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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
Form 10-K
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 |
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For the Fiscal Year Ended December 31, 2004 |
Commission file number 000-25271
Covad Communications Group, Inc.
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Incorporated in Delaware
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I.R.S. Employer Identification No.: 77-0461529 |
110 Rio Robles, San Jose, California 95134
(408) 952-6400
Securities registered pursuant to Section 12(b) of the
Act:
None
Securities registered pursuant to Section 12(g) of the
Act:
Common Stock, par value $0.001 per share
Stock Purchase Rights Pursuant To Rights Agreement
Indicate by check mark whether the registrant: (1) has
filed all reports required to be filed by Section 13 or
15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past
90 days. Yes þ No o
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of Regulation S-K is not
contained herein, and will not be contained, to the best of
registrant’s knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this
Form 10-K or any amendment to this
Form 10-K. o
Indicate by check mark whether the registrant is an accelerated
filer (as defined by Exchange Act Rule 12b-2 of the
Act) Yes
þ No
o
The aggregate market value of the voting and non-voting common
equity held by non-affiliates computed by reference to the price
at which the common equity was sold on June 30, 2004 as
reported on the OTC Bulletin Board, was approximately
$551.8 million. Shares of common equity held by each
officer and director and by each person who owns 5% or more of
the outstanding common equity have been excluded in that such
persons may be deemed to be affiliates. This determination of
affiliate status is not necessarily a conclusive determination
for other purposes.
Indicate by check mark whether the registrant has filed all
documents and reports required to be filed by Section 12,
13 or 15(d) of the Securities Exchange Act of 1934 subsequent to
the distribution of securities under a plan confirmed by a
court. Yes þ No o
As of March 1, 2005 there were 263,915,726 shares
outstanding of the Registrant’s Common Stock and no shares
outstanding of the Registrant’s Class B Common Stock.
COVAD COMMUNICATIONS GROUP, INC.
For the Fiscal Year Ended December 31, 2004
TABLE OF CONTENTS
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PART I
The following discussion contains forward-looking statements,
including statements regarding our growth rates, cash needs, the
adequacy of our cash reserves, relationships with customers and
vendors, market opportunities, legislative and regulatory
proceedings, operating and capital expenditures, expense
reductions and operating results. Each of these statements
involve risks and uncertainties. As a result, 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.”
(All dollar and share amounts are presented in thousands,
except per share amounts)
Overview
We provide voice and data communications products and services
to consumers and businesses. We provide these services
throughout the United States in approximately 125 major
metropolitan areas, which include over 900 cities. Our
telecommunications network allows us to offer services to more
than 50 million homes and businesses. Our products and
services include high-speed, or broadband, data communications,
Internet access connectivity, Voice over Internet Protocol
telephony, or VoIP, and a variety of related services. We
primarily use digital subscriber line, or DSL, and DS-1, also
referred to as T-1, technologies to deliver our services. In
order to provide our services we purchase network elements, such
as telecommunication lines and central office facilities, from
the traditional local telephone companies, which are often
referred to as the incumbent local telephone companies, or
ILECs, and other carriers, and then combine these network
elements with our own nationwide network facilities. We purchase
the majority of these network elements from Verizon
Communications, Inc., or Verizon, BellSouth Telecommunications,
Inc., or BellSouth, SBC Communications, Inc., or SBC, and Qwest
Corporation, or Qwest, which are also known as the regional Bell
operating companies, or RBOCs. As of December 31, 2004, we
had approximately 533,200 broadband access end-users and 567
VoIP business customers with a combined total of approximately
20,500 VoIP stations.
We operate two business segments, Wholesale and Direct.
Wholesale is a provider of high-speed data connectivity services
to Internet service providers, or ISPs, and telecommunications
carrier customers. As of December 31, 2004, Wholesale had
approximately 454,600 DSL and T-1 lines in service, up from
445,000 lines at the end of the previous year. The majority of
our services are sold through our Wholesale segment.
Our Direct segment sells VoIP, high-speed data connectivity and
related value-added services through multiple channels including
telesales, field sales, affinity partner programs, and our
website. Direct focuses on the small business market and also
sells to enterprise customers that purchase our services for
distribution across their enterprise. Direct ended 2004 with
approximately 78,600 DSL and T-1 lines in service, up from
72,000 lines at the end of the previous year.
Our business is in transition due to changes in federal and
state telecommunications regulations and our resellers’
changing strategies. Sales of our stand-alone DSL services have
slowed, and we continue to experience higher churn among our
existing end-users, particularly from our base of consumer
end-users, due to pricing pressures from competitors offering
service bundles, as well as other factors. As a result, we have
increased our focus on direct sales of bundled VoIP and data
communications services to small and medium-sized businesses.
This transition presents a substantial business opportunity for
us as well as a number of new challenges. While we believe we
are favorably positioned to take advantage of this opportunity,
our ability to grow our sales of these services is inherently
difficult to predict, and we cannot predict whether sales of
these services will offset slowing sales of our stand-alone DSL
services.
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We were originally incorporated in California as Covad
Communications Company in October 1996. In July 1997, we were
incorporated in Delaware as Covad Communications Group, Inc., a
holding company that conducts substantially all of its business
through its operating wholly-owned subsidiaries. We introduced
our services commercially in December 1997 in the
San Francisco Bay Area.
On August 15, 2001, Covad Communications Group, Inc. filed
a voluntary petition under Chapter 11 of the United States
Bankruptcy Code for the purpose of confirming a pre-negotiated
plan of reorganization with the majority holders of our debt. On
December 20, 2001, the plan of reorganization was
consummated. This plan of reorganization retired approximately
$1,351,488 in aggregate face amount of outstanding notes.
We were delisted from the NASDAQ National Market on
July 20, 2001 and our common stock currently trades on
NASDAQ’s “OTC Bulletin Board” under the
symbol COVD.OB.
Industry Background
DSL technology first emerged in the 1990’s and is
commercially available today to address performance bottlenecks
of the public switched telephone network. DSL equipment, when
deployed at each end of standard copper telephone lines,
increases the data carrying capacity of copper telephone lines
from analog modem speeds of up to 56.6 kilobits per second, for
the fastest consumer modems, and Integrated Services Digital
Network, or ISDN, speeds of up to 128 kilobits per second to DSL
speeds of up to 8 megabits per second downstream and up to 1.5
megabits per second upstream, depending on the length and
condition of the copper line.
The passage of the 1996 Telecommunications Act created a legal
framework for competitive telecommunications companies to
provide local, analog and digital communications services in
competition with the ILECs. The 1996 Telecommunications Act
allowed these competitive telecommunications companies to use
the existing infrastructure built by the ILECs rather than
constructing a competing infrastructure at significant cost.
Among other things, this infrastructure includes telephone lines
and space in the ILECs central offices.
Our Service Offerings
Our service offerings can be grouped into two main categories,
data and voice services. Our customers can purchase these
services separately or together as bundled services. Within our
data suite of services, we offer a variety of business and
consumer-grade broadband access services, two managed security
services, email and hosting services. Our business-grade
services are called TeleSpeed, TeleSoho, and TeleXtend, and our
consumer-grade services are called TeleSurfer. Our direct sales
channel also offers VoIP, managed security services and Virtual
Private Networks, or VPN, services under the TeleDefend brand,
in addition to email and hosting services. In addition,
resellers may purchase high-capacity network backhaul services
from us to connect their facilities to our network and to
provide direct technical support for their end-users.
The specific number of potential end-users who qualify for
service varies by central office and by region and is affected
by line quality, distance and type of telephone loop facility
deployed in a particular area. Prices for our end-user services
vary depending on the performance level of the service and the
underlying technology used to deliver the service. Our prices
also vary for high volume customers that are eligible for volume
discounts. See “Item 1. Business — Risk
Factors — We may experience decreasing margins on the
sale of our services, which may impair our ability to achieve
profitability or positive cash flow” for a discussion of
some of the risks associated with our ability to sustain current
price levels in the future.
We launched service in December 1997 with our TeleSpeed
services. We provision TeleSpeed services via symmetric
(download and upload speeds are equal) DSL, or SDSL, and ISDN
DSL, or IDSL, technologies. These services are offered in a
variety of speeds ranging from 144 kilobits to 1.5 megabits per
second. TeleSpeed services are intended to connect individual
end-users on previously unused conventional telephone lines to
our DSL equipment in their serving central office and from there
to our network serving that
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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.
TeleSpeed services are offered with specific service levels of
performance and times for repairs based on our service level
agreements, or SLAs.
We introduced our TeleSoho service in September 2001. We
designed TeleSoho for the Small Office/ Home Office, or SoHo,
customer segment, with merged features from our consumer and
business services. The service is asymmetric (faster download
than upload speeds), offering speeds up to 6.0 megabits per
second downstream and up to 768 kilobits per second upstream,
and can be delivered to customers using a self or professional
installation. TeleSoho is provisioned with an asymmetric DSL, or
ADSL, router capable of supporting up to four end-users and can
support one fixed Internet Protocol, or IP, address.
Line-sharing, line-splitting and self-installations reduce the
monthly recurring cost and the up-front cost for installation of
the service. TeleSoho services do not include service level
agreements.
In July 2004, we introduced second-line TeleSoho services, which
we provision over a dedicated telephone line. Our second-line
TeleSoho services provide similar features and performance as
our TeleSoho line-shared services, but allow a customer to
cancel his or her phone line with the local voice provider. In
addition, our second-line TeleSoho service includes limited
service level commitments.
We introduced our TeleXtend services in November 2001. These
services allow end-users to connect to our network equipment in
their local central offices over a T-1 line. The
availability of TeleXtend services is not limited by distance
from the servicing central office and is accompanied with our
best SLAs.
We introduced our TeleSurfer service in April 1999. TeleSurfer
is designed for consumers. This service is asymmetric, offering
speeds up to 3.0 megabits per second downstream and up to 384
kilobits per second upstream and uses dynamic IP addressing. We
generally deliver this service to customers using a
self-installation kit over a line-shared or line-split loop.
Line-sharing, line-splitting and self-installations reduce the
monthly recurring cost and the up-front cost for installation of
the service. This is a “best effort” service and is
not sold with SLAs.
In July 2004, we introduced second-line TeleSurfer services,
which we provision over a dedicated telephone line. Our
second-line TeleSurfer services provide similar features and
performance TeleSurfer line-shared services, but allow a
customer to cancel his or her phone line with the local voice
provider.
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Voice over Internet Protocol |
In June 2004, we completed our acquisition of GoBeam, Inc., or
GoBeam, and introduced our business-class VoIP services to
small and medium-sized businesses. These services enable
customers to use IP and Internet connections to make local and
long distance telephone calls over Covad’s network instead
of using the traditional telephone network. We sell two VoIP
services, vPBX and PBXi. vPBX is intended as a substitute for a
small company’s telephone Private Branch Exchange, or PBX,
and includes call features such as “find me, follow
me”, web conferencing, call forwarding, instant messaging
and unified voicemail and fax services. PBXi has many of the
same features as our vPBX service, but it works with an end
user’s existing PBX to deliver local, long distance and
Internet services over one managed network connection, an
alternative to using multiple connections.
We believe that our VoIP service provides cost advantages over
PBX models because our customers do not need to purchase
additional telephone line connections from other providers or
install telephone switches at their premises. Customers of our
VoIP service also can realize productivity improvements and
reduce costs for in-house technical personnel, who typically are
required to install and maintain a PBX-based telephone service.
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While our new VoIP service targets a large market, we must
quickly develop our capability to market and sell these services
through various channels. We also must further develop the
internal systems and processes to support these new services and
additional customers.
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Asynchronous Transfer Mode, or ATM, Network
Services |
We also provide DS-3 and OC-3 circuit backhaul services from our
regional network to a reseller’s site. This service
aggregates data traffic from individual end-users in a region
and transmits the packets of information to the reseller over a
single high-capacity connection. The service utilizes ATM
protocol that operates at up to 45 megabits per second for DS-3
circuits and up to 155 megabits per second for OC-3 circuits.
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Broadband Internet Access Service |
Our Broadband Internet Access Service, or BIA, allows our
resellers to sell broadband to their end-user customers without
having to invest in network facilities. This service currently
bundles IP services with our high-speed connectivity services to
provide a complete connection to the Internet. The additional IP
services include end-user authentication, authorization and
accounting, IP address assignment and management, domain name
service and IP routing and connectivity.
In addition to access and voice services, we offer value-added
services to customers who purchase services directly from us.
These services include:
TeleDefend: This is a security and private networking
service that we offer to small and medium-sized businesses. We
currently offer two versions of TeleDefend, TeleDefend Firewall,
which protects businesses with only one site, and TeleDefend
VPN/ Firewall, which allows businesses with multiple sites to
communicate securely.
Email and Web Hosting: These services allow small and
medium-sized businesses to have a custom domain name, for
example www.mybusiness.com, as well as business-class email and
web hosting. All services come with anti-spam and anti-virus
protection and easy-to-use website building tools and templates.
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Wireless Broadband Access |
During 2004 we completed a limited market trial of high-speed
wireless access and we are in the process of conducting a
similar technical trial. We plan to launch a second market trial
in 2005. A high-speed wireless offering would provide us with
several benefits, including expanded network reach and reduced
dependence on the ILECs. Our development of this service is at a
very early stage and broad deployment of the service, if we
pursue it, would require significant resources.
Sales and Marketing
We sell our broadband services on a wholesale basis to ISPs,
telecommunications carriers and other resellers. These resellers
purchase our services on a wholesale basis and sell them under
their own brand. We had over 390 resellers as of
December 31, 2004. For 2004, our 30 largest resellers
collectively provided 93.4% of our total wholesale net revenues
and 67.4% of our total net revenues. For 2004, Earthlink, Inc.
and AT&T Corp., two of our resellers, accounted for 16.9%
and 13.8%, respectively, of our total net revenues. As of
December 31, 2004, we had approximately 454,600 end-users
purchasing services through our resellers.
We offer our resellers a range of DSL and T-1 services that they
in turn offer to their business and consumer customers. They can
either combine our DSL and T-1 lines with their own Internet
access services or purchase our BIA services and resell the
combination to their customers. Our agreements with our
resellers generally have terms of one to three years and are
nonexclusive. We generally do not require these resellers to
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generate a minimum number of end-users or a minimum amount of
revenue, but we grant volume discounts based on subscriber
volume.
We believe that strategic resellers with established brand names
provide us with an attractive opportunity to deliver our
services to a larger number of end-users. The cost of customer
acquisition for broadband services is significant, so leveraging
the brand of our resellers, their customer bases, and embedded
direct and indirect sales channels helps us reduce this cost.
We provide our resellers with sales and marketing support. We
work jointly with our resellers to develop and fund marketing
programs that are specific to their target markets, product
offerings and sales objectives. We work to improve the cost of
acquisition by assisting our resellers with direct marketing,
promotions, and incentive programs.
We also sell our services directly and indirectly to end-user
customers. We sell a suite of enhanced services directly through
our direct sales force, telephone sales and Web sales
capabilities. We also sell our services indirectly via a variety
of third parties such as sales agents, referral partners and
affinity groups. Our approach to this market is to combine our
national network with other features to deliver services to
small offices, home offices and small and medium-sized
businesses. As of December 31, 2004, we had approximately
78,600 broadband lines and 20,500 VoIP stations in service
through this channel.
Our marketing programs and communications to small and
medium-sized businesses are designed to increase brand awareness
and encourage potential customers to contact our telesales
center or visit our website. We use national and local marketing
campaigns. We employ a wide variety of media, including
television, on-line advertisements, direct mail, radio and print.
Our telesales and field sales teams sell our services via
outbound calling and “feet on the street” sales. Our
telesales groups make outbound calls to individuals or
organizations that have visited our website and to lists of
pre-qualified businesses that match the profile of customers who
have purchased services from Covad in the past. The field sales
organization targets small and medium-sized businesses and
larger companies with many branch offices that have “small
business like” broadband needs, such as connecting remote
offices back to their corporate headquarters.
Our referral resources include sales agents, dealers and
referral partners that receive commissions in exchange for
referring customers to us. In many cases, the sales agents,
dealers and referral partners are telecommunications specialists
that provide information technology, telecommunications, and
networking services and products to business customers. By being
part of the Covad Alliance Network, our partners are able to
complement their existing services and provide our broadband and
VoIP services to their customers.
Service Deployment and Operations
ISPs, telecommunications carriers and corporate information
technology managers typically have had to assemble their digital
communications connections using multiple services and equipment
suppliers, leading to additional work, cost and coordination
problems. With our services, we emphasize a “one-stop”
service solution for our customers. This service solution
includes end-user premises wiring and configuration, ongoing
network monitoring and customer reporting, customer service and
technical support, and operational support systems that reduce
costs and improve performance for us and our customers.
Network Architecture and Technology
We designed our network to provide the following attributes,
which we believe are important requirements for our existing and
potential customers:
Consistent and Scalable Performance. We believe that
public packet networks will play an increasingly central role in
the telecommunications services market in the United States.
With this in mind, we designed our network for scalability and
consistent performance as we add new users and services. We have
designed a
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nationwide network that is organized around our regional
metropolitan areas and interconnected across the country.
Intelligent End-to-End Network Management. Because
customers’ lines are continuously connected, they can also
be monitored. We have visibility from the ISP or enterprise site
across the network all the way down to the end-user’s
premises equipment. Because our network is centrally managed, we
can identify and dynamically enhance network quality, service
and performance.
Flexibility. We have designed our network to be flexible
in handling various types of network traffic, starting with
data, recently adding voice, and potentially extending to video
information in the future. This flexibility will allow us to
carry not only value-added services such as VoIP, but will also
allow us to control the prioritization of content delivery over
our national network. We accomplish the prioritization and
quality of service control using ATM technology, which allows us
to support both non-real time and real-time applications and
provides fair allocation of bandwidth among customers.
Network Operations Centers. Our entire network is managed
from a network operations center located in the
San Francisco Bay Area. We provide end-to-end network
management using advanced network management tools on a 24x7
basis, which enhances our ability to address performance or
connectivity issues.
Nationwide Broadband Access and Internet Connectivity. We
link each of our metropolitan areas together with leased
high-speed private backbone network connections. Our Internet
access points are strategically located at high-speed
interconnection facilities across the country in order to
increase the performance and decrease the latency of connections
to the Internet for our customers.
Private Metropolitan Network. We operate our own private
metropolitan network in each region that we enter. The network
consists of high-speed communications circuits that we lease to
connect our hubs, our equipment in individual central offices,
our Internet access points, and our resellers and direct
customers with multiple locations. We have leased fiber optic
networks using Synchronous Optical Network, or SONET, technology
in two of our major metropolitan areas. Our metropolitan
networks operate at speeds of 45 megabits per second to 4.8
gigabits per second.
Central Office Spaces. Through our interconnection
agreements with the ILECs, we lease space in central offices
where we offer service. We require access to these spaces for
our equipment and for persons employed by or under contract with
us. We place Digital Subscriber Line Access Multiplexers, or
DSLAMs in our central office spaces to provide the high-speed
DSL signals on each copper line to our end-users. As of
December 31, 2004, we had 2052 operational central offices.
Telephone Lines. We lease the telephone lines running to
end-users from the ILECs under terms specified in our
interconnection agreements. We lease lines that, in many cases,
must be specially conditioned by the ILECs to carry digital
signals, usually at an additional charge relative to that for
voice grade telephone lines. We also provide some of our
services over telephone lines that already carry the voice
service of an ILEC, known as line-sharing. Our continuing
ability to use these line-shared telephone lines is dependent on
our ability to maintain and enter into agreements with the four
largest ILECs, the RBOCs, or to obtain favorable regulatory
rulings.
DSL Modems and On-Site Connection. We buy customer
premises equipment, or CPE, from our suppliers for resale to our
customers. In order to provide our business-class services to an
end-user we currently have to configure and install CPE along
with any required on-site wiring needed to connect the CPE to
the copper line leased from the ILEC. For our consumer access
services, CPE is included in self-installation kits provided by
us or our resellers. We ship the kits to end-users, who, in the
vast majority of the cases, perform their own installation.
Competition
We face significant competition in the markets for business and
consumer Internet access, network access and voice services and
we expect this competition to intensify. The principal bases of
competition in our
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markets include price and performance, discounted rates for
bundles of services, breadth of service availability,
reliability of service, network security, and ease of access and
use.
We face competition from the RBOCs, cable modem service
providers, competitive telecommunications companies, traditional
and new national long distance carriers, VoIP service providers,
telephone equipment providers, ISPs, on-line service providers
and wireless and satellite service providers.
RBOCs — All of the largest RBOCs in our target
markets offer DSL and voice services. As a result, the RBOCs
represent strong competition in all of our target service areas
and we expect this competition to intensify. The RBOCs have an
established brand name and reputation for quality in their
service areas, possess sufficient capital to deploy DSL
equipment rapidly, own the telephone lines themselves and can
bundle data services with their existing voice and other
services to achieve economies of scale in serving their
customers. Some of the RBOCs are aggressively pricing their
consumer DSL services as low as $19.95 per month when
ordered as part of a bundle of services, placing pricing
pressure on our consumer grade services. The RBOCs are also able
to offer services through fiber and fiber-fed loops, and the
telephone companies are not required to provide us with access
to these facilities.
Cable Modem Service Providers. Cable modem service
providers such as Comcast Corporation, Cox Communications, Time
Warner, Inc. and Charter Communications are deploying high-speed
Internet access services over hybrid fiber-coaxial cable
networks. Many of these providers have also announced their
plans to offer voice services. Hybrid fiber-coaxial cable is a
combination of fiber optic and coaxial cable and has become the
primary architecture utilized by cable operators in recent and
ongoing upgrades of their systems. Where deployed, these
networks provide similar and in some cases higher-speed Internet
access than we provide.
Competitive Telecommunications Companies. Many
competitive telecommunications companies, such as DSL.net, Inc.,
Mpower Communications Corporation and New Edge Networks, Inc.,
offer high-speed digital services using a business strategy
similar to ours. Similarly, there are several competitive
telecommunications companies, such as Vonage, Primus
Telecommunications and 8x8, offering and developing VoIP
services and others are likely to do so in the future.
National Interexchange Carriers. Interexchange carriers,
such as AT&T, Sprint, MCI, Qwest and Level 3
Communications, have deployed large-scale Internet access
networks on ATM networks, sell data connectivity and voice
services to businesses and residential customers and have high
brand recognition. These providers also have interconnection
agreements with many of the ILECs and have collocation spaces in
central offices from which they are currently offering or could
begin to offer competitive DSL services. Many of these companies
provide DSL-based services in competition with us. In addition,
some of these companies, such as AT&T, Sprint, and MCI, are
our resellers.
VoIP Service Providers. Many new start-ups are entering
the VoIP market. Start-ups such as M3, PingTone and others can
potentially use aggressive selling and pricing tactics to obtain
customers and pose a competitive threat to our VoIP business.
Telephone Equipment Providers. Telephone equipment
providers such as Nortel, Avaya, Cisco and Lucent are offering
VoIP services, which represent an alternative to the hosted VoIP
services that we provide.
Internet Service Providers. ISPs such as Earthlink and
Speakeasy.net provide Internet access to residential and
business customers, generally using a variety of
telecommunications services such as T-1, satellite, cable modem,
wireless, dial-up, ISDN and DSL services. These ISPs can and do
compete with us in certain instances at the retail and wholesale
levels. Many ISPs resell our competitors’ services and
could even become competitive DSL and voice service providers
themselves.
On-Line Service Providers. On-line service providers
include companies such as AOL and MSN, a subsidiary of Microsoft
Corp., that provide content and applications ranging from news
and sports to consumer video conferencing. These services are
designed for broad consumer access, which enables the provision
of digital services to a significant number of consumers. In
addition, they provide Internet connectivity, ease-of-use and
consistency of environment. Many of these on-line service
providers have developed their own access
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networks for modem connections. AOL’s parent company, Time
Warner, Inc., owns certain cable systems throughout the United
States. Some of these systems offer cable modem service, and AOL
has deployed its Internet services over these networks. AOL is
one of our resellers and promotes some of our products under a
“bring your own access” model.
Wireless and Satellite Data Service Providers. Wireless
and satellite data service providers continue to develop
wireless and satellite-based Internet connectivity. We face
competition from terrestrial wireless services including:
third-generation wireless networks, two Gigahertz
(“GHz”) and 28 GHz wireless cable systems,
2.5 GHz Broadband Radio Service, and Local Multi-channel
Distribution System and 18 GHz, 39 GHz and 50 GHz
point-to-point and point-to-multi-point microwave systems. Some
of our resellers, such as MCI and XO Communications, hold many
of these microwave licenses and are offering broadband data
services over this spectrum. Other companies hold point-to-point
microwave licenses to provide fixed wireless services such as
voice, data and videoconferencing. Third-generation mobile, or
3G, or augmented second generation mobile, or 2.5G, systems are
being deployed or are expected to be deployed in the near future
by providers such as Cingular Wireless, Sprint, Verizon and
T-Mobile. These wireless services tend to have equal or slower
speeds than DSL and are generally more expensive to deploy.
We also may face competition from satellite-based systems.
StarBand Communications Inc., DirecTV, 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
network does not currently reach.
Interconnection Agreements with the Regional Bell Operating
Companies
A critical aspect of our business is our interconnection
agreements with the four largest ILECs, the RBOCs.
These agreements cover a number of aspects including:
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prices we pay to lease access, both for stand-alone and
line-shared lines; |
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special conditioning on certain of these lines to enable the
transmission of digital signals; |
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prices and terms of central office space for our equipment; |
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prices we pay and access we have to data transport facilities
connecting our facilities in different central offices and
network points of presence; |
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interfaces that we can use to place orders, report network
problems and monitor responses to our requests; |
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dispute resolution process we use to resolve disagreements; and |
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terms of the interconnection agreement, its transferability to
successors, its liability limits and other general aspects of
the relationship |
We have entered into interconnection agreements with or
otherwise obtained interconnection rights from the four RBOCs in
all the states covering the metropolitan areas we serve. RBOCs
often do not agree to our requested provisions in
interconnection agreements. When we cannot agree, the 1996
Telecommunications Act provides for arbitration of
interconnection agreement terms before state public utility
commissions, or PUCs. We have not consistently prevailed in
obtaining our desired provisions in such agreements.
Some of our interconnection agreements have a term of three
years. A party can request renegotiation of these agreements
prior to the agreement’s expiration date if there is a
change in law. We will also have to renew these agreements when
they expire. Although we expect to renew the interconnection
agreements that require renewal and believe the 1996
Telecommunications Act limits the ability of ILECs not to renew
such agreements, we may not succeed in extending or
renegotiating our interconnection agreements on favorable terms.
Additionally, disputes have arisen and will likely arise in the
future as a result of differences in
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interpretations of the interconnection agreements. In the past,
these disputes have delayed our deployment of our network. Such
disputes have also adversely affected our service to our
customers and our ability to enter into additional
interconnection agreements with the RBOCs in other states.
Finally, the interconnection agreements are subject to state
PUC, Federal Communications Commission, or 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 our services and facilities to the
extent that we provide interstate and international
communications services. To the extent we provide certain
identifiable intrastate services, our services and facilities
are subject to state regulations. Rates for the services and
network elements we purchase from the RBOCs are, in many cases,
determined by the applicable state PUCs. In addition, local
municipal governments assert jurisdiction over our facilities
and operations. The jurisdictional reach of the various federal,
state and local authorities is uncertain because it is subject
to ongoing controversy and judicial review.
Recent Developments. On December 15, 2004, the FCC
announced changes in its rules regarding the obligations of
ILECs to share their networks with competitive
telecommunications companies like us. These rules include the
following changes:
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If certain criteria are met, ILECs can stop providing new
transport services between the telephone companies’ central
offices at regulated rates, which are usually lower than
commercially available rates. These criteria are based on the
number of users served by the connected central offices and the
number of alternative providers collocated in the central
offices. For existing transport services where the criteria are
met, ILECs would be required to continue to provide the service
for either twelve or eighteen months after the order goes into
effect, but during this period the price would increase by 15%.
We currently purchase this interoffice transport from the ILECs
in order to carry traffic over our network. We expect that this
change will increase our data transport costs, but at this time
we cannot reliably quantify the aggregate amount of these
increases. |
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In addition, ILECs are no longer required to provide new
high-capacity unbundled DS-1 and DS-3 loops at regulated rates
in locations where certain criteria are met. These criteria are
based on the number of users served by the central office and
the number of alternative providers collocated in the central
office. For existing high- capacity DS-1 and DS-3 loops where
the criteria are met, ILECs would be required to continue to
provide the loop for twelve months after the order goes into
effect, but during this period the price would increase by 15%.
We use DS-1 loops to provide business-grade services to our
end-users. We expect this change will increase our cost to
purchase DS-1 and DS-3 loops in affected central offices, but at
this time we cannot reliably quantify the aggregate amount of
these increases. |
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ILECs are no longer required to provide new dark fiber loops at
regulated rates. For existing dark fiber loops, ILECs would be
required to continue to provide the dark fiber loops for twelve
months after the order goes into effect, but during this period
the price would increase by 15%. In certain areas, we purchase
dark fiber to transport data traffic within our network.
Currently we purchase our dark fiber from non-ILEC providers.
However, if we are unable to purchase dark fiber from non-ILEC
providers in the future, we expect this change will increase our
cost to purchase dark fiber loops; at this time we cannot
reliably quantify the aggregate amount of these increases, if
any. |
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Competitive telecommunications carriers, including our
resellers, will no longer be permitted to order voice services
from the ILECs under an arrangement known as the Unbundled
Network Element Platform, or UNE-P, for new customers at
regulated rates, and, after a twelve month transition period,
will no longer be able to provide service to existing customers
using UNE-P. The existence of UNE-P had allowed us to bundle our
data services with the voice services of competitive
telecommunications |
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providers through line-splitting arrangements. We will only be
able to continue bundling services in this manner with
competitive telecommunications providers that reach agreements
with the ILECs to allow them continued access to UNE-P or
similar resold services. If these competitive telecommunications
providers cannot reach agreements with the ILECs for continued
access to UNE-P, we expect that our ability to continue to
provide bundled services with these providers will cease,
however, at this time we cannot reliably quantify such impact.
We are also exploring alternative methods of delivering
residential voice services with which we and our resellers can
package our data services. For example, we plan to test
line-powered voice access service that would enable our
resellers to offer local and long distance voice services to
their customers in competition with the local telephone
companies. |
The new rules were published on February 4, 2005, and take
effect on March 11, 2005. Implementation of the rules is
governed by the interconnection agreements between ILECs and
competitive carriers. The implementation and interpretation of
the rules, including the dates that specific aspects of the new
rules affect network elements, may be the subject of disputes in
state public utilities commissions and other venues.
The FCC decision mentioned above was a modification of the
FCC’s previous Triennial Review order, which was issued on
August 21, 2003, referred to as the Original Triennial
Review Order. This order also represented a significant
development for us because the FCC decided to phase out its rule
requiring line-sharing pursuant to Section 251 of the 1996
Telecommunications Act over a three-year period. Line-sharing
allows us to provision services using ADSL technology over the
same telephone line that the ILEC is using to provide voice
services. The phase-out period will be handled in the following
manner:
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Our line-shared customers as of October 2, 2003 were
grandfathered indefinitely at current rates, terms and
conditions. These line-shared customers provided approximately
$89,857 and $137,149, or 20.9% and 35.3%, of our revenues for
the years ended December 31, 2004 and 2003, respectively. |
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For line-shared customers acquired from October 3, 2003 to
October 2, 2004, the FCC-mandated maximum price for the
high-frequency portion of the telephone line is 25% of the cost
of a separate telephone line during the first year, 50% during
the second year and 75% during the third year. After the third
year, we are required to transition these customers to new
arrangements. |
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As of October 3, 2004, we cannot acquire new line-shared
customers at regulated rates under Section 251 of the
Telecommunications Act of 1996. |
We have reached agreements that provide us with continued access
to line-sharing with three of the four RBOCs (SBC, Verizon and
Qwest), accounting for approximately 91.7 percent of our
line-shared customer base. Our agreement with SBC regarding
line-sharing expires in September of 2005. In the event that we
do not obtain favorable regulatory rulings for line-sharing or
enter into and maintain line-sharing agreements with the RBOCs,
we will be required to purchase a separate telephone line in
order to provide services to an end-user in the areas served by
RBOCs. If this occurs we may stop selling stand-alone
consumer-grade services to new customers, because the cost of a
separate telephone line is significantly higher than what we
currently pay for a shared line and requires us to dispatch a
technician to install the service. Our inability to acquire new
line-shared customers would slow our growth and negatively
impact our ability to sell consumer DSL services.
In the Original Triennial Review Order, and subsequent orders,
the FCC also decided that ILECs are not required to allow us to
access certain types of fiber and fiber-fed loops and to the
packet-switching functions of fiber-fed telephone lines to
provision DSL services. In a subsequent order, released
October 27, 2004, the FCC also granted the RBOCs
forbearance from the obligation to provide access to the
packet-switching functions of fiber-fed telephone lines under
section 271 of the Telecommunications Act of 1996. This
means that, unless we reach agreements with the RBOCs or obtain
favorable regulatory rulings from the FCC or state regulators,
we will continue to be unable to provide our most commonly-used
services to end-users served by affected fiber-fed lines. Our
inability to access fiber and fiber-fed packet-switching
functions is significant for our business because it limits the
addressable market for our DSL services, thereby limiting our
growth. In addition, the RBOCs are increasing their deployment
of fiber loops and fiber-fed remote terminal architectures,
thereby limiting our addressable market.
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Each FCC decision in this area has been challenged by various
participants in the telecommunications industry, and the RBOCs
have already challenged the FCC’s new rules in court. We
expect that many of the components of these rules will be the
subject of continuing litigation that could influence their
ultimate impact. As such, it is not possible for us to predict
the final effects of these rules with assurance.
The FCC rulemaking process described above has been extremely
disruptive to our partners who utilize UNE-P to provide
competitive voice services as part of a bundle with our DSL
services. Some of our larger resellers, including MCI and
AT&T, have indicated that they will scale back or eliminate
their residential voice services as a result of the FCC’s
decisions.
Investors should review this discussion of the FCC’s recent
rulemaking carefully to understand the potentially significant
effects that these proceedings may have on our ability to
continue to engage in our business as we have in the past, as
the FCC’s rulings create a number of uncertainties, risks,
challenges and opportunities for us.
Federal and State VoIP Regulation. VoIP services are
generally free of the types of government regulation that apply
to traditional voice services. As a result of the growing
deployment of VoIP services, the FCC is conducting regulatory
proceedings that could affect our regulatory duties and rights
as a VoIP provider. There is regulatory uncertainty as to the
imposition of access charges and other taxes, fees and
surcharges on VoIP services and whether such services are
subject to traditional regulation on voice services. If the FCC
chose to adopt such regulations, it could impact our ability to
offer new services in a cost-efficient manner.
The state PUCs are also conducting regulatory proceedings that
could impact our rights and obligations with respect to VoIP. In
an order released November 12, 2004, the FCC determined
that Internet telephony services like our VoIP service are not
subject to traditional regulation by the state public utility
commissions. Based on this order, a federal appeals court
recently vacated state commission rules which would have
regulated Internet telephony services like our VoIP service at
the state level. At this point, a number of state public utility
commissions have filed petitions for judicial review of the
FCC’s November 12, 2004 decision. It is unclear what
the outcome of this litigation will be.
We cannot predict the outcome of these regulatory and legal
proceedings or any similar petitions and regulatory proceedings
pending before the FCC or state PUCs. Moreover, we cannot
predict how their outcomes may affect our operations or whether
the FCC or state PUCs will impose additional requirements,
regulations or charges upon our provision of VoIP services.
Other 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 communications
businesses, preempts many of the state barriers to local
telecommunications service competition that previously existed
in state and local laws and regulations, and sets basic
standards for relationships between telecommunications
providers. The law delegates to the FCC and the states broad
regulatory and administrative authority to implement the 1996
Telecommunications Act.
Among other things, the 1996 Telecommunications Act removes
barriers to entry in the local telecommunications market. It
also requires that ILECs provide nondiscriminatory access and
interconnection to potential competitors. Regulations
promulgated by the FCC under the 1996 Telecommunications Act
specify in greater detail the requirements imposed on the ILECs
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 allow
companies like us to interconnect with the ILECs.
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 Telecommunications Act, the FCC has been
less stringent in its review of tariff filings by the four
largest ILECs, the RBOCs, including filings for DSL services. In
particular, without substantive review of the cost support for
RBOCs DSL services, rates for those services may be below cost
and may facilitate price squeezes,
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predatory pricing or other exclusionary strategies by incumbent
local telephone companies that harm our business. The FCC is
also considering whether it should eliminate regulations that
apply to the RBOCs provision of services that are competitive
with ours. The FCC granted SBC limited relief from dominant
regulation, but has not yet acted to provide such relief to the
other three RBOCs. We expect that any additional regulatory
freedom granted to the RBOCs will increase the competition we
face from the RBOCs services and could reduce our access to ILEC
facilities and 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 approval from the FCC for our
interstate services or file tariffs for such services. We
generally do not file tariffs for our interstate services. We
provide our interstate services to our customers on the basis of
contracts rather than tariffs. We believe that it is unlikely
that the FCC will require us to file tariffs for our interstate
services in the future. We are, however, required to comply with
certain obligations that attach to all telecommunications
carriers. For example, we are required to make payments into the
Federal Universal Service Fund, or FUSF. The FUSF is a federal
fund to support various programs that ensure the availability of
telecommunications services to, for example, schools, libraries,
hospitals, and in high-cost regions of the country. We are
required to pay a percentage of our interstate and international
telecommunications revenue to the FUSF, and we generally pass
that percentage through to our customers. The amount we are
required to pay into the FUSF varies depending on the breakdown
between, for example, our telecommunications revenue and
non-telecommunications, such as equipment sales and installation
services, revenue. In addition, we are not required to pay into
the FUSF for any revenues derived from information services. The
FCC has a proceeding underway to reexamine its FUSF contribution
rules, and the FCC and its FUSF collection agent periodically
change the rules related to those contributions, including the
percentage and time period of interstate telecommunications
revenue that a carrier must contribute to the FUSF. To the
extent those rules are changed, or new interpretations of those
rules results in an increase in the FUSF contributions that we
must make, we may be subject to increased liability for payments
beyond what we have already contributed.
In February 2002, the FCC opened an inquiry into how its
existing regulations impact the retail deployment of broadband
services by the nation’s telephone companies. Although we
do not believe that the outcome of this proceeding will impair
our ability to purchase unbundled network elements, we
anticipate that telephone companies will advocate for such an
outcome. While we do not believe this advocacy will prevail, we
cannot provide any assurance at this point.
Other State Regulation. To the extent we provide
identifiable intrastate services or have otherwise submitted
ourselves to the jurisdiction of the relevant state
telecommunications regulatory PUCs, we are subject to state
jurisdiction. In addition, certain states have required prior
state certification as a prerequisite for processing and
deciding an arbitration petition for interconnection under the
1996 Telecommunications Act. We are authorized to operate as a
competitive local exchange carrier in all of the states covering
metropolitan statistical areas we serve. We file tariffs in
certain states for intrastate services as required by state law
or regulation. We are also subject to periodic financial and
other reporting requirements of these states with respect to
certain intrastate services. Jurisdictional determinations that
some or all of our services are intrastate services could harm
our business. In particular, we could be deemed liable for
payments into state universal service funds, which require
telecommunications carriers providing intrastate services to pay
a percentage of their intrastate revenues to support state
programs that ensure universal availability of
telecommunications and related services. We do not believe that
the services we offer on an interstate basis are subject to such
state assessments, but a state commission or judicial decision
to the contrary could subject us to liability for such payments.
Each state PUC has proceedings to determine the rates, charges
and terms and conditions for collocation and unbundled network
elements. Unbundled network elements are the various portions of
an ILEC’s network that a competitive telecommunications
company can lease for purposes of building a facilities-based
competitive network, including telephone lines, central office
collocation space, inter-office transport, operational support
systems, local switching and rights of way. The rates in many of
our interconnection agreements are interim rates and will be
prospectively, and, in some cases, retroactively, affected by
the permanent rates
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set by the various state PUCs. We have participated in unbundled
network element rate proceedings in several states in an effort
to reduce these rates. If any state commission decides to
increase unbundled network element rates our operating results
would be adversely affected.
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 with respect to 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 ILECs, in
certain instances we deploy our own facilities and, therefore,
may need to obtain certain municipal permits or other
authorizations. The actions of municipal governments in imposing
conditions on the grant of permits or other authorizations or
their failure to act in granting such permits or other
authorizations could harm our business.
The foregoing does not purport to describe all present and
proposed federal, state and local regulations and legislation
affecting the telecommunications industry. Other existing
federal regulations are currently the subject of judicial
proceedings, legislative hearings and administrative proposals
which could change, in varying degrees, the manner in which
communications companies operate in the United States. The RBOCs
have periodically introduced federal and state legislation to
relieve them from some or all of their obligations to provide us
with access to their networks. Some states legislatures have
approved these proposals. It would be reasonable to expect that
the RBOCs will seek additional state and federal legislation
that, if enacted into law, would adversely affect our business.
The ultimate outcome of these proceedings and the ultimate
impact of the 1996 Telecommunications Act or any final
regulations adopted pursuant to the 1996 Telecommunications Act
on our business cannot be determined at this time but may well
be adverse to our interests. We cannot predict the impact, if
any, that future regulation or regulatory changes may have on
our business and we can give you no assurance that such future
regulation or regulatory changes will not harm our business. See
“Part I. Item 1. Business — Risk
Factors — Our services are subject to government
regulation, and changes in current or future laws or regulations
could adversely affect our business” and “Part I.
Item 1. Business — Risk Factors —
Charges for network elements are generally outside of our
control because they are proposed by the ILECs and are subject
to costly regulatory approval processes.”
Significant Customers
We had over 390 wholesale customers as of December 31,
2004. For 2004, 2003 and 2002, our 30 largest wholesale
customers in each such year collectively comprised 67.4%, 71.6%
and 79.5% of our total net revenues, respectively. Two of our
wholesale customers, Earthlink, Inc. and AT&T Corp.,
accounted for 16.9% and 13.8%, 21.5% and 12.5%, and for 20.0%
and 10.4% of our total net revenues for 2004, 2003 and 2002,
respectively.
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 sixteen patents granted and a number of patent
applications pending. We intend to seek additional patent
protection for our systems and services to the extent possible.
These patents may not be issued to us. Even if they are issued,
they may not protect our intellectual property from competition.
Competitors may design around or seek to invalidate these
patents.
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Further, effective patent, copyright, trademark and trade secret
protection may be unavailable or limited in certain foreign
countries. The global nature of the Internet makes it virtually
impossible to control the ultimate destination of our
proprietary information. Steps taken by us may not prevent
misappropriation or infringement of our technology. Litigation
may be necessary in the future to enforce our intellectual
property rights to protect our trade secrets or to determine the
validity and scope of the proprietary rights of others. Such
litigation could result in substantial costs and diversion of
resources. In addition, others may sue us alleging infringement
of their intellectual property rights.
A manufacturer of telecommunications hardware named
“COVID” has filed an opposition to our trademark
application for the mark “COVAD and design.” Covid is
also seeking to cancel our trademark registration for the
“Covad” name. We do not believe that these challenges
to our trademark application and granted trademark have merit.
However, these proceedings are unpredictable and there is no
guarantee we will prevail. If we do not succeed, it could limit
our ability to provide our services under the “COVAD”
name.
Employees
As of December 31, 2004, we had 1,141 employees. None of
our employees are represented by a labor union, and we consider
our relations with our employees to be good. Our ability to
achieve our financial and operational objectives depends in
large part upon the continued service of our senior management
and key technical, sales, marketing, legal, finance, human
resources 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.
Available Information
We make available free of charge on or through our Internet
address located at www.covad.com our annual report on
Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K, and amendments to those reports filed
or furnished pursuant to Section 13(a) or 15(d) of the
Securities Exchange Act of 1934, as amended, as soon as
reasonably practicable after we electronically file that
material with, or furnish it to, the Securities and Exchange
Commission, or SEC. Materials we file with the SEC may be read
and copied at the SEC’s Public Reference Room at
450 Fifth Street, NW, Washington, D.C. 20549. This
information may also be obtained by calling the SEC at
1-800-SEC-0330. The SEC also maintains an Internet website that
contains reports, proxy and information statements, and other
information regarding issuers that file electronically with the
SEC at www.sec.gov. We will provide a copy of any of the
foregoing documents to stockholders upon request. Requests
should be sent to Covad Communications Group, Inc., 110 Rio
Robles, San Jose, California, 95134, Attn: Investor
Relations.
Risk Factors
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Our services are subject to government regulation, and
changes in current or future laws or regulations and the methods
of enforcing the law and regulations could adversely affect our
business. |
Our services are subject to federal, state and local government
regulations. In particular, the company and its resellers are
dependent on certain provisions of the 1996 Telecommunications
Act to procure certain facilities and services from the ILECs
that are necessary to provide services. As a result, our
business is highly dependent on rules and rulings from the FCC,
legislative actions at both the state and federal level, and
rulings from state public utility commissions.
For instance, over the last two years the FCC has made
substantial changes to the regulatory environment in which we
operate. The FCC’s August 21, 2003 Triennial Review
order and its announcement of further changes on
December 15, 2004, limited, and in some cases eliminated
our access to some of the network elements that we use to
operate our business. Where we no longer have regulated access
to network elements, our costs are likely to increase as a
result of these orders and we may be unable to profitably offer
some of our services. We may be unable to adapt to the changed
regulatory environment, in its current form, or to future
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changes, whether resulting from these orders or from subsequent
action by the courts, the FCC or other regulatory authorities.
In addition, as a result of the FCC’s December 15,
2004 order and subsequent rules that were issued on
February 4, 2005, our resellers will no longer be permitted
to order voice services for new customers utilizing regulated
UNE-P services provided by the traditional phone companies, and,
after a twelve month transition period, will no longer be able
to provide service to pre-existing customers using UNE-P. The
existence of UNE-P allowed our resellers to offer bundles that
combine our data services with their residential voice services.
Some of our larger resellers, including MCI and AT&T, have
already indicated that they will scale back or eliminate their
residential voice services as a result of these decisions. Other
resellers may also decide not to sell residential voice
services, or may use alternative means of providing residential
voice service that allow them to offer their own data services,
as opposed to reselling our services.
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Charges for network elements are generally outside of our
control because they are proposed by the ILECs and are subject
to costly regulatory approval processes. |
ILECs provide the telephone lines that connect each end-user to
our equipment located in their central offices. The 1996
Telecommunications Act generally requires that charges for these
unbundled network elements be cost-based and nondiscriminatory.
Nonetheless, the nonrecurring and recurring monthly charges for
lines (telephone wires) that we require vary greatly. These
rates are subject to negotiations between us and the ILECs and
to the approval of the state PUCs. Consequently, we are subject
to the risk that the non-recurring and recurring charges for
lines and other unbundled network elements will increase based
on higher rates proposed by the ILECs and approved by state PUCs
from time to time, which would increase our operating expenses
and reduce our ability to provide competitive products.
The impact of judicial and regulatory decisions on the prices we
pay to the ILECs for collocation and unbundled network elements
is highly uncertain. There is a risk that any new prices set by
the regulators could be materially higher than current prices.
As a result of the FCC’s recent decisions, it is likely
that we will pay higher prices for line-shared lines,
high-capacity lines and data transport between many of the
ILEC’s central offices. If we are required to pay higher
prices to the ILECs for collocation and network components as a
result of the FCC’s recent decisions and other judicial and
regulatory decisions, it could materially increase our operating
expenses and reduce our ability to provide competitive products.
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Our business will be adversely affected if our
interconnection agreements are not renewed or if they are
modified on unfavorable terms. |
We are required to enter into interconnection agreements
covering each of the metropolitan areas we serve with the
appropriate ILECs in order to provide service in those regions.
Many of our existing interconnection agreements have a maximum
term of three years. Therefore, we will have to renegotiate
these agreements with the ILECs when they expire. A number of
these agreements have expired and we are currently in the
process of renegotiating them. We may not succeed in extending
or renegotiating these interconnection agreements on favorable
terms or at all.
As the FCC modifies, changes and implements rules related to
unbundling and collocation, we generally have to renegotiate our
interconnection agreements to implement those new or modified
rules. For example, we are involved in a number of
renegotiations of interconnection agreements to reflect the
FCC’s recent decisions. We may be unable to renegotiate
these agreements in a timely manner, or we may be forced to
arbitrate and litigate with the RBOCs in order to obtain
agreement terms that fully comply with FCC rules.
Additionally, disputes have arisen and will continue to arise in
the future as a result of differences in interpretations of the
interconnection agreements. These disputes have delayed the
deployment of network capabilities and services, and resolution
of the litigated matters will require ongoing expenditures and
management time. In addition, the interconnection agreements are
subject to state PUCs, FCC and judicial oversight. These
government authorities may modify the terms of the
interconnection agreements in a way that reduces our access to,
or increases the cost of, the network components that we
purchase from the ILECs.
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We depend on a limited number of customers for the
preponderance of our revenues, and we are highly dependent on
sales through our resellers. |
The majority of our revenue comes from Internet service
providers, telecommunications carriers and other customers who
resell our Internet access services to their business and
consumer end-users. Our agreements with our resellers are
generally non-exclusive, and many of our customers also resell
services offered by our competitors. Our agreements with our
resellers generally do not contain purchase commitments. A
limited number of resellers account for a significant portion of
our revenues. Our top 30 resellers accounted for approximately
67.4% of our net revenue for the year ended December 31,
2004. We expect that our reseller customers will continue to
account for a significant portion of our revenue and new end
user additions.
If we were to lose one or more of our key resellers or if one or
more of our key resellers stopped providing us with orders or
removed end-users from our network, our revenue and line-growth
could be materially adversely affected. Consolidations, mergers
and acquisitions involving our key resellers have occurred in
the past and may occur in the future. These consolidations,
mergers and acquisitions may cause key resellers to stop
providing us with orders or to remove end-users from our
network. On January 31, 2005, one of our major resellers,
AT&T Corp., announced that it had agreed to be acquired by
SBC, one of the largest RBOCs. This acquisition is subject to
regulatory, antitrust and other forms of review. Based upon the
statements of the parties, subject to the outcome of these
reviews, the transaction is expected to close in the first half
of 2006. For the year ended December 31, 2004, AT&T
accounted for 13.8% of our revenue. SBC is both one of our
competitors and a reseller of our services. At this time, we
cannot predict the effects of this transaction on our revenues
derived from AT&T or SBC, or the timing of any such effects.
Based on our agreements with several competitive telephone
companies, we have the ability to offer our services over a
telephone line that is being used by a voice provider other than
the ILECs. All of these competitive telephone companies
currently use UNE-P. As a result of the FCC’s
December 15, 2004 order and subsequent rules that were
issued on February 4, 2005, our resellers will no longer be
permitted to order voice services for new customers utilizing
regulated UNE-P services provided by the traditional phone
companies, and, after a twelve month transition period, will no
longer be able to provide service to pre-existing customers
using UNE-P. Some of our larger resellers, including MCI and
AT&T, have already indicated that they will scale back or
eliminate their residential voice services as a result of the
FCC’s decisions. Other resellers may also decide not to
sell residential voice services, or may use alternative means of
providing residential voice service that allow them to offer
their own data services, as opposed to reselling our services.
It is therefore unclear whether our resellers will increase the
number of end-users that purchase these services.
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The markets in which we operate are highly competitive,
and we may not be able to compete effectively, especially
against established industry competitors with significantly
greater financial resources. |
We face significant competition in the markets for business and
consumer Internet access, network access and voice services and
we expect this competition to intensify. In addition, the RBOCs
dominate the current market and have a monopoly on telephone
lines. We pose a competitive risk to the RBOCs and, as both our
competitors and our suppliers, they have the ability and the
motivation to disadvantage our business. We also face
competition from cable modem service providers, competitive
telecommunications companies, traditional and new national long
distance carriers, Internet service providers, on-line service
providers and wireless and satellite service providers. Many of
these competitors have longer operating histories, greater name
recognition, better strategic relationships and significantly
greater financial, technical or marketing resources than we do.
As a result, these competitors may be able to:
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develop and adopt new or emerging technologies; |
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respond to changes in customer requirements more quickly; |
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devote greater resources to the development, promotion and sale
of their products and services; |
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form new alliances and rapidly acquire significant market share; |
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undertake more extensive marketing campaigns; |
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adopt more aggressive pricing policies; and |
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devote substantially more resources to developing high-speed
digital services |
The intense competition from our competitors, including the
RBOCs, the cable modem service providers and the competitive
telecommunications companies could harm our business.
The RBOCs represent the dominant competition in all of our
target service areas, and we expect this competition to
intensify. These competitors have established brand names and
reputations for quality service, possess sufficient capital to
deploy DSL equipment rapidly, have their own telephone lines and
can bundle digital data services with their existing voice,
wireless and other services to achieve economies of scale in
serving customers. They can also offer service to end-users from
certain central offices and using fiber and fiber-fed loops that
are not available to us. Certain RBOCs are aggressively pricing
their DSL services as low as $19.95 per month when ordered
as part of a bundle, which has slowed sales of stand-alone DSL
services by our reseller partners and increased the rate of
churn among our existing users. If we are unable to enter into
and maintain agreements with the RBOCs that provide us with
access to line-sharing at reasonable rates, we will be unable to
price our consumer services at a price that is competitive with
the RBOCs.
Cable modem service providers, such as Cox Communications, and
their respective cable company customers, have deployed
high-speed Internet access services over coaxial cable networks.
These networks provide similar, and in some cases, higher-speed
data services than we provide. In addition, cable providers are
beginning to bundle VoIP telephony and other services, such as
video-on-demand, with their Internet access offerings. 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.
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Failure to complete development, testing and introduction
of new services, including VoIP services, could affect our
ability to compete in the industry |
We continuously develop, test and introduce new services that
are delivered over our network. These new services are intended
to allow us to address new segments of the communications
marketplace and to compete for additional customers. In some
cases, the introduction of new services requires the successful
development of new technology. To the extent that upgrades of
existing technology are required for the introduction of new
services, the success of these upgrades may depend on the
conclusion of contract negotiations with vendors and vendors
meeting their obligations in a timely manner. In addition, new
service offerings may not be widely accepted by customers. If we
are not able to successfully complete the development and
introduction of new services, including VoIP services, line
powered voice, and wireless services in a timely manner, our
business could be materially adversely affected.
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We may need to raise additional capital under difficult
financial market conditions. |
We believe our current cash, cash equivalents, and short-term
investments should be sufficient to meet our anticipated cash
needs for working capital and capital expenditures until we
become cash flow positive. We have a business plan that we
believe will take us to the point where our operations will
yield a positive cash flow without raising additional capital.
This business plan is based upon several assumptions, including
growth of our subscriber base with a reasonable per subscriber
profit margin and improvements in productivity. If actual events
differ from these assumptions, we may be required to alter our
business plan to reflect these changes. We will continue to
monitor events to determine if such adjustments to our business
plan are appropriate.
We are currently facing a variety of challenges that may affect
the assumptions contained in our business plan, including, among
others:
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changes in government regulations and legal actions challenging
government regulations; |
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customer disconnection rates that reduce our revenues; |
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significant price reductions by our competitors; |
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higher levels of marketing expense required to acquire and
retain end-users that purchase our services from us and from our
resellers; |
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the need to upgrade our systems by investing in our existing and
future technology and infrastructure; |
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investment opportunities in complementary businesses,
acquisitions or other opportunities; |
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any adverse resolution of lawsuits against us; and |
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additional risk factors mentioned throughout this section |
We entered into a 10-year resale agreement with SBC in December
2001 under which SBC, its affiliates or special agents will
resell the Company’s DSL services. As part of the resale
agreement, SBC made a $75,000 non-interest-bearing prepayment,
which is collateralized by substantially all of our domestic
assets. As of December 31, 2004, the outstanding balance of
the SBC’s prepayment was approximately $52,350. This
collateralization of the outstanding balance of SBC’s
prepayment, in addition to the existence of $125,000 in
3% convertible notes, may limit our ability to raise
additional capital through sales of our debt or equity
securities.
Adverse business, regulatory or legislative developments may
require us to raise additional financing, raise our prices or
substantially decrease our cost structure. We also recognize
that we may not be able to raise additional capital 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, our financial condition will
be adversely affected.
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In order to become cash flow positive and to achieve
profitability, we must add end-users and sell additional
services to our existing end-users while minimizing the cost to
expand our network infrastructure. |
We must increase the volume of Internet, data and voice
transmission on our network in order to realize the anticipated
cash flow, operating efficiencies and cost benefits of our
network. If we do not add new customers and maintain our
relationships with current customers, we may not be able to
substantially increase traffic on our network, which would
adversely affect our profitability. To accomplish this strategy,
we must, among other things:
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acquire new end-users; |
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enter into and maintain agreements with the RBOCs or obtain
favorable regulatory rulings that provide us with access to
unbundled network elements on terms and conditions that allow us
to profitably sell our consumer services; |
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enhance and improve our VoIP services; |
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upgrade our network to improve reliability and remain
competitive; |
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expand our direct sales capability and infrastructure in a
cost-effective manner; and |
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continue to implement and improve our management information
systems, including our client ordering, provisioning, dispatch,
trouble ticketing, customer billing, accounts receivable,
payable tracking, collection, fixed assets, transaction-based
taxes and other management information systems |
Our growth has placed, and will continue to place, significant
demands on our management and operations. We expect to implement
system upgrades, new software releases and other enhancements
which could cause disruption and dislocation in our business. If
we are successful in implementing our marketing strategy, we may
have difficulty responding to demand for our services and
technical support in a timely manner and in accordance with our
customers’ expectations. We expect these demands to require
the addition of new management personnel and the increased
outsourcing of Covad functions to third parties. We may be
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unable to do this successfully, in which case we could
experience an adverse effect on our financial performance.
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If we do not reduce our end-user disconnection rate our
revenue and end-user growth will decline. |
We experience high disconnection or “churn” rates. Our
high end-user churn rate continues to impair the growth we need
to cover the cost of maintaining our network. These
disconnections occur as a result of several factors, including
end-users who:
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move to a new location; |
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disconnect because of better offers in the market; and |
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disconnect because they do not like our service or the service
provided by our resellers |
While we are working to address problems with the end-user
experience, many of these factors are beyond our control. As a
result, we may see additional increases in our churn rates even
if we improve the customer experience. In addition, promotions
and rebates that we offer to our resellers and end-users are
based on an assumption that a given end-user will maintain our
service for a period of time. If our disconnection rate
increases for more recently added end-users, we may not recoup
the money we spend on these promotions and rebates.
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We may experience decreasing margins on the sale of our
services, which may impair our ability to achieve profitability
or positive cash flow. |
Prices for our services have steadily decreased since we first
began operations. We expect we will experience an overall price
decrease for our services due to competition, volume-based
pricing and other factors. We currently charge higher prices for
some of our services than some of our competitors do for similar
services. As a result, we cannot assure you that our customers
will select our services over those of our competitors. In
addition, prices for digital communications services in general
have fallen historically, and we expect this trend to continue.
As a result of these factors, we cannot predict whether demand
for our services will exist at prices that enable us to achieve
profitability or positive cash flow.
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Our internal controls may not prevent or detect all
misstatements, and may become inadequate |
Our internal control over financial reporting is designed to
provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements
for external purposes in accordance with generally accepted
accounting principles. Because of its inherent limitations,
internal control over financial reporting may not prevent or
detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures
may deteriorate. In addition, we expect that the growth of our
business will require us to implement new controls and to
improve our existing controls. We may fail to timely implement
new or improved controls, and those new or improved controls may
prove ineffective. If we fail to maintain an effective system of
internal controls or prevent fraud, we could be subject to
costly litigation, investors could lose confidence in our
reported financial information and our brand and operating
results could be harmed, which could have an adverse effect on
the trading price of our ordinary shares.
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Some of our resellers are facing financial difficulties,
which makes it more difficult to predict our revenues. |
Some of our reseller customers may experience financial
difficulties, including bankruptcy. If a customer cannot provide
us with reasonable assurance of payment, then we only recognize
revenue when we collect cash for our services, assuming all
other criteria for revenue recognition have been met, and only
after we have collected all previous accounts receivable
balances. Although we will continue to try to obtain payments
from these customers, it is likely that one or more of these
customers will not pay us for our services. With respect to
resellers that are in bankruptcy proceedings, we similarly may
not be able to collect sums owed to us by
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these customers and we also may be required to refund
pre-petition amounts paid to us during the 90 days prior to
the bankruptcy filing.
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The development of our direct business poses operational
challenges and may cause our resellers to place fewer orders
with us or may cause us to lose resellers. |
Sales of services directly to end-user customers represent a
significant and growing part of our business. As we expand our
direct business, we will face new operational challenges. These
challenges include, but are not limited to, our ability to:
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recruit, hire and train additional direct sales teams; |
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create effective automated systems to provision, manage and bill
for VoIP services; |
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manage expanding and increasingly diverse distribution channels; |
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effectively manage additional vendors; and |
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enhance our network and access products to provide
business-class VoIP services |
In addition, some of our existing resellers may perceive us as a
potential or actual competitor. As a result, these resellers may
reduce the volume or the rate of growth of the sales of our
services, or may cease to resell our services entirely.
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The communications industry is undergoing rapid
technological changes, and new technologies may be superior to
the technology we use. |
The communications industry is subject to rapid and significant
technological change, including continuing developments in DSL
and VoIP technology and alternative technologies for providing
broadband and telephony communications, such as cable modem,
satellite and wireless technology. As a consequence, our success
may depend on:
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third parties, including some of our competitors and potential
competitors, to develop and provide us with access to new
communications and networking technology; |
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our ability to anticipate or adapt to new technology on a timely
basis; and |
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our ability to adapt to new products and technologies that may
be superior to, or may not be compatible with, our products and
technologies |
The investments required to address technological changes are
difficult to predict and may exceed our available resources. If
we fail to adapt successfully to technological changes or fail
to obtain access to important technologies, our business will be
adversely affected.
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A system failure could delay or interrupt service to our
customers, which could reduce demand for our services. |
Our operations depend upon our ability to support our highly
complex network infrastructure and avoid damage from fires,
earthquakes, terrorist attacks, floods, power losses, excessive
sustained or peak user demand, telecommunications failures,
network software flaws, transmission cable cuts and similar
events. 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 an ILEC or other service
provider to provide communications capacity as a result of a
natural disaster, operational disruption, labor dispute or any
other reason could cause interruptions in our services. We have
previously had difficulties obtaining service from the ILECs due
to their labor disputes. Any damage or failure that interrupts
our operations could harm our business.
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A breach of network security could delay or interrupt
service to our customers, which could reduce demand for our
services. |
Our network may be vulnerable to unauthorized access, computer
viruses, worms and Trojan horses and other disruptions. Internet
service providers, telecommunications carriers and corporate
networks have in the past experienced, and may in the future
experience, interruptions in service as a result of accidental
or intentional actions of Internet users, current and former
employees and others. Unauthorized access could also potentially
jeopardize the security of confidential information stored in
our computer systems, our end-users and our reseller’s
end-users. This might result in liability to us and also might
deter potential customers from purchasing or selling our
services. While we attempt to implement and develop additional
security measures we have not implemented all of the security
measures commercially available, and we may not implement such
measures in a timely manner or at all. Moreover, these measures,
if and when implemented, may be circumvented, and eliminating
computer viruses and alleviating other security problems may
require interruptions, delays or cessation of service to our
customers and our reseller’s customers, which could harm
our business.
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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 telecommunications industry and the loss of
any of them could negatively affect our ability to execute our
business strategy. Additionally, we do not have “key
person” life insurance policies on any of our employees.
Our future success also depends on our continuing ability to
identify, hire, train and retain other highly qualified
technical, operations, sales, marketing, finance, legal, human
resource, and managerial personnel as we add end-users to our
network. Competition for qualified personnel is intense. The
significant drop in our stock price has greatly reduced or
eliminated the value of stock options held by many of our
employees, making it more difficult to retain employees in a
competitive market. In addition, in the event that our employees
unionize, we could incur higher ongoing labor costs and
disruptions in our operations in the event of a strike or other
work stoppage.
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We depend on a limited number of third parties for
equipment supply, software utilities, service and installation
and if we are unable to obtain these items from these third
parties we may not be able to deliver our services as
required. |
We rely on outside parties to manufacture our network equipment
and provide certain network services. These services, software
and equipment include:
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DSLAMs; |
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customer premises equipment, including modems, routers, bridges
and other devices; |
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network routing and switching hardware; |
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customer support; |
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installation services; |
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customized software design and maintenance; |
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network management software; |
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systems management software; |
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database management software; |
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collocation space; |
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software used in our products; |
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hosting, email and IP provisioning services; |
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softswitches, used to provide VoIP services; and |
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Internet connectivity and Internet protocol services |
We have in the past experienced supply problems with certain
vendors. These vendors may not be able to meet our needs in a
satisfactory and timely manner in the future, which may cause us
to lose revenue. In addition, we may not be able to obtain
additional vendors when needed.
Our reliance on third-party vendors involves additional risks,
including:
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the possibility that some of our vendors will leave the DSL
equipment business or will stop supporting equipment that we
already have installed; |
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the absence of guaranteed capacity; |
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the possibility that software vendors will stop supporting
software that we use; and |
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reduced control over delivery schedules, quality assurance,
production yields and costs |
Any of these events could have a material adverse impact on our
business and operating results.
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We use third party vendors offshore for tasks that were
previously done by our employees. |
In 2003 we began using offshore vendors to assist us with
software development and certain customer support functions.
Since we have historically used employees for most of our
software development, we have limited experience in managing
offshore software development projects. Because we are using a
third-party vendor to manage the day to day operations, we do
not have as much control over the hiring and oversight of the
vendors’ employees. In addition, the differences in time
zones, languages and culture may make it difficult to integrate
the vendors’ software development teams with our internal
resources. As a result, this arrangement may impair our ability
to modify and improve our software and to develop new software
in a timely manner. In addition, we have provided these vendors
with access to our intellectual property. While we have taken
certain contractual and procedural steps to protect our
intellectual property, if any of the vendors or their employees
improperly uses our intellectual property, it may be more
difficult for us to assert our intellectual property rights
because we may not be able to use United States courts to
enforce our rights.
In outsourcing certain customer support functions to offshore
vendors, we face similar integration problems as we do with our
software outsourcing arrangements. In addition, these vendors
may have difficulties communicating with our customers and
resolving non-standard customer issues. We also may experience
difficulties as we integrate the vendor’s systems with our
own.
Some of these offshore locations have experienced civil unrest
and terrorism and have been involved in conflicts with
neighboring countries. If some of these locations become engaged
in armed hostilities, particularly if these hostilities are
protracted or involved the threat of or use of weapons of mass
destruction, our vendors’ operations could be adversely
affected. While we have attempted to contractually protect
ourselves against calamities, if our vendors’ operations
are adversely affected, our customer service and software
development efforts could be negatively impacted.
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We have made and may make acquisitions of complementary
technologies or businesses in the future, which may disrupt our
business and be dilutive to our existing stockholders. |
We intend to consider acquisitions of businesses and
technologies in the future on an opportunistic basis.
Acquisitions of businesses and technologies involve numerous
risks, including the diversion of management attention,
difficulties in assimilating the acquired operations, loss of
key employees from the acquired company, and difficulties in
transitioning key customer relationships. In addition, these
acquisitions may result in dilutive issuances of equity
securities, the incurrence of additional debt and large one-time
expenditures. Any such acquisition may not provide the benefits
originally anticipated, and there may be difficulty in
integrating the service offerings and networks gained through
acquisitions and strategic investments with our
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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,
unexpected liabilities nevertheless may accompany such strategic
investments and acquisitions.
In addition, the purchase price of an acquired business may
exceed the current fair value of the net tangible assets of the
acquired business. As a result, we would be required to record
material amounts of goodwill and other intangible assets, which
could result in significant impairment charges and amortization
expense in future periods. These charges, in addition to the
results of operations of such acquired businesses, could have a
material adverse effect on our business, financial condition and
results of operations. We cannot forecast the number, timing or
size of future acquisitions, or the effect that any such
acquisitions might have on our operating or financial results.
Under generally accepted accounting principles, we are required
to review our intangible assets for impairment whenever events
or changes in circumstances indicate that the carrying value of
these assets may not be recoverable. In addition, we are
required to review our goodwill and indefinite-lived intangible
assets on an annual basis. If presently unforeseen events or
changes in circumstances arise which indicate that the carrying
value of our goodwill or other intangible assets may not be
recoverable, we will be required to perform impairment reviews
of these assets, which have carrying values of approximately
$36,626 as of December 31, 2004. An impairment review could
result in a write-down of all or a portion of these assets to
their fair values. We will perform an annual impairment review
during the fourth quarter of each fiscal year or more frequently
if we believe indicators of impairment exist. In light of the
large carrying value associated with our goodwill and intangible
assets, any write-down of these assets may result in a
significant charge to our statement of operations in the period
any impairment is determined and could cause our stock price to
decline.
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We must pay federal, state and local taxes and other
surcharges on our service, the applicability and levels of which
are uncertain. |
Telecommunications providers pay a variety of surcharges and
fees on their gross revenues from interstate and intrastate
services. Interstate surcharges include FUSF and Common Carrier
Regulatory Fees. In addition, state regulators impose similar
surcharges and fees on intrastate services and the applicability
of these surcharges and fees to our services is uncertain in
many cases. The division of our services between interstate and
intrastate services, and between services that are subject to
surcharges and fees and those that are not, is a matter of
interpretation and may in the future be contested by the FCC or
state authorities. The FCC is currently considering the nature
of Internet service provider-bound traffic and new
interpretations or changes in the characterization of
jurisdictions or service categories could cause our payment
obligations, pursuant to the relevant surcharges, to increase or
result in liabilities. In addition, periodic revisions by state
and federal regulators of the applicable surcharges may increase
the surcharges and fees we currently pay. In addition, we may be
required to pay certain state taxes, including sales taxes,
depending on the jurisdictional treatment of the services we
offer. The amount of those taxes could be significant, depending
on the extent to which the various states choose to tax our
services.
The federal government and many states apply transaction-based
taxes to the sales of our products and services and to our
purchases of telecommunications services from various carriers.
We are in discussions with federal and state tax authorities
regarding the extent of our transaction-based tax liabilities.
It is reasonably possible that our estimates of our
transaction-based tax liabilities could materially change in the
near term. We may or may not be able to recover some of those
taxes from our customers.
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We are a party to litigation and adverse results of such
litigation matters could negatively impact our financial
condition and results of operations. |
We are a defendant in some of the litigation matters described
in “Part I, Item 3. Legal Proceedings.”
While we are vigorously defending these lawsuits, the total
outcome of these litigation matters is inherently
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unpredictable, and there is no guarantee we will prevail.
Adverse results in any of these actions could negatively impact
our financial condition and results of operations and, in some
circumstances result in a material adverse effect on us. In
addition, defending such actions could result in substantial
costs and diversion of resources that could adversely affect our
financial condition, results of operations and cash flows.
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Our intellectual property protection may be inadequate to
protect our proprietary rights. |
We regard certain aspects of our products, services and
technology as proprietary. We attempt to protect them with
patents, copyrights, trademarks, trade secret laws, restrictions
on disclosure and other methods. These methods may not be
sufficient to protect our technology. We also generally enter
into confidentiality or license agreements with our employees
and consultants, and generally control access to and
distribution of our documentation and other proprietary
information. Despite these precautions, it may be possible for a
third party to copy or otherwise obtain and use our products,
services or technology without authorization, or to develop
similar technology independently.
Currently, we have been issued sixteen patents and we have a
number of additional patent applications pending. We intend to
prepare additional applications and to seek patent protection
for our systems and services. These patents may not be issued to
us. If issued, they may not protect our intellectual property
from competition. Competitors could design around or seek to
invalidate these patents.
Effective patent, copyright, trademark and trade secret
protection may be unavailable or limited in certain foreign
countries. The global nature of the Internet makes it virtually
impossible to control the ultimate destination of our
proprietary information. The steps that we have taken may not
prevent misappropriation or infringement of our technology.
Litigation may be necessary in the future to enforce our
intellectual property rights, to protect our trade secrets or to
determine the validity and scope of the proprietary rights of
others. Such litigation could result in substantial costs and
diversion of resources and could harm our business.
|
|
|
The price of our common stock may continue to fluctuate
significantly. |
The market price for our common stock has been, and is likely to
continue to be, highly volatile, which may result in losses to
investors. We believe that a number of factors contribute to
this fluctuation and may cause our stock price to decline in the
future. While it is not possible to foresee all of the events
that could adversely affect the price of our common stock or
cause such price to remain volatile, a few of the factors
include:
|
|
|
| |
• |
state and federal regulatory and legislative actions; |
| |
| |
• |
general economic conditions and the condition of the
telecommunications industry; |
| |
| |
• |
our ability to maintain existing customers and add new customers
and recognize revenue from distressed customers; |
| |
| |
• |
our ability to reach profitability and cash flow positive
operations; |
| |
| |
• |
adverse litigation results; |
| |
| |
• |
announcements of new products, services or pricing by our
competitors or the emergence of new competing technologies; |
| |
| |
• |
our failure to meet the expectations of investors or of analysts; |
| |
| |
• |
the adoption of new, or changes in existing, accounting rules,
guidelines and practices, which may materially impact our
financial statements and may materially alter the expectations
of securities analysts or investors; |
| |
| |
• |
the level of demand for broadband Internet access services and
VoIP telephony services; |
| |
| |
• |
departures of key personnel; and |
| |
| |
• |
effective internal controls over financial reporting |
25
In addition, we were delisted from the NASDAQ National Market on
July 20, 2001 and our common stock currently trades on
NASDAQ’s Over-the-Counter Bulletin Board. This
contributes to our volatility and may affect the liquidity of
our common stock.
The stock market has periodically experienced significant price
and volume fluctuations that have particularly affected the
market prices of common stock of technology companies. These
changes have often been unrelated to the operating performance
of particular companies. These broad market fluctuations may
also negatively affect the market price of our common stock.
|
|
|
Substantial leverage and debt service obligations may
adversely affect our cash flow. (Refer to
Item 7 — Management’s Discussion and
Analysis of Financial Condition and Results of
Operation — “Liquidity, Capital Resources and
Contractual Cash Obligations” for additional
information) |
We may be unable to generate cash sufficient to pay the
principal of, interest on and other amounts due in respect of
our indebtedness when due. We may also add equipment loans and
lease lines to finance capital expenditures and may obtain
additional long-term debt, working capital lines of credit and
lease lines some of which may be on less than optimal terms.
Our substantial leverage could have significant negative
consequences, including:
|
|
|
| |
• |
increasing our vulnerability to general adverse economic and
industry conditions; |
| |
| |
• |
limiting our ability to obtain additional financing; |
| |
| |
• |
requiring the dedication of a portion of our expected cash flow
from operations to service our indebtedness, thereby reducing
the amount of our expected cash flow available for other
purposes, including capital expenditures; |
| |
| |
• |
limiting our flexibility in planning for, or reacting to,
changes in our business and the industry in which we
compete; and |
| |
| |
• |
placing us at a possible competitive disadvantage relative to
less leveraged competitors and competitors that have better
access to capital resources |
(All dollar amounts are presented in thousands)
We are headquartered in San Jose, California in an
86,000 square feet facility under a lease that will expire
on October 31, 2008. In addition, we lease approximately
38,000 and 66,000 square feet of space for our call center
operations in Herndon, Virginia and Denver, Colorado,
respectively. We manage our network operations center in a
36,000 square feet location separate from our corporate
headquarters in San Jose, California. We also lease office
space with an approximate combined total of 36,000 square
feet in some of the metropolitan areas in which we conduct
operations. In June 2002, we completed the sale of our property
(consisting of land, a building and certain improvements) in
Manassas, Virginia, and recognized a gain of $133 which
represents the net proceeds of $13,334 less the aggregate
carrying value of $13,201.
We also lease central office space from the ILECs in areas in
which we operate or plan to operate under the terms of our
interconnection agreements and obligations imposed by state
public utilities commissions and the FCC. The productive use of
our central office space is subject to the terms of our
interconnection agreements. We will need to increase our central
office space if we choose to expand our network geographically.
|
|
| ITEM 3. |
Legal Proceedings |
(All dollar amounts are presented in thousands)
In April 1999, we filed a lawsuit against Bell Atlantic, now
Verizon, and its affiliates in the United States District Court
for the District of Columbia. We are pursuing antitrust and
other claims in this lawsuit arising
26
out of Verizon’s conduct as a supplier of network
facilities, including central office space, transmission
facilities and telephone lines. In December 2000, we also filed
a lawsuit against BellSouth Telecommunications and its
subsidiaries in the United States District Court for the
Northern District of Georgia. We are pursuing claims in this
lawsuit that are similar to our claims against Verizon. Both
courts dismissed some of our claims based on the ruling of the
United States Court of Appeals of the Seventh Circuit in
Goldwasser v. Ameritech. The court in the Verizon case also
dismissed our remaining claims on other grounds. We voluntarily
dismissed our remaining claims in the BellSouth case so we could
pursue certain issues on appeal. We appealed the BellSouth and
Verizon decisions to the United States Court of Appeals for the
Eleventh Circuit and the United States Court of Appeals for the
District of Columbia, respectively. On August 2, 2002, the
Eleventh Circuit Court of Appeals reversed the lower
court’s decision in the BellSouth case and remanded the
case for further proceedings. BellSouth appealed this decision
to the United States Supreme Court. On January 20, 2004,
the United States Supreme Court reversed a decision entitled
Verizon Communications v. Law Offices of Curtis Trinko,
which rejected the Goldwasser decision. The Supreme Court also
vacated the Eleventh Circuit’s decision in our case against
BellSouth and remanded the case to the Eleventh Circuit for
review in light of the Trinko decision. Although we believe the
Trinko decision does not impact our cases, both BellSouth and
Verizon claim that Trinko supports the dismissal of our
lawsuits. On June 25, 2004, the Eleventh Circuit reversed
portions of the lower court’s decision in the BellSouth
case and remanded the case for further proceedings. On
November 24, 2004, we requested that the United
States Supreme Court review certain portions of the Eleventh
Circuit’s decision unrelated to our antitrust claims. The
Supreme Court denied our request. The Court of Appeals for the
District of Columbia also recently reversed in part and affirmed
in part the District Court’s decision in our case against
Verizon and remanded the case to the United States District
Court for further proceedings. We cannot predict the outcome of
these proceedings at this time.
On June 11, 2001, Verizon Communications filed a lawsuit
against us in the United States District Court for the Northern
District of California. Verizon is a supplier of telephone lines
that we use to provide services to our customers. In its amended
complaint, Verizon claims that we falsified trouble ticket
reports with respect to the telephone lines that we ordered and
seeks unspecified monetary damages, characterized as being in
the “millions”, and injunctive relief. The current
complaint asserts causes of action for negligent and intentional
misrepresentation and violations of California’s unfair
competition statute. On November 13, 2002, the District
Court entered summary judgment in favor of us and dismissed
Verizon’s claims against us in their entirety. Verizon
appealed the dismissal of its lawsuit. In July 2004 the Ninth
Circuit Court of Appeals partially reversed the District
Court’s decision and indicated that Verizon could attempt
to pursue a claim against us for breach of contract. The matter
has been sent back to the District Court for further
proceedings. We believe we have strong defenses to this lawsuit,
but litigation is inherently unpredictable and there is no
guarantee we will prevail.
Several stockholders filed complaints in the United States
District Court for the Southern District of New York, on behalf
of themselves and purported classes of stockholders, against us
and several former and current officers and directors in
addition to some of the underwriters in our stock offerings.
These lawsuits are so-called IPO allocation cases, challenging
practices allegedly used by certain underwriters of public
equity offerings during the late 1990s and 2000. On
April 19, 2002 the plaintiffs amended their complaint and
removed us as a defendant. Certain directors and officers are
still named in the complaint. The plaintiffs claim that we
failed to disclose the arrangements that some of these
underwriters purportedly made with certain investors. The
plaintiffs and the issuer defendants have reached a tentative
agreement to settle the matter, and we believe the tentative
settlement will not have a material adverse effect on our
consolidated financial position or results of operations. That
settlement, however, has not been finalized. If the settlement
is not finalized, we believe we have strong defenses to these
lawsuits and we intend to contest them vigorously. However,
litigation is inherently unpredictable and there is no guarantee
we will prevail.
In June 2002, Dhruv Khanna was relieved of his duties as our
General Counsel and Secretary. Shortly thereafter,
Mr. Khanna alleged that, over a period of years, certain
current and former directors and officers had breached their
fiduciary duties to Covad by engaging in or approving actions
that constituted waste and self-dealing, that certain current
and former directors and officers had provided false
representations to our
27
auditors and that he had been relieved of his duties in
retaliation for his being a purported whistleblower and because
of racial or national origin discrimination. He threatened to
file a shareholder derivative action against those current and
former directors and officers, as well as a wrongful termination
lawsuit. Mr. Khanna was placed on paid leave while his
allegations were being investigated.
Our Board of Directors appointed a special investigative
committee, which initially consisted of Dale Crandall and
Hellene Runtagh, to investigate the allegations made by
Mr. Khanna. Richard Jalkut was appointed to this committee
shortly after he joined our Board of Directors. This committee
retained an independent law firm to assist in its investigation.
Based on this investigation, the committee concluded that
Mr. Khanna’s allegations were without merit and that
it would not be in the best interests of Covad to commence
litigation based on these allegations. The committee considered,
among other things, that many of Mr. Khanna’s
allegations were not accurate, that certain allegations
challenged business decisions lawfully made by management or the
Board, that the transactions challenged by Mr. Khanna in
which any director had an interest were approved by a majority
of disinterested directors in accordance with Delaware law, that
the challenged director and officer representations to the
auditors were true and accurate, and that Mr. Khanna was
not relieved of his duties as a result of retaliation for
alleged whistleblowing or racial or national origin
discrimination. Mr. Khanna has disputed the
committee’s work and the outcome of its investigation.
After the committee’s findings had been presented and
analyzed, we concluded in January 2003 that it would not be
appropriate to continue Mr. Khanna on paid leave status,
and determined that there was no suitable role for him at Covad.
Accordingly, he was terminated as an employee of Covad.
Based on the events mentioned above, in September 2003,
Mr. Khanna filed a purported class action and a derivative
action against our current and former directors in the Court of
Chancery of the State of Delaware in and for New Castle County.
On August 3, 2004, Mr. Khanna amended his Complaint
and two additional purported shareholders joined the lawsuit. In
this action the plaintiffs seek recovery on behalf of the
company from the individual defendants for their purported
breach of fiduciary duty. The plaintiffs also seek to invalidate
our election of directors in 2002, 2003 and 2004 because they
claim that our proxy statements were misleading. On or about
October 11, 2004, we filed a motion to dismiss the amended
complaint in its entirety and a motion to disqualify
Mr. Khanna and the additional plaintiffs as class
representatives. The motions have not yet been scheduled for
hearing. We are unable to predict the outcome of this lawsuit.
We are also a party to a variety of pending or threatened legal
proceedings as either plaintiff or defendant, or are engaged in
business disputes that arise in the ordinary course of business.
Failure to resolve these various legal disputes and
controversies without excessive delay and cost and in a manner
that is favorable to us could significantly harm our business.
We do not believe the ultimate outcome of these matters will
have a material impact on our consolidated financial position
and results of operations. However, litigation is inherently
unpredictable and there is no guarantee we will prevail or
otherwise not be adversely affected.
We are subject to state PUCs, FCC and other regulatory and court
decisions as they relate to the interpretation and
implementation of the 1996 Telecommunications Act, the
interpretation of competitive telecommunications company
interconnection agreements in general, and our interconnection
agreements in particular. In some cases we may be bound by or
may otherwise be significantly impacted by the results of
ongoing proceedings of these bodies or the legal outcomes of
other contested interconnection agreements that are similar to
our agreements. The results of any of these proceedings could
harm our business.
In addition, we are engaged in a variety of legal negotiations,
arbitrations and regulatory and court proceedings with multiple
ILECs. These negotiations, arbitrations and proceedings concern
the ILECs denial of central office space, the cost and delivery
of transmission facilities and telephone lines and central
office spaces, billing issues and other operational issues.
Other than the payment of legal fees and expenses, which are not
quantifiable but are expected to be material, we do not believe
that these matters will result in material liability to us and
the potential gains are not quantifiable at this time. An
unfavorable result in any of these negotiations, arbitrations
and proceedings, however, could have a material adverse effect
on our consolidated financial position and results of operations
if we are denied or charged higher rates for transmission lines
or central office spaces.
28
|
|
| ITEM 4. |
Submission of Matters to a Vote of Security Holders |
During the fourth quarter of 2004, we did not submit any matters
to the vote of our security holders.
PART II
|
|
| ITEM 5. |
Market for Registrant’s Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity
Securities |
Market Price Information and Dividend Policy for Our Common
Stock
Since July 20, 2001, our common stock has traded on
NASDAQ’s OTC Bulletin Board under the symbol COVD.OB.
The following table sets forth, for the periods indicated, the
high and low closing sales prices for our common stock as
reported by NASDAQ’s OTC Bulletin Board.
| |
|
|
|
|
|
|
|
|
| |
|
High | |
|
Low | |
| |
|
| |
|
| |
|
Fiscal Year Ending December 31, 2003
|
|
|
|
|
|
|
|
|
|
First Quarter
|
|
$ |
1.40 |
|
|
$ |
0.57 |
|
|
Second Quarter
|
|
$ |
1.27 |
|
|
$ |
0.55 |
|
|
Third Quarter
|
|
$ |
6.89 |
|
|
$ |
0.87 |
|
|
Fourth Quarter
|
|
$ |
6.17 |
|
|
$ |
2.84 |
|
|
Fiscal Year Ending December 31, 2004
|
|
|
|
|
|
|
|
|
|
First Quarter
|
|
$ |
4.16 |
|
|
$ |
1.84 |
|
|
Second Quarter
|
|
$ |
2.58 |
|
|
$ |
1.62 |
|
|
Third Quarter
|
|
$ |
2.36 |
|
|
$ |
1.27 |
|
|
Fourth Quarter
|
|
$ |
2.34 |
|
|
$ |
1.45 |
|
On December 31, 2004, the last reported sale price for our
common stock on the OTC Bulletin Board was $2.15 per
share. As of February 4, 2005 there were 17,920 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 any future
earnings for use in the expansion and operation of our business.
Thus, we do not anticipate paying any cash dividends on our
common stock in the foreseeable future. Our Board of Directors
will determine our future dividend policy.
29
|
|
| ITEM 6. |
Selected Financial Data |
(All dollar and share amounts are presented in thousands,
except per share amounts)
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
For the Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
|
2001 | |
|
2000 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
Consolidated Statement of Operations Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues, net
|
|
$ |
429,197 |
|
|
$ |
388,851 |
|
|
$ |
383,496 |
|
|
$ |
332,596 |
|
|
$ |
158,736 |
|
|
Cost of sales (exclusive of depreciation and amortization)
|
|
|
266,172 |
|
|
|
288,122 |
|
|
|
298,336 |
|
|
|
461,875 |
|
|
|
432,153 |
|
|
Selling, general and administrative expenses
|
|
|
146,241 |
|
|
|
140,081 |
|
|
|
150,373 |
|
|
|
199,908 |
|
|
|
292,991 |
|
|
Depreciation and amortization
|
|
|
77,410 |
|
|
|
73,884 |
|
|
|
127,088 |
|
|
|
150,839 |
|
|
|
178,425 |
|
|
Provision for restructuring expenses
|
|
|
1,409 |
|
|
|
1,235 |
|
|
|
— |
|
|
|
14,364 |
|
|
|
4,988 |
|
|
Provision for long-lived asset impairment
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
11,988 |
|
|
|
589,388 |
|
|
Loss from operations
|
|
|
(60,000 |
) |
|
|
(114,570 |
) |
|
|
(180,992 |
) |
|
|
(536,880 |
) |
|
|
(1,354,192 |
) |
|
Interest expense
|
|
|
(4,927 |
) |
|
|
(5,526 |
) |
|
|
(5,581 |
) |
|
|
(92,782 |
) |
|
|
(109,863 |
) |
|
Reorganization expenses, net
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(62,620 |
) |
|
|
— |
|
|
Gain on extinguishment of debt
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
1,033,727 |
|
|
|
— |
|
|
Income (loss) before cumulative effect of change in accounting
principle
|
|
|
(60,761 |
) |
|
|
(112,302 |
) |
|
|
(184,828 |
) |
|
|
344,758 |
|
|
|
(1,433,887 |
) |
|
Cumulative effect of change in accounting principle
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(9,249 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss)
|
|
$ |
(60,761 |
) |
|
$ |
(112,302 |
) |
|
$ |
(184,828 |
) |
|
$ |
344,758 |
|
|
$ |
(1,443,136 |
) |
|
Basic and diluted per share amounts:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) before cumulative effect of change in
accounting principle
|
|
$ |
(0.24 |
) |
|
$ |
(0.50 |
) |
|
$ |
(0.84 |
) |
|
$ |
1.94 |
|
|
$ |
(9.41 |
) |
|
Cumulative effect of accounting change
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(0.06 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss)
|
|
$ |
(0.24 |
) |
|
$ |
(0.50 |
) |
|
$ |
(0.84 |
) |
|
$ |
1.94 |
|
|
$ |
(9.47 |
) |
|
Weighted-average common shares used in computing basic and
diluted per share amounts
|
|
|
249,187 |
|
|
|
224,950 |
|
|
|
219,744 |
|
|
|
177,347 |
|
|
|
152,359 |
|
|
Pro forma amounts assuming the accounting change is applied
retroactively:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
(1,433,887 |
) |
|
Net loss attributable to common stockholders
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
(1,433,887 |
) |
|
Basic and diluted net loss per common share
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
(9.41 |
) |
30
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
As of December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
|
2001 | |
|
2000 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
Consolidated Balance Sheet Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash, cash equivalents and short-term investments
|
|
$ |
150,996 |
|
|
$ |
114,345 |
|
|
$ |
202,492 |
|
|
$ |
283,863 |
|
|
$ |
869,834 |
|
|
Property and equipment, net
|
|
$ |
78,707 |
|
|
$ |
94,279 |
|
|
$ |
108,737 |
|
|
$ |
215,804 |
|
|
$ |
338,409 |
|
|
Total assets
|
|
$ |
385,225 |
|
|
$ |
334,711 |
|
|
$ |
442,161 |
|
|
$ |
675,168 |
|
|
$ |
1,511,485 |
|
|
Long-term obligations, including capital leases
|
|
$ |
125,734 |
|
|
$ |
50,000 |
|
|
$ |
50,165 |
|
|
$ |
50,011 |
|
|
$ |
1,374,673 |
|
|
Total stockholders’ equity (deficit)
|
|
$ |
(8,635 |
) |
|
$ |
(5,553 |
) |
|
$ |
82,299 |
|
|
$ |
259,829 |
|
|
$ |
(182,663 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
As of and for the Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
|
2001 | |
|
2000 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
Other Operating and Financial Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Collocation facilities
|
|
|
2,052 |
|
|
|
1,819 |
|
|
|
1,802 |
|
|
|
1,718 |
|
|
|
1,859 |
|
|
Homes and businesses passed (approximately)
|
|
|
50,000,000 |
|
|
|
46,000,000 |
|
|
|
46,000,000 |
|
|
|
40,000,000 |
|
|
|
40,000,000 |
|
|
Lines in service
|
|
|
533,200 |
|
|
|
517,000 |
|
|
|
381,000 |
|
|
|
351,000 |
|
|
|
274,000 |
|
|
Capital expenditures for property and equipment
|
|
$ |
38,743 |
|
|
$ |
44,142 |
|
|
$ |
22,782 |
|
|
$ |
15,732 |
|
|
$ |
319,234 |
|
|
Capital expenditures for collocation fees and purchases of other
intangibles assets
|
|
$ |
7,900 |
|
|
$ |
14,889 |
|
|
$ |
3,782 |
|
|
$ |
7,940 |
|
|
$ |
25,038 |
|
|
|
| ITEM 7. |
Management’s Discussion and Analysis of Financial
Condition and Results of Operation |
(All dollar and share amounts are presented in thousands,
except per share amounts)
The following discussion of our financial condition and
results of operations should be read in conjunction with the
consolidated financial statements and the related notes thereto
included elsewhere in this Annual Report on Form 10-K. This
discussion contains forward-looking statements, the accuracy of
which involves risks and uncertainties. Our actual results could
differ materially from those anticipated in the forward-looking
statements for many reasons including, but not limited to, those
discussed in “Part I. Item 1. Business-Risk
Factors” and elsewhere in this Annual Report on
Form 10-K. We disclaim any obligation to update information
contained in any forward-looking statement. See —
Forward-Looking Statements.”
Overview
We provide voice and data communications products and services
to consumers and businesses. We provide these services
throughout the United States in approximately 125 major
metropolitan areas, which include over 900 cities. Our
telecommunications network allows us to offer services to
approximately 50 million homes and businesses. Our products
and services include high-speed, or broadband, data
communications, Internet access connectivity, Voice over
Internet Protocol telephony, or VoIP, and a variety of related
services. We primarily use digital subscriber line, or DSL, and
DS-1, also referred to as T-1, technologies to deliver our
services. In order to provide our services we purchase network
elements, such as telecommunication lines and central office
facilities, from the traditional local telephone companies,
which are often referred to as the incumbent local telephone
companies, or ILECs, and other carriers, and then combine these
network elements with our own nationwide network facilities. We
purchase the majority of these network elements from Verizon
Communications, Inc., or Verizon, BellSouth Telecommunications,
Inc., or BellSouth, SBC Communications, Inc., or SBC, and Qwest
Corporation, or Qwest, which are also known as the regional Bell
operating companies, or RBOCs. As of December 31, 2004, we
had approximately
31
533,200 broadband access end-users and 567 VoIP business
customers with a combined total of approximately
20,500 VoIP stations.
We operate two business segments, Wholesale and Direct.
Wholesale is a provider of high-speed data connectivity services
to Internet service providers, or ISPs, and telecommunications
carrier customers. As of December 31, 2004, Wholesale had
approximately 454,600 DSL and T-1 lines in service, up from
445,000 lines at the end of the previous year. The majority
of our services are sold through our Wholesale segment.
Our Direct segment sells VoIP, high-speed data connectivity and
related value-added services through multiple channels including
telesales, field sales, affinity partner programs, and our
website. Direct focuses on the small business market and also
sells to enterprise customers that purchase our services for
distribution across their enterprise. Direct ended 2004 with
approximately 78,600 DSL and T-1 lines in service, up from
72,000 lines at the end of the previous year.
Since our inception, we have and continue to generate
significant net and operating losses and negative operating cash
flow, except for 2004, in which we generated positive operating
cash flows. Our cash reserves are limited and our business plan
is based on assumptions that we believe are reasonable, but some
of which are out of our control. If actual events differ from
our assumptions, we may need to raise additional capital on
terms that are less favorable than we desire.
The FCC’s recent decisions, as described in more detail in
Item 1, —
Business — “Government Regulation”,
have created a number of uncertainties, challenges and potential
opportunities for us. The final effect of these developments
will be subject to further proceedings at the FCC and the
reactions of the various participants in the telecommunications
industry, and many of these components are, or likely will be,
the subject of continuing litigation that could influence the
decisions’ ultimate impact. As such, it is very difficult
for us to predict with a high degree of certainty the final
effects of the FCC’s decisions. As a result of these
events, we are exploring alternative methods of selling bundled
voice and data services directly to end-users and through our
resellers. However, we may be unsuccessful in identifying
feasible or profitable alternatives.
|
|
|
Our Opportunities and Challenges |
Our business is in transition due to changes in federal and
state telecommunications regulations and our resellers’
changing strategies. Sales of our stand-alone DSL services have
slowed, and we continue to experience a high level of churn
among our existing end-users due to competitive pricing
pressures and other factors. As a result, we have increased our
focus on direct sales of bundled VoIP and data communications
services to small and medium-sized businesses. This transition
presents a substantial business opportunity for us. While we
believe we are favorably positioned to take advantage of this
opportunity, our ability to grow our sales of these services is
inherently difficult to predict, and we cannot predict whether
sales of these services will offset declines in sales of our
stand-alone DSL services.
Given the facts above and the highly competitive, dynamic and
heavily regulated nature of our business environment, we face a
complex array of factors that create challenges and
opportunities for us. Key matters upon which we are focused at
this time include the following:
Efficient use of cash — Since we exited our
voluntary bankruptcy proceedings at the end of 2001, we have
been able to decrease the amount of cash used in our operations,
and concluded 2004 with working capital of approximately
$79,000. We have reduced our expenses over the past three years
and continue to manage expenses closely. Our ability to attain
cash flow sufficiency will largely depend on the rate at which
we can grow our revenues and control our expenditures.
Manage through a transition in the delivery of broadband
Internet access services to consumers — The
delivery of stand-alone high-speed Internet connectivity
services by our ISP customers is facing intense competition from
the RBOCs and cable providers like Comcast, Adelphia and Cox
Communications, who are aggressively pricing their consumer
broadband services, often as part of a bundled service offering.
We believe
32
these market conditions have placed additional pricing pressure
on us and our resellers, reduced the number of orders for our
services, and have caused a higher level of churn among our
end-users. During the first half of 2004, these conditions
caused reductions of approximately 2,600 in our total number of
end-users. However, we experienced an increase in net additions
of approximately 18,800 in the second half of 2004.
A portion of our current orders are generated by line-splitting
arrangements with voice providers that bundle our data services
with their voice services. The viability of these line-splitting
arrangements is dependent on the ability of these voice
providers to enter into agreements with the RBOCs that provide
them with continued access to UNE-P or similar voice resale
platforms. We are also exploring other methods of selling
bundled voice and data services directly to end-users and to our
resellers but we may be unsuccessful in identifying feasible or
profitable alternatives. Our operational results in 2005 and
beyond will be dependent on the extent to which we can continue
sales of our services under bundling arrangements.
Obtain acceptable line-sharing terms from the
ILECs — We currently support our consumer and
small office/home office focused resellers through line-sharing.
We currently generate 20.9% of our revenues from the sale of our
line-shared services. While we expect that the revenues we
generate from line-sharing with the RBOCs will decline in future
periods, we think this market will continue to be important to
us. Since the RBOCs are the incumbent local telephone companies
in almost all of the metropolitan areas where we offer our
services, our ability to generate significant revenue from the
sale of our line-shared DSL services will depend on whether we
are able to reach long-term agreements with the RBOCs, like our
agreement with Verizon and Qwest or obtain favorable regulatory
rulings that will allow us to share telephone lines for new
customers on reasonable terms.
Expand and diversify our sources of revenue —
We are taking steps to improve our prospects for revenue growth.
First, we have expanded our network by adding central office
locations, which will allow us to offer our services to more
end-users. Second, we will continue our efforts to diversify our
revenue sources by adding new services such as VoIP and by
adding new resellers.
New market opportunities — We believe that VoIP
services have the potential to be a significant contributor to
our future revenues. However, we are in the early stages of
offering this capability, and our success in providing this new
service will depend on our ability to offer a service that is
competitive with voice services provided by other
telecommunications service providers and to continue to improve
this service.
On February 28, 2005, Susan Crawford resigned as the
Company’s Senior Vice President and acting Chief Financial
Officer, effective March 15, 2005. On March 2, 2005,
the Board of Directors appointed John Trewin as the
Company’s Senior Vice President and Chief Financial
Officer, effective March 16, 2005.
On February 4, 2005, regarding the assignment for the
benefit of creditors of BlueStar Communications Group, Inc., or
BlueStar, which is explained in Note 3 to our Consolidated
Financial Statements in Item 8, the Seventh Circuit Court
for Davidson County, Tennessee ordered the Assignee to make a
final distribution of funds of the estates to holders of allowed
claims. Such final distribution has been made. As previously
disclosed in our financial statements, we believe that such
final distribution and liquidation of the estate is an event
that qualifies for us to recognize the deferred gain of $53,963
that resulted from the deconsolidation of Bluestar on
June 25, 2001. Consequently, we anticipate that we will
recognize such gain during the three months ending
March 31, 2005.
|
|
|
Critical Accounting Policies and Estimates |
Our discussion and analysis of financial condition and results
of operations is based upon our consolidated financial
statements, which have been prepared in accordance with
accounting principles generally accepted in the United States.
For additional information regarding our critical accounting
policies, please see Note 1 to our Consolidated Financial
Statements in Item 8. The application of these policies
requires us to make estimates that affect the reported amounts
of assets, liabilities, revenues and expenses, and related
disclosures of contingent assets and liabilities. We base our
accounting estimates on historical experience and other
33
factors that we believe to be reasonable under the
circumstances. However, actual results may vary from these
estimates under different assumptions or conditions. We have
discussed the development and selection of critical accounting
policies and estimates with our audit committee. The following
is a summary of our critical accounting policies and estimates
we make in preparing our consolidated financial statements:
|
|
|
| |
• |
We recognize revenues when persuasive evidence of our
arrangement with the customer exists, service has been provided
to the customer, the price to the customer is fixed or
determinable and collectibility of the sales price is reasonably
assured. We recognize up-front fees associated with service
activation over the expected term of the customer relationship,
which is presently estimated to be twenty-four to forty-eight
months using the straight-line method. Similarly, we treat the
incremental direct costs of service activation, which consist
principally of customer premises equipment, service activation
fees paid to other telecommunications companies and sales
commissions, as deferred charges in amounts no greater than the
up-front fees that are deferred, and such incremental direct
costs are amortized to expense using the straight-line method
over a range of twenty-four to forty-eight months. |
| |
| |
• |
We perform ongoing credit evaluations of our customers’
financial condition and maintain an allowance for estimated
credit losses. In addition, we have billing disputes with some
of our customers. These disputes arise in the ordinary course of
business in the telecommunications industry and we believe that
their impact on our accounts receivable and revenues can be
reasonably estimated based on historical experience. In
addition, certain customer revenues are subject to refund if the
end-user terminates service within thirty days of service
activation. Accordingly, we maintain allowances, through charges
to revenues, based on our estimate of the ultimate resolution of
these disputes and future service cancellations, and our
reported revenue in any period could be different than what is
reported if we employed different assumptions in estimating the
outcomes of these items. |
| |
| |
• |
We state our inventories at the lower of cost or market. In
assessing the ultimate recoverability of inventories, we are
required to make estimates regarding future customer demand. |
| |
| |
• |
We record property and equipment and intangible assets at cost,
subject to adjustments for impairment. We depreciate or amortize
property and equipment and intangible assets using the
straight-line method over their estimated useful lives. In
assessing the recoverability of our property and equipment and
intangible assets, we must make assumptions regarding estimated
future cash flows and other factors to determine the fair value
of the respective assets. If these estimates and assumptions
change in the future, we may be required to record additional
impairment charges relating to our property and equipment and
intangible assets. |
| |
| |
• |
We record goodwill when the consideration paid for an
acquisition exceeds the fair value of net tangible and
intangible assets acquired. We measure and test goodwill for
impairment on an annual basis or more frequently if we believe
indicators of impairment exists. The performance of the test
involves a two-step process. The first step compares the fair
value of the reporting unit to its carrying amount, including
goodwill. The fair value of the reporting unit is determined by
calculating the market capitalization of the reporting unit as
derived from quoted market prices or other generally accepted
valuation methods if quoted market prices are not available. A
potential impairment exists if the fair value of the reporting
unit is lower than its carrying amount. The second step of the
process is only performed if a potential impairment exists, and
it involves determining the difference between the fair values
of the reporting unit’s net assets, other than goodwill, to
the fair value of the reporting unit. If the difference is less
than the net book value of goodwill, impairment exists and is
recorded. We determine our reporting units, for purposes of
testing for impairment, by determining (i) how we manage
our operations, (ii) if a component of an operating unit
constitutes a business for which discrete financial information
is available and our management regularly review such financial
information, and (iii) how the acquired entity is
integrated with our operations. Based on these criteria, we
determined that our Wholesale and Direct segments are our
reporting units. On June 8, 2004, we completed the
acquisition of all of the outstanding shares of privately-held
GoBeam, Inc., as described in Note 6 to our consolidated
financial statements, “Acquisition of GoBeam,
Inc.” We integrated and |
34
|
|
|
| |
|
manage the GoBeam business within our Direct segment.
Accordingly, the recorded goodwill from the acquisition of
GoBeam was allocated to the Direct segment for purposes of
testing for impairment. |
| |
| |
• |
We are a party to a variety of legal proceedings, as either
plaintiff or defendant, and are engaged in other disputes that
arise in the ordinary course of business. We are required to
assess the likelihood of any adverse judgments or outcomes to
these matters, as well as potential ranges of probable losses
for certain of these matters. The determination of the
liabilities to be recognized, if any, for loss contingencies is
made after analysis of each individual situation based on the
facts and circumstances. However, it is reasonably possible that
the liabilities reflected in our consolidated balance sheets for
loss contingencies and business disputes could change in the
near term due to new facts and circumstances, the effects of
which could be material to our consolidated financial position
and results of operations. |
| |
| |
• |
We continue to analyze the applicability of certain
transaction-based taxes to sales of our products and services
and purchases of telecommunications circuits from various
carriers. This analysis includes discussions with authorities of
jurisdictions in which we do business and various
transaction-based tax experts to determine the extent of our
transaction-based tax liabilities. We believe that these
discussions will be concluded without a material adverse effect
on our consolidated financial position and results of
operations. In addition, we continue to analyze the probable
applicability of employment-related taxes for certain
stock-based compensation provided to employees in prior periods.
We believe that the analysis of the probable applicability of
these taxes will be concluded without a material adverse effect
to our consolidated financial position and results of
operations. However, it is reasonably possible that our
estimates of our transaction-based and employment-related tax
liabilities could change in the near term, the effects of which
could be material to our consolidated financial position and
results of operations. |
| |
| |
• |
We make market development funds, or MDF, available to certain
customers for the reimbursement of co-branded advertising
expenses and other purposes. To the extent that MDF is used by
our customers for co- branded advertising, and the customers
provide us with third-party evidence of such co-branded
advertising and we can reasonably estimate the fair value of our
portion of the advertising, such amounts are charged to
advertising expense as incurred. Other MDF activities are
recorded as reductions of revenues as incurred. Amounts payable
to customers relating to rebates and customer incentives are
recorded as reductions of revenues based on our estimate of
sales incentives that will ultimately be claimed by customers. |
| |
| |
• |
We account for income taxes using the liability method, under
which deferred tax assets and liabilities are determined based
on differences between the financial reporting and tax bases of
our assets and liabilities. We record a valuation allowance on
our deferred tax assets to arrive at an amount that is more
likely than not to be realized. In the future, should we
determine that we are able to realize all or part of our
deferred tax assets, which presently are fully reserved, an
adjustment to our deferred tax assets would increase income in
the period in which the determination was made. |
| |
| |
• |
We account for stock-based awards to employees using the
intrinsic value method, and non-employees using the fair value
method. Under the intrinsic value method, when the exercise
price of our employee stock options equals or exceeds the market
price of the underlying stock on the date of grant, we do not
record compensation expense in our consolidated statement of
operations. We use the intrinsic value method in accounting for
employee stock options because the alternative fair value
accounting requires us to use option valuation models that were
not developed for use in valuing employee stock options. Rather,
such option valuation models were developed for use in
estimating the fair value of traded options that have no vesting
restrictions and are fully transferable. Because our employee
stock options have characteristics significantly different from
those of traded options and because changes in the subjective
input assumptions can materially affect the fair value estimates
of these valuation models, we believe such existing models do
not necessarily provide a reliable single measure of the fair
value of our employee stock options. |
35
|
|
|
Recent Accounting Pronouncements |
In December 2004, the Financial Accounting Standards Board, or
FASB, issued Statement of Financial Accounting Standards, or
SFAS, No. 123 (revised 2004), “Share-Based
Payment”, or SFAS 123R, that addresses the accounting
for share-based payment transactions in which an enterprise
receives employee services in exchange for either equity
instruments of the enterprise or liabilities that are based on
the fair value of the enterprise’s equity instruments or
that may be settled by the issuance of such equity instruments.
The statement eliminates the ability to account for share-based
compensation transactions using the intrinsic value method as
prescribed by Accounting Principles Board, or APB, Opinion
No. 25, “Accounting for Stock Issued to
Employees,” and generally requires that such transactions
be accounted for using a fair-value-based method and recognized
as expenses in our consolidated statement of income. The
statement requires companies to assess the most appropriate
model to calculate the value of the options. We currently use
the Black-Scholes option pricing model to value options and are
currently assessing which model we may use in the future under
the statement and may deem an alternative model to be the most
appropriate. The use of a different model to value options may
result in a different fair value than the use of the
Black-Scholes option pricing model. In addition, there are a
number of other requirements under the new standard that will
result in differing accounting treatment than currently
required. These differences include, but are not limited to, the
accounting for the tax benefit on employee stock options and for
stock issued under our employee stock purchase plan. In addition
to the appropriate fair value model to be used for valuing
share-based payments, we will also be required to determine the
transition method to be used at date of adoption. The allowed
transition methods include prospective and retroactive adoption
options. Under the retroactive options, prior periods may be
restated either as of the beginning of the year of adoption or
for all periods presented. The prospective method requires that
compensation expense be recorded for all unvested stock options
and restricted stock at the beginning of the first quarter of
adoption of SFAS 123R, while the retroactive methods would
record compensation expense for all unvested stock options and
restricted stock beginning with the first period restated. The
effective date of the new standard for our consolidated
financial statements is our third fiscal quarter in 2005.
Upon adoption, this statement will have a significant impact on
our consolidated financial statements as we will be required to
expense the fair value of our stock option grants and stock
purchases under our employee stock purchase plan rather than
disclose the impact on our consolidated net income within our
footnotes as is our current practice (see Note 1 of the
notes of the consolidated financial statements contained
herein). The amounts disclosed within our footnotes are not
necessarily indicative of the amounts that will be expensed upon
the adoption of SFAS 123R. Compensation expense calculated
under SFAS 123R may differ materially from amounts
currently disclosed within our footnotes based on changes in the
fair value of our common stock, changes in the number of options
granted or the terms of such options, the treatment of tax
benefits and changes in interest rates or other factors. In
addition, upon adoption of SFAS 123R we may choose to use a
different valuation model to value the compensation expense
associated with employee stock options.
In December 2004, the FASB issued SFAS No. 153
“Exchanges of Non-monetary Assets.” SFAS eliminates
the exception from fair value measurement for non-monetary
exchanges of similar productive assets in paragraph 21
(b) of APB opinion 29, “Accounting for
Non-monetary Transactions”, and replaces it with an
exception for exchanges that do not have commercial substance.
SFAS 153 specifies that a non-monetary exchange has
commercial substance if the future cash flows of the entity are
expected to change significantly as a result of the exchange.
SFAS 153 is effective for fiscal periods beginning after
June 15, 2005. We are currently evaluating the effect that
the adoption of SFAS 153 will have on our consolidated
statement of operations and financial condition for fiscal
periods beginning after June 15, 2005.
In November 2004, the FASB issued SFAS No. 151
“Inventory Costs — an amendment of Accounting
Research Bulletin No. 43, Chapter 4”.
SFAS 151 amends the guidance in ARB No. 43,
Chapter 4, “Inventory Pricing,”, to clarify the
accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material, or spoilage.
Paragraph 5 of ARB 43, previously stated that under some
circumstances, items such as idle facility expense, excessive
spoilage, double freight, and re-handling costs may be so
abnormal as to require treatment as current period charges.
SFAS 151 requires that such items be recognized as current
36
period charges regardless of whether they meet the criterion of
“so abnormal”. In addition, SFAS 151 requires
that allocation of fixed production overheads to the costs of
conversion be based on the normal capacity of the production
facilities. SFAS 151 is effective for fiscal periods
beginning after June 15, 2005. We are currently evaluating
the effect that the adoption of SFAS 151 will have on our
consolidated statement of operations and financial condition for
fiscal periods beginning after June 15, 2005.
In March 2004, the FASB approved Emerging Issue Task Force, or
EITF, Issue 03-6, “Participating Securities and the
Two-Class Method under SFAS 128.” EITF
Issue 03-6 supersedes the guidance in Topic No. D-95,
“Effect of Participating Convertible Securities on the
Computation of Basic Earnings per Share,” and requires the
use of the two-class method of participating securities. The
two-class method is an earnings allocation formula that
determines earnings per share for each class of common stock and
participating security according to dividends declared (or
accumulated) and participation rights in undistributed earnings.
In addition, EITF Issue 03-6 addresses other forms of
participating securities, including options, warrants, forwards
and other contracts to issue an entity’s common stock, with
the exception of stock-based compensation subject to the
provisions of Opinion 25 and SFAS 123. EITF Issue 03-6
is effective for reporting periods beginning after
March 31, 2004 and should be applied by restating
previously reported earnings per share. The adoption of EITF
Issue 03-6 did not have a significant effect on our
consolidated financial statements for the year ended
December 31, 2004.
Results of Operations for the years ended December 31,
2004, 2003 and 2002
|
|
|
Business Segment Information |
In 2004, we managed our business segments based upon differences
in customers, services and marketing channels, even though the
assets and cash flows from these operations were not independent
of each other. Our wholesale segment, or Wholesale, is a
provider of high-speed connectivity services to ISPs, and
enterprise and telecommunications carrier customers. Our direct
segment, or Direct, is a provider of voice and data
communication services, which include VoIP, high-speed Internet
access and other related services to individuals, small and
medium-sized businesses, and other organizations. We reported
all other operations and activities as Corporate Operations.
These operations and activities were primarily comprised of
general corporate functions to support our revenue producing
segments and included costs and expenses for headquarters
facilities and equipment, depreciation and amortization, network
capacity and non-recurring or unusual items not directly
attributable or allocated to the segments, gains and losses on
our investments, and income and expenses from our treasury and
financing activities. We do not allocate such operating expenses
and other income and expense items to our business segments
because we believe these expenses and other income items are not
directly managed or controlled by our business segments.
We measure our business segments profitability as income from
operations, excluding certain operating expenses such as
depreciation and amortization, and other income and expenses
items. We record business segments’ net revenues based upon
the differences in customers and related marketing channels.
Wholesale net revenues are primarily driven by products and
services sold to large resellers, whereas Direct net revenues
are primarily driven by products and services sold directly to
end-users. Our business segments’ operating expenses are
primarily comprised of network costs and labor and related
non-labor expenses to provision services and to provide support
to our customers. Our business segments network costs consist of
end-user circuits, aggregation circuits, central office space,
Internet transit charges, customer premises equipment and
equipment maintenance. Operating expenses also consist of labor
and related non-labor expenses for customer care, dispatch, and
repair and installation activities.
We allocate network costs to our business segments based on
their consumption of circuit or equipment capacity. We allocate
end-user circuit costs to a segment based on the products and
services sold by such segment. Aggregation circuits are
allocated based on actual capacity usage determined by the total
number of customers in a segment utilizing those circuits.
Customer premises equipment, or CPE, cost is directly assigned
to a business segment based on installations performed by such
segment and the cost of each specific CPE. We allocate labor
costs from our operations to our business segments based on
resource consumption formulas, which are primarily based on
installations, percentage of total lines in service and trouble
tickets by
37
segment. We assign employee compensation for our sales forces
directly to the business segments based on the customers they
sell to and serve. We assign advertising and promotions to the
business segments primarily based on expenditures incurred to
stimulate demand for target customer within those segments.
During the year ended December 31, 2003, a matter was
identified related to prior financial reporting periods that
necessitated the recording of additional expense. Such matter
was related to the modification of stock options granted to
certain employees in prior years. These modifications occurred
upon the separation of such employees from our Company,
principally during 2000. Accordingly, for the year ended
December 31, 2003, we recorded additional stock-based
compensation expense in the amount of $1,236, or $0.01 per
share. Such amount is reflected in our selling, general and
administrative expenses for the year ended December 31,
2003. We do not believe this amount is material to the periods
in which it should have been recorded, nor do we believe it is
material to our consolidated operating results for the year
ended December 31, 2003. This adjustment is principally
related to 2000, the impact of which would have been to increase
selling, general and administrative expenses and net loss by
$1,236 or $0.01 per share for such year. As explained
below, certain other adjustments were recorded during 2002 that
related to prior periods. $1,139 of such amounts pertained to
2000, the effect of which would have been to decrease the
Company’s 2000 net loss by $0.01 per share. The
aggregate effect of the adjustments recorded during the years
ended December 31, 2003 and 2002 to the previously reported
results of operations for the year ended December 31, 2000
would be to increase net loss by $97, or $0.00 per share,
for such year if these adjustments had been recorded in 2000.
As part of the continuing evaluation of our network assets
during the year ended December 31, 2002, certain matters
were identified related to prior financial reporting periods
that necessitated the recording of adjustments to certain
expenses. Such matters were related principally to changes in
our network configuration, which necessitated reductions of the
remaining estimated useful lives of certain network equipment,
the capitalization of certain network and product costs that
should have been charged to operating expenses when they were
incurred and various restructuring activities that resulted in
the abandonment of certain network equipment and leasehold
improvements. Accordingly, for the year ended December 31,
2002, we recorded additional depreciation expense of $6,989,
cost of sales of $2,635, loss on the disposition of property and
equipment of $635 and interest expense of $51. In addition, as
part of our financial statement close process for the year ended
December 31, 2002, we discovered that amortization expense
related to non-cash deferred stock-based compensation was
overstated in prior periods by $3,213. Therefore, for the year
ended December 31, 2002, we recorded reductions of cost of
sales of $320 and selling, general and administrative expense of
$2,893. Furthermore, as part of the review of our
December 31, 2002 tax accruals, we determined that we had
overstated our transaction-based tax and other tax accruals in
prior periods by $4,804, which we adjusted during the year ended
December 31, 2002 through a reduction of cost of sales. The
adjustment was primarily driven by various complex rules
surrounding our estimated liability to the Federal Universal
Service Fund, or FUSF. We do not believe any of the
aforementioned amounts are material to the periods in which they
should have been recorded, nor do we believe the prospective
correction of such amounts during the year ended
December 31, 2002 is material to our consolidated operating
results for such year. The prospective correction of the
aforementioned amounts relating to prior periods increased our
2002 consolidated net loss by $2,294, or $0.01 per share,
and decreased our 2001 net loss by $3,433 or $0.02 per
share.
Revenues, net
The primary component of our net revenues is earned monthly
broadband subscription billings for DSL services. We also earn
revenues from monthly subscription and usage billings related to
our VoIP services, monthly billings for T-1 circuits, monthly
billings for high-capacity circuits sold to our wholesale
customers and to a lesser degree from dial-up services sold to
end-users. Because we do not recognize revenue from billings to
financially distressed customers until we receive payment and
until our ability to keep the payment is reasonably assured, our
reported revenues for 2004, 2003 and 2002 have been impacted by
whether we receive, and the timing of receipt of, payments from
these customers. Our revenues also include billings for
installation fees and equipment sales, which are recognized as
revenue over the expected life of the
38
relationship with the end-user, and FUSF charges billed to our
customers. We record customer incentives and rebates that we
offer to attract and retain customers as reductions to gross
revenues. We regularly have billing disputes with our customers.
These disputes arise in the ordinary course of business in the
telecommunications industry, and we believe their impact on our
accounts receivable and revenues can be reasonably estimated
based on historical experience. In addition, certain revenues
are subject to refund if an end-user terminates service within
thirty days of the service activation. Accordingly, we maintain
allowances, through charges to revenues, based on our estimate
of the ultimate resolution of these disputes and future service
cancellations.
Our net revenues of $429,197 for 2004 increased by $40,346, or
10.4%, when compared to our net revenues of $388,851 for 2003.
This increase was primarily attributable to a $41,625 increase
in broadband net revenues as a result of adding end-users to our
network, a $12,738 reduction in customer rebates and incentives,
$5,040 of net revenues as a result of the introduction of our
new VoIP services, and a $2,124 increase in other revenues.
These increases were partially offset by a $10,013 reduction in
installation fees and equipment sales primarily driven by a
$6,204 decrease in broadband net revenues some of which is
related to lower selling prices, a $2,896 reduction in dial-up
revenue as a result of the continuing decrease in demand for
this service, a $1,643 reduction in hi-capacity circuits sales
and a $669 decrease in revenue recognized from financially
distressed customers. We expect to continue to add VoIP stations
to our network and also expect to continue to add broadband end
users, subject to the effect on our wholesale customers of
uncertainty caused by regulatory events discussed in
“Overview — Recent Developments.” This
uncertainty may cause these resellers to stop marketing certain
of our services or otherwise change their strategies. It is
possible that these conditions will cause our revenue to decline
in future periods. We also expect to continue to experience
competitive pricing pressures for our current services and
equipment products. As a result, we expect customer rebates and
incentives to continue to be an element of our sales and
marketing programs in order to respond to competitive market
conditions.
Our net revenues of $388,851 for 2003 increased by $5,355, or
1.4%, when compared to our net revenues of $383,496 for 2002.
This increase was primarily attributable to a $51,041 increase
in broadband net revenues as a result of adding end-users to our
network. This increase was partially offset by a $15,361
reduction in installation fees and equipment sales primarily
driven by lower selling prices, a $11,100 increase in customer
rebates and incentives due to higher sales to our wholesale
customers, a $8,349 decrease in revenue recognized from
financially distressed partners, a $6,035 reduction of revenue
from hi-capacity circuits as a result of customer network
configuration changes and consolidation, and a $4,841 decrease
in dial-up revenue primarily as a result of a decreasing demand
for this service.
|
|
|
Segment Revenues and Significant Customers |
Our segment net revenues were as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
Wholesale
|
|
$ |
309,899 |
|
|
$ |
298,221 |
|
|
$ |
326,659 |
|
|
As a percent of net revenues
|
|
|
72.2 |
% |
|
|
76.7 |
% |
|
|
85.2 |
% |
|
Direct
|
|
$ |
119,298 |
|
|
$ |
90,630 |
|
|
$ |
56,837 |
|
|
As a percent of net revenues
|
|
|
27.8 |
% |
|
|
23.3 |
% |
|
|
14.8 |
% |
Our wholesale net revenues for 2004 increased by $11,678, or
3.9%, when compared to 2003. This increase was primarily
attributable to a $10,023 increase in broadband revenue as a
result of adding end-users to our network, and a $12,738
reduction in customer rebates and incentives. These increases
were offset by a $11,335 reduction in installation fees and
equipment sales primarily driven by lower selling prices. Our
direct net revenues for 2004 increased by $28,668, or 31.6%,
when compared to 2003. This increase was primarily attributable
to a $25,640 increase in broadband subscription revenue as a
result of adding end-users to our network, and $5,040 of VoIP
subscription revenue as a result of adding a VoIP offering to
our suite of products and services (refer to note 6 for a
discussion on our acquisition of GoBeam) and a $1,322 increase
in installation fees and equipment sales due to higher sales
volume. These increases were offset by a $2,896 reduction in
dial-up revenue as a result of a decreasing demand for this
service.
39
Our wholesale net revenues for 2003 decreased by $28,438, or
8.7%, when compared to 2002. This decrease was primarily
attributable to a $15,361 reduction in installation fees and
equipment sales principally driven by lower selling prices, a
$11,100 increase in customer rebates and incentives due to
higher sales to our wholesale customers, a $6,035 decrease of
revenue from hi-capacity circuits as a result of customer
network configuration changes and consolidation, and a $8,349
reduction in revenue recognized from financially distressed
partners. These decreases were partially offset by a $12,558
increase in broadband revenue as a result of adding end-users to
our network. Our direct net revenues for 2003 increased by
$33,793, or 59.5%, when compared to 2002. This increase was
primarily attributable to a $38,483 increase in broadband
revenue as a result of adding end-users to our network,
partially offset by a $4,841 reduction in dial-up revenue as a
result of a decreasing demand for this service.
We had over 390 wholesale customers as of December 31, 2004
compared to approximately 300 and 150 as of December 31,
2003 and 2002, respectively. The increases resulted primarily
from the addition of smaller resellers. For 2004, 2003 and 2002,
our 30 largest wholesale customers in each such year
collectively comprised 93.4%, 93.3% and 93.3% of our total
wholesale net revenues, respectively, and 67.4%, 71.6% and 79.5%
of our total net revenues, respectively. Amounts owed to us from
these customers collectively comprised 65.1% and 70.3% of our
gross accounts receivable balance as of December 31, 2004
and 2003, respectively.
Two of our wholesale customers, Earthlink, Inc. and AT&T
Corp., accounted for 16.9% and 13.8%, 21.5% and 12.5%, and for
20.0% and 10.4% of our total net revenues for 2004, 2003 and
2002, respectively. Amounts owed to us from these customers
totaled 17.9% and 20.9%, and 20.9% and 17.1% of our gross
accounts receivables as of December 31, 2004 and 2003,
respectively. On January 31, 2005, AT&T announced that
it had agreed to be acquired by SBC, one of the largest RBOCs.
This acquisition is subject to regulatory, antitrust and other
forms of review. Based upon the statements of the parties,
subject to the outcome of this review, the transaction is
expected to close in the first half of 2006. At this time, we
cannot reliably predict the effects of this transaction on our
revenues derived from AT&T, or the timing of any such
effects.
We had over 78,600 direct end-users as of December 31, 2004
compared to approximately 72,000 and 42,600 as of
December 31, 2003 and 2002, respectively. As of
December 31, 2004, we had 567 VoIP business customers with
approximately 20,500 stations utilizing our VoIP services.
|
|
|
Wholesaler Financial Difficulties |
We have identified certain of our customers who were essentially
current in their payments for our services prior to
December 31, 2004, or have subsequently paid all or
significant portions of the respective amounts that we recorded
as accounts receivable as of December 31, 2004, that we
believe may be at risk of becoming financially distressed.
Revenues from these customers accounted for approximately 7.7%,
11.6% and 34.6% of our total net revenues for 2004, 2003 and
2002, respectively. As of December 31, 2004, amounts owed
to us from these customers comprised 8.8% of our gross accounts
receivable balance. If these customers are unable to demonstrate
their ability to pay for our services in a timely manner in
periods ending subsequent to 2004, revenue from such customers
will only be recognized when cash is collected, as described
above.
Operating expenses include cost of sales, selling, general and
administrative expenses, provision for bad debts, depreciation
and amortization expenses, provision for restructuring expenses
and litigation-related expenses.
Our total operating expenses were as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
Amount
|
|
$ |
489,197 |
|
|
$ |
503,421 |
|
|
$ |
564,488 |
|
|
As a percent of net revenues
|
|
|
114.0 |
% |
|
|
129.5 |
% |
|
|
147.2 |
% |
40
|
|
|
Cost of sales (exclusive of depreciation and amortization) |
Cost of sales consists primarily of the costs of provisioning
and maintaining telecommunications circuits and central office
space, equipment sold to our customers, labor and related
expenses and other non-labor items to operate and maintain our
network and related system infrastructure.
Our cost of sales was as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
Amount
|
|
$ |
266,172 |
|
|
$ |
288,122 |
|
|
$ |
298,336 |
|
|
As a percent of net revenues
|
|
|
62.0 |
% |
|
|
74.1 |
% |
|
|
77.8 |
% |
Our cost of sales for 2004 decreased by $21,950, or 7.6%, when
compared to 2003. This decrease was attributable to (i) a
decrease in network costs of $3,422 primarily as a result of a
$6,570 decrease in installation expenses and continued network
cost management efforts and $5,000 related to the effects of
amounts back billed by one of telecommunications vendors during
2003 and the partial resolution of such amount in 2004, offset
by a $8,148 increase in network costs primarily due to the
addition of broadband and VoIP subscribers to our network,
(ii) a decrease in the cost of equipment sold of $6,125
primarily as a result of $2,991 of migration expenses associated
with the Qwest customer list acquisition that occurred during
2003, and $3,134 as a result of lower installations and improved
inventory management, (iii) a decrease in other costs of
$6,560 primarily as a result of a decrease in the amortization
of network and product costs subject to deferral, and
(iv) an increase in labor and other operating expenses of
$1,739 primarily as a result of $6,251 from transaction-based
tax settlements that occurred during 2003, and a $5,885 increase
in contract labor and other services, offset by a $8,594
decrease in salaries and incentives and stock-based compensation
expenses, of which $3,756 relates to our 2003 ESPP, which is
subject to variable accounting, and $2,135 from charges recorded
during 2003 for the probable applicability of employment-related
taxes related to certain stock-based compensation provided to
employee in prior periods. In addition, during 2004, we ceased
the accrual of a transaction-based tax because we determined we
should not be subject to this tax. This change in accounting
estimate decreased our cost of sales and our net loss by
approximately $3,636, or $0.01 per share, for 2004. Lastly,
during 2004, we changed our estimates of certain property,
transaction-based and employment-related tax liabilities due to
the expiration of the prescribed statutory period for the
corresponding tax returns and due to lower property tax
valuations and actual tax assessments on our network assets.
These changes in accounting estimates decreased our cost of
sales and our net loss by approximately $3,946, or
$0.02 per share, for 2004.
Our cost of sales for 2003 decreased by $10,214, or 3.4%, when
compared to 2002. This decrease was primarily attributable to
improved management of our network costs, offset by costs
associated with the addition of subscribers to our network. In
addition, during 2003, we changed our estimates of certain
liabilities for transaction-based taxes and property taxes based
on settlements reached with various states and local
jurisdictions on our transaction-based taxes and additional
compilation of data on the valuation of our taxable property and
equipment. These changes in accounting estimate decreased our
cost of sales and our net loss by $8,439, or $0.04 a share, in
2003. Also during 2003, we changed our estimates of certain
liabilities for collocation and network services as a result of
the resolution of various billing disputes with our vendors and
on our receipt of an invoice in December 2003 from a vendor for
certain services provided by such vendor primarily in 2001 and
2000. These changes in accounting estimate increased our cost of
sales and our net loss by $3,414, or $0.02 per share,
during the 2003. Cost of sales for 2003 include $6,018 of
migration expenses from the Qwest customer list acquisition,
$2,135 for the probable applicability of employment-related
taxes related to certain stock-based compensation provided to
employees in prior periods, and $4,721 from the amortization of
deferred variable stock-based compensation expenses related to
our 2003 Employee Stock Purchase Plan, or ESPP. Cost of sales
for 2002 include a credit of $5,550 from the settlement of
certain disputed network service obligations during the year and
customer acquisition costs of $3,674 associated with the
acquisition of InternetConnect assets.
41
We expect cost of sales to increase in future periods as we add
subscribers and services to our network but to decrease as a
percentage of our net revenues as we leverage some of our fixed
costs. To offset some of the increased costs, we plan to
continue to execute cost-saving programs and improve the
delivery of our services. As discussed in “Part I,
Item 1 — Business — Government
Regulation”, there is uncertainty concerning our ability to
continue to purchase certain network elements at regulated
prices from the ILECs as a result of the FCC’s Triennial
Review decision. As a result of those legal and regulatory
proceedings, it is possible that the ILECs could substantially
increase the cost or reduce the availability of these network
elements, which would substantially increase our overall network
cost structure and might cause us to discontinue our consumer
grade services.
Our cost of sales was allocated as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
Wholesale Segment
|
|
$ |
175,687 |
|
|
$ |
209,334 |
|
|
$ |
206,586 |
|
|
Direct Segment
|
|
|
54,016 |
|
|
|
46,124 |
|
|
|
31,301 |
|
|
Corporate Operations
|
|
|
36,469 |
|
|
|
32,664 |
|
|
|
60,449 |
|
| |
|
|
|
|
|
|
|
|
|
| |
Total
|
|
$ |
266,172 |
|
|
$ |
288,122 |
|
|
$ |
298,336 |
|
| |
|
|
|
|
|
|
|
|
|
Our cost of sales for the Wholesale segment for 2004 decreased
by $33,647, or 16.1%, when compared to 2003. This decrease was
attributable to (i) a decrease in network costs of $6,473,
as a result of a decrease in installations and continued network
cost management, (ii) a decrease in the cost of equipment
sold of $3,134 due to lower installations and improved inventory
management, (iii) a $8,787 decrease in amortization of
network and product cost subject to deferral, (iv) a $9,299
decrease in salaries and incentives, and (v) a $2,318
decrease in stock-based compensation expenses related to our
2003 ESPP. In addition, during 2004, we changed our estimates of
certain liabilities for some elements of our network costs that
are not yet billed by our suppliers and ceased the accrual of a
transaction-based tax, as described above, which decreased our
cost of sales by $3,636. Our cost of sales for the Direct
segment for 2004 increased by $7,892, or 17.1%, when compared to
2003. This increase was attributable to (i) a $2,529
increase in network costs due to addition of broadband and VoIP
subscribers to our network, (ii) a $2,306 increase in
amortization of network and product costs subject to deferral;
(iii) a $6,048 increase in contract labor and other
services principally due to VoIP, partially offset by (i) a
$2,991 decrease in the cost of equipment due to the migration
expenses associated with the Qwest customer list acquisition
that occurred during 2003. Our cost of sales for Corporate
Operations for 2004 increased by $3,805, or 11.6%, when compared
to 2003. This increase was primarily attributable to (i) a
$6,251 increase in transaction-based taxes due to various tax
settlements that occurred during 2003, (ii) a $4,600
increase in contract labor and other service expenses, and
(iii) a $437 increase in network costs due to the addition
of central office locations, offset by a (i) $1,438
decrease in stock-based compensation expenses related to our
2003 ESPP, and (ii) $2,135 from charges recorded during
2003 for the probable applicability of employment-related taxes
related to certain stock-based compensation provided to
employees in prior periods. In addition, we reduced our
estimates on property tax liabilities in 2004 by $3,946 as
described above.
Our cost of sales for the Wholesale segment for 2003 increased
by $2,748, or 1.3%, when compared to 2002. This increase was
attributable to (i) a $5,550 credit from the settlement of
certain disputed network service obligations during 2002,
(ii) a $2,914 increase in stock-based compensation expenses
related to our 2003 ESPP, offset by a decrease of approximately
$8,277 in network costs due to improved management of our
network capacity. Also during 2003, we changed our estimates of
certain liabilities for collocation and network services as a
result of the resolution of various billing disputes with our
vendors and on our receipt of an invoice in December 2003 from a
vendor for certain services provided by such vendor primarily in
2001 and 2000. These changes in accounting estimate increased
our cost of sales and our net loss by $2,561 during the 2003.
Our cost of sales for the Direct segment for 2003 increased by
$14,823, or 47.4%, when compared to 2002. This increase was
attributable to (i) a $11,626 increase in network costs due
to addition of broadband subscribers to our network,
(ii) $6,018 increase in the cost of equipment sold
primarily due to the migration expenses associated with the
Qwest customer list acquisition, offset by customer acquisition
costs of $3,674
42
associated with the acquisition of InternetConnect assets during
2002. In addition, during 2003, we changed our estimates of
certain liabilities for collocation and network services as a
result of the resolution of various billing disputes with our
vendors as described above. This change in accounting estimate
increased our cost of sales by $853. Our cost of sales for
Corporate Operations for 2003 decreased by $27,785, or 46.0%,
when compared to 2002. This decrease was primarily attributable
to improved management of our network capacity and a decrease in
other expenses, offset by $1,807 increase in stock-based
compensation expenses related to our 2003 ESPP and $2,135 for
the probable applicability of employment-related taxes related
to certain stock-based compensation provided to employees in
prior periods.
Selling, General and
Administrative Expenses
Selling, general and administrative expenses consist primarily
of salaries and related expenses, other non-labor items, and our
promotional and advertising expenses.
Our selling, general and administrative expenses were as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
Amount
|
|
$ |
146,241 |
|
|
$ |
140,081 |
|
|
$ |
150,373 |
|
|
As a percent of net revenues
|
|
|
34.1 |
% |
|
|
36.0 |
% |
|
|
39.2 |
% |
Our selling, general and administrative expenses for 2004
increased by $6,160, or 4.4%, when compared to 2003. This
increase was primarily attributable to (i) a $17,305
increase in advertising expenses, which include marketing
programs to promote our VoIP products, (ii) a $4,726
increase in professional services, primarily related to our
implementation of the provisions of the Sarbanes-Oxley Act,
offset by (i) a $9,442 reduction in incentive and
stock-based compensation expenses, of which $6,089 relates to
our 2003 ESPP, which is subject to variable accounting, and
(ii) $3,800 from charges recorded during 2003 for the
probable applicability of employment-related taxes related to
certain stock-based compensation provided to employees in prior
periods. In addition, during 2004, we changed our estimates of
certain property, transaction-based and employment-related tax
liabilities due to the expiration of the prescribed statutory
period for the corresponding tax returns and due to lower
property tax valuations and actual tax assessments on our
network assets. These changes in accounting estimates decreased
our selling, general and administrative expenses and our net
loss by approximately $2,515, or $0.01 per share, during
2004.
Our selling, general and administrative expenses for 2003
decreased by $10,292, or 6.8%, when compared to 2002. This
decrease was attributable to a $19,433 decrease in advertising
expenses and a $3,541 decrease in compensation and other
expenses, offset by charges of $1,236 for additional stock-based
compensation and $3,796 for the potential applicability of
employment-related taxes related to certain stock-based
compensation provided to employees in prior periods and $7,650
from the amortization of deferred variable stock-based
compensation expenses related to our 2003 ESPP.
We expect to increase our selling, general and administrative
expenses primarily as a result of sales compensation and
increased marketing efforts associated with efforts to promote
growth in sales of our VoIP services.
Our selling, general and administrative expenses were allocated
as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
Wholesale Segment
|
|
$ |
10,476 |
|
|
$ |
13,069 |
|
|
$ |
14,244 |
|
|
Direct Segment
|
|
|
39,984 |
|
|
|
20,346 |
|
|
|
44,513 |
|
|
Corporate Operations
|
|
|
95,781 |
|
|
|
106,666 |
|
|
|
91,616 |
|
| |
|
|
|
|
|
|
|
|
|
| |
Total
|
|
$ |
146,241 |
|
|
$ |
140,081 |
|
|
$ |
150,373 |
|
| |
|
|
|
|
|
|
|
|
|
Our selling, general and administrative expenses for the
Wholesale segment for 2004 decreased by $2,593, or 19.8%, when
compared to 2003. This decrease was primarily attributable to a
$2,382 decrease in
43
salaries, incentive and stock-based compensation expenses, of
which $1,922 relates to our 2003 ESPP, which is subject to
variable accounting. Our selling, general and administrative
expenses for the Direct segment for 2004 increased by $19,638,
or 96.5%, when compared to 2003. This increase was attributable
to $17,540 increase in sales and advertising expenses, which
include marketing programs to promote our VoIP products and a
$2,684 increase in salaries, primarily as a result of our VoIP
sales force, offset by a decrease in stock-based compensation of
$586 related to our 2003 ESPP, which is subject to variable
accounting. Our selling, general and administrative expenses for
Corporate Operations for 2004 decreased by $10,885, or 10.2%,
when compared to 2003. This decrease was primarily attributable
to a $8,962 decrease in salaries, incentive and stock-based
compensation expenses, of which $3,581 relates to our 2003 ESPP,
which is subject to variable accounting and a $3,800 reduction
from charges recorded in 2003 for the probable applicability of
employment-related taxes related to certain stock-based
compensation provided to employees in prior periods, offset by
$4,726 increase in professional and other services, primarily
related to our implementation of the provisions of the
Sarbanes-Oxley Act. In addition, we reduced our estimates by
$2,515 for certain property, transaction-based and
employment-related tax liabilities due to the expiration of the
prescribed statutory period for the corresponding tax returns
and due to lower property tax valuations and actual tax
assessments on our fixed assets as described above.
Our selling, general and administrative expenses for the
Wholesale segment for 2003 decreased by $1,175, or 8.2%, when
compared to 2002. This decrease was attributable to a $2,669
decrease in compensation and other expenses, and a $921 decrease
in advertising expenses, offset by an increase of $2,415 in the
amortization of deferred variable stock-based compensation
expenses related to our 2003 ESPP. Our selling, general and
administrative expenses for the Direct segment for 2003
decreased by $24,167, or 54.3%, when compared to 2002. This
decrease was attributable to a $20,917 decrease in advertising
expenses, a $3,986 decrease in compensation and other expenses,
offset by an increase of $736 in the amortization of deferred
variable stock-based compensation expenses related to our 2003
ESPP. Our selling, general and administrative expenses for
Corporate Operations for 2003 increased by $15,050, or 16.4%,
when compared to 2002. This increase was attributable to a
$3,113 increase in compensation and other expenses, $4,500 of
stock-based compensation expenses related to our 2003 ESPP, a
$2,405 increase in advertising expenses, a charge of $1,236 for
additional stock-based compensation and $3,796 for the potential
applicability of employment-related taxes related to certain
stock-based compensation provided to employees in prior periods.
|
|
|
Provision for Bad Debts (Bad Debt Recoveries) |
Our provision for bad debts (bad debt recoveries) was $(2,035),
$99 and $319 for 2004, 2003 and 2002, respectively. Our bad
debts for 2004 decreased by $2,134 when compared to 2003. This
decrease was primarily attributable to the recovery in 2004 of
amounts due to us from one of our wholesale customers that were
previously written off. Our bad debt in 2003 was generally in
line with 2002.
|
|
|
Depreciation and Amortization |
Our depreciation and amortization of property and equipment, or
depreciation, was $56,825, $56,559 and $112,438 for 2004, 2003
and 2002, respectively. Our depreciation for 2004 increased by
$266 when compared to 2003 primarily as a result of the
expansion of our network during 2004, offset by certain
historical assets becoming fully depreciated. Our depreciation
for 2003 decreased by $55,879 when compared to 2002 primarily as
a result of asset retirements and certain assets becoming fully
depreciated during 2003 and 2002. We expect depreciation and
amortization to increase in future periods as we add more
broadband and VoIP end-users to our network. This increase in
depreciation will be partially offset as historical assets
continue to become fully depreciated.
Our amortization of intangible assets, or amortization, was
$20,585, $17,325 and $14,650 for 2004, 2003 and 2002,
respectively. Our amortization for 2004 and 2003 increased
primarily as a result of the resumption of our network build and
augmentation in selected markets during such years, which
increased collocation fee expenditures and related amortization
expenses. In addition, amortization in 2004 increased as a
result of the acquisition of certain customer lists during 2004
and 2003. We expect amortization of intangible assets to
continue to increase as we augment our network.
44
As explained above, we do not allocate depreciation and
amortization expense to our business segments.
|
|
|
Provision for Restructuring Expenses |
Our provision for restructuring expenses was $1,409 for 2004, of
which $426 was paid after December 31, 2004, and $1,235 for
2003. In 2004, we reduced our workforce by approximately 77
employees, or 6.9% of our workforce. The reductions covered
employees in the areas of sales and marketing, operations and
corporate functions. In connection with the 2004 reductions, we
recorded restructuring expenses, consisting primarily of
employee severance benefits, of $374, $281, and $754 in our
Wholesale segment, our Direct segment and our corporate
operations, respectively. Similarly, in 2003, we reduced our
workforce by approximately 113 employees, or 10.2% of our
workforce. The reductions covered employees in the areas of
sales and marketing, operations and corporate functions. In
connection with the 2003 reductions, we recorded restructuring
expenses, consisting primarily of employee severance benefits,
of $103, $349, and $783 in our Wholesale segment, our Direct
segment and our Corporate Operations, respectively. We did not
record restructuring expenses during 2002. We continue to
evaluate whether additional restructuring is necessary, and we
may incur additional charges to operations related to any
further restructuring activities in future periods.
|
|
|
Litigation-related Expenses |
We recorded a non-cash credit to litigation-related expenses of
$11,628 for 2002 as a result of a settlement in one of our legal
proceedings. We did not recognize similar charges or credits for
2004 and 2003.
Our net interest expense was $2,259, $3,421 and $459 for 2004,
2003 and 2002, respectively. Net interest expense during 2004
consisted primarily of interest expense on our
3% convertible senior debentures due 2024 and our 11%
long-term note payable to SBC, which we repaid in March of 2004,
less interest income earned on our cash, cash equivalents and
short-term investments balances. Net interest expense during
2003 and 2002 consisted primarily of interest expense on our 11%
long-term note payable to SBC, less interest income earned on
our cash, cash equivalents and short-term investments balances.
We expect future net interest to be limited to the interest on
our 3% convertible senior debentures due 2024 offset by
interest income on our cash balances.
Our losses and write-downs on investments for 2003 and 2002 were
$1,026 and $1,847, respectively. For 2003, our losses and
write-downs on investments included impairment write-downs of
equity investments of $747 and our equity in the losses of
unconsolidated affiliates of $279. For 2002, our losses and
write-downs on investments included a net realized loss on
short-term investments of $17, an impairment write-down of an
equity investment of $388, our equity in the losses of
unconsolidated affiliates of $806 and a net realized loss on the
sale of certain investments in unconsolidated affiliates of
$636. We did not record similar losses or write-downs on
investments in 2004.
|
|
|
Miscellaneous Income (Expense), net |
Our miscellaneous income (expense) was $1,498, $6,715 and
$(1,530) for 2004, 2003 and 2002, respectively. The decrease in
2004 when compared to 2003 resulted principally from $5,000 of
royalty payments received from a license agreement on our OSS
software in 2003. Our miscellaneous income for 2004 included a
$1,600 payment received as a result of a legal settlement. Our
miscellaneous expense for 2002 was primarily comprised of losses
on the disposition of fixed assets.
45
We made no provision for income taxes in any period presented in
the accompanying consolidated financial statements because we
incurred operating losses in each of these periods. As of
December 31, 2004, we had net operating loss carryforwards
for federal tax purposes of approximately $870,540, which will
begin to expire in 2021, if not utilized. We also had aggregate
net operating loss carryforwards for state income tax purposes
of approximately $1,301,146, of which $171,016 will expire in
2005, $34,484 in 2006, and $1,095,646 through 2024, if not
utilized. In addition, we had capital loss carryforwards for
federal and state income tax purposes of approximately $27,025
which will begin to expire in 2006. On June 8, 2004, we
completed our acquisition of all of the outstanding shares of
privately-held GoBeam (Note 6). The acquisition was
effectuated by merging one of our wholly-owned subsidiaries with
and into GoBeam, with GoBeam surviving the merger as a
wholly-owned subsidiary. The merger is intended to qualify as a
tax-free reorganization. As a result of the acquisition, our net
operating loss carryforwards includes GoBeam’s existing, as
of acquisition date, federal and state net operating loss of
$39,587 and $27,600 respectively. Tax benefits related to
pre-acquisition losses of acquired entity will be utilized first
to reduce any associated intangibles and goodwill.
The utilization of our net operating loss may be subject to
substantial annual limitation due to the “change in
ownership” provisions of the Internal Revenue Code of 1986,
as amended, and similar state provisions. The annual limitation
may result in the expiration of net operating losses and tax
credits before utilization.
Realization of our deferred tax assets relating to net operating
loss carryforwards and other temporary differences is dependent
upon future earnings, the timing and amount of which are
uncertain. Accordingly, our net deferred tax assets have been
fully offset by a valuation allowance. The valuation allowance
increased by $34,259, $39,071 and $129,529 in 2004, 2003 and
2002, respectively.
Selected Quarterly Financial Information (Unaudited)
Covad’s 2004 and 2003 unaudited condensed consolidated
selected quarterly financial information is as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Three Months Eended | |
| |
|
| |
| |
|
March 31 | |
|
June 30 | |
|
September 30 | |
|
December 31 | |
| |
|
| |
|
| |
|
| |
|
| |
|
2004:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues, net
|
|
$ |
108,477 |
|
|
$ |
107,326 |
|
|
$ |
105,687 |
|
|
$ |
107,707 |
|
|
Gross profit (exclusive of depreciation and amortization)
|
|
$ |
40,183 |
|
|
$ |
44,578 |
|
|
$ |
39,748 |
|
|
$ |
38,516 |
|
|
Depreciation and amortization
|
|
$ |
19,246 |
|
|
$ |
19,204 |
|
|
$ |
19,406 |
|
|
$ |
19,554 |
|
|
Net loss
|
|
$ |
(13,531 |
) |
|
$ |
(7,406 |
) |
|
$ |
(13,804 |
) |
|
$ |
(26,020 |
) |
|
Basic and diluted net loss per share
|
|
$ |
(0.06 |
) |
|
$ |
(0.03 |
) |
|
$ |
(0.05 |
) |
|
$ |
(0.10 |
) |
|
2003:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues, net
|
|
$ |
90,860 |
|
|
$ |
92,445 |
|
|
$ |
100,507 |
|
|
$ |
105,039 |
|
|
Gross profit (exclusive of depreciation and amortization)
|
|
$ |
21,983 |
|
|
$ |
23,813 |
|
|
$ |
23,292 |
|
|
$ |
31,641 |
|
|
Depreciation and amortization
|
|
$ |
18,589 |
|
|
$ |
17,776 |
|
|
$ |
17,829 |
|
|
$ |
19,690 |
|
|
Net loss
|
|
$ |
(34,722 |
) |
|
$ |
(27,287 |
) |
|
$ |
(33,431 |
) |
|
$ |
(16,862 |
) |
|
Basic and diluted net loss per share
|
|
$ |
(0.16 |
) |
|
$ |
(0.12 |
) |
|
$ |
(0.15 |
) |
|
$ |
(0.07 |
) |
During the three months ended December 31, 2004 we recorded
approximately $2,900 of incremental expense related to our 2003
ESPP, which is subject to variable accounting, as a result of
the fluctuation of our common stock price. In addition, during
the three months ended December 31, 2004 we recorded
approximately $2,700 of incremental professional services
expense as a result of our year end audit and Sarbanes-Oxley
compliance procedures. These amounts were partially offset by
approximately $4,000 of recoveries and settlements related to
our network costs.
46
As explained above, during the year ended December 31,
2003, a matter was identified related to prior financial
reporting periods that necessitated the recording of additional
expense. Such matter was related to the modification of stock
options granted to certain employees in prior years. These
modifications occurred upon the separation of such employees
from our Company, principally during 2000. Accordingly, for the
year ended December 31, 2003, we recorded additional
stock-based compensation expense in the amount of $1,236, or
$0.01 per share. Such amount is reflected in our selling,
general and administrative expenses for the year ended
December 31, 2003. We do not believe this amount is
material to the periods in which it should have been recorded,
nor do we believe it is material to our consolidated operating
results for the year ended December 31, 2003. This
adjustment is principally related to 2000, the impact of which
would have been to increase selling, general and administrative
expenses and net loss by $1,236, or $0.01 per share for
such year.
The impact on prior financial reporting periods in 2003 would
have been as follows if the amounts described above had been
recorded in the proper financial reporting periods:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Three Months Ended | |
|
|
| |
|
| |
|
Year Ended | |
| |
|
March 31, | |
|
June 30, | |
|
September 30, | |
|
December 31, | |
|
December 31, | |
| |
|
2003 | |
|
2003 | |
|
2003 | |
|
2003 | |
|
2003 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
Net loss, as reported
|
|
$ |
(34,722 |
) |
|
$ |
(27,287 |
) |
|
$ |
(33,431 |
) |
|
$ |
(16,862 |
) |
|
$ |
(112,302 |
) |
|
Effect of prospectively correcting certain differences relating
to prior periods, which is included in net loss, as reported
|
|
|
— |
|
|
|
1,236 |
|
|
|
— |
|
|
|
— |
|
|
|
1,236 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss, net of effect of prospectively correcting certain
differences relating to prior periods
|
|
$ |
(34,722 |
) |
|
$ |
(26,051 |
) |
|
$ |
(33,431 |
) |
|
$ |
(16,862 |
) |
|
$ |
(111,066 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss, as reported
|
|
$ |
(0.16 |
) |
|
$ |
(0.12 |
) |
|
$ |
(0.15 |
) |
|
$ |
(0.07 |
) |
|
$ |
(0.50 |
) |
|
Effect of prospectively correcting certain differences relating
to prior periods, which is included in net loss, as reported
|
|
|
— |
|
|
|
0.01 |
|
|
|
— |
|
|
|
— |
|
|
|
0.01 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss, net of effect of prospectively correcting certain
differences relating to prior periods
|
|
$ |
(0.16 |
) |
|
$ |
(0.11 |
) |
|
$ |
(0.15 |
) |
|
$ |
(0.07 |
) |
|
$ |
(0.49 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Related Party Transactions
A member of our Board of Directors, Richard Jalkut, is the
President and CEO of TelePacific Communications
(“TelePacific”), one of our resellers. We recognized
revenues from TelePacific of $369, $611 and $1,311 for 2004,
2003 and 2002, respectively. Accounts receivables from
TelePacific were $29 and $103 as of December 31, 2004 and
2003, respectively. L. Dale Crandall, one of our directors, is
also a director of BEA Systems (“BEA”), one of our
vendors. We paid $890, $2,232 and $121 to BEA in 2004, 2003 and
2002, respectively. Charles Hoffman, our CEO, is a director of
Chordiant Software (“Chordiant”), one of our vendors.
We paid $3,387 to Chordiant in 2004. No amounts were paid to
this vendor in 2003 and 2002.
We believe these transactions were negotiated on an arms-length
basis which terms we believe are comparable to transactions that
would likely be negotiated with unrelated parties.
Liquidity, Capital Resources and Contractual Cash
Obligations
Over the last five years we have invested substantial capital
for the procurement, design and construction of our central
office collocation facilities, the design, creation,
implementation and maintenance of our internally used software,
the purchase of telecommunications equipment and the design,
development and maintenance of our networks. We expect that in
future periods our expenditures related to the purchase of
infrastructure equipment necessary for the development and
expansion of our networks and the development
47
of new regions will be relatively lower than in recent periods
while incremental, or “success-based”, expenditures
related to the addition of subscribers in existing regions will
increase proportionately in relation to the number of new
subscribers that we add to our network.
Our cash and cash equivalents balance for 2004 increased by
$52,130. The change in cash and cash equivalents was a follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
Net cash provided by (used in):
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Operating activities
|
|
$ |
3,676 |
|
|
$ |
(45,553 |
) |
|
$ |
(76,042 |
) |
| |
Investing activities
|
|
|
(29,780 |
) |
|
|
8,508 |
|
|
|
(40,113 |
) |
| |
Financing activities
|
|
|
78,234 |
|
|
|
8,005 |
|
|
|
2,761 |
|
| |
|
|
|
|
|
|
|
|
|
| |
Total
|
|
$ |
52,130 |
|
|
$ |
(29,040 |
) |
|
$ |
(113,394 |
) |
| |
|
|
|
|
|
|
|
|
|
Net cash used in our operating activities for 2004 improved by
$49,229 when compared to 2003. This improvement was attributable
to a decrease in our net loss, adjusted for non-cash and
non-operating items, of $48,144, and the net change in our
operating assets and liabilities of $1,085, primarily as a
result of the change in our unbilled revenues, driven by lower
installations. Net cash used in our operating activities for
2003 improved by $30,489 when compared to 2002. This improvement
was attributable to a decrease in our net loss, adjusted for
non-cash and non-operating items, of $39,684, offset by the net
change in our operating assets and liabilities of $9,195. The
net change in our operating assets and liabilities was primarily
attributable to $6,943 from the change in our restricted cash
and cash equivalents related to our bankruptcy proceedings,
$3,920 from the change in our accounts receivable and payables
and other operating assets and liabilities partly driven by the
timing of our cash receipts and cash disbursements, $2,249 from
the change in our unbilled revenues as a result of higher
installations, partially offset by $5,338 from the change in
unearned revenues as a result of the resolution of certain
pre-petition cash receipts related to the bankruptcy proceedings
of some of our wholesale customers. We expect our cash usage in
our operating activities to increase in 2005, primarily as a
result of our product, sales and marketing activities to promote
our broadband and VoIP services.
Our investing activities consist primarily of purchases of
short-term investments, capital expenditures for property and
equipment and expenditures to acquire collocation facilities.
Net cash used in our investing activities for 2004 increased by
$38,288 when compared to 2003. This increase was primarily
attributable to the net cash effect of purchase and maturity
activities on our short-term investments of $43,828, a decrease
in cost recoveries from internal-use software of $7,345, offset
by a decrease in capital expenditures for property and equipment
and collocation fees of $12,388. Net cash used in our investing
activities for 2003 improved by $48,621 when compared to 2002.
This improvement was primarily attributable to the net cash
effect of purchase, sale and maturity activities on our
short-term investments of $91,536, and an increase in cost
recoveries from internal-use software of $6,531, offset by an
increase in capital expenditures for property and equipment and
collocation fees of $32,467, and a decrease in proceeds from the
sale of assets of $16,630. We expect that in 2005 our
expenditures related to the purchase of infrastructure equipment
necessary for the development and expansion of our networks and
the development of new regions will be relatively lower than in
recent periods while incremental, or “success-based”,
expenditures related to the addition of subscribers in existing
regions will increase proportionately in relation to the number
of new subscribers that we add to our network.
Our financing activities consist primarily of proceeds and
repayments of long-term debt and proceeds from the issuance of
our common stock under our employee stock-based compensation
plans. Net cash
48
provided by our financing activities for 2004 increased by
$70,229 when compared to 2003. This increase was primarily
attributable to the net proceeds on the issuance of our senior
unsecured convertible bonds of $119,961, offset by the principal
repayment of our note to SBC of $50,000. Net cash provided by
our financing activities for 2003 increased by $5,244 when
compared to 2002. This increase was primarily attributable to
the proceeds on the issuance of our common stock under our
employee stock-based compensation plans. We expect that in 2005
our cash from financing activities will be primarily related to
the proceeds of issuance of common stock under our employee
stock-based compensation plans.
Our total cash balance in 2004 increased by $36,292 from 2003.
As of December 31, 2004, we had a total cash balance of
$153,529. This balance was comprised of $117,506 in unrestricted
cash and cash equivalents, $33,490 in unrestricted short-term
investments, and $2,533 in restricted cash and cash equivalents.
We expect to use additional cash resources primarily to increase
sales and marketing activities as we expand the offering of VoIP
services to new markets across our broadband network. The amount
of this additional usage of cash to expand the offering of our
VoIP services will depend on our ability to control incremental
selling, general and administrative expenses, the amount of
capital expenditures that is required to grow the subscriber
base, development of operating support systems and software, and
our ability to generate demand for our VoIP services. In
addition, we may wish to selectively pursue possible
acquisitions of, or investments in businesses, technologies or
products complementary to ours in order to expand our geographic
presence, broaden our product and service offerings and achieve
operating efficiencies. We may not have sufficient liquidity, or
we may be unable to obtain additional financing on favorable
terms or at all, in order to finance such an acquisition or
investment.
Based on our 2005 business plan, we believe we will be able to
continue as a going concern through December 31, 2005 using
only our unrestricted cash, cash equivalents and short term
investment balances in existence as of December 31, 2004.
Our 2005 business plan includes certain discretionary spending
that is based on several assumptions, including growth of our
subscriber base with a reasonable per subscriber profit margin
and improvements in productivity. If necessary, we will curtail
this discretionary spending so that we can continue as a going
concern through December 31, 2005 using only our
unrestricted cash, cash equivalent and short term investment
balances in existence as of December 31, 2004. Adverse
business, legal, regulatory or legislative developments, such as
the inability to continue accessing certain network elements
from the RBOCs, may require us to raise additional financing,
raise our prices or substantially decrease our cost structure.
We also recognize that we may not be able to raise additional
capital. If we are unable to acquire additional capital on
favorable terms if needed, or are required to raise it on terms
that are less satisfactory than we desire, our financial
condition will be adversely affected.
Our cash requirements for 2005 and beyond for developing,
deploying and enhancing our network and operating our business
will depend on a number of factors including:
|
|
|
| |
• |
further development of our VoIP capabilities, systems and
software to expand our VoIP services; |
| |
| |
• |
our continuing ability to reach agreements with the ILECs to
access line-shared telephone lines, remote terminals and other
facilities, all at reasonable prices; |
| |
| |
• |
rates at which resellers and end-users purchase and pay for our
services and the pricing of such services; |
| |
| |
• |
financial condition of our customers; |
| |
| |
• |
levels of marketing required to acquire and retain customers and
to attain a competitive position in the marketplace; |
| |
| |
• |
rates at which we invest in engineering, development and
intellectual property with respect to existing and future
technology; |
| |
| |
• |
operational costs that we incur to install, maintain and repair
end-user lines and our network as a whole; |
49
|
|
|
| |
• |
pending and any future litigation; |
| |
| |
• |
existing and future technology; |
| |
| |
• |
unanticipated opportunities; |
| |
| |
• |
network development schedules and associated costs; and |
| |
| |
• |
number of regions entered and the timing of entry and services
offered |
|
|
|
Contractual Cash Obligations |
Our contractual debt, lease and purchase obligations as of
December 31, 2004 for the next five years, and thereafter,
were as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
2005 | |
|
2006-2007 | |
|
2008-2009 | |
|
Thereafter |
|
Total | |
| |
|
| |
|
| |
|
| |
|
|
|
| |
|
Note payable to debentures
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
125,000 |
|
|
$ |
— |
|
|
$ |
125,000 |
|
|
Interest on note payable
|
|
|
3,750 |
|
|
|
7,500 |
|
|
|
4,531 |
|
|
|
— |
|
|
|
15,781 |
|
|
Capital leases
|
|
|
665 |
|
|
|
56 |
|
|
|
13 |
|
|
|
— |
|
|
|
734 |
|
|
Office leases
|
|
|
4,262 |
|
|
|
5,997 |
|
|
|
2,918 |
|
|
|
— |
|
|
|
13,177 |
|
|
Other operating leases
|
|
|
123 |
|
|
|
98 |
|
|
|
— |
|
|
|
— |
|
|
|
221 |
|
|
Purchase obligations
|
|
|
4,475 |
|
|
|
281 |
|
|
|
— |
|
|
|
— |
|
|
|
4,756 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
$ |
13,275 |
|
|
$ |
13,932 |
|
|
$ |
132,462 |
|
|
$ |
— |
|
|
$ |
159,669 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
We lease certain vehicles, equipment and office facilities under
various non-cancelable operating leases that expire at various
dates through 2009. Our office leases generally require us to
pay operating costs, including property taxes, insurance and
maintenance, and contain scheduled rent increases and certain
other rent escalation clauses. Rent expense is reflected in our
consolidated financial statements on a straight-line basis over
the terms of the respective leases.
In 2002, we entered into a three-year, non-exclusive agreement
with MCI, for the right to provide certain network services to
us. We have a monthly minimum usage requirement which began in
June 2002. The agreement expires in May 2005 and has a remaining
purchase obligation of $3,350 as of December 31, 2004.
Similarly, in 2002 we entered into a three-year, non-exclusive
agreement with AT&T Corp. for the right to provide certain
data services to us. We have an annual minimum usage requirement
which began in January 2002. The agreement expired in December
2004. In addition, in 2002, we entered into a four-year,
non-exclusive agreement with AT&T Corp. for the right to
provide long distance services to us. We have an annual minimum
usage requirement which began in April 2002. The agreement
expires in March 2006 and has a minimum remaining aggregate
usage commitment of approximately $1,406 as of December 31,
2004.
As part of our ongoing business, we do not participate in
transactions that generate relationships with unconsolidated
entities of financial partnerships, such as entities often
referred to as structured finance or special purpose entities,
or SPEs, which would have been established for the purpose of
facilitating off-balance sheet arrangements or other
contractually narrow or limited purpose. As of December 31,
2004, we were not involved in any SPE transactions.
Forward-Looking Statements
We include certain estimates, projections, and other
forward-looking statements in our reports, in presentations to
analysts and others, and in other publicly available material.
Future performance cannot be assured. Actual results may differ
materially from those in forward-looking statements. The
statements contained in this Report on Form 10-K that are
not historical facts are “forward-looking statements”
(as such term is defined in Section 27A of the Securities
Act and Section 21E of the Exchange Act), which can be
identified by the use of forward-looking terminology such as
“estimates,” “projects,”
“anticipates,” “expects,”
“intends,” “believes,” or the negative
thereof or other variations thereon or comparable terminology,
or by discussions of strategy that involve risks and
uncertainties.
50
Examples of such forward-looking statements include but are not
limited to expectations regarding:
|
|
|
| |
• |
impact of the FCC’s recent decisions and related
litigation, and our ability to obtain ILEC network elements and
facilities at reasonable rates; |
| |
| |
• |
continuing deployment of local voice services by providers other
than the ILECs and our ability to bundle our data services with
the voice services of these alternative providers; |
| |
| |
• |
timing of our cash flows; |
| |
| |
• |
extent to which customers purchase our services; |
| |
| |
• |
relationships with our strategic partners and other potential
third parties; |
| |
| |
• |
pricing for our services in the future; |
| |
| |
• |
margins on our service offerings; |
| |
| |
• |
possibilities that we will increase our revenues; |
| |
| |
• |
plans to make strategic investments and acquisitions and the
effect of such investments and acquisitions; |
| |
| |
• |
estimates and expectations of future operating results, the
adequacy of our cash reserves, and the number of anticipated
installed lines; |
| |
| |
• |
plans to increase sales of value-added services, like Voice over
Internet Protocol; |
| |
| |
• |
anticipated capital expenditures; |
| |
| |
• |
plans to enter into business arrangements with broadband-related
service providers; |
| |
| |
• |
regulatory changes; |
| |
| |
• |
feasibility of alternative access solutions, like wireless; |
| |
| |
• |
effects of litigation currently pending; and |
| |
| |
• |
other statements contained in this Report on Form 10-K
regarding matters that are not historical facts |
These statements are only estimates or predictions. We can give
you no assurance that future results will be achieved. Actual
events or results may differ materially as a result of risks
facing us or actual results differing from the assumptions
underlying such statements. Such risks and assumptions that
could cause actual results to vary materially from the future
results indicated, expressed or implied in such forward-looking
statements include our ability to:
|
|
|
| |
• |
adapt our business plan in response to further developments
resulting from the FCC’s recent decisions and related
litigation; |
| |
| |
• |
collect receivables from customers; |
| |
| |
• |
retain and recruit employees; |
| |
| |
• |
successfully market our services to customers and generate
customer demand for our services; |
| |
| |
• |
successfully defend our company against litigation; |
| |
| |
• |
successfully manage our operating costs and overhead while
continuing to provide good customer service; |
| |
| |
• |
successfully continue to increase the number of business-grade
lines and VoIP stations; |
| |
| |
• |
achieve favorable pricing for our services; |
| |
| |
• |
respond to increasing competition; |
| |
| |
• |
manage growth of our operations, particularly the expansion of
our Direct business; |
51
|
|
|
| |
• |
maintain suitable interconnection agreements with the ILECs in
the areas where we provide service, all in a timely manner, at
reasonable costs and on satisfactory terms that provide us with
access to ILECs network elements and facilities that we use to
provide our services; and |
| |
| |
• |
retain end-users that are served by customers facing financial
difficulties |
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 |
(All dollar amounts are presented in thousands)
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 the
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 majority of our investment portfolio.
In addition, all of our outstanding indebtedness as of
December 31, 2004 is fixed-rate debt.
The table below presents the carrying value and related
weighted-average interest rates for our cash and cash
equivalents, short-term investments and restricted cash and cash
equivalents as of December 31, 2004:
| |
|
|
|
|
|
|
|
|
| |
|
Carrying Value | |
|
Interest Rate | |
| |
|
| |
|
| |
|
Cash and cash equivalents
|
|
$ |
117,506 |
|
|
|
2.13% |
|
|
Short-term investments
|
|
|
33,490 |
|
|
|
1.93% |
|
|
Restricted cash and cash equivalents
|
|
|
2,533 |
|
|
|
1.26% |
|
| |
|
|
|
|
|
|
| |
|
$ |
153,529 |
|
|
|
2.07% |
|
| |
|
|
|
|
|
|
52
|
|
| 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 Registered Public Accounting Firms are filed as part
of this report. |
| |
|
|
|
|
| |
|
Page | |
| |
|
| |
|
Report of Independent Registered Public Accounting Firm
|
|
|
54 |
|
|
Report of Ernst & Young LLP, Independent Registered
Public Accounting Firm
|
|
|
56 |
|
|
Consolidated Balance Sheets
|
|
|
57 |
|
|
Consolidated Statements of Operations
|
|
|
58 |
|
|
Consolidated Statements of Stockholders’ Equity (Deficit)
|
|
|
59 |
|
|
Consolidated Statements of Cash Flows
|
|
|
60 |
|
|
Notes to Consolidated Financial Statements
|
|
|
61 |
|
53
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of
Covad Communications Group, Inc.
We have completed an integrated audit of Covad Communications
Group, Inc.’s 2004 consolidated financial statements and of
its internal control over financial reporting as of
December 31, 2004 in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Our
opinions, based on our audit, are presented below.
Consolidated financial statements
In our opinion, the consolidated financial statements listed in
the accompanying index, present fairly, in all material
respects, the financial position of Covad Communications Group,
Inc. and its subsidiaries at December 31, 2004, and the
results of their operations and their cash flows for the year
ended December 31, 2004 in conformity with accounting
principles generally accepted in the United States of America.
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 audit. We
conducted our audit of these statements in accordance with the
standards of the Public Company Accounting Oversight Board
(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 of financial statements includes examining, on a test
basis, evidence supporting the amounts and disclosures in the
financial statements, assessing the accounting principles used
and significant estimates made by management, and evaluating the
overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.
Internal control over financial reporting
Also, in our opinion, management’s assessment, included in
“Management’s Report on Internal Control over
Financial Reporting”, appearing under Item 9A, that
the Company maintained effective internal control over financial
reporting as of December 31, 2004 based on criteria
established in Internal Control — Integrated
Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO), is fairly
stated, in all material respects, based on those criteria.
Furthermore, in our opinion, the Company maintained, in all
material respects, effective internal control over financial
reporting as of December 31, 2004, based on criteria
established in Internal Control — Integrated
Framework issued by the COSO. The Company’s management
is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness
of internal control over financial reporting. Our responsibility
is to express opinions on management’s assessment and on
the effectiveness of the Company’s internal control over
financial reporting based on our audit. We conducted our audit
of internal control over financial reporting in accordance with
the standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was
maintained in all material respects. An audit of internal
control over financial reporting includes obtaining an
understanding of internal control over financial reporting,
evaluating management’s assessment, testing and evaluating
the design and operating effectiveness of internal control, and
performing such other procedures as we consider necessary in the
circumstances. We believe that our audit provides a reasonable
basis for our opinions.
A company’s internal control over financial reporting is a
process designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with
generally accepted accounting principles. A company’s
internal control over financial reporting includes those
policies and procedures that (i) pertain to the maintenance
of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the
company; (ii) provide reasonable assurance that
transactions are recorded as necessary to permit preparation of
financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the
company are being made only in accordance with authorizations of
management and directors of the company; and (iii) provide
reasonable assurance regarding prevention or timely detection of
unauthorized
54
acquisition, use, or disposition of the company’s assets
that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over
financial reporting may not prevent or detect misstatements.
Also, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree
of compliance with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers
LLP
San Jose, California
March 14, 2005
55
Report of Ernst and Young LLP, Independent Registered Public
Accounting Firm
The Board of Directors and Stockholders
Covad Communications Group, Inc.
We have audited the accompanying consolidated balance sheet of
Covad Communications Group, Inc. as of December 31, 2003,
and the related consolidated statements of operations,
stockholders’ equity (deficit), and cash flows for each of
the two years in the period ended December 31, 2003. These
financial statements are the responsibility of the
Company’s management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by
management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above
present fairly, in all material respects, the consolidated
financial position of Covad Communications Group, Inc. at
December 31, 2003, and the consolidated results of its
operations and its cash flows for each of the two years in the
period ended December 31, 2003, in conformity with
U.S. generally accepted accounting principles.
Walnut Creek, California
February 12, 2004,
except for (i) the fourth and twelfth paragraphs
of Note 13 and (ii) Note 14, as to which
the dates are May 11, 2004 and May 27, 2004,
respectively
56
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
| |
|
|
|
|
|
|
|
|
|
| |
|
December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
| |
|
| |
|
| |
| |
|
(All dollar and share | |
| |
|
amounts are presented in | |
| |
|
thousands, except par value) | |
|
ASSETS |
|
Current assets:
|
|
|
|
|
|
|
|
|
|
Cash and cash equivalents
|
|
$ |
117,506 |
|
|
$ |
65,376 |
|
|
Short-term investments
|
|
|
33,490 |
|
|
|
48,969 |
|
|
Restricted cash and cash equivalents
|
|
|
2,533 |
|
|
|
2,892 |
|
|
Accounts receivable, net
|
|
|
30,041 |
|
|
|
28,528 |
|
|
Unbilled revenues
|
|
|
3,825 |
|
|
|
5,127 |
|
|
Other receivables
|
|
|
1,204 |
|
|
|
637 |
|
|
Inventories
|
|
|
4,629 |
|
|
|
5,335 |
|
|
Prepaid expenses and other current assets
|
|
|
2,553 |
|
|
|
3,761 |
|
| |
|
|
|
|
|
|
| |
Total current assets
|
|
|
195,781 |
|
|
|
160,625 |
|
|
Property and equipment, net
|
|
|
78,707 |
|
|
|
94,279 |
|
|
Collocation fees and other intangible assets, net
|
|
|
34,561 |
|
|
|
40,848 |
|
|
Goodwill
|
|
|
36,626 |
|
|
|
— |
|
|
Deferred costs of service activation
|
|
|
30,152 |
|
|
|
31,486 |
|
|
Deferred customer incentives, net
|
|
|
2,683 |
|
|
|
4,431 |
|
|
Deferred debt issuance cost
|
|
|
4,231 |
|
|
|
— |
|
|
Other long-term assets
|
|
|
2,484 |
|
|
|
3,042 |
|
| |
|
|
|
|
|
|
| |
Total assets
|
|
$ |
385,225 |
|
|
$ |
334,711 |
|
| |
|
|
|
|
|
|
| |
|
LIABILITIES AND STOCKHOLDERS’ DEFICIT |
|
Current liabilities:
|
|
|
|
|
|
|
|
|
|
Accounts payable
|
|
$ |
20,755 |
|
|
$ |
12,982 |
|
|
Accrued compensation
|
|
|
15,619 |
|
|
|
21,661 |
|
|
Accrued collocation and network service fees
|
|
|
24,160 |
|
|
|
18,714 |
|
|
Accrued transaction-based taxes
|
|
|
33,730 |
|
|
|
35,268 |
|
|
Accrued interest
|
|
|
1,121 |
|
|
|
5,683 |
|
|
Accrued market development funds and customer incentives
|
|
|
3,182 |
|
|
|
7,024 |
|
|
Unresolved claims related to bankruptcy proceedings
|
|
|
71 |
|
|
|
7,378 |
|
|
Collateralized customer deposit
|
|
|
7,906 |
|
|
|
— |
|
|
Unearned revenues
|
|
|
4,420 |
|
|
|
— |
|
|
Other accrued liabilities
|
|
|
5,753 |
|
|
|
5,607 |
|
| |
|
|
|
|
|
|
| |
Total current liabilities
|
|
|
116,717 |
|
|
|
114,317 |
|
|
Long-term debt
|
|
|
125,000 |
|
|
|
50,000 |
|
|
Collateralized customer deposit
|
|
|
44,444 |
|
|
|
60,258 |
|
|
Deferred gain resulting from deconsolidation of subsidiary
|
|
|
53,963 |
|
|
|
53,963 |
|
|
Unearned revenues
|
|
|
51,518 |
|
|
|
61,726 |
|
|
Other long-term liabilities
|
|
|
2,218 |
|
|
|
— |
|
| |
|
|
|
|
|
|
| |
Total liabilities
|
|
|
393,860 |
|
|
|
340,264 |
|
|
Commitments and contingencies (Notes 9 and 10)
|
|
|
|
|
|
|
|
|
|
Stockholders’ deficit:
|
|
|
|
|
|
|
|
|
|
Preferred stock, $0.001 par value; 5,000 shares
authorized; no shares issued and outstanding at
December 31, 2004 and 2003
|
|
|
— |
|
|
|
— |
|
|
Common stock, $0.001 par value; 590,000 shares
authorized; 263,681 shares issued and outstanding at
December 31, 2004 (230,163 shares issued and
outstanding at December 31, 2003)
|
|
|
264 |
|
|
|
230 |
|
|
Common stock — Class B, $0.001 par value;
10,000 shares authorized; no shares issued and outstanding
at December 31, 2004 and 2003
|
|
|
— |
|
|
|
— |
|
|
Additional paid-in capital
|
|
|
1,695,424 |
|
|
|
1,651,267 |
|
|
Deferred stock-based compensation
|
|
|
(939 |
) |
|
|
(14,459 |
) |
|
Accumulated other comprehensive loss
|
|
|
(985 |
) |
|
|
(953 |
) |
|
Accumulated deficit
|
|
|
(1,702,399 |
) |
|
|
(1,641,638 |
) |
| |
|
|
|
|
|
|
| |
Total stockholders’ deficit
|
|
|
(8,635 |
) |
|
|
(5,553 |
) |
| |
|
|
|
|
|
|
| |
Total liabilities and stockholders’ deficit
|
|
$ |
385,225 |
|
|
$ |
334,711 |
|
| |
|
|
|
|
|
|
See accompanying notes.
57
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
| |
|
(All dollar and share amounts are presented | |
| |
|
in thousands, except per share amounts) | |
|
Revenues, net
|
|
$ |
429,197 |
|
|
$ |
388,851 |
|
|
$ |
383,496 |
|
|
Operating expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Cost of sales (exclusive of depreciation and amortization)
|
|
|
266,172 |
|
|
|
288,122 |
|
|
|
298,336 |
|
| |
Selling, general and administrative
|
|
|
146,241 |
|
|
|
140,081 |
|
|
|
150,373 |
|
| |
Provision for bad debts (bad debt recoveries)
|
|
|
(2,035 |
) |
|
|
99 |
|
|
|
319 |
|
| |
Depreciation and amortization of property and equipment
|
|
|
56,825 |
|
|
|
56,559 |
|
|
|
112,438 |
|
| |
Amortization of collocation fees and other intangible assets
|
|
|
20,585 |
|
|
|
17,325 |
|
|
|
14,650 |
|
| |
Provision for restructuring expenses
|
|
|
1,409 |
|
|
|
1,235 |
|
|
|
— |
|
| |
Litigation-related expenses
|
|
|
— |
|
|
|
— |
|
|
|
(11,628 |
) |
| |
|
|
|
|
|
|
|
|
|
| |
|
Total operating expenses
|
|
|
489,197 |
|
|
|
503,421 |
|
|
|
564,488 |
|
| |
|
|
|
|
|
|
|
|
|
|
Loss from operations
|
|
|
(60,000 |
) |
|
|
(114,570 |
) |
|
|
(180,992 |
) |
|
Other income (expense):
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Interest income
|
|
|
2,668 |
|
|
|
2,105 |
|
|
|
5,122 |
|
| |
Realized loss on short-term investments
|
|
|
— |
|
|
|
— |
|
|
|
(17 |
) |
| |
Provision for impairment of investments in unconsolidated
affiliates
|
|
|
— |
|
|
|
(747 |
) |
|
|
(388 |
) |
| |
Equity in losses of unconsolidated affiliates
|
|
|
— |
|
|
|
(279 |
) |
|
|
(806 |
) |
| |
Loss on disposal of investments in unconsolidated affiliate
|
|
|
— |
|
|
|
— |
|
|
|
(636 |
) |
| |
Interest expense
|
|
|
(4,927 |
) |
|
|
(5,526 |
) |
|
|
(5,581 |
) |
| |
Miscellaneous income (expense), net
|
|
|
1,498 |
|
|
|
6,715 |
|
|
|
(1,530 |
) |
| |
|
|
|
|
|
|
|
|
|
| |
Other income (expense), net
|
|
|
(761 |
) |
|
|
2,268 |
|
|
|
(3,836 |
) |
| |
|
|
|
|
|
|
|
|
|
|
Net loss
|
|
$ |
(60,761 |
) |
|
$ |
(112,302 |
) |
|
$ |
(184,828 |
) |
| |
|
|
|
|
|
|
|
|
|
|
Basic and diluted net loss per share
|
|
$ |
(0.24 |
) |
|
$ |
(0.50 |
) |
|
$ |
(0.84 |
) |
| |
|
|
|
|
|
|
|
|
|
|
Weighted-average common shares used in computing basic and
diluted per share amounts
|
|
|
249,187 |
|
|
|
224,950 |
|
|
|
219,744 |
|
| |
|
|
|
|
|
|
|
|
|
See accompanying notes.
58
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(DEFICIT)
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
Accumulated | |
|
|
|
|
| |
|
|
|
|
|
|
|
|
|
Other | |
|
|
|
Total | |
| |
|
Preferred Stock |
|
Common Stock | |
|
Additional | |
|
Deferred | |
|
Comprehensive | |
|
|
|
Stockholders’ | |
| |
|
|
|
| |
|
Paid-In | |
|
Stock-Based | |
|
Income | |
|
Accumulated | |
|
Equity | |
| |
|
Shares | |
|
Amount |
|
Shares | |
|
Amount | |
|
Capital | |
|
Compensation | |
|
(Loss) | |
|
Deficit | |
|
(Deficit) | |
| |
|
| |
|
|
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
| |
|
(All dollar and share amounts are presented in thousands) | |
|
Balances at December 31, 2001
|
|
|
— |
|
|
$ |
— |
|
|
|
216,542 |
|
|
$ |
216 |
|
|
$ |
1,606,737 |
|
|
$ |
(257 |
) |
|
$ |
(2,359 |
) |
|
$ |
(1,344,508 |
) |
|
$ |
259,829 |
|
|
Issuance of common stock
|
|
|
— |
|
|
|
— |
|
|
|
5,418 |
|
|
|
6 |
|
|
|
4,303 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
4,309 |
|
|
Issuance of common stock upon exercise of options
|
|
|
— |
|
|
|
— |
|
|
|
1,006 |
|
|
|
1 |
|
|
|
398 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
399 |
|
|
Issuance of common stock upon emergence from Chapter 11
bankruptcy
|
|
|
— |
|
|
|
— |
|
|
|
217 |
|
|
|
— |
|
|
|
261 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
261 |
|
|
Issuance of warrants
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
3,790 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
3,790 |
|
|
Stock-based compensation
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
285 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
285 |
|
|
Deferred stock-based compensation
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
290 |
|
|
|
(290 |
) |
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
Amortization (reversal) of deferred stock-based compensation
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(3,745 |
) |
|
|
387 |
|
|
|
— |
|
|
|
— |
|
|
|
(3,358 |
) |
|
Unrealized losses on available-for-sale securities
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
270 |
|
|
|
— |
|
|
|
270 |
|
|
Foreign currency translation
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
1,342 |
|
|
|
— |
|
|
|
1,342 |
|
|
Net loss
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(184,828 |
) |
|
|
(184,828 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balances at December 31, 2002
|
|
|
— |
|
|
|
— |
|
|
|
223,183 |
|
|
|
223 |
|
|
|
1,612,319 |
|
|
|
(160 |
) |
|
|
(747 |
) |
|
|
(1,529,336 |
) |
|
|
82,299 |
|
|
Issuance of common stock
|
|
|
— |
|
|
|
— |
|
|
|
1,996 |
|
|
|
2 |
|
|
|
1,721 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
1,723 |
|
|
Issuance of common stock upon exercise of options
|
|
|
— |
|
|
|
— |
|
|
|
4,984 |
|
|
|
5 |
|
|
|
6,453 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
6,458 |
|
|
Issuance of warrants
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
2,640 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
2,640 |
|
|
Stock-based compensation
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
1,356 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
1,356 |
|
|
Deferred stock-based compensation
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
26,778 |
|
|
|
(26,778 |
) |
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
Amortization (reversal) of deferred stock-based compensation
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
12,479 |
|
|
|
— |
|
|
|
— |
|
|
|
12,479 |
|
|
Unrealized losses on available-for-sale securities
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(206 |
) |
|
|
— |
|
|
|
(206 |
) |
|
Net loss
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(112,302 |
) |
|
|
(112,302 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balances at December 31, 2003
|
|
|
— |
|
|
|
— |
|
|
|
230,163 |
|
|
|
230 |
|
|
|
1,651,267 |
|
|
|
(14,459 |
) |
|
|
(953 |
) |
|
|
(1,641,638 |
) |
|
|
(5,553 |
) |
|
Issuance of common stock
|
|
|
— |
|
|
|
— |
|
|
|
5,316 |
|
|
|
5 |
|
|
|
4,722 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
4,727 |
|
|
Issuance of common stock upon exercise of options
|
|
|
— |
|
|
|
— |
|
|
|
1,951 |
|
|
|
2 |
|
|
|
2,149 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
2,151 |
|
|
Issuance of common stock for bankruptcy filing related
transactions
|
|
|
— |
|
|
|
— |
|
|
|
6,496 |
|
|
|
7 |
|
|
|
6,944 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
6,951 |
|
|
Issuance of common stock for business acquisition expenses
|
|
|
|
|
|
|
|
|
|
|
834 |
|
|
|
1 |
|
|
|
1,780 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
1,781 |
|
|
Issuance of common stock to vendors
|
|
|
— |
|
|
|
— |
|
|
|
8 |
|
|
|
— |
|
|
|
13 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
13 |
|
|
Issuance of common stock for business acquisition
|
|
|
— |
|
|
|
— |
|
|
|
18,724 |
|
|
|
19 |
|
|
|
39,345 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
39,364 |
|
|
Issuance of restricted stock
|
|
|
— |
|
|
|
— |
|
|
|
189 |
|
|
|
— |
|
|
|
660 |
|
|
|
(660 |
) |
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
Amortization (reversal) of stock- based compensation
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(11,456 |
) |
|
|
14,180 |
|
|
|
— |
|
|
|
— |
|
|
|
2,724 |
|
|
Unrealized losses on available-for-sale securities
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(32 |
) |
|
|
— |
|
|
|
(32 |
) |
|
Net loss
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(60,761 |
) |
|
|
(60,761 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balances at December 31, 2004
|
|
|
— |
|
|
$ |
— |
|
|
|
263,681 |
|
|
$ |
264 |
|
|
$ |
1,695,424 |
|
|
$ |
(939 |
) |
|
$ |
(985 |
) |
|
$ |
(1,702,399 |
) |
|
$ |
(8,635 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
See accompanying notes.
59
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
| |
|
(All dollar amounts are presented in | |
| |
|
thousands) | |
|
Operating Activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss
|
|
$ |
(60,761 |
) |
|
$ |
(112,302 |
) |
|
$ |
(184,828 |
) |
|
Adjustments to reconcile net loss to net cash provided by (used
in) operating activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Provision for bad debts (bad debt recoveries), net
|
|
|
(2,035 |
) |
|
|
99 |
|
|
|
319 |
|
| |
Depreciation and amortization
|
|
|
77,410 |
|
|
|
73,884 |
|
|
|
127,088 |
|
| |
Loss on disposition of property and equipment
|
|
|
669 |
|
|
|
112 |
|
|
|
1,712 |
|
| |
Non-cash litigation-related expenses
|
|
|
— |
|
|
|
— |
|
|
|
(11,628 |
) |
| |
Amortization (reversal) of deferred stock-based
compensation, net
|
|
|
2,724 |
|
|
|
12,479 |
|
|
|
(3,358 |
) |
| |
Amortization of deferred customer incentives
|
|
|
1,749 |
|
|
|
— |
|
|
|
— |
|
| |
Other stock-based compensation
|
|
|
13 |
|
|
|
1,367 |
|
|
|
305 |
|
| |
Other non-cash charges
|
|
|
809 |
|
|
|
1,749 |
|
|
|
803 |
|
| |
Accretion of interest on investments, net
|
|
|
(716 |
) |
|
|
(1,090 |
) |
|
|
(209 |
) |
| |
Provision for impairment of investments in unconsolidated
affiliates
|
|
|
— |
|
|
|
747 |
|
|
|
388 |
|
| |
Equity in losses of unconsolidated affiliates
|
|
|
— |
|
|
|
279 |
|
|
|
806 |
|
| |
Miscellaneous income from internal-use software license royalties
|
|
|
— |
|
|
|
(5,606 |
) |
|
|
— |
|
| |
Loss on disposal of investment in unconsolidated affiliates
|
|
|
— |
|
|
|
— |
|
|
|
636 |
|
|
Net changes in operating assets and liabilities, net of assets
acquired and liabilities assumed in purchase acquisition:
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Restricted cash and cash equivalents
|
|
|
— |
|
|
|
(316 |
) |
|
|
6,627 |
|
| |
Accounts receivable
|
|
|
1,055 |
|
|
|
(6,881 |
) |
|
|
1,180 |
|
| |
Unbilled revenues
|
|
|
1,302 |
|
|
|
(1,206 |
) |
|
|
1,043 |
|
| |
Inventories
|
|
|
730 |
|
|
|
(239 |
) |
|
|
2,153 |
|
| |
Prepaid expenses and other assets
|
|
|
741 |
|
|
|
1,995 |
|
|
|
4,159 |
|
| |
Deferred costs of service activation
|
|
|
1,334 |
|
|
|
8,800 |
|
|
|
17,676 |
|
| |
Accounts payable
|
|
|
4,407 |
|
|
|
2,067 |
|
|
|
(4,927 |
) |
| |
Unresolved claims related to bankruptcy proceedings
|
|
|
(356 |
) |
|
|
(3 |
) |
|
|
(2,930 |
) |
| |
Collateralized customer deposit
|
|
|
(7,908 |
) |
|
|
(7,933 |
) |
|
|
(6,809 |
) |
| |
Other current liabilities
|
|
|
(11,703 |
) |
|
|
(1,466 |
) |
|
|
(1,366 |
) |
| |
Unearned revenues
|
|
|
(5,788 |
) |
|
|
(12,089 |
) |
|
|
(24,882 |
) |
| |
|
|
|
|
|
|
|
|
|
| |
|
Net cash provided by (used in) operating activities
|
|
|
3,676 |
|
|
|
(45,553 |
) |
|
|
(76,042 |
) |
|
Investing Activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Restricted cash and cash equivalents
|
|
|
359 |
|
|
|
— |
|
|
|
— |
|
|
Purchase of short-term investments
|
|
|
(144,105 |
) |
|
|
(131,903 |
) |
|
|
(237,088 |
) |
|
Maturities of short-term investments
|
|
|
160,268 |
|
|
|
191,894 |
|
|
|
165,526 |
|
|
Proceeds from the sale of short-term investments
|
|
|
— |
|
|
|
— |
|
|
|
40,017 |
|
|
Purchase of property and equipment
|
|
|
(38,743 |
) |
|
|
(44,142 |
) |
|
|
(22,782 |
) |
|
Proceeds from sale of property and equipment
|
|
|
115 |
|
|
|
181 |
|
|
|
13,451 |
|
|
Recovery of internal-use software costs
|
|
|
— |
|
|
|
7,345 |
|
|
|
814 |
|
|
Payment of collocation fees and purchase of other intangible
assets
|
|
|
(7,900 |
) |
|
|
(14,889 |
) |
|
|
(3,782 |
) |
|
Proceeds from sale of investments in unconsolidated affiliates
|
|
|
— |
|
|
|
— |
|
|
|
3,360 |
|
|
Cash acquired through acquisition
|
|
|
107 |
|
|
|
— |
|
|
|
— |
|
|
Acquisition costs
|
|
|
(473 |
) |
|
|
— |
|
|
|
— |
|
|
Decrease in other long-term assets
|
|
|
592 |
|
|
|
22 |
|
|
|
371 |
|
| |
|
|
|
|
|
|
|
|
|
| |
Net cash provided by (used in) investing activities
|
|
|
(29,780 |
) |
|
|
8,508 |
|
|
|
(40,113 |
) |
|
Financing Activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Proceeds from the issuance of senior unsecured convertible
debentures, net
|
|
|
119,961 |
|
|
|
— |
|
|
|
— |
|
|
Principal payments of long-term debt
|
|
|
(50,000 |
) |
|
|
— |
|
|
|
— |
|
|
Principal payments under capital lease obligations
|
|
|
(386 |
) |
|
|
(165 |
) |
|
|
(328 |
) |
|
Proceeds from the issuance of common stock
|
|
|
6,878 |
|
|
|
8,170 |
|
|
|
3,089 |
|
|
Proceeds from the issuance of common stock related to an
acquisition
|
|
|
1,781 |
|
|
|
— |
|
|
|
— |
|
| |
|
|
|
|
|
|
|
|
|
| |
Net cash provided by financing activities
|
|
|
78,234 |
|
|
|
8,005 |
|
|
|
2,761 |
|
| |
|
|
|
|
|
|
|
|
|
|
Net increase (decrease) in cash and cash equivalents
|
|
|
52,130 |
|
|
|
(29,040 |
) |
|
|
(113,394 |
) |
|
Cash and cash equivalents at beginning of year
|
|
|
65,376 |
|
|
|
94,416 |
|
|
|
207,810 |
|
| |
|
|
|
|
|
|
|
|
|
| |
Cash and cash equivalents at end of year
|
|
$ |
117,506 |
|
|
$ |
65,376 |
|
|
$ |
94,416 |
|
| |
|
|
|
|
|
|
|
|
|
|
Supplemental Disclosures of Cash Flow Information:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash paid during the year for interest
|
|
$ |
8,535 |
|
|
$ |
5,510 |
|
|
$ |
80 |
|
| |
|
|
|
|
|
|
|
|
|
|
Supplemental Schedule of Non-Cash Investing and Financing
Activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Equipment purchased through capital leases
|
|
$ |
959 |
|
|
$ |
— |
|
|
$ |
482 |
|
| |
|
|
|
|
|
|
|
|
|
|
Common stock issued in settlement of claims related to bankruptcy
|
|
$ |
6,951 |
|
|
$ |
— |
|
|
$ |
— |
|
| |
|
|
|
|
|
|
|
|
|
|
Common stock, options, and warrants issued for acquisition of
business
|
|
$ |
39,364 |
|
|
$ |
— |
|
|
$ |
— |
|
| |
|
|
|
|
|
|
|
|
|
See accompanying notes.
60
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2004, 2003 and 2002
(All dollar and share amounts are presented in thousands,
except per share amounts)
|
|
| 1. |
Nature of Operations and Summary of Significant Accounting
Policies |
|
|
|
Organization, Business and Basis of Presentation |
|
|
|
Organization and Business |
Covad Communications Group, Inc., together with the subsidiaries
through which businesses are conducted (collectively
“Covad” or “the Company”), provides voice
and data communications products and services to consumers and
businesses. The Company provides these services throughout the
United States in approximately 125 major metropolitan areas,
which includes over 900 cities. The Company’s
telecommunications network allows it to offer services to
approximately 50 million homes and businesses. The
Company’s products and services include high-speed, or
broadband, data communications, Internet access connectivity,
Voice over Internet Protocol telephony, or VoIP, and a variety
of related services. The Company primarily uses digital
subscriber line, or DSL, and DS-1, also referred to as T-1,
technologies to deliver its services. In order to provide its
services the Company purchases network elements, such as
telecommunication lines and central office facilities, from the
traditional local telephone companies, which are often referred
to as the incumbent local telephone companies, or ILECs, and
other telecommunication carriers, and then combine these network
elements with its own nationwide network facilities. The Company
purchases the majority of these network elements from Verizon
Communications, Inc., or Verizon, BellSouth Telecommunications,
Inc., or BellSouth, SBC Communications, Inc., or SBC, and Qwest
Corporation, or Qwest, which are also known as the regional Bell
operating companies, or RBOCs. As of December 31, 2004, the
Company had approximately 533,200 broadband access end-users and
567 VoIP business customers with a combined total of
approximately 20,500 VoIP stations.
The Company operates two business segments, Wholesale and
Direct. Wholesale is a provider of high-speed data connectivity
services to Internet service providers, or ISPs, and
telecommunications carrier customers. As of December 31,
2004, Wholesale had approximately 454,600 DSL and T-1 lines in
service. The Company’s Direct segment sells VoIP,
high-speed data connectivity and related value-added services
through multiple channels including telesales, field sales,
affinity partner programs, and its website. Direct focuses on
the small business market and also sells to enterprise customers
that purchase the Company’s services for distribution
across their enterprise. Direct ended 2004 with approximately
78,600 DSL and T-1 lines in service.
Based on the Company’s 2005 business plan, the Company
believes it will be able to continue as a going concern through
December 31, 2005 using only its unrestricted cash, cash
equivalents and short term investment balances in existence as
of December 31, 2004. The Company’s 2005 business plan
includes certain discretionary spending that is based on several
assumptions, including growth of its subscriber base with a
reasonable per subscriber profit margin and improvements in
productivity. If necessary, the Company will curtail this
discretionary spending so that it can continue as a going
concern through December 31, 2005 using only its
unrestricted cash, cash equivalent and short term investment
balances in existence as of December 31, 2004. Adverse
business, legal, regulatory or legislative developments, such as
the inability to continue accessing certain network elements
from the RBOCs, may require the Company to raise additional
financing, raise its prices or substantially decrease its cost
structure. The Company also recognizes that it may not be able
to raise additional capital. If the Company is unable to acquire
additional capital on favorable terms if needed, or is required
to raise it on terms that are less satisfactory than it desires,
its financial condition will be adversely affected.
61
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The consolidated financial statements include the accounts of
Covad and its wholly owned subsidiaries, except for the accounts
of BlueStar Communications Group, Inc. and its wholly owned
subsidiaries, which have been excluded from the Company’s
consolidated financial statements effective June 25,
2001 (Note 3). All significant intercompany accounts and
transactions have been eliminated in consolidation.
During the year ended December 31, 2003, a matter was
identified related to prior financial reporting periods that
necessitated the recording of additional expense. Such matter
was related to the modification of stock options granted to
certain employees in prior years. These modifications occurred
upon the separation of such employees from the Company,
principally during 2000. Accordingly, for the year ended
December 31, 2003, the Company recorded additional
stock-based compensation expense in the amount of $1,236
($0.01 per share). Such amount is reflected in the
Company’s selling, general and administrative expenses for
the year ended December 31, 2003. The Company does not
believe this amount is material to the periods in which it
should have been recorded, nor does it believe it is material to
its consolidated operating results for the year ended
December 31, 2003. This adjustment is principally related
to 2000, the impact of which would have been to increase
selling, general and administrative expenses and net loss by
$1,236 ($0.01 per share) for such year. As explained below,
certain other adjustments were recorded during 2002 that related
to prior periods. $1,139 of such amounts pertained to 2000, the
effect of which would have been to decrease the Company’s
2000 net loss by $0.01 per share. The aggregate effect
of the adjustments recorded during the year ended
December 31, 2003 and 2002 to the previously reported
results of operations for the year ended December 31, 2000
would be to increase net loss by $97, or $0.00 per share,
for such year if these adjustments had been recorded in 2000.
As part of the Company’s continuing evaluation of its
network assets during the year ended December 31, 2002,
certain matters were identified related to prior financial
reporting periods that necessitated the recording of adjustments
to certain expenses. Such matters were related principally to
(i) changes in the Company’s network configuration,
which necessitated reductions of the remaining estimated useful
lives of certain network equipment, (ii) the capitalization
of certain network and product costs that should have been
charged to operating expenses when they were incurred and
(iii) various restructuring activities that resulted in the
abandonment of certain network equipment and leasehold
improvements. Accordingly, for the year ended December 31,
2002, the Company recorded additional (i) depreciation
expense of $6,989 ($1,306 of which was recorded during the
fourth quarter of 2002), (ii) cost of sales of $2,635
($1,930 of which was recorded during the fourth quarter of
2002), (iii) loss on the disposition of property and
equipment of $635 (all of which was recorded during the fourth
quarter of 2002), and (iv) interest expense of $51 (all of
which was recorded during the fourth quarter of 2002). In
addition, as part of the Company’s financial statement
close process for the year ended December 31, 2002, the
Company discovered that it had overstated its amortization
expense relating to non-cash deferred stock-based compensation
in prior periods by $3,213. Therefore, for the year ended
December 31, 2002, the Company recorded reductions of
(i) cost of sales of $320 (all of which was recorded during
the fourth quarter of 2002) and (ii) selling, general and
administrative expense of $2,893 (all of which was recorded
during the fourth quarter of 2002). Furthermore, as part of the
Company’s review of its December 31, 2002 tax
accruals, it determined that it had overstated its
transaction-based tax and other tax accruals in prior periods by
$4,804, which the Company adjusted during the year ended
December 31, 2002 (all of which was recorded during the
fourth quarter of 2002). The adjustment was primarily driven by
various complex rules surrounding the Company’s estimated
liability to the Federal Universal Service Fund
(“FUSF”). The Company does not believe any of the
aforementioned amounts are material to the periods in which they
should have been recorded, nor does it believe the prospective
correction of such amounts during the year ended
December 31, 2002 is material to its consolidated operating
results for such year (the prospective correction of the
aforementioned amounts relating to prior periods increased the
Company’s 2002
62
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
consolidated net loss by $2,294, or $0.01 per share, and
decreased the Company’s 2001 net loss by $3,433 or
$0.02 per share).
|
|
|
Summary of Significant Accounting Policies |
The preparation of financial statements in conformity with
accounting principles generally accepted in the United States
requires the Company to make estimates and assumptions that
affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual
results may differ materially from those estimates. The
Company’s critical accounting estimates include
(i) revenue recognition and the establishment of accounts
receivable allowances (Notes 1 and 2), (ii) inventory
valuation (Note 1), (iii) reorganization and
restructuring liabilities (Note 3), (iv) useful life
assignments and impairment evaluations associated with property
and equipment and intangible assets (Notes 1, 4 and 5),
(v) anticipated outcomes of legal proceedings and other
disputes (Notes 2, and 10), (vi) transaction-based tax
and employment-related tax liabilities (Note 10) and
(vii) valuation allowances associated with deferred tax
assets (Note 12).
|
|
|
Cash Equivalents and Short-Term Investments |
The Company considers all highly liquid investments with a
maturity of three months or less from the date of original
issuance to be cash equivalents. As of December 31, 2004
and 2003, cash equivalents consisted principally of money market
mutual funds. All of the Company’s investments are
classified as available-for-sale and stated at their fair market
values, which are determined based on quoted market prices. The
Company’s short-term investments had original maturities
greater than three months, but less than one year, from the
balance sheet dates. The Company determines the appropriate
classification of investments at the time of purchase and
reevaluates such designation at the end of each period.
Unrealized gains and losses on available-for-sale securities are
included as a separate component of stockholders’ equity.
Realized gains and losses on available-for-sale securities are
determined based on the specific identification of the cost of
securities sold.
Short-term investments consisted of the following:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
December 31, 2004 | |
| |
|
| |
| |
|
|
|
Gross |
|
Gross | |
|
|
| |
|
Amortized | |
|
Unrealized |
|
Unrealized | |
|
|
| |
|
Cost | |
|
Gains |
|
Losses | |
|
Fair Value | |
| |
|
| |
|
|
|
| |
|
| |
|
U.S. Government agency securities
|
|
$ |
21,952 |
|
|
$ |
— |
|
|
$ |
(22 |
) |
|
$ |
21,930 |
|
|
Commercial paper
|
|
|
11,564 |
|
|
|
— |
|
|
|
(4 |
) |
|
|
11,560 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
| |
Total available-for-sale securities
|
|
$ |
33,516 |
|
|
$ |
— |
|
|
$ |
(26 |
) |
|
$ |
33,490 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
December 31, 2003 | |
| |
|
| |
| |
|
|
|
Gross | |
|
Gross |
|
|
| |
|
Amortized | |
|
Unrealized | |
|
Unrealized |
|
|
| |
|
Cost | |
|
Gains | |
|
Losses |
|
Fair Value | |
| |
|
| |
|
| |
|
|
|
| |
|
U.S. Government agency securities
|
|
$ |
38,961 |
|
|
$ |
7 |
|
|
$ |
— |
|
|
$ |
38,968 |
|
|
Certificates of deposit
|
|
|
10,000 |
|
|
|
1 |
|
|
|
— |
|
|
|
10,001 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
| |
Total available-for-sale securities
|
|
$ |
48,961 |
|
|
$ |
8 |
|
|
$ |
— |
|
|
$ |
48,969 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
As of December 31, 2004, the contractual maturities of all
available-for-sale securities are between February 1, 2005
and July 5, 2005.
63
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Realized losses resulting from the sale of available-for-sale
securities was as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
| |
|
Year Ended |
| |
|
December 31, |
| |
|
|
| |
|
2004 |
|
2003 | |
|
2002 |
| |
|
|
|
| |
|
|
|
Losses
|
|
$ |
— |
|
|
$ |
— |
|
|
$(17) |
| |
|
|
|
|
|
|
|
|
| |
Total
|
|
$ |
— |
|
|
$ |
— |
|
|
$(17) |
| |
|
|
|
|
|
|
|
|
|
|
|
Restricted Cash and Cash Equivalents |
As of December 31, 2004 and 2003, the Company held $2,533
and $2,892, respectively, in money market mutual funds, which
(i) collateralize irrevocable letters of credit pertaining
to certain operating lease commitments (Note 9) or
(ii) are restricted for the payment of unresolved
bankruptcy claims.
Other investments consist primarily of strategic investments in
privately held entities. These investments in privately held
companies are accounted for under either the cost or equity
methods of accounting, depending on the Company’s ownership
and ability to significantly influence these entities.
The Company performs periodic reviews of its investments for
impairment. Impairment write-downs create a new carrying value
for the investment and the Company does not record subsequent
increases in fair value in excess of the new carrying value for
these types of privately held investments accounted for under
the cost or equity methods. The Company recorded write-downs of
$747 and $388 during the years ended December 31, 2003 and
2002, respectively, related to impairments of its privately held
investments. No similar impairments were recorded during the
year ended December 31, 2004.
|
|
|
Concentrations of Credit Risk, Significant Customer and, Key
Suppliers |
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash and
cash equivalents, short-term investments and restricted cash and
cash equivalents. The Company’s cash and investment
policies limit cash equivalents, short-term investments and
restricted cash and cash equivalents to short-term, investment
grade instruments. Cash and cash equivalents, short-term
investments and restricted cash and cash equivalents are held
primarily with various domestic and international financial
institutions with high credit ratings. The Company has not
experienced any significant losses on its cash, cash equivalents
or restricted cash and cash equivalents.
The Company conducts business primarily with ISPs, enterprise
customers and telecommunications carrier customers in the United
States. As more fully described in Note 2, the Company has
concentrations of credit risk with a small number of customers,
and certain of the Company’s customers were experiencing
financial difficulties as of December 31, 2004, 2003 and
2002 and were not current in their payments for the
Company’s services at those dates. The Company performs
ongoing credit evaluations of its customers’ financial
condition and generally does not require collateral. An
allowance is maintained for estimated credit losses and doubtful
accounts, these allowances are derived by (i) specific
facts and circumstances on the financial condition of individual
customers, and (ii) credit loss history on the accounts
receivable portfolio.
The Company is dependent on a limited number of suppliers for
certain equipment used to provide its services. The Company has
generally been able to obtain an adequate supply of such
equipment. However, an extended interruption in the supply of
equipment currently obtained from its suppliers could adversely
affect the Company’s business and results of operations.
64
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The Company is a minority shareholder of Certive Corporation.
The Company’s Chairman of the Board of Directors, Charles
McMinn, is also the Chairman and principal stockholder of
Certive (Note 6).
The Company’s former vice-chairman and former interim chief
executive officer, Frank Marshall, who was also a member of the
Company’s board of directors from October 1997 to December
2002, was a minority stockholder and former member of the board
of directors of one of the Company’s former ISP customers,
InternetConnect, which filed for bankruptcy protection in 2001
(Note 6).
A member of the Company’s Board of Directors, Richard
Jalkut, is the President and CEO of TelePacific Communications
(“TelePacific”), one of the Company’s resellers.
The Company recognized revenues from TelePacific of $369, $611
and $1,311 for the years ended December 31, 2004, 2003 and
2002, respectively. Accounts receivables from TelePacific were
$29 and $103 as of December 31, 2004 and 2003,
respectively. Another member of the Company’s Board of
Directors, L. Dale Crandall, is a director of BEA Systems
(“BEA”), one of the Company’s vendors. The
Company paid $890 and $2,232 to BEA during the years ended
December 31, 2004 and 2003, respectively. Accounts payable
to BEA was $21 as of December 31, 2004, respectively.
Charles Hoffman, the Company’s CEO, is also a director of
Chordiant Software (“Chordiant”), one of our vendors.
The Company paid $3,387 to Chordiant in 2004. No amounts were
paid to this vendor in 2003. No amounts were due to this vendor
as of December 31, 2004 and 2003.
Inventories, consisting primarily of customer premises
equipment, are stated at the lower of cost, determined using the
“first-in, first-out” method, or market. Shipping and
handling costs incurred in conjunction with the sale of
inventory are included as an element of cost of sales.
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 ranges of
useful lives:
| |
|
|
|
Leasehold improvements
|
|
5 years or the term of the lease, whichever is less |
|
Computer equipment
|
|
2 to 5 years |
|
Computer software
|
|
3 to 5 years |
|
Furniture and fixtures
|
|
2 to 5 years |
|
Networks and communication equipment
|
|
2 to 5 years |
The Company incurs significant costs associated with
internal-use software, which consists principally of software
used to operate its operational support systems
(“OSS”), network assets, and website. The Company
charges pre-development, training and maintenance costs to
expense as they are incurred. Software and website development
costs, which include direct costs such as labor and contractors,
are capitalized when they can be segregated from other
non-capitalizable labor activities and when it is probable that
the project will be completed and the software or website will
be used as intended. Costs incurred for upgrades and
enhancements to the Company’s software or website are
capitalized when it is probable that such efforts will result in
additional and significant functionality. Capitalized software
and website costs are amortized to expense over the estimated
useful life of the software or website. Amortization of
internal-use software costs was $3,566, $3,699 and $6,240 for
the years ended December 31, 2004, 2003, and 2002,
respectively. The Company accounts for incidental sales of
licenses for its OSS software on a cost recovery basis
(Note 6). In 2004, the Company began recording royalty
payments for licensing its OSS software as other revenue as the
cost of the licensed software has been fully recovered.
65
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The Company leased certain equipment under capital lease
agreements. Assets and liabilities under capital leases are
recorded at the lesser of the present value of the aggregate
future minimum lease payments, including estimated bargain
purchase options, or the fair value of the assets under lease.
Assets under capital leases are amortized over the lease term or
the useful life of the assets. Amortization of assets under
capital leases is included in depreciation and amortization
expense.
|
|
|
Collocation Fees and Other Intangible Assets |
Collocation fees represent nonrecurring fees paid to other
telecommunications carriers for the right to use central office
space to house equipment owned or leased by the Company. Such
nonrecurring fees are capitalized as intangible assets and
amortized over five years using the straight-line method. The
Company’s collocation agreements also require periodic
recurring payments, which are charged to expense as incurred.
All such collocation agreements are cancelable by the Company at
any time.
Other intangible assets consist of a customer lists acquired
from third parties (Note 6). Such customer lists are being
amortized over a period of twenty-four to forty-eight months,
representing a weighted-average life of thirty months, using the
straight-line method.
As of December 31, 2004, the Company’s estimated
annual amortization expenses associated with collocation fees
and other intangible assets for the next five years were as
follows:
| |
|
|
|
|
|
2005
|
|
$ |
16,750 |
|
|
2006
|
|
$ |
7,636 |
|
|
2007
|
|
$ |
5,610 |
|
|
2008
|
|
$ |
3,753 |
|
|
2009
|
|
$ |
812 |
|
|
|
|
Change in Accounting Estimate |
During the year ended December 31, 2004, the Company
reduced its estimates on property tax liabilities, primarily
caused by lower property valuations and actual tax assessments
on its network assets. For the year ended December 31, 2004
this change in accounting estimate reduced the Company’s
cost of sales by $1,824, and selling, general and administrative
expenses by $544, and net loss by approximately $2,368
($0.01 per share). In addition, during the three months
ended June 30, 2004, the Company ceased the accrual of a
transaction-based tax because it determined it should not be
subject to this tax. The determination was based on the
Company’s revised interpretation of the applicability of
the tax. The Company believes that such determination
prospectively removes the “probable” condition
required by Statement of Financial Accounting Standard 5
(“SFAS 5”) to accrue a contingent liability. For
the year ended December 31, 2004, this change in accounting
estimate had the effect of lowering the Company’s cost of
sales and net loss, compared to the prior year period, by
approximately $3,636 ($0.01 per share). The Company did not
reverse the liability of approximately $19,455 that was accrued
at the statutory tax rate as of March 31, 2004, because the
Company believes that the liability was properly recorded based
upon its interpretation of the tax law at that time coupled with
the guidance provided by SFAS 5. The Company believes that
the criteria for derecognizing the liability for the tax
reflected in its condensed consolidated balance sheet as of
March 31, 2004, will be met when one of the following
occurs: (i) a ruling, either judicial or from the Internal
Revenue Service (“IRS”), that it is not subject to the
tax, (ii) a ruling, either judicial or from the IRS that a
company with similar facts and circumstances to the Company is
not subject to the tax, (iii) a settlement with the IRS on
this matter or, (iv) the expiration of the applicable
statute of limitations. Furthermore, during the year ended
December 31, 2004, the Company recorded a bad debt recovery
in the amount of $1,600 as a result of a settlement of a
previously written down account receivables balance from one of
its wholesale customers. For the year ended December 31,
2004, this change in accounting estimate reduced the
Company’s provision for bad debts and
66
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
net loss by $1,600 ($0.01 per share). During the year ended
December 31, 2004, the Company also reduced its estimates
of a transaction-based tax liability and certain employment
related tax liabilities due to the expiration of the prescribed
statutory period for the corresponding tax returns. For the year
ended December 31, 2004, these changes in accounting
estimates reduced the Company’s cost of sales by $2,023,
selling, general and administrative expenses by $1,971 and net
loss by $3,994 ($0.02 per share).
During the year ended December 31, 2003, the Company
reduced its estimates of accrued liabilities for customer
incentives based on the compilation of sufficient historical
data with which to estimate sales incentives that will not
ultimately be claimed by customers. For the year ended
December 31, 2003, this change in accounting estimate
increased the Company’s revenues by $2,355, and reduced the
Company’s net loss by $2,750 ($0.01 per share).
|
|
|
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.
The Company accounts for stock-based awards to
(i) employees (including non-employee directors) using the
intrinsic value method and (ii) non-employees using the
fair value method.
Under the intrinsic value method, when the exercise price of the
Company’s employee stock options equals the market price of
the underlying stock on the date of grant, no compensation
expense is recognized. The following table illustrates the pro
forma effect on net loss and loss per share for the years ended
December 31, 2004, 2003 and 2002 had the Company applied
the fair value method to account for stock-based awards to
employees:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
Net loss, as reported
|
|
$ |
(60,761 |
) |
|
$ |
(112,302 |
) |
|
$ |
(184,828 |
) |
|
Stock-based employee compensation expense (reversal) included in
the determination of net loss, as reported
|
|
|
2,724 |
|
|
|
13,715 |
|
|
|
(3,112 |
) |
|
Stock-based employee compensation expense that would have been
included in the determination of net loss if the fair value
method had been applied to all awards
|
|
|
(21,593 |
) |
|
|
(20,507 |
) |
|
|
(28,471 |
) |
| |
|
|
|
|
|
|
|
|
|
|
Pro forma net loss
|
|
$ |
(79,630 |
) |
|
$ |
(119,094 |
) |
|
$ |
(216,411 |
) |
| |
|
|
|
|
|
|
|
|
|
|
Basic and diluted net loss per common share:
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
As reported
|
|
$ |
(0.24 |
) |
|
$ |
(0.50 |
) |
|
$ |
(0.84 |
) |
| |
|
|
|
|
|
|
|
|
|
| |
Pro forma
|
|
$ |
(0.32 |
) |
|
$ |
(0.53 |
) |
|
$ |
(0.98 |
) |
| |
|
|
|
|
|
|
|
|
|
The weighted-average grant date fair value of stock-based awards
to employees was $2.46, $1.76 and $0.83 per share during
the years ended December 31, 2004, 2003 and 2002,
respectively. Such weighted-average grant date fair values were
estimated using the Black-Scholes option valuation model and the
assumptions listed in Note 13 under the caption “Pro
Forma Stock-Based Compensation Information.”
67
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The Company charges the costs of advertising to expense as
incurred. Advertising expense for the years ended
December 31, 2004, 2003 and 2002 was $24,955, $7,650 and
$27,083, 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
required by Company policy and the Company can reasonably
estimate the fair value of its portion of the advertising, such
amounts are charged to advertising expense as incurred. Other
amounts payable to customers relating to rebates, customer
incentives and nonqualified MDF activities are recorded as
reductions of revenues as incurred.
The Company accounts for legal costs expected to be incurred in
connection with a loss contingency as incurred.
The Company uses the liability method to account for income
taxes. Under this method, deferred tax assets and liabilities
are determined based on differences between financial reporting
and tax bases of assets and liabilities. Deferred tax assets and
liabilities are measured using enacted tax rates and laws that
will be in effect when the differences are expected to reverse.
Valuation allowances are established when necessary to reduce
deferred tax assets to the amount expected to be realized.
|
|
|
Fair Values of Financial Instruments |
The following methods and assumptions were used to estimate the
fair values of the Company’s financial instruments:
Cash, Cash Equivalents, Short Term Investments and Restricted
Cash and Cash Equivalents. The carrying amounts of these
assets approximate their respective fair values, which were
determined based on quoted market prices.
Borrowings. The fair values of borrowings, including
long-term debt and capital lease obligations, are estimated
based on quoted market prices, where available, or by
discounting the future cash flows using estimated borrowing
rates at which similar types of borrowing arrangements with the
same remaining maturities could be obtained by the Company. The
aggregate fair value of the Company’s long-term debt and
capital lease obligations was $98,753 as of December 31,
2004, as compared to the aggregate carrying amount of $125,734
as of such date. The aggregate fair value of the Company’s
long-term debt was $58,646 as of December 31, 2003, as
compared to the aggregate carrying amount of $50,000 as of such
date.
The functional currency of the Company’s unconsolidated
affiliates is the local currency. The investments in these
unconsolidated affiliates are translated into U.S. dollars
at year-end exchange rates, and the Company’s equity in the
income or losses of these affiliates is translated at average
exchange rates prevailing during the year. Translation
adjustments are included in “Accumulated other
comprehensive loss,” a separate component of
stockholders’ equity (deficit).
68
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
|
|
|
Basic and Diluted Net Loss per Share |
Basic net loss per share is computed by using the
weighted-average number of shares of the Company’s common
stock during the period, less the weighted-average number of
common shares subject to repurchase.
Diluted per share amounts are determined in the same manner as
basic per share amounts, except that the number of
weighted-average common shares used in the computations includes
dilutive common shares subject to repurchase and is increased
assuming the (i) exercise of dilutive stock options and
warrants using the treasury stock method and
(ii) conversion of dilutive convertible debt instruments.
However, diluted net loss per share is the same as basic net
loss per share in the periods presented in the accompanying
consolidated statements of operations because the impact of
(i) common shares subject to repurchase, (ii) the
assumed exercise of outstanding stock options and warrants is
not dilutive.
The following table presents the calculation of weighted-average
common shares used in the computations of basic and diluted net
loss per share amounts presented in the accompanying
consolidated statements of operations:
| |
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
Weighted-average shares of common stock outstanding
|
|
|
249,295 |
|
|
|
224,950 |
|
|
|
219,750 |
|
|
Less weighted-average shares of common stock subject to
repurchase
|
|
|
108 |
|
|
|
— |
|
|
|
6 |
|
| |
|
|
|
|
|
|
|
|
|
|
Weighted-average common shares used in computing basic per share
amounts
|
|
|
249,187 |
|
|
|
224,950 |
|
|
|
219,744 |
|
| |
|
|
|
|
|
|
|
|
|
For the years ended December 31, 2004, 2003 and 2002,
outstanding options and warrants were excluded from the
calculation of diluted net loss per share, as the effect would
be anti-dilutive. Total outstanding options and warrants to
purchase common stock at December 31, 2004 were 22,997 and
6,514 shares at weighted-average exercise price of $6.10
and $2.85, respectively. Total outstanding options and warrants
to purchase common stock at December 31, 2003 were 21,677
and 6,512 shares at a weighted-average exercise price of
$7.09 and $2.85, respectively. Total outstanding options and
warrants to purchase common stock at December 31, 2002 were
25,675 and 3,737 shares at a weighted-average exercise
price of $7.80 and $5.48, respectively.
For the year ended December 31, 2004, common stock issuable
upon the assumed conversion of convertible debentures were
excluded from the calculation of diluted net loss per share as
the effect would be anti-dilutive. These debentures are
convertible into 39,380 shares of the Company’s common
stock.
Significant components of the Company’s comprehensive loss
are as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
|
|
Year Ended December 31, | |
| |
|
Cumulative | |
|
| |
| |
|
Amounts | |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
| |
|
Net loss
|
|
$ |
(1,702,399 |
) |
|
$ |
(60,761 |
) |
|
$ |
(112,302 |
) |
|
$ |
(184,828 |
) |
|
Unrealized gains (losses) on available-for-sale securities
|
|
|
(23 |
) |
|
|
(32 |
) |
|
|
(206 |
) |
|
|
270 |
|
|
Foreign currency translation adjustment
|
|
|
(962 |
) |
|
|
— |
|
|
|
— |
|
|
|
1,342 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
Comprehensive loss
|
|
$ |
(1,703,384 |
) |
|
$ |
(60,793 |
) |
|
$ |
(112,508 |
) |
|
$ |
(183,216 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
69
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Goodwill is recorded when the consideration paid for an
acquisition exceeds the fair value of net tangible and
intangible assets acquired. Goodwill is measured and tested for
impairment on an annual basis or more frequently if the Company
believes indicators of impairment exist. The performance of the
test involves a two-step process. The first step compares the
fair value of the reporting unit to its carrying amount,
including goodwill. The fair value of the reporting unit is
determined by calculating the market capitalization of the
reporting unit as derived from quoted market prices or other
generally accepted valuation methods if quoted market prices are
not available. A potential impairment exists if the fair value
of the reporting unit is lower than its carrying amount. The
second step of the process is only performed if a potential
impairment exists, and it involves determining the difference
between the fair values of the reporting unit’s net assets,
other than goodwill, to the fair value of the reporting unit. If
the difference is less than the net book value of goodwill, an
impairment exists and is recorded.
The Company determines its reporting units, for purposes of
testing for impairment, by determining (i) how the Company
manages its operations, (ii) if a component of an operating
unit constitutes a business for which discrete financial
information is available and the Company management regularly
reviews such financial information, and (iii) how an
acquired entity, is integrated with the Company. Based on these
criteria, the Company determined that its Wholesale and Direct
segments are its reporting units.
On June 8, 2004, the Company completed its acquisition of
all of the outstanding shares of privately-held GoBeam, Inc.
(“GoBeam”), as described in Note 6,
“Acquisition of GoBeam, Inc.” The Company
integrated and manages the GoBeam business within its Direct
segment. Accordingly, the recorded goodwill from the acquisition
of GoBeam was allocated to the Direct segment for purposes of
testing for impairment.
|
|
|
Collateralized Customer Deposit |
The Company entered into a 10-year resale agreement with SBC in
December 2001 under which SBC, its affiliates or special agents
will resell the Company’s DSL services. Under the
arrangement with SBC, the Company recognizes revenue consistent
with its revenue recognition policy, which is described in
Note 2, “Revenue Recognition,” to its
condensed consolidated financial statements. As part of the
resale agreement, SBC made a $75,000 noninterest-bearing
prepayment, which is collateralized by substantially all of the
Company’s domestic assets. As the Company provides certain
products and services to SBC, the resultant billings are
recognized as revenue in accordance with the Company’s
revenue recognition policy and are offset by the prepayment to
the extent of SBC’s right to do so under the resale
agreement. The total balance of the prepayment as of
December 31, 2004 was $52,350. The Company categorizes a
portion of the prepayment liability as a current liability,
based upon the amount of expected billings over the next twelve
months, with the remainder classified as long term. The amount
of billings expected over the next twelve months is an estimate
based on the current quantity of products and services for which
SBC is being billed, and the actual amount sold during this
period may be greater or lesser than this estimated amount. SBC
recently announced that it has reached an agreement to acquire
AT&T, another one of the Company’s wholesale customers.
SBC has indicated that the acquisition is not expected to be
completed until the first half of 2006. This acquisition may
affect SBC’s timing and utilization of the prepayment. The
Company will continue to monitor these events to determine
whether a change in these classifications is appropriate.
|
|
|
Recent Accounting Pronouncements |
In December 2004, the Financial Accounting Standards Board, or
FASB, issued Statement of Financial Accounting Standards, or
SFAS, No. 123 (revised 2004), “Share-Based
Payment”, or SFAS 123R, that addresses the accounting
for share-based payment transactions in which an enterprise
receives employee services in exchange for either equity
instruments of the enterprise or liabilities that are based on
the fair value of the enterprise’s equity instruments or
that may be settled by the issuance of such equity instruments.
The
70
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
statement eliminates the ability to account for share-based
compensation transactions using the intrinsic value method as
prescribed by Accounting Principles Board, or APB, Opinion
No. 25, “Accounting for Stock Issued to
Employees,” and generally requires that such transactions
be accounted for using a fair-value-based method and recognized
as expenses in the Company’s consolidated statement of
income. The statement requires companies to assess the most
appropriate model to calculate the value of the options. The
Company currently uses the Black-Scholes option pricing model to
value options and is currently assessing which model it may use
in the future under the statement and may deem an alternative
model to be the most appropriate. The use of a different model
to value options may result in a different fair value than the
use of the Black-Scholes option pricing model. In addition,
there are a number of other requirements under the new standard
that will result in differing accounting treatment than
currently required. These differences include, but are not
limited to, the accounting for the tax benefit on employee stock
options and for stock issued under the Company’s employee
stock purchase plan. In addition to the appropriate fair value
model to be used for valuing share-based payments, the Company
will also be required to determine the transition method to be
used at date of adoption. The allowed transition methods include
prospective and retroactive adoption options. Under the
retroactive options, prior periods may be restated either as of
the beginning of the year of adoption or for all periods
presented. The prospective method requires that compensation
expense be recorded for all unvested stock options and
restricted stock at the beginning of the first quarter of
adoption of SFAS 123R, while the retroactive methods would
record compensation expense for all unvested stock options and
restricted stock beginning with the first period restated. The
effective date of the new standard for the Company’s
consolidated financial statements is its third fiscal quarter in
2005.
Upon adoption, this statement will have a significant impact on
the Company’s consolidated financial statements as it will
be required to expense the fair value of its stock option grants
and stock purchases under its employee stock purchase plan
rather than disclose the impact on its consolidated net income
within its footnotes as is its current practice (Note 1).
The amounts disclosed within the Company’s footnotes are
not necessarily indicative of the amounts that will be expensed
upon the adoption of SFAS 123R. Compensation expense
calculated under SFAS 123R may differ materially from
amounts currently disclosed within the Company’s footnotes
based on changes in the fair value of its common stock, changes
in the number of options granted or the terms of such options,
the treatment of tax benefits and changes in interest rates or
other factors. In addition, upon adoption of SFAS 123R the
Company may choose to use a different valuation model to value
the compensation expense associated with employee stock options.
In December 2004, the FASB issued SFAS No. 153
“Exchanges of Non-monetary Assets.” SFAS eliminates
the exception from fair value measurement for non-monetary
exchanges of similar productive assets in paragraph 21
(b) of APB opinion 29, “Accounting for
Non-monetary Transactions”, and replaces it with an
exception for exchanges that do not have commercial substance.
SFAS 153 specifies that a non-monetary exchange has
commercial substance if the future cash flows of the entity are
expected to change significantly as a result of the exchange.
SFAS 153 is effective for fiscal periods beginning after
June 15, 2005. The Company is currently evaluating the
effect that the adoption of SFAS 153 will have on its
consolidated statement of operations and financial condition for
fiscal periods beginning after June 15, 2005.
In November 2004, the FASB issued SFAS No. 151
“Inventory Costs — an amendment of Accounting
Research Bulletin No. 43, Chapter 4”.
SFAS 151 amends the guidance in ARB No. 43,
Chapter 4, “Inventory Pricing,”, to clarify the
accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material, or spoilage.
Paragraph 5 of ARB 43, previously stated that under some
circumstances, items such as idle facility expense, excessive
spoilage, double freight, and re-handling costs may be so
abnormal as to require treatment as current period charges.
SFAS 151 requires that such items be recognized as current
period charges regardless of whether they meet the criterion of
“so abnormal”. In addition, SFAS 151 requires
that allocation of fixed production overheads to the costs of
conversion be based on the normal capacity of the production
facilities. SFAS 151 is effective for fiscal periods
beginning after June 15, 2005. The Company is
71
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
currently evaluating the effect that the adoption of
SFAS 151 will have on its consolidated statement of
operations and financial condition for fiscal periods beginning
after June 15, 2005.
In March 2004, the FASB approved Emerging Issue Task Force, or
EITF, Issue 03-6, “Participating Securities and the
Two — Class Method under Statement of Financial
Accounting Standards, or SFAS, 128.” EITF Issue 03-6
supersedes the guidance in Topic No. D-95, “Effect of
Participating Convertible Securities on the Computation of Basic
Earnings per Share,” and requires the use of the two-class
method of participating securities. The two-class method is an
earnings allocation formula that determines earnings per share
for each class of common stock and participating security
according to dividends declared (or accumulated) and
participation rights in undistributed earnings. In addition,
EITF Issue 03-6 addresses other forms of participating
securities, including options, warrants, forwards and other
contracts to issue an entity’s common stock, with the
exception of stock-based compensation (unvested options and
restricted stock) subject to the provisions of Opinion 25 and
SFAS 123. EITF Issue 03-6 is effective for reporting
periods beginning after March 31, 2004 and should be
applied by restating previously reported earnings per share. The
adoption of EITF Issue 03-6 did not have a significant
effect on the Company’s consolidated financial statements
for the year ended December 31, 2004.
Future results of operations involve a number of risks and
uncertainties. Factors that could affect future operating
results and cash flows and cause actual results to vary
materially from historical results include, but are not limited
to:
|
|
|
| |
• |
changes in government policy, regulation and enforcement or
adverse judicial or administrative interpretations and rulings
or legislative action relating to regulations, enforcement and
pricing, including, but not limited to, changes that affect the
continued availability of the unbundled network elements of the
local exchange carriers network and the costs associated
therewith; |
| |
| |
• |
dependence on the availability and functionality of the networks
of the incumbent local exchange carriers; |
| |
| |
• |
increased price competition in local and long distance services,
including bundled services, and overall competition within the
telecommunications industry; and |
| |
| |
• |
adverse determinations in certain litigation matters |
Negative developments in these areas could have a material
effect on our business, financial condition and results of
operations.
Revenues from recurring service are recognized when
(i) persuasive evidence of an arrangement between the
Company and the customer exists, (ii) service has been
provided to the customer, (iii) the price to the customer
is fixed or determinable and (iv) collectibility of the
sales prices is reasonably assured. If a customer is
(i) experiencing financial difficulties and, (ii) is
not current in making payments for the Company’s services
or, (iii) is essentially current in making payments but,
subsequent to the end of the reporting period, the financial
condition of such customer deteriorates significantly or such
customer files for bankruptcy protection, then, based on this
information, the Company may determine that the collectibility
of revenues from this customer is not reasonably assured or its
ability to retain some or all of the payments received from a
customer that has filed for bankruptcy protection is not
reasonably assured. Accordingly, the Company classifies this
group of customers as “financially distressed” for
revenue recognition purposes. Revenues from financially
distressed customers are recognized when cash for the services
to those customers is collected, assuming all other criteria for
revenue recognition have been met, but only after the collection
of all previous outstanding
72
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
accounts receivable balances. Payments received from financially
distressed customers during a defined period prior to their
filing of petitions for bankruptcy protection are recorded in
the consolidated balance sheets caption “Unearned
revenues” if the Company’s ability to retain these
payments is not reasonably assured.
Revenues earned for which the customer has not been billed are
recorded as “Unbilled revenues” in the consolidated
balance sheets. Amounts billed in advance of providing service
are deferred and recorded as an element of the consolidated
balance sheets caption “Unearned revenues.” Included
in revenues are Federal Universal Service Fund
(“FUSF”) charges billed to customers aggregating
$5,381, $4,993 and $8,233 for the years ended December 31,
2004, 2003 and 2002, respectively. Shipping and handling charges
billed to customers are included in the Company’s net
revenues.
The Company recognizes up-front fees associated with service
activation over the expected term of the customer relationships,
which ranges from 24 to 48 months, using the straight-line
method. The Company treats the incremental direct costs of
service activation (which consist principally of customer
premises equipment, service activation fees paid to other
telecommunications companies and sales commissions) as deferred
charges in amounts that are no greater than the up-front fees
that are deferred. These deferred incremental direct costs are
amortized to expense using the straight-line method over 24 to
48 months.
The Company has billing disputes with some of its customers.
These disputes arise in the ordinary course of business in the
telecommunications industry and their impact on the
Company’s accounts receivable and revenues can be
reasonably estimated based on historical experience. In
addition, certain revenues are subject to refund if the end-user
terminates service within 30 days of service activation.
Accordingly, the Company maintains allowances, through charges
to revenues, based on the Company’s estimates of
(i) the ultimate resolution of the disputes and
(ii) future service cancellations. The allowance for
service credits and bad debts is calculated generally as a
percentage, based on historical trends, of balances that meet
certain criteria plus specific reserves for known disputes. As
stated above, revenues from financially distressed customers are
recognized when cash for the services to those customers is
collected but only after the collection of all previous
outstanding accounts receivable balances. Upon determining that
a customer is financially distressed, the Company establishes an
allowance, through a charge to bad debt expense, based on the
outstanding balance of such customer.
Accounts receivable consisted of the following:
| |
|
|
|
|
|
|
|
|
|
| |
|
December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
| |
|
| |
|
| |
|
Gross accounts receivable
|
|
$ |
31,607 |
|
|
$ |
33,402 |
|
|
Allowance for service credits
|
|
|
(1,405 |
) |
|
|
(2,124 |
) |
|
Allowance for bad debts
|
|
|
(161 |
) |
|
|
(2,750 |
) |
| |
|
|
|
|
|
|
| |
Accounts receivable, net
|
|
$ |
30,041 |
|
|
$ |
28,528 |
|
| |
|
|
|
|
|
|
The Company’s accounts receivable valuation accounts were
as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
Allowance for service credits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance at beginning of period
|
|
$ |
2,124 |
|
|
$ |
2,077 |
|
|
$ |
5,648 |
|
|
Provision
|
|
|
4,914 |
|
|
|
2,886 |
|
|
|
2,322 |
|
|
Write-offs
|
|
|
(5,136 |
) |
|
|
(1,557 |
) |
|
|
(3,748 |
) |
|
Recoveries
|
|
|
(497 |
) |
|
|
(1,282 |
) |
|
|
(2,145 |
) |
| |
|
|
|
|
|
|
|
|
|
|
Balance at end of period
|
|
$ |
1,405 |
|
|
$ |
2,124 |
|
|
$ |
2,077 |
|
| |
|
|
|
|
|
|
|
|
|
73
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
| |
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
Allowance for bad debts:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance at beginning of period
|
|
$ |
2,750 |
|
|
$ |
3,311 |
|
|
$ |
2,835 |
|
|
Provision
|
|
|
487 |
|
|
|
275 |
|
|
|
3,812 |
|
|
Write-offs
|
|
|
(1,051 |
) |
|
|
(462 |
) |
|
|
(2,652 |
) |
|
Recoveries
|
|
|
(2,025 |
) |
|
|
(374 |
) |
|
|
(684 |
) |
| |
|
|
|
|
|
|
|
|
|
|
Balance at end of period
|
|
$ |
161 |
|
|
$ |
2,750 |
|
|
$ |
3,311 |
|
| |
|
|
|
|
|
|
|
|
|
The Company had over 390 wholesale customers as of
December 31, 2004. For the years ended December 31,
2004, 2003 and 2002, the Company’s 30 largest wholesale
customers in each such year collectively comprised 93.4%, 93.3%
and 93.3% of the Company’s total wholesale net revenues,
respectively, and 67.4%, 71.6% and 79.5% of the Company’s
total net revenues, respectively. As of December 31, 2004
and 2003, receivables from these customers collectively
comprised 65.1% and 70.3%, respectively, of the Company’s
gross accounts receivable balance.
Two of the Company’s wholesale customers, Earthlink, Inc.
and AT&T Corp., accounted for 16.9% and 13.8%, 21.5% and
12.5%, and for 20.0% and 10.4% of the Company’s total net
revenues for the years ended December 31, 2004, 2003 and
2002, respectively. Accounts receivable from these customers
totaled 17.9% and 20.9%, and 20.9% and 17.1% of the
Company’s gross accounts receivables as of
December 31, 2004 and 2003, respectively. No other
individual customer accounted for more than 10% of the
Company’s total net revenues in 2004, 2003 and 2002.
|
|
|
Wholesaler Financial Difficulties |
During the years ended December 31, 2004, 2003 and 2002,
the Company issued billings to its financially distressed
customers aggregating $3,517, $5,139 and $42,881, respectively,
that were not recognized as revenues or accounts receivable in
the accompanying consolidated financial statements at the time
of such billings. However, in accordance with the revenue
recognition policy described above, the Company recognized
revenues from certain of these customers when cash was collected
aggregating $2,823, $4,367 and $47,609 during the years ended
December 31, 2004, 2003 and 2002, respectively. Revenues
from customers that filed for bankruptcy accounted for
approximately 0.3%, 1.3% and 5.6% of the Company’s total
net revenues for the years ended December 31, 2004, 2003
and 2002, respectively. The Company had contractual receivables
from its financially distressed customers totaling $1,317 and
$1,093 as of December 31, 2004 and 2003, respectively,
which are not reflected in the accompanying consolidated balance
sheet as of such date. Although MCI filed for bankruptcy
protection on July 21, 2002, the Company continued to
recognize revenues from MCI on an accrual basis during 2002,
2003 and 2004 (MCI emerged from bankruptcy in April 2004) based
on its specific facts and circumstances in relation to the
revenue recognition criteria described above. Consequently, the
amounts in this paragraph related to financially distressed
customers exclude amounts pertaining to MCI.
The Company has obtained persuasive evidence indicating that the
financial condition of one of its customers, which was
designated as financially distressed in 2000, improved
significantly during the year ended December 31, 2002,
principally as a result of a capital infusion during this
period. Consequently, the Company concluded that collection of
its billings to this customer was now reasonably assured.
Therefore, the Company resumed the recognition of revenues from
this customer on an accrual basis during 2002, which resulted in
the recognition of revenues in the amount of approximately
$1,542 that relate to services rendered in periods ended prior
to January 1, 2002. Similarly, the Company resumed the
recognition of revenue on an
74
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
accrual basis for another wholesale customer during 2002. The
Company did not, however, recognize additional revenue from
services rendered in prior periods because this customer was
current in its payments. No similar amounts were recognized
during the other periods reported in the accompanying
consolidated financial statements.
The Company has identified certain of its customers who were
essentially current in their payments for the Company’s
services prior to December 31, 2004, or have subsequently
paid all or significant portions of the respective amounts that
the Company recorded as accounts receivable as of
December 31, 2004, that the Company believes may be at risk
of becoming financially distressed. Revenues from these
customers accounted for approximately 7.7%, 11.6% and 34.6% of
the Company’s total net revenues for the years ended
December 31, 2004, 2003 and 2002, respectively. As of
December 31, 2004, receivables from these customers
comprised 8.8% of the Company’s gross accounts receivable
balance. If these customers are unable to demonstrate their
ability to pay for the Company’s services in a timely
manner in periods ending subsequent to 2004, revenue from such
customers will only be recognized when cash is collected, as
described above.
The Company reduced its workforce by approximately 77 and 113
employees, which represented approximately 6.9% and 10.2% of the
Company’s workforce during the years ended
December 31, 2004 and 2003, respectively. The reductions
covered employees in the areas of sales and marketing,
operations and corporate functions. In connection with the
reductions in force, the Company recorded a charge to operations
for the years ended December 31, 2004 and 2003 of $1,409,
of which $426 was paid after December 31, 2004, and $1,235,
respectively, relating to employee severance benefits, all of
which was paid during the year ended December 31, 2004 and
2003. The expenses associated with these reductions in force
were $374 and $103 related to the Company’s Wholesale
segment, and $281 and $349 related to the Company’s Direct
segment. The remaining $754 and $783 in expenses associated with
these reductions in force were related to the Company’s
Corporate Operations for the years ended December 31, 2004
and 2003, respectively. Management continues to evaluate whether
additional restructuring is necessary, and the Company may incur
additional charges to operations related to any further
restructuring activities in future periods.
|
|
|
Other Restructuring Activities |
On September 22, 2000, the Company acquired BlueStar
Communications Group, Inc. and its subsidiaries (collectively
“BlueStar”), in a transaction accounted for as a
purchase. BlueStar, a wholly owned subsidiary of the Company,
provided broadband communications and Internet services to small
and medium sized businesses. Continued losses at BlueStar,
caused the Company’s board of directors to decide, on
June 22, 2001, to cease the Company’s funding of
BlueStar’s operations.
On June 25, 2001, BlueStar made an irrevocable assignment
for the benefit of creditors (“ABC”) of all its assets
to an independent trustee (the “Assignee”) in the
State of Tennessee. An ABC under Tennessee law is a non-judicial
alternative to a plan of liquidation under Chapter 7 of the
Bankruptcy Code. As a result of the ABC, BlueStar’s former
assets are no longer controlled by BlueStar or the Company and
cannot be used by either BlueStar’s or the Company’s
boards of directors to satisfy the liabilities of BlueStar.
Consequently, the liquidation of BlueStar’s assets and the
settlement of its liabilities are currently under the sole
control of the Assignee and the control of BlueStar’s
assets no longer rests with the Company. Consequently, the
Company deconsolidated BlueStar effective June 25, 2001,
which resulted in the recognition of a deferred gain in the
amount of $55,200 in the Company’s consolidated balance
sheet as of December 31, 2001. Such deferred gain
represented the difference between the carrying values of
BlueStar’s assets (aggregating $7,900) and liabilities
(aggregating $63,100) as of June 25, 2001. During 2003 and
2002, the deferred gain was reduced by $9 and $1,228,
respectively, because certain BlueStar assets were inadvertently
not deconsolidated on June 25, 2001.
75
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Therefore, the deconsolidation of BlueStar resulted in a
deferred gain balance of $53,963 in the Company’s
consolidated balance sheets as of December 31, 2004 and
2003. The Company determined that the entire amount of the
deferred gain will be recognized, as an element of other income
(expense), upon the completion, evidenced by an order from the
Tennessee state court, of the liquidation of BlueStar’s
assets by the Assignee in the ABC.
|
|
| 4. |
Property and Equipment |
Property and equipment consisted of the following:
| |
|
|
|
|
|
|
|
|
|
| |
|
December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
| |
|
| |
|
| |
|
Leasehold improvements
|
|
$ |
10,239 |
|
|
$ |
10,339 |
|
|
Computer equipment
|
|
|
53,045 |
|
|
|
48,801 |
|
|
Computer software
|
|
|
47,291 |
|
|
|
33,912 |
|
|
Furniture and fixtures
|
|
|
17,303 |
|
|
|
17,515 |
|
|
Network and communication equipment
|
|
|
380,559 |
|
|
|
362,910 |
|
| |
|
|
|
|
|
|
| |
|
|
508,437 |
|
|
|
473,477 |
|
|
Less accumulated depreciation and amortization
|
|
|
429,730 |
|
|
|
379,198 |
|
| |
|
|
|
|
|
|
| |
Property and equipment, net
|
|
$ |
78,707 |
|
|
$ |
94,279 |
|
| |
|
|
|
|
|
|
In June 2002, the Company completed the sale of its property
(consisting of land, a building and certain improvements) in
Manassas, Virginia, and recognized a gain of $133 which
represents the net proceeds of $13,334 less the aggregate
carrying value of $13,201.
|
|
| 5. |
Collocation Fees and Other Intangibles |
Collocation fees and other intangibles consisted of the
following:
| |
|
|
|
|
|
|
|
|
|
| |
|
December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
| |
|
| |
|
| |
|
Collocation fees
|
|
$ |
93,665 |
|
|
$ |
86,796 |
|
|
Customer lists and other intangibles
|
|
|
10,470 |
|
|
|
3,750 |
|
| |
|
|
|
|
|
|
| |
|
|
104,135 |
|
|
|
90,546 |
|
|
Less accumulated amortization
|
|
|
69,574 |
|
|
|
49,698 |
|
| |
|
|
|
|
|
|
| |
Collocation fees and other intangibles, net
|
|
$ |
34,561 |
|
|
$ |
40,848 |
|
| |
|
|
|
|
|
|
6. Business
Acquisition, Asset Acquisitions and Equity Investments
|
|
|
Acquisition of InternetConnect Assets |
On January 3, 2002, the Company purchased substantially all
of the assets of InternetConnect, a related party (Note 1),
in an auction supervised by the United States Bankruptcy Court
for the Central District of California. The purchase price for
these assets was $5,470 in cash, $235 of which had been
deposited with InternetConnect’s agent prior to
January 1, 2002. Under the terms of the asset purchase
agreement, the Company may be required to pay additional cash of
up to $1,880, depending upon the outcome of a previous
post-petition bankruptcy claim filed against InternetConnect by
the Company, which is still pending before the court. The
Company did not assume any liabilities or obligations of
InternetConnect or hire any of
76
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
InternetConnect’s employees. In addition, the Company does
not believe the assets acquired from InternetConnect constitute
a self-sustaining, integrated set of activities and assets that
would constitute a business.
The tangible assets of InternetConnect purchased by the Company
consisted of accounts receivable, refundable deposits and
property and equipment. The Company also purchased the right,
but not the obligation, to assume InternetConnect’s
customer contracts. However, the Company did not exercise this
right. Instead, the Company solicited the approximately 9,250
DSL, T-1, virtual private network (“VPN”) and dial-up
customers of InternetConnect, and approximately 6,200 of such
customers executed new contracts with the Company or its
resellers subsequent to January 3, 2002.
The Company has allocated the aforementioned purchase price
based on the estimated fair values of the elements of this
transaction as of January 3, 2002, as follows:
| |
|
|
|
|
|
|
Accounts receivable
|
|
$ |
1,386 |
|
|
Refundable deposits
|
|
|
349 |
|
|
Property and equipment
|
|
|
61 |
|
|
Customer acquisition costs
|
|
|
3,674 |
|
| |
|
|
|
| |
Total purchase price
|
|
$ |
5,470 |
|
| |
|
|
|
The customer acquisition costs of $3,674 described above were
charged to cost of sales for the year ended December 31,
2002 based on the Company’s accounting policy for costs of
this nature that are not accompanied by up-front fees
(Note 2).
|
|
|
Acquisition of Qwest Customer List |
On June 5, 2003, the Company purchased a customer list from
Qwest Communications Corporation and Qwest Interprise America,
Inc. (collectively, “Qwest”) pertaining to
approximately 23,000 DSL subscribers who were not located in the
states where Qwest provides local telephone services
(substantially all of whom were not, indirectly, end-user
customers of the Company as of June 5, 2003 under the
then-existing wholesale DSL services agreement with Qwest). In
exchange for the customer list, the Company paid $3,750 in cash
and released Qwest from its obligations under the wholesale DSL
services agreement. In addition, the Company agreed to pay Qwest
an additional amount of up to $1,250 if certain numbers of these
customers migrate to the Company’s network within a defined
period, which has now elapsed. The additional level of
successful migrations was not achieved and, consequently, the
Company was not required to pay such additional amount to Qwest.
The Company did not assume any liabilities or obligations of
Qwest or hire any of Qwest’s employees. In addition, the
Company does not believe the customer list acquired from Qwest
constitutes a self-sustaining, integrated set of activities and
assets that would constitute a business. Approximately 13,000 of
these customers were migrated to the Company’s network as
of December 31, 2003.
The Company recorded the $3,750 cash payment to Qwest for the
customer list as an intangible asset, and such intangible asset
is being amortized on a straight-line basis to operations over a
twenty-four month period, which is the Company’s estimate
of the aggregate expected term of its customer relationships.
|
|
|
Acquisition of GoBeam, Inc. |
On June 8, 2004, the Company completed its acquisition of
all of the outstanding shares of privately-held GoBeam, a
Delaware corporation based in Pleasanton, California, that
provides VoIP solutions to small and medium-sized businesses.
The Company acquired GoBeam to accelerate its plan to enter the
VoIP market. As a result of the acquisition, the Company has
added a VoIP offering to its current portfolio of products and
services. In addition, the Company also plans to realize certain
costs synergies and strategic value from combining the two
enterprises. These factors contributed to a purchase price that
was in excess of the fair
77
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
value of GoBeam’s net tangible and intangible assets
acquired and, as a result, the Company recorded goodwill in
connection with this transaction. The acquisition was
effectuated by merging a wholly-owned subsidiary of the Company
with and into GoBeam, with GoBeam surviving the merger as a
wholly-owned subsidiary of the Company. The merger is intended
to qualify as a tax-free reorganization.
As a result of the merger, the Company issued 18,724 shares
of its common stock. Additionally, the Company has reserved
266 shares to cover shares issuable upon exercise of
assumed GoBeam stock options and 3 shares to cover assumed
warrants. Of the shares issued in conjunction with the merger,
2,216 shares have been placed in an escrow account until
August 2005 to cover GoBeam’s indemnification obligations
under the merger agreement.
The Company accounted for the acquisition of GoBeam using the
purchase method of accounting. Accordingly, the Company’s
condensed consolidated financial statements include the results
of operations of GoBeam for periods ending after the date of
acquisition. The Company valued the common share options and
warrants issued, for accounting purposes, based on an average
market price of $2.08 per share, which is based on the
average closing price for a range of two trading days before and
after the measurement date of the transaction, June 4,
2004. The outstanding GoBeam stock options were converted into
options to purchase approximately 266 shares of the
Company’s common stock. In addition, the outstanding GoBeam
warrants were converted into warrants to purchase 3 shares
of the Company’s common stock. The value of the options and
warrants was determined using the Black-Scholes option pricing
model with inputs of 1.284 for volatility, four-year expected
life and a risk-free interest rate of 3.27%. The values of the
options and assumed warrants, as well as direct acquisition
costs, were included as elements of the total purchase cost.
The total purchase cost of the GoBeam acquisition has been
allocated to the assets and liabilities of GoBeam based upon
estimates of their fair values. The following tables set forth
the total purchase cost and the allocation thereof:
| |
|
|
|
|
|
|
|
|
Total purchase cost:
|
|
|
|
|
| |
Value of common shares issued
|
|
$ |
38,910 |
|
| |
Value of assumed GoBeam options and warrants
|
|
|
454 |
|
| |
|
|
|
| |
|
|
39,364 |
|
|
Acquisition costs
|
|
|
473 |
|
| |
|
|
|
| |
|
Total purchase cost
|
|
$ |
39,837 |
|
| |
|
|
|
|
Purchase price allocation:
|
|
|
|
|
| |
Tangible net liabilities acquired
|
|
$ |
(4,479 |
) |
| |
Intangible assets acquired:
|
|
|
|
|
| |
|
Customer relationships
|
|
|
6,600 |
|
| |
|
Internal use software
|
|
|
1,090 |
|
| |
|
Goodwill
|
|
|
36,626 |
|
| |
|
|
|
| |
|
|
Total purchase consideration
|
|
$ |
39,837 |
|
| |
|
|
|
The tangible assets of GoBeam acquired by the Company
aggregating $1,723 consisted principally of cash, accounts
receivable and property and equipment. The liabilities of GoBeam
assumed by the Company aggregating $6,202 consisted principally
of accounts payable and accrued expenses.
The customer relationships were valued using an income approach,
which projects the associated revenue, expenses and cash flows
attributable to the customer base. These cash flows are then
discounted to their present value. Through December 31,
2004, this intangible asset was being amortized on a
straight-line basis over a period of forty-eight months which
represents the expected life of the customer relationships.
78
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The internal use software was valued using the replacement cost
approach. This approach estimates value based upon estimated
cost to recreate the software with equivalent functionality.
Through December 31, 2004, this intangible asset was being
amortized on a straight-line basis over a period of sixty months.
Goodwill was determined based on the residual difference between
the purchase cost and the values assigned to identified tangible
and intangible assets and liabilities, and is not deductible for
tax purposes. The Company will test for impairment of these
assets on at least an annual basis.
The following unaudited pro forma financial information presents
the consolidated results of operations of the Company as if the
acquisition of GoBeam had occurred at the beginning of the
periods presented. For the years ended December 31, 2004,
net loss included GoBeam merger expenses of $4,247 (none in 2003
and 2002). For the year ended December 31, 2003, net loss
included a charge of $1,848 for cost associated with the exit of
a real estate property lease (none in 2004 and 2002). This
financial information does not purport to be indicative of the
results of the operations that would have occurred had the
acquisition been made at the beginning of the periods presented,
or the results that may occur in the future:
| |
|
|
|
|
|
|
|
|
| |
|
Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
| |
|
| |
|
| |
|
Revenue
|
|
$ |
432,148 |
|
|
$ |
393,257 |
|
|
Net loss
|
|
$ |
(68,331 |
) |
|
$ |
(124,538 |
) |
|
Basic and diluted net loss per share
|
|
$ |
(0.27 |
) |
|
$ |
(0.51 |
) |
Upon closing of the acquisition of GoBeam, the Company
effectively granted 337 shares of restricted common stock
to certain employees of GoBeam. The restricted stock was valued
on the date of issuance at $1.96 and vested over a period of two
years. Accordingly the Company recorded deferred stock-based
compensation of $660 during the year ended December 31,
2004. During the three months ended September 30, 2004, as
a result of the resignation of one of the Company’s
executives, the Company reversed $289 of such deferred
stock-based compensation and cancelled 148 shares of the
restricted common stock. The remaining net deferred stock-based
compensation balance of $371 at December 31, 2004 is being
amortized on an accelerated basis over the vesting period
consisted with the method described in FIN 28. For the year
ended December 31, 2004, the Company recognized $181 of
stock-based compensation related to such amount. The remaining
$190 will be amortized over the next seventeen months.
As part of the acquisition of GoBeam the Company sold
834 shares for $1,781, or $2.13 per share, to pay for
GoBeam’s merger expenses.
|
|
|
Unconsolidated Investments in Affiliates |
The following table lists the Company’s unconsolidated
investments in affiliates as of December 31, 2004 and 2003:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
|
|
|
|
|
|
Investment | |
| |
|
|
|
Ownership | |
|
|
|
Carrying | |
| |
|
|
|
Percentage | |
|
|
|
Value | |
| |
|
|
|
| |
|
Method of | |
|
| |
| Entity Name |
|
Date of Investment(s) |
|
2004 | |
|
2003 | |
|
Accounting | |
|
2004 | |
|
2003 | |
| |
|
|
|
| |
|
| |
|
| |
|
| |
|
| |
|
ACCA Networks Co., Ltd.
|
|
August 2000 |
|
|
10% |
|
|
|
10% |
|
|
|
Equity |
|
|
|
— |
|
|
|
— |
|
|
Certive Corporation
|
|
November 1999; May 2000 |
|
|
2% |
|
|
|
5% |
|
|
|
Equity |
|
|
|
— |
|
|
|
— |
|
In August 2000, the Company acquired a 42% preferred equity
interest in ACCA Networks Co., Ltd. (“ACCA”), a
privately held, Japanese telecommunications company, in exchange
for cash payments aggregating approximately $11,700, which the
Company believes is representative of the fair value of such
79
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
investment based on significant concurrent investments in ACCA
made by new, non-strategic investors. The difference between the
cost of the Company’ equity investment in ACCA and its
proportional share of ACCA’s net assets had been fully
amortized as of December 31, 2001. As of December 31,
2004, the Company’s equity interest in ACCA was diluted to
approximately 10% due to ACCA’s financings in 2002 and
2001. In March 2005, ACCA completed a public offering of its
shares in Japan, which further diluted the Company’s equity
interest to approximately 8%.
In addition, in August 2000, the Company also licensed its OSS
software to ACCA for $9,000, of which $2,000 and $2,000 was
received in cash during 2001 and 2000, respectively. The
remainder of $5,000, which was scheduled to be received in 2005,
was received in December 2003 in accordance with an amendment to
the August 2000 OSS software license agreement. The Company
recorded the $5,000 payment received in December 2003 as
miscellaneous income, because the carrying value of the OSS
software licensed to ACCA was fully recovered at that time. The
Company may also receive certain on-going royalty payments from
ACCA under terms of the amended OSS license agreement. Such
payments amounted to $2,124, $2,345 and $814 during the years
ended December 31, 2004, 2003 and 2002, respectively. As
stated above, the OSS software licensed to ACCA had a net book
value of zero at December 31, 2004. Beginning in 2004, the
Company records royalty payments as other revenue.
As of December 31, 2004 and 2003, the Company held a 2% and
5%, respectively, preferred equity interest in Certive
Corporation (“Certive”), a privately held, development
stage application service provider. The dilution of the
Company’s equity interest in Certive resulted from
Certive’s additional equity financing in 2004. As stated in
Note 1, the Company’s chairman is also the chairman
and a principal stockholder of Certive. During 2003, the Company
determined that its investment in Certive was impaired due to
Certive’s financial condition and market prospects.
Accordingly, the Company wrote-off the remaining carrying value
of its investment through a charge to operations of $747 in 2003.
On March 10, 2004, the Company completed a private
placement of $125,000 in aggregate principal amount of
3% Convertible Senior Debentures (“Debentures”)
due 2024, which are convertible into shares of the
Company’s common stock at a conversion price of
approximately $3.1742 per share, subject to certain
adjustments. The Debentures mature on March 15, 2024. The
Company may redeem some or all of the Debentures for cash at any
time on or after March 20, 2009. Holders of the Debentures
have the option to require the Company to purchase the
Debentures in cash, in whole or in part, on March 15, 2009,
2014 and 2019. The holders of the Debentures will also have the
ability to require the Company to purchase the Debentures in the
event that the Company undergoes a change in control. In each
case, the redemption or purchase price would be at 100% of their
principal amount, plus accrued and unpaid interest thereon. Net
proceeds from the Debentures were approximately $119,961 after
commission and other transaction costs. The Company incurred
approximately $5,039 in transaction costs in conjunction with
the placement of the Debentures. The debt issuance costs are
being amortized to operations over sixty months, the period
through to the first date that holders have the option to
require the Company to purchase the Debentures.
Under a registration rights agreement that the Company entered
into in connection with the private placement of the Debentures,
the Company agreed to file a registration statement on
Form S-3 to register the resale of the Debentures and the
common stock issuable upon conversion of the Debentures, by
June 8, 2004, and to use reasonable best efforts to have it
declared effective by October 6, 2004. If the registration
statement was not declared effective by October 6, 2004,
the Company was required to pay interest penalties until the
earlier of the date in which the registration statement is
declared effective or the date in which the registration
statement is no longer required to be kept effective. Since the
registration statement was not declared effective
80
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
by this date, the Company must pay an interest penalty that
accrues at a rate equal to 0.25% per year of the aggregate
principal amount of the Debentures until January 4, 2005.
If the registration statement is not declared effective by
January 4, 2005, the interest penalties will increase and
accrue at a rate equal to 0.50% per year of the aggregate
principal amount of the Debentures. The Company’s
registration statement became effective on December 13,
2004.
On March 11, 2004, the Company used a portion of the net
proceeds of the offering to repay its 11% note payable to
SBC. The payment amounted to $56,569, which included $50,000 of
principal and $6,569 of accrued interest.
As of December 31, 2003, the Company’s long-term debt
consisted of a $50,000 principal amount term note payable to
SBC, as described below.
Immediately prior to Covad’s emergence from Chapter 11
bankruptcy on December 20, 2001, the Company’s new
agreements with SBC became effective. One such agreement (the
“Credit Agreement”) involved a term note payable that
was collateralized by substantially all of the Company’s
domestic assets. This note bore interest at 11%, which was
payable quarterly beginning in December 2003. The entire unpaid
principal balance was payable in December 2005. The Company paid
off the note in full on March 11, 2004.
As of December 31, 2004 and 2003, the Company had a $3,000
revolving line of credit with a bank that is available through
May 2005. At the Company’s option, borrowings under this
credit facility bear interest at certain fixed or variable
rates. As of December 31, 2004 and 2003, the Company had
issued irrevocable letters of credit aggregating $2,533 and
$2,583, respectively, under this line of credit in favor of
lessors of equipment and facilities.
The capitalized costs and accumulated amortization related to
assets under capital leases, primarily comprised of computer
equipment and office equipment, were $1,120 and $386,
respectively, as of December 31, 2004 (the corresponding
amounts were $165 and $165, respectively, as of
December 31, 2003).
|
|
| 9. |
Operating Leases and Purchase Obligations |
The Company leases vehicles, equipment and office space under
various non-cancelable operating leases. The facility leases
generally require the Company to pay operating costs, including
property taxes, insurance and maintenance, and contain scheduled
rent increases and certain other rent escalation clauses. The
Company recognizes rent expense on a straight-line basis over
the terms of the respective leases. Future
81
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
minimum lease payments by year under operating leases with
non-cancelable terms in excess of one year, along with future
minimum payments to be received under non-cancelable subleases,
are as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Gross Lease | |
|
Less Sublease | |
|
Net Lease | |
| |
|
Payments | |
|
Payments | |
|
Payments | |
| |
|
| |
|
| |
|
| |
|
Year ending December 31,
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
2005
|
|
$ |
4,385 |
|
|
$ |
47 |
|
|
$ |
4,338 |
|
| |
2006
|
|
|
3,460 |
|
|
|
31 |
|
|
|
3,429 |
|
| |
2007
|
|
|
2,635 |
|
|
|
13 |
|
|
|
2,622 |
|
| |
2008
|
|
|
2,182 |
|
|
|
— |
|
|
|
2,182 |
|
| |
2009
|
|
|
736 |
|
|
|
— |
|
|
|
736 |
|
| |
Thereafter
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
| |
|
|
|
|
|
|
|
|
|
| |
|
Total
|
|
$ |
13,398 |
|
|
$ |
91 |
|
|
$ |
13,307 |
|
| |
|
|
|
|
|
|
|
|
|
Rent expense, which is net of sublease income of $501, $533 and
$402 in 2004, 2003 and 2002, respectively, totaled $6,571,
$7,874 and $8,710 for the years ended December 31, 2004,
2003 and 2002, respectively.
In 2002, the Company entered into a three-year, non-exclusive
agreement with MCI, for the right to provide certain network
services to the Company. The Company has a monthly minimum usage
requirement which began in June 2002. The agreement expires in
May 2005 and the Company has a minimum remaining aggregate
purchase obligation of approximately $3,350 as of
December 31, 2004. Similarly, in 2002, the Company entered
into a three-year, non-exclusive agreement with AT&T for the
right to provide certain data services to the Company. The
Company has an annual minimum usage requirement which began in
January 2002. The agreement expired in December 2004. In
addition, in 2002, the Company entered into a four-year,
non-exclusive agreement with AT&T for the right to provide
long distance services to the Company. The Company has an annual
minimum usage requirement which began in April 2002. The
agreement expires in March 2006 and the Company has a minimum
remaining aggregate usage commitment of approximately $1,406 as
of December 31, 2004.
Aggregate payments by year for the Company’s purchase
obligations are as follows:
| |
|
|
|
|
|
|
|
Year ending December 31,
|
|
|
|
|
| |
2005
|
|
$ |
4,475 |
|
| |
2006
|
|
|
281 |
|
| |
|
|
|
| |
|
Total
|
|
$ |
4,756 |
|
| |
|
|
|
Cost of sales recognized pursuant to the aforementioned purchase
obligations totaled $8,000 and $1,292, respectively, for the
years ended December 31, 2004 and 2003. No similar amounts
for these purchase obligations were recorded during 2002.
On December 13, 2001, the United States Bankruptcy Court
for the District of Delaware (the “Bankruptcy Court”)
entered an order confirming the Company’s pre-negotiated
First Amended Plan of Reorganization as modified on
November 26, 2001 (the “Plan”). On
December 20, 2001 (the “Effective
82
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Date”), the Plan was consummated and the Company emerged
from bankruptcy. Under the Plan, the Company settled several
claims against it. These claims include:
|
|
|
| |
• |
the class action lawsuits filed in the United States District
Court for the Northern District of California. This settlement
is described in more detail below; |
| |
| |
• |
the lawsuits filed in the Superior Court of the State of
California for the County of Santa Clara by six purchasers
of the convertible notes that the Company issued in September
2000; |
| |
| |
• |
disputed claims made by former shareholders of Laser Link.net,
Inc.; and |
| |
| |
• |
disputed claims made by GE Capital and its subsidiary, Heller
Financial Group |
As of December 31, 2004 and 2003, there were approximately
$71 and $8,341, respectively, in unresolved claims related to
the Company’s Chapter 11 bankruptcy proceedings. As of
December 31, 2004 and 2003, the Company had recorded $71
and $7,378, respectively, for these unresolved claims in its
consolidated balance sheets. However, it is reasonably possible
that the Company’s unresolved Chapter 11 bankruptcy
claims could ultimately be settled for amounts that differ from
the amounts recorded in the Company’s consolidated balance
sheets.
In April 1999, the Company filed a lawsuit against Bell Atlantic
(now Verizon) and its affiliates in the United States District
Court for the District of Columbia. The Company is pursuing
antitrust and other claims in this lawsuit arising out of
Verizon’s conduct as a supplier of network facilities,
including central office space, transmission facilities and
telephone lines. In December 2000, the Company also filed a
lawsuit against BellSouth Telecommunications and its
subsidiaries in the United States District Court for the
Northern District of Georgia. The Company is pursuing claims in
this lawsuit that are similar to its claims against Verizon.
Both courts dismissed some of the Company’s claims based on
the ruling of the Seventh Circuit in Goldwasser v.
Ameritech. The court in the Verizon case also dismissed the
Company’s remaining claims on other grounds. The Company
voluntarily dismissed its remaining claims in the BellSouth case
so it could pursue certain issues on appeal. The Company
appealed these decisions to the United States Court of Appeals
for the Eleventh Circuit and the United States Court of Appeals
for the District of Columbia. On August 2, 2002, the
Eleventh Circuit Court of Appeals reversed the lower
court’s decision in the BellSouth case and remanded the
case for further proceedings. BellSouth appealed this decision
to the United States Supreme Court. On January 20, 2004,
the United States Supreme Court reversed a decision entitled
Verizon Communications v. Law Offices of Curtis Trinko,
which rejected the Goldwasser decision. The Supreme Court also
vacated the Eleventh Circuit’s decision in the
Company’s case against BellSouth and remanded the case to
the Eleventh Circuit for review in light of the Trinko decision.
Although the Company believes the Trinko decision does not
impact these cases, both BellSouth and Verizon claim that Trinko
supports the dismissal of the Company’s lawsuits. On
June 25, 2004, the Eleventh Circuit reversed portions of
the lower court’s decision in the BellSouth case and
remanded that case for further proceedings. On November 24,
2004, the Company requested that the United States Supreme Court
review certain portions of the Eleventh Circuit’s decision
unrelated to the Company’s antitrust claims. The Supreme
Court denied the Company’s request. The Court of Appeals
for the District of Columbia also recently reversed in part and
affirmed in part the District Court’s decision and remanded
the Company’s case against Verizon to the District Court
for further proceedings. The Company cannot predict the outcome
of these proceedings at this time.
On June 11, 2001, Verizon filed a lawsuit against the
Company in the United States District Court for the Northern
District of California. Verizon is a supplier of telephone lines
that the Company uses to provide services to its customers. In
its amended complaint, Verizon claims that the Company falsified
trouble ticket reports with respect to the telephone lines that
the Company ordered and seeks unspecified monetary damages
(characterized as being in the “millions”) and
injunctive relief. The current complaint asserts causes of
action for negligent and intentional misrepresentation and
violations of California’s unfair competition statute. On
November 13, 2002, the District Court entered summary
judgment in favor of the Company and dismissed
83
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Verizon’s claims against the Company in their entirety.
Verizon appealed the dismissal of its lawsuit and in July 2004
the Ninth Circuit Court of Appeals partially reversed the
District Court’s decision and indicated that Verizon could
attempt to pursue a claim against the Company for breach of
contract. The matter has been sent back to the District Court
for further proceedings. The Company believes it has strong
defenses to this lawsuit, but litigation is inherently
unpredictable and there is no guarantee it will prevail.
Several stockholders have filed complaints in the United States
District Court for the Southern District of New York, on behalf
of themselves and purported classes of stockholders, against the
Company and several former and current officers and directors in
addition to some of the underwriters who handled the
Company’s stock offerings. These lawsuits are so-called IPO
allocation cases, challenging practices allegedly used by
certain underwriters of public equity offerings during the late
1990s and 2000. On April 19, 2002, the plaintiffs amended
their complaint and removed the Company as a defendant. Certain
directors and officers are still named in the complaint. The
plaintiffs claim that the Company and others failed to disclose
the arrangements that some of these underwriters purportedly
made with certain investors. The plaintiffs and the issuer
defendants have reached a tentative agreement to settle the
matter, and the Company believes the tentative settlement will
not have a material adverse effect on its consolidated financial
position or results of operations. That settlement, however, has
not been finalized. If the settlement is not finalized, the
Company believes it has strong defenses to these lawsuits and
intends to contest them vigorously. However, litigation is
inherently unpredictable and there is no guarantee that the
Company will prevail.
In June 2002, Dhruv Khanna was relieved of his duties as the
Company’s General Counsel and Secretary. Shortly
thereafter, Mr. Khanna alleged that, over a period of
years, certain current and former directors and officers had
breached their fiduciary duties to the Company by engaging in or
approving actions that constituted waste and self-dealing, that
certain current and former directors and officers had provided
false representations to the Company’s auditors and that he
had been relieved of his duties in retaliation for his being a
purported whistleblower and because of racial or national origin
discrimination. He threatened to file a shareholder derivative
action against those current and former directors and officers,
as well as a wrongful termination lawsuit. Mr. Khanna was
placed on paid leave while his allegations were being
investigated.
The Company’s Board of Directors appointed a special
investigative committee, which initially consisted of Dale
Crandall and Hellene Runtagh, to investigate the allegations
made by Mr. Khanna. Richard Jalkut was appointed to this
committee shortly after he joined the Company’s Board of
Directors. This committee retained an independent law firm to
assist in its investigation. Based on this investigation, the
committee concluded that Mr. Khanna’s allegations were
without merit and that it would not be in the best interests of
the Company to commence litigation based on these allegations.
The committee considered, among other things, that many of
Mr. Khanna’s allegations were not accurate, that
certain allegations challenged business decisions lawfully made
by management or the Board, that the transactions challenged by
Mr. Khanna in which any director had an interest were
approved by a majority of disinterested directors in accordance
with Delaware law, that the challenged director and officer
representations to the auditors were true and accurate, and that
Mr. Khanna was not relieved of his duties as a result of
retaliation for alleged whistleblowing or racial or national
origin discrimination. Mr. Khanna has disputed the
committee’s work and the outcome of its investigation.
After the committee’s findings had been presented and
analyzed, the Company concluded in January 2003 that it would
not be appropriate to continue Mr. Khanna on paid leave
status, and determined that there was no suitable role for him
at the Company. Accordingly, he was terminated as an employee of
the Company.
Based on the events mentioned above, in September 2003,
Mr. Khanna filed a purported class action and a derivative
lawsuit against the Company’s current and former directors
in the Court of Chancery of the State of Delaware in and for New
Castle County. On August 3, 2004, Mr. Khanna amended
his Complaint and two additional purported shareholders joined
the lawsuit. In this action the plaintiffs seek recovery on
behalf of the Company from the individual defendants for their
purported breach of fiduciary duty. The plaintiffs also seek
84
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
to invalidate the Company’s election of directors in 2002,
2003 and 2004 because they claim that the Company’s proxy
statements were misleading. On or about October 11, 2004
the Company filed a motion to dismiss the amended complaint in
its entirety and a motion to disqualify Mr. Khanna and the
additional plaintiffs as class representatives. The motions have
not yet been scheduled for hearing. The Company is unable to
predict the outcome of this lawsuit.
The Company is also a party to a variety of other pending or
threatened legal proceedings as either plaintiff or defendant,
or is engaged in business disputes that arise in the ordinary
course of business. Failure to resolve these various legal
disputes and controversies without excessive delay and cost and
in a manner that is favorable to the Company could significantly
harm its business. The Company does not believe the ultimate
outcome of these matters will have a material impact on its
consolidated financial position and results of operations.
However, litigation is inherently unpredictable and there is no
guarantee the Company will prevail or otherwise not be adversely
affected.
In September 2004 the Company reached a settlement in a legal
dispute. In connection with this settlement the Company received
a payment of approximately $1,600.
The Company is subject to state public utility commission, FCC
and other regulatory and court decisions as they relate to the
interpretation and implementation of the 1996 Telecommunications
Act. In addition, the Company is engaged in a variety of legal
negotiations, arbitrations and regulatory and court proceedings
with multiple telephone companies. These negotiations,
arbitrations and proceedings concern the telephone
companies’ denial of central office space, the cost and
delivery of transmission facilities and telephone lines and
central office spaces, and other operational issues. Other than
the payment of legal fees and expenses, which are not
quantifiable but are expected to be material, the Company does
not believe that these matters will result in material liability
to it and the potential gains are not quantifiable at this time.
An unfavorable result in any of these negotiations, arbitrations
and proceedings, however, could have a material adverse effect
on the Company’s consolidated financial position and
results of operations if it is denied or charged higher rates
for transmission lines or central office spaces.
Purchasers of the Company’s common stock and purchasers of
the convertible senior notes the Company issued in September
2000 filed complaints on behalf of themselves and alleged
classes of stockholders and holders of convertible notes against
the Company and certain present and former officers of the
Company in the United States District Court for the Northern
District of California (the “District Court”) alleging
violations of federal securities laws on behalf of persons who
purchased or otherwise acquired the Company’s securities,
including common stock and notes, during the period from
April 19, 2000 to May 24, 2001. In 2001, the Company
and the officer and director defendants agreed to settle the
litigation. The settlement provided for the distribution to the
plaintiffs of $16,500 in cash to be funded by the Company’s
insurance carriers and 6,495,844 shares of the
Company’s common stock. Consequently, the Company recorded
a liability of approximately $18,578 in its consolidated balance
sheet as of December 31, 2001 through a charge to
litigation-related expenses for the year then ended in
connection with this anticipated settlement. As a result of
changes in the fair market value of the Company’s common
stock, the Company decreased this liability to $6,950 as of
December 31, 2002 through a credit to litigation-related
expenses in the amount of $11,628 for the year ended
December 31, 2002. The settlement was subject to the
approval of the District Court and, on December 18, 2002,
the District Court issued its final judgment and dismissal
order. One class member subsequently filed an appeal pertaining
to the final judgment, but this appeal only related to the
allocation of the settlement proceeds between the plaintiffs and
their attorneys. On February 18, 2004, the Ninth Circuit
affirmed the District Court’s final judgment. Consequently,
on such date the Company considered the 6,495,844 shares
validly issued and outstanding. The distribution of the shares
was completed in April of 2004.
85
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
As of December 31, 2004, the Company had disputes with a
number of telecommunications companies concerning the balances
owed to such carriers for collocation fees and certain network
services. The Company believes that such disputes will be
resolved without a material adverse effect on its consolidated
financial position and results of operations. However, it is
reasonably possible that the Company’s estimates of its
collocation fee and network service obligations, as reflected in
the accompanying condensed consolidated balance sheets, could
change in the near term, and the effects could be material to
the Company’s consolidated financial position and results
of operations. In this regard, on February 26, 2002, the
Company executed a settlement agreement with Verizon involving
certain disputed collocation fee and network service
obligations. Under the terms of this settlement agreement,
(i) the Company was relieved of an accrued collocation fee
and network service obligation with a balance of $5,570, which
was recorded as a reduction of cost of sales during the fourth
quarter of 2001 and (ii) Verizon’s ultimate damage
award or settlement, if any, pursuant to the Company’s
antitrust lawsuit against Verizon will be reduced by
approximately $6,600. Furthermore, in May 2002, the Company
executed a settlement agreement with another of its
telecommunications company involving certain disputed network
service obligations. Under the terms of this settlement
agreement, the Company was relieved of a network service
obligation with a recorded balance of $6,018 through a
combination of a $468 payment and a $5,550 credit that reduced
cost of sales during the year ended December 31, 2002.
During 2003, the Company changed its estimates of certain
liabilities for collocation and network services as a result of
(i) the resolution of various billing disputes with its
vendors and (ii) the receipt of an invoice in December 2003
from a vendor for certain telecommunication services provided by
such vendor primarily in 2000 and 2001. During 2004, the Company
resolved approximately $1,900 related to the invoice received in
2003, which reduced the Company’s cost of sales, and is
currently disputing the remaining balance of $2,000.
The Company performs ongoing analysis of the applicability of
certain transaction-based taxes to (i) sales of its
products and services and (ii) purchases of
telecommunications circuits from various carriers. This analysis
includes discussions with authorities of significant
jurisdictions in which the Company does business to determine
the extent of its transaction-based tax liabilities. It is the
Company’s opinion that this analysis will be concluded
without a material adverse effect on its consolidated financial
position and results of operations. However, it is reasonably
possible that the Company’s estimates of its
transaction-based tax liabilities, as reflected in the
accompanying condensed consolidated balance sheets, could change
in the near term, and the effects could be material to the
Company’s consolidated financial position and results of
operations. During the year ended December 31, 2003, the
Company changed its estimates of certain accrued liabilities for
transaction-based and property taxes based on settlement
agreements reached with various states and local jurisdictions
where the Company does business. These changes in accounting
estimate reduced the Company’s net loss by $8,439 ($0.04
per share). No such changes in estimate were recognized during
the year ended December 31, 2002.
The Company is analyzing the applicability of employment-related
taxes for certain stock-based compensation provided to employees
in prior periods. Due to the probable applicability of these
taxes, the Company recorded an estimated liability through a
charge to operations in the amount of $5,931 during the year
ended December 31, 2003. During the year ended
December 31, 2004, the Company determined that it does not
owe a portion of this tax, approximately $3,079, and
consequently, released the amount as a benefit to the statement
of operations. It is the Company’s opinion that such
discussions will be concluded without a material adverse effect
on its consolidated financial position and results of
operations. However, it is reasonably possible that the
Company’s estimates of these tax liabilities, as reflected
in the accompanying condensed consolidated balance sheets as of
December 31, 2004, could change in the near term, and the
effects could be material to the Company’s consolidated
financial position and results of operations.
86
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
|
|
|
Indemnification Agreements |
From time to time, the Company enters into certain types of
contracts that contingently require it to indemnify various
parties against claims from third parties. These contracts
primarily relate to: (i) certain real estate leases, under
which the Company may be required to indemnify property owners
for environmental and other liabilities, and other claims
arising from the Company’s use of the applicable premises,
(ii) certain agreements with the Company’s officers,
directors and employees, under which the Company may be required
to indemnify such persons for liabilities arising out of their
employment relationship, (iii) contracts under which the
Company may be required to indemnify customers against
third-party claims that a Company product infringes a patent,
copyright or other intellectual property right and
(iv) procurement or license agreements under which the
Company may be required to indemnify licensors or vendors for
certain claims that may be brought against them arising from the
Company’s acts or omissions with respect to the supplied
products or technology.
Generally, a maximum obligation under these contracts is not
explicitly stated. Because the obligated amounts associated with
these types of agreements are not explicitly stated, the overall
maximum amount of the obligation cannot be reasonably estimated.
Historically, the Company has not been required to make payments
under these obligations, and no liabilities have, therefore,
been recorded for these obligations in the Company’s
consolidated balance sheets.
Effective December 20, 2001, immediately prior to
Covad’s emergence from Chapter 11 bankruptcy, the
Company entered into a series of agreements with SBC, including
(i) a $50,000 Credit Agreement, which since then has been
repaid, (ii) a 10-year resale agreement (the “Resale
Agreement”) under which SBC, its affiliates or special
agents will resell the Company’s DSL services. SBC made a
$75,000 noninterest-bearing prepayment, which is collateralized
by substantially of the Company’s domestic assets, to the
Company on December 20, 2001 under the terms of the Resale
Agreement, and (iii) a termination and mutual general
release agreement (the “Termination Agreement”) that
resulted in the cancellation of various agreements entered into
in September 2000, except for the stock purchase agreement and
an interconnection and line-sharing agreement that remains in
effect. The Company received a payment of $10,000 from SBC on
December 20, 2001 under the terms of the Termination
Agreement, which was deferred and is being recognized as revenue
on a straight-line basis over the 10-year term of the Resale
Agreement.
108 shares of the Company’s common stock outstanding
at December 31, 2004 (none in 2003) were subject to
repurchase provisions, which generally lapse over a two-year
period from the date of issuance.
Common stock reserved for future issuance as of
December 31, 2004 was as follows:
| |
|
|
|
|
|
|
Bankruptcy claims
|
|
|
583 |
|
|
Outstanding options
|
|
|
22,997 |
|
|
Options available for grant
|
|
|
11,683 |
|
|
Employee stock purchase plan
|
|
|
7,568 |
|
|
Convertible debentures
|
|
|
39,380 |
|
|
Outstanding warrants
|
|
|
6,514 |
|
| |
|
|
|
| |
Total
|
|
|
88,725 |
|
| |
|
|
|
87
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
|
|
|
Stockholder Protection Rights Plan |
On February 15, 2000, the Company’s board of directors
adopted a Stockholder Protection Rights Plan under which
stockholders received one right for each share of the
Company’s common stock or Class B common stock owned
by them. The rights become exercisable, in most circumstances,
upon the accumulation by a person or group of 15% or more of the
Company’s outstanding shares of common stock. Each right
entitles the holder to purchase from the Company, as provided by
the Stockholder Protection Rights Agreement, one one-thousandth
of a share of participating preferred stock, par value
$.001 per share, for $400 per share, subject to
adjustment. As of December 31, 2004 and 2003, none of these
rights were exercisable.
On January 1, 2003, in conjunction with an amendment to an
agreement with AT&T Corp., the Company granted AT&T
three warrants to purchase shares of the Company’s common
stock as follows: 1,000 shares for $0.94 per share;
1,000 shares for $3.00 per share; and
1,000 shares for $5.00 per share. Such warrants were
immediately exercisable, fully vested and nonforfeitable at the
date of grant. Accordingly, the measurement date for these
warrants was the date of grant. The aggregate fair value of such
warrants of $2,640 was recorded as a deferred customer incentive
during the year ended December 31, 2003 and is being
recognized as a reduction of revenues on a straight-line basis
over the three-year term of the agreement because the Company
believes that future revenues from AT&T will exceed the fair
value of the warrants described above. The aggregate fair value
was determined using the Black-Scholes option valuation model
with the following facts and assumptions: closing price of the
Company’s common stock on December 31, 2002 of
$0.94 per share; expected life of seven years (which is
also the contractual life of the warrants); dividend yield of
zero; volatility of 1.52; and a risk-free interest rate of
3.36%. None of these warrants were exercised during 2004 or
2003, or had expired as of December 31, 2004. As of
December 31, 2004 and 2003 the carrying amount of the
warrants was $660 and $1,650, respectively.
On September 4, 2002, in conjunction with the execution of
a five-year agreement with America Online, Inc.
(“AOL”), a wholesale customer, the Company granted AOL
three warrants to purchase 1,500 shares of the
Company’s common stock for $1.06 per share,
1,000 shares of the Company’s common stock for
$3.00 per share and 1,000 shares of the Company’s
common stock for $5.00 per share. Such warrants were
immediately exercisable, fully vested and nonforfeitable at the
date of grant. Accordingly, the measurement date for these
warrants was the date of grant. The aggregate fair value of such
warrants of $3,790, which was determined using the Black-Scholes
option valuation model with the following facts and assumptions:
closing price of the Company’s common stock on
September 4, 2002 of $1.14 per share; expected
life of seven years (which is also the contractual life of the
warrants); dividend yield of zero; volatility of 1.56; and a
risk-free interest rate of 3.63%, was recorded as a deferred
customer incentive during the year ended December 31, 2002
and is being recognized as a reduction of revenues on a
straight-line basis over the five-year term of the agreement
because the Company believes that future revenues from AOL will
exceed the fair value of the warrants described above. None of
these warrants were exercised during 2004, 2003 or 2002, or had
expired as of December 31, 2004. As of December 31,
2004 and 2003 the carrying amount of the warrants was $2,023 and
$2,781, respectively.
Other warrants for the purchase of 14 shares of the
Company’s common stock were outstanding as of
December 31, 2004. Such warrants are exercisable at a
purchase price ranging from $0.01 to $2.13 per share and
fully vested as of December 31, 2004. Unless exercised, all
such warrants will expire during periods ending between October
2007 and March 2008. Warrants for the purchase of
225 shares of the Company’s common stock expired in
February 2003.
88
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The Company has made no provision for income taxes in any period
presented in the accompanying consolidated financial statements
because it incurred operating losses in each of these periods.
The difference between the income tax benefits computed at the
federal statutory rate of 35% and the Company’s actual
income tax benefits for 2004, 2003 and 2002 are as follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Year Ended December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
Federal benefit at statutory rate
|
|
$ |
(21,266 |
) |
|
$ |
(39,306 |
) |
|
$ |
(64,690 |
) |
|
State benefit, net of federal benefit
|
|
|
(3,038 |
) |
|
|
(4,829 |
) |
|
|
(9,386 |
) |
|
Net operating losses with no current benefits
|
|
|
22,290 |
|
|
|
38,636 |
|
|
|
75,090 |
|
|
Deferred variable stock-based compensation
|
|
|
1,099 |
|
|
|
4,330 |
|
|
|
— |
|
|
Other
|
|
|
915 |
|
|
|
1,169 |
|
|
|
(1,014 |
) |
| |
|
|
|
|
|
|
|
|
|
| |
Income tax expense (benefit)
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
— |
|
| |
|
|
|
|
|
|
|
|
|
Deferred income taxes reflect the net tax effect of temporary
differences between the carrying amounts of assets and
liabilities for financial reporting purposes and amounts used
for income tax purposes. Significant components of the
Company’s deferred tax assets and liabilities for federal
and state income taxes are as follows:
| |
|
|
|
|
|
|
|
|
|
| |
|
December 31, | |
| |
|
| |
| |
|
2004 | |
|
2003 | |
| |
|
| |
|
| |
|
Deferred tax assets:
|
|
|
|
|
|
|
|
|
|
Net operating loss carryforwards
|
|
$ |
370,489 |
|
|
$ |
327,574 |
|
|
Capital loss carryforwards
|
|
|
10,810 |
|
|
|
16,919 |
|
|
Deferred and unearned revenue
|
|
|
32,259 |
|
|
|
37,921 |
|
|
Deconsolidation of subsidiary
|
|
|
21,585 |
|
|
|
21,585 |
|
|
Unconsolidated investments in affiliates
|
|
|
6,725 |
|
|
|
6,725 |
|
|
Depreciation and amortization
|
|
|
43,241 |
|
|
|
38,158 |
|
|
Other
|
|
|
12,891 |
|
|
|
12,231 |
|
| |
|
|
|
|
|
|
| |
Total deferred tax assets
|
|
|
498,000 |
|
|
|
461,113 |
|
|
Deferred tax liabilities
|
|
|
(2,628 |
) |
|
|
— |
|
| |
|
|
|
|
|
|
| |
Net deferred tax assets
|
|
|
495,372 |
|
|
|
461,113 |
|
|
Valuation allowance
|
|
|
(495,372 |
) |
|
|
(461,113 |
) |
| |
|
|
|
|
|
|
| |
Net deferred taxes
|
|
$ |
— |
|
|
$ |
— |
|
| |
|
|
|
|
|
|
Realization of the Company’s deferred tax assets relating
to net operating loss carryforwards and other temporary
differences is dependent upon future earnings, the timing and
amount of which are uncertain. Accordingly, the Company’s
net deferred tax assets have been fully offset by a valuation
allowance. The valuation allowance increased by $34,259, $39,071
and $129,529 during 2004, 2003 and 2002, respectively.
As of December 31, 2004, the Company had net operating loss
carryforwards for federal income tax purposes of $870,540, which
will expire beginning in 2021, if not utilized. The Company also
had aggregate net operating loss carryforwards for state income
tax of approximately $1,301,146, of which $171,016 will expire
in 2005, $34,484 will expire in 2006, and $1,095,646 will expire
thereafter, if not utilized. In addition, the Company had
capital loss carryforwards for both federal and state income tax
purposes of approximately
89
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
$27,025, which begin to expire in 2006, if not utilized. On
June 8, 2004, the Company completed its acquisition of all
of the outstanding shares of privately-held GoBeam, Inc.
(Note 6). The acquisition was effectuated by merging a
wholly-owned subsidiary of the Company with and into GoBeam,
with GoBeam surviving the merger as a wholly-owned subsidiary of
the Company. The merger is intended to qualify as a tax-free
reorganization. As a result of its acquisition, the
Company’s net operating loss carryforwards includes
GoBeam’s existing, as of acquisition date, federal and
state net operating loss carryforwards of $39,587 and $27,600,
respectively. Tax benefits related to pre-acquisition losses of
the acquired entity will be utilized first to reduce any
associated intangibles and goodwill.
The tax benefits associated with employee stock options provided
cumulative deferred tax benefits of approximately $8,858 and
$6,938 for the years ended December 31, 2004 and 2003,
respectively. Such deferred tax benefits have been offset by a
valuation allowance and will be credited to additional paid-in
capital when realized.
The utilization of the Company’s net operating loss may be
subject to substantial annual limitation due to the “change
in ownership” provisions of the Internal Revenue Code of
1986, as amended, and similar state provisions. The annual
limitation may result in the expiration of net operating losses
and tax credits before utilization.
|
|
| 13. |
Employee Benefit Plans |
|
|
|
Defined Contribution Plan |
The Company has a defined contribution retirement plan under
Section 401(k) of the Internal Revenue Code that covers
substantially all employees. Eligible employees may contribute
amounts to the plan, via payroll withholding, subject to certain
limitations. The Company does not match contributions by plan
participants.
In connection with the Company’s acquisition of Laser
Link.net, Inc. (“Laser Link”) on March 20, 2000
and BlueStar on September 22, 2000, the Company merged
Laser Link’s and BlueStar’s defined contribution
retirement plan under Section 401(k) of the Internal
Revenue Code into the Company’s defined contribution
retirement plan.
|
|
|
1998 Employee Stock Purchase Plan |
In January 1999, the Company adopted the 1998 Employee Stock
Purchase Plan. Under this plan, eligible employees could
purchase common stock at 85% of the lesser of the fair market
value of the Company’s common stock on the first day of the
applicable twenty-four month offering period or the last day of
the applicable six month purchase period. The 1998 Employee
Stock Purchase Plan was terminated on April 28, 2003.
|
|
|
2003 Employee Stock Purchase Plan |
In June 2003, the Company adopted the 2003 Employee Stock
Purchase Plan (the “2003 Stock Purchase Plan”). Under
the 2003 Stock Purchase Plan, eligible employees may purchase
common stock at 85% of: (i) the fair market value of the
Company’s common stock on the first day of the applicable
twenty-four month offering period, or (ii) the fair market
value on the last day of the applicable six-month purchase
period. The offering period that commenced in July 2003 and ends
in June 2005 is subject to variable accounting. Accordingly, the
Company recorded deferred stock-based compensation of $15,637
and $26,778 as of December 31, 2004 and 2003, respectively.
During the years ended December 31, 2004 and 2003, the
Company recognized stock-based compensation expense of $2,526
and $12,371, respectively. The remaining net deferred
stock-based compensation balance of $740 and $14,407 at
December 31, 2004 and 2003,
90
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
respectively, which will fluctuate with changes in the
Company’s stock price, is being amortized to operations
over the remainder of the life of the offering period.
The number of shares that may be issued under the 2003 Employee
Stock Purchase Plan is subject to an annual increase to be added
on January 1 of each year equal to the lesser of either
(a) 2% of the outstanding shares of the Company’s
stock on such date, (b) 7 million shares or
(c) an amount determined by a committee of the board.
The 1997 Stock Plan (the “Plan”) provides for the
grant of stock purchase rights and options to purchase shares of
common stock to employees and consultants from time to time as
determined by the Company’s board of directors. The options
expire from two to eight years after the date of grant. As of
December 31, 2004, the Company has reserved approximately
11,683 shares of the Company’s common stock under the
Plan for sale and issuance at prices to be determined by the
Company’s board of directors. The number of shares that may
be issued under the Plan is subject to an annual increase to be
added on the first day of the Company’s fiscal year equal
to the lesser of (a) 3% of the outstanding shares of the
Company’s stock on such date or (b) an amount
determined by the board.
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 1,435 shares of the Company’s common stock
will be available for issuance under the Laser Link Plan. The
options granted under the Laser Link plan are included in the
data set forth below.
In connection with the Company’s acquisition of BlueStar,
the Company assumed BlueStar’s stock option plan.
BlueStar’s stock option plan provides for the grant of
options to purchase shares of common stock to employees and
consultants from time to time. The options expire up to ten
years after the date of grant. The Company assumed the BlueStar
stock option plan at the time it acquired BlueStar and it is no
longer issuing options under the BlueStar stock option plan. A
maximum of 1,251 shares of the Company’s common stock
will be available for issuance under the BlueStar stock option
plan. The options granted under the BlueStar stock option plan
are included in the data set forth below.
In connection with the Company’s acquisition of GoBeam, the
Company assumed GoBeam’s stock option plan. GoBeam’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 GoBeam stock option plan at the
time it acquired GoBeam and it is no longer issuing options
under the GoBeam stock option plan. A maximum of 266 shares
of the Company’s common stock will be available for
issuance under the GoBeam stock option plan. The options granted
under the GoBeam stock option plan are included in the data set
forth below.
91
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The following table summarizes stock option activity for the
years ended December 31, 2004, 2003 and 2002:
| |
|
|
|
|
|
|
|
|
|
| |
|
Number of Shares of |
|
Option Price Per |
| |
|
Common Stock |
|
Share |
| |
|
|
|
|
|
Balance as of December 31, 2001
|
|
|
31,600 |
|
|
|
$0.001 — $149.79 |
|
| |
Granted
|
|
|
2,231 |
|
|
|
$0.940 — $ 2.30 |
|
| |
Exercised
|
|
|
(1,006 |
) |
|
|
$0.001 — $ 2.56 |
|
| |
Cancelled
|
|
|
(7,150 |
) |
|
|
$0.001 — $149.79 |
|
| |
|
|
|
|
|
|
|
|
|
Balance as of December 31, 2002
|
|
|
25,675 |
|
|
|
$0.001 — $149.79 |
|
| |
Granted
|
|
|
7,196 |
|
|
|
$0.570 — $ 5.53 |
|
| |
Exercised
|
|
|
(4,984 |
) |
|
|
$0.001 — $ 5.44 |
|
| |
Cancelled
|
|
|
(6,210 |
) |
|
|
$0.296 — $149.79 |
|
| |
|
|
|
|
|
|
|
|
|
Balance as of December 31, 2003
|
|
|
21,677 |
|
|
|
$0.001 — $149.79 |
|
| |
Granted and assumed
|
|
|
6,867 |
|
|
|
$1.460 — $ 3.51 |
|
| |
Exercised
|
|
|
(1,951 |
) |
|
|
$0.001 — $ 3.72 |
|
| |
Cancelled
|
|
|
(3,596 |
) |
|
|
$0.001 — $149.79 |
|
| |
|
|
|
|
|
|
|
|
|
Balance as of December 31, 2004
|
|
|
22,997 |
|
|
|
$0.001 — $149.79 |
|
| |
|
|
|
|
|
|
|
|
The following is a summary of the status of stock options
outstanding at December 31, 2004:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Options Outstanding |
|
Options Exercisable |
| |
|
|
|
|
| |
|
Number of |
|
Weighted-Average |
|
Weighted-Average |
|
Number of |
|
Weighted-Average |
| Exercise Price Range |
|
Shares |
|
Life Remaining |
|
Exercise Price |
|
Shares |
|
Exercise Price |
| |
|
|
|
|
|
|
|
|
|
|
|
$0.001 — $0.67
|
|
|
2,466 |
|
|
|
4.56 |
|
|
$ |
0.54 |
|
|
|
1,816 |
|
|
$ |
0.53 |
|
|
$0.68 — $0.84
|
|
|
2,525 |
|
|
|
4.51 |
|
|
|
0.83 |
|
|
|
2,161 |
|
|
|
0.83 |
|
|
$0.86 — $1.17
|
|
|
848 |
|
|
|
5.52 |
|
|
|
1.05 |
|
|
|
503 |
|
|
|
1.06 |
|
|
$1.18 — $1.28
|
|
|
3,876 |
|
|
|
6.24 |
|
|
|
1.28 |
|
|
|
2,070 |
|
|
|
1.28 |
|
|
$1.29 — $2.25
|
|
|
2,537 |
|
|
|
6.18 |
|
|
|
1.73 |
|
|
|
1,238 |
|
|
|
1.72 |
|
|
$2.28 — $2.56
|
|
|
2,753 |
|
|
|
4.74 |
|
|
|
2.53 |
|
|
|
2,152 |
|
|
|
2.56 |
|
|
$2.59 — $3.31
|
|
|
284 |
|
|
|
5.11 |
|
|
|
3.07 |
|
|
|
183 |
|
|
|
3.00 |
|
|
$3.34 — $3.34
|
|
|
4,011 |
|
|
|
7.16 |
|
|
|
3.34 |
|
|
|
933 |
|
|
|
3.34 |
|
|
$3.51 — $30.04
|
|
|
2,324 |
|
|
|
3.71 |
|
|
|
16.23 |
|
|
|
2,015 |
|
|
|
18.02 |
|
|
$30.67 — $149.79
|
|
|
1,373 |
|
|
|
2.91 |
|
|
|
49.26 |
|
|
|
1,373 |
|
|
|
49.26 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$0.001 — $149.79
|
|
|
22,997 |
|
|
|
5.35 |
|
|
$ |
6.10 |
|
|
|
14,444 |
|
|
$ |
8.39 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
In addition to the adjustments for stock-based compensation
described in Note 1 under “Adjustments” during
the year ended December 31, 2002, the Company reversed
approximately $136 of stock-based compensation recorded in prior
years due to the termination of certain employees (none in
2003). During the years ended December 31, 2004 and 2003,
the Company recorded (reversed) deferred stock-based
compensation of $(11,143) and $26,778 as a result of stock
options subject to variable accounting that were granted under
the 2003 Stock Purchase Plan. During the years ended
December 31, 2004 and 2002, the Company recorded deferred
stock-based compensation of approximately $660 and $426,
respectively, as a result of employment status changes, stock
option grants and restricted stock issuances with exercise or
purchase prices that were less than the fair value of the
Company’s common stock at the date of grant or issuance
(none in 2003). These amounts are being amortized to operations
over the respective vesting periods of the underlying
92
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
options using a graded vesting method. Amortization
(reversal) of deferred stock-based compensation for the
years ended December 31, 2004, 2003 and 2002 was
approximately $2,724, $12,479 and $(3,358), respectively.
During the year ended December 31, 2002, the Company
extended the exercise period of options granted to certain
former employees for the purchase of 272 shares of the
Company’s common stock. Consequently, for the year ended
December 31, 2002, the Company recognized stock-based
compensation expense of $221, which represents the difference
between the exercise price of these options and the fair value
of the Company’s common stock on the respective dates of
the option award modifications. The Company did not modify any
stock-based awards in 2004 or 2003.
The Company grants options to consultants from time to time in
exchange for services. In general, these options vest over the
contractual period of the consulting arrangement. No options
were granted to consultants in 2004, 2003 or 2002. The fair
value of options granted prior to 2002 is being amortized to
operating expenses over the vesting term of the options. The
Company recorded expenses related to these options of $3, $120
and $64 for the fair value of these options in 2004, 2003 and
2002, respectively. As of December 31, 2004, 2003 and 2002
the fair value of the remaining unvested options granted to
consultants was $3, $22 and $3, respectively. These charges are
subject to adjustment based on the fair value of the
Company’s common stock on the date the options vest.
|
|
|
Pro forma Stock-Based Compensation Information |
Pro forma information regarding the results of operations and
net income (loss) per share is determined as if the Company had
accounted for its employee stock options using the fair value
method. Under this method, the fair value of each option granted
is estimated on the date of grant using the Black-Scholes option
valuation model.
The Company uses the intrinsic value method in accounting for
its employee stock options because, as discussed below, the
alternative fair value accounting requires the use of option
valuation models that were not developed for use in valuing
employee stock options. Under the intrinsic value method, when
the exercise price of the Company’s employee stock options
equals or exceeds the market price of the underlying stock on
the date of grant, no compensation expense is recognized.
Option valuation models were developed for use in estimating the
fair value of traded options that have no vesting restrictions
and are fully transferable. In addition, option valuation models
require the input of highly subjective assumptions, including
the expected life of the option. Because the Company’s
employee stock options have characteristics significantly
different from those of traded options and because changes in
the subjective input assumptions can materially affect the fair
value estimates, in management’s opinion, the existing
models do not necessarily provide a reliable single measure of
the fair value of its employee stock options.
For the years ended December 31, 2004, 2003 and 2002, the
fair value of the Company’s stock-based awards to employees
was calculated using the following weighted-average assumptions:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
Stock Options | |
|
Employee Stock Purchase Plan | |
| |
|
| |
|
| |
| |
|
2004 | |
|
2003 | |
|
2002 | |
|
2004 | |
|
2003 | |
|
2002 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
Expected life of options in years
|
|
|
4.0 |
|
|
|
4.0 |
|
|
|
4.0 |
|
|
|
1.0 |
|
|
|
0.5 |
|
|
|
0.5 |
|
|
Volatility
|
|
|
123.70 |
% |
|
|
131.70 |
% |
|
|
152.10 |
% |
|
|
123.70 |
% |
|
|
131.70 |
% |
|
|
152.10 |
% |
|
Risk-free interest rate
|
|
|
3.27 |
% |
|
|
2.10 |
% |
|
|
3.10 |
% |
|
|
2.61 |
% |
|
|
1.08 |
% |
|
|
1.72 |
% |
|
Expected dividend yield
|
|
|
0.00 |
% |
|
|
0.00 |
% |
|
|
0.00 |
% |
|
|
0.00 |
% |
|
|
0.00 |
% |
|
|
0.00 |
% |
93
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The Company sells to businesses and consumers indirectly through
Internet service providers, or ISPs, telecommunications carriers
and other resellers. The Company also sells its services
directly to business and consumer end-users through its field
sales force, telephone sales, referral agents and its website.
The Company was managed in 2003 as two strategic business units,
Covad Strategic Partnerships, or CSP, and Covad Broadband
Solutions, or CBS. Beginning in January 2004, the Company
realigned its business and no longer maintains CSP and CBS as
separate business units. The Company presently operates two
business segments, wholesale and direct, which are described
below in more detail.
The Company’s business segments are strategic business
units that are managed based upon differences in customers,
services and marketing channels, even though the assets and cash
flows from these operations are not independent of each other.
The Company’s wholesale segment, or Wholesale, is a
provider of high-speed connectivity services to ISPs and
enterprise and telecommunications carrier customers. The
Company’s direct segment, or Direct, is a provider of voice
over Internet protocol, or VoIP, high-speed connectivity,
Internet access and other services to individuals, small and
medium-sized businesses, corporations and other organizations.
All other business operations and activities of the Company are
reported as Corporate Operations. These operations and
activities are primarily comprised of general corporate
functions to support the Company’s revenue producing
segments as well as costs and expenses for headquarters
facilities and equipment, depreciation and amortization, network
capacity and other non-recurring or unusual items not directly
attributable or allocated to the segments, gains and losses on
the Company’s investments, and income and expenses from the
Company’s treasury and financing activities.
The Company evaluates performance and allocates resources to the
segments based on income or loss from operations, excluding
certain operating expenses, such as depreciation and
amortization, and other income and expense items. The Company
does not segregate its assets or its cash flows between its two
segments because these resources are not managed separately by
segment. The Company similarly manages its capital expenditures
and cash needs as one entity. Therefore, the Company does not
allocate such operating expenses and other income and expense
items to its business segments because it believes that these
expenses and other income items are not directly managed or
controlled by its business segments.
94
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Segment information, including a reconciliation to the
respective balances in the Company’s consolidated financial
statements, as of December 31, 2004, 2003 and 2002, are as
follows:
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
|
|
|
|
Total | |
|
Corporate | |
|
Consolidated | |
| |
|
Wholesale | |
|
Direct | |
|
Segments | |
|
Operations | |
|
Total | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
As of and for the year ended December 31, 2004:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenue, net
|
|
$ |
309,899 |
|
|
$ |
119,298 |
|
|
$ |
429,197 |
|
|
$ |
— |
|
|
$ |
429,197 |
|
|
Intersegment revenues
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Total revenues, net
|
|
|
309,899 |
|
|
|
119,298 |
|
|
|
429,197 |
|
|
|
— |
|
|
|
429,197 |
|
|
Cost of sales (exclusive of depreciation and amortization)
|
|
|
175,687 |
|
|
|
54,016 |
|
|
|
229,703 |
|
|
|
36,469 |
|
|
|
266,172 |
|
|
Selling, general and administrative
|
|
|
10,476 |
|
|
|
39,984 |
|
|
|
50,460 |
|
|
|
95,781 |
|
|
|
146,241 |
|
|
Provision for bad debts (recoveries)
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(2,035 |
) |
|
|
(2,035 |
) |
|
Depreciation and amortization
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
56,825 |
|
|
|
56,825 |
|
|
Amortization of intangible assets
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
20,585 |
|
|
|
20,585 |
|
|
Provision for restructuring expenses
|
|
|
374 |
|
|
|
281 |
|
|
|
655 |
|
|
|
754 |
|
|
|
1,409 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Total operating expenses
|
|
|
186,537 |
|
|
|
94,281 |
|
|
|
280,818 |
|
|
|
208,379 |
|
|
|
489,197 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) from operations
|
|
|
123,362 |
|
|
|
25,017 |
|
|
|
148,379 |
|
|
|
(208,379 |
) |
|
|
(60,000 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest income
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
2,668 |
|
|
|
2,668 |
|
|
Equity in losses of unconsolidated affiliates
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
Interest expense
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(4,927 |
) |
|
|
(4,927 |
) |
|
Other income, net
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
1,498 |
|
|
|
1,498 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Total other income (expense), net
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(761 |
) |
|
|
(761 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Net income (loss)
|
|
$ |
123,362 |
|
|
$ |
25,017 |
|
|
$ |
148,379 |
|
|
$ |
(209,140 |
) |
|
$ |
(60,761 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Assets
|
|
$ |
47,994 |
|
|
$ |
18,707 |
|
|
$ |
66,701 |
|
|
$ |
318,524 |
|
|
$ |
385,225 |
|
|
Capital expenditures for property and equipment
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
38,743 |
|
|
$ |
38,743 |
|
|
Payment of collocation fees and purchase of other intangible
assets
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
7,900 |
|
|
$ |
7,900 |
|
95
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
|
|
|
|
Total | |
|
Corporate | |
|
Consolidated | |
| |
|
Wholesale | |
|
Direct | |
|
Segments | |
|
Operations | |
|
Total | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
As of and for the year ended December 31, 2003:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenue, net
|
|
$ |
298,221 |
|
|
$ |
90,630 |
|
|
$ |
388,851 |
|
|
$ |
— |
|
|
$ |
388,851 |
|
|
Intersegment revenues
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Total revenues, net
|
|
|
298,221 |
|
|
|
90,630 |
|
|
|
388,851 |
|
|
|
— |
|
|
|
388,851 |
|
|
Cost of sales (exclusive of depreciation and amortization)
|
|
|
209,334 |
|
|
|
46,124 |
|
|
|
255,458 |
|
|
|
32,664 |
|
|
|
288,122 |
|
|
Selling, general and administrative
|
|
|
13,069 |
|
|
|
20,346 |
|
|
|
33,415 |
|
|
|
106,666 |
|
|
|
140,081 |
|
|
Provision for bad debts
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
99 |
|
|
|
99 |
|
|
Depreciation and amortization
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
56,559 |
|
|
|
56,559 |
|
|
Amortization of intangible assets
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
17,325 |
|
|
|
17,325 |
|
|
Provision for restructuring expenses
|
|
|
103 |
|
|
|
349 |
|
|
|
452 |
|
|
|
783 |
|
|
|
1,235 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Total operating expenses
|
|
|
222,506 |
|
|
|
66,819 |
|
|
|
289,325 |
|
|
|
214,096 |
|
|
|
503,421 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) from operations
|
|
|
75,715 |
|
|
|
23,811 |
|
|
|
99,526 |
|
|
|
(214,096 |
) |
|
|
(114,570 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest income
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
2,105 |
|
|
|
2,105 |
|
|
Provision for impairment of investment in unconsolidated
affiliates
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(747 |
) |
|
|
(747 |
) |
|
Equity in losses of unconsolidated affiliates
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(279 |
) |
|
|
(279 |
) |
|
Interest expense
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(5,526 |
) |
|
|
(5,526 |
) |
|
Other income, net
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
6,715 |
|
|
|
6,715 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Total other income (expense), net
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
2,268 |
|
|
|
2,268 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Net income (loss)
|
|
$ |
75,715 |
|
|
$ |
23,811 |
|
|
$ |
99,526 |
|
|
$ |
(211,828 |
) |
|
$ |
(112,302 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Assets
|
|
$ |
52,210 |
|
|
$ |
17,362 |
|
|
$ |
69,572 |
|
|
$ |
265,139 |
|
|
$ |
334,711 |
|
|
Capital expenditures for property and equipment
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
44,142 |
|
|
$ |
44,142 |
|
|
Payment of collocation fees and purchase of other intangible
assets
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
14,889 |
|
|
$ |
14,889 |
|
96
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
|
|
|
|
Total | |
|
Corporate | |
|
Consolidated | |
| |
|
Wholesale | |
|
Direct | |
|
Segments | |
|
Operations | |
|
Total | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
As of and for the year ended December 31, 2002:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues, net
|
|
$ |
326,659 |
|
|
$ |
56,837 |
|
|
$ |
383,496 |
|
|
$ |
— |
|
|
$ |
383,496 |
|
|
Intersegment revenues
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Total revenues, net
|
|
|
326,659 |
|
|
|
56,837 |
|
|
|
383,496 |
|
|
|
— |
|
|
|
383,496 |
|
|
Cost of sales (exclusive of depreciation and amortization)
|
|
|
206,586 |
|
|
|
31,301 |
|
|
|
237,887 |
|
|
|
60,449 |
|
|
|
298,336 |
|
|
Selling, general and administrative
|
|
|
14,244 |
|
|
|
44,513 |
|
|
|
58,757 |
|
|
|
91,616 |
|
|
|
150,373 |
|
|
Provision for bad debts
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
319 |
|
|
|
319 |
|
|
Depreciation and amortization
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
112,438 |
|
|
|
112,438 |
|
|
Amortization of intangible assets
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
14,650 |
|
|
|
14,650 |
|
|
Non-cash litigation-related expenses
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(11,628 |
) |
|
|
(11,628 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Total operating expenses
|
|
$ |
220,830 |
|
|
$ |
75,814 |
|
|
$ |
296,644 |
|
|
$ |
267,844 |
|
|
$ |
564,488 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) from operations
|
|
|
105,829 |
|
|
|
(18,977 |
) |
|
|
86,852 |
|
|
|
(267,844 |
) |
|
|
(180,992 |
) |
|
Interest income
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
5,122 |
|
|
|
5,122 |
|
|
Realized loss on short-term investments
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(17 |
) |
|
|
(17 |
) |
|
Provision for impairment of investment in unconsolidated
affiliates
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(388 |
) |
|
|
(388 |
) |
|
Equity in losses of unconsolidated affiliates
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(806 |
) |
|
|
(806 |
) |
|
Loss on disposal of investment in unconsolidated affiliates
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(636 |
) |
|
|
(636 |
) |
|
Interest expense
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(5,581 |
) |
|
|
(5,581 |
) |
|
Other expense, net
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(1,530 |
) |
|
|
(1,530 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Total other income (expense), net
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
(3,836 |
) |
|
|
(3,836 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Net income (loss)
|
|
$ |
105,829 |
|
|
$ |
(18,977 |
) |
|
$ |
86,852 |
|
|
$ |
(271,680 |
) |
|
$ |
(184,828 |
) |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Assets
|
|
$ |
58,158 |
|
|
$ |
11,335 |
|
|
$ |
69,493 |
|
|
$ |
372,668 |
|
|
$ |
442,161 |
|
|
Investments in unconsolidated affiliates:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Domestic
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
1,026 |
|
|
$ |
1,026 |
|
|
Capital expenditures for property and equipment
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
22,782 |
|
|
$ |
22,782 |
|
|
Payment of collocation fees
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
— |
|
|
$ |
3,782 |
|
|
$ |
3,782 |
|
On February 4, 2005, regarding the assignment for the
benefit of creditors of BlueStar (Note 3), the Seventh
Circuit Court for Davidson County, Tennessee ordered the
Assignee to make a final distribution of funds of the estates to
holders of allowed claims. Such final distribution has been
made. As previously disclosed in its consolidated financial
statements, the Company believes that such final distribution
and liquidation of the estate is an event that qualifies for it
to recognize the deferred gain that resulted from the
deconsolidation of Bluestar on June 25, 2001. Consequently,
the Company anticipates that it will recognize such gain during
the three months ending March 31, 2005.
97
|
|
| ITEM 9. |
Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure |
On April 12, 2004, the Company filed a current report on
Form 8-K, pursuant to Item 4 thereof, reporting that
the Company had dismissed Ernst & Young LLP as its
independent registered public accounting firm and had determined
to engage PricewaterhouseCoopers LLP as its independent
registered public accounting firm for the fiscal year 2004.
The Company does not have any disagreements with its accountants
on accounting and financial disclosure matters.
|
|
| ITEM 9A. |
Controls and Procedures |
|
|
|
Evaluation of Disclosure Controls and Procedures: |
We have performed an evaluation under the supervision and with
the participation of our management, including our Chief
Executive Officer (CEO) and Chief Financial Officer (CFO),
of the effectiveness of our disclosure controls and procedures,
as defined in Rule 13a-15(e) under the Securities Exchange
Act of 1934 (the Exchange Act). In designing and evaluating our
disclosure controls and procedures, management recognized that
disclosure controls and procedures, no matter how well designed
and operated, can provide only reasonable, not absolute,
assurance that the objectives of the disclosure controls and
procedures are met. Additionally, in designing disclosure
controls and procedures, our management necessarily was required
to apply its judgment in evaluating the cost-benefit
relationship of possible disclosure controls and procedures.
Based on that evaluation, our management, including our CEO and
CFO, concluded that our disclosure controls and procedures were
effective as of December 31, 2004 to provide reasonable
assurance that information required to be disclosed by us in the
reports filed or submitted by us under the Exchange Act is
recorded, processed, summarized and reported within the time
periods specified in the SEC’s rules and forms.
|
|
|
Management’s Report on Internal Control over
Financial Reporting: |
Our management is responsible for establishing and maintaining
an adequate system of internal control over financial reporting
as defined in Rule 13a-15(f) under the Securities Exchange
Act of 1934 (the Exchange Act). Our internal control over
financial reporting was designed to provide reasonable assurance
regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in
accordance with generally accepted accounting principles.
Our management assessed the effectiveness of our internal
control over financial reporting as of December 31, 2004.
In making their assessment, management used the criteria set
forth by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) in Internal
Control — Integrated Framework. Because of its
inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of
any evaluation of effectiveness to future periods are subject to
the risk that controls may become inadequate because of changes
in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.
Based on our assessment we concluded that, as of
December 31, 2004, our internal control over financial
reporting was effective based on the criteria set forth by COSO
in Internal Control — Integrated Framework.
Our management’s assessment of the effectiveness of the
Company’s internal control over financial reporting as of
December 31, 2004, has been audited by
PricewaterhouseCoopers LLP, an independent registered public
accounting firm, as stated in their report that appears under
Item 8 — Financial Statements and Supplementary
Data.
|
|
|
Changes in Internal Control over Financial
Reporting: |
There were no changes in our internal control over financial
reporting that occurred during the fourth quarter of the period
covered by this Annual Report on Form 10-K that have
materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.
98
|
|
| ITEM 9B. |
Other Information |
In our current report on Form 8-K as originally filed
March 1, 2005, we incorrectly reported that David McMorrow,
our Executive Vice President, Sales, received a raise of $50,000
when the correct amount of his raise was $20,000.
Mr. McMorrow’s new annual base salary of $250,000 was
listed correctly.
PART III
|
|
| ITEM 10. |
Directors and Executive Officers of the Registrant |
Our current executive officers and directors and their
respective ages as of January 1, 2005, are as follows:
| |
|
|
|
|
|
|
| Name |
|
Age | |
|
Position |
| |
|
| |
|
|
|
Charles E. Hoffman
|
|
|
55 |
|
|
President and Chief Executive Officer |
|
Patrick J. Bennett
|
|
|
57 |
|
|
Executive Vice President |
|
Andrew S. Lockwood
|
|
|
48 |
|
|
Executive Vice President, Market Development |
|
P. Michael Hanley
|
|
|
47 |
|
|
Executive Vice President, Customer Experience |
|
James Kirkland
|
|
|
45 |
|
|
General Counsel and Senior Vice President |
|
David McMorrow
|
|
|
37 |
|
|
Executive Vice President, Sales |
|
Susan Crawford
|
|
|
46 |
|
|
Senior Vice President and Acting Chief Financial Officer |
|
Charles McMinn
|
|
|
53 |
|
|
Chairman, Board of Directors |
|
Hellene S. Runtagh
|
|
|
56 |
|
|
Director |
|
Daniel C. Lynch
|
|
|
63 |
|
|
Director |
|
Larry Irving
|
|
|
49 |
|
|
Director |
|
Robert C. Hawk
|
|
|
65 |
|
|
Director |
|
L. Dale Crandall
|
|
|
63 |
|
|
Director |
|
Richard A. Jalkut
|
|
|
60 |
|
|
Director |
Charles E. Hoffman has served as our President and Chief
Executive Officer and as a Director since June 2001.
Mr. Hoffman previously served as President and Chief
Executive Officer of Rogers Wireless, Inc. from 1998 to 2001.
From 1996 to 1998 he served as President, Northeast Region for
Sprint PCS. Prior to that, he spent 16 years at
Southwestern Bell from 1980 to 1996 in various senior positions,
including regional manager, general manager and vice president
and general manager. Mr. Hoffman serves on the board of
directors of Chordiant Software and Visage Mobile.
Patrick J. Bennett joined Covad in October 2001 as our
Executive Vice President and General Manager, Covad Broadband
Solutions and became Executive Vice President in January 2004.
Prior to joining Covad, Mr. Bennett served as Senior Vice
President with TESSCO Technologies from March 2001 to October
2001. Before that, Mr. Bennett was with Rogers Wireless,
Inc. where he served as its Executive Vice President and Chief
Operating Officer from December 1999 to March 2001 and as its
Senior Vice President, Sales, from April 1998 to December 1999.
Andrew S. Lockwood joined Covad in July 2002 as our
Senior Vice President of Marketing and in January 2003 was
appointed as Executive Vice President, Covad Strategic
Partnerships. He became our Executive Vice President, Market
Development, in January 2004. Mr. Lockwood brings to Covad
21 years of experience in telecommunications, sales and
marketing. Prior to joining Covad, he was Senior Vice President
and General Manager of Inktomi’s Wireless Division from
January 2000 to June 2002 where he was responsible for software
engineering, product management, marketing, sales, finance,
human resources and strategy. Prior to his position at Inktomi,
Mr. Lockwood spent eight years at British
Telecommunications, known as BT, in a variety of senior
management positions, most recently as vice president of the
Advance Alliance from February 1999 to November 1999. He was
also deputy COO at and general manager of the Retail and
Logistics Sector Telfort Mobil Netherlands, and held senior
positions in Cable Television Services, BT Mobile and BT
Cellular.
99
P. Michael Hanley joined Covad in February 2002 as
our Senior Vice President, Organizational Transformation and was
made Executive Vice President, Customer Experience, in September
2003. Mr. Hanley came to Covad from Rogers Wireless, Inc.
where he served as its Vice President, Organizational
Transformation from 1999 to 2001 and as its Vice President,
Credit Operations from 1996 to 1999.
James Kirkland joined Covad in October 2003 as our
General Counsel and Senior Vice President. Prior to joining
Covad, Mr. Kirkland served as General Counsel and Senior
Vice President of Spectrum Development for the privately-held
Clearwire Technologies, Inc. from April 2001 to October 2003.
Prior to joining Clearwire Mr. Kirkland was a member of the
law firm of Mintz Levin Cohn Ferris Glovsky & Popeo,
P.C, where he had practiced since September 1984.
David McMorrow joined Covad in 1998 as our Vice President
of Sales, Eastern Region, was made Senior Vice President,
Strategic Development in May 2002 and became our Executive Vice
President, Sales, in January 2004.
Susan Crawford joined Covad in September 2002 as Vice
President, Financial Planning & Analysis and Investor
Relations and was appointed Senior Vice President,
Planning & Priorities Management in August 2004 and has
been Acting Chief Financial Officer since November 2004. Prior
to joining Covad, Ms. Crawford served as Senior Vice
President and Chief Financial Officer of RealNames Corporation
from July 2001 to August 2002. Ms. Crawford served as Vice
President, Finance and Chief Financial Officer of PowerTV, Inc.
from May 2000 to July 2001. From April 1999 to May 2000,
Ms. Crawford served as Vice President, Finance of Superior
Telecommunications, Inc., and from February 1997 to April 1999,
Ms. Crawford served as a Director of Finance for Scientific
Atlanta. On February 28, 2005, Ms. Crawford resigned
as Senior Vice President and Acting Chief Financial Officer,
effective March 15, 2005.
John Trewin will join us as Senior Vice President and
Chief Financial Officer, effective March 16, 2005. Prior to
joining Covad, Mr. Trewin served from April 2003 to
February 2005 as the principal of Trewin & Associates,
counseling domestic and international clients in the areas of
finance, Securities and Exchange Commission compliance, investor
relations and information technology. From January 1995 to
January 2002, Mr. Trewin served as Vice President, Finance
and Chief Financial Officer of California Micro Devices
Corporation.
Charles McMinn is one of our founders and has been the
Chairman of the Board of Directors since October 2000.
Mr. McMinn previously served as our Chairman of the Board
of Directors from July 1998 to September 1999. He served as our
President, Chief Executive Officer and as a member of the Board
of Directors from October 1996 to July 1998. Mr. McMinn has
over 20 years of experience in creating, financing,
operating and advising high technology companies. From November
of 1999 to October 2000, Mr. McMinn served as Chief
Executive Officer and is a founder of Certive Corporation and he
is still chairman of Certive’s board of directors. From
July 1995 to October 1996, and from August 1993 to June 1994,
Mr. McMinn managed his own consulting firm, Cefac
Consulting, which focused on strategic consulting for
information technology and communications businesses. From June
1994 to November 1995, he served as Principal, Strategy
Discipline, at Gemini Consulting. From August 1992 to June 1993,
he served as President and Chief Executive Officer of Visioneer
Communications, Inc. and from October 1985 to June 1992 was a
general partner at InterWest Partners, a venture capital firm.
Mr. McMinn began his Silicon Valley career as the product
manager for the 8086 microprocessor at Intel.
L. Dale Crandall has served as a member of our Board
of Directors since June 2002. Mr. Crandall also chairs the
Audit Committee of our Board of Directors. Mr. Crandall
previously served in various management positions with Kaiser
Foundation Health Plan, Inc. and Hospitals, including President
and Chief Operating Officer from March 2000 until his retirement
in June 2002, and Senior Vice President, Finance and
Administration, from June 1998 until March 2000. Prior to
joining Kaiser, he served as Executive Vice President, Chief
Financial Officer and Treasurer of APL Limited from April 1995
until February 1998. From 1963 to 1995, Mr. Crandall was
employed by PricewaterhouseCoopers LLP where his last position
was Southern California Group Managing Partner. He is also a
member of the boards of directors of Union Bank of California,
Coventry Health Care, Ansell Limited, Captara Corporation and
BEA Systems and a Trustee of Dodge and Cox mutual funds.
100
Richard A. Jalkut has served as a member of our Board of
Directors since July 2002. Mr. Jalkut has more than
35 years of experience in the telecommunications industry,
including extensive senior executive and start-up experience. He
has been the President and CEO of TelePacific, a Los
Angeles-based competitive local exchange carrier, since March
2002, and also serves on its Board of Directors. Prior to
joining TelePacific, he was President and CEO of Pathnet Telecom
from September 1997 to August 2001. Mr. Jalkut spent
32 years with NYNEX where he served as the President, CEO
and Chairman. He is also a member of the boards of directors of
HSBC-USA, Birch Telecom and IKON Office Solutions, where he
serves as the lead independent director.
Robert C. Hawk has served as a member of our Board of
Directors since April 1998. Mr. Hawk has been President of
Hawk Communications since April 1998 and had previously served
as President and Chief Executive Officer of U S WEST
Multimedia Communications, a regional telecommunications service
provider, where he headed the cable, data and telephony
communications business from May 1996 to April 1997. He was
president of the Carrier Division of US West Communications,
Inc., from September 1990 to May 1996. He currently serves on
the board of Centillium Communications and several private
companies.
Larry Irving has served as a member of our Board of
Directors since April 2000. Mr. Irving has served as the
President and CEO of the Irving Information Group, a strategic
consulting firm since October 1999. Prior to founding the Irving
Information Group, Mr. Irving served for almost seven years
as Assistant Secretary of Commerce for Communications and
Information, where he was a principal advisor to the President,
Vice President and Secretary of Commerce on domestic and
international communications and information policy issues,
including the development of policies related to the Internet
and Electronic Commerce. Prior to joining the Clinton-Gore
Administration, Mr. Irving served ten years on Capitol
Hill, most recently as Senior Counsel to the U.S. House of
Representatives Subcommittee on Telecommunications and Finance.
He also served as Legislative Director, Counsel and Chief of
Staff (acting) to the late Congressman Mickey Leland
(D-Texas). During the previous four years, Mr. Irving was
associated with the Washington, D.C. law firm of
Hogan & Hartson, specializing in communications law,
antitrust law and commercial litigation.
Daniel C. Lynch is a private investor. He has served as a
member of our Board of Directors since April 1997. From December
1990 to December 1995, he served as chairman of the board of
directors of Softbank Forums, a provider of education and
conference services for the information technology industry.
Mr. Lynch founded Interop Company in 1986, which is now a
division of the successor to Softbank Forums, Key3Media.
Mr. Lynch is a member of the Association for Computing
Machinery and the Internet Society. He is also a member of the
Board of Trustees of the Santa Fe Institute and the
Bionomics Institute. He previously served as Director of the
Information Processing Division for the Information Sciences
Institute in Marina del Rey, where he led the Arpanet team that
made the transition from the original NCP protocols to the
current TCP/ IP based protocols. Mr. Lynch previously
served as a member of the board of directors of UUNET
Technologies, Inc., from April 1994 until August 1996 and is a
director of a private company.
Hellene S. Runtagh has served as a member of our Board of
Directors since November 1999. Ms. Runtagh is the former
President and Chief Executive Officer of the Berwind Group, a
position she held from June 2001 through December 2001.
Ms. Runtagh also 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.
Ms. Runtagh also serves on the Board of Directors of
Lincoln Electric Holdings Inc. and Avaya Inc.
See Part I. Item 3 “Legal Proceedings” for
information relating to our Chapter 11 proceeding in 2001.
101
Classified Board
The Board of Directors is divided into three classes. The term
of office and directors in each class is as follows:
| |
|
|
|
|
| Class |
|
Directors |
|
Term of Office |
| |
|
|
|
|
|
Class I
|
|
Daniel C. Lynch
Richard A. Jalkut
Larry Irving |
|
• expires at the annual meeting of stockholders in
2006 and at each third succeeding annual meeting thereafter |
|
Class II
|
|
L. Dale Crandall
Hellene S. Runtagh |
|
• expires at the annual meeting of stockholders in
2007 and at each third succeeding annual meeting thereafter |
|
Class III
|
|
Charles McMinn
Robert C. Hawk
Charles E. Hoffman |
|
• expires at the annual meeting of stockholders in
2005 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 four of our outside
directors, Messrs. Crandall, Lynch and Hawk and
Ms. Runtagh, with Mr. Crandall serving as the
chairperson. The Board of Directors has determined that
Mr. Crandall is an “audit committee financial
expert” as described in applicable SEC rules. Each member
of the Audit Committee is independent, as defined in
Rule 4200(a) (15) of the National Association of
Securities Dealers’ listing standards.
The Audit Committee is responsible for oversight of our
financial reporting process and internal audit function. The
Audit Committee also monitors the work of management and the
independent auditors and their activities with respect to our
financial reporting process and internal controls.
The Compensation Committee currently consists of three of our
outside directors, Messrs. Irving and Lynch and
Ms. Runtagh. The primary responsibilities of the
Compensation Committee include:
|
|
|
| |
• |
reviewing and determining the compensation policy for our
executives and other employees as directed by the Board of
Directors; |
| |
| |
• |
reviewing and determining all forms of compensation to be
provided to our executive officers; and |
| |
| |
• |
unless otherwise directed by the Board, administering our
equity-based compensation plans. |
In September 2002, the Board of Directors established a
Nominating and Corporate Governance Committee that consists of
three outside directors, Messrs. Hawk, Irving and Jalkut.
The primary responsibilities of the Nominating and Corporate
Governance Committee include:
|
|
|
| |
• |
proposing nominees for election as directors; |
| |
| |
• |
board appraisals and performance standards; and |
| |
| |
• |
oversight of corporate governance matters. |
We also have a Pricing Committee and Management Compensation
Committee. The Pricing Committee currently consists of one
outside director, Mr. Irving and two inside directors,
Messrs. McMinn and Hoffman. The function of the Pricing
Committee is to set the price for the sale of our common stock
to third-parties as well as other special projects. The function
of the Management Compensation Committee, which consists solely
of one inside director, Mr. Hoffman, is to review and
determine the compensation policy for employees other than our
executive officers and directors and to review and determine all
forms of compensation for such employees.
102
Code of Conduct
We have adopted a Code of Conduct that applies to all
Covad’s employees, including its principal executive
officer, principal financial officer and principal accounting
officer. A copy of this code is available on our website at
www.covad.com/companyinfo/code of conduct.shtml.
We intend to disclose any changes in or waivers from its code of
conduct that are required to be publicly disclosed by posting
such information on its website or by filing a Form 8-K.
Director Compensation
Non-employee directors receive the following compensation:
|
|
|
| |
• |
an annual retainer of $18,000 is paid to each director in two
equal cash payments every six months. For the years ended, in
lieu of receiving the cash payments, a director could elect to
receive a grant of an option to purchase 5,000 shares,
vesting in equal monthly installments over one year. For 2005
forward, Covad will no longer offer its directors the ability to
receive an option to purchase shares in lieu of the cash
payments; |
| |
| |
• |
for each Board meeting that a director attends, we pay a $1,000
fee; |
| |
| |
• |
for each Committee meeting that a director attends on a
different day from a Board meeting, we pay a fee of $1,000; |
| |
| |
• |
each new director receives an initial stock option grant to
purchase 60,000 shares of our common stock, and each
ongoing director receives annual grants of options to
purchase 15,000 shares of our common stock; |
| |
| |
• |
the above-referenced annual grants of options to
purchase 15,000 shares vest in equal monthly
installments over one year rather than equal monthly
installments over four years; |
| |
| |
• |
each member of our Audit Committee, other than the Chairperson,
receives an initial stock option grant to
purchase 10,000 shares of our common stock when he or
she is first appointed to the Audit Committee; thereafter, each
such member receives an annual grant of an option to
purchase 5,000 shares of our common stock; |
| |
| |
• |
the Chairperson of our Audit Committee receives an initial
option to purchase 10,000 shares of our common stock
when appointed to the Audit Committee; therefore, the
Chairperson receives an annual grant of an option to
purchase 10,000 shares of our common stock for
continued service; and |
| |
| |
• |
the above referenced annual grants of options to Audit Committee
members and the Chairperson of the Audit Committee vest in equal
monthly installments over one year |
The exercise price for each of these stock options was set at
the market price on the grant date, and except where noted
above, each option vests over a period of four years.
In February 2003, each member of our Board of Directors received
a one-time grant of an option to
purchase 45,000 shares at an exercise price equal to
$1.28, the market price on February 5, 2003, the date of
grant. These options vest monthly over three years.
In January 2001, each member of the Board of Directors received
a one-time stock option grant to
purchase 50,000 shares at $2.56, the market price on
January 23, 2001, the grant date. These options vested
monthly over four years and allow for early exercise, with our
repurchase right lapsing over four years. Mr. McMinn, who
as a new director received a stock option grant to
purchase 60,000 shares at $2.56, the market price on
January 23, 2001, the grant date, did not receive the
January 2001 grant. Mr. McMinn’s option also allows
for early exercise, with our repurchase right lapsing over four
years.
In April 2001, we provided Mr. McMinn with a stock option
grant to purchase 200,000 shares of our common stock.
The option was 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
vested over the following six months.
103
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 2004 except Susan Crawford
filed an amended Form 3 on January 19, 2005,
correcting her Form 3 filed on December 1, 2004.
|
|
| 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 our Chief Executive Officer or was one of our five
other most highly compensated executive officers (collectively,
the “Named Executive Officers”) during the fiscal year
ended December 31, 2004.
SUMMARY COMPENSATION TABLE
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
|
|
|
|
|
|
Long-Term Compensation | |
|
|
| |
|
|
|
|
|
|
|
| |
|
|
| |
|
|
|
|
|
Restricted | |
|
Securities | |
|
|
| |
|
|
|
Annual Compensation | |
|
Stock | |
|
Underlying | |
|
|
| |
|
Fiscal | |
|
| |
|
Awards | |
|
Options/SARs | |
|
All Other | |
| Name and Principal Position |
|
Year | |
|
Salary | |
|
Bonus | |
|
($) | |
|
(#) | |
|
Compensation(1) | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
Charles E. Hoffman(2)
|
|
|
2004 |
|
|
$ |
542,308 |
|
|
$ |
444,370 |
|
|
|
— |
|
|
|
625,000 |
|
|
$ |
774 |
|
| |
President and Chief |
|
|
2003 |
|
|
$ |
500,004 |
|
|
$ |
733,593 |
|
|
|
— |
|
|
|
625,000 |
|
|
$ |
428 |
|
| |
Executive Officer |
|
|
2002 |
|
|
$ |
500,004 |
|
|
$ |
542,483 |
|
|
|
— |
|
|
|
— |
|
|
$ |
414 |
|
|
Patrick J. Bennett(3)
|
|
|
2004 |
|
|
$ |
285,000 |
|
|
$ |
111,490 |
|
|
|
— |
|
|
|
100,000 |
|
|
$ |
774 |
|
| |
Executive Vice President |
|
|
2003 |
|
|
$ |
285,000 |
|
|
$ |
194,216 |
|
|
|
— |
|
|
|
98,000 |
|
|
$ |
774 |
|
| |
|
|
|
2002 |
|
|
$ |
285,000 |
|
|
$ |
126,343 |
|
|
|
— |
|
|
|
— |
|
|
$ |
774 |
|
|
Mark A. Richman(4)
|
|
|
2004 |
|
|
$ |
276,845 |
|
|
$ |
70,226 |
|
|
|
— |
|
|
|
100,000 |
|
|
$ |
137,966 |
(8) |
| |
Executive Vice President, |
|
|
2003 |
|
|
$ |
239,231 |
|
|
$ |
164,310 |
|
|
|
— |
|
|
|
98,000 |
|
|
$ |
180 |
|
| |
Chief Financial Officer |
|
|
2002 |
|
|
$ |
228,077 |
|
|
$ |
100,723 |
|
|
|
— |
|
|
|
— |
|
|
$ |
180 |
|
|
P. Michael Hanley(5)
|
|
|
2004 |
|
|
$ |
271,154 |
|
|
$ |
105,477 |
|
|
|
— |
|
|
|
150,000 |
|
|
$ |
270 |
|
| |
Executive Vice President, |
|
|
2003 |
|
|
$ |
229,231 |
|
|
$ |
163,176 |
|
|
|
— |
|
|
|
98,000 |
|
|
$ |
270 |
|
| |
Customer Experience |
|
|
2002 |
|
|
$ |
192,923 |
|
|
$ |
76,738 |
|
|
|
— |
|
|
|
— |
|
|
$ |
229 |
|
|
Andrew S. Lockwood(6)
|
|
|
2004 |
|
|
$ |
254,808 |
|
|
$ |
89,142 |
|
|
|
— |
|
|
|
100,000 |
|
|
$ |
260 |
|
| |
Executive Vice President, |
|
|
2003 |
|
|
$ |
265,000 |
|
|
$ |
150,418 |
|
|
|
— |
|
|
|
98,000 |
|
|
$ |
270 |
|
| |
Market Development |
|
|
2002 |
|
|
$ |
106,000 |
|
|
$ |
23,342 |
|
|
|
— |
|
|
|
200,000 |
|
|
$ |
114 |
|
|
James Kirkland(7)
|
|
|
2004 |
|
|
$ |
230,000 |
|
|
$ |
89,974 |
|
|
|
— |
|
|
|
150,000 |
|
|
$ |
43,358 |
(9) |
| |
Senior Vice President, |
|
|
2003 |
|
|
$ |
35,385 |
|
|
$ |
32,589 |
|
|
|
— |
|
|
|
125,000 |
|
|
$ |
24,858 |
(10) |
| |
General Counsel and |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
Secretary |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
(1) |
The dollar amount represents premium payments the Company made
for these executives’ term life insurance. |
| |
| |
(2) |
Mr. Hoffman joined Covad in June 2001. |
| |
| |
(3) |
Mr. Bennett joined Covad in October 2001. |
| |
| |
(4) |
Mr. Richman resigned from Covad in November 2004. |
| |
| |
(5) |
Mr. Hanley joined Covad in February 2002. |
104
|
|
|
| |
(6) |
Mr. Lockwood joined Covad in August 2002. |
| |
| |
(7) |
Mr. Kirkland joined Covad in October 2003. |
| |
| |
(8) |
Amount includes $166 for term life insurance and $137,800 for
payment per agreement between Covad and Mr. Richman for
consultation services and release of all claims. |
| |
| |
(9) |
Amount includes $37,625 for moving expenses, $5,463 for life
insurance, as well as $270 for term life insurance. |
|
|
| (10) |
Amount includes $24,830 for moving expenses, as well as $28 for
term life insurance. |
Option/ SAR Grants in Last Fiscal Year
The following table sets forth information regarding stock
options granted to Named Executive Officers during the fiscal
year ended December 31, 2004.
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
|
|
Individual Grants |
|
|
|
|
|
|
| |
|
|
|
|
|
|
|
|
| |
|
|
|
Percent of Total |
|
|
|
|
|
Potential Realizable Value |
| |
|
Number of |
|
Options |
|
|
|
|
|
at Assumed Annual Rates |
| |
|
Securities |
|
Granted to |
|
Exercise |
|
|
|
of Stock Price Appreciation |
| |
|
Underlying |
|
Employees in |
|
Price |
|
|
|
for Option Term ($)(3) |
| |
|
Options |
|
Fiscal 2003 |
|
per |
|
|
|
|
| Name |
|
Granted (#) |
|
(%)(2) |
|
Share |
|
Expiration Date |
|
5% |
|
10% |
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
Charles E. Hoffman
|
|
|
625,000 |
(1) |
|
|
9.47 |
% |
|
$ |
3.34 |
|
|
|
02/26/12 |
|
|
$ |
996,688 |
|
|
$ |
2,387,242 |
|
|
Patrick J. Bennett
|
|
|
100,000 |
(1) |
|
|
1.51 |
% |
|
|
3.34 |
|
|
|
02/26/12 |
|
|
|
159,470 |
|
|
|
381,959 |
|
|
P. Michael Hanley
|
|
|
150,000 |
(1) |
|
|
2.27 |
% |
|
|
3.34 |
|
|
|
02/26/12 |
|
|
|
239,205 |
|
|
|
572,938 |
|
|
James Kirkland
|
|
|
150,000 |
(1) |
|
|
2.27 |
% |
|
|
3.34 |
|
|
|
02/26/12 |
|
|
|
239,205 |
|
|
|
572,938 |
|
|
Mark A. Richman
|
|
|
100,000 |
(1) |
|
|
1.51 |
% |
|
|
3.34 |
|
|
|
02/26/12 |
|
|
|
159,470 |
|
|
|
381,959 |
|
|
Andrew S. Lockwood
|
|
|
100,000 |
(1) |
|
|
1.51 |
% |
|
$ |
3.34 |
|
|
|
02/26/12 |
|
|
$ |
159,470 |
|
|
$ |
381,959 |
|
|
|
| (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 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 25% of the option shares on the
twelve-month anniversary of the grant date with the remainder
vesting in 36 equal monthly installments); (iv) the options
are not transferable and (v) all options are otherwise
subject to the terms and provisions of our 1997 Stock Plan. |
| |
| (2) |
Based on options covering an aggregate of 6,600,710 shares
we granted during 2004 pursuant to our 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
our 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 our estimate or
projection of future stock price growth. |
105
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, 2004, and the number and year-end value of
shares of the our common stock underlying the unexercised
options held by the Named Executive Officers.
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
|
|
|
|
Number of Securities | |
|
|
| |
|
|
|
|
|
Underlying Unexercised | |
|
Value of Unexercised | |
| |
|
|
|
|
|
Options at | |
|
In-The-Money Options at | |
| |
|
Shares | |
|
Value | |
|
December 31, 2004 | |
|
December 31, 2004 ($)(2) | |
| |
|
Acquired on | |
|
Realized | |
|
| |
|
| |
| Name |
|
Exercise (#) | |
|
($)(1) | |
|
Exercisable | |
|
Unexercisable | |
|
Exercisable | |
|
Unexercisable | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
Charles E. Hoffman
|
|
|
— |
|
|
$ |
— |
|
|
|
2,454,166 |
|
|
|
1,145,834 |
|
|
$ |
2,918,343 |
|
|
$ |
703,907 |
|
|
Patrick J. Bennett
|
|
|
— |
|
|
|
— |
|
|
|
239,249 |
|
|
|
158,751 |
|
|
|
316,688 |
|
|
|
102,572 |
|
|
P. Michael Hanley
|
|
|
— |
|
|
|
— |
|
|
|
249,665 |
|
|
|
198,335 |
|
|
|
286,605 |
|
|
|
94,655 |
|
|
James Kirkland
|
|
|
— |
|
|
|
— |
|
|
|
67,709 |
|
|
|
207,291 |
|
|
|
— |
|
|
|
— |
|
|
Andrew S. Lockwood
|
|
|
— |
|
|
|
— |
|
|
|
197,582 |
|
|
|
200,418 |
|
|
|
166,605 |
|
|
|
114,655 |
|
|
Mark A. Richman
|
|
|
256,541 |
|
|
$ |
287,531 |
|
|
|
— |
|
|
|
— |
|
|
$ |
— |
|
|
$ |
— |
|
|
|
| (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 our common stock of
$2.15 on December 31, 2004. An option is
“in-the-money” if the market value of the common stock
exceeds the exercise price. |
Employment Agreements and Change in Control Arrangements
In May 2001, we entered into a written employment agreement with
Charles Hoffman, our President and Chief Executive Officer.
Mr. Hoffman receives compensation in the form of a $500,000
annual base salary and a bonus of $375,000 if he attains certain
performance goals. Mr. Hoffman also received (i) a
signing bonus of $100,000, and (ii) stock options to
purchase 2,500,000 shares of our common stock at an
exercise price of $0.84 per share. In December 2002,
Mr. Hoffman’s targeted annual bonus was increased to
100%. In February 2004, Mr. Hoffman received a merit
increase of $50,000, bringing his annual base salary to
$550,000. Mr. Hoffman has agreed to be bound by customary
confidentiality provisions. In the event that Mr. Hoffman
is terminated without cause, we have agreed to pay his salary
for an additional year from his termination date, provided that
he does not become employed by one of our competitors.
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.
We have also entered into restricted stock purchase agreements
with certain of our directors. The shares of our common stock
issued pursuant to these restricted stock purchase agreements
are subject to our 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.
We originally adopted our Executive Severance Plan (the
“Plan”) in 2003, and the Plan was scheduled to expire
on December 31, 2004. On October 1, 2004, our
Compensation Committee amended the Plan and extended it until
December 31, 2007. The amended Plan continues to provide
that upon termination of service covered executives will
generally receive an amount equal to six months of their
salaries unless they are terminated for Cause (as defined in the
Plan) or Uncorrected Performance Deficiencies (as defined in the
Plan).
106
On October 4, 2004, we entered into Change in Control
Agreements with our executive officers that provide each covered
executive with specific additional rights and additional
benefits. Upon the termination of a covered executive’s
employment under certain circumstances following a change in
control, the executive will be entitled to receive special
termination benefits, including a lump sum payment of one to
three years base salary and target bonus. The special
termination benefits are generally payable if we terminate the
executive without cause within either one year or two years
following a change in control (depending on the covered
executive’s position with us). The special benefits are
also payable if the executive resigns as a result of certain
actions taken by us (including a reduction in the
executive’s compensation or responsibilities or a change in
the executive’s job location) within either one year or two
years following a change in control (depending on the covered
executive’s position with us). The agreement with our chief
executive officer further provides that special termination
benefits are also payable upon voluntarily termination of
employment for any reason during the 30-day period following the
first anniversary of the date of the change in control.
In addition, in certain circumstances where a payment or
distribution by us to the executive is determined to be subject
to the excise tax imposed by Section 4999 of the Internal
Revenue Code, the executive will be entitled to receive a
payment on an after-tax basis equal to the excise tax imposed.
Compensation Committee Interlocks and Insider
Participation
Mr. Irving, Mr. Lynch and Ms. Runtagh currently
serve on the Compensation Committee. No interlocking
relationship exists between the Board of Directors or the
Compensation Committee and the Board of Directors or
compensation committee of any other company, nor has any such
interlocking relationship existed in the past.
Limitation on Liability and Indemnification Matters
Our Amended and Restated Certificate of Incorporation limits the
liability of our directors to the maximum extent permitted by
Delaware law, and our Bylaws provide that we will indemnify our
directors and officers and may indemnify our other employees and
agents to the fullest extent permitted by law. We also entered
into agreements to indemnify our directors and executive
officers, in addition to the indemnification provided for in our
Bylaws. Our Board of Directors believes that these provisions
and agreements are necessary to attract and retain qualified
directors and executive officers.
|
|
| ITEM 12. |
Security Ownership of Certain Beneficial Owners and
Management |
The following table sets forth certain information regarding
ownership of our common stock as of February 1, 2005 by:
|
|
|
| |
• |
each Named Executive Officer; |
| |
| |
• |
each of our directors; |
| |
| |
• |
all of our executive officers and directors as a group; and |
| |
| |
• |
all persons known to Covad to beneficially own 5% or more of our
common stock |
Share ownership in each case includes shares issuable upon
exercise of outstanding options and warrants that are
exercisable within 60 days of February 1, 2005 as
described in the footnotes below. Percentage ownership is
calculated pursuant to SEC Rule 13d-3(d)(1) and based on
263,884,742 shares of our common
107
stock outstanding as of February 1, 2005. Except as
otherwise indicated, the address of each of the persons in this
table is as follows: c/o Covad Communications Group, Inc.,
110 Rio Robles, San Jose, California 95134.
| |
|
|
|
|
|
|
|
|
| |
|
Shares Beneficially Owned | |
| |
|
| |
| Beneficial Owner |
|
Number | |
|
Percentage | |
| |
|
| |
|
| |
|
FMR Corp.(1)
|
|
|
26,227,635 |
|
|
|
9.88 |
% |
|
Charles McMinn(2)
|
|
|
3,688,997 |
|
|
|
1.40 |
% |
|
Charles E. Hoffman(3)
|
|
|
2,887,658 |
|
|
|
1.09 |
% |
|
Robert Hawk(4)
|
|
|
765,160 |
|
|
|
* |
|
|
P. Michael Hanley(5)
|
|
|
301,914 |
|
|
|
* |
|
|
Patrick J. Bennett(6)
|
|
|
279,021 |
|
|
|
* |
|
|
Andrew S. Lockwood(7)
|
|
|
235,706 |
|
|
|
* |
|
|
Hellene S. Runtagh(8)
|
|
|
233,416 |
|
|
|
* |
|
|
Daniel Lynch(9)
|
|
|
185,273 |
|
|
|
* |
|
|
Larry Irving(10)
|
|
|
184,812 |
|
|
|
* |
|
|
L. Dale Crandall(11)
|
|
|
142,500 |
|
|
|
* |
|
|
David McMorrow(12)
|
|
|
138,236 |
|
|
|
* |
|
|
Richard A. Jalkut(13)
|
|
|
111,250 |
|
|
|
* |
|
|
Susan Crawford(14)
|
|
|
90,629 |
|
|
|
* |
|
|
James Kirkland(15)
|
|
|
87,799 |
|
|
|
* |
|
|
All current executive officers and directors as a group
(14 persons)
|
|
|
9,332,371 |
|
|
|
3.53 |
% |
|
|
|
| |
* |
Represents beneficial ownership of less than 1% of our
outstanding stock. |
|
|
|
| |
(1) |
This includes: (1) 24,647,361 shares beneficially
owned by Fidelity Management & Research Company as a
result of it acting as investment adviser to various investment
companies registered under Section 8 of the Investment
Company Act of 1940, which includes 1,575,200 shares owned
by these investment companies resulting from the assumed
conversion of $5,000,000 principal amount of our convertible
Debentures; and (2) 1,580,274 shares held by Fidelity
Management Trust Company, a wholly-owned subsidiary of FMR
Corp. Edward C. Johnson 3d, FMR Corp., through its control of
Fidelity Management & Research Company, and the funds
each has the sole power to dispose of the 24,647,361 shares
owned by the Fidelity Funds. The voting power with respect to
the shares held by Fidelity Management & Research
Company rests solely with the Boards of Trustees of each of the
investment companies to which it acts as investment adviser.
Edward C. Johnson 3d and FMR Corp., through its control of
Fidelity Management Trust Company, each has the sole power
to dispose of the 1,580,274 shares owned by Fidelity
Management Trust Company and the sole power to vote or to
direct the voting of 1,554,411 of these shares and no power to
vote or direct the voting of 25,863 of the shares. The
information provided with respect to these shareholders is based
solely upon a Schedule 13G dated February 14, 2005,
filed by such shareholders with the Securities and Exchange
Commission. The Company has not done any independent
investigation with respect to the beneficial ownership of these
shareholders. The address for FMR Corp. is 82 Devonshire Street,
Boston, MA 02109. |
| |
| |
(2) |
Includes 4,375 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
| |
| |
(3) |
Includes 156,250 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
| |
| |
(4) |
Includes 5,000 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
| |
| |
(5) |
Includes 17,500 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
108
|
|
|
| |
(6) |
Includes 15,416 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
| |
| |
(7) |
Includes 15,417 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
| |
| |
(8) |
Includes 5,000 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
| |
| |
(9) |
Includes 5,208 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
|
|
| (10) |
Includes 4,375 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
| |
| (11) |
Includes 8,127 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
| |
| (12) |
Includes 13,334 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
| |
| (13) |
Includes 6,667 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
| |
| (14) |
Includes 7,916 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
| |
| (15) |
Includes 11,459 shares of common stock subject to options
exercisable within 60 days of February 1, 2005. |
Securities Authorized for Issuance under Equity Compensation
Plans
The following table provides information about our common stock
that may be issued upon the exercise of options, warrants and
rights under our existing equity compensation plans as of
December 31, 2004.
| |
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
|
|
|
|
Number of | |
| |
|
|
|
|
|
securities | |
| |
|
Number of | |
|
Weighted- | |
|
remaining available | |
| |
|
securities to be | |
|
average exercise | |
|
for future issuance | |
| |
|
issued upon | |
|
price of | |
|
under equity | |
| |
|
exercise of | |
|
outstanding | |
|
compensation | |
| |
|
outstanding | |
|
options, | |
|
plans (excluding | |
| |
|
options, warrants | |
|
warrants and | |
|
securities reflected | |
| |
|
and rights | |
|
rights | |
|
in column (a)) | |
| Plan Category |
|
(a) | |
|
(b) | |
|
(c) | |
| |
|
| |
|
| |
|
| |
|
Equity compensation plans approved by security holders(1)
|
|
|
22,836,340 |
|
|
|
6.08 |
|
|
|
19,250,902 |
|
|
Equity compensation plans not approved by security holders(2)
|
|
|
160,870 |
|
|
|
6.44 |
|
|
|
266,225 |
|
| |
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
22,997,210 |
|
|
|
6.10 |
|
|
|
19,517,127 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
| (1) |
These plans consist of the 1997 Stock Plan and the 2003 Employee
Stock Purchase Plan. The 1997 Stock 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 Covad’s board of directors. The number of
shares that may be issued under the 1997 Stock Option Plan is
subject to an annual increase to be added on the first day of
Covad’s fiscal year equal to the lesser of (a) 3% of
the outstanding shares of Covad’s stock on such date or
(b) an amount determined by the board. The 2003 Employee
Stock Purchase Plan allows employees to purchase shares of
Covad’s common stock at a discount from the market prices
during set purchase periods. The number of shares that may be
issued under the 2003 Employee Stock Purchase Plan is subject to
an annual increase to be added on January 1 of each year equal
to the lesser of either (a) 2% of the outstanding shares of
Covad’s stock on such date, (b) 7 million shares
or (c) an amount determined by a committee of the board.
Securities available for future issuance under Covad’s |
109
|
|
|
2003 Employee Stock Purchase Plan are included in column
(c) but are not included in columns (a) and
(b) because amount and price of securities purchased in an
offering period are determined at the end of such offering
period. Covad’s next offering period ends in June 2004. |
| |
| (2) |
These plans consist of the LaserLink.Net, Inc. 1997 Stock Plan,
the BlueStar Communications Group, Inc. 2000 Stock Incentive
Plan and the Infraswitch Corporation 2000 Employee and
Consultant Equity Incentive Plan, all of which were assumed by
Covad in connection with the acquisitions of each company and
are described in Note 13 of the Financial Statements. Covad
does not intend to grant additional options under these plans. |
|
|
| ITEM 13. |
Certain Relationships and Related Transactions |
(All dollar and share amounts are presented in thousands,
except per share amounts)
Strategic Investments and Relationships
On March 10, 2004, Covad completed a private placement of
$125,000 in aggregate principal amount of 3% Convertible
Senior Debentures (“Debentures”) due 2024, which are
convertible into shares of Covad’s common stock at a
conversion price of approximately $3.1742 per share,
subject to certain adjustments. The Debentures mature on
March 15, 2024. Covad may redeem some or all of the
Debentures for cash at any time on or after March 20, 2009.
Holders of the Debentures have the option to require Covad to
purchase the Debentures in cash, in whole or in part, on
March 15, 2009, 2014 and 2019. The holders of the
Debentures will also have the ability to require us to purchase
the Debentures in the event that Covad undergoes a change in
control. In each case, the redemption or purchase price would be
at 100% of their principal amount, plus accrued and unpaid
interest thereon. Net proceeds from the Debentures were
approximately $119,961 after commission and other transaction
costs. Covad incurred approximately $5,039 in transaction costs
in conjunction with the placement of the Debentures. The debt
issuance costs are being amortized to operations over sixty
months, the period through to the first date that holders have
the option to require us to purchase the Debentures.
In September 2002, we granted three warrants to a customer,
America Online, Inc. (“AOL”). These warrants provide
AOL with the right to purchase 1,500 shares of our
common stock for $1.06 per share, 1,000 shares of our
common stock for $3.00 per share, and 1,000 shares of
our common stock for $5.00 per share. These warrants have a
seven-year term and are immediately exercisable, fully vested
and non-forfeitable at the time of grant. In January 2003, we
granted three warrants to another customer, AT&T Corp., or
AT&T. These warrants provide AT&T with the right to
purchase 1,000 shares of our common stock for
$0.94 per share, 1,000 shares of our common stock for
$3.00 per share, and 1,000 shares of our common stock
for $5.00 per share. These warrants have a seven-year term
and are immediately exercisable, fully vested and
non-forfeitable at the time of grant.
Transactions with Management and Others
A member of our Board of Directors, Richard Jalkut, is the
President and CEO of TelePacific, one of our resellers. We
recognized revenues from TelePacific of $369, $611 and $1,311
for the years ended December 31, 2004, 2003 and 2002,
respectively. Accounts receivables from TelePacific were $29 and
$103 as of December 31, 2004 and 2003, respectively.
Another member of our Board of Directors, Dale Crandall, is a
member of the Board of Directors of BEA, which supplies us with
software and related support. We paid $890, $2,232 and $121 to
BEA during the years ended December 31, 2004, 2003 and
2002, respectively. Charles Hoffman, our CEO, is a director of
Chordiant, one of our vendors. We paid $3,387 to Chordiant in
2004. No amounts were paid to this vendor in 2003 and 2002.
Gary Hoffman, a sibling of our Chief Executive Officer, Charles
E. Hoffman, is employed by Covad. In 2004, Gary Hoffman received
$80 of base salary and $26 of sales commissions, as well as an
option grant to purchase 4 shares of our common stock at an
exercise price of $3.34.
We believe these transactions were negotiated on an arms-length
basis which terms we believe are comparable to transactions that
would likely be negotiated with unrelated parties.
110
|
|
| ITEM 14. |
Principal Accounting Fees and Services |
(All dollar amounts are presented in thousands)
For the year ended December 31, 2004, the following table
sets forth the aggregate fees and related expenses for
professional services provided by PricewaterhouseCoopers LLP
(“PwC”) during 2004 and Ernst & Young LLP
(“E&Y”) during 2004 and 2003. The audit committee
considered the provision of the services corresponding to these
fees, and the audit committee believes that the provision of
these services is compatible with PwC and E&Y maintaining
their independence. The audit committee pre-approval policies
and procedures require prior approval of each engagement of PwC
and E&Y to perform services. We adopted these pre-approval
policies in September 2002 in accordance with the requirements
of the Sarbanes-Oxley Act and the professional services listed
below that were provided after September 2002 were approved in
accordance with these policies.
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
| |
|
2004 | |
|
|
| |
|
| |
|
2003 | |
| |
|
PwC | |
|
E&Y | |
|
E&Y | |
| |
|
| |
|
| |
|
| |
|
Audit fees
|
|
$ |
3,996 |
|
|
$ |
524 |
|
|
$ |
1,952 |
|
|
Audit-related fees
|
|
|
— |
|
|
|
— |
|
|
|
3 |
|
|
Tax fees
|
|
|
— |
|
|
|
— |
|
|
|
258 |
|
|
All other fees
|
|
|
2 |
|
|
|
— |
|
|
|
— |
|
| |
|
|
|
|
|
|
|
|
|
| |
TOTAL
|
|
$ |
3,998 |
|
|
$ |
524 |
|
|
$ |
2,213 |
|
| |
|
|
|
|
|
|
|
|
|
For the year ended December 31, 2004, fees for PwC audit
services include fees associated with the integrated annual
audit, reviews of Covad’s quarterly reports on
Form 10-Q, accounting consultations and SEC registration
statements. All other fees include fees associated with the
annual subscription to PwC’s online accounting and auditing
research tool.
For the year ended December 31, 2004, fees for E&Y
audit services include fees associated with SEC registration
statements and the transition from E&Y to PwC as its
independent registered public accounting firm. For the year
ended December 31, 2003, fees for E&Y audit services
include fees associated with the annual audit, reviews of
Covad’s quarterly reports on Form 10-Q, accounting
consultations and SEC registration statements. Audit-related
fees include fees associated with the annual subscription to
E&Y’s online accounting and auditing research tool. Tax
fees included tax compliance, tax advice and tax planning.
111
PART IV
|
|
| Item 15. |
Exhibits, Financial Statement Schedules |
(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
Registered Public Accounting Firms are filed as part of this
report. |
Report of Independent Registered Public Accounting Firm
Report of Ernst & Young LLP, Independent Registered
Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders’ Equity (Deficit)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
|
|
|
| |
(2) |
Financial Statement Schedules. Financial statement
schedules not filed herein are omitted because of the absence of
conditions under which they are required or because the
information called for is shown in the consolidated financial
statements and notes thereto. |
| |
| |
(3) |
Exhibits. The Exhibits listed below and on the
accompanying Index to Exhibits immediately following the
signature page hereto are filed as part of, or incorporated by
reference into, this Report on Form 10-K. |
EXHIBIT INDEX
| |
|
|
|
|
| Exhibit |
|
|
| Number |
|
Description |
| |
|
|
| |
2 |
.1(1) |
|
Plan: First Amended Plan of Reorganization, as Modified, of
Covad Communications Group, Inc. dated November 26, 2001. |
| |
2 |
.2(2) |
|
Order Pursuant to Section 1129 of the Bankruptcy Code
Confirming the Debtor’s First Amended Chapter 11 Plan
of Reorganization, as Modified (Docket No. 214). |
| |
2 |
.3(3) |
|
Agreement and Plan of Merger, dated as of March 2, 2004,
among Covad Communications Group, Inc., Covad Communications
Investment Corp., GoBeam, Inc. and Eduardo Briceno, as
Representative. |
| |
3 |
.1(4) |
|
Amended and Restated Certificate of Incorporation. |
| |
3 |
.2(5) |
|
Certificate of Amendment of Certificate of Incorporation of the
Registrant filed on July 14, 2000. |
| |
3 |
.3(6) |
|
Certificate of Amendment of Certificate of Incorporation of the
Registrant filed on December 20, 2001. |
| |
3 |
.4(7) |
|
Bylaws, as currently in effect. |
| |
4 |
.1(8) |
|
Indenture, dated as of March 10, 2004 between the
Registrant and The Bank of New York, as Trustee. |
| |
4 |
.2(8) |
|
Resale Registration Rights Agreement, dated as of March 10,
2004 among the Registrant and Banc of America Securities LLC. |
| |
4 |
.3(8) |
|
Form of Debenture for the Registrant’s 3% Convertible
Senior Debentures due 2024. |
| |
4 |
.4(9) |
|
Stockholder Protection Rights Agreement dated February 15,
2000. |
| |
4 |
.5(10) |
|
Amended and Restated Stockholder Protection Rights Agreement,
dated as of November 1, 2001. |
| |
10 |
.1(11) |
|
Form of Indemnification Agreement entered into between the
Registrant and each of the Registrant’s executive officers
and directors. |
| |
10 |
.2(12) |
|
1998 Employee Stock Purchase Plan and related agreements. |
112
| |
|
|
|
|
| Exhibit |
|
|
| Number |
|
Description |
| |
|
|
| |
10 |
.3(13) |
|
1997 Stock Plan and related option agreement, as currently in
effect. |
| |
10 |
.22(14) |
|
Stock Purchase Agreement between SBC Communications Inc. and
Covad Communications Group, Inc., dated September 10, 2000. |
| |
10 |
.23(15) |
|
Resale and Marketing Agreement between SBC Communications Inc.
and Covad Communications Group, Inc., dated September 10,
2000. |
| |
10 |
.24(16) |
|
Credit Agreement dated as of November 12, 2001 by and
between Covad Communications Group, Inc. and SBC Communications
Inc. |
| |
10 |
.25(17) |
|
Resale Agreement dated as of November 12, 2001 by and among
SBC Communications Inc., Covad Communications Group, Inc., Covad
Communications Company, DIECA Communications Company and Laser
Link.net, Inc. |
| |
10 |
.26(18) |
|
Term Loan Note dated December 20, 2001 made by Covad
Communications Group, Inc. in favor of SBC Communications Inc. |
| |
10 |
.27(19) |
|
Deed of Trust, Assignment of Leases and Rents, Security
Agreement and Financing Statement dated effective as of
December 20, 2001 made by DIECA Communications, Inc. in
favor of Title Associates of Virginia, Inc., for the
benefit of SBC Communications Inc. |
| |
10 |
.28(20) |
|
Pledge Agreement dated as of December 20, 2001 made by
Covad Communications Group, Inc. to SBC Communications Inc. |
| |
10 |
.30(21) |
|
Security Agreement dated as of December 20, 2001 made by
Covad Communications Company in favor of SBC Communications Inc. |
| |
10 |
.31(22) |
|
Intellectual Property Security Agreement dated as of
December 20, 2001 made by Covad Communications Company in
favor of SBC Communications Inc. |
| |
10 |
.32(23) |
|
Subsidiary Guaranty dated as of December 20, 2001 made by
Covad Communications Company in favor of and for the benefit of
SBC Communications Inc. |
| |
10 |
.33(24) |
|
Capital Markets Debt Subordination Provisions. |
| |
10 |
.34(25) |
|
General Unsecured Debt Subordination Agreement. |
| |
10 |
.35(26) |
|
Form of Warrant to Purchase Common Stock Issued by the
Registrant on September 3, 2002 to America Online, Inc. |
| |
10 |
.36(27) |
|
Form of Warrant to Purchase Common Stock Issued by the
Registrant on January 1, 2003 to AT&T Corp. |
| |
10 |
.37(28) |
|
Covad Communications Group, Inc., 2003 Employee Stock Purchase
Plan. |
| |
10 |
.38(29) |
|
Covad Communications Group, Inc. Executive Severance Plan and
Summary Plan Description. |
| |
10 |
.39(30) |
|
General Release of All Claims executed by Anjali Joshi. |
| |
10 |
.40(31) |
|
Letter Agreement between Covad Communications and Charles
Hoffman dated May 29, 2001. |
| |
10 |
.41(32) |
|
Lease Agreement for 110 Rio Robles, San Jose, California,
between Covad Communications and CarrAmerica Realty Corporation
dated August 6, 2003. |
| |
10 |
.43(33) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and Charles E. Hoffman |
| |
10 |
.44(34) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and Patrick J. Bennett |
| |
10 |
.45(35) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and P. Michael Hanley |
| |
10 |
.46(36) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and James A. Kirkland |
| |
10 |
.47(37) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and Andrew Lockwood |
| |
10 |
.48(38) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and David McMorrow |
113
| |
|
|
|
|
| Exhibit |
|
|
| Number |
|
Description |
| |
|
|
| |
10 |
.49(39) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and Mark A. Richman |
| |
10 |
.50(40) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and Susan Crawford |
| |
10 |
.51(41) |
|
Indemnification Agreement between Covad Communications Group,
Inc. and Susan Crawford |
| |
10 |
.52(42) |
|
General Release of All Claims by and between Covad
Communications Group, Inc. and Mark Richman |
| |
21 |
.1 |
|
Subsidiaries of the Registrant. |
| |
23 |
.1 |
|
Consent of PricewaterhouseCoopers LLP, Independent Registered
Public Accounting Firm. |
| |
23 |
.2 |
|
Consent of Ernst & Young LLP, Independent Registered
Public Accounting Firm. |
| |
24 |
.1 |
|
Power of Attorney (incorporated in the signature page herein). |
| |
31 |
.1 |
|
Certification Pursuant to Rule 13a-14(a). |
| |
31 |
.2 |
|
Certification Pursuant to Rule 13a-14(a). |
| |
32 |
.1* |
|
Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002. |
| |
32 |
.2* |
|
Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002. |
|
|
|
| |
* |
These certifications accompany the Registrant’s Annual
Report on Form 10-K and are not deemed filed with the SEC. |
|
|
|
| |
(1) |
Incorporated by reference to the exhibit of corresponding number
filed with our current report on Form 8-K as originally
filed on December 28, 2001. |
| |
| |
(2) |
Incorporated by reference to Exhibit 99.12 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| |
(3) |
Incorporated by reference to Exhibit 2.1 filed with our
quarterly report on Form 10-Q as originally filed on
May 17, 2004. |
| |
| |
(4) |
Incorporated by reference to Exhibit 3.2 filed with our
registration statement on Form S-1/ A (No. 333-38688)
as originally filed on July 17, 2000 and as subsequently
amended. |
| |
| |
(5) |
Incorporated by reference to Exhibit 3.5 filed with our
registration statement on Form S-1/ A (No. 333-38688)
as originally filed on July 17, 2000 and as subsequently
amended. |
| |
| |
(6) |
Incorporated by reference to Exhibit 3.3 filed with our
Annual Report on Form 10-K as filed on March 29, 2002. |
| |
| |
(7) |
Incorporated by reference to the exhibit of corresponding number
filed with our registration statement on Form S-1
(No. 333-63899) as originally filed on September 21,
1998 and as subsequently amended. |
| |
| |
(8) |
Incorporated by reference to the exhibit of corresponding number
filed with our quarterly report on Form 10-Q as originally
filed on May 17, 2004. |
| |
| |
(9) |
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. |
|
|
| (10) |
Incorporated by reference to Exhibit 4.1 filed with our
current report on Form 8-K as originally filed on
December 14, 2001. |
| |
| (11) |
Incorporated by reference to Exhibit 10.1 filed with our
registration statement on Form S-1 (No. 333-63899) as
originally filed on September 21, 1998 and as subsequently
amended. |
| |
| (12) |
Incorporated by reference to Exhibit 10.2 filed with our
Annual Report on Form 10-K as filed on March 29, 2002. |
| |
| (13) |
Incorporated by reference to Exhibit 10.3 filed with our
Annual Report on Form 10-K as filed on March 29, 2002. |
114
|
|
| (14) |
Incorporated by reference to Exhibit 4.1 filed with our
current report on Form 8-K as originally filed on
September 12, 2000 and as subsequently amended. |
| |
| (15) |
Incorporated by reference to Exhibit 4.2 filed with our
current report on Form 8-K as originally filed on
September 12, 2000 and as subsequently amended. |
| |
| (16) |
Incorporated by reference to Exhibit 10.2 filed with our
quarterly report on Form 10-Q as originally filed on
November 14, 2001. |
| |
| (17) |
Incorporated by reference to Exhibit 10.1 filed with our
quarterly report on Form 10-Q as originally filed on
November 14, 2001. |
| |
| (18) |
Incorporated by reference to Exhibit 99.4 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (19) |
Incorporated by reference to Exhibit 99.5 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (20) |
Incorporated by reference to Exhibit 99.6 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (21) |
Incorporated by reference to Exhibit 99.7 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (22) |
Incorporated by reference to Exhibit 99.8 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (23) |
Incorporated by reference to Exhibit 99.9 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (24) |
Incorporated by reference to Exhibit 99.10 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (25) |
Incorporated by reference to Exhibit 99.11 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (26) |
Incorporated by reference to Exhibit 99.1 filed with our
current report on Form 8-K as originally filed
September 5, 2002. |
| |
| (27) |
Incorporated by reference to Exhibit 99.1 filed with our
current report on Form 8-K as originally filed
January 7, 2003. |
| |
| (28) |
Incorporated by reference to Exhibit 10.38 filed with our
quarterly report on Form 10-Q as filed on July 31,
2003. |
| |
| (29) |
Incorporated by reference to Exhibit 10.1 filed with our
current report on Form 8-K as originally filed
October 6, 2004. |
| |
| (30) |
Incorporated by reference to Exhibit 10.40 filed with our
quarterly report on Form 10-Q as filed on October 24,
2003. |
| |
| (31) |
Incorporated by reference to Exhibit 10.41 to our annual
report on Form 10-K as originally filed on
February 27, 2004. |
| |
| (32) |
Incorporated by reference to Exhibit 10.42 to our annual
report on Form 10-K as originally filed on
February 27, 2004. |
| |
| (33) |
Incorporated by reference to Exhibit 10.2 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (34) |
Incorporated by reference to Exhibit 10.3 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (35) |
Incorporated by reference to Exhibit 10.4 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (36) |
Incorporated by reference to Exhibit 10.5 to our current
report on Form 8-K as originally filed on October 6,
2004. |
115
|
|
| (37) |
Incorporated by reference to Exhibit 10.6 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (38) |
Incorporated by reference to Exhibit 10.7 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (39) |
Incorporated by reference to Exhibit 10.8 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (40) |
Incorporated by reference to Exhibit 10.2 to our current
report on Form 8-K as originally filed on November 24,
2004. |
| |
| (41) |
Incorporated by reference to Exhibit 10.1 to our current
report on Form 8-K as originally filed on December 6,
2004. |
| |
| (42) |
Incorporated by reference to Exhibit 10.1 to our current
report on Form 8-K as originally filed on November 24,
2004. |
116
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the Registrant has duly caused
this report to be signed on its behalf by the undersigned,
thereunto duly authorized, on March 14, 2005.
|
|
| |
COVAD COMMUNICATIONS GROUP, INC. |
|
|
| |
|
| |
Susan Crawford |
| |
Senior Vice President and |
| |
Acting Chief Financial Officer |
Pursuant to the requirements of the Securities Exchange Act of
1934, this report has been signed below by the following persons
on behalf of the Registrant and in the capacities indicated on
March 14, 2005.
| |
|
|
|
|
| Signature |
|
Title |
| |
|
|
| |
/s/ Charles E. Hoffman
(Charles E. Hoffman) |
|
Chief Executive Officer and Director
(Principal Executive Officer) |
| |
/s/ Susan Crawford
(Susan Crawford) |
|
Senior Vice President and Acting Chief Financial Officer
(Principal Financial and Accounting Officer) |
| |
/s/ Charles McMinn
(Charles McMinn) |
|
Chairman of the Board of Directors |
| |
/s/ L. Dale Crandall
(L. Dale Crandall) |
|
Director |
| |
/s/ Robert Hawk
(Robert Hawk) |
|
Director |
| |
/s/ Hellene S. Runtagh
(Hellene Runtagh) |
|
Director |
| |
/s/ Larry Irving
(Larry Irving) |
|
Director |
| |
/s/ Daniel Lynch
(Daniel Lynch) |
|
Director |
| |
/s/ Richard A. Jalkut
(Richard Jalkut) |
|
Director |
117
EXHIBIT INDEX
| |
|
|
|
|
| Exhibit |
|
|
| Number |
|
Description |
| |
|
|
| |
2 |
.1(1) |
|
Plan: First Amended Plan of Reorganization, as Modified, of
Covad Communications Group, Inc. dated November 26, 2001. |
| |
2 |
.2(2) |
|
Order Pursuant to Section 1129 of the Bankruptcy Code
Confirming the Debtor’s First Amended Chapter 11 Plan
of Reorganization, as Modified (Docket No. 214). |
| |
2 |
.3(3) |
|
Agreement and Plan of Merger, dated as of March 2, 2004,
among Covad Communications Group, Inc., Covad Communications
Investment Corp., GoBeam, Inc. and Eduardo Briceno, as
Representative. |
| |
3 |
.1(4) |
|
Amended and Restated Certificate of Incorporation. |
| |
3 |
.2(5) |
|
Certificate of Amendment of Certificate of Incorporation of the
Registrant filed on July 14, 2000. |
| |
3 |
.3(6) |
|
Certificate of Amendment of Certificate of Incorporation of the
Registrant filed on December 20, 2001. |
| |
3 |
.4(7) |
|
Bylaws, as currently in effect. |
| |
4 |
.1(8) |
|
Indenture, dated as of March 10, 2004 between the
Registrant and The Bank of New York, as Trustee. |
| |
4 |
.2(8) |
|
Resale Registration Rights Agreement, dated as of March 10,
2004 among the Registrant and Banc of America Securities LLC. |
| |
4 |
.3(8) |
|
Form of Debenture for the Registrant’s 3% Convertible
Senior Debentures due 2024. |
| |
4 |
.4(9) |
|
Stockholder Protection Rights Agreement dated February 15,
2000. |
| |
4 |
.5(10) |
|
Amended and Restated Stockholder Protection Rights Agreement,
dated as of November 1, 2001. |
| |
10 |
.1(11) |
|
Form of Indemnification Agreement entered into between the
Registrant and each of the Registrant’s executive officers
and directors. |
| |
10 |
.2(12) |
|
1998 Employee Stock Purchase Plan and related agreements. |
| |
10 |
.3(13) |
|
1997 Stock Plan and related option agreement, as currently in
effect. |
| |
10 |
.22(14) |
|
Stock Purchase Agreement between SBC Communications Inc. and
Covad Communications Group, Inc., dated September 10, 2000. |
| |
10 |
.23(15) |
|
Resale and Marketing Agreement between SBC Communications Inc.
and Covad Communications Group, Inc., dated September 10,
2000. |
| |
10 |
.24(16) |
|
Credit Agreement dated as of November 12, 2001 by and
between Covad Communications Group, Inc. and SBC Communications
Inc. |
| |
10 |
.25(17) |
|
Resale Agreement dated as of November 12, 2001 by and among
SBC Communications Inc., Covad Communications Group, Inc., Covad
Communications Company, DIECA Communications Company and Laser
Link.net, Inc. |
| |
10 |
.26(18) |
|
Term Loan Note dated December 20, 2001 made by Covad
Communications Group, Inc. in favor of SBC Communications Inc. |
| |
10 |
.27(19) |
|
Deed of Trust, Assignment of Leases and Rents, Security
Agreement and Financing Statement dated effective as of
December 20, 2001 made by DIECA Communications, Inc. in
favor of Title Associates of Virginia, Inc., for the
benefit of SBC Communications Inc. |
| |
10 |
.28(20) |
|
Pledge Agreement dated as of December 20, 2001 made by
Covad Communications Group, Inc. to SBC Communications Inc. |
| |
10 |
.30(21) |
|
Security Agreement dated as of December 20, 2001 made by
Covad Communications Company in favor of SBC Communications Inc. |
| |
10 |
.31(22) |
|
Intellectual Property Security Agreement dated as of
December 20, 2001 made by Covad Communications Company in
favor of SBC Communications Inc. |
| |
10 |
.32(23) |
|
Subsidiary Guaranty dated as of December 20, 2001 made by
Covad Communications Company in favor of and for the benefit of
SBC Communications Inc. |
| |
10 |
.33(24) |
|
Capital Markets Debt Subordination Provisions. |
118
| |
|
|
|
|
| Exhibit |
|
|
| Number |
|
Description |
| |
|
|
| |
10 |
.34(25) |
|
General Unsecured Debt Subordination Agreement. |
| |
10 |
.35(26) |
|
Form of Warrant to Purchase Common Stock Issued by the
Registrant on September 3, 2002 to America Online, Inc. |
| |
10 |
.36(27) |
|
Form of Warrant to Purchase Common Stock Issued by the
Registrant on January 1, 2003 to AT&T Corp. |
| |
10 |
.37(28) |
|
Covad Communications Group, Inc., 2003 Employee Stock Purchase
Plan. |
| |
10 |
.38(29) |
|
Covad Communications Group, Inc. Executive Severance Plan and
Summary Plan Description. |
| |
10 |
.39(30) |
|
General Release of All Claims executed by Anjali Joshi. |
| |
10 |
.40(31) |
|
Letter Agreement between Covad Communications and Charles
Hoffman dated May 29, 2001. |
| |
10 |
.41(32) |
|
Lease Agreement for 110 Rio Robles, San Jose, California,
between Covad Communications and CarrAmerica Realty Corporation
dated August 6, 2003. |
| |
10 |
.43(33) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and Charles E. Hoffman |
| |
10 |
.44(34) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and Patrick J. Bennett |
| |
10 |
.45(35) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and P. Michael Hanley |
| |
10 |
.46(36) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and James A. Kirkland |
| |
10 |
.47(37) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and Andrew Lockwood |
| |
10 |
.48(38) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and David McMorrow |
| |
10 |
.49(39) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and Mark A. Richman |
| |
10 |
.50(40) |
|
Change in Control Agreement between Covad Communications Group,
Inc. and Susan Crawford |
| |
10 |
.51(41) |
|
Indemnification Agreement between Covad Communications Group,
Inc. and Susan Crawford |
| |
10 |
.52(42) |
|
General Release of All Claims by and between Covad
Communications Group, Inc. and Mark Richman |
| |
21 |
.1 |
|
Subsidiaries of the Registrant. |
| |
23 |
.1 |
|
Consent of PricewaterhouseCoopers LLP, Independent Registered
Public Accounting Firm. |
| |
23 |
.2 |
|
Consent of Ernst & Young LLP, Independent Registered
Public Accounting Firm. |
| |
24 |
.1 |
|
Power of Attorney (incorporated in the signature page herein). |
| |
31 |
.1 |
|
Certification Pursuant to Rule 13a-14(a). |
| |
31 |
.2 |
|
Certification Pursuant to Rule 13a-14(a). |
| |
32 |
.1* |
|
Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002. |
| |
32 |
.2* |
|
Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002. |
|
|
|
| |
* |
These certifications accompany the Registrant’s Annual
Report on Form 10-K and are not deemed filed with the SEC. |
119
|
|
|
| |
(1) |
Incorporated by reference to the exhibit of corresponding number
filed with our current report on Form 8-K as originally
filed on December 28, 2001. |
| |
| |
(2) |
Incorporated by reference to Exhibit 99.12 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| |
(3) |
Incorporated by reference to Exhibit 2.1 filed with our
quarterly report on Form 10-Q as originally filed on
May 17, 2004. |
| |
| |
(4) |
Incorporated by reference to Exhibit 3.2 filed with our
registration statement on Form S-1/ A (No. 333-38688)
as originally filed on July 17, 2000 and as subsequently
amended. |
| |
| |
(5) |
Incorporated by reference to Exhibit 3.5 filed with our
registration statement on Form S-1/ A (No. 333-38688)
as originally filed on July 17, 2000 and as subsequently
amended. |
| |
| |
(6) |
Incorporated by reference to Exhibit 3.3 filed with our
Annual Report on Form 10-K as filed on March 29, 2002. |
| |
| |
(7) |
Incorporated by reference to the exhibit of corresponding number
filed with our registration statement on Form S-1
(No. 333-63899) as originally filed on September 21,
1998 and as subsequently amended. |
| |
| |
(8) |
Incorporated by reference to the exhibit of corresponding number
filed with our quarterly report on Form 10-Q as originally
filed on May 17, 2004. |
| |
| |
(9) |
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. |
|
|
| (10) |
Incorporated by reference to Exhibit 4.1 filed with our
current report on Form 8-K as originally filed on
December 14, 2001. |
| |
| (11) |
Incorporated by reference to Exhibit 10.1 filed with our
registration statement on Form S-1 (No. 333-63899) as
originally filed on September 21, 1998 and as subsequently
amended. |
| |
| (12) |
Incorporated by reference to Exhibit 10.2 filed with our
Annual Report on Form 10-K as filed on March 29, 2002. |
| |
| (13) |
Incorporated by reference to Exhibit 10.3 filed with our
Annual Report on Form 10-K as filed on March 29, 2002. |
| |
| (14) |
Incorporated by reference to Exhibit 4.1 filed with our
current report on Form 8-K as originally filed on
September 12, 2000 and as subsequently amended. |
| |
| (15) |
Incorporated by reference to Exhibit 4.2 filed with our
current report on Form 8-K as originally filed on
September 12, 2000 and as subsequently amended. |
| |
| (16) |
Incorporated by reference to Exhibit 10.2 filed with our
quarterly report on Form 10-Q as originally filed on
November 14, 2001. |
| |
| (17) |
Incorporated by reference to Exhibit 10.1 filed with our
quarterly report on Form 10-Q as originally filed on
November 14, 2001. |
| |
| (18) |
Incorporated by reference to Exhibit 99.4 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (19) |
Incorporated by reference to Exhibit 99.5 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (20) |
Incorporated by reference to Exhibit 99.6 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (21) |
Incorporated by reference to Exhibit 99.7 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (22) |
Incorporated by reference to Exhibit 99.8 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (23) |
Incorporated by reference to Exhibit 99.9 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
120
|
|
| (24) |
Incorporated by reference to Exhibit 99.10 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (25) |
Incorporated by reference to Exhibit 99.11 filed with our
current report on Form 8-K as originally filed on
December 28, 2001. |
| |
| (26) |
Incorporated by reference to Exhibit 99.1 filed with our
current report on Form 8-K as originally filed
September 5, 2002. |
| |
| (27) |
Incorporated by reference to Exhibit 99.1 filed with our
current report on Form 8-K as originally filed
January 7, 2003. |
| |
| (28) |
Incorporated by reference to Exhibit 10.38 filed with our
quarterly report on Form 10-Q as filed on July 31,
2003. |
| |
| (29) |
Incorporated by reference to Exhibit 10.1 filed with our
current report on Form 8-K as originally filed
October 6, 2004. |
| |
| (30) |
Incorporated by reference to Exhibit 10.40 filed with our
quarterly report on Form 10-Q as filed on October 24,
2003. |
| |
| (31) |
Incorporated by reference to Exhibit 10.41 to our annual
report on Form 10-K as originally filed on
February 27, 2004. |
| |
| (32) |
Incorporated by reference to Exhibit 10.42 to our annual
report on Form 10-K as originally filed on
February 27, 2004. |
| |
| (33) |
Incorporated by reference to Exhibit 10.2 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (34) |
Incorporated by reference to Exhibit 10.3 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (35) |
Incorporated by reference to Exhibit 10.4 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (36) |
Incorporated by reference to Exhibit 10.5 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (37) |
Incorporated by reference to Exhibit 10.6 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (38) |
Incorporated by reference to Exhibit 10.7 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (39) |
Incorporated by reference to Exhibit 10.8 to our current
report on Form 8-K as originally filed on October 6,
2004. |
| |
| (40) |
Incorporated by reference to Exhibit 10.2 to our current
report on Form 8-K as originally filed on November 24,
2004. |
| |
| (41) |
Incorporated by reference to Exhibit 10.1 to our current
report on Form 8-K as originally filed on December 6,
2004. |
| |
| (42) |
Incorporated by reference to Exhibit 10.1 to our current
report on Form 8-K as originally filed on November 24,
2004. |
121