152,500 $150,360(15)
President, Covad 1999 $183,077(4) $ 91,667 -- 450,001 $ 171(16)
Communications International, 1998 -- -- -- -- --
BV
Catherine Hemmer................. 2000 $334,615 -- -- 175,000 $ 87,860(17)
Executive Vice President, 1999 $180,769 $109,500 $882,500(9) -- $ 87,740(18)
Chief Operating Officer 1998 $ 58,359(5) $ 56,000 -- 437,713 $ 84,363(19)
Terry Moya....................... 2000 $209,615 $ 88,919 -- 227,501 $ 240(16)
Executive Vice President, 1999 $ 70,673(6) $ 36,458 $526,200(10) 240,000 $ 40,065(20)
External Affairs and Corporate 1998 -- -- -- -- --
Development
Dhruv Khanna..................... 2000 $263,462 -- -- 52,501 $ 270(16)
Executive Vice President, 1999 $176.923 $ 85,000 -- -- $ 180(16)
Human Resources, General Counsel 1998 $147,835 $ 80,000 -- -- $ 145(16)
and Secretary
Joseph Devich.................... 2000 $265,385(7) -- -- 75,000 $300,210(21)
Former Executive Vice President, 1999 $167,308 $101,250 $882,500(9) -- $ 50,210(22)
Corporate Services(2) 1998 $ 52,981(8) $ 20,137 -- 380,622 $ 76,961(23)
- --------
(1) On November 1, 2000, the Company announced the resignation of Mr.
Knowling. Frank J. Marshall has been appointed to replace Mr. Knowling on
an interim basis and Mr. Knowling received compensation provided per his
employment agreement.
(2) Mr. Devich resigned from the Company in December 2000.
(3) Pro rated based on an annual salary of $400,000 from hiring date of July
8, 1998.
(4) Pro rated based on an annual salary of $200,000 from hiring date of
January 20, 1999
(5) Pro rated based on an annual salary of $160,000 from hiring date of August
10, 1998.
(6) Pro rated based on an annual salary of $175,000 from hiring date of July
26, 1999.
(7) Pro rated based on an annual salary of $300,000 through December 2000.
(8) Pro rated based on an annual salary of $150,000 from hiring date of August
13, 1998.
108
(9) This value is based upon the closing price of $29.416 for 30,000 shares
granted on November 3, 1999 to Ms. Hemmer and Mr. Devich. Twenty-five
percent of these shares vest on the four consecutive anniversaries of the
grant date. As of December 29, 2000, twenty-five percent of these shares
were vested and each grant was valued at $49,686 based on a closing price
of $1.6562.
(10) This value is based upon the closing price of $35.083 for 15,000 shares
granted on July 26, 1999 to Mr. Moya. Twenty-five percent of these shares
vest on the four consecutive anniversaries of the grant date. As of
December 29, 2000, twenty-five percent of these shares were vested and
valued at $24,843 based on a closing price of $1.6562.
(11) Includes 450,000 options to purchase common stock, all of which were
granted in February 2000 and voluntarily rescinded in September 2000.
(12) Includes the outstanding balance of $250,000 on a note which was forgiven
in connection with Mr. Knowling's resignation and premium payments for Mr.
Knowling's term life insurance.
(13) Includes $750,000 for the final installment of Mr. Knowling's sign-on
bonus as well as $420 for term life insurance premium, plus scheduled loan
forgiveness of $125,000 on a $500,000 note which was secured by Mr.
Knowling's residence.
(14) Includes $750,000 for the first installment of Mr. Knowling's sign-on
bonus as well as $343 for term life insurance premium.
(15) Includes scheduled loan forgiveness of $150,000 on a $600,000 note which
was secured by Mr. Davenport's residence as well as premium payments for
Mr. Davenport's term life insurance.
(16) The dollar amount represents premium payments the Company made for these
executives' term life insurance policy.
(17) Includes scheduled loan forgiveness of $87,500 on a $350,000 note which
was secured by Ms. Hemmer's residence as well as premium payments for Ms.
Hemmer's term life insurance.
(18) Includes scheduled loan forgiveness of $87,500 on a $350,000 note which
was secured by Ms. Hemmer's residence as well as premium payments for Ms.
Hemmer's term life insurance.
(19) Includes a payment of $84,275 as a sign-on bonus as well as $88 for term
life insurance premium.
(20) Includes a payment of $40,000 as a sign-on bonus as well as $65 for term
life insurance premium.
(21) Includes a $150,000 severance payment, scheduled loan forgiveness of
$50,000 as well as forgiveness of the outstanding balance of $100,000 in
connection with Mr. Devich's resignation on a $200,000 note which was
secured by Mr. Devich's residence and $210 for Mr. Devich's term life
insurance premium.
(22) Includes scheduled loan forgiveness of $50,000 on a $200,000 note which
was secured by Mr. Devich's residence as well as premium payments for Mr.
Devich's term life insurance.
(23) Includes a payment of $76,883 as a sign-on bonus as well as $78 for term
life insurance premium.
(24) Mr. Davenport resigned from the Company in May 2001. Mr. Davenport's
duties will be assumed by Terry Moya, Executive Vice President, External
Affairs and Corporate Development.
109
Option/SAR Grants In Last Fiscal Year
The following table sets forth information regarding stock options granted
to Named Executive Officers during the fiscal year ended December 31, 2000.
Individual Grants
------------------------------------------------
Potential Realizable
Percent of ------------------------------
Number of Total Options Value at Assumed Annual Rates
Securities Granted to Exercise Of Stock Price Appreciation
underlying Employees in Price For Option Term ($)(3)
Options Fiscal Per Expiration ------------------------------
Name Granted (#)(1) 2000 (%)(2) Share Date 5% 10%
- ---- -------------- ------------- -------- ---------- -------------- ---------------
Frank J. Marshall....... 60,000 0.4371% $56.625 2/15/08 $ 1,622,155 $ 3,885,343
Robert Davenport,
III(6)................. 52,500 0.3825% $ 56.63 2/15/08 $ 1,419,511 $ 3,399,975
100,000 0.7285% $ 15.69 8/11/08 $ 749,128 $ 1,794,291
Catherine Hemmer........ 75,000 0.5264% $ 56.63 2/15/08 $ 2,027,873 $ 4,857,108
100,000 0.7285% $ 1.59 12/08/08 $ 76,097 $ 182,265
Dhruv Khanna............ 52.501 0.3825% $ 56.63 2/15/08 $ 1,419,538 $ 3,400,040
Terry Moya.............. 52,501 0.3825% $ 56.63 2/15/08 $ 1,419,538 $ 3,400,040
100,000 0.6746% $ 15.94 9/05/08 $ 761,064 $ 1,822,881
75,000 0.5059% $ 1.594 12/08/08 $ 57,073 $ 136,699
Joseph Devich(4)........ 75,000 0.5264% $ 56.63 1/03/01 $ 2,027,873 $ 4,857,108
Robert E. Knowling,
Jr.(5)................. 450,000 3.2783% $ 56.63 02/15/08 $12,167,236 $29,142,645
- --------
(1) The material terms of the option grants are as follows: (i) the options
consist of qualified and nonqualified stock options; (ii) all have an
exercise price equal to the fair market value on the date of grant; (iii)
grants generally have an 8-year term and become exercisable over a four-
year period (for example, grants of initial stock options to new employees
typically vest at a rate of 12.5% of the option shares on the six-month
anniversary of the grant date with the remainder vesting in 42 equal
monthly installments); (iv) the options are not transferable and (v) all
options are otherwise subject to the terms and provisions of the Company's
1997 Stock Plan. See "--1997 Stock Plan."
(2) Based on options covering an aggregate of 14,824,509 shares the Company
granted during 2000 pursuant to the Company's 1997 Stock Plan.
(3) These amounts represent hypothetical gains that could be achieved for the
options if exercised at the end of the option term. The potential
realizable values are calculated by assuming that the Company's common
stock appreciates at the annual rate shown, compounded annually, from the
date of grant until expiration of the granted options. The assumed 5% and
10% rates of stock price appreciation are mandated by the rules of the
Securities and Exchange Commission and do not represent the Company's
estimate or projection of future stock price growth.
(4) Mr. Devich resigned from the Company in December 2000.
(5) Mr. Knowling resigned from the Company in October 2000. This table includes
450,000 options to purchase common stock which were granted in February
2000 and voluntarily rescinded in September 2000.
(6) Mr. Davenport resigned from the Company in May 2001.
110
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, 2000 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. None of the Named Executive
Officers exercised or held stock appreciation rights during the year ended
December 31, 2000.
Options Exercised During Number Of Securities
2000 Underlying Unexercised Value Of Unexercised
---------------------------- Options At In-The-Money Options At
Shares December 31, 2000 December 31, 2000 ($)(2)
Acquired On Value ------------------------- ---------------------------
Name Exercise (#) Realized ($)(1) Exercisable Unexercisable Exercisable Unexercisable
---- ------------ --------------- ----------- ------------- ------------- -------------
Robert E. Knowling,
Jr.(3)................. 318,913 $11,704,610.12 2,338,275 -- $2,833,521.65 --
Robert Davenport,
III(3)................. 52,500 $ 2,988,519.15 182,394 367,608 -- --
Catherine Hemmer........ -- -- 200,956 324,258 -- --
Frank J. Marshall....... -- -- 62,373 68,127 $ 56,915.00 --
Dhruv Khanna............ -- -- 10,937 41,564 -- --
Terry Moya.............. 3,750 $ 68,553.01 93,933 296,568 -- --
Joseph Devich(3)........ 78,375 $ 2,094,213.39 46,744 237,244 -- --
- --------
(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 $1.656 on December 29, 2000.
An option is "in-the-money" if the market value of the common stock exceeds
the exercise price.
(3) Messrs. Knowling, Davenport and Devich resigned from the Company in October
2000, May 2001 and October 2000, respectively.
Employment Agreements And Change In Control Arrangements
Five of the Company's Section 16 officers, except the Company's Interim
Chief Executive Officer, have entered into severance agreements with the
Company under which the benefits would be triggered by a change of control. In
general, a change of control for the purposes of these agreements, is defined
as either (i) the acquisition of 20% of outstanding common stock of the
Company; (ii) a 25% change in the composition of the Board of Directors which
is completed without the approval of the Board of Directors; or
(iii) stockholder approval of a merger without 80% continuity of interest or of
sale or other disposition of substantially all of the Company's assets.
These agreements provide for a one-year employment term for these officers
upon a qualifying "change in control" and provide that such officer's
compensation and benefits cannot be reduced during the one-year term. In
addition, these contracts provide a basic severance benefit equal to two times
the sum of such officer's base salary and target bonus. Should an officer be
terminated within one year of a change in control, without cause or should the
officer terminate employment for "good reason" within that period, in addition
to the severance payment described above, such officer shall be entitled to (i)
a pro rata bonus for the year of termination; (ii) distribution of deferred
compensation; (iii) cash in lieu of any forfeited retirement/401(k) benefits;
and (iv) two years medical and other insurance benefits. Moreover, under
certain circumstances, such officer may defer severance and deferred
compensation payment upon six months advance notice. These agreements may also
provide additional rights including, but not limited to, legal fee
reimbursement, interest on delinquent payments, a board hearing if terminated
"for cause," and no obligation to mitigate damages.
In December 2000, the Company entered into written employment agreements
with Mark Perry, the Company's Executive Vice President and Chief Financial
Officer, John McDevitt, the Company's Executive Vice President, Sales and
Marketing, Terry Moya, the Company's Executive Vice President, External Affairs
and Corporate Development and Catherine Hemmer, the Company's Executive Vice
President and Chief
111
Operating Officer. The Company will offer a similar written employment
agreement to Anjali Joshi, our Executive Vice President, Engineering. These
agreements have a 12-month term, except for Ms. Hemmer's agreement, which has
an 18-month term. If the Company terminates any of these officers without cause
(as that term is defined in the agreement), or if an officer resigns for good
reason (as that term is defined in the agreement), the Company must continue to
pay their annual salary through the term of the agreement, plus a pro rated
portion of their bonus. In the event of a change of control (as that term is
defined in the agreement), these employment agreements are null and void.
In 1998, the Company entered into a written employment agreement with Robert
Knowling, Jr., the former Chairman of the Board of Directors, President and
Chief Executive Officer, who resigned on November 1, 2000. In connection with
his resignation, Mr. Knowling will continue to receive compensation in the form
of a $500,000 annual base salary for a period of two years and a $250,000
annual bonus for two years, so long as Mr. Knowling does not become employed by
one of the Company's direct competitors. Mr. Knowling received (i) a signing
bonus of $1,500,000, one half of which was paid when he began working for the
Company, and the remaining half of which was paid once he worked for the
Company for one full year (July 1999), and (ii) stock options to purchase
4,725,000 shares of the Company's common stock at an exercise price of
$0.45 per share. As provided in the agreement, in August 1998 the Company
loaned Mr. Knowling $500,000 pursuant to a Note Secured by Deed of Trust that
bears no interest during his employment. The loan has been forgiven in
connection with his resignation. See "Certain Relationships and Related
Transactions--Employee Loans."
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. See "--1997 Stock Plan."
We have also entered into restricted stock purchase agreements with certain
of the Company's officers and 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. See "Certain Relationships and Related Transactions--
Issuance of Common Stock."
1997 Stock Plan
Structure
The 1997 Plan consists of three types of equity incentive programs: (i)
qualifying stock options ("Incentive Stock Options") intended to qualify within
the meaning of Section 422 of the Code; (ii) non-qualifying stock options (or
"Non-Statutory Stock Options") not intended to qualify within the meaning of
Section 422 of the Code; and (iii) stock purchase rights ("SPRs") for shares of
common stock.
Administration
The Plan is administered by the Company's Board of Directors or a committee
appointed by the Board of Directors and consisting of non-employee directors
within the meaning of Section 16(b) of the Exchange Act and outside directors
within the meaning of Section 162(m) of the Code (referred to as the
"Administrator"). Subject to the provisions of the Plan, the Administrator has
the authority, in its discretion: (i) to determine the fair market value of the
Company's common stock; (ii) to select the employees, directors or consultants
to whom options and SPRs may be granted under the Plan; (iii) to determine the
number of shares of common stock to be covered by each option and SPR granted
under the Plan; (iv) to approve forms of agreement for use
112
under the Plan; (v) to determine the terms and conditions of any option or SPR
granted under the Plan such as the exercise price, the time or times when
options or SPRs may be exercised (which may be based on performance criteria),
any vesting acceleration or waiver of forfeiture restrictions; (vi) to reduce
the exercise price of any option or SPR to the then current fair market value;
(vii) to institute an option exchange program; (viii) to construe and interpret
the terms of the Plan and awards granted pursuant to the Plan; (ix) to
prescribe, amend and rescind rules and regulations relating to the Plan; (x) to
modify or amend each option or SPR; (xi) to allow optionees to satisfy
withholding tax obligations by electing to have the Company withhold from the
shares to be issued upon exercise of an option or SPR that number of shares
having a fair market value equal to the amount required to be withheld; (xii)
to authorize any person to execute on behalf of the Company any instrument
required to effect the grant of an option or SPR previously granted by the
Administrator; and (xiii) to make all other determinations deemed necessary or
advisable for administering the Plan.
Eligibility
All employees, directors and consultants are eligible to participate in the
1997 Plan. Incentive Stock Options may be granted only to employees (including
officers and directors). Non-Statutory Stock Options and SPRs may be granted to
employees, directors and consultants. To the extent that the aggregate fair
market value of the shares with respect to which Incentive Stock Options are
exercisable for the first time by an optionee during any calendar year (under
all plans of the Company and any parent or subsidiary) exceed $100,000, such
options are treated as Non-Statutory Stock Options. No optionee may be granted,
in any fiscal year, options to purchase more than 4,500,000 shares (subject to
adjustment for future stock splits and dividends); provided that, in connection
with his or her initial service, an optionee may be granted options to purchase
up to an additional 2,000,000 shares that shall not count against such limit.
Securities Subject To The Plan
As of January 1, 2001, the number of shares of the Company's common stock
which are reserved for issuance under the Plan is 59,657,761 shares, plus an
annual increase on the first day of each fiscal year equal to the lesser of (i)
3% of the outstanding shares on such date or (ii) an amount determined by the
Company's Board of Directors, with the total annual increase being capped at
20,000,000 shares. In 2001, the 3% annual increase consisted of 5,308,123
shares plus 10,000,000 additional shares approved at the Company's Annual
Meeting held June 30, 2000 for the Year 2001.
These shares may be authorized, but unissued, or reacquired common stock. If
an option or SPR expires or becomes unexercisable without having been exercised
in full, or is surrendered pursuant to an option exchange program, the
unpurchased shares that were subject thereto may become available for future
grant or sale under the Plan.
Participation In The Plan
As of January 1, 2001, 27,734,375 shares of common stock were subject to
outstanding options and SPRs under the Plan, 39,952,644 options had been issued
under the Plan (net of cancelled options), and we can grant up to
19,705,117 additional options within the Plan's limits.
1998 Employee Stock Purchase Plan
The 1998 Employee Stock Purchase Plan was adopted by the Company's Board of
Directors in December 1998, and approved by the stockholders in January 1999.
As of January 1, 2001, a total of 8,927,727 shares of the Company's common
stock have been reserved for issuance under this plan, plus annual increases
equal to the lesser of (i) 2% of the outstanding shares on such date or (ii) an
amount determined by the Board of Directors. To date, 1,118,024 shares have
been issued under the 1998 Employee Stock Purchase Plan.
113
The 1998 Employee Stock Purchase Plan, which is intended to qualify under
Section 423 of the Internal Revenue Code of 1986, as amended (the "Code"),
contains consecutive, overlapping, twenty-four month offering periods. Each
offering period includes four six-month purchase periods. The offering periods
generally start on the first trading day on or after May 1 and November 1 of
each year, except for the first offering period which commenced on the first
trading day after the Company's initial public offering (January 22, 1999) and
ends on the last trading day on or before October 31, 2000.
Employees are eligible to participate if they are customarily employed by
the Company or any of the Company's participating subsidiaries for at least 30
hours per week and more than five months in any calendar year. However, no
employee may be granted a right to purchase stock under the 1998 Employee Stock
Purchase Plan (i) to the extent that, immediately after the grant of the right
to purchase stock, the employee would own stock possessing 5% or more of the
total combined voting power or value of all classes of the Company's capital
stock, or (ii) to the extent that his or her rights to purchase stock under all
the Company's employee stock purchase plans accrues at a rate which exceeds
$25,000 worth of stock for each calendar year. The 1998 Employee Stock Purchase
Plan permits participants to purchase the Company's common stock through
payroll deductions of up to 12% of the participant's "compensation."
Compensation is defined as the participant's base straight time gross earnings
and commissions but excludes payments for overtime, shift premium, incentive
compensation, incentive payments, bonuses and other compensation. The maximum
number of shares a participant may purchase during a single purchase period is
5,000 shares.
Amounts deducted and accumulated by the participant are used to purchase
shares of the Company's common stock at the end of each purchase period. The
price of stock purchased under the 1998 Employee Stock Purchase Plan is
generally 85% of the lower of the fair market value of the Company's common
stock (i) at the beginning of the offering period or (ii) at the end of the
purchase period. In the event the fair market value at the end of a purchase
period is less than the fair market value at the beginning of the offering
period, the participants will be withdrawn from the current offering period
following exercise and automatically re-enrolled in a new offering period. The
new offering period will use the lower fair market value as of the first date
of the new offering period to determine the purchase price for future purchase
periods. Participants may end their participation at any time during an
offering period, and they will be paid their payroll deductions to date.
Participation ends automatically upon termination of employment.
Laser Link.Net, Inc. 1997 Stock Plan
On March 20, 2000, pursuant to the Agreement and Plan of Merger dated as of
March 8, 2000, Laser Link.Net, Inc. was acquired in a merger of Lightsaber
Acquisition Co. ("Lightsaber"), the Company's wholly-owned subsidiary, with
Laser Link in which Lightsaber was the surviving entity (the "Merger"). As part
of the Merger, the Company agreed to assume the Laser Link.Net, Inc. 1997 Stock
Option Plan (the "Laser Link Plan") and each outstanding option under the Laser
Link Plan. As a result, the Company will issue shares of the Company's common
stock, subject to adjustment in the number of shares and exercise price of the
original options, upon exercise of outstanding stock options previously issued
under the Laser Link Plan. In the Merger, each share of Laser Link common stock
was converted into .173535 share of the Company's common stock (the "Exchange
Ratio").
Structure. The Laser Link Plan consists of two types of equity incentive
programs: (i) qualifying stock options ("Incentive Stock Options") intended to
qualify within the meaning of Section 422 of the Internal Revenue Code of 1986,
as amended (the "Code") and (ii) non-qualifying stock options (or "Non-
Statutory Stock Options") not intended to qualify within the meaning of Section
422 of the Code.
Administration. The Laser Link Plan is administered by either the Company's
Board of Directors or an Option Committee consisting of outside directors
appointed by the Board of Directors (the "Administrator"). Subject to the
provisions of the Laser Link Plan, the Administrator has the authority, in its
discretion: (i) to select the employees, directors or consultants to whom
options may be granted under the Laser Link Plan; (ii) to determine the number
of shares of common stock to be covered by each option granted under the Laser
114
Link Plan; (iii) to determine the time or times at which options may be granted
and whether those options are Incentive Stock Options or Non-Statutory Stock
Options; (iv) to determine the price at which options are exercisable, the rate
of exercisability and the duration of each option; and (v) to prescribe, amend
and rescind rules and regulations relating to the Laser Link Plan.
Eligibility. All key employees, directors and important consultants are
eligible to participate in the Laser Link Plan. However, in view of the Merger,
it is anticipated that no further options will be granted under the Laser Link
Plan.
Under the Laser Link Plan Incentive Stock Options may be granted only to
employees (including officers and directors who are employees). Non-Statutory
Stock Options may be granted to employees, directors and consultants of the
Company's. No optionholder may be granted options to purchase more than 90% of
the shares authorized for issuance under the Laser Link Plan.
Securities Subject to the Laser Link Plan. As of the date of the Merger,
10,000,000 shares of Laser Link's common stock, par value $0.01, were reserved
for issuance under the Laser Link Plan. After the Merger, based on the Exchange
Ratio, a maximum of 1,735,350 shares of the Company's common stock will be
available for issuance under the Laser Link Plan.
BlueStar Communications Group, Inc. 2000 Stock Incentive Plan
On September 25, 2000, pursuant to the Agreement and Plan of Merger dated as
of June 15, 2000, BlueStar Communications Group, Inc. ("BlueStar") was acquired
in a merger of Covad Acquisition Corp. ("CAC"), the Company's wholly owned
subsidiary, with BlueStar in which CAC was the surviving entity (the "Merger").
As part of the Merger, the Company agreed to assume the BlueStar Communications
Group, Inc. 2000 Stock Incentive Plan (the "BlueStar Plan") and each
outstanding option under the BlueStar Plan.
As a result, the Company will issue shares of the Company's common stock,
subject to adjustment in the number of shares and exercise price of the
original options, upon exercise of outstanding stock options previously issued
under the BlueStar Plan. In the Merger, each share of BlueStar common stock was
converted into .053 share of the Company's common stock (the "Exchange Ratio").
In light of the Exchange Ratio, there are 207,146 shares of the Company's
common stock subject to the BlueStar Plan.
In general, the BlueStar Plan consists of five types of equity incentive
programs: (i) the Discretionary Option Grant Program under which eligible
persons may, at the discretion of the Plan Administrator, be granted options to
purchase shares of common stock; (ii) the Salary Investment Option Grant
Program under which eligible employees may elect to have a portion of their
base salary invested each year in special options; (iii) the Stock Issuance
Program under which eligible persons may, at the discretion of the Plan
Administrator, be issued shares of common stock directly, either through the
immediate purchase of such shares or as a bonus for services rendered the
Company (or any parent or subsidiary); (iv) the Automatic Option Grant Program
under which eligible non-employee Board members shall automatically receive
options at periodic intervals to purchase shares of common stock; and (v) the
Director Fee Option Grant Program under which non-employee Board members may
elect to have all or any portion of their annual retainer fee otherwise payable
in cash applied to a special option grant.
The persons eligible to participate in the Discretionary Option Grant and
Stock Issuance Programs include (i) employees; (ii) non-employee members of the
Board of Directors or the board of directors of any parent or subsidiary; and
(iii) consultants and other independent advisors who provide services to the
Company (or any parent or subsidiary). Only employees who are Section 16
Insiders or other highly compensated individuals participate in the Salary
Investment Option Grant Program. Only non-employee Board members may
participate in the Automatic Option Grant and Director Fee Option Grant
Programs.
115
No one person participating in the BlueStar Plan may receive options,
separately exercisable stock appreciation rights and direct stock issuances for
more than 53,000 shares of common stock (in the aggregate) per calendar year.
The stock issuable under the BlueStar Plan includes shares of authorized but
unissued or reacquired common stock. The maximum number of shares of common
stock initially reserved for issuance over the term of the BlueStar Plan shall
not exceed 452,541 shares.
As of the date of the Merger, 7,027,077 shares of BlueStar's common stock,
par value $0.01, were reserved for issuance under existing options granted
under the BlueStar Plan. It is anticipated that no further options will be
granted or shares will be issued under the BlueStar Plan. After the Merger,
based on the Exchange Ratio, a maximum of 1,251,182 shares of the Company's
common stock will be issuable pursuant to existing options granted under the
BlueStar Plan.
While the BlueStar Plan provides for automatic share increase each year
through 2005 based on the outstanding common stock, the Company does not intend
to avail itself of this increased availability since it anticipates that no
further options will be granted under the BlueStar Plan.
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.
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 all Section 16(a) filing requirements
were met during fiscal 2000, except the following forms which were filed late
by Larry Irving (Form 3 due March 5, 2000), Chuck Haas (Form 3 due December, 12
2000); Dhruv Khanna (Form 4 due July 10, 2000 and Form 5 due February 14,
2000); Robert Hawk (Form 5 due February 14, 2000), Catherine Hemmer (Form 5 due
February 14, 2000), Michael Lach (Form 5 due February 14, 2000), Timothy Laehy
(Form 5 due February 14, 2000), Jane Marvin (Form 5 due February 14, 2000),
John McDevitt (Form 5 due February 14, 2000), Terry Moya (Form 5 due
February 14, 2000), Mark H. Perry (Form 5 due February 14, 2000) and Frank
Thomas (Form 5 due February 14, 2000). Based solely upon representations from
these officers and directors, each of these late forms were filed in connection
with single transactions.
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 May 1, 2001 by:
(i) each Named Executive Officer;
(ii) each of the Company's directors;
(iii) all of the Company's executive officers and directors as a group; and
(iv) all persons known to the Company to beneficially own 5% or more of
the Company's common stock.
116
Share ownership in each case includes shares issuable upon exercise of
outstanding options and warrants that are exercisable within 60 days of May 1,
2001 as described in the footnotes below. Percentage ownership is calculated
pursuant to SEC Rule 13d-3(d)(1). Except as otherwise indicated, the address of
each of the persons in this table, other than the selling stockholders, is as
follows: c/o Covad Communications Group, Inc., 4250 Burton Drive, Santa Clara,
California 95054.
Shares Beneficially
Owned
---------------------
Beneficial Owner Number Percentage
---------------- ---------- ----------
SBC Communications, Inc.(1)............................. 9,373,169 5.21%
Charles McMinn(2)....................................... 3,557,474 1.98%
Rich Shapero(3)......................................... 2,593,768 1.44%
Chuck Haas(4)........................................... 5,347,531 2.97%
Dhruv Khanna(5)......................................... 5,348,595 2.97%
Catherine Hemmer(6)..................................... 503,919 *
Robert Davenport, III(7)................................ 285,031 *
Robert Hawk(8).......................................... 307,018 *
Daniel Lynch(9)......................................... 540,416 *
Frank J. Marshall(10)................................... 816,439 *
Hellene Runtagh(11)..................................... 43,831 *
Larry Irving(12)........................................ 22,707 *
Terry Moya(13).......................................... 165,272 *
Robert E. Knowling Jr. ................................. 671,400 *
Joseph Devich........................................... 22,835 *
All current executive officers and directors as a group
(16 persons)........................................... 29,354,673 16.31%
- --------
* Represents beneficial ownership of less than 1% of the Company's
outstanding stock.
(1) Based on a Form 13G filed November 6, 2000 with the Securities and
Exchange Commission by SBC Communications, Inc.
(2) Includes 33,377 shares of common stock subject to options exercisable
within 60 days of May 1, 2001.
(3) Includes 3,750 shares of common stock subject to options exercisable
within 60 days of May 1, 2001.
(4) Includes 5,416 shares of common stock subject to options exercisable
within 60 days of May 1, 2001.
(5) Includes 7,479 shares of common stock subject to options exercisable
within 60 days of May 1, 2001.
(6) Includes 31,778 shares of common stock subject to options exercisable
within 60 days of May 1, 2001 as well as 13,683 shares of the Company's
common stock beneficially owned by Ms. Hemmer's husband which may be
attributable to Ms. Hemmer.
(7) Includes 27,690 shares of common stock subject to options exercisable
within 60 days of May 1, 2001.
(8) Includes 3,805 shares of common stock subject to options exercisable
within 60 days of May 1, 2001.
(9) Includes 6,750 shares of common stock subject to options exercisable
within 60 days of May 1, 2001.
(10) Includes 37,083 shares of common stock subject to options exercisable
within 60 days of May 1, 2001.
(11) Includes 5,834 shares of common stock subject to options exercisable
within 60 days of May 1, 2001.
(12) Includes 4,584 shares of common stock subject to options exercisable
within 60 days of May 1, 2001.
(13) Includes 19,147 shares of common stock subject to options exercisable
within 60 days of May 1, 2001.
117
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Series C Preferred Stock and Warrant Subscription Agreement
On February 20, 1998, we entered into a Series C Preferred Stock and Warrant
Subscription Agreement (the "Subscription Agreement") with Warburg, Pincus
Ventures, L.P. ("Warburg") & Crosspoint Venture Partners 1996 ("Crosspoint")
and Intel Corporation ("Intel"). Under this agreement, Warburg and Crosspoint
unconditionally agreed to purchase an aggregate of 8,646,214 shares of our
Series C Preferred Stock and warrants to purchase an aggregate of 7,094,250
shares of our Series C Preferred Stock for an aggregate purchase price of $16.0
million at a date that we were to determine but, in any event, not later than
March 11, 1999. We agreed to either call this commitment or complete an
alternate equity financing of at least $16.0 million by March 11, 1999. A
proposed alternate equity financing providing for a price per share greater
than or equal to $1.8511 and including securities that were equal in right
with, or more favorable to us than, our Series C Preferred Stock as set forth
in our Amended and Restated Certificate of Incorporation required unanimous
approval by a majority of our disinterested directors. In consideration of this
commitment, we issued to Warburg and Crosspoint warrants to purchase an
aggregate of 2,541,222 shares of our common stock at a purchase price of
$0.0022 per share. The parties agreed that the stock purchases by AT&T Ventures
and NEXTLINK Communications Inc. (now XO Communications) constituted an
alternate equity financing (see below). As a result, we did not issue and sell
our Series C Preferred Stock to Warburg and Crosspoint. Messrs. Henry Kressel
and Joseph Landy, two of our former directors, are affiliated with Warburg, and
Mr. Shapero, one of our current directors, is affiliated with Crosspoint.
On April 24, 1998, the Subscription Agreement was amended pursuant to an
Assignment and Assumption Agreement to which we were a party along with
Warburg, Crosspoint and Mr. Hawk. By the terms of this agreement, Warburg and
Crosspoint assigned to Mr. Hawk their obligation to purchase 54,022 shares of
our Series C Preferred Stock and 44,338 warrants to purchase Series C Preferred
Stock for an aggregate purchase price of $100,001.65. On the same date, Mr.
Hawk purchased 54,022 shares of our Series C Preferred Stock at a price per
share of $1.8511. As a result of this amendment, the aggregate obligation of
Warburg and Crosspoint to purchase our Series C Preferred Stock and warrants to
purchase Series C Preferred Stock was reduced from 8,646,214 shares to
8,592,192 shares and from 7,094,250 shares to 7,049,911 shares, respectively,
for an aggregate purchase price of $15.9 million (reduced from $16.0 million).
On the same date, the Amended and Restated Stockholder Rights Agreement dated
March 11, 1998 (the "Stockholder Rights Agreement") was amended to add Mr. Hawk
as a party.
The warrants to purchase our common stock issued upon the signing of the
Subscription Agreement had five-year terms (but had to be exercised prior to
the closing of our initial public offering), had purchase prices of $0.0015 per
share, were immediately exercisable and contained net exercise provisions.
Prior to our initial public offering, Warburg and Crosspoint exercised their
warrants to purchase Series C Preferred Stock for 3,048,907 and 762,364 shares
of our common stock.
On March 11, 1998, we amended the Stockholder Rights Agreement, to extend
the rights held by Warburg, Crosspoint, and Intel to our warrants to purchase
common stock, Series C Preferred Stock and warrants to purchase Series C
Preferred Stock issued or issuable to Warburg, Crosspoint and Intel pursuant to
the Subscription Agreement (see below).
The Intel Stock Purchase
As provided in the Subscription Agreement, Intel purchased 540,216 shares of
our Series C Preferred Stock and warrants to purchase 443,250 shares of our
Series C Preferred Stock for an aggregate purchase price of $1.0 million
concurrently with the issuance of our 1998 notes in March 1998. We did not have
any obligation to issue the warrants to purchase Series C Preferred Stock to
Intel until such time as Warburg and Crosspoint funded their respective
commitments under the Subscription Agreement. The parties agreed that our
initial public offering constituted an alternate equity financing and,
therefore, we did not issue the warrants to
118
purchase Series C Preferred Stock to Intel. In connection with its agreement to
purchase such Series C Preferred Stock and warrants to purchase Series C
Preferred Stock, we issued to Intel warrants to purchase an aggregate of
238,167 shares of our common stock at a purchase price of $0.0015 per share.
Prior to our initial public offering, Intel exercised its warrants for 238,167
shares of our common stock.
Transactions in Connection with the Formation of the Delaware Holding Company
We were originally incorporated in California as Covad Communications
Company ("Covad California") in October 1996. In July 1997, we were
incorporated in Delaware as part of our strategy to operate through a holding
company structure and to conduct substantially all of our operations through
subsidiaries. To effect the holding company structure, in July 1997 we entered
into an Exchange Agreement with the existing holders of the common stock and
Series A Preferred Stock of Covad California to acquire all of such stock in
exchange for a like number of shares of our common and preferred stock, so that
after giving effect to the exchange Covad California became our wholly-owned
subsidiary. In addition, we entered into an Assumption Agreement pursuant to
which we assumed certain outstanding obligations of Covad California, including
a $500,000 demand note issued to Warburg and certain commitments to issue stock
options to two of our consultants.
In connection with the Exchange Agreement, Mr. McMinn, our Chairman of the
Board of Directors, and two of our current officers, Mr. Khanna and Mr. Haas,
each exchanged 6,750,000 shares of common stock of Covad California, originally
purchased for $.0019 per share, for a like number of our shares of common stock
pursuant to restricted stock purchase agreements. In addition, Mr. Lynch, one
of our directors, exchanged 324,000 shares of common stock of Covad California,
originally purchased for $0.148 per share, for a like number of our shares of
common stock pursuant to a restricted stock purchase agreement. The common
stock issued to Messrs. McMinn, Khanna, Haas and Lynch are generally subject to
vesting over a period of four years. This vesting is subject to acceleration
upon a change of control involving a merger, sale of all or substantially all
our assets or a shift in 50% or more of the voting power of our capital stock.
Our repurchase rights lapse 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
agreements.
Issuance of Common Stock
On July 15, 1997, we issued 2,531,250 shares of our common stock to Mr. Rex
Cardinale, one of our former officers, for a purchase price of $0.148 per
share. On August 30,1997, we issued 776,250 shares of our common stock to Mr.
Laehy, one of our former officers, for a purchase price of $0.0222 per share.
On October 14, 1997, we issued 324,000 shares of our common stock to Mr.
Marshall, our Chief Executive Officer and one of our directors, for a purchase
price of $0.0222 per share. On April 24, 1998, we issued 216,000 shares of our
common stock to Mr. Hawk, one of our directors, for a purchase price of $0.296
per share. On August 28, 1998, we issued 90,000 shares of our common stock to
Mr. Hawk for a purchase price of $2.555 per share. The shares of our common
stock issued to Messrs. Cardinale, Laehy, Marshall, and Hawk were issued
pursuant to restricted stock purchase agreements which contain vesting and
change of control provisions similar to those contained in the above-described
restricted stock purchase agreements of Messrs. McMinn, Khanna, Haas and Lynch.
Issuance of Series A Preferred Stock
On June 30, 1997 Covad California issued 225,000 shares of Series A
Preferred Stock to each of Messrs. McMinn, Khanna and Haas and 450,000 shares
of Series A Preferred Stock to Mr. Lynch for a purchase price of $0.222 per
share. In July 1997, these shares were exchanged for a like number of our
shares of Series A Preferred Stock pursuant to the Exchange Agreement.
119
Issuance of Series B Preferred Stock
In July 1997, we sold an aggregate of 25,500,001 shares of our Series B
Preferred Stock, of which 18,000,000 shares were sold to Warburg, 4,500,000
shares were sold to Crosspoint and 3,000,001 shares were sold to Intel. The
purchase price of our Series B Preferred Stock was $0.333 per share. A portion
of the purchase price of the Series B Preferred Stock was paid by cancellation
of a $500,000 demand note issued to Warburg in June 1997. Messrs. Kressel and
Landy, each of whom formerly served as members of our Board of Directors, are
affiliated with Warburg. Mr. Shapero, who currently serves on our Board of
Directors, is affiliated with Crosspoint. On February 12, 1998, we sold an
additional 150,003 shares of Series B Preferred Stock at a purchase price of
$0.666 per share to Mr. Marshall.
The Strategic Investments and Relationships
In January 1999, we received equity investments from AT&T Ventures, NEXTLINK
Communications Inc. (now XO Communications) and Qwest Communications
International, Inc. AT&T Ventures purchased an aggregate of 2,250,874 shares of
our Series C-1 Preferred Stock at $1.8511 per share and an aggregate of
1,736,112 shares of our Series D-1 Preferred Stock at $12.00 per share. These
purchases represent an aggregate investment of $25 million, of which $11
million was invested by AT&T Venture Fund II, LP and $14 million was invested
by two affiliated funds. NEXTLINK Communications Inc. (now XO Communications)
purchased 1,800,699 shares of our Series C-1 Preferred Stock at $1.8511 per
share and 925,926 shares of our Series D-1 Preferred Stock at $12.00 per share,
representing an investment of $20 million. Qwest Communications International,
Inc. purchased 1,350,523 shares of our Series C-1 Preferred Stock at $1.8511
per share and 1,041,667 shares of our Series D-1 Preferred Stock at $12.00 per
share, representing an aggregate investment of $15 million. At the completion
of our initial public offering, our Series C-1 Preferred Stock converted into
our Class B common stock on a one-for-one basis. The Series D-1 Preferred Stock
also converted into our Class B common stock at that time on a one-for-one
basis. These strategic investors have agreed not to transfer any of our Series
C-1 Preferred Stock, Series D-1 Preferred Stock or Class B common stock to any
non-affiliated third party until January 2000. They have also each agreed not
to acquire more than 10% of our voting stock without our consent until January
2002. In addition, until January 2002, they have agreed to vote any voting
securities they hold as recommended by our Board of Directors. Since this time,
all of our Class B common stock has been converted into our common stock.
Concurrently with these strategic equity investments, we entered into
commercial agreements with AT&T Corp., NEXTLINK Communications Inc. (now XO
Communications) and Qwest Communications International, Inc. These agreements
provide for the purchase, marketing and resale of our services at volume
discounts, our purchase of fiber optic transport bandwidth at volume discounts,
collocation of network equipment and development of new DSL services. These
agreements have terms ranging from six months to several years subject to
earlier termination in certain circumstances. We cannot predict the number of
line orders that AT&T Corp., NEXTLINK Communications Inc. (now XO
Communications) or Qwest Communications International, Inc. will generate, if
any, whether line orders will be below our expectations or the expectations of,
AT&T Corp., NEXTLINK Communications Inc. (now XO Communications) or Qwest
Communications International, Inc. or whether AT&T Corp., NEXTLINK
Communications Inc. (now XO Communications) or Qwest Communications
International, Inc. will discontinue selling our services entirely.
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. SBC also agreed for a 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.
120
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. This agreement also provides
incentives for SBC to sell business lines provided by us, and we
announced that SBC will begin marketing both symmetric business service
DSL and asymmetric consumer service DSL provided by Covad throughout the
United States.
. 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 loop 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.
BlueStar Acquisition
On September 25, 2000, we completed our acquisition of BlueStar
Communications Group, Inc. Our current Chairman of the Board of Directors,
Charles McMinn, was a member of BlueStar's Board of Directors and a BlueStar
shareholder when this acquisition occurred, however, he was not a member of our
Board of Directors at that time. Two of our directors, Robert Hawk and Richard
Shapero, were also shareholders of BlueStar when this acquisition took place
and Mr. Shapero was also a member of BlueStar's Board of Directors. Both Mr.
Shapero and Mr. Hawk did not participate in meetings of our Board of Directors
concerning the review and approval of the BlueStar acquisition.
In connection with our acquisition of BlueStar, we agreed to place
approximately 800,000 shares in a third-party escrow account. These shares were
part of the approximately 6.1 million shares that were initially issued in
connection with the acquisition. These escrow shares would be returned to us to
the extent that we discovered that representations and warranties that were
made to us by BlueStar at the time of the acquisition were not true. We also
agreed to issue up to an additional 5.0 million shares if BlueStar met certain
operating and financial criteria during 2001. We have reached an agreement with
the BlueStar shareholders' representative to resolve both of these matters by
providing the BlueStar shareholders with 3.25 million of the 5.0 million
shares, in exchange for a release of all claims against us. The 800,000 escrow
shares would be returned to us under this agreement. This agreement is
conditioned upon obtaining approval by 80% of the BlueStar shareholders, which
approval has not yet been obtained. Mr. Hawk and Mr. Shapero also did not
participate in meetings of our Board of Directors to the extent that such
meetings concerned the review and approval of this agreement.
Equipment Lease Financing
In 1998, we incurred a total of $865,000 of equipment lease financing
obligations (including principal and interest) through a sale lease-back
transaction with Charter Financial, Inc. ("Charter Financial"). These leases
were paid in full in 2000 and are no longer outstanding. Warburg, a principal
stockholder of us at the time this transaction was entered into, owns a
majority of the capital stock of Charter Financial. We believe that the terms
of the lease financing with Charter Financial were completed at rates similar
to those available from
121
alternative providers. Our belief that the terms of the sale lease-back
arrangement are similar to those available from alternative providers is based
on the advice of its our officers who reviewed at least two alternative
proposals and who reviewed and negotiated the terms of the arrangement with
Charter Financial.
Vendor Relationship
Crosspoint, who was one of our principal stockholders, previously owned
approximately 12% of the capital stock of Diamond Lane, one of our vendors.
Payments to Diamond Lane in 1998 and 1999 totaled approximately $51,539,000. We
believe that the terms of our transactions with Diamond Lane were completed at
rates similar to those available from alternative vendors. This belief is based
on our management team's experience in obtaining vendors and the fact that we
sought competitive bidders before entering into the relationship with Diamond
Lane. Diamond Lane was acquired by Nokia Communications, which continues to be
a significant supplier of our network equipment.
Minority Investments
Mr. McMinn is a member of the Board of Directors of DishnetDSL, a DSL
provider in India, and holds options to purchase shares of that company. Mr.
McMinn is also on the Board of Directors and owns shares of Certive
Corporation. We are a minority investor in both of these companies. Our
investments in these companies were made when Mr. McMinn was not on our board.
Registration Rights
Certain holders of our common stock are entitled to registration rights.
Pursuant to the Stockholder Rights Agreement holders of 30,112,927 shares of
common stock and holders of 6,379,177 shares of Class B common stock
(collectively, the "Rights Holders") are entitled to certain rights with
respect to the registration under the Securities Act of the shares of common
stock held by them or issuable upon conversion of the Class B common stock.
Commencing January 2000, the Class B common stock became convertible into
common stock at the election of the holder. As of April 2000, all Class B
common stock had been so converted.
The Rights Holders are entitled to demand, "piggy-back" and S-3 registration
rights, subject to certain limitations and conditions. The number of securities
requested to be included in a registration involving the exercise of demand and
"piggy-back" rights are subject to a pro rata reduction based on the number of
shares of common stock held by each Rights Holder and any other security
holders exercising their respective registration rights to the extent that the
managing underwriter advises that the total number of securities requested to
be included in the underwriting is such as to materially and adversely affect
the success of the offering. The registration rights terminate as to any Rights
Holder at the later of (i) three years after our initial public offering or
(ii) such time as such Rights Holder may sell under Rule 144 in a three month
period all registrable securities then held by such Rights Holder.
Pursuant to the Warrant Registration Rights Agreement dated March 11, 1999,
between us and Bear, Stearns & Co. Inc. and BT Alex. Brown Incorporated,
holders of the warrants that were issued in connection with our 1998 note
offering in March 1998 are entitled to certain registration rights with respect
to the shares of common stock issuable upon exercise of such warrants. The
warrant holders are entitled to demand and "piggy-back" registration rights,
subject to certain limitations and conditions. Like the Rights Holders, the
number of securities that a warrant holder may request to be included in a
registration involving an exercise of its demand or "piggy-back" rights is
subject to a pro rata reduction. Such a reduction will be based upon the number
of shares held by each warrant holder and any other security holders exercising
their respective registration rights to the extent that the managing
underwriter advises us that the total number of securities requested to be
included in the underwriting is such as to materially and adversely affect the
success of the offering.
122
Employment Agreements
In 1998, we entered into a written employment agreement with Robert
Knowling, Jr., the former Chairman of the Board of Directors, President and
Chief Executive Officer, who resigned on November 1, 2000. Mr. Knowling will
continue to receive compensation in the form of a $500,000 annual base salary
for a period of two years and a $250,000 annual bonus for two years, so long as
Mr. Knowling does not become employed by one of our direct competitors. Mr.
Knowling received (i) a signing bonus of $1,500,000, one half of which was paid
when he began working for us, and the remaining half of which was paid once he
worked for us for one full year in July 1999, and (ii) stock options to
purchase 4,725,000 shares of our common stock at an exercise price of $0.45 per
share. Mr. Knowling has agreed to be bound by customary confidentiality
provisions. As provided in the agreement, in August 1998 we loaned Mr. Knowling
$500,000 pursuant to a Note Secured by Deed of Trust that bears no interest
during his employment. The loan has been forgiven in connection with his
resignation. See "Certain Relationships and Related Transactions--Employee
Loans."
In December 2000, we entered into written employment agreements with Mark
Perry, our Executive Vice President and Chief Financial Officer, John McDevitt,
our Executive Vice President, Sales and Marketing, Terry Moya, our Executive
Vice President, External Affairs and Corporate Development and Catherine
Hemmer, our Executive Vice President and Chief Operating Officer. These
agreements have a 12-month term, except for Ms. Hemmer's agreement, which has
an 18-month term. If we terminate any of these officers without cause (as that
term is defined in the agreement), or if an officer resigns for good reason (as
that term is defined in the agreement), we must continue to pay their annual
salary through the term of the agreement, plus a pro rated portion of their
bonus. In the event of a change of control (as that term is defined in the
agreement), these employment agreements are null and void.
With respect to all options granted under our 1997 Stock Plan, in the event
that we merge with or into another corporation resulting in a change of control
involving a shift in 50% or more of the voting power of our capital stock, or
the sale of all or substantially all of our 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. See
"--1997 Stock Plan."
We have also entered into restricted stock purchase agreements with certain
of the Company's officers and directors. The shares of our 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. See "Certain Relationships and Related Transactions--Issuance of
Common Stock."
Employee Loans
In August 1998, we loaned Robert E. Knowling, Jr., our former Chairman of
the Board, President and Chief Executive Officer, pursuant to his employment
agreement, the principal amount of $500,000 pursuant to a Note Secured by Deed
of Trust, which was secured by Mr. Knowling's primary residence. As of November
1, 2000, the outstanding balance of $250,000 on this note was forgiven in
connection with Mr. Knowling's resignation from his position with the Company.
In August 1998, we loaned Joseph Devich, one of our former officers, the
principal amount of $200,000 pursuant to a Note Secured by Deed of Trust, which
was secured by the primary residence of Mr. Devich. This note had provisions
for forgiveness based upon the continued employment of Mr. Devich and was
subject to acceleration in certain events. No interest was charged on this
note. The outstanding balance of $100,000 on this note was forgiven in
connection with Mr. Devich's resignation from the Company.
In October 1998, we loaned Catherine Hemmer, our Executive Vice President
and Chief Operating Officer, and her husband, one of the Company's employees,
the principal amount of $600,000 pursuant to a Note
123
Secured By Deed of Trust, which was secured by the primary residence of the
Hemmers. The outstanding principal balance of this note becomes due in four
equal annual installments commencing August 10, 1999, with the last installment
due on August 10, 2002. No interest is charged on the note. This note has
provisions for forgiveness based upon continued employment of each of the
Hemmers and is subject to acceleration in certain events.
In April 2000, we loaned Jane Marvin, one of our resigning officers, the
principal amount of $500,000 for the purchase of a primary residence. The loan
is secured by such primary residence. The remaining balance on the loan must be
paid in full within 120 days of Ms. Marvin's resignation. In addition, in
December 1999, we loaned Ms. Marvin $80,705.46 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 resigning officers, the
principal amount of $600,000 for the purchase of a primary residence. The loan
is secured by such primary residence. The remaining balance on this loan must
be paid in full over the next three years.
In August 2000, we loaned John McDevitt, one of our officers, the principal
amount of $100,000 pursuant to a note. The entire principal balance of the note
becomes due and payable in one lump sum in August 2001. Interest is payable on
the note at a rate of 6.60% per annum, compounded semiannually. In addition, in
January 2001, we loaned Mr. McDevitt $500,000 for the purchase of a primary
residence. The loan is secured by such primary residence. The principal balance
of the loan is due and payable in four equal annual installments beginning at
the first year anniversary of the commencement of Mr. McDevitt's employment. No
interest will be charged on this loan. The loan will be forgiven based upon his
continued employment and is subject to acceleration in certain events.
In October 2000, we loaned Terry Moya, one of our officers, the principal
amount of $35,000 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
on the earlier to occur of October 2005 or the sale of the pledged shares.
Interest is payable at a rate of 6.60% per annum, compounded semiannually.
124
COVAD COMMUNICATIONS GROUP, INC.
GLOSSARY OF TERMS
Access Line--A circuit that connects a telephone end-user to the ILEC
Central Office.
Analog Modem--A telecommunications device that allows the communication of
digital information over analog telephone lines and through the public switched
telephone network by translating such information in a way that simulates and
uses only the bandwidth of normal voice transmissions.
Asynchronous Transfer Mode (ATM)--A standard packet-switching protocol that
segments digital information into 53-byte cells (each cell has a 5-byte
standard packet-switching header and 48 bytes of data) that are switched very
quickly throughout a network over virtual circuits. ATM is able to accommodate
multiple types of media (voice, video and data).
Bandwidth--Refers to the maximum amount of data that can be transferred
through a computer's backplane or communications channel in a given time. It is
usually measured in Hertz for analog communications and bits per second for
digital communication.
Central Office--ILEC facility where traditional telephone lines are
connected to a local loop and where our subscriber lines are joined to
switching equipment and connected to our network.
CLEC (Competitive Local Exchange Carrier)--Category of telephone service
provider (carrier) that offers services similar to those of the ILEC, as
allowed by recent changes in telecommunications law and regulation. A CLEC may
also provide other types of services such as long distance, Internet access and
entertainment.
Communications Act Of 1934--The federal legislation governing broadcast and
non-broadcast communications, including both wireless and wired telephone
service, and which established the FCC.
DSL (Digital Subscriber Line)--A technology which enables high-speed
transmission of digital data over traditional copper telephone lines.
FCC (Federal Communications Commission)--The U.S. government agency charged
with the oversight of communications originating in the United States and
crossing state lines.
Frame-Relay--A high-speed packet-switched data communications protocol used
across the interface between user devices (such as hosts and routers) and
network equipment (such as switching nodes).
HFC (Hybrid Fiber Coax)--A combination of fiber optic and coaxial cable,
which has become the primary architecture utilized by cable operators in recent
and ongoing upgrades of their systems. An HFC architecture generally utilizes
fiber optic wire between the head-end and the nodes and coaxial wire from nodes
to individual end-users.
ILEC (Incumbent Local Exchange Carrier)--The local exchange carrier that was
the monopoly carrier in a region, prior to the opening of local exchange
services to competition.
ILEC Collocation--A location serving as the interface point for a CLEC
network's interconnection to that of the ILEC. Collocation can be (i) physical,
in which the CLEC places and directly maintains equipment in the ILEC Central
Office, or (ii) virtual, in which the CLEC leases a facility, similar to that
which it might build, to effect a presence in the ILEC Central Office.
Interconnection (Co-Carrier) Agreement--A contract between an ILEC and a
CLEC for the interconnection of the two networks and CLEC access to ILEC UNEs.
These agreements set out the financial and operational aspects of such
interconnection and access.
ISP (Internet Service Provider)--A vendor that provides subscribers access
to the Internet.
125
ISDN (Integrated Services Digital Network)--ISDN provides standard
interfaces for digital communication networks and is capable of carrying data,
voice, and video over digital circuits. ISDN protocols are used worldwide for
connections to public ISDN networks or to attach ISDN devices to ISDN-capable
Private Branch Exchange systems (ISPBXs). Developed by the International
Telecommunications Union, ISDN includes two user-to-network interfaces: basic
rate interface (BRI) and primary rate interface (PRI). An ISDN interface
contains one signaling channel (D-channel) and a number of information channels
("bearer" or B channels). The D-channel is used for call setup, control, and
call clearing on the B-channels. It also transports feature information while
calls are in progress. The B-channels carry the voice, data, or video
information.
IXC (Interexchange Carrier)--Facilities-based long distance/interLATA
carriers (e.g., AT&T, MCI WorldCom and Sprint), who also provide intraLATA toll
service and may operate as CLECs.
KBPS (Kilobits Per Second)--One thousand bits per second.
LATA (Local Access And Transport Area)--A geographic area inside of which a
local telephone company can offer switched telecommunications services,
including long distance (known as toll). There are 196 LATAs in the United
States.
MBPS (Megabits Per Second)--One million bits per second.
RBOCS (Regional Bell Operating Companies)--ILECs created by AT&T's
divestiture of its local exchange business. The remaining RBOCs include
BellSouth, Verizon Communications, Qwest Communications, Inc. and SBC
Communications, Inc.
T1--This is a Bell system term for a digital transmission link with a
capacity of 1.544 Mbps.
UNES (Unbundled Network Elements)--The various portions of an ILEC's network
that a CLEC can lease for purposes of building a facilities-based competitive
network, including copper lines, Central Office collocation space, inter-office
transport, operational support systems, local switching and rights of way.
126
PART IV
ITEM 14. 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
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
exhibits or 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
Number Description
------- -----------
2.1 Agreement and Plan of Merger Among Covad Communications Group, Inc.,
LightSaber Acquisition Co. and Laser Link.Net, Inc., dated as of
March 8, 2000.
2.2 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.
2.3 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.
2.4 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.
3.2 Amended and Restated Certificate of Incorporation.
3.4 Bylaws, as currently in effect.
3.5 Certificate of Amendment of Certificate of Incorporation of the
Registrant filed on July 14, 2000.
4.1 Indenture dated as of March 11, 1998 between the Registrant and The
Bank of New York.
4.4 Warrant Registration Rights Agreement dated as of March 11, 1998 among
the Registrant and Bear, Stearns & Co., Inc. and BT Alex. Brown
Incorporated.
4.5 Specimen 13 1/2% Senior Note Due 2008.
4.6 Amended and Restated Stockholders Rights Agreement dated January 19,
1999 among the Registrant and certain of its stockholders.
4.7 Indenture dated as of February 18, 1999 among the Registrant and The
Bank of New York.
4.8 Registration Rights Agreement dated as of February 18, 1999 among the
Registrant and the Initial Purchasers.
127
Exhibit
Number Description
------- -----------
4.9 Specimen 12 1/2% Senior Note Due 2009.
4.10 Indenture dated as of January 28, 2000, between the Registrant and
United States Trust Company of New York.
4.11 Registration Rights Agreement dated as of January 28, 2000, between
the Registrant and Bear, Stearns & Co., Inc.
4.12 Specimen 12% Senior Note Due 2010.
4.14 Stockholder Protection Rights Agreement dated February 15, 2000.
4.15 Stock Restriction Agreement among Covad Communications and certain
stockholders of BlueStar.
4.16 Indenture, dated as of September 25, 2000, between the Company and
United States Trust Company of New York.
4.17 Specimen 6% Convertible Senior Note.
9.1 Stockholders Agreement among Covad Communications and certain
stockholders of BlueStar.
10.1 Form of Indemnification Agreement entered into between the Registrant
and each of the Registrant's executive officers and directors.
10.5 Series C Preferred Stock and Warrant Subscription Agreement dated as
of February 20, 1998 among the Registrant, Warburg, Pincus Ventures,
L.P., Crosspoint Venture Partners 1996 and Intel Corporation, as
amended by the Assignment and Assumption Agreement and First
Amendment to the Series C Preferred Stock and Warrant Subscription
Agreement dated as of April 24, 1998 among the Registrant, Warburg,
Crosspoint and Robert Hawk.
10.6 Employment Agreement dated June 21, 1999 between the Registrant and
Robert E. Knowling, Jr.
10.7 Sublease Agreement dated July 6, 1998 between Auspex Systems, Inc. and
the Registrant with respect to Registrant's facilities in Santa
Clara, California.
10.8 1998 Employee Stock Purchase Plan and related agreements, as currently
in effect.
10.10 Form of Warrant to purchase Common Stock issued by the Registrant on
February 20, 1998 to Warburg, Pincus Ventures, L.P., Crosspoint
Ventures Partners 1996 and Intel Corporation.
10.11 Note Secured by Deed of Trust dated October 7, 1998 issued by
Catherine A. Hemmer and John J. Hemmer in favor of the Registrant.
10.12 1997 Stock Plan and related option agreement, as currently in effect.
10.13 Series C-1 Preferred Stock Purchase Agreement dated as of December 30,
1998 among the Registrant, AT&T Venture Fund II, LP and two
affiliated funds.
10.14 Series D-1 Preferred Stock Purchase Agreement dated as of December 30,
1998 among the Registrant, AT&T Venture Fund II, LP and two
affiliated funds.
10.15 Series C-1 Preferred Stock Purchase Agreement dated as of December 30,
1998 between the Registrant and NEXTLINK Communications, Inc.
10.16 Series D-1 Preferred Stock Purchase Agreement dated as of December 30,
1998 between the Registrant and NEXTLINK Communications, Inc.
10.17 Series C-1 Preferred Stock Purchase Agreement dated as of January 19,
1998 between the Registrant and U.S. Telesource, Inc.
10.18 Series D-1 Preferred Stock Purchase Agreement dated as of January 19,
1998 between the Registrant and U.S. Telesource, Inc.
10.21 Resale Registration Rights Agreement, among the Company, Bear, Stearns
& Co., Inc., Morgan Stanley & Co. Incorporated, Credit Suisse First
Boston Corporation, Deutsche Bank Securities, Inc. and Goldman, Sachs
& Co.
128
Exhibit
Number Description
------- -----------
10.22 Stock Purchase Agreement between SBC Communications Inc. and Covad
Communications Group, Inc., dated September 10, 2000.
10.23 Resale and Marketing Agreement between SBC Communications Inc. and
Covad Communications Group, Inc., dated September 10, 2000.
21.1 Subsidiaries of the Registrant.
23.1 Consent of Ernst & Young LLP, independent auditors.
24.1 Power of Attorney.
(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, 2000.
The Company filed a Current Report on Form 8-K on October 5 and on October
11, 2000 announcing merger of Covad Acquisition Corporation, a Delaware
corporation and a wholly-owned subsidiary of Covad Communications Group, Inc.,
with and into BlueStar Communications Group, Inc., a Delaware corporation.
The Company filed a Current Report on Form 8-K on November 24, 2000
announcing the acquisition of Loop Holdings Europe APS, a Danish entity which
owns preferred shares representing 70% of Loop Telecom, S.A., a Spanish full-
service broadband service provider for small and medium-sized businesses.
The Company filed a Current Report on Form 8-K on November 29, 2000
announcing that, with respect to its acquisition of BlueStar Communications
Group, Inc., neither financial statements nor pro forma financial information
originally omitted from its Reports on Form 8-K, filed on October 5 and on
October 11, 2000 in accordance with the rules and regulations of the Securities
and Exchange Commission, are required to be filed pursuant to such rules and
regulations.
The Company filed a Current Report on Form 8-K on December 12, 2000
announcing new management's business plan for 2001.
129
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.
COVAD COMMUNICATIONS GROUP, INC.
/s/ Mark H. Perry
By: _________________________________
Mark H. Perry
Executive Vice President and
Chief Financial Officer
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Frank J. Marshall and/or Mark H. Perry and
either of them, jointly and severally, his attorneys-in-fact, each with full
power of substitution, for him in any and all capacities, to sign any and all
amendments to this Report on Form 10-K, and to file the same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each of said
attorneys-in-fact, or his substitute or substitutes, may do or cause to be done
by virtue hereof.
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 on May 23, 2001 in the capacities indicated.
Signature Title
--------- -----
/s/ Frank J. Marshall Interim Chief Executive Officer and
___________________________________________ Director (Principal Executive Officer)
(Frank J. Marshall)
/s/ Mark H. Perry Executive Vice President and Chief
___________________________________________ Financial Officer (Principal Financial and
(Mark H. Perry) Accounting Officer)
/s/ Charles McMinn Chairman of the Board of Directors
___________________________________________
(Charles McMinn)
/s/ Robert Hawk Director
___________________________________________
(Robert Hawk)
/s/ Hellene Runtagh Director
___________________________________________
(Hellene Runtagh)
/s/ Larry Irving Director
___________________________________________
(Larry Irving)
/s/ Daniel Lynch Director
___________________________________________
(Daniel Lynch)
/s/ Rich Shapero Director
___________________________________________
(Rich Shapero)
130
EXHIBIT INDEX
Exhibit
Number Description
------- -----------
2.1(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.
2.2(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.
2.3(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.
2.4(10) 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.
3.2(12) Amended and Restated Certificate of Incorporation.
3.4(12) Bylaws, as currently in effect.
3.5(8) Certificate of Amendment of Certificate of Incorporation of the
Registrant filed on July 14, 2000.
4.1(1) Indenture dated as of March 11, 1998 between the Registrant and The
Bank of New York.
4.4(1) Warrant Registration Rights Agreement dated as of March 11, 1998
among the Registrant and Bear, Stearns & Co., Inc. and BT Alex.
Brown Incorporated.
4.5(1) Specimen 13 1/2% Senior Note Due 2008.
4.6(1) Amended and Restated Stockholders Rights Agreement dated January 19,
1999 among the Registrant and certain of its stockholders.
4.7(2) Indenture dated as of February 18, 1999 among the Registrant and The
Bank of New York.
4.8(2) Registration Rights Agreement dated as of February 18, 1999 among the
Registrant and the Initial Purchasers.
4.9(2) Specimen 12 1/2% Senior Note Due 2009.
4.10(7) Indenture dated as of January 28, 2000, between the Registrant and
United States Trust Company of New York.
4.11(7) Registration Rights Agreement dated as of January 28, 2000, between
the Registrant and Bear, Stearns & Co., Inc.
4.12(7) Specimen 12% Senior Note Due 2010.
4.14(4) Stockholder Protection Rights Agreement dated February 15, 2000.
4.15(8) Stock Restriction Agreement among Covad Communications and certain
stockholders of BlueStar, (included in Exhibit 2.2).
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, incorporated by reference to
Exhibit A included in Exhibit 4.1 above.
9.1(8) Stockholders Agreement among Covad Communications and certain
stockholders of BlueStar (included in Exhibit 2.2).
10.1(2) Form of Indemnification Agreement entered into between the Registrant
and each of the Registrant's executive officers and directors.
Exhibit
Number Description
------- -----------
10.5(2) Series C Preferred Stock and Warrant Subscription Agreement dated as
of February 20, 1998 among the Registrant, Warburg, Pincus
Ventures, L.P., Crosspoint Venture Partners 1996 and Intel
Corporation, as amended by the Assignment and Assumption Agreement
and First Amendment to the Series C Preferred Stock and Warrant
Subscription Agreement dated as of April 24, 1998 among the
Registrant, Warburg, Crosspoint and Robert Hawk.
10.6(2) Employment Agreement dated June 21, 1999 between the Registrant and
Robert E. Knowling, Jr.
10.7(2) Sublease Agreement dated July 6, 1998 between Auspex Systems, Inc.
and the Registrant with respect to Registrant's facilities in Santa
Clara, California.
10.8(2) 1998 Employee Stock Purchase Plan and related agreements, as
currently in effect.
10.10(2) Form of Warrant to purchase Common Stock issued by the Registrant on
February 20, 1998 to Warburg, Pincus Ventures, L.P., Crosspoint
Ventures Partners 1996 and Intel Corporation.
10.11(5) Note Secured by Deed of Trust dated October 7, 1998 issued by
Catherine A. Hemmer and John J. Hemmer in favor of the Registrant.
10.12(5) 1997 Stock Plan and related option agreement, as currently in
effect.
10.13(5) Series C-1 Preferred Stock Purchase Agreement dated as of December
30, 1998 among the Registrant, AT&T Venture Fund II, LP and two
affiliated funds.
10.14(5) Series D-1 Preferred Stock Purchase Agreement dated as of December
30, 1998 among the Registrant, AT&T Venture Fund II, LP and two
affiliated funds.
10.15(5) Series C-1 Preferred Stock Purchase Agreement dated as of December
30, 1998 between the Registrant and NEXTLINK Communications, Inc.
10.16(5) Series D-1 Preferred Stock Purchase Agreement dated as of December
30, 1998 between the Registrant and NEXTLINK Communications, Inc.
10.17(5) Series C-1 Preferred Stock Purchase Agreement dated as of January
19, 1998 between the Registrant and U.S. Telesource, Inc.
10.18(5) Series D-1 Preferred Stock Purchase Agreement dated as of January
19, 1998 between the Registrant and U.S. Telesource, Inc.
10.21(9) Resale Registration Rights Agreement, among the Company, Bear,
Stearns & Co., Inc., Morgan Stanley & Co. Incorporated, Credit
Suisse First Boston Corporation, Deutsche Bank Securities, Inc. and
Goldman, Sachs & Co.
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.
21.1 Subsidiaries of the Registrant.
23.1 Consent of Ernst & Young LLP, independent auditors.
24.1 Power of Attorney (Included on the signature page herein).
- --------
(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 the exhibit of corresponding number 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 the exhibit of corresponding number 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 of corresponding number 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 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.