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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
-----------------
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 2001
[_] TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from__________to__________
Commission file number 000-25271
COVAD COMMUNICATIONS GROUP, INC.
(Exact Name of Registrant as Specified in Its Charter)
Delaware 4813 77-0461529
(State or Other (Primary Standard
Jurisdiction Industrial (I.R.S. Employer
of Incorporation or Classification Code
Organization) Number) Identification No.)
3420 Central Expressway, Santa Clara, California 95051
(408) 616-6500
(Address and Telephone Number of Principal Executive Offices)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, Par Value $0.001 Per Share
(Title of Class)
Stock Purchase Rights Pursuant To Rights Agreement
(Title of Class)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of the voting and non-voting common equity held
by non-affiliates computed by reference to the price at which the common equity
was sold on March 1, 2002 as reported on the OTC Bulletin Board, was
approximately $333 million. Shares of common equity held by each officer and
director and by each person who owns 5% or more of the outstanding common
equity have been excluded in that such persons may be deemed to be affiliates.
This determination of affiliate status is not necessarily a conclusive
determination for other purposes.
APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS:
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court.
YES [X] NO [_]
APPLICABLE ONLY TO CORPORATE ISSUERS:
As of March 22, 2002, there were 220,562,012 shares outstanding of the
Registrant's Common Stock and no shares outstanding of the Registrant's Class B
Common Stock.
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PART I
ITEM 1. BUSINESS
The following discussion contains forward-looking statements that involve
risks and uncertainties, including statements regarding our growth rates, cash
needs, the adequacy of our cash reserves, relationships with customers and
vendors, market opportunities, operating and capital expenses, expense
reductions and operating results. Actual results could differ materially from
those anticipated in the forward-looking statements as a result of certain
factors including, but not limited to, those discussed in "Part I. Item 1.
Business--Risk Factors" and elsewhere in this Report.
We disclaim any obligation to update information contained in any
forward-looking statement. See "Part II. Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations--Forward Looking
Statements."
Overview
We are a leading provider of high-speed Internet connectivity ("broadband")
services to both business and consumer end-users sold through direct and
wholesale channels, and possess the nation's largest digital subscriber line
("DSL") network not owned by a traditional telephone company. This national
network encompasses more than 1,700 central offices in operation across the
U.S. in 94 metropolitan statistical areas and passes more than 40 million, or
approximately 40 to 45 percent, of all homes and businesses in the U.S. Our
services include a range of high-speed, high-capacity Internet access
connectivity and related services using DSL, T1, Virtual Private Network
("VPN"), and firewall technologies.
We leverage our national network by selling (1) on a wholesale basis through
Internet service providers, telecommunications carriers, and other customers;
and (2) on a direct basis through field sales, telephone sales, value-added
resellers and our website. Enterprise customers purchase our services to
provide their employees with high-speed remote access to the enterprise's local
area network ("RLAN access"). As of December 31, 2001, we had approximately
351,000 DSL and other high-speed lines in service (approximately thirteen
percent of which are associated with financially-distressed customers), and
provided service to more than 150 wholesale customers including AT&T
Corporation, XO Communications, EarthLink, Inc., Megapath Networks, and
Speakeasy.net. In addition, we sell to branded virtual service providers who
purchase turnkey dial-up services for resale to their customers or affiliate
groups. As of December 31, 2001, we also provide dial-up Internet access
service to over 190,000 subscribers through Covad.net, our direct sales channel.
Recent Developments
On December 13, 2001, the United States Bankruptcy Court for the District of
Delaware (the "Bankruptcy Court") entered an order confirming our
pre-negotiated First Amended Plan of Reorganization, as modified on November
26, 2001 (the "Plan"). On December 20, 2001 (the "Effective Date"), the Plan
was consummated and we emerged from bankruptcy. Under our Plan, we were able to
retire approximately $1.4 billion in aggregate face amount of outstanding notes
in exchange for a combination of approximately $271.7 million in cash and
approximately 35.3 million common shares, or 15% of the reorganized company. We
also settled other claims against the company as part of our reorganization.
See "Part II. Item 8. Notes to Consolidated Financial Statements, Note 2,
Reorganization Under Bankruptcy Proceedings." for additional details.
On January 4, 2002, we purchased substantially all of the assets of one of
our customers, InternetConnect, in an auction supervised by the U.S. Bankruptcy
Court for the Central District of California. The purchase price for the assets
of InternetConnect was $7.4 million. We did not assume any liabilities or
obligations of InternetConnect. The assets purchased included accounts
receivable, cash, equipment and other assets including approximately 9,250
end-user connections. The majority of these lines were on our network when we
purchased the assets. We have offered most of these end-users similar services
and we expect that a significant portion of these end-users will migrate to our
direct service.
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On February 27, 2002, the United States House of Representatives approved
H.R. 1542, principally sponsored by Congressmen Tauzin (R-LA) and Dingell
(D-MI). This bill would need to be approved by the United States Senate and the
President before it could become a law. This bill contains several provisions
that, if enacted into law, would impair the expansion of our business.
Specifically, H.R. 1542 would permit the Bell Operating Companies to enter the
long distance data market without first satisfying the market-opening
provisions of the 1996 Act, including the obligations to provide
nondiscriminatory access to unbundled network elements. In addition, the
legislation would, in its current form, eliminate the legal requirement that
telephone companies provide access to local loops that consist of a combination
of fiber and copper, rather than just copper. If our ability to lease such
loops were eliminated, it would severely impact our addressable market and our
ability to compete effectively with the telephone companies' retail DSL
offerings. It is unclear whether additional amendments may be made to the
legislation that would impact our business in a positive or negative way. It is
equally unclear whether this legislation will ever become law. Passage of this
or any similar legislation could adversely affect our business (See "Part I.
Item 1. Business--Government Regulation" and "Part I. Item 1. Business--Risk
Factors" for a more detailed discussion of this topic).
In February 2002, Terry Moya, our Executive Vice President, External Affairs
and Corporate Development left the Company and has threatened litigation
against the Company as described in "Part I. Item 3. Legal Proceedings." In
March 2002, Cathy Hemmer, our Executive Vice President and Chief Operations
Officer, announced her intentions to leave the company at the end of the month
to pursue other opportunities. The responsibilities of these executives have
been assumed by other members of our executive management team. While these
departures may cause some disruption, we do not believe they will have a
material impact on our business.
Industry Background
Emergence of DSL Technology
DSL technology first emerged in the 1990's and is commercially available
today to address performance bottlenecks of the public switched telephone
network. DSL equipment, when deployed at each end of standard copper telephone
lines, increases the data carrying capacity of copper telephone lines from
analog modem speeds of up to 56.6 kilobits per second (for the fastest consumer
modems) and ISDN speeds of up to 128 kilobits per second to DSL speeds of up to
8 megabits per second downstream and up to 1.5 megabits per second upstream,
depending on the length and condition of the copper line. Recent advances in
semiconductor technology, digital signal processing algorithms as well as
falling equipment prices have made the widespread deployment of DSL technology
more economical. We anticipate that equipment prices will continue to decrease
on a per user basis as a result of continued advances in semiconductor
technologies and increases in equipment production volumes.
Because DSL technology reuses the existing copper plant, it is generally
less expensive on a per user basis to deploy on a widespread scale than
alternative technologies, such as cable, wireless, and satellite technologies.
As a result, a significant portion of the investment in a DSL network is
success-based, requiring a comparatively lower initial fixed investment.
Subsequent variable investments in DSL technology are directly related to the
number of end-user subscribers. New services such as VPNs and firewalls can
easily be deployed over a DSL network, leveraging the investment in collocation
space and the overall network.
Growing Market Demand for Broadband Communications and Bandwidth Services
High-speed connectivity has become important to small and medium-sized
businesses and consumers due to the dramatic increase in Internet usage. This
has resulted in both the need to improve the efficiency of the time spent
on-line as well as the desire to have quick access to higher quality,
graphics-intensive on-line services and documents. According to industry
experts, the number of digital subscriber lines is expected to expand in the
U.S. from approximately 4.5 million lines at year-end 2001 to over 20.9 million
lines by 2006, with the majority of this growth occurring in the residential
sector.
3
As use of the Internet, intranets and extranets increases, we expect the
market size for both small and medium-sized business access, consumer Internet,
RLAN access and virtual private networks to continue to grow, causing the
demand for high-speed connectivity services to also grow. The full potential of
Internet and local area network applications, however, cannot be realized
without removing the performance bottlenecks of the existing public switched
telephone network and moving toward an "always connected" network. Over the
last ten years, increases in telecommunications bandwidth have significantly
lagged improvements in microprocessor performance, and most Internet users can
only connect to the Internet or their corporate local area network by low-speed
analog telephone lines.
Connections that are faster than dial-up are available, however, including:
. Integrated Services Digital Networks ("ISDN")--An ISDN line transmits
digital signals over ordinary analog lines and is capable of carrying
data at speeds up to 128 kilobits per second.
. T1 and Fractional T1 Lines--T1 and Fractional T1 Lines are telephone
industry terms for specialized digital transmission links with a capacity
of 1.544 megabits per second or portions thereof.
. Frame-Relay Circuits--A frame-relay circuit is a high-speed
packet-switched data communications protocol used across the interface
between user devices (such as hosts and routers) and network equipment
(such as switching nodes) at speeds up to 45 megabits per second.
. Cable Modems--Cable modems provide Internet access over hybrid
fiber-coaxial cable at downstream speeds up to 10 megabits per second.
. Satellite--Satellite connections offer one-way and two-way high speed
connections with speeds up to 150 Kbps upstream and 500 Kbps downstream.
Direct visibility to the satellite is critical.
. Wireless--Wireless services can be fixed or mobile in nature with fixed
services offering speeds up to 5 Mbps and mobile services offering speeds
up to 2 Mbps.
While these services are generally available in the United States, they are
frequently expensive, complex to order, install and maintain and, in some
cases, not as widely available as DSL technology.
Impact of Regulatory Developments
The passage of the 1996 Telecommunications Act created a legal framework for
competitive telecommunications companies to provide local, analog and digital
communications services in competition with the traditional telephone
companies. The 1996 Telecommunications Act eliminated a substantial barrier to
entry for competitive telecommunications companies by enabling them to leverage
the existing infrastructure built by the traditional telephone companies rather
than constructing a competing infrastructure at significant cost. The 1996
Telecommunications Act requires traditional telephone companies, among other
things, to:
. allow competitive telecommunications companies to lease telephone wires
on a line-by-line basis;
. provide central office space for the competitive telecommunications
companies' DSL and other equipment required to connect to leased
telephone lines;
. lease access on traditional telephone companies' inter-central office
fiber backbone to link the competitive telecommunications companies'
equipment; and
. allow competitive telecommunications companies to electronically connect
into traditional telephone companies' operational support systems to
place orders and access their databases.
In particular, the 1996 Telecommunications Act, as interpreted by the
Federal Communications Commissions ("FCC"), emphasizes the need for
competition-driven innovations in the deployment of advanced telecommunications
services, such as DSL services.
4
Business Strategy
Our objective is to become the leading nationwide provider of high-speed
Internet connectivity and related services to enable the advancement of
business and consumer applications that are enhanced by broadband
communications. The key elements of our strategy to achieve this objective are
as follows:
Drive our business toward profitability and positive cash flow. In response
to changes in the economy and the capital markets, we adopted a business plan
that helped to lower our cost structure in an effort to reach profitability
earlier than previously planned with less capital. Specific steps we have taken
in this regard include:
. completing our Chapter 11 proceeding, which eliminated approximately $1.4
billion in debt;
. assigning our subsidiary, BlueStar Communications Group ("BlueStar"), for
the benefit of BlueStar's creditors;
. reducing our workforce by approximately 2,600 employees from a peak of
approximately 4,000 employees in 2000 to approximately 1,400 employees
(excluding temporary workers) as of December 31, 2001;
. reducing the size of our network to approximately 1,700 central offices
through the closing of approximately 200 underproductive or not fully
built out central offices within the Covad network and approximately 250
central offices related to BlueStar;
. reducing the rebates and other incentives that we provide to our
customers;
. consolidating offices throughout the United States, including relocating
our corporate headquarters in Santa Clara, California;
. downsizing our international operations and discontinuing plans to fund
additional international expansion while continuing to manage existing
investments;
. enhancing productivity in our operations to increase customer
satisfaction while reducing costs;
. streamlining our direct sales and marketing channel and supplementing it
with telephone sales and sales through our website; and
. evaluating and implementing other cost reduction strategies including
salary freezes and reductions in travel, facilities and advertising
expenses.
Increase subscribers in our targeted metropolitan statistical areas. As of
December 31, 2001 our network was operational in 94 of the top metropolitan
statistical areas nationwide, passing 40% of all homes and businesses in the
United States. We plan to maintain our network size at substantially these
levels in the near term while we focus on adding subscribers in these markets.
Consequently, the amount of capital expenditures associated with an expansion
of the network will be greatly reduced and will be primarily dependent upon
subscriber growth.
Establish and maintain sales and marketing relationships with leading
Internet service providers, telecommunications carriers and other DSL resellers
to drive subscriber growth. We principally target Internet service providers,
telecommunications carriers and other DSL resellers that can offer their
end-users cost and performance advantages for Internet access using our
services. In most cases, we provide connections to Internet service providers,
which then offer high-speed Internet access using our network. In other cases,
we provide wholesale DSL and Internet access services for resale by our
customers. In this way we:
. carry the traffic of multiple Internet service providers,
telecommunications carriers and other customers in any region, increasing
our volume and reducing our costs per subscriber;
. leverage our selling efforts through the sales and support staff of these
Internet service providers, telecommunications carriers and other
customers;
5
. offer Internet service providers, telecommunications carriers and other
customers a competitive alternative to ILECs as wholesale service
providers; and
. provide Internet service providers, telecommunications carriers and other
customers a high-speed service offering to compete with cable-based
Internet access.
Sell directly to selected business end-users. We also provide high-speed
access, Internet access, web hosting, electronic mail, and VPN services
directly to business end-users. Our strategy is to utilize a combination of
direct field salespeople, telephone sales, websales and third-party referrals
to sell into all of our markets.
Develop and commercialize value-added services. We intend to introduce
value-added services to our customers and leverage the value of the network
access we offer today. Offering services such as voice over DSL, DSL plus
Internet Protocol (DSL + IP), Managed Security Systems, Private Networking and
our Virtual Service Provider ("VSP") offerings will allow us to bundle service
offerings to our customers and increase the number of channels through which we
sell our services. We believe this is an important part of our strategy and
will allow us to build upon our success in adding and retaining subscribers.
In late 2001 we introduced TeleXtend, which is Internet access services
using T1 technology. These services allow us to offer higher-bandwidth services
to customers outside the traditional reach of DSL, and to meet the needs of
businesses looking for an Internet connection with higher service levels. We
expect that T1 services will allow us to generate higher revenue and earn
higher margins from services sold to small business customers. They will also
allow us to offer services to medium and large enterprises with higher
bandwidth needs.
In early 2002, we also introduced a suite of managed security services,
including a managed firewall and a site-to-site VPN service. These services
allow us to address what we believe is a large and underserved small and medium
sized business security market. We believe these services will increase our
average revenue per business customer as we offer more services to the same
customer.
Continue to develop our operational support systems ("OSS") and explore
potential commercialization. Covad has developed a proprietary OSS, which we
believe is an industry leader in the automation of provisioning, monitoring and
customer support of a broadband network and broadband related services. This
system is comprised of internally custom developed software and supplemented
with various third party applications. We will continue to refine this system
architecture to allow for further productivity improvements and cost reductions.
We have been approached in the past and may be approached in the future by
parties interested in licensing our OSS for use in domestic and international
markets. These licensing opportunities will be evaluated on a case-by-case
basis and may result in licensing agreements. Such licenses may provide us with
license payments, an equity stake in the licensee and/or royalty payments. We
do not believe that such activity will detract from our core business nor will
it result in significant new revenues.
Take advantage of new regulatory developments. In late 1999, the FCC
required the major local phone companies to provide us, and other competitive
local carriers, with "line sharing." This allows us to provide our services
over the same telephone wire used by the traditional telephone companies to
provide analog voice services. In addition, the conditions adopted by the FCC
in October 1999 in connection with the SBC Communications, Inc./Ameritech Corp.
merger include provisions for line sharing and reductions in costs for
telephone wires in certain circumstances. Beginning in 2000, we started to
provision new orders for our consumer-grade services over line-shared telephone
wires. Asymmetric DSL and standard telephone service can exist on a single line
and most, if not all, of the traditional telephone companies provision their
own asymmetric services on the same line as existing voice services. Now,
almost all of our new consumer orders are provisioned over line shared lines.
6
We see line sharing as an important opportunity for us for four reasons.
First, line sharing significantly reduces the monthly recurring charges we
incur for telephone loops. Second, line sharing reduces the time it takes
traditional telephone companies to deliver telephone loops because the
telephone loop already exists. Third, line sharing helps resolve lack of
telephone loop problems that we have encountered when ordering telephone loops
in some areas of the country. And fourth, line sharing has enabled us to offer
self-installation, which reduces our costs and should improve the end-user
installation experience. Some of our traditional telephone company competitors
have challenged the FCC decision regarding line sharing.
Our Competitive Strengths
We were formed to capitalize on the substantial business opportunity created
by the growing demand for high-speed Internet and network access, the
commercial availability of low-cost DSL technology, and the passage of the 1996
Telecommunications Act. Competitive strengths of our solution to provide
high-speed connectivity services include:
. an attractive value proposition that provides two-way high-speed
connectivity to business and consumer customers at similar or lower
prices than the alternative high-speed technologies currently available;
. a nationwide network service delivery capability that covers
approximately 40% of all homes and businesses in the United States;
. multiple distribution channels including indirect sales (such as Internet
service providers, telecommunications resellers, and other third party
resellers), direct sales (including field sales, telephone sales,
websales), third party referral services and national brand entities;
. a mix of high-margin business end-users along with lower-margin,
high-volume consumer end-users;
. a widely available, continuously connected, relatively secure, business
grade network that facilitates deployment of Internet and Intranet
applications; and
. a management team experienced in the data communications,
telecommunications and personal computer industries.
Attractive Value Proposition. We offer higher bandwidth digital connections
than some alternative services. Our services also do not vary with usage and
are offered at similar or lower prices than similar alternative services. For
business Internet users, our high-end services offer two-way bandwidth
comparable to that offered by T1 and frame-relay circuits at lower price
points. For the RLAN market, our mid-range services are three to six times the
speed of ISDN lines and up to ten times the speed of the fastest consumer
analog modems at monthly prices similar to or lower than those for heavily used
ISDN lines. We believe that many of our enterprise customers can justify
deploying our lines to their employees if their employees' productivity
improves by only a few hours per month based on increases in the number of
hours worked and decreases in commute time and time spent waiting for
information. For consumer Internet users, our Internet service provider
customers resell our services at prices comparable to current cable modem and
local phone company services. Unlike cable modems, however, where multiple
users share a single coaxial cable, our service provides a dedicated, two-way
connection from each end-user's home or business to our network. We believe our
dedicated high-speed, two-way connection provides a superior end-user
experience.
We have leveraged our first-mover advantage to deploy a large nationwide
network and grow our number of lines installed. We were the first to widely
roll out DSL services on a commercial basis in the U.S., making DSL service
available for purchase in the San Francisco Bay Area in December 1997. We
believe that we have leveraged our first-mover advantage to rapidly expand our
network into our targeted metropolitan regions across the United States. We
believe that our more than 1,700 central offices give us one of the nation's
largest DSL networks, passing more than 40 million homes and businesses. We
have also developed proprietary OSS software and procedures to allow us to
efficiently add subscribers to our network. As of December 31, 2001, we
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had approximately 351,000 lines in service nationwide (approximately 13% of
which are associated with financially distressed customers) and we have
demonstrated the capacity to add over 1,000 subscribers per day to our network
using our OSS tools.
A wide-variety of channels to reach end-users. We have leveraged the
brands, sales and marketing, operational capabilities, and existing customer
base of major and startup Internet service providers and telecommunications
carriers to generate demand for our services. We are increasing the use of our
own direct sales force, telephone sales, websales and third party referral
services to generate end-user orders for our services in certain markets. We
believe our broad approach to generate end-user demand for our services is one
of our key competitive strengths.
A mix of high-margin business end-users and lower-margin consumer
end-users. Unlike our cable modem service and traditional local telephone
company competitors, we have historically targeted and continue to target small
business end-users who desire more robust services which generate higher
margins than our consumer end-user services. Because our business end-user base
is a very significant percentage of our total end-user base (approximately 52%
of our installed lines as of December 31, 2001), we believe our mix of services
generate a significantly higher average sales price per end-user than our
larger competitors. We have been successful in penetrating a significant
portion of the small business market in many of the cities in which we offer
our services. By balancing a reduced cost of service delivery through line
sharing and self-install kits for consumer installations while offering lower
prices targeted at higher volume, lower-margin consumer end-users, we believe
that we will obtain the necessary economies of scale in reducing our average
per unit costs of providing our services. We therefore believe our mix of
business and consumer end-users is one of our competitive strengths.
Widely available, always-connected relatively secure network. Our strategy
of providing comprehensive coverage in each region we serve is designed to
ensure that our services are available to the vast majority of potential
end-users. Our network provides 24-hour, always-on connectivity, unlike ISDN
lines and analog modems, which require customers to dial-up each time for
Internet or RLAN access. Also, because we use dedicated connections from each
end-user to our network, our customers can reduce the risk of unauthorized
access relative to other shared forms of broadband access, such as cable modems.
Experienced management team. Our management team includes individuals with
extensive experience in the data communications, telecommunications and
personal computer industries, including Charles E. Hoffman, President, Chief
Executive Officer and Director (former Chief Executive Officer of Rogers
Wireless); Charles McMinn, Chairman of the Board of Directors (Covad founder
and former Chief Executive Officer of Certive Corporation); Mark A. Richman,
Senior Vice President and Chief Financial Officer (former Chief Financial
Officer at MainStreet Networks); Anjali Joshi, Executive Vice President,
Engineering (former Program Manager at AT&T Corp.); Dhruv Khanna, Executive
Vice President, Secretary, and General Counsel, Legal and External Affairs
(Covad founder and former in-house counsel for Intel Corporation's
communications products division); Chuck Haas, Executive Vice President &
General Manager, Covad Wholesale (Covad founder and former Manager of Business
Development at Intel Corporation); Patrick Bennett, Executive Vice President &
General Manager, Covad Direct (former Senior Vice President of Marketing and
Product Development at TESSCO); Carol Karney, Senior Vice President, Strategic
Partnerships (former Global Communications Manager at Mobil Oil); and Michael
Hanley, Senior Vice President, Organizational Transformation (former Vice
President, Organizational Transformation at Rogers Wireless).
Our Service Offerings
We offer ten business-grade services, two consumer grade services and two
managed security services. Our business grade services are offered under the
TeleSpeed (six services), TeleSoho (one service) and TeleXtend (three services)
brands and our consumer-grade services are offered under the TeleSurfer brand.
Managed security services and VPN services are offered under the TeleDefend
brand. In addition, Internet service provider and enterprise customers may
purchase backhaul services from us to connect their facilities to our network.
8
We believe that substantially all, if not all, of the potential end-users in
our target markets generally can be served with one of our services. The
specific number of potential end-users who qualify for service will vary by
central office, by region and will be affected by line quality. Prices for our
end-user services vary depending upon the performance level of the service and
the underlying technology used to deliver the service. Our prices also vary for
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. The chart below compares the
performance and target markets for each of our end-user services:
Maximum Maximum
"Downstream" "Upstream"
Speed To Speed From Range*
Services End-User End-User (Feet) Market Usage
- -------- ------------ ---------- --------- ------------
TeleSpeed 144.. 144 Kbps 144 Kbps 35,000 ISDN replacement
TeleSpeed 192.. 192 Kbps 192 Kbps 15,000 Business Internet, RLAN
TeleSpeed 384.. 384 Kbps 384 Kbps 15,000 Business Internet, RLAN
TeleSpeed 768.. 768 Kbps 768 Kbps 13,000 Business Internet
TeleSpeed 1.1.. 1.1 Mbps 1.1 Mbps 12,000 Business Internet
TeleSpeed 1.5.. 1.5 Mbps 1.5 Mbps 7,000 T1 Equivalent
TeleSoho....... 1.5 Mbps 384 Kbps 15,000 Small Office/Home Office
TeleXtend 384.. 384 Kbps 384 Kbps Unlimited Business Internet
TeleXtend 768.. 768 Kbps 768 Kbps Unlimited Business Internet
TeleXtend 1.5.. 1.5 Mbps 1.5 Mbps Unlimited Business Internet, T1 replacement
TeleDefend..... N/A N/A N/A VPN, Managed Firewall
TeleSurfer..... 608 Kbps 128 Kbps 15,000 Consumer
TeleSurfer Plus 1.5 Mbps 384 Kbps 15,000 Consumer
- --------
* Estimated maximum distance from the end-user to the central office.
TeleSpeed
We launched service in December 1997 with our TeleSpeed services. These
services are intended to connect individual end-users on previously unused
conventional telephone wires to our DSL equipment in their serving central
office and from there to our network serving that metropolitan statistical
area. The particular TeleSpeed service available to an end-user depends in
large part on the end-user's distance to their respective central office.
TeleSpeed 144. Our TeleSpeed 144 service operates at speeds up to 144
kilobits per second in each direction, which is similar to the performance of
an ISDN line. This service, which can use existing ISDN equipment at the
end-user site, is targeted at the ISDN replacement market where its per month
flat rate can compare favorably to ISDN services from the traditional telephone
company when per-minute usage charges apply. It is also the service that we
offer on telephone wires that are either too long to carry our higher speed
services or are served by digital loop carrier systems or similar equipment
where a continuous copper connection is not available from the end-user site to
a central office.
TeleSpeed 192. This service provides one-and-a-half to three times the
performance of ISDN lines at similar or lower price points to heavily-used ISDN
lines.
TeleSpeed 384. This service provides three to six times the performance of
ISDN lines or approximately one-fourth the band width of a T1 data circuit, at
similar price points to heavily-used ISDN lines. The target markets for this
service are small businesses needing moderate speed access to the Internet or
enterprises seeking a telecommuter solution at a reasonable price compared to
alternate solutions.
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TeleSpeed 768. This service provides one-half the bandwidth of a T1 data
circuit at substantially less than one-half of the monthly price that we
estimate is typical for T1 service. The target market for the TeleSpeed 768
service is small businesses needing moderate speed access to the Internet but
who have previously been unable to afford the price of such a service. The
service also competes favorably from a price/performance standpoint with
traditional fractional T1 and frame-relay services for these same customers.
TeleSpeed 1.1. This service provides over two-thirds the bandwidth of a T1
data circuit at less than one-half of the monthly price that we estimate is
typical for T1 service. The target market for the TeleSpeed 1.1 service is
small businesses needing T1-level access to the Internet but which are unable
to afford the price of such a service. The service also competes favorably from
a price/performance standpoint with traditional fractional T1 and frame-relay
services for these same customers.
TeleSpeed 1.5. This service provides bandwidth comparable to a T1 data
circuit at less than one-half of the monthly price that we estimate is typical
for T1 service. The service also provides the highest performance of any
TeleSpeed service to stream video or other multimedia content to end-user
locations.
TeleSpeed Remote. TeleSpeed Remote provides high-speed network access for
end-users to their corporate networks. This service is targeted at businesses
that want high-speed remote office connections at a lower cost than ISDN or
frame-relay services. For example, this service can provide a corporation's
employees that are located outside of their corporate office's general
geographic region with high-speed access to their corporate network.
TeleSoho
TeleSoho. Our TeleSoho service was introduced in September 2001. We
designed this service for the Small Office/Home Office ("SoHo") customer
segment, with merged features from our consumer and business services. The
service is asymmetric, offering speeds up to 1.5 megabits per second downstream
and up to 384 kilobits per second upstream, and can be delivered to customers
using self installation or professional installation. TeleSoho is provisioned
with an ADSL router capable of supporting up to four end users and can support
one fixed IP address.
TeleXtend
Our TeleXtend services were introduced in November 2001. These services
allow end-users to connect to our network equipment in their servicing central
office and from there to our network serving that metropolitan statistical
area. The TeleXtend services available to end users are not limited by distance
from the servicing central office or the quality of the line connecting the end
user to the central office. As of December 31, 2001, TeleXtend services were
available in 395 central offices and 516 central offices as of March 5, 2002.
TeleXtend 384. This service provides three to six times the performance of
ISDN lines at similar price points to heavily-used ISDN lines and at price
points favorable to fractional T1 services from other providers. The target
market for this service is small businesses needing moderate speed access to
the Internet but who are unable to receive adequate speeds from DSL services
due to distance or loop quality.
TeleXtend 768. This service provides one-half the bandwidth of a T1 data
circuit at substantially less than one-half of the monthly price that we
estimate is typical for T1 service from other providers. The target market for
the TeleSpeed 768 service is small businesses needing moderate speed access to
the Internet but who are unable to receive adequate speeds from DSL services
due to distance or loop quality and have been unable to afford the price of
competitive T1-based service offerings.
TeleXtend 1.5. This service provides full T1 bandwidth for substantially
less than the monthly price that we estimate is typical for T1 services from
other providers. The target markets for the TeleXtend 1.5 service are small
businesses needing high speed access to the Internet but who are unable to
receive adequate speeds from
10
DSL services due to distance or loop quality and have been unable to afford the
price of competitive T1-based service offerings, and larger businesses looking
to replace existing frame relay or T1 services with a more cost-effective
alternative.
TeleSurfer
Our TeleSurfer service was introduced in April 1999 and is designed for the
consumer segment. This service is asymmetrical and intended to operate over the
digital spectrum of the phone line currently used by an end-user to receive
their basic voice service. This service offers speeds up to 1.5 megabits per
second downstream and up to 384 kilobits per second upstream. We generally
deliver this service to customers using self installation over a line-shared
loop. Line-sharing and self installation reduce the up front costs to the end
user for installation of the service.
TeleSurfer. This consumer-grade service is an asymmetric service, offering
speeds up to 608 kilobits per second downstream and up to 128 kilobits per
second upstream. This service is our base consumer service. The target market
for this service is a consumer using either dial-up analog or ISDN connections
for web access.
TeleSurfer Plus. This is a premium consumer-grade asymmetric service,
offering speeds up to 1.5 megabits per second downstream and up to 384 kilobits
per second upstream. The target market for this service is a consumer using
analog or ISDN connections for web access that require faster speeds than our
base service.
DSL + IP
This service currently bundles Internet protocol services with our
high-speed connectivity services. The additional Internet protocol services
include end-user authentication, authorization and accounting, Internet
protocol address assignment and management, domain name service and Internet
protocol routing and connectivity.
VSP
This service provides a complete dial-up service for organizations and
businesses that want to offer Internet services to their customers without
having to develop their own Internet capabilities. We provide Internet services
to end-users under the brand name of our customer or co-branded with Covad.net.
These Internet services are a turnkey solution that includes dial-up and
high-speed access, registration, connection and Internet software, web sites,
network authentication, electronic mail, billing and reporting, news, web-space
and end-user service and technical support.
TeleDefend
TeleDefend Firewall is a managed firewall service that provides security to
businesses with only one site. It helps prevent unauthorized users from hacking
into a business' local area network ("LAN") and viewing, stealing, or damaging
confidential information. TeleDefend VPN/Firewall is a site-to-site private
networking solution with a built-in managed firewall that helps provide
security to businesses with multiple sites. It gives a business the ability to
securely connect multiple sites and also helps to prevent unauthorized users
from hacking into its head office LAN or remote office LANs.
TeleDefend Firewall and TeleDefend VPN/Firewall were designed to provide a
turnkey solution to meet the unique needs of the small and medium-sized
business. Key features include professional up-front consultation and
configuration, self installation with telephone support, regular maintenance,
24x7 customer support and proactive monitoring, and service level agreements
("SLAs"). TeleDefend Firewall and TeleDefend VPN/Firewall are based on a custom
integrated security device from NetScreen Technologies that uses industry
leading security technologies, including stateful packet inspection firewall,
IPSec tunnels and Triple DES ("3DES") encryption.
11
Other Services
We also provide DS3 and OC3 circuit backhaul services from our regional
network to a customer's site. This service aggregates individual end-users in a
metropolitan statistical area and transmits the packet information to the
customer on a single high-speed line. The service utilizes an asynchronous
transfer mode ("ATM") protocol that efficiently handles the high data rates
involved and operates at up to 45 megabits per second for DS3 circuits and up
to 155 megabits per second for OC3 circuits. In addition to monthly service
charges, we impose non-recurring order set-up charges for end-users for our
services. Customers must also purchase a DSL modem from us or a third party for
each service connection. Certain of our customers also purchase inside wiring
and professional installation services from us.
Customers
We offer our services to Internet service providers, telecommunications
carriers, branded virtual service providers, enterprises and other DSL
resellers as well as directly to end-users. As of December 31, 2001, we had
approximately 351,000 lines in service (approximately thirteen percent of which
are associated with financially-distressed customers) and we had received
orders for our services from more than 150 Internet service provider,
enterprise and telecommunications carrier customers.
Wholesale
Our agreements with Internet service providers and other DSL resellers
generally have terms of one year and are nonexclusive. We do not require
Internet service providers to generate a minimum number of end-users and
generally grant volume discounts based on subscriber volume. We serve Internet
service providers who provide their own Internet access service and have
started serving Internet service providers who choose to obtain access to the
Internet through us (DSL + IP). In both cases, the Internet service providers
purchase our services on a wholesale basis and sell these services under their
own brand.
We also enter into customer agreements with telecommunications carriers,
including competitive telecommunications companies and interexchange carriers.
Under these agreements our telecommunication carrier customers typically resell
our services to their new and existing customers. These carriers currently
market our services primarily to small, medium and enterprise businesses that
purchase voice services from them.
We also sell our services through branded virtual service providers. In
these agreements a company with a recognized brand would utilize Covad as the
underlying Internet service provider by which it may provide service to an
existing base of customers who are potential purchasers of dial-up and
high-speed Internet service.
The following is a list of selected customers:
Selected
Selected Internet Service Telecommunications
Providers Carriers
--------- --------
EarthLink, Inc. AT&T Corporation
Megapath Networks WorldCom Group
Speakeasy.net Genuity Inc.
XO Communications SBC Communications, Inc.
During the calendar year 2001, EarthLink, AT&T Corporation, and XO
Communications became our largest customers based on lines in service and
revenue. We added several important customers in 2001 including Megapath
Networks and continue to grow our business through our indirect channel that at
year end 2001 had included approximately 125 active customers.
12
In 2001, several of our customers, were in a state of financial difficulty.
This condition caused us to stop recognizing revenue for these customers at the
time of billing because we could no longer be reasonably assured of the
collectibility of their payments. If a customer cannot provide us with
reasonable assurance of timely payments, then we only recognize revenue when
cash is received and after the collection of all outstanding accounts
receivable balances. Some of our Internet service provider customers have filed
for bankruptcy protection and we expect this trend to continue. These
bankruptcies have impaired our ability to collect the amounts owed to us and
limited our ability to migrate these lines to other Internet service provider
customers or to our own network. We have been required to continue to provide
services to these Internet service providers during their bankruptcy
proceedings. As of December 31, 2001, we estimate that the number of our lines
that remain in service with customers for which we only recognize revenue when
the customer pays for our services is approximately thirteen percent of our
installed base of lines, excluding lines that are in the process of being
disconnected. Based upon management's analysis, we expect more than 50% of the
lines that are with these customers will be restored to ordinary revenue
recognition status and the remainder will be disconnected.
Direct
Our initial practice with respect to enterprise customers was to sell our
RLAN service directly to them for use by their employees. Now, our enterprise
customers are not only choosing to purchase services directly from us, but also
indirectly from our Internet service provider or telecommunications service
provider customers. In addition, we began selling a suite of enhanced services
directly to end-users in certain markets by using a direct field sales force,
telephone sales, websales and a variety of third parties as referral resources
to whom we pay a one-time commission for the referral. Our approach to this
market is to combine our high quality national network with exceptional ISP
features to deliver a true value add service to SoHo, small and medium size
businesses.
As of December 31, 2001, our direct channel represented approximately four
percent of our lines in service and approximately 14.0% of our revenue for the
year then ended. We intend to continue to grow our direct channel.
Sales and Marketing
Wholesale Channel. For the Internet access markets, we sell our services to
Internet service providers, telecommunications carriers and others for sale to
their business and consumer end-users. These customers can either combine our
lines with their Internet access services or purchase wholesale Internet access
services from us and resell the combination to their existing and new
end-users. A key element of our wholesale strategy is to enter into
relationships with leading telecommunications companies, including competitive
telecommunications carriers and interexchange carriers, pursuant to which those
companies resell our services to their customers. We believe continuing to add
to our wholesale channel with partners such as EarthLink, SBC Communications
and AT&T Corporation will enable us to penetrate our target markets in the
Enterprise, small and medium-sized businesses ("SMB"), SoHo and consumer
segments more rapidly and at a profitable cost of acquisition.
We address these markets through sales and marketing personnel dedicated to
the wholesale channel. We supplement our sales efforts through training
programs and marketing programs that help our partners to acquire new
subscribers at a lower cost of acquisition and increase their orders to us.
These marketing and sales programs include support on direct marketing
campaigns, promotions and incentives designed to grow sales.
Direct Channel. Our direct sales organization focuses on selling high-speed
connectivity solutions to SoHo, small and medium-sized business users through
telephone sales, web sales, and a field sales organization. In addition, the
direct sales group has partnerships with systems integrators and value-added
resellers that sell our services to small and medium sized businesses. The
direct sales channel sells on a national basis and is also used as a migration
mechanism for DSL subscribers who were formerly customers of financially
challenged Internet service providers. Direct sales are an integral part of our
growth plans today and are expected to become a more significant percentage of
our sales in the future.
13
Branding and Marketing Programs. Our marketing programs are focused on
building our brand and growing sales in the small to medium-sized business
segment. We primarily pursue highly targeted direct marketing campaigns to
small businesses we have identified as likely to benefit from our services. We
support these campaigns with compelling offers and incentives to encourage
potential customers to purchase our services. In 2002 we aim to grow our brand
position in the small and medium-sized business segment by leveraging our
market leadership, quality of service and educating potential customers on the
benefits of using our services.
Service Deployment and Operations
Internet service providers, telecommunications carriers and corporate
information technology managers typically have had to assemble their digital
communications connections using multiple service and equipment suppliers,
leading to additional work, cost and coordination problems. With our services,
we emphasize a one-stop service solution for our customers. This service
solution includes:
. extending our network to customers and end-users with various needs and
configuration requirements;
. end-user premises wiring and DSL modem configuration;
. ongoing network monitoring and customer reporting;
. customer service and technical support; and
. operational support systems that reduce costs and improve performance for
us and our customers.
Extending Our Network to Customers and End-Users. We work with our Internet
service provider, enterprise, telecommunications carrier and other customers to
extend our network to each customer premise and each end-user premise by
ordering circuits from the traditional telephone company or a competitive
telecommunications company, interconnecting the customers and end-users to our
network, testing the circuits, configuring customer and end-user premise
equipment and monitoring the circuits from our network operations center.
End-User Premises Wiring, DSL Modem Configuration and Self-Installs. We use
our own and subcontracted field service crews and trucks to perform any
required inside wiring and to configure DSL modems at each end-user site. We
also provide self-install kits for end-users and permit our resellers to
provide their own self-install kits to end-users.
Network Monitoring. We monitor our network from our network operations
centers in order to identify and correct network problems. We have also
extended some of our network monitoring capabilities to our Internet service
provider, enterprise and telecommunications carrier customers so that they can
directly monitor their end-users for greater operational efficiency.
Customer Reporting. We communicate regularly with our customers about the
status of their end-users. We also operate a toll-free customer care help-line.
Additionally, we provide web-based tools to allow individual Internet service
providers and enterprise information technology managers and telecommunications
carriers to monitor their end-users directly, to place orders for new
end-users, to enter trouble tickets on end-user lines and to communicate with
us on an ongoing basis.
Customer Service and Technical Support. We provide 24x7 on-line support to
our Internet service provider customers and enterprise information technology
managers. The Internet service provider and information technology manager and
telecommunications carriers serve as the initial contact for service and
technical support, and we provide the second level of support. For customers
using our VSP offering, we provide the first level of support for their
customers.
14
Operational Support System. We have developed what we believe to be the
industry-leading OSS for DSL networks. Our OSS is based on web interfaces and
is highly automated. These features are intended to and should allow us to
scale our businesses rapidly because they eliminate many manual processes such
as line testing, network path configuration, equipment configuration, order
taking and verification and billing.
Network Architecture and Technology
We designed our network to provide the following attributes, which we
believe, are important requirements for our existing and potential customers:
Consistent and Scalable Performance. We believe that eventually public
packet networks will evolve to replace the over 40 million analog modems
currently connected to circuit switched networks that have been deployed in the
United States. As such, we designed our network for scalability and consistent
performance to all users as the network grows. We have designed a nation-wide
network that is organized around our regional metropolitan areas and
interconnected across the country.
Intelligent End-to-End Network Management. Because the customers' and
end-users' lines are continuously connected, they can also always be monitored.
We have visibility from the Internet service provider or enterprise site across
the network and to the end-user's premise equipment. Because our network is
centrally managed, we can identify and dynamically enhance network quality,
service and performance and address network problems promptly.
Flexibility. We have designed our network to be flexible in handling
various types of network traffic, starting with data, but extending to
real-time voice and video information in the future. This flexibility will
allow us to directly offer, or enter into arrangements with other entities to
offer, not only value-added services such as voice over DSL, and will also
allow us to control the prioritization of content delivery within 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.
The primary components of our network are the network operations center, our
high-speed national backbone network, Internet access points, high-speed
private metropolitan networks, central office spaces, including digital
subscriber line access multiplexers ("DSLAMs"), copper telephone lines and DSL
modems.
Network Operations Centers. Our entire network is managed from a network
operations center located in the San Francisco Bay Area. We provide end-to-end
network management using advanced network management tools on a 24x7 basis,
which enhances our ability to address performance or connectivity issues before
they affect the end-user experience. From the network operations center, we can
monitor the equipment and circuits in all of our Internet access points,
national backbone network, each metropolitan network, each central office
(including DSLAMs) and potentially individual end-user lines (including the DSL
modems).
Nationwide Broadband Access and Internet Connectivity. We link each of our
metropolitan areas together with our leased high-speed private backbone network
connections. Our Internet access points are strategically located at high-speed
interconnection facilities across the country in order to increase the
performance and decrease the latency of connections to the Internet for our
customers. Many of our customers choose to use our network rather than
developing their own national backbone.
Private Metropolitan Network. We operate our own private metropolitan
network in each region that we enter. The network consists of high-speed
communications circuits that we lease to connect our hubs, our equipment in
individual central offices, our Internet access points, and our Internet
service provider, enterprise and telecommunications carrier customers. This
network operates at speeds of 45 to 622 megabits per second.
15
Central Office Spaces. Through our interconnection agreements with the
traditional telephone companies, we have secured space in every central office
where we offer service. These central office spaces are designed to offer the
same high reliability and availability standards as the traditional telephone
company's other central office space. We require access to these spaces for our
equipment and for persons employed by or under contract with us. We place
DSLAMs in our central office spaces to provide the high-speed DSL signals on
each copper line to our end-users. As of December 31, 2001, we had more than
1,700 operational central offices.
Telephone Wires. We lease the telephone wires running to end-users from the
traditional telephone companies under terms specified in our interconnection
agreements. We lease lines that, in numerous cases, must be specially
conditioned by the traditional telephone companies to carry digital signals,
usually at an additional charge relative to that for voice grade telephone
wires. We also provide some of our services over telephone wires that already
carry the voice service of a traditional telephone company.
DSL Modems and On-Site Connection. We buy DSL modems from our suppliers for
resale to our Internet service provider or enterprise customers for use by
their end-users. We also buy DSL modems to resell to our retail customers. We
configure and install these modems along with any required on-site wiring
needed to connect the modem to the copper line leased from the traditional
telephone company. DSL modems are also included in self-installation kits
provided by us or our resellers, and shipped to end-users to do their own
installation.
Ongoing Network Development. Our ongoing service development and
engineering efforts focus on the design and development of new technologies and
services to increase the speed, efficiency, reliability and security of our
network and to facilitate the development of network applications by ourselves
and third parties that will increase the use of our network.
Competition
The markets for business and consumer Internet access and network access
services are intensely competitive, and we expect that these markets will
become increasingly competitive in the future. The principal bases of
competition in our markets include (in no particular order):
. price/performance;
. breadth of service availability;
. reliability of service;
. network security;
. ease of access and use;
. service bundling;
. content bundling;
. customer support;
. marketing support;
. brand recognition;
. operating scale and cost efficiency;
. operating experience;
. relationships with Internet service providers and other third parties; and
. capital resources.
16
We face competition from traditional telephone companies, cable modem
service providers, competitive telecommunications companies, traditional and
new national long distance carriers, Internet service providers, on-line
service providers and wireless and satellite service providers.
Traditional Telephone Companies. All of the largest traditional telephone
companies in our target markets offer DSL services. As a result, the
traditional telephone companies represent strong competition in all of our
target service areas, and we expect this competition to intensify. The
traditional telephone companies have an established brand name and reputation
for quality in their service areas, possess sufficient capital to deploy DSL
equipment rapidly, own the telephone wires themselves and can bundle digital
data services with their existing voice services to achieve economies of scale
in serving their customers. Certain of the traditional telephone companies are
aggressively pricing their consumer DSL services as low as $21.95 per month
without ISP services and $39.95 with an ISP, placing pricing pressure on our
consumer grade services. The traditional telephone companies are also in a
position to offer service from central offices where we are unable to secure
space because of asserted or actual space restrictions. The traditional
telephone companies are also able to offer consumer services through remote
terminals, which for technical reasons do not allow the provisioning of our
consumer grade services as well as some of our business grade services.
Cable Modem Service Providers. Cable modem service providers such as AT&T
Broadband, Comcast Corp, Cox Communications, AOL Time Warner, and Charter
Communications are deploying high-speed Internet access services over hybrid
fiber-coaxial cable networks. Hybrid fiber-coaxial cable is a combination of
fiber optic and coaxial cable and has become the primary architecture utilized
by cable operators in recent and ongoing upgrades of their systems. Where
deployed, these networks provide similar and in some cases higher-speed
Internet access than we provide. In most instances, they also offer these
services at lower price points than our TeleSurfer services. We believe the
cable modem service providers face a number of challenges that providers of DSL
services do not face. For example, different regions within a metropolitan
statistical area may be served by different cable modem service providers,
making it more difficult to offer the blanket coverage required by potential
wholesale customers as well as the economies of scale that result from one
contiguous network. Also, some of the current cable infrastructure in the
United States must be upgraded to support cable modems, a process which we
believe is significantly more expensive and time-consuming than the deployment
of DSL-based networks. Further, unlike DSL networks, cable networks typically
do not serve business areas. Therefore, we do not view cable modem service
providers as significant competition in the business market segment.
Competitive Telecommunications Companies. Many competitive
telecommunications companies such as DSL.net, Inc., Mpower Communications
Corporation and New Edge Networks Inc. offer high-speed digital services using
a business strategy similar to ours. Some of these competitors offer DSL-based
access services and others are likely to do so in the future. Companies such as
XO Communications and Allegiance Telecom have extensive fiber networks in many
metropolitan areas, primarily providing high-speed digital and voice circuits
to large corporations and have deployed DSL equipment and provide DSL-based
services. They also have interconnection agreements with the traditional
telephone companies pursuant to which they have acquired central office space
in many markets targeted by us. Further, some of our resellers (such as XO
Communications and Qwest) have either made investments in our competitors or
are deploying their own DSL capabilities.
National Interexchange Carriers. Interexchange carriers, such as AT&T,
Sprint, WorldCom, Qwest and Level 3 Communications have deployed large-scale
Internet access networks or ATM networks, sell connectivity to businesses and
residential customers and have high brand recognition. In early 2001, AT&T
purchased the DSL network assets of former competitor NorthPoint Communications
and in the summer of 2001, WorldCom purchased the DSL network of former
competitor Rhythms NetConnections. They also have interconnection agreements
with many of the traditional telephone companies and a number of spaces in
central offices from which they are currently offering or could begin to offer
competitive DSL services. Many of these companies have begun to provide
DSL-based services in competition with us. In addition, some of these
companies, such as AT&T, WorldCom (through UUNET) and Qwest, are our resellers.
17
Internet Service Providers. Internet service providers such as Genuity,
UUNET Technologies (a WorldCom company), EarthLink, Inc., XO Communications,
and Speakeasy.net provide Internet access to residential and business
customers, generally using a variety of telecommunications services such as T1,
satellite, wireless, dial-up, ISDN and DSL services. These Internet service
providers can and do compete with us in certain instances at the retail level
and at the wholesale level. To the extent we are not able to recruit Internet
service providers as customers for our service, Internet service providers
resell our competitors' services and could even become competitive DSL service
providers themselves.
On-Line Service Providers. On-line service providers include companies such
as AOL Time Warner and MSN (a subsidiary of Microsoft Corp.) that provide, over
the Internet and through proprietary on-line services, content and applications
ranging from news and sports to consumer video conferencing. These services are
designed for broad consumer access over telecommunications-based transmission
media which enable the provision of digital services to a significant number of
consumers. In addition, they provide Internet connectivity, ease-of-use and
consistency of environment. Many of these on-line service providers have
developed their own access networks for modem connections. AOL Time Warner owns
certain cable systems throughout the United States. Some of these systems offer
cable modem service and AOL has begun the deployment of its Internet services
over these networks. If these on-line service providers extend their access
networks to DSL or other high-speed service technologies, they would become
stronger competitors of ours.
Wireless and Satellite Data Service Providers. Wireless and satellite data
service providers continue to develop wireless and satellite-based Internet
connectivity. We face competition from terrestrial wireless services including:
third-generation wireless networks, two Gigahertz ("Ghz") and 28 Ghz wireless
cable systems (Multi-channel Microwave Distribution System ("MMDS") and Local
Multi-channel Distribution System ("LMDS")), and 18 Ghz, 39 Ghz and 50 Ghz
point-to-point and point-to-multi-point microwave systems. Some of our
resellers, such as WorldCom and XO Communications hold many of these microwave
licenses and are offering broadband data services over this spectrum. Companies
such as Teligent Inc. and WinStar Communications, Inc., hold point-to-point
microwave licenses to provide fixed wireless services such as voice, data and
videoconferencing. Many of the companies that have historically offered these
alternative connectivity solutions have scaled back their operations, suspended
service, or sold their operations. Winstar Communications sold substantially
all of its operating assets in its bankruptcy proceedings to IDT Corporation
and Aerie Networks recently acquired the Ricochet Network from the bankruptcy
proceedings of Metricom, Inc. Many of these wireless providers are having some
difficulty with these newer technologies as they are relatively immature.
Geographical issues, such as line of sight, surrounding LMDS and MMDS
deployment make widespread deployment difficult. Third generation cellular (3G)
or augmented second generation cellular (2.5G) systems are being deployed or
are expected to be deployed in the near future by providers such as AT&T
Wireless, Cingular, Sprint, Verizon and Voice Stream. These wireless services
tend to have equal or slower speeds than DSL and are generally more expensive
to deploy.
We also may face competition from satellite-based systems. StarBand
Communications Inc., Hughes Communications (a subsidiary of General Motors
Corporation and provider of DirecTV and DirecPC), EchoStar Communications
Corporation, Globalstar, Lockheed, Teledesic and others have either deployed or
are planning to deploy satellite networks to provide broadband voice and data
services. Such services could offer a competitive alternative to our DSL
services and these providers may be able to sell services in areas where our
DSL network does not currently reach.
Many of our competitors have used the difficulties faced by competitive
telecom companies to attempt to dissuade potential customers from purchasing
our services. We expect these efforts to continue in the near future, which may
lead to reduced demand for our services and higher cancellation rates.
18
Interconnection Agreements with Traditional Telephone Companies
A critical aspect of our business is our interconnection agreements with the
traditional telephone companies. These agreements cover a number of aspects
including:
. the price we pay to lease access (both for entire loops and line-shared
loops) to the traditional telephone company's telephone wires;
. the special conditioning the traditional telephone company provides on
certain of these lines to enable the transmission of digital signals;
. the price and terms of central office space for our equipment in the
traditional telephone company's central offices and remote terminals;
. the price we pay and access we have to the traditional telephone
company's transport facilities;
. the OSS and interfaces that we can use to place orders, report network
problems and monitor the traditional telephone company's response to our
requests;
. the dispute resolution process that we use to resolve disagreements on
the terms of the interconnection contract; and
. the term of the interconnection agreement, its transferability to
successors, its liability limits and other general aspects of the
traditional telephone company relationship.
We have entered into interconnection agreements with or otherwise obtained
interconnection rights from the different major traditional telephone companies
in all the states covering our metropolitan statistical areas. Traditional
telephone companies do not, in many cases, agree to our requested provisions in
interconnection agreements and we have not consistently prevailed in obtaining
all of our desired provisions in such agreements either voluntarily or through
the interconnection arbitration process. We cannot be sure that we will be able
to continue to sign interconnection agreements with existing or other
traditional telephone companies. The traditional telephone companies are also
permitting competitive telecommunications companies to adopt previously signed
interconnection agreements. In certain instances, we have adopted the
interconnection agreement of another competitive telecommunications company.
Other competitive telecommunications companies have also adopted the same or
modified versions of our interconnection agreements, and may continue to do so
in the future.
Many of our interconnection agreements have a term of three years. We will
have to renegotiate these agreements when they expire. The 1996
Telecommunications Act provides for arbitration of interconnection agreement
terms before state commissions. In many states, we are currently arbitrating
the rates, terms and conditions of such agreements. Although we expect to renew
the interconnection agreements that require renewal and believe the 1996
Telecommunications Act and the agreements themselves limit the ability of
traditional telephone companies not to renew such agreements, we may not
succeed in these arbitrations or in extending or renegotiating our
interconnection agreements on favorable terms. Additionally, disputes have
arisen and will likely arise in the future as a result of differences in
interpretations of the interconnection agreements. For example, we are in
litigation proceedings with certain of the traditional telephone companies. In
the past, these disputes have delayed our deployment of our network. Such
disputes have also adversely affected our service to our customers and our
ability to enter into additional interconnection agreements with the
traditional telephone companies in other states. Finally, the interconnection
agreements are subject to state commission, FCC and judicial oversight. These
government authorities may modify the terms of the interconnection agreements
in a way that hurts our business.
Government Regulation
Overview. Our services are subject to a variety of federal regulations.
With respect to certain activities and for certain purposes, we have submitted
our operations to the jurisdiction of state and local authorities who may
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also assert more extensive jurisdiction over our facilities and services. The
FCC has jurisdiction over all of our services and facilities to the extent that
we provide interstate and international services. To the extent we provide
identifiable intrastate services, our services and facilities are subject to
state regulations. Rates for the services and network elements we purchase from
the traditional local telephone companies are generally determined by the
States, consistent with federal law. In addition, local municipal government
authorities also assert jurisdiction over our facilities and operations. The
jurisdictional reach of the various federal, state and local authorities is
subject to ongoing controversy and judicial review and we cannot predict the
outcome of such review.
Federal Regulation. We must comply with the requirements of the
Communications Act of 1934, as amended by the 1996 Telecommunications Act, as
well as the FCC's regulations under the statute. The 1996 Telecommunications
Act eliminates many of the pre-existing legal barriers to competition in the
telecommunications and video programming communications businesses, preempts
many of the state barriers to local telecommunications service competition that
previously existed in state and local laws and regulations and sets basic
standards for relationships between telecommunications providers. The law
delegates to the FCC and the states broad regulatory and administrative
authority to implement the 1996 Telecommunications Act.
Among other things, the 1996 Telecommunications Act removes barriers to
entry in the local telecommunications market. It does this by preempting
certain state and local laws that are barriers to competition and by requiring
traditional telephone companies to provide nondiscriminatory access and
interconnection to potential competitors, such as cable operators, wireless
telecommunications providers, interexchange carriers and competitive
telecommunications companies.
Regulations promulgated by the FCC under the 1996 Telecommunications Act
specify in greater detail the requirements of the 1996 Telecommunications Act
imposed on the traditional telephone companies to open their networks to
competition by providing competitors interconnection, central office and remote
terminal space, access to unbundled network elements, retail services at
wholesale rates and nondiscriminatory access to telephone poles, ducts,
conduits and rights-of-way. The requirements enable companies such as us to
interconnect with the traditional telephone companies in order to provide local
telephone exchange services and to use portions of the traditional telephone
companies' existing networks to offer new and innovative services such as our
TeleSpeed, TeleSurfer and TeleXtend services.
These FCC requirements have been subject to litigation before several courts
and reconsideration at the FCC. Currently, the FCC's rules for pricing of
unbundled network elements are on appeal before the United States Supreme
Court. On July 18, 2000, the United States Court of Appeals for the Eighth
Circuit struck down the FCC's total element long run incremental cost
methodology which the FCC previously required state commissions to use in
setting the prices for collocation and for unbundled network elements that we
purchase from the traditional telephone companies. The court also rejected an
alternative cost methodology based on "historical costs" which was advocated by
the traditional telephone companies. In rejecting the FCC's cost methodology,
the court held that, under the 1996 Telecommunications Act, it is permissible
for the FCC to prescribe a forward-looking incremental cost methodology that is
based on actual incremental costs. The Supreme Court agreed to hear
consolidated appeals of the Eighth Circuit decision in January 2001. Oral
argument and briefing in those cases are complete, and a decision from the
Supreme Court is expected imminently. The outcome of this proceeding and
subsequent FCC and state commissions implementation actions is uncertain.
In addition to considering the FCC's pricing methodology the FCC's rules
requiring incumbent LECs to combine network elements for requesting carriers
are also before the Supreme Court. Those rules are generally applicable only to
voice carriers using the so-called "UNE-Platform" or "UNE-P" combination of
network elements. Should the Supreme Court strike down or otherwise modify
these combination rules, it may affect our ability to expand our service
offerings in the future.
The FCC's March 1999 collocation rules are currently on appeal to the D.C.
Circuit Court of Appeals for a second time as a result of a March 2000 D.C.
Circuit Court of Appeals decision and subsequent FCC decision on
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remand. In its March 2000 decision, the appeals court required the FCC to
revise its rules concerning the types of equipment that we may collocate on the
traditional telephone company premises, the steps that traditional telephone
companies may take to separate their equipment from our equipment and the
ability of one competitive carrier to interconnect with another competitive
carrier on premises owned by a traditional local telephone company. The FCC
issued a decision on remand that revised its rules in a manner that permits
incumbent telephone companies to exercise more discretion in determining the
placement of equipment in central offices. The traditional telephone companies
may implement the FCC's ruling and any subsequent court decision in a manner
that impairs our ability to obtain collocation space and collocate the
equipment of our choice on their premises. Such actions by the traditional
telephone companies could adversely affect our business and disrupt our
existing network design, configuration and services. In addition, the appellate
court may remand the FCC's collocation rules a second time, which could create
further uncertainty regarding the terms and conditions to which our collocation
arrangements are subject.
The FCC's November 1999 and January 2001 rules regarding line-sharing and
spectrum management policy are currently on appeal before the D.C. Circuit
Court of Appeals. Oral argument before the Court is scheduled for March 2002.
We rely on line-sharing to serve a large percentage of our customers, and the
availability of the line-sharing UNE is crucially important to our ability to
serve those customers. If the appellate court rules in favor of the challenge
to the FCC's line-sharing rules, such a ruling could have an adverse affect on
our ability to offer service to a large number of our customers. In addition,
many FCC unbundling and collocation rules are implemented by state commissions,
such as in interconnection arbitrations. State commission implementation
decisions are subject to appeal in either federal or state court. Since our
business plan depends upon the unbundling and collocation provisions of the
1996 Telecommunications Act, the results of these proceedings, challenges, and
appeals could significantly impact our ability to provide our services.
In the fourth quarter of 2001, the FCC commenced a rulemaking proceeding as
part of its triennial review of its unbundling rules. In this proceeding, the
FCC has undertaken a top to bottom reexamination of its unbundling rules. These
rules provide the legal means by which we obtain access to unbundled loops,
line-sharing, interoffice transport, operations support systems (OSS), and
other network elements that are vital to our business plan and our ability to
serve current and future customers. Should the FCC decide to scale back the
list of UNEs that incumbent LECs are required to provide, such a decision would
have an adverse impact on our ability to offer service to our customers. In
particular, we rely on unbundled loops and line-sharing, purchased from the
incumbent telephone companies pursuant to FCC rules, in order to reach end
users. Should the FCC decide to change its rules to limit our access to such
elements, our ability to provide our services would be significantly impacted.
In addition, the FCC has pending before it a petition by several traditional
telephone companies to eliminate the legal requirement that they provide leased
access to high-capacity loops. Access to such loops is vital to such Covad
products as TeleXtend, a new service that offers service comparable to
telephone company "T1" retail services, at a lower price. We use high-capacity
loops leased from the telephone companies, and the FCC's decision to limit the
availability of such loops would impact our ability to offer our TeleExtend
service.
In February 2002, the FCC opened an inquiry into how its existing
regulations impact the retail deployment of broadband services by the nation's
phone companies. The FCC's inquiry is into the proper regulatory classification
of retail services provided by the phone companies, and not whether the
obligation to open the phone company networks should be eliminated. As
currently framed, the FCC's inquiry would not directly impact our ability to
offer our own wholesale broadband services to ISPs. Even though our continued
access to phone company facilities is not directly impacted by this FCC
inquiry, we believe the inquiry did cause concerns for our shareholders and
potential shareholders. The FCC's inquiry also seems to indicate that the FCC
may be sympathetic to the phone companies' claim that they need regulatory
relief in order to compete with cable modem providers. This inquiry also may
increase the likelihood of future decisions from the FCC that adversely impact
our ability to access the phone companies' facilities. Even the perception that
the FCC is sympathetic to the concerns of the phone companies might create
uncertainty about our ability to provide continuing service, which could
adversely impact our ability to attract new customers and the value of our
shares.
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Aside from rulemaking proceedings, other actions by the FCC impact our
business. The 1996 Telecommunications Act also allows the Regional Bell
Operating Companies or "RBOCs," the traditional telephone companies created by
AT&T's divestiture of its local exchange business (now BellSouth, Verizon, SBC
and Qwest), to provide interLATA long distance services in their own local
service regions upon a showing that the RBOC makes its own facilities available
for interconnection and access to companies like us in accordance with the Act.
As a result, we are active in the RBOC long distance entry process before the
state commissions, the FCC and the Department of Justice, all of which have a
role in ensuring that the RBOC provides access and interconnection as required
by the Act. The FCC has approved nine RBOC applications to date, for Verizon in
New York, Massachusetts, Pennsylvania, and Connecticut and SBC in Texas,
Oklahoma, Kansas, Missouri and Arkansas. There are several other BOC
applications for long distance authority currently pending at the FCC, and more
filings are anticipated in the immediate future. In particular, BellSouth and
Qwest, neither of which has successfully applied for long distance authority at
the FCC, are both expected to file applications in the next few months. Given
the FCC's grant of several applications, the FCC is likely to thereafter grant
similar applications by Verizon, SBC and the other RBOCs in other states. We
have opposed such applications where we believe we have not received access and
interconnection as required by the Act. Grants of long-distance authority to
RBOCs will likely affect the level of cooperation we receive from each of the
RBOCs. In addition, the approval of such entries will likely adversely affect
the level of cooperation.
The FCC also reviews and approves telecommunications industry mergers. In
approving the merger of SBC and Ameritech in October 1999, the FCC required
SBC/Ameritech to create a structurally-separate advanced services affiliate
throughout the SBC/Ameritech service territory. The FCC required SBC/Ameritech
to provide its own in-region DSL services through this affiliate as a condition
to freeing the affiliate from traditional telephone company regulation. The
provision of DSL services by such an affiliate could harm our business. In June
2000, Bell Atlantic and GTE were ordered by the FCC to create such a similar
affiliate in the context of their merger into Verizon. In January 2001,
however, the D.C. Circuit Court of Appeals reversed and vacated the FCC's
SBC/Ameritech Merger Order on the basis that the separate affiliate requirement
was inconsistent with the 1996 Telecommunications Communications Act. Both
Verizon and SBC could now decide to alter, or even to eliminate, the separate
affiliates through which they have provided advanced services like DSL. To the
extent those separate affiliates provided assurances of nondiscriminatory
provisioning practices, the discontinuance of those affiliates will remove an
important competitive safeguard.
In addition, the 1996 Telecommunications Act provides relief from the
earnings restrictions and price controls that have governed the local telephone
business for many years. Since passage of the 1996 Act, traditional telephone
company tariff filings at the FCC, including filings for DSL services, have
been subjected to increasingly less regulatory review. In particular, without
substantive review of the cost support for traditional telephone company DSL
services, rates for those services may be below cost and may facilitate price
squeezes, predatory pricing or other exclusionary strategies by traditional
telephone companies that may harm our business. In addition, under the 1996
Telecommunications Act, the FCC is considering eliminating certain regulations
that apply to the traditional telephone companies' provision of services that
are competitive with ours. The timing and the extent of regulatory freedom and
pricing flexibility granted to the traditional telephone companies will affect
the competition we face from the traditional telephone companies' competitive
services. In December 2001, the FCC adopted a public notice seeking comment on
whether it should treat the DSL retail services of traditional telephone
companies as "non-dominant" services. The effect of declaring such services
non-dominant would be the elimination of the tariff filings for DSL services,
including the requirement that the telephone companies provide cost support for
their pricing determinations. The elimination of the tariffing and cost
imputation requirements would facilitate telephone company price squeezes and
similar predatory conduct, which could raise the prices we pay for crucial
inputs to our business. Although the FCC has not publicly signaled its intent
in this proceeding, the chance that the FCC will lift some or all of these
safeguards is a risk to our ability to secure timely access to network elements
at a sustainable price.
Further, the 1996 Telecommunications Act provides the FCC with the authority
to forbear from regulating entities such as us who are classified as
"non-dominant" carriers. The FCC has exercised its forbearance authority.
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As a result, we are not obligated to obtain prior certificate approval from the
FCC for our interstate services or file tariffs for such services. We have
determined not to file tariffs for our interstate services. We provide our
interstate services to our customers on the basis of contracts rather than
tariffs. We believe that it is unlikely that the FCC will require us to file
tariffs for our interstate services in the future. We are, however, required to
submit to certain obligations that attach to all telecommunications carriers.
For example, we are required to make quarterly payments into the federal
universal service fund ("FUSF"). The FUSF is a fund mandated by Congress to
provide cost support for various programs that ensure the availability of
telecommunications services to, for example, schools and libraries, hospitals,
and high-cost regions of the country. We are required to pay a percentage of
our interstate and international telecommunications revenue to the FUSF, and we
generally pass that percentage through to our customers pursuant to FCC rules.
The amount we are required to pay into the FUSF varies depending on the
breakdown between, for example, our telecommunications revenue and
non-telecommunications (such as equipment sales and installation services)
revenue. In addition, we are not required to pay into the FUSF for any
information services revenue, such as that derived by Covad.net, which is an
ISP. 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 of interstate
telecommunications revenue that a carrier must contribute to the FUSF. To the
extent those rules are changed, or interpretation of those rules results in an
increase in the FUSF contributions that we must make, we may be subject to
increased liability for payments beyond what we have already contributed.
The impact of these judicial and regulatory decisions on the prices we pay
to the traditional telephone companies for collocation and unbundled network
elements is highly uncertain. There is a risk that any new prices set by the
regulators, particularly if the Supreme Court should remand the FCC's pricing
methodology, could be materially higher than current or currently expected
prices. If we are required to pay higher prices to the local telephone
companies for collocation and unbundled network elements, it could have a
material adverse effect on our business.
Any changes in applicable federal law and regulations, in particular,
changes in its interconnection agreements with traditional telephone companies,
the prospective entry of the RBOCs into the in-region long distance business
and grant of regulatory freedom and pricing flexibility to the traditional
telephone companies could harm our business.
State Regulation. To the extent we provide identifiable intrastate services
or have otherwise submitted ourselves to the jurisdiction of the relevant state
telecommunications regulatory commissions, we are subject to such jurisdiction.
In addition, certain states have required prior state certification as a
prerequisite for processing and deciding an arbitration petition for
interconnection under the 1996 Telecommunications Act. We are authorized to
operate as a competitive local exchange carrier in all of our targeted
metropolitan statistical areas. We have pending arbitration proceedings in
different states for interconnection arrangements with the relevant traditional
telephone companies. We have concluded arbitration proceedings in a number of
states by entering into interconnection agreements with the relevant
traditional telephone companies. We have filed tariffs in certain states for
intrastate services as required by state law or regulation. We are also subject
to periodic financial and other reporting requirements of these states with
respect to our intrastate services.
The different state commissions have various proceedings to determine the
rates, charges and terms and conditions for collocation and unbundled network
elements. Unbundled network elements are the various portions of a traditional
telephone company's network that a competitive telecommunications company can
lease for purposes of building a facilities-based competitive network,
including telephone wires, central office collocation space, inter-office
transport, operational support systems, local switching and rights of way. The
rates set forth in many of our interconnection agreements are interim rates and
will be prospectively, and, in some cases, retroactively, affected by the
permanent rates set by the various state commissions for such unbundled network
elements as unbundled loops and interoffice transport. We have participated in
unbundled network element rate proceedings in several states in an effort to
reduce these rates. If any state commission decides to increase unbundled
network element rates our operating results would suffer. The applicability of
the various state regulations on our business and compliance
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requirements will be further affected by the extent to which our services are
determined to be intrastate services. Jurisdictional determinations of our
services as intrastate services could harm our business. In particular, we
could be deemed liable for payments into state universal service funds, which
are programs that require telecommunications carriers providing intrastate
services to pay a percentage of their intrastate revenues to support various
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.
Local Government Regulation. We may be required to obtain various permits
and authorizations from municipalities in which we operate our own facilities.
The issue of whether actions of local governments over the activities of
telecommunications carriers, including requiring payment of franchise fees or
other surcharges, pose barriers to entry for competitive telecommunications
companies which may be preempted by the FCC is the subject of litigation.
Although we rely primarily on the unbundled network elements of the traditional
telephone companies, in certain instances we deploy our own facilities,
including fiber optic cables, and therefore may need to obtain certain
municipal permits or other authorizations. The actions of municipal governments
in imposing conditions on the grant of permits or other authorizations or their
failure to act in granting such permits or other authorizations could harm our
business.
The foregoing does not purport to describe all present and proposed federal,
state and local regulations and legislation affecting the telecommunications
industry. Other existing federal regulations are currently the subject of
judicial proceedings, legislative hearings and administrative proposals which
could change, in varying degrees, the manner in which communications companies
operate in the United States. In particular, in the 107th Congress the United
States House of Representatives approved H.R. 1542, principally sponsored by
Congressmen Tauzin (R-LA) and Dingell (D-MI). This bill would need to be
approved by the Senate and the President before it can become law. It contains
several provisions that, if enacted into law, would pose an obstacle to the
expansion of our business. Specifically, H.R. 1542 would permit the Bell
Operating Companies to enter the long distance data market without first
satisfying the market-opening provisions of the 1996 Act, including the
obligations to provide nondiscriminatory access to unbundled network elements.
In addition, the proposed legislation would, in its current form, eliminate the
legal requirement that telephone companies provide access to local loops that
consist of a combination of fiber and copper, rather than just copper. If our
ability to lease such loops is eliminated, it would severely impact our
addressable market and our ability to compete effectively with the telephone
companies' retail DSL offerings. It is unclear whether additional amendments
may be made to the legislation that would impact our business in a positive or
negative way. It is equally unclear whether this legislation will ever become
law. Passage into law of this or any similar legislation could adversely affect
our business.
The ultimate outcome of these proceedings and the ultimate impact of the
1996 Telecommunications Act or any final regulations adopted pursuant to the
1996 Telecommunications Act on our business cannot be determined at this time
but may well be adverse to our interests. We cannot predict the impact, if any,
that future regulation or regulatory changes may have on our business and we
can give you no assurance that such future regulation or regulatory changes
will not harm our business. See "Part I. Item 1. Business--Risk Factors--Our
services are subject to government regulation, and changes in current or future
laws or regulations could adversely affect our business" and "Part I. Item 1.
Business--Risk Factors--Challenges in obtaining space for our equipment on
premises owned by the traditional local telephone companies harms our business."
Intellectual Property
We regard certain aspects of our products, services and technology as
proprietary and attempt to protect them with patents, copyrights, trademarks,
trade secret laws, restrictions on disclosure and other methods. These methods
may not be sufficient to protect our technology. We also generally enter into
confidentiality or license agreements with our employees and consultants, and
generally control access to and distribution of our documentation and other
proprietary information. Despite these precautions, it may be possible for a
third party to copy or otherwise obtain and use our products, services or
technology without authorization, or to develop similar technology
independently.
24
Currently we have two patents granted and a number of patent applications
pending, and intend to prepare additional applications and to seek additional
patent protection for our systems and services to the extent possible. The
pending and any future patent applications may not be issued to us, and if
issued, they may not protect our intellectual property from competition which
could seek to design around or invalidate these patents.
Further, effective patent, copyright, trademark and trade secret protection
may be unavailable or limited in certain foreign countries. The global nature
of the Internet makes it virtually impossible to control the ultimate
destination of our proprietary information. Steps taken by us may not prevent
misappropriation or infringement of our intellectual property rights, and
litigation may be necessary in the future to enforce our intellectual property
rights to protect our trade secrets or to determine the validity and scope of
the proprietary rights of others. Such litigation could result in substantial
costs and diversion of resources. In addition, others may sue us alleging
infringement of their intellectual property rights.
A manufacturer of telecommunications hardware named "COVID" has filed an
opposition to our trademark application for the mark "COVAD and design." Covid
has also filed a complaint in the United States District Court for the District
of Arizona, alleging claims for false designation of origin, infringement and
unfair competition. Covid is also seeking to cancel our trademark registration
for the "Covad" name. We do not believe that this lawsuit or the opposition to
our trademark application and granted trademark have merit, but these legal
proceedings are unpredictable and there is no guarantee we will prevail. If we
do not succeed, it could limit our ability to provide our services under the
"COVAD" name.
Employees
As of December 31, 2001, we had approximately 1,400 employees. None of our
employees are represented by a labor union, and we consider our relations with
our employees to be good. Our ability to achieve our financial and operational
objectives depends in large part upon the continued service of our senior
management and key technical, sales, marketing, legal and managerial personnel,
and our continuing ability to attract and retain highly qualified technical,
sales, marketing, legal and managerial personnel. Competition for such
qualified personnel is intense, particularly in software development, network
engineering and product management. In addition, in the event that our
employees unionize, we could incur higher ongoing labor costs and disruptions
in our operations in the event of a strike or other work stoppage.
Risk Factors
We may need to raise additional capital under difficult financial market
conditions in order to maintain our operations
Management has developed a business plan that it believes 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 the growth of our subscriber base with a reasonable per subscriber
profit margin and improvements in productivity. We are currently facing a
variety of challenges which affect the cash needs of the Company, including:
. the failure or inability of some of our Internet service provider
customers to pay their bills for our services;
. the fact that we have generated significant net losses and that we
continue to experience negative cash flow from our operations;
. increased customer disconnection rates that will adversely impact
revenues;
. the growth of our revenue and line count in each geographic area;
. the rate at which customers and end-users purchase and pay for our
different services
. ability to maintain pricing levels of our services;
25
. the level of marketing required to acquire and retain customers and to
attain a competitive position in each region we enter;
. the rate at which we invest in engineering and development and
intellectual property with respect to existing and future technology;
. investment opportunities in complementary businesses, acquisitions or
other opportunities; and
. the possibility of an adverse resolution of the lawsuits against us.
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 do not have a
significant surplus of cash, however, so adverse business, legal, regulatory or
legislative developments may require us to obtain additional financing. If we
have the opportunity, we may also choose to raise additional capital sooner,
depending on market conditions, to allow us to increase our capital
expenditures, expand our services into new regions, expand our network, or
offer lower prices to our customers to increase subscriber volume.
We may be unsuccessful in raising sufficient capital at all or on terms that
would not meaningfully dilute the ownership percentage of existing
shareholders. Moreover, we believe that current capital market conditions,
particularly for our industry, are very difficult. There also may be some
negative perceptions that remain from our recent Chapter 11 proceeding, the
difficulties we have experienced with our financial reporting and internal
controls issues in 2001 and 2000 and the revenue recognition challenges that we
continue to face as a result of our customers' financial difficulties. These
factors may severely restrict our ability to obtain additional financing. If we
are unable to obtain required additional capital or are required to obtain it
on terms less satisfactory than we desire, there may be a material adverse
effect on our financial condition which would require a restructuring, sale or
liquidation of our company, in whole or in part.
In addition, our credit agreement with SBC Communications contains covenants
that limit our ability to incur additional debt, and also restricts certain
investments. As a result, we may not be able to undertake certain activities
which management believes are in our best interest to develop our business. As
a result of the limitations on our ability to obtain additional debt financing,
we may be required to raise funding through the issuance of equity securities,
which we may be unable to do on acceptable terms.
We have no commitments for any future financing and there can be no
assurance that we will be able to obtain additional financing in the future
from either debt or equity financings, bank loans, collaborative arrangements
or other sources on terms acceptable to us, or at all. Any additional equity
financing will be dilutive to our stockholders. Collaborative arrangements, if
necessary to raise additional funds, may require us to relinquish rights to,
among other things, market our services in certain territories.
Our internal controls need to be improved
In the course of preparing the financial statements for the year ended
December 31, 2000, internal control weaknesses were discovered, which continued
into 2001. During 2001 we have taken corrective action, including the hiring of
key personnel, the use of outside consultants, and documenting key policies and
procedures that we believe improved our internal controls. We are continuing
our efforts to improve such controls. However, these procedures are relatively
new and are still being improved. Our growth continues to stress these internal
controls and we cannot assure you that our current control procedures will be
adequate for any future growth.
Our business may suffer unless financial market conditions improve
The current financial market conditions pose a variety of additional
challenges to our business. First, the financial condition of many of our
Internet service provider customers has deteriorated, and continues to
deteriorate because of their inability to raise additional funds for their
businesses. In the quarter ended December 31, 2001, these financially
distressed customers accounted for approximately thirteen percent of our
26
installed base of lines. The ability of these customers to generate additional
revenue for us has been reduced dramatically, if not eliminated. Our inability
to rapidly replace this portion of our distribution channel will have a
material adverse impact on our business.
Second, many of our Internet service provider customers are making and will
continue to make significant cutbacks in their sales and marketing efforts and
capital expenditures, which will in turn adversely affect our financial
results. Since our Internet service provider customers face many of the same
challenges that we face, we may be adversely affected by these reductions since
it is uncertain what effect such reductions will have on their operations,
customer and/or end-user relationships, growth prospects and financial results.
Any significant adverse effect on our Internet service provider customers may
adversely affect us.
Third, the continued uncertainty in the overall economy could also have a
material adverse impact on the demand for our services from our customers and
our own direct sales.
Fourth, in order to fund continued development, deployment and expansion of
our networks and fund operating losses, we may need to access the capital
markets. If adequate funds are unavailable or not available on acceptable
terms, we may further revise our business strategies and/or further delay,
curtail, reduce the scope of, or eliminate the expansion of our networks,
operations and/or our marketing and sales efforts. Should we revise our
business strategies, we may not achieve break even on a cash-flow basis or turn
profitable as planned, expected or announced.
The financial uncertainty of the DSL industry caused us to lose orders
We continue to receive reports that our competitors are using the
bankruptcies of NorthPoint Communications and Rhythms NetConnections and the
financial difficulties of the competitive telecom sector to discourage
end-users from purchasing our services. We have seen and expect that some
end-users will either purchase DSL services from the traditional telephone
companies, or purchase alternative technologies instead of our DSL services.
The demise of NorthPoint Communications and Rhythms NetConnections and our
own Chapter 11 proceeding caused significant press, analyst, investor,
customer, end-user and employee concerns about the viability of our business in
2001, and these concerns may continue to exist. It is likely that these
concerns contributed to the following conditions that we experienced in 2001
and may continue to experience:
. greater cancellation of orders placed and disconnects of lines already in
service;
. fewer orders from existing customers;
. loss of existing customers;
. inability to sign up new customers and book new orders; and
. reduced revenues and growth.
Each of the effects has had, is having, and will continue to have a material
adverse impact on our business.
We may not be able to expand as quickly as we need to achieve profitability
Our strategy is to significantly increase the number of end-users on our
network within our existing metropolitan statistical areas. To accomplish this
strategy, we must, among other things:
. market to and acquire a substantial number of customers and end-users;
. expand our direct sales capability and infrastructure;
. continue to implement and improve our operational, financial and
management information systems, including our client ordering,
provisioning, dispatch, trouble ticketing and other operational systems as
27
well as our billing, accounts receivable and payable tracking,
collection, fixed assets and other financial management systems;
. hire and train additional qualified management and technical personnel;
. manage and resolve any disputes, which have arisen and may in the future
arise with our traditional telephone company suppliers;
. establish and maintain relationships with third parties to market and
sell our services, install network equipment and provide field service;
and
. continue to expand and upgrade our network infrastructure.
We may be unable to do these things successfully. As a result, we may be
unable to deploy our services in a timely manner or achieve the operational
growth necessary to meet our business strategy.
Our growth has placed, and will continue to place, significant demands on
our management, operational and capital resources. We expect to implement
system upgrades, new software releases and other enhancements, which could
cause disruption and dislocation in our business. If we are successful in
implementing our marketing strategy, we may have difficulty responding to
demand for our services and technical support in a timely manner and in
accordance with our customers' expectations. We expect these demands to require
the addition of new management personnel and the increased outsourcing of Covad
functions to third parties. We may be unable to do this successfully, in which
case we could experience a reduction in the growth of our line orders and
therefore our revenues.
Direct sales are becoming a larger portion of our business strategy and we
intend to increase our direct sales efforts significantly in 2002. This will
require significant management and operational resources and may cause
disruption to our business and our relationships with our existing resellers.
It is also uncertain whether we will be able to profitably expand our direct
sales capability.
Previously, we deployed new software systems that caused some disruption to
our business while enhancing the productivity and efficiency of certain
operational practices. Future changes in our processes that we introduce or we
are required to introduce as a result of our arrangements with the traditional
telephone companies could cause similar or more serious disruption to our
ability to provide our services and to our overall business.
Thus far we have electronically linked our own ordering software systems to
the software systems of most of our traditional telephone company suppliers.
Such electronic linkage is essential for us to successfully place a large
volume of orders for access to telephone wires. There is no assurance that we
will be successful in electronically linking our software system to those of
all of the traditional telephone companies on whom we rely for access to their
telephone wires. Even if we have such electronic links, we cannot assure you
that we will be able to process all of our orders through such electronic
links, which would require additional human intervention. Our failure to
electronically link our systems with those of all major traditional telephone
companies would severely harm our ability to provide our services in large
volume to our customers.
Our rapid expansion also placed considerable strain on our ability to
reconcile the bills that we receive from the phone companies for the network
elements and services that we use to deliver our services. We receive thousands
of pages of bills every month that often contain errors that are difficult to
detect. Even with a manual review, it is likely that we will not detect all of
the errors in these bills. As a result, we may be overbilled by the phone
companies for their services. We are working with the phone companies to
automate this process, but we expect that we will have to continue to devote
considerable resources to the review of these bills.
We have experienced increased cancellations and disconnections
Since our inception a significant percentage of orders for our services have
been cancelled. The primary reasons for these cancellations are:
. the subscriber is too far from our central office;
28
. the lack of adequate facilities; or
. service is not available at their location.
The cancellation rates for consumer line-shared orders are particularly high
in the territories of the two large traditional local telephone companies on
the East Coast, BellSouth and Verizon East. Based upon our experiences with
other traditional local telephone companies like Pacific Bell, we believe that
our consumer line-shared order cancellation rates will decline as we work
through various operational issues, as well as regulatory and legal issues
relating to the performance of the traditional local telephone companies.
However, our failure to significantly reduce our current cancellation rates and
improve our operational and other processes with the traditional local
telephone companies will continue to have a material adverse impact on our
customer relationships, bookings, installations, revenues and our ability to
acquire new customers.
Our high customer disconnection rate continues to impair the expansion of
our business. These disconnections have occurred as a result of several
factors, including disconnections of end-users served by partners that were not
paying for their services, disconnection requests that were not immediately
processed, disconnections in regions where we stopped offering our services as
a result of our restructuring, and other reasons. We may see additional
increases in our disconnection rates for various reasons. Our failure to
significantly reduce our disconnection rate would have a material adverse
effect on our business.
We are dependent on a limited number of customers for the preponderance of
our revenues, and we are highly dependent on sales through our resellers
We primarily market our Internet access services through Internet service
providers, telecommunications carriers and other customers for resale to their
business and consumer end-users. To date, a limited number of Internet service
providers have accounted for the significant majority of our revenues. For
example, in the fourth quarter of 2001, one of our Internet service providers,
EarthLink, provided approximately 56% of our orders and a significant percent
of our revenues. As a result, a significant reduction in the number of
end-users or revenues provided by one or more of our key customers could
materially harm our operating results including revenue and line-growth in any
given period. We expect that our Internet service provider customers and
telecommunications carriers will account for the majority of our future market
penetration and revenue growth.
Our agreements with our customers are generally non-exclusive. Many of our
customers also resell services offered by our competitors. In addition, a
number of our customers have committed to provide large numbers of end-users in
exchange for price discounts. If our customers do not meet their volume
commitments or otherwise do not sell our services to as many end-users as we
expect, our business will suffer. In addition, future relationships we may
establish with other third parties may not result in significant line orders or
revenue.
We stopped recognizing revenue for several of our Internet service provider
customers in 2001 because we could no longer be reasonably assured of payment
from these customers. If a customer cannot provide us with reasonable assurance
of payment, then we only recognize revenue when the customer actually pays for
our services and after we have collected all previous accounts receivable
balances. As of December 31, 2001, the number of our lines that remain in
service with Internet service provider customers for which we only recognize
revenue when the customer pays for our services is approximately 44,000,
excluding lines that are in the process of being disconnected. With respect to
these Internet service provider customers, approximately 84% of their lines are
business lines and approximately 16% are consumer lines. Business lines carry a
higher profit margin than consumer lines. Based upon our experience to this
point, we expect that approximately 50% of the lines that are with these
customers will be restored to ordinary revenue recognition status and the
remainder will be disconnected.
Although we will continue to try to obtain payments from these customers, it
is unlikely that we will obtain payment in full from one or more of these
customers. With respect to the Internet service provider customers that are in
bankruptcy proceedings, as well as any additional Internet service provider
customers that seek bankruptcy protection, there can be no assurance that we
will ultimately collect sums owed to us by these customers and it
29
remains uncertain what consequence, if any, bankruptcy proceedings would have
on lines installed for such customers. Moreover, to the extent that we receive
payments from customers that subsequently seek bankruptcy protection, we may be
required to return some or all of these payments to the bankruptcy trustee. For
example, XO Communications is a customer that represented 9% of our revenue in
2001 and has announced a plan to restructure its debt. XO may have to file for
bankruptcy protection as part of this plan. Consequently, beginning in the
fourth quarter of 2001, we began recognizing revenue received from XO
Communications on a cash basis. In addition, XO may stop doing business with
us. The inability of our Internet service provider customers to pay these past
due amounts, and to make timely payments for our services in the future, has
adversely affected our financial condition and results of operations and may
continue to do so in the future.
Some of our Internet service provider customers, including CAIS and
InternetConnect, filed for bankruptcy protection in 2001. We purchased
substantially all the assets of InternetConnect and are in the process of
moving its end users to our network or to one of our Internet service provider
customers. Based upon our experience with other purchases of end users from
distressed partners, we expect that as much as one-half of these end-users will
not continue to purchase our services.
We expect that some additional Internet service provider customers will be
unable to obtain additional funding and therefore will be unable to pay for our
service, which means that we will not receive the revenue associated with these
additional Internet service provider customers. We have terminated our
contracts with some of these Internet service provider customers and we have
and may continue to disconnect end-users that are purchasing our services from
delinquent Internet service providers. There can be no assurance that these
end-users will continue to purchase our services from us or from another one of
our Internet service provider customers. Even if we are able to transition
these end-users to another Internet service provider or to ourselves, such
migrations will require a significant amount of our resources and cause
disruptions in our processes and operations, which may impair our ability to
install new lines as they are ordered. Any of these circumstances could
adversely affect our business.
We are a party to litigation and adverse results of such litigation matters
could negatively impact our financial condition and results of operations
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. It claims that we falsified trouble ticket reports with respect to
the phone lines that we ordered from it and made false statements to the public
and governmental authorities critical of Verizon, and seeks unspecified
monetary damages (characterized as being in the "millions") and injunctive
relief. The complaint asserts causes of action for negligent and intentional
misrepresentation and violations of the Lanham Act and the California unfair
business practices statute. An adverse judgment in this matter could have a
material adverse impact on our business because of the financial impact. It
could also harm our reputation with the state public utilities commissions and
the Federal Communications Commission, which would adversely impact our
regulatory efforts.
In addition, we are party to other litigation described in "Part I, Item 3.
Legal Proceedings." While we are vigorously defending these lawsuits, the total
outcome of these litigation matters is inherently unpredictable and there is no
guarantee we will prevail. Moreover, we cannot guarantee the successful
resolution of these actions and an adverse result in these actions, including
settlement of these actions, could negatively impact our financial condition
and results of operations and, in some circumstances, result in a material
adverse effect on us. In addition, defending such actions could result in
substantial costs and diversion of resources that could adversely affect our
financial condition, results of operations and cash flows.
We rely upon distributions from our subsidiaries to service our indebtedness
and our indebtedness is effectively subordinated to the indebtedness of our
subsidiaries
We are a holding company. As such, we conduct substantially all of our
operations through our subsidiaries. As of December 31, 2001, we had
approximately $76.3 million of total indebtedness (including capital lease
30
obligations and the future minimum payments under our operating leases). Our
agreement with SBC Communications permits us and our subsidiaries to incur
additional indebtedness in the future. Our cash flow and ability to service our
indebtedness will depend upon the cash flow of our subsidiaries and payments of
funds by those subsidiaries to us in the form of repayment of loans, dividends
or otherwise. These subsidiaries are separate and distinct legal entities with
no legal obligation to pay any amounts due on our indebtedness or to make funds
available for this purpose. In addition, our subsidiaries may become parties to
financing arrangements which may contain limitations on the ability of our
subsidiaries to pay dividends or to make loans or advances to us or otherwise
make cash flow available to us.
If we were unable to generate sufficient cash flow or are otherwise unable
to obtain funds necessary to meet required payments of principal, premium, if
any, and interest on our indebtedness, we would be in default under the terms
of the agreements governing such indebtedness. In that case, SBC Communications
could elect to declare all of the funds borrowed to be due and payable together
with accrued and unpaid interest. If an acceleration occurs and we do not have
sufficient funds to pay the accelerated indebtedness, the holders could
initiate enforcement action against us.
In addition, in the event of any distribution or payment of our assets in
any foreclosure, dissolution, winding-up, liquidation or reorganization, SBC
Communications will have a secured claim to our assets, prior to the
satisfaction of any unsecured claim from such assets. In the event of our
bankruptcy, liquidation or reorganization, holders of our equity will be
entitled to payment from the remaining assets only after payment of, or
provision for, all indebtedness, including secured indebtedness. In any of the
foregoing events, we may not have sufficient assets to make any payments with
respect to our equity.
We were delisted from the Nasdaq National Market and this limits the public
market for our common stock
We were delisted from the Nasdaq National Market on July 20, 2001 and our
common stock currently trades on Nasdaq's "OTC Bulletin Board." Our delisting
from the Nasdaq National Market has adversely affected the liquidity and price
of our common stock and it may have a long-term adverse impact on our ability
to raise capital in the future.
The price of our common stock may fluctuate significantly, which may result
in losses for investors
The market price for our common stock has been and is likely to continue to
be highly volatile. We expect our common stock to be subject to fluctuations as
a result of a variety of factors, including factors beyond our control. These
include:
. changes in market valuations of Internet and telecommunications related
companies;
. our ability to recognize revenue;
. any loss of major customers, or inability of major customers to make
payments;
. any deviations in net revenues or in losses from levels expected by
securities analysts;
. actual or anticipated variations in quarterly operating results,
including the pace of the expansion of our business;
. adverse litigation results;
. announcements of new products or services by us or our competitors or new
competing technologies;
. the addition or loss of Internet service provider or enterprise customers
or subscribers;
. changes in financial estimates or recommendations by securities analysts
including our failure to meet the expectations of our stockholders or of
analysts;
. the adoption of new, or changes in existing, accounting rules, guidelines
and practices, which may materially impact our financial statements and
may materially alter the expectations of securities analysts or investors;
31
. conditions or trends in the telecommunications industry, including
legislative and regulatory developments;
. growth of the Internet and on-line commerce industries;
. announcements by us or our competitors of significant acquisitions,
strategic partnerships, joint ventures or capital commitments;
. additions or departures of key personnel;
. future equity or debt offerings or our announcements of such offerings;
. general market and general economic conditions;
. volume fluctuations, which are particularly common among highly volatile
securities of Internet related companies; and
. other events or factors, many of which are beyond our control.
Future sales or issuances of our common stock may depress our stock price
Sales of a substantial number of shares of our common stock in the public
market, or the appearance that such shares are available for sale, could
adversely affect the market price for our common stock. As of March 22, 2002,
we had 220,562,012 shares of common stock outstanding. A significant number of
these shares are not publicly traded but are available for immediate resale to
the public, subject to certain volume limitations under the securities laws and
lock-up arrangements. As of January 1, 2002, we also have 11,194,003 shares of
our common stock reserved for issuance pursuant to options under our 1997 Stock
Plan. As of January 1, 2002, we have 31,600,330 shares that are subject to
outstanding options issued pursuant to our 1997 Stock Plan and the stock option
plans we assumed in connection with our acquisitions of BlueStar and Laser
Link.net. We have also reserved approximately 6,503,927 shares of common stock
for issuance under our 1998 Employee Stock Purchase Plan as of January 1, 2002.
Shares underlying vested options are generally eligible for immediate resale in
the public market. In addition, a significant portion of our stockholders have
certain registration rights with respect to their shares.
Pursuant to the MOU we signed with the plaintiffs in the securities class
action in the United States District Court for the Northern District of
California, we would distribute approximately 6.5 million shares to individuals
if the final settlement is approved by that court (see Part I. Item 3. "Legal
Proceedings" for a more detailed discussion of this matter). We expect that the
court will consider the final settlement in the second or third quarter of
2002. If these shares are distributed to these individuals, they will be
eligible for immediate resale in the public markets.
We sold 9,373,169 shares of our common stock to SBC Communications, Inc. in
the fourth quarter of 2000. SBC agreed not to transfer any of these shares
until November 2001, and, after that period, SBC agreed to offer us the first
opportunity to purchase shares that it intends to sell. We are not aware of any
sales of these shares by SBC. Sales of shares of our common stock by SBC could
adversely affect the price of our stock.
We may issue additional shares of capital stock, or warrants or other
convertible securities in connection with future financings, which, given our
current stock price, will have a dilutive effect on existing stockholders and
may adversely affect our stock price.
Anti-takeover effects of certain charter and bylaw provisions, Delaware law,
our indebtedness, our Stockholder Protection Rights Plan and our change in
control severance arrangements could prevent a change in our control
Our Board of Directors has the authority to issue up to 5,000,000 shares of
preferred stock and to determine the price, rights, preferences, privileges and
restrictions, including voting rights, of those shares without any
32
further vote or action by the stockholders. The issuance of preferred stock,
while providing desirable flexibility in connection with possible acquisitions
and other corporate purposes, could have the effect of making it more difficult
for a third party to acquire a majority of our outstanding voting stock. Our
charter and bylaws provide for a classified board of directors, limitations on
the ability of stockholders to call special meetings and act by written
consent, the lack of cumulative voting for directors and procedures for advance
notification of stockholder nominations and proposals. These provisions, as
well as Section 203 of the Delaware General Corporation Law to which we are
subject, could discourage potential acquisition proposals and could delay or
prevent a change of control.
Our agreements with SBC Communications provide that, in the event of certain
changes in control, SBC could require us to repay its $50 million loan and the
unused portion of its $75 million prepayment. In addition, our Stockholder
Protection Rights Plan contains provisions that make a hostile takeover
prohibitively expensive and, in effect, requires interested suitors to
cooperate with the Board of Directors prior to acquiring more than 15% of our
capital stock. There is no guarantee that the Stockholder Protection Rights
Plan will not discourage takeover attempts, which would otherwise result in a
premium to our stockholders.
The provisions in the charter, bylaws, indebtedness and Stockholder
Protection Rights Plan could have the effect of discouraging others from making
tender offers for our shares and, as a consequence, they also may inhibit
increases in the market price of our shares that could result from actual or
rumored takeover attempts. Such provisions also may have the effect of
preventing changes in our management.
We may experience decreasing margins on the sale of our services, which may
impair our ability to achieve profitability or positive cash flow
We may experience an overall price decrease for our services due to
competition, volume-based pricing, an increase in the proportion of our
revenues generated by our consumer services and other factors. Currently, we
charge higher prices for some of our services than some of our competitors do
for their similar services. As a result, we cannot assure you that our
customers and their end-user customers will select our services over those of
our competitors. In addition, prices for digital communications services in
general have fallen historically, and we expect this trend to continue. We have
provided and expect in the future to provide price discounts to customers that
commit to sell our services to a large number of their end-user customers. Our
consumer-grade services have lower prices and significantly lower profit
margins than our business-grade services. In recent months, the number of
orders that we have received for consumer-grade services have been greater than
the number of orders we have received for business-grade services.
We expect that the percentage of our revenues which we derive from our
consumer services will continue to increase and will likely reduce our overall
profit margins. We also expect to reduce prices periodically in the future to
respond to competition and to generate increased sales volume. As a result, we
cannot predict whether demand for our services will exist at prices that enable
us to achieve profitability or positive cash flow.
The markets we face are highly competitive and we may not be able to compete
effectively, especially against established industry competitors with
significantly greater financial resources
The markets we face for business and consumer Internet access and remote
network access services are intensely competitive. We expect that these markets
will become increasingly competitive in the future. In addition, the
traditional telephone companies dominate the current market and have a monopoly
on telephone wires. We pose a competitive risk to the traditional telephone
companies and, as both our competitors and our suppliers, they have the ability
and the motivation to harm our business. We also face competition from cable
modem service providers, competitive telecommunications companies, traditional
and new national long distance carriers, Internet service providers, on-line
service providers and wireless and satellite service providers. Many of these
competitors have longer operating histories, greater name recognition, better
strategic relationships and significantly greater financial, technical or
marketing resources than we do. Our ability to stay competitive may
33
be reduced if our new business plan is not successful, or if we are unable to
obtain additional financing as and when needed. As a result, these competitors:
. may be able to develop and adopt new or emerging technologies and respond
to changes in customer requirements or devote greater resources to the
development, promotion and sale of their products and services more
effectively than we can;
. may form new alliances and rapidly acquire significant market share; and
. may be able to undertake more extensive marketing campaigns, adopt more
aggressive pricing policies and devote substantially more resources to
developing high-speed digital services.
The intense competition from our competitors, including the traditional
telephone companies, the cable modem service providers and the competitive
telecommunications companies could harm our business.
The traditional telephone companies represent the dominant competition in
all of our target service areas and we expect this competition to intensify.
For example, they have an established brand name and reputation for high
quality in their service areas, possess sufficient capital to deploy DSL
equipment rapidly, have their own telephone wires and can bundle digital data
services with their existing analog voice services to achieve economies of
scale in serving customers. Certain of the traditional telephone companies are
aggressively pricing their DSL services as low as $30 per month, placing
pricing pressure on our services. While we are now allowed to provide our data
services over the same telephone wires which provide analog voice services, we
have experienced difficulties in implementing this ability, and in many
instances, final prices for shared-line access have not been established. There
is no assurance that we can provide our services in this manner without running
into operational, technical or financial obstacles, including those created by
the traditional telephone companies. Further, they can offer service to
end-users from certain central offices where we are unable to secure central
office space and offer service. In addition, consolidations involving the
traditional telephone companies may further the traditional telephone
companies' efforts to compete with us since the combined entities will benefit
from the resources of the traditional telephone company. Accordingly, we may be
unable to compete successfully against the traditional telephone companies.
The risks posed to us by the traditional telephone companies as our key
suppliers and competitors are also compounded by the role some of these
companies, such as SBC and Qwest, play as our resellers. These competitors may
determine not to fulfill their obligations despite their contractual
commitments to us. The failure by these resellers to fulfill their obligations
to us would have a material adverse impact on our business.
Cable modem service providers, such as Cox Communications, and their
respective cable company customers, are deploying high-speed Internet access
services over coaxial cable networks. Where deployed, these networks provide
similar, and in some cases, higher-speed Internet access and RLAN access than
we provide. They also offer these services at lower price points than our
TeleSurfer services. As a result, competition with the cable modem service
providers may have a significant negative effect on our ability to secure
customers and may create downward pressure on the prices we can charge for our
services.
Many competitive telecommunications companies offer high-speed data services
using a business strategy similar to ours. Some of these competitors have been
offering DSL-based access services and others are likely to do so in the
future. These companies may be acquired in whole or in part by one or more of
our established resellers on highly favorable terms because of the currently
low market values of companies in this sector or because they are in
bankruptcy. In such instances, we could lose one or more of our resellers and
face more robust competition, which would have a material adverse impact on our
business. One of our significant resellers, AT&T, acquired the operating assets
of NorthPoint Communications. Similarly, UUNet is one of our resellers and is
also a subsidiary of Worldcom, which recently acquired the assets of Rhythms
NetConnections. In addition, some competitive telecommunications companies have
extensive fiber networks in many metropolitan areas primarily providing
high-speed digital and voice circuits to large corporations, and have
interconnection agreements with traditional telephone companies pursuant to
which they have acquired central office space in
34
many of our existing and target markets. Further, certain of our resellers have
made investments in our competitors, and some of our resellers have deployed
their own facilities to provide DSL-based access services. As a result of these
factors, we may be unsuccessful in generating a significant number of new
customers or retaining existing customers.
Our business is difficult to evaluate because we have a limited operating
history
We were incorporated in October 1996 and introduced our services
commercially in the San Francisco Bay Area in December 1997. Because of our
limited operating history, you have limited operating and financial data upon
which to evaluate our business. You should consider that we have the risks of
an early stage company in a new and rapidly evolving market. To overcome these
risks, we must:
. attract and retain end-user
. expand our direct sales;
. respond to competitive developments;
. reduce our dependence on financially weak resellers;
. potentially raise additional capital if our existing funds ultimately
prove to be insufficient in order for us to reach cash flow positive
status;
. continue to attract, retain and motivate qualified employees;
. continue to upgrade our technologies in response to competition and
market factors;
. manage our traditional telephone company suppliers;
. rapidly install high-speed access lines;
. effectively manage the growth of our operations; and
. deliver additional value added services to our customers without causing
existing customers to cease reselling our services or reducing the volume
or rate of growth of sales of our services.
We have a history of losses and expect losses in the future
We have incurred substantial losses and experienced negative cash flow each
fiscal quarter since our inception in 1997. Although we have significantly
reduced our capital expenditures, we expect to incur additional net losses and
negative cash flow at least into the second half of 2003. Our future cash
requirements for developing, deploying and enhancing our network and operating
our business, as well as our revenues, will depend on a number of factors
including:
. the number of regions entered, the timing of entry and services offered;
. network development schedules, closures and associated costs;
. the rate at which customers and end-users purchase our services and the
pricing of such services;
. the financial condition of our customers;
. the migration of end-users from financially-unsound customers to
financially sound customers or to our own retail business;
. the level of marketing required to acquire and retain customers and to
attain a competitive position in the marketplace;
. the network integration efforts between our different affiliated
companies and the efficient migration of customers and end-users between
these networks;
. investments in and acquisitions of businesses that are complementary to
ours to support the growth of our business;
35
. the rates at which we invest in engineering and development and
intellectual property with respect to existing and future technology;
. pending litigation;
. existing and future technology; and
. unanticipated opportunities.
Our operating results are likely to fluctuate in future periods and may fail
to meet the expectations of securities analysts and investors
Our annual and quarterly operating results are likely to fluctuate
significantly in the future as a result of numerous factors, many of which are
outside of our control. These factors include:
. the effect of our revised business plan and our recent bankruptcy filing
on our relationships with our customers;
. the amount and timing of capital expenditures and other costs relating to
the filling of our network and the marketing of our services;
. difficulties we may face in accessing the capital markets to fund such
capital expenditures;
. the bankruptcy or other financial difficulties experienced by our
Internet service provider customers;
. our ability to collect receivables from our customers;
. receipt of timely payment from our Internet service provider and other
customers;
. our ability to migrate end-users from financially-unsound customers to
financially sound customers or to our own retail business;
. delays in the commencement of operations in new regions and the
generation of revenue because certain network elements have lead times
that are controlled by traditional telephone companies and other third
parties;
. the ability to develop and commercialize new services by us or our
competitors;
. the ability to order or deploy our services on a timely basis to
adequately satisfy end-user demand;
. our ability to successfully operate our network and integrate the
networks of our different affiliated companies;
. the rate at which customers subscribe to our services;
. the efficiency with which we operate redundant network and operational
capabilities;
. the necessity of decreasing the prices for our services due to
competition, volume-based pricing and other factors;
. our ability to retain Internet service provider, enterprise and
telecommunications carrier customers and limit end-user churn rates;
. our ability to migrate end-users from the network of one of our
affiliates to another;
. our ability to minimize costs of closing portions of our network,
including central offices and other facilities in particular markets;
. our ability to successfully defend our company against litigation;
. the mix of line orders between consumer end-users and business end-users
(which typically have higher margins);
. our ability to expand our direct sales channel in a profitable manner;
36
. the success of our relationships with AT&T, SBC and other third parties
and distribution channels in generating significant end-user demand;
. our ability to reduce our capital expenditures and other expenses without
jeopardizing our relationships with key customers and suppliers;
. the timing and willingness of traditional telephone companies to provide
us with space on their premises and the prices, terms and conditions on
which they make available the space to us;
. the development and operation of our billing and collection systems and
other operational systems and processes;
. our ability to improve and maintain the level of our internal controls;
. our inventory and supply-chain management;
. the rendering of accurate and verifiable bills by our traditional
telephone company suppliers and resolution of billing disputes;
. the incorporation of enhancements, upgrades and new software and hardware
products into our network and operational processes that may cause
unanticipated disruptions;
. the changing interpretation and enforcement of regulatory developments
and court rulings concerning the 1996 Telecommunications Act,
interconnection agreements and the anti-trust laws;
. legislative changes in the 1996 Telecommunications Act;
. our ability to integrate the businesses we acquire into our business
efficiently; and
. the availability of equipment and services from key vendors.
As a result, it is likely that in some future quarters our operating results
will be below the expectations of securities analysts and investors. If this
happens, the trading price of our common stock would likely decline.
We cannot predict whether we will be successful because our business strategy
is largely unproven
We believe that we were the first competitive telecommunications company to
widely provide high-speed Internet and network access using DSL technology. To
date, much of our business strategy remains unproven. To be successful, we must
develop and market services that achieve broad commercial acceptance by
Internet service provider, enterprise and telecommunications carrier customers
in our targeted metropolitan statistical areas. Because our business and the
demand for high-speed digital communications services are in the early stages
of development, we are uncertain whether our services will achieve broad
commercial acceptance.
It is uncertain whether our strategy of selling a significant portion of our
services through Internet service providers, telecommunication carriers and
others will be successful. This strategy creates marketing, operational and
other challenges and complexities that are less likely to appear in the case of
a single entity providing integrated DSL and Internet service provider
services. For example, cable modem service providers, such as Time Warner,
Inc., market, sell and provide high-speed services, Internet access and content
services on an integrated basis. Since we are currently selling most of our
services to end-users through third parties, our ability to retain these
end-users is largely dependent on the performance of these resellers. If these
resellers fail to satisfy their obligations to their end-users, or if they do
not pay us for our services, we may lose end-users or we may be forced to
disconnect end-users. Also, our direct sales effort may adversely affect our
relationship with our current Internet service provider customers, since we
will be providing some of the services that they provide.
Our expanding direct sales capability is still being developed. It is
uncertain whether we can rapidly grow our direct subscriber base in a cost
effective manner. Our inability to effectively manage the growth of our direct
subscriber base could adversely affect our results.
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The mergers and acquisitions between America Online, Inc. and Time Warner,
Inc., between NTT and Verio, and between NEXTLINK and Concentric Network
Corporation (now XO Communications)--highlight a growing trend among service
providers and telecommunications carriers to combine the marketing, selling and
provisioning of high-speed data transmission services, Internet access and
content services. While we do not believe that such combined entities providing
integrated services will materially adversely affect our business, no assurance
can be given that such combinations will not ultimately have such a material
adverse effect. Further, no assurance can be given that additional acquisitions
of Internet service providers by traditional and local competitive
telecommunications carriers, and other strategic alliances between such
entities, will not harm our business.
One of our competitors, NorthPoint Communications, has sold its network
assets to AT&T. The acquisition of these assets by AT&T will potentially reduce
the orders we receive from AT&T, introduce a formidable new competitor into our
market, create uncertainty in the financial and business markets, and may
reduce the prices our customers pay us for lines because of increased
competition. Another one of our competitors, Rhythms NetConnections, sold its
assets to Worldcom. One of Worldcom's subsidiaries, UUNet, is our reseller and
has stopped sending us new orders for our services.
In light of our increasing number of direct sales to end users and other
changes we have made in our business, some of our existing Internet service
provider customers may perceive us as a potential or actual competitor instead
of as a supplier. Such Internet service providers may therefore reduce the
volume or the rate of growth of the sales of our services, or may cease to
resell our services. No assurance can be given that our provision of additional
services will not alienate some or all of our existing customers and thus harm
our business.
Our services are subject to government regulation, and changes in current or
future laws or regulations and the methods of enforcing the law and
regulations could adversely affect our business
Our services are subject to federal, state and local government regulations.
The 1996 Telecommunications Act, which became effective in February 1996,
introduced widespread changes in the regulation of the telecommunications
industry, including the digital access services segment in which we operate.
The 1996 Telecommunications Act eliminates many of the pre-existing legal
barriers to competition in the telecommunications services business and sets
basic criteria for relationships between telecommunications providers.
Among other things, the 1996 Telecommunications Act removes barriers to
entry in the local telecommunications markets by preempting state and local
laws that restrict competition by providing competitors interconnection, access
to unbundled network elements, collocation, and retail services at wholesale
rates. The FCC's primary rules interpreting the 1996 Telecommunications Act
were issued on August 8, 1996. The U.S. Court of Appeals has reviewed these
rules for the Eighth Circuit, the U.S. Court of Appeals for the District of
Columbia, and the U.S. Supreme Court, among others. The U.S. Supreme Court
overruled the Eighth Circuit in January 1999 and upheld most of the FCC rules.
In September 1999, the FCC adopted unbundling rules that responded to the
Supreme Court's January 1999 decision. The FCC is currently considering
petitions to reconsider this decision, and appeals of this and related FCC
decisions are also currently pending before various federal courts, including
the Supreme Court.
Since August 1996, the FCC has proposed and adopted further rules related to
our ability to obtain access to unbundled network elements and other services.
These decisions also have been the subject of litigation and appeals. In the
December 2001, the FCC began a top to bottom review of its unbundling rules,
and the FCC could as part of that proceeding restrict or eliminate access to
elements of the telephone company network that are crucial to our business.
In August 1998, the FCC stated that its rules required traditional local
telephone companies to provide us access to copper wires in order to provide
"advanced services," such as our DSL services.
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In November 1999, the FCC ruled that traditional local telephone companies
must provide access to "line sharing" on an unbundled basis. The FCC reaffirmed
this decision in January 2001. Line sharing permits us to provide a DSL service
on the same telephone wire in which an end-user has analog, local telephone
service. Only certain DSL technologies, such as ADSL, are designed to work on
the same line as analog telephone service. Most traditional telephone companies
provide ADSL service exclusively over line sharing. Without access to line
sharing, we have to have the traditional telephone company install an
additional telephone line to an end-user's premises. Without line sharing, we
may not be able to provide a product that is competitive with the traditional
telephone company's offering. A group of traditional telephone companies has
appealed this decision to the D.C. Circuit Court of Appeals, and an adverse
result in that court proceeding could harm our business.
In January 2001, the FCC reaffirmed its line-sharing rules and also
interpreted those rules as requiring traditional local telephone companies to
facilitate "line-splitting"--the provisioning on a single loop of DSL service
by a company like Covad while another competitive local exchange carrier
provides analog, dial-up telephone service on the lower frequencies of the same
loop. Beginning in 2001, we began provisioning new orders for consumer-grade
services over line-shared telephone wires. In addition, we provide certain
small office and home office customers with DSL service provided over
line-shared lines. If the traditional telephone companies fail to deliver
line-shared telephone wires in sufficient quantities or to deliver functioning
line-shared telephone wires in an acceptable period of time, the growth of our
consumer business will be adversely affected. In addition, traditional local
telephone companies have appealed both of these decisions to the D.C. Circuit
Court of Appeals. The outcome of these appeals is uncertain and an unfavorable
outcome could have a material adverse impact on our business.
We have not entered into interconnection agreements that take full advantage
of all of the new federal rules related to unbundling and collocation. We
anticipate that traditional telephone companies will continue to challenge
these new rules in regulatory proceedings and court challenges. In addition, we
anticipate that traditional telephone companies will resist full implementation
of these federal and state rules. Any unfavorable decisions by the courts, the
FCC, or state telecommunications regulatory commissions could harm our
business. In addition, a failure to enforce these rules by the appropriate
court, FCC, or state authority in a timely basis could slow down our deployment
of services or could otherwise harm our business.
FCC actions other than rulemaking proceedings can also impact our business.
The 1996 Telecommunications Act also allows the Regional Bell Operating
Companies (RBOCs, now BellSouth, Verizon, SBC and Qwest), which are the
traditional telephone companies created by AT&T's divestiture of its local
exchange business, to provide interLATA long distance services in their own
local service regions upon a showing that the RBOC provides interconnection and
access to companies like Covad as required by the Act. As a result, Covad is
active in the RBOC interLATA entry process before the state commissions, the
FCC, and the Department of Justice, all of which have a role in ensuring that
the RBOC provides access and interconnection as required by the Act. The FCC
has approved nine RBOC applications to date, for Verizon in New York,
Massachusetts, Pennsylvania, and Connecticut and SBC in Texas, Oklahoma,
Kansas, Missouri and Arkansas. There are several other BOC applications for
long distance authority currently pending at the FCC, and more filings are
anticipated in the immediate future. In particular, BellSouth and Qwest,
neither of which has ever successfully applied for long distance authority at
the FCC, are both expected to file applications in the next few months. Covad
has opposed such applications where it believes it has not received access and
interconnection as required by the Act. Grants of long-distance authority to
RBOCs will likely adversely affect the level of cooperation we receive from
each of the RBOCs.
In approving the merger of SBC and Ameritech in October 1999, the FCC
required SBC/Ameritech to create a structurally separate advanced services
affiliate throughout the SBC/Ameritech service territory. The FCC required
SBC/Ameritech to provide its own in-region DSL services through this affiliate,
and the affiliate would be free from traditional telephone company regulation.
The provision of DSL services by such an affiliate could harm our business. In
June 2000, Bell Atlantic and GTE were ordered by the FCC to create such a
similar affiliate, in the context of their merger into Verizon. However, in
January 2001, the D.C. Circuit Court of
39
Appeals reversed and vacated the FCC's SBC/Ameritech Merger Order on the basis
that the separate affiliate requirement was inconsistent with the
Communications Act. Both Verizon and SBC could now be permitted by this Court
decision to alter, or even to eliminate the separate affiliates through which
they have provided services like DSL. To the extent those separate affiliates
provided assurances of nondiscriminatory provisioning practices, the
discontinuance of those affiliates will remove important competitive safeguards.
Changes to current regulations, the adoption of new regulations or policies
by the FCC or state regulatory authorities, court decisions, or legislation,
such as changes to the 1996 Telecommunications Act, could harm our business. On
February 27, 2002, the United States House of Representatives approved H.R.
1542, principally sponsored by Congressmen Tauzin (R-LA) and Dingell (D-MI).
This bill would need to be approved by the United States Senate and the
President before it can become a law. This bill contains several provisions
that, if enacted into law, would impair the expansion of our business.
Specifically, H.R. 1542 would permit the Bell Operating Companies to enter the
long distance data market without first satisfying the market-opening
provisions of the 1996 Act, including the obligations to provide
nondiscriminatory access to unbundled network elements. In addition, the
legislation would, in its current form, eliminate the legal requirement that
telephone companies provide access to local loops that consist of a combination
of fiber and copper, rather than just copper. If our ability to lease such
loops were eliminated, it would severely impact our addressable market and our
ability to compete effectively with the telephone companies' retail DSL
offerings. It is unclear whether additional amendments may be made to the
legislation that would impact our business in a positive or negative way. It is
equally unclear whether this legislation will ever become law. Passage into law
of this or any similar legislation could adversely affect our business.
In addition to regulatory proceedings and decisions, we rely significantly
upon private antitrust and other litigation to ensure that traditional local
telephone companies provide us access to their networks as required by federal
and state antitrust law, the Communications Act, and other legal requirements.
We are pursuing antitrust and other remedies in federal district court against
Verizon and BellSouth. In pursuing this litigation, we have incurred
substantial expenses and overhead costs that may or may not lead to
satisfactory results. A recent Seventh Circuit Court of Appeals decision in
Goldwasser v. Ameritech has cast doubt and uncertainty as to our ability to
pursue private antitrust remedies for actions by traditional local telephone
companies that also violate the Communications Act. Some federal district
courts in subsequent rulings have followed the Goldwasser decision, while
others have not. We believe that the Goldwasser decision has already reduced
traditional local telephone company incentives to provide us access to their
networks as required by law. In particular, the United States District Court
for the Northern District of Georgia dismissed most of the claims in our
antitrust suit against BellSouth, citing Goldwasser as its principal
precedential basis for doing so. We have appealed that decision to the United
States Court of Appeals for the Eleventh Circuit. The U.S. Department of
Justice and the Federal Communications Commission filed a joint amicus brief
with the Eleventh Circuit urging the Court to reverse the decision of the
District Court. We believe that the participation of these government agencies
in our appeal provides important support for our position, but we cannot
predict the outcome of this matter. In addition, Verizon has filed a motion to
dismiss our pending litigation against it in federal district court in
Washington, D.C., also on the basis of the Goldwasser decision. While we are
opposing Verizon's motion to dismiss and believe that our position should
prevail, we cannot predict the outcome of these motions.
Charges for unbundled network elements are generally outside of our control
because they are proposed by the traditional telephone companies and are
subject to costly regulatory approval processes
Traditional telephone companies provide the unbundled DSL-capable lines or
telephone wires that connect each end-user to our equipment located in the
central offices. The 1996 Telecommunications Act generally requires that
charges for these unbundled network elements be cost-based and
nondiscriminatory. The nonrecurring and recurring monthly charges for
DSL-capable lines (telephone wires) that we require vary greatly. These rates
are subject to negotiations between us and the traditional telephone companies
and to the approval of the state regulatory commissions. The rate approval
processes for DSL-capable lines and other unbundled network elements typically
involve a lengthy review of the rates proposed by the traditional telephone
companies
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in each state. The ultimate rates approved typically depend on the traditional
telephone company's initial rate proposals and the policies of the state public
utility commission. These rate approval proceedings are time-consuming and
expensive. Consequently, we are subject to the risk that the non-recurring and
recurring charges for DSL-capable lines and other unbundled network elements
will increase based on rates proposed by the traditional telephone companies
and approved by state regulatory commissions from time to time, which would
harm our operating results.
On July 18, 2000, the United States Court of Appeals for the Eighth Circuit
struck down the FCC's total element long run incremental cost methodology
("TELRIC"), which the FCC previously required state commissions to use in
setting the prices for collocation and for unbundled network elements we
purchase from the traditional telephone companies. The Court also rejected an
alternative cost methodology based on "historical costs," which was advocated
by the traditional telephone companies. In rejecting the FCC's cost
methodology, the Court held that it is permissible for the FCC to prescribe a
forward-looking incremental cost methodology that is based on actual
incremental costs under the 1996 Telecommunications Act. In January 2001, the
Supreme Court agreed to hear the appeal of this Eighth Circuit decision and
oral argument in the case has already been held. A decision in this case is
expected soon.
The Eighth Circuit's decision and the current Supreme Court appeal create
additional uncertainty concerning the prices that we are obligated to pay the
traditional telephone companies for collocation and unbundled network elements.
The FCC may also adopt, or be required to adopt, new rules to reflect the cost
methodology that was approved by the Eighth Circuit. It is uncertain whether
the Eighth Circuit's decision will be affirmed by the United States Supreme
Court. It is also uncertain whether the FCC and the state commissions will
implement a new cost methodology as a result of this decision.
The impact of these judicial and regulatory decisions on the prices we pay
to the traditional telephone companies for collocation and unbundled network
elements is highly uncertain. There is a risk that any new prices set by the
regulators could be materially higher than current or currently expected
prices. If we are required to pay higher prices to the local telephone
companies for collocation and unbundled network elements, it could have a
material adverse effect on our business.
Challenges in obtaining space for our equipment on premises owned by the
traditional local telephone companies harms our business
We must secure physical space from traditional local telephone companies for
our equipment in their central offices in order to provide our intended
services in our targeted metropolitan statistical areas. In the past, we have
experienced rejections of our applications to secure this space in many central
offices, and we are likely to receive rejections when we apply for space in
remote terminals. We must place our equipment in remote terminals, or in the
alternative access electronic equipment installed by the telephone companies,
in order to provide higher speed DSL service to a larger number of users.
Remote terminals are used by traditional telephone companies to serve end-users
through a combination of fiber optic technology and copper wires. Traditional
telephone companies are increasing their deployment of fiber-fed remote
terminal architectures (for example, SBC's "Project Pronto"). For us to provide
copper based DSL services to these end-users, we need to address the technical
means of accessing the copper telephone wires that terminate at these remote
terminals. The legal parameters that define the access that the telephone
companies must provide us, and technical means by which we will secure such
access, has not been definitely settled by the FCC, state commissions, and our
interconnection agreement negotiations with the telephone companies. It is
unclear whether we will be successful in our efforts to secure access to
network elements provisioned through remote terminals.
Our business will suffer if our interconnection agreements are not renewed or
if they are modified on unfavorable terms
We are required to enter into and implement interconnection agreements in
each of our targeted metropolitan statistical areas with the appropriate
traditional telephone companies in order to provide service in
41
those regions. We may be unable to timely enter into these agreements, which is
prerequisite for us to provide service in those areas. Many of our existing
interconnection agreements have a maximum term of three years. Therefore, we
will have to renegotiate these agreements with the traditional telephone
companies when they expire. We may not succeed in extending or renegotiating
them on favorable terms or at all.
As the FCC modifies, changes and implements rules related to unbundling and
collocation, we generally have to renegotiate our interconnection agreements
with the traditional telephone companies in order to implement those new or
modified rules. We may be unable to renegotiate these agreements in a timely
manner, or we may be forced to arbitrate and litigate with the traditional
telephone companies in order to obtain agreement terms that fully comply with
FCC rules. As a result, although the FCC may implement rules or policies
designed to speed or improve our ability to provide services, we may not be
able to timely implement those rules or policies.
Additionally, disputes have arisen and will continue to arise in the future
as a result of differences in interpretations of the interconnection
agreements. For example, we are in litigation proceedings with certain of the
traditional telephone companies. These disputes have delayed the deployment of
our network, and resolution of the litigated matters will cause us ongoing
expenditure of money and management time. They may have also negatively
affected our service to our customers and our ability to enter into additional
interconnection agreements with the traditional telephone companies in other
states. In addition, the interconnection agreements are subject to state
commission, FCC and judicial oversight. These government authorities may modify
the terms of the interconnection agreements in a way that harms our business.
Our success depends on our retention of certain key personnel, our ability to
hire additional key personnel and the maintenance of good labor relations
We depend on the performance of our executive officers and key employees. In
particular, our senior management has significant experience in the data
communications, telecommunications and personal computer industries, and the
loss of any of them could negatively affect our ability to execute our business
strategy. Additionally, we do not have "key person" life insurance policies on
any of our employees.
In February 2002, Terry Moya, our Executive Vice President, External Affairs
and Corporate Development left us to pursue other opportunities. In March 2002,
Cathy Hemmer, our Executive Vice President and COO, announced her intention to
leave us at the end of the month to pursue other opportunities. The
responsibilities of these executives were assumed by other members of our
executive management team. These departures may cause disruption to our
business and may lead to the departures of other employees.
Our future success also depends on our continuing ability to identify, hire,
train and retain other highly qualified technical, operations, sales,
marketing, financial, legal, human resource, and managerial personnel as we add
end-users to our network. Competition for such qualified personnel is intense.
The significant drop in our stock price has greatly reduced or eliminated the
value of stock options held by our employees, making it more difficult to
retain employees in this competitive market. This is particularly the case in
software development, network engineering and product management. We also may
be unable to attract, assimilate or retain other highly qualified technical,
operations, sales, marketing, financial, legal, human resource and managerial
personnel. Our business will be harmed if we cannot attract the necessary
technical, operations, sales, marketing, financial, legal, human resource and
managerial personnel. In addition, in the event that our employees unionize, we
could incur higher ongoing labor costs and disruptions in our operations in the
event of a strike or other work stoppage.
We depend on a limited number of third parties for equipment supply, service
and installation
We rely on outside parties to manufacture our network equipment and provide
certain network services. These services and equipment include:
. digital subscriber line access multiplexers;
42
. customer premise equipment modems;
. network routing and switching hardware;
. network management software;
. systems management software;
. database management software;
. collocation space; and
. Internet connectivity and Internet protocol services.
As we sign additional service contracts, we will need to increase
significantly the amount of manufacturing and other services supplied by third
parties in order to meet our contractual commitments. We have in the past
experienced supply problems with certain of our vendors. These vendors may not
be able to meet our needs in a satisfactory and timely manner in the future. In
addition, we may not be able to obtain additional vendors when needed. We have
identified alternative suppliers for technologies that we consider critical.
However, it could take us a significant period of time to establish
relationships with alternative suppliers for critical technologies and
substitute their technologies into our network.
Our reliance on third-party vendors involves additional risks, including:
. the possibility that some manufacturers will leave the DSL equipment
business because of the financial uncertainties facing many DSL companies;
. the absence of guaranteed capacity; and
. reduced control over delivery schedules, quality assurance, production
yields and costs.
The loss of any of our relationships with these suppliers could harm our
business.
We have made and may make acquisitions of complementary technologies or
businesses in the future, which may disrupt our business and be dilutive to
our existing stockholders
In addition to our recent purchase of InternetConnect's assets, 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, large one-time expenses and the
creation of goodwill or other intangible assets that result in significant
amortization expense. Any acquisition, including the InternetConnect asset
purchase, may not provide the benefits originally anticipated, and there may be
difficulty in integrating the service offerings and networks gained through
acquisitions and strategic investments with our own. In a strategic investment
where we acquire a minority interest in a company, we may lack control over the
operations and strategy of the business, and we cannot guarantee that such lack
of control will not interfere with the integration of services and distribution
channels of the business with our own. Although we attempt to minimize the risk
of unexpected liabilities and contingencies associated with acquired businesses
through planning, investigation and negotiation, such unexpected liabilities
nevertheless may accompany such strategic investments and acquisitions.
We cannot guarantee that we successfully will:
. identify attractive acquisition and strategic investment candidates;
. complete and finance additional acquisitions on favorable terms; or
. integrate the acquired businesses or assets into our own.
43
We cannot guarantee that the integration of our business with any acquired
company's business will be accomplished smoothly or successfully, if at all.
Any of these factors could materially harm our business or our operating
results in a given period.
The broadband communications industry is undergoing rapid technological
changes and new technologies may be superior to the technology we use
The broadband communications industry is subject to rapid and significant
technological change, including continuing developments in DSL technology,
which does not presently have widely accepted standards, and alternative
technologies for providing broadband communications, such as cable modem and
wireless technology. As a consequence:
. we will rely on third parties, including some of our competitors and
potential competitors, to develop and provide us with access to
communications and networking technology;
. our success will depend on our ability to anticipate or adapt to new
technology on a timely basis; and
. we expect that new products and technologies will emerge that may be
superior to, or may not be compatible with, our products and technologies.
If we fail to adapt successfully to technological changes or fail to obtain
access to important technologies, our business will suffer.
A system failure could delay or interrupt service to our customers
Our operations depend upon our ability to support our highly complex network
infrastructure and avoid damage from fires, earthquakes, floods, power losses,
excessive sustained or peak user demand, telecommunications failures, network
software flaws, transmission cable cuts and similar events. In connection with
our cost-cutting efforts, we also closed our second network operations center
in Virginia. The occurrence of a natural disaster or other unanticipated
problem at our network operations center or any of our regional data centers
could cause interruptions in our services. Additionally, failure of a
traditional telephone company or other service provider, such as competitive
telecommunications companies, to provide communications capacity that we
require, as a result of a natural disaster, operational disruption or any other
reason, could cause interruptions in our services. Any damage or failure that
causes interruptions in our operations could harm our business.
A breach of network security could delay or interrupt service to our customers
Our network may be vulnerable to unauthorized access, computer viruses and
other disruptive problems. Internet service provider, telecommunications
carrier and corporate networks have in the past experienced, and may in the
future experience, interruptions in service as a result of accidental or
intentional actions of Internet users, current and former employees and others.
Unauthorized access could also potentially jeopardize the security of
confidential information stored in the computer systems of our customers and
the customers' end-users. This might result in liability to our customers and
also might deter potential customers. We intend to implement security measures
that are standard in the telecommunications industry and to develop additional
security measures. We have not yet developed and implemented many of these
security measures and we may not implement such measures in a timely manner.
Moreover, these measures, if and when implemented, may be circumvented, and
eliminating computer viruses and alleviating other security problems may
require interruptions, delays or cessation of service to our customers and such
customers' end-users, which could harm our business.
Interference in the traditional telephone companies' copper plant could
degrade the performance of our services
Certain tests indicate that some types of DSL technology may cause
interference with, and be interfered with by other signals present in a
traditional telephone company's copper plant, usually with lines in close
proximity. In addition, as we continue to implement line sharing with the
traditional local telephone companies,
44
our ADSL data services may be interfered with by the voice services of the
traditional local telephone companies carried over the same line or adjacent
lines. If it occurs, such interference could cause degradation of performance
of our services or the services of the traditional local telephone companies
and render us unable to offer our services on selected lines. The amount and
extent of such interference will depend on the condition of the traditional
telephone company's copper plant and the number and distribution of DSL and
other signals in such plant and cannot now be ascertained. When interference
occurs, it is difficult to detect.
In November 1999, the FCC established a loop spectrum policy designed to
facilitate the introduction of new loop technologies (such as new flavors of
xDSL) while at the same time minimizing interference. The FCC also established
a Network Reliability and Interoperability Council V (NRIC V), of which Covad
is a member, to recommend further policies and procedures in this regard. NRIC
V has recently completed its term, and substantial spectrum management issues
remain unresolved. As a result, the procedures to resolve interference issues
between competitive telecommunications companies and traditional telephone
companies are still being developed and may not be effective ultimately.
In the past we have agreed to and litigated interference resolution
procedures with certain traditional telephone companies. However, we may be
unable to successfully negotiate similar procedures with other traditional
telephone companies in future interconnection agreements or in renewals of
existing interconnection agreements and may be required to litigate these
issues. In addition, the failure of the traditional telephone companies to take
timely action to resolve interference issues could harm the provision of our
services. If our TeleSpeed and TeleSurfer services cause widespread network
degradation or are perceived to cause that type of interference, actions by the
traditional telephone companies or state or federal regulators could harm our
reputation, brand image, service quality, customer satisfaction and retention,
and overall business. Moreover, ostensible interference concerns have in the
past been, continue to currently and may in the future be used by the
traditional telephone companies as a pretext to delay the deployment of our
services and otherwise harm our business.
Our intellectual property protection may be inadequate to protect our
proprietary rights
We regard certain aspects of our products, services and technology as
proprietary. We attempt to protect them with patents, copyrights, trademarks,
trade secret laws, restrictions on disclosure and other methods. These methods
may not be sufficient to protect our technology. We also generally enter into
confidentiality or license agreements with our employees and consultants, and
generally control access to and distribution of our documentation and other
proprietary information. Despite these precautions, it may be possible for a
third party to copy or otherwise obtain and use our products, services or
technology without authorization, or to develop similar technology
independently.
Currently, we have been issued one patent and we have a number of additional
patent applications pending. We intend to prepare additional applications and
to seek patent protection for our systems and services. These patents may not
be issued to us. If issued, they may not protect our intellectual property from
competition. Competitors could seek to design around or invalidate these
patents.
Effective patent, copyright, trademark and trade secret protection may be
unavailable or limited in certain foreign countries. The global nature of the
Internet makes it virtually impossible to control the ultimate destination of
our proprietary information. The steps that we have taken may not prevent
misappropriation or infringement of our technology. Litigation may be necessary
in the future to enforce our intellectual property rights, to protect our trade
secrets or to determine the validity and scope of the proprietary rights of
others. Such litigation could result in substantial costs and diversion of
resources and could harm our business.
We must comply with federal, state and local tax and other surcharges on our
service, the levels of which are uncertain
Telecommunications providers pay a variety of surcharges and fees on their
gross revenues from interstate services and intrastate services. Interstate
surcharges include Federal Universal Service Fees, Common Carrier
45
Regulatory Fees and TRS Fund fees. In addition, state regulators impose similar
surcharges and fees on intrastate services and the interpretation of these
surcharges and fees is uncertain in many cases. The division of our services
between interstate services and intrastate services is a matter of
interpretation and may in the future be contested by the FCC or relevant state
commission authorities. The FCC is currently considering the jurisdictional
nature of Internet service provider-bound traffic, as a result of a March 24,
2000 decision by the United States Court of Appeals for the D.C. Circuit
related to the jurisdictional nature of analog, dial-up traffic to the
Internet. A change in the characterization of their jurisdictions could cause
our payment obligations, pursuant to the relevant surcharges, to increase. In
addition, pursuant to periodic revisions by state and federal regulators of the
applicable surcharges, we may be subject to increases in the surcharges and
fees currently paid. Also, a determination of the jurisdictional nature of our
DSL services may require us to commit additional resources to regulatory
compliance, such as tariff filings. 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 chose to tax
our services. We may or may not be able to recover those tax payments from our
customers. To the extent we are not able to do so, our tax liability may be
greater than we anticipated.
ITEM 2. PROPERTIES
We are headquartered in Santa Clara, California in a facility under lease
that will expire on March 31, 2004. We also lease office space in many of the
metropolitan statistical areas in which we conduct operations. We also own a
facility in Manassas, Virginia. We recently entered into a non-binding letter
of intent to sell our Manassas facility for $14.0 million. The sale is
conditioned upon (1) the buyer's completion of its due diligence and (2) the
negotiation and signing of definitive agreements relating to the sale.
We have completed the process of consolidating our office space in Santa
Clara as well as our office spaces in Denver and Virginia. In connection with
our restructuring, we closed a facility in Alpharetta, Georgia. We also lease
central office space from the traditional telephone company in each region that
we operate or plan to operate under the terms of our interconnection agreements
and obligations imposed by state public utilities commissions and the FCC.
While the terms of these leases are perpetual, the productive use of our
central office space is subject to the terms of our interconnection agreements.
We will increase our central office space if we choose to expand our network
geographically.
ITEM 3. LEGAL PROCEEDINGS
On December 13, 2001, the United States Bankruptcy Court for the District of
Delaware (the "Bankruptcy Court") entered an order confirming our
pre-negotiated First Amended Plan of Reorganization, as modified on November
26, 2001 (the "Plan"). On December 20, 2001 (the "Effective Date"), the Plan
was consummated and we emerged from bankruptcy. Under our Plan, we settled
several claims against us. These claims include:
. The class action lawsuits filed in the United States District Court for
the Northern District of California, provided that this settlement will
not be final unless it is approved by that court. This settlement is
described in more detail below.
. The lawsuits filed in the Superior Court of the State of California for
the County of Santa Clara by six purchasers of the convertible notes that
we issued in September 2000.
. Disputed claims made by former shareholders of Laser Link.net.
. Disputed claims made by GE Capital and its subsidiary, Heller Financial
Group.
As of December 31, 2001, there were approximately $31.6 million in
unresolved claims related to our Chapter 11 bankruptcy proceedings. As of
December 31, 2001, we have recorded $22.2 million for these unresolved claims
in its consolidated balance sheet. However, it is reasonably possible that our
unresolved Chapter 11 bankruptcy claims could ultimately be settled for amounts
that differ from this $22.2 million amount.
46
See "Part II. Item 8. Notes to Consolidated Financial Statements, Note 2,
Reorganization Under Bankruptcy Proceedings," for additional details.
Purchasers of our common stock and purchasers of the convertible notes we
issued in September 2000 have filed complaints on behalf of themselves and
alleged classes of stockholders and holders of convertible notes against us and
certain of our present and former officers and directors. These complaints were
filed in the United States District Court Northern District of California in
the fourth quarter of 2000. The complaints have been consolidated and the lead
plaintiff has filed its amended consolidated complaint. The amended
consolidated complaint alleges violations of federal securities laws on behalf
of persons who purchased or otherwise acquired our securities, including those
who purchased common stock and those who purchased our convertible notes during
the periods from April 19, 2000 to May 24, 2001. The relief sought includes
monetary damages and equitable relief. The Company and the officer and director
defendants entered into a memorandum of understanding ("MOU") with counsel for
the lead plaintiffs in this litigation that tentatively resolves the
litigation. The MOU sets forth the terms upon which the Company, the officer
and director defendants and the plaintiffs agree to settle the litigation.
Pursuant to the MOU, the plaintiffs agreed to support and vote in favor of our
bankruptcy plan if it provided for the distribution of $16.5 million in cash to
be funded by the Company's D&O insurance carriers and approximately 6.5 million
shares of our common stock. The plaintiffs voted in favor of the Plan. The
settlement provided for in the MOU is subject to the approval of the District
Court. The approximately 6.5 million shares issuable to the plaintiffs upon
such approval by the District Court were issued on the Effective Date of the
bankruptcy and are being held by the Company in escrow, pending approval by the
District Court. We believe we have strong defenses to the claims alleged in the
lawsuit and intend to contest the lawsuit vigorously if the parties do not
execute and file with the District Court a final settlement or if the District
Court does not approve the final settlement. Because this action is at an early
stage, however, we are unable to provide you with an evaluation of the ultimate
outcome of the litigation if the parties do not execute a final settlement
agreement or the court does not approve the final settlement agreement.
However, we believe it is more likely than not that this settlement will be
completed. We do not expect this process to be completed for several months.
In April 1999, we filed a lawsuit against Bell Atlantic (now Verizon) and
its affiliates in the United States District Court for the District of
Columbia. We are pursuing antitrust and other claims in this lawsuit. We also
recently filed a lawsuit against BellSouth Telecommunications and its
subsidiaries in the United States District Court for the Northern District of
Georgia. We are pursuing antitrust and other claims in this lawsuit arising out
of BellSouth's conduct as a supplier of network facilities, including central
office space, transmission facilities and telephone lines. Both BellSouth and
Verizon have asked the courts to dismiss Covad's cases on the basis of the
ruling of the Seventh Circuit in Goldwasser v. Ameritech, which dismissed a
consumer antitrust class action against Ameritech. Covad is opposing the
BellSouth and Verizon motions, and while we believe our position should
prevail, we cannot predict the outcome of these motions.
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. It claims that we falsified trouble ticket reports with respect to
the phone lines that we ordered and made false statements to the public and
governmental authorities critical of Verizon, and seeks unspecified monetary
damages (characterized as being in the "millions") and injunctive relief. The
complaint asserts causes of action for negligent and intentional
misrepresentation and violations of the Lanham Act and the California unfair
business practices statute. We believe we have strong defenses to this lawsuit,
but litigation is inherently unpredictable and there is no guarantee we will
prevail.
A manufacturer of telecommunications hardware named "COVID" has filed an
opposition to our trademark application for the mark "COVAD and design" and is
seeking to cancel our registration of the COVAD trademark. We do not believe
that this opposition has merit, but trademark proceedings are unpredictable and
there is no guarantee we will prevail. If we do not succeed, it could limit our
ability to provide our services under the "COVAD" name. COVID has also filed a
complaint in the United States District Court for the District of
47
Arizona, alleging claims for false designation of origin, infringement and
unfair competition. COVID is seeking an injunction to stop us from using the
COVAD trademark, as well as an award of monetary damages. We do not believe
that these claims have any merit, but the outcome of litigation is
unpredictable and we cannot guarantee that we will prevail.
In connection with his departure, Terry Moya, our former Executive Vice
President, Corporate Development and External Affairs, has threatened
litigation against the company for wrongful termination, breach of contract and
misrepresentation. We believe that his assertions are without merit and that we
would have strong defenses to any legal action, but because no legal action has
been filed we are unable to provide an evaluation of the ultimate outcome of
any potential litigation.
See "Part I. Item 1. Business--Customers" for a description of bankruptcy
proceedings of certain of our customers and the disposition of our lines that
remain in service with certain of these customers.
We are also a party to a variety of legal proceedings as either plaintiff or
defendant, or are engaged in business disputes that arise in the ordinary
course of business. We do not believe the ultimate outcome of these matters
will have a material impact on our financial condition or results of operations.
Failure to resolve these various legal disputes and controversies without
excessive delay and cost and in a manner that is favorable to us could
significantly harm our business. We are not currently engaged in any other
legal proceedings that we believe could have a material adverse effect on our
business, prospects, operating results and financial condition. We are,
however, subject to state commission, FCC and court decisions as they relate to
the interpretation and implementation of the 1996 Telecommunications Act, the
interpretation of competitive telecommunications company interconnection
agreements in general and our interconnection agreements in particular. In some
cases, we may be deemed to be bound by or we may otherwise be significantly
impacted by the results of ongoing proceedings of these bodies or the legal
outcomes of other contested interconnection agreements that are similar to our
agreements. The results of any of these proceedings could harm our business.
In addition, we are engaged in a variety of negotiations, arbitrations and
regulatory proceedings with multiple traditional telephone companies. These
negotiations, arbitrations and regulatory proceedings concern the traditional
telephone companies' denial of physical central office space to us in certain
central offices, the cost and delivery of central office space, the delivery of
transmission facilities and telephone lines and other operational issues. We
remain involved in certain regulatory proceedings against SBC affiliates
Pacific Bell, Southwestern Bell, and Ameritech. An unfavorable outcome in any
of these negotiations, arbitrations and regulatory proceedings could have a
material adverse effect on our consolidated financial position, results of
operations and cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the quarter ended December 31, 2001, we did not submit any matters to
the vote of our security holders. In connection with our proceeding under
Chapter 11 of the United States Bankruptcy Code, certain holders of our common
stock and our notes approved our First Amended Plan of Reorganization, as
modified.
48
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Price Information and Dividend Policy For Our Common Stock
Our common stock traded on the Nasdaq National Market under the symbol
"COVD" from January 22, 1999, the date of our initial public offering, to July
20, 2001. On July 20, 2001, our common stock was delisted from the NASDAQ
National Market. Since July 20, 2001, our common stock has traded on Nasdaq's
OTC Bulletin Board. Prior to January 22, 1999, there was no public market for
our common stock. The following table sets forth, for the period indicated, the
high and low closing sales prices for our common stock as reported by the
Nasdaq National Market. These prices have been adjusted to account for stock
splits in May 1999 and April 2000.
High Low
------ ------
Fiscal Year Ended December 31, 2000
First Quarter....................... $66.25 $38.63
Second Quarter...................... $45.75 $15.44
Third Quarter....................... $23.06 $13.38
Fourth Quarter...................... $12.00 $ 1.34
Fiscal Year Ending December 31, 2001
First Quarter....................... $ 4.72 $ 1.16
Second Quarter...................... $ 1.52 $ 0.66
Third Quarter....................... $ 0.91 $ 0.35
Fourth Quarter...................... $ 3.07 $ 0.35
On March 15, 2002, the last reported sale price for our common stock on the
OTC Bulletin Board was $1.80 per share. As of March 22, 2002, there were 1,139
holders of record of our common stock, and there were no holders of record of
our Class B common stock.
We have never declared or paid any dividends on our common stock. We
currently anticipate that we will retain all of our future earnings for use in
the expansion and operation of our business. Thus, we do not anticipate paying
any cash dividends on our common stock in the foreseeable future. Our future
dividend policy will be determined by our Board of Directors.
49
ITEM 6. SELECTED FINANCIAL DATA
For the Year Ended December 31,
-----------------------------------------------------------------
2001 2000 1999 1998 1997
------------ ------------ ------------ ----------- ----------
(dollars in thousands, except per share amounts)
Consolidated Statement of Operations Data:
Revenues, net......................................... $ 332,596 $ 158,736 $ 66,488 $ 5,326 $ 26
Depreciation and amortization......................... 150,839 178,425 37,602 3,406 70
Provision for restructuring expenses.................. 14,364 4,988 -- -- --
Provision for long-lived asset impairment............. 11,988 589,388 -- -- --
Loss from operations.................................. (536,880) (1,354,192) (171,601) (37,682) (2,767)
Interest expense...................................... (92,782) (109,863) (44,472) (15,217) (12)
Reorganization expenses, net.......................... 62,620 -- -- -- --
Loss before extraordinary item and cumulative effect
of change in accounting principle.................... (688,969) (1,433,887) (195,397) (48,121) (2,612)
Extraordinary item.................................... 1,033,727 -- -- -- --
Cumulative effect of change in accounting
principle............................................ -- (9,249) -- -- --
------------ ------------ ------------ ----------- ----------
Net income (loss)..................................... $ 344,758 $ (1,443,136) $ (195,397) $ (48,121) $ (2,612)
Basic and diluted per share amounts:
Net income (loss) before extraordinary item and
cumulative effect of change in accounting
principle........................................ $ (3.89) $ (9.41) $ (1.83) $ (3.75) $ (0.35)
Extraordinary item................................ $ 5.83 $ -- $ -- $ -- $ --
Cumulative effect of accounting change............ $ -- $ (0.06) $ -- $ -- $ --
Net income (loss)................................. $ 1.94 $ (9.47) $ (1.83) $ (3.75) $ (0.35)
Weighted average common shares used in
computing basic and diluted per share
amounts.......................................... 177,347,193 152,358,589 107,647,812 12,844,203 7,361,000
Pro forma amounts assuming the accounting change
is applied retroactively:
Net income (loss)................................. $ 344,758 $ (1,433,887) $ (204,646) $ (48,121) $ (2,612)
Net income (loss) attributable to common
Stockholders..................................... $ 344,758 $ (1,433,887) $ (205,792) $ (48,121) $ (2,612)
Basic and diluted net income (loss) per common
share............................................ $ 1.94 $ (9.41) $ (1.91) $ (3.75) $ (0.35)
As of December 31,
-----------------------------------------------------------------
2001 2000 1999 1998 1997
------------ ------------ ------------ ----------- ----------
Consolidated Balance Sheet Data:
Cash, cash equivalents and short-term investments..... $ 283,863 $ 869,834 $ 767,357 $ 64,450 $ 4,378
Net property and equipment............................ 215,804 338,409 186,059 59,145 3,014
Total assets.......................................... 675,168 1,511,485 1,147,606 139,419 8,074
Long-term obligations, including current portion...... 50,011 1,374,673 375,050 142,879 783
Total stockholders' equity (deficit).................. 259,829 (182,663) 690,291 (24,706) 6,498
As of and for the Year Ended December 31,
-----------------------------------------------------------------
2001 2000 1999 1998 1997
------------ ------------ ------------ ----------- ----------
Other Operating and Financial Data:
Homes and businesses passed........................... 40,000,000 40,000,000 29,000,000 6,000,000 278,000
Lines installed....................................... 351,000 274,000 57,000 4,000 26
Capital expenditures for property and equipment....... $ 15,732 $ 319,234 $ 174,054 $ 41,177 $ 1,617
50
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
The following discussion of our financial condition and results of
operations should be read in conjunction with the consolidated financial
statements and the related notes thereto included elsewhere in this Annual
Report on Form 10-K. This discussion contains forward-looking statements, the
accuracy of which involve risks and uncertainties. Our actual results could
differ materially from those anticipated in the forward-looking statements for
many reasons including, but not limited to, those discussed in "Part I. Item 1.
Business--Risk Factors" and elsewhere in this Annual Report on Form 10-K. We
disclaim any obligation to update information contained in any forward-looking
statement. See "--Forward Looking Statements."
All amounts are presented in thousands, except share and per share amounts
Overview
We are a leading provider of high-speed Internet connectivity ("broadband")
and related communications services, which we sell to businesses and consumers
indirectly through Internet service providers, telecommunications carriers and
other resellers. These wholesale partners generally resell our services to
their business and consumer end-users. We also sell our services directly to
business and consumer end-users through our field sales force, telephone sales
and our website. Our other customers are large companies with established brand
names or other organizations that resell our Internet access services. These
services include a range of high-speed, high-capacity gateways for connecting
end-users to the Internet and corporate networks using traditional copper
telephone wiring. The technology that makes this possible is commonly referred
to as "digital subscriber line" or "DSL."
Incorporated in October 1996, we have a relatively short operating history
introducing our services commercially in the San Francisco Bay Area in December
1997. As of December 31, 2001, we believe we have one of the largest nationally
deployed digital subscriber line networks based on approximately 1,700
operational central offices that pass more than 40 million homes and businesses
in the U.S As of December 31, 2001, we had approximately 351,000 high-speed
Internet access lines in service using digital subscriber line technology
(approximately 13% of which are associated with financially distressed
customers). We have received orders for our services from more than 150
Internet service provider and telecommunications carrier customers, including
AT&T Corporation, XO Communications, EarthLink, Inc., UUNET Technologies (a
WorldCom company), and Megapath Networks and Speakeasy.net, both privately
owned companies. We also provide dial-up Internet access service to over
190,000 customers through Covad.net, our direct sales channel. We are also
developing a variety of services that are enhanced or enabled by our high-speed
network and we are entering into business arrangements in order to bring a
variety of additional service offerings to our customers and their end-users.
Since our inception, we have generated significant net losses and we
continue to experience negative operating cash flow. As of December 31, 2001,
we had an accumulated deficit of $1,344,508. We expect losses and negative cash
flow to continue at least into the second half of 2003. Although we currently
have a plan in place that we believe will get us to cash flow positive without
raising additional capital, our cash reserves are limited and our plan is based
on assumptions, some of which are out of our immediate control. If our
assumptions are not met, we may need to raise additional capital on terms that
are less satisfactory than we desire, which may have a material adverse effect
on our financial condition and could cause significant dilution to our
shareholders.
In the course of preparing the financial statements for the year ended
December 31, 2000, internal control weaknesses were discovered, which continued
into 2001. During 2001 we implemented new control procedures that we believe
improved our internal controls, including the hiring of key personnel, the use
of outside consultants, and documenting key policies and procedures and we are
continuing our efforts to improve such controls. However, these procedures are
relatively new and are still being improved. Our growth continues to stress
these internal controls and we cannot assure you that there will not be
additional control weaknesses in the future.
51
On June 25, 2001, our former subsidiary, BlueStar, made an irrevocable
assignment for the benefit of its creditors ("ABC") of all its assets to an
independent trustee (the "Assignee") in the state of Tennessee. Immediately
thereafter, the Assignee began an orderly liquidation of BlueStar that is
expected to occur over a period of approximately one year. On July 25, 2001,
certain creditors of BlueStar filed an involuntary petition for relief under
Chapter 7 of the Bankruptcy Code, which was dismissed on October 11, 2001. 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 us or BlueStar and cannot be used by
either BlueStar's or our Board of Directors to satisfy the liabilities of
BlueStar. Consequently, the liquidation of BlueStar's assets and the
discharging of its liabilities are currently under the sole control of the
Assignee. Therefore, we deconsolidated BlueStar effective June 25, 2001, which
resulted in the recording of a deferred gain in the amount of approximately
$55,200 in our condensed consolidated balance sheet as of December 31, 2001.
Such deferred gain represents the difference between the carrying values of
BlueStar's assets (aggregating approximately $7,900) and liabilities
(aggregating approximately $63,100) as of June 25, 2001. We will recognize such
deferred gain as an extraordinary item when the liquidation of BlueStar is
complete and its liabilities have been discharged. We currently do not have an
estimate as to when we will be able to recognize this gain.
On August 15, 2001 (the "Petition Date"), we filed a voluntary petition (the
"Petition") under Chapter 11 of the United States Bankruptcy Code (the
"Bankruptcy Code") for the purpose of confirming our pre-negotiated First
Amended Plan of Reorganization, as modified on November 26, 2001, (the "Plan")
with the majority holders (the "Noteholders") of our senior notes. The Petition
was filed with the United States Bankruptcy Court for the District of Delaware
(the "Bankruptcy Court") and was assigned Case No. 01-10167 (JJF). Our
operating subsidiaries did not commence bankruptcy proceedings and continued to
operate in the ordinary course of business. On December 13, 2001, the
Bankruptcy Court entered an order confirming the Plan and, on December 20, 2001
(the "Effective Date"), the Plan was consummated and we emerged from
bankruptcy. However, the Bankruptcy Court still maintains jurisdiction over
certain administrative matters related to the implementation of the Plan,
including the unresolved claims described in "Note 2 to our consolidated
financial statements--Reorganization Under Bankruptcy Proceedings". Under our
Plan, we were able to extinguish approximately $1,394,020 in aggregate face
amount of outstanding Notes, including accrued interest in exchange for a
combination of approximately $271,708 in cash and 35,292,800 common shares, or
15% of the reorganized company. We also recorded an extraordinary gain on the
extinguishment of debt in the amount of $1,033,727.
On November 13, 2001, we announced the signing of a loan agreement and the
restructuring of our resale and marketing agreement with SBC Communications
Inc. We expect that the cash generated from these agreements, will enable us to
fully fund our operations to cash flow positive. The new agreements include
four elements: a one-time $75,000 prepayment, collateralized by all of our
assets, that SBC can use toward the purchase of our services during the next 10
years; a $50,000 four-year loan collateralized by substantially all of our
domestic assets; a payment to us of a $10,000 restructuring fee in exchange for
eliminating SBC's revenue commitments under the original resale and marketing
agreement and the elimination of a $15,000 co-op-marketing fee, which was
required in the previous resale and marketing agreement, owed by us to SBC. We
received these funds on December 20, 2001 and the amounts are reflected in our
cash balance as of December 31, 2001. These agreements with SBC contain
customary change of control provisions that would require us to repay (1) any
outstanding principal and interest on the loan; and (2) any unused portion of
the prepayment, if a change of control occurred. They also contain default
provisions that would allow SBC to accelerate any unpaid portion of the
prepayment and the loan in the event that we default.
During the year ended December 31, 2001, we implemented a business plan, in
response to changes in the economy and the capital markets, that helped to
lower our cost structure in an effort to reach profitability earlier than
previously planned. Specific steps we have taken in this regard include:
assigning for the benefit of creditors our BlueStar Communications Group
subsidiary; eliminating our high yield bond debt through a successful voluntary
reorganization; reducing our workforce by as many as 2,600 employees from a
peak of approximately 4,000 employees in 2000 to approximately 1,400 employees
as of December 31, 2001; reducing the size of our network to approximately
1,700 central offices; reducing the amount and quantity of rebates and other
incentives
52
that we provide to our customers; consolidating and/or closing offices
throughout the United States; enhancing productivity in our operations to
increase customer satisfaction while reducing costs; streamlining our direct
sales and marketing channel and supplementing it with telephone sales and sales
through our website; and evaluating and implementing other cost reduction
strategies including salary freezes and reductions in travel, facilities and
advertising expenses.
We disaggregate our business operations based upon differences in services
and marketing channels even though the cash flows from these operations are not
largely independent of each other. Our wholesale division ("Wholesale") is a
provider of high-speed connectivity services, which include DSL technology, to
ISP, enterprise and telecommunications customers. Our direct division
("Direct"), is a provider of Internet access services to individuals,
corporations and other organizations. Corporate operations represent general
corporate expenses, headquarters facilities and equipment, investments, and
other items not allocated to the segments.
We evaluate performance of the segments based on segment operating results.
Revenue Recognition and Change in Accounting Principle
See Note 1 to our consolidated financial statements for a discussion of our
revenue recognition policy.
During the fourth quarter of 2000, retroactive to January 1, 2000, we
changed our method of accounting for up-front fees associated with service
activation and the related incremental direct costs in accordance with SEC
Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in Financial
Statements." Previously, we had recognized up-front fees as revenues upon
activation of service. Under the new accounting method, which was adopted
retroactive to January 1, 2000, we now recognize up-front fees associated with
service activation over the expected term of the customer relationship, which
is presently estimated to be 24 months, using the straight-line method. Also as
a result of the adoption of SAB No. 101, retroactive to January 1, 2000, we now
treat the incremental direct costs of service activation (which consist
principally of customer premises equipment, service activation fees paid to
other telecommunications companies, service delivery and sales commissions) as
deferred charges in amounts that are no greater than the up-front fees that are
deferred, and such deferred incremental direct costs are amortized to expense
using the straight-line method over 24 months.
The cumulative effect of the change in accounting principle resulted in a
charge to operations of $9,249, which is included in net loss for the year
ended December 31, 2000. The effect of the change in accounting principle on
the year ended December 31, 2000 was to increase loss before cumulative effect
of change in accounting principle by $51,550 ($0.33 per share). For the years
ended December 31, 2001 and 2000, we recognized approximately $11,661 and
$18,661, respectively, in revenue that was included in the cumulative effect
adjustment as of January 1, 2000. The effect of that revenue during 2001 and
2000 was to increase net income/decrease net loss by $ 3,067 and $4,624,
respectively. Although SAB 101 substantially alters the timing of recognition
of certain revenues and treatment of certain costs in our consolidated
financial statements, it does not affect our consolidated cash flows.
Internet Service Provider Resale Channel Difficulties
In order to limit our exposure to the potential financial difficulties of
some of our wholesale partners, we have implemented certain policies and taken
a series of actions. We may stop taking new orders from them, but continue to
install and maintain previously accepted orders. We may terminate our contracts
with those partners who are unresponsive to our efforts to maintain an on-going
business relationship. While our goal is to maintain consistent high quality
service to end-users, we may also decide to disconnect some end-users that are
purchasing our services from certain customers. Although we have successfully
migrated lines, there can be no assurance that migrated end-users will continue
to purchase our services. Even if we are able to migrate end-users, this
process requires a significant amount of our resources, which may impair our
ability to install new lines as they are ordered. Any of these circumstances
could adversely affect our business. We have also worked proactively to collect
outstanding amounts billed to these customers.
53
Even though we are making progress in reducing the number of subscribers for
which we are not currently recognizing revenue, there is no assurance that we
will be able to completely restore the remaining lines to revenue producing
status or that we will not encounter future payment problems from our
customers. Based on our experience to this point, we may lose as many as 50% of
the lines associated with these delinquent partners. However, in light of the
financial position of many Internet service providers, should a particular
Internet service provider customer become subject to reorganization or
bankruptcy proceedings, no assurance can be given that we will be able to
collect payments owed to us or retain payments or other consideration
(including subscriber lines) already received by us.
Related Parties
Our former interim chief executive officer, who is also a member of our
board of directors, is a minority stockholder and former member of the board of
directors of one of our ISP customers, InternetConnect, which filed for
bankruptcy protection in 2001. We recognized revenues of $5,601, $7,189, and
$2,135 related to this customer during the years ended December 2001, 2000, and
1999, respectively. Gross accounts receivable from this customer amounted to
$1,375 as of December 31, 2000 (none at December 31, 2001). On January 4, 2002,
we purchased substantially all of the assets of InternetConnect (Note 1) in an
auction supervised by the United States Bankruptcy Court for the Central
District of California. The purchase price for the assets of InternetConnect
was $7,350 in cash. We did not assume any liabilities or obligations of
InternetConnect. The assets purchased included cash, accounts receivable,
equipment and other assets and approximately 9,250 lines, which include DSL and
T1 broadband connections, along with VPN customers. The majority of these lines
are currently on the our network.
We purchased equipment from a supplier that was partially owned by one of
our stockholders. Purchases from this supplier totaled $45,695 for the year
ended December 31, 1999. During 1999, an unrelated party acquired this
supplier. In addition, we acquired an equity interest in a new supplier during
1999 and disposed of this interest in 2001. Purchases from this new supplier
totaled $13,928, $54,538 and $3,401 for the years ended December 31, 2001, 2000
and 1999, respectively. We also purchased certain products from a company in
which one of our directors and former interim chief executive officer serves as
a director. Purchases from this vendor totaled $33 in 2001. Purchases were not
made from this vendor in 2000 or 1999.
Results of Operations
Three Years Ended December 31, 2001
Revenues, net
We recorded net revenues of $332,596 for the year ended December 31, 2001,
an increase of (i) $173,860 (109.5 percent) over revenues of $158,736 for the
year ended December 31, 2000 and (ii) $266,108 (400.2 percent) over revenues of
$66,488 for the year ended December 31, 1999. The increases in revenues are
mainly attributable to growth in the number of customers and end-users
resulting from our sales and marketing efforts, the addition of new wholesale
partners and the expansion of our national network. We expect revenues to
increase in future periods as we add additional end-users, introduce new
services and increase our sales and marketing efforts. Revenues for the year
ended December 31, 2001 were comprised of $285,707 from our wholesale channel
and $46,889 from our direct channel.
During the years ended December 31, 2001 and 2000, we issued billings to our
financially distressed customers, including those that have filed for
bankruptcy protection, aggregating $74,928 and $45,278, respectively (none in
1999). These billings were not recognized as revenues or accounts receivable in
our consolidated financial statements. However, we ultimately recognized
revenues from certain of these customers on a cash basis aggregating $29,003
and $2,814 during the years ended December 31, 2001 and 2000, respectively
(none in 1999).
54
Network and Product Costs
We recorded network and product costs of $456,586 for the year ended
December 31, 2001, $430,298 for the year ended December 31, 2000, and $101,445
for the year ended December 31, 1999. For the year ended December 31, 2001,
network and product costs were 137.3 percent of revenues, a significant
improvement from the year ended December 31, 2000, when network and product
costs were 271.1 percent of revenues. This compares to 152.6 percent for the
year ended December 31, 1999. The increase in absolute dollars for network and
product costs in all periods is attributable to the expansion of our network
and increased orders resulting from sales and marketing efforts. The decrease
in percentage from the year ended December 31, 2000 to the year ended December
31, 2001 is attributable to the downsizing of our network to approximately
1,700 central offices, cost reduction efforts to lower network costs related to
data transport and a reduction in headcount within our operations and
engineering groups as well as increased revenue from a growing subscriber base.
Included in network and product costs for the year ended December 31, 2001, is
a recovery of $5,570 from disputed collocation claims that were recognized in
the fourth quarter of 2001. We expect network and product costs to increase in
future periods due to increased sales activity and expected revenue growth, but
to decrease as a percentage of revenue as we begin to fully realize the
economies of scale that can exist within our business.
Sales, Marketing, General and Administrative Expenses
Sales, marketing, general and administrative expenses were $205,197 (61.7
percent of revenues) for the year ended December 31, 2001, $294,846 (185.7
percent of revenues) for the year ended December 31, 2000, and $96,086 (144.5
percent of revenues) for the year ended December 31, 1999. Sales, marketing,
general and administrative expenses consist primarily of salaries, expenses for
the development of business, the development of corporate identification,
promotional and advertising materials, and expenses for the establishment of
our management team. The decrease in expenses from 2000 to 2001 is attributable
to a reduction in our workforce, a reduction in office space throughout the
United States, and other cost reduction measures related to advertising and
marketing expenses as well as salaries freezes and reduced travel by employees.
The increase in sales, marketing, general and administrative expense from 1999
to 2000 is attributable to growth in personnel in all areas and the continued
expansion of our sales and marketing efforts, deployment of our network,
expansion of our facilities and building of our operating infrastructure.
Sales, marketing, general and administrative expenses are expected to remain
relatively flat and continue to decrease as a percentage of revenue as we
continue to grow our business.
Operating expenses, which include network and product costs and selling,
marketing, general and administrative expenses, for the year ended December 31,
2001, were comprised of $484,818 from our wholesale channel and $90,651 from
our direct channel.
Provision for Bad Debts (Bad Debt Recoveries)
We recorded net bad debt expenses (recoveries) of $(658) for the year ended
December 31, 2001, $11,257 for the year ended December 31, 2000, and $2,956 for
the year ended December 31, 1999 respectively. Bad debt expense (recovery) was
(0.2)%, 7.1%, and 4.4% of net revenue for the periods ending December 31, 2001,
2000, and 1999, respectively. The decrease in the amount of bad debt expense
from 2000 to 2001 is the result of improved collections. The increase in
percentage from the year ended December 31, 1999 to the year ended December 31,
2000 is to account for the increased risk that some of our resellers
experienced in obtaining additional financing and our experiences from prior
periods.
Depreciation and Amortization
Depreciation and amortization include:
. depreciation of network costs and related equipment;
. depreciation of information systems, furniture and fixtures;
55
. amortization of improvements to central offices, regional data centers
and network operations center facilities and corporate facilities;
. amortization of capitalized software costs; and
. amortization of intangible assets.
Depreciation and amortization of property and equipment was $137,920 for the
year ended December 31, 2001, $91,205 for the year ended December 31, 2000, and
$27,888 for the year ended December 31, 1999. The increase was due to the
addition of equipment and facilities placed in service throughout the years
ended December 31, 1999 and 2000. We expect depreciation and amortization to
remain relatively unchanged in the future due to our expectations that our
capital expenditures in the near term will be less than historical amounts as
we believe that the geographic footprint of our network will remain relatively
unchanged and future capital expenditures will be mostly limited to adding
capacity to our network to support the addition of new users.
Amortization expenses for the years ended December 31, 2001, 2000 and 1999
were $12,919, $87,220 and $9,714 respectively. The increase in expense from
1999 to 2000 is attributable to the amortization of goodwill that was recorded
as a result of the acquisition of LaserLink in the first quarter of 2000 and
the acquisition of BlueStar in the third quarter of 2000. The decrease in
expense from 2000 to 2001 is a direct result of the impairment and
corresponding write-down of the goodwill, that was recorded as a result of
these acquisitions, during the fourth quarter of 2000.
Following the completion of our long-lived asset impairment analysis as of
December 31, 2000, as discussed below, we also re-evaluated the remaining
estimated useful lives of our long-lived assets, including intangibles. As a
result, effective January 1, 2001, we reduced the remaining estimated useful
lives of all long-lived assets (excluding buildings and leasehold improvements)
that previously had estimated useful lives in excess of five years such that
the residual balances and any subsequent additions are now depreciated or
amortized over five years. This change in accounting estimate increased our
loss before extraordinary item by $14,006 ($.08 per share) and decreased our
net income by $14,006 ($.08 per share) in 2001.
Depreciation and amortization expenses for the year ended December 31, 2001,
were comprised of $127,908 from our wholesale channel and $2,393 from our
direct channel.
Provision for Restructuring Expenses
In the fourth quarter of 2000, we announced our decision to effect a new
business plan to help lower our cost structure in an effort to reach cash flow
positive earlier than previously planned. These decisions were driven by
changes in the overall economy and the capital markets, and based upon a
comprehensive review of internal operations. Specific steps that were taken:
. reducing the size of our network to approximately 1,700 central offices
through the closing approximately 200 underproductive or not fully built
out central offices within the Covad specific network and approximately
250 central offices that were related to BlueStar Communications Group;
. reducing our workforce by as many as 2,500 employees from a peak of
approximately 4,000 employees in 2000 to approximately 1,400 employees as
of December 31, 2001;
. consolidating and/or closing offices throughout the United States,
including our corporate headquarters in Santa Clara, California;
. assigning for the benefit of creditors our BlueStar Communications Group
subsidiary; and
. evaluating and implementing other cost reduction strategies including
salary freezes and reductions in travel, facilities and advertising
expenses.
56
In connection with our restructuring efforts, we recorded a charge to
operations of $4,988 in the fourth quarter of 2000 relating to employee
severance benefits that met the requirements for accrual as of December 31,
2000. During the year ended December 31, 2001, the total workforce was reduced
and we paid $3,849 in severance benefits, which were charged against the
restructuring liability recorded as of December 31, 2000.
We recorded additional restructuring expenses aggregating $14,364 during the
year ended December 31, 2001, of which $2,140 related to the BlueStar shutdown.
These expenses consist principally of collocation and building lease
termination costs that met the requirements for accrual in 2001. During the
year ended December 31, 2001, we paid collocation and building lease
termination costs of $12,355, which were charged against the restructuring
liabilities recorded during 2001. We continue to consider whether additional
restructuring is necessary, and additional charges to operations related to any
further restructuring activities may be incurred by in future periods.
Provision for Long-Lived Asset Impairment
During the year ended December 31, 2001, we recorded an expense in the
amount of $11,988 for the impairment of certain long-lived assets. In the
fourth quarter of 2001, we determined that certain communication equipment was
obsolete, based on its discontinued use in our network. We also made the
decision to sell (subject to certain approvals) our Manassas, Virginia,
facility including land, building and certain furniture and fixtures. In March
2002, we entered into a non-binding agreement with a third party to sell this
property for less than the current book value. Accordingly, we recorded a
write-down of this property and equipment for $9,999 during the fourth quarter
of 2001. We also recorded a write-down of goodwill in the amount of $1,989
during 2001.
At the end of 2000, various indicators pointed to a possible impairment of
our long-lived assets. Such indicators included deterioration in the business
climate for Internet and DSL service companies, the reduced availability of
private or public funding for such businesses, significant declines in the
market values of our competitors in the DSL service industry and changes in our
strategic plans. We performed asset impairment tests by comparing the expected
aggregate undiscounted cash flows to the carrying amounts of the long-lived
assets. Based on the results of these tests, we determined that our long-lived
assets were impaired. With the assistance of independent valuation experts, we
then determined the fair value of our long-lived assets. Fair value was
determined using the discounted cash flow method and the market comparison
method. A write-down of $589,388 was recorded as of the fourth quarter of 2000,
reflecting the amount by which the carrying amount of certain long-lived assets
exceed their respective fair values. The write-down consisted of $390,600 for
goodwill, $92,400 for other intangible assets and $106,388 for certain property
and equipment. In connection with this write-down, all of the goodwill recorded
as part of the Laser Link and BlueStar acquisitions has been eliminated. No
impairment write-downs of long-lived assets were recorded during 1999.
Litigation-related Expenses
We recorded litigation-related expenses of $31,160 for the year ended 2001,
including a cash payment of $5,359 and a non-cash charge of $25,801 for the
value of 9,328,334 shares of common stock that either have been issued or are
expected to be issued. Of these shares, 2,000,000 have been issued and
6,495,844 are expected to be distributed upon the approval of the Memorandum of
Understanding described in "Part I. Item 3 Legal Proceedings." We will adjust
this charge in subsequent quarters based on our stock price until such time as
the final distribution of certain shares is made. We recognized $4,000 of these
charges in the second quarter ended June 30, 2001, $1,907 in the third quarter
ended September 30, 2001 and $25,253 in the fourth quarter ended December 31,
2001. We did not recognize similar charges for the years ended December 31,
2000 and 1999.
Write-off of In-process Research & Development Costs
During the year ended December 31, 2000, we recorded an expense in the
amount of $3,726, for the write-off of in-process research and development
("IPRD") costs that we obtained through the acquisition of Laser Link. There
were no write-offs of IPRD for the periods ending December 31, 2001 and
December 31, 1999.
57
Net Interest Expense
Net interest expense for the years ended December 31, 2001, 2000, and 1999
was $68,189, $56,962, and $23,796, respectively. Net interest expense during
these periods consisted primarily of interest expense on our 13.5% senior
discount notes due 2008 issued in March 1998, our 12.5% senior notes due 2009
issued in February 1999, our 12% senior notes due 2010, our 6% convertible
senior notes due 2005 and capital lease obligations. Net interest expense was
partially offset by interest income earned on cash balances on hand during the
year. For the year ended December 31, 2001, our contractual interest obligation
on the above identified notes was $142,356. During the year ended December 31,
2001, we completed a reorganization under Chapter 11 of the United States
Bankruptcy Code. Under our Plan, we were able to extinguish approximately
$1,394,020 in aggregate face amount of outstanding Notes, including accrued
interest, in exchange for a combination of approximately $271,708 in cash and
35,292,800 common shares, or 15% of the reorganized company. As a result of the
extinguishment, we did not recognize interest expense of $49,574 for the year
ended December 31, 2001 on these Notes.
Upon our emergence from Chapter 11 bankruptcy on December 20, 2001 (Note
2--Reorganization Under Bankruptcy Protection), we entered into a series of new
agreements with SBC (Note 11--Stockholders' Equity (Deficit)). One such
agreement (the "Credit Agreement") involves a term note payable that is
collateralized by substantially all of our domestic assets. This note bears
interest at 11%, which is payable quarterly beginning in December 2003. The
entire unpaid principal balance is payable in December 2005. However, we have
the right to prepay the principal amount of the note, in whole or in part, at
any time without penalty.
We expect future net interest expense to be limited to capital lease
obligations and accrued interest on our 11.0% note payable to SBC offset by
interest earned on cash balances.
Reorganization Items
During the year ended December 31, 2001, we recognized expenses directly
associated with our Chapter 11 bankruptcy proceeding in the amount of $63,229.
These reorganization expenses consisted of non-cash adjustments to unamortized
debt issuance costs and discounts and professional fees for legal and financial
advisory services. For the year ended December 31, 2001, we recognized interest
income in the amount of $609 on accumulated cash that we did not disburse as a
result of our Chapter 11 bankruptcy proceeding. This interest income has been
offset against the reorganization expenses in our consolidated statement of
operations for the year ended December 31, 2001.
Investment Losses
We recorded losses and write-downs on investments for the year ended
December 31, 2001, in the amount of $25,149. This included impairment write
downs of equity investments of $10,069, our equity in the losses of
unconsolidated affiliates of $13,769 and the recognition of other than
temporary losses on short-term investments of $1,311. We recorded losses and
write-downs on investments for the year ended December 31, 2000 in the amount
of $35,857. This included impairment write-downs of equity investments of
$17,826, our equity in the losses of unconsolidated affiliates of $6,452 and
the recognition of other than temporary losses on short-term investments of
$11,579. We did not recognize similar items for the year ended December 31,
1999.
Extraordinary Item--gain on the extinguishment of debt
We recorded a gain on the extinguishment of debt in the amount of $1,033,727
for the year ended December 31, 2001. See Note 2 to our consolidated financial
statements--Reorganization Under Bankruptcy Proceedings--for additional
information.
Income Taxes
We made no provision for taxes because we operated at a loss, before the
extraordinary gain on the extinguishment of debt, for the year ended December
31, 2001. No tax provision was recorded on the
58
extraordinary gain on the extinguishment of debt due to the relevant federal
income tax provisions with respect to the treatment of debt extinguishment
income in Chapter 11 bankruptcy proceedings. Additionally, we made no provision
for taxes because we operated at a loss for the years ended December 31, 2000
and 1999. As of December 31, 2001, we had net operating loss carryforwards for
federal tax purposes of approximately $267,200 which will expire in 2021, if
not utilized. The federal operating loss carryforwards have been reduced by
approximately $950,000 as a result of the bankruptcy. We also had net operating
loss carryforwards for state income tax purposes of approximately $937,600
which begin to expire in 2004, if not utilized.
Realization of our deferred tax assets relating to net operating loss
carryforwards is dependent upon future earnings, the timing and amount of which
are uncertain. Accordingly, our net deferred tax assets have been fully offset
by a valuation allowance. The valuation allowance increased (decreased) by
$(145,941), $411,672, and $8,300 during 2001, 2000, and 1999, respectively.
Preferred Dividends
We did not recognize any preferred dividends for the years ended December
31, 2001 and 2000. The holders of preferred stock were entitled to receive
dividends payable in preference and priority to any payment of dividends on
common stock. The cumulative dividends at December 31, 1998 for preferred stock
were approximately $1,100, all of which were converted into 133,587 shares of
common stock in connection with our IPO in January 1999. For the year ended
December 31, 1999, this was recorded as a preferred dividend.
Critical Accounting Policies and Estimates
Our discussion and analysis of financial condition and results of operations
are based upon our consolidated financial statements, which have been prepared
in accordance with accounting principles generally accepted in the United
States. The preparation of our financial statements requires us to make
estimates that affect the reported amounts of assets, liabilities, revenues and
expenses, and related disclosures of contingent assets and liabilities. We base
our accounting estimates on historical experience and other factors that are
believed to be reasonable under the circumstances. However, actual results may
vary from these estimates under different assumptions or conditions. The
following is a summary of our critical accounting policies and estimates, which
are more fully described in the referenced notes to our consolidated financial
statements:
. As more fully described in Note 4, we recognize revenues when (i)
persuasive evidence of an arrangement between the customer and us exists,
(ii) service has been provided to the customer, (iii) the price to the
customer is fixed and determinable and (iv) collectibility of the sales
price is reasonably assured. We recognize up-front fees associated with
service activation over the expected term of the customer relationship,
which is presently estimated to be 24 months, using the straight-line
method. Similarly, we treat the incremental direct costs of service
activation as deferred charges in amounts no greater than the up-front
fees that are deferred, and such incremental direct costs are amortized
to expense using the straight-line method over 24 months.
. As more fully described in Notes 1 and 4, we have concentrations of
credit risk with a small number of customers, certain of which were
experiencing financial difficulties as of December 31, 2001 and 2000 and
were not current in their payments for our services as of those dates.
Accordingly, we recognized revenues from these customers on a cash basis
in certain periods, after the collection of all previous outstanding
accounts receivable balances. We perform ongoing credit evaluations of
our customers' financial condition and maintain an allowance for
estimated credit losses. In addition, we have billing disputes with
certain of our customers. These disputes arise in the ordinary course of
business in the telecommunications industry and their impact on our
accounts receivable and revenues can be reasonably estimated based on
historical experience. We maintain an allowance, through charges to
revenues, based on our estimate of the ultimate resolution of these
disputes.
59
. As more fully described in Note 1, we state our inventories at the lower
of cost or market. In assessing the ultimate recoverability of
inventories, we are required to make estimates regarding future customer
demand.
. As more fully described in Notes 2 and 3, we implemented significant
reorganization and restructuring plans in 2001 and 2000. In this regard,
we consummated a plan of reorganization under Chapter 11 of the United
States Bankruptcy Code on December 20, 2001. However, as of December 31,
2001, we had certain unresolved claims relating to our Chapter 11
bankruptcy proceedings that are in dispute. Therefore, it is reasonably
possible that such disputed bankruptcy claims could ultimately be settled
for amounts that differ from the aggregate liability for such claims
reflected in our consolidated balance sheet as of December 31, 2001. In
addition, as more fully described in Note 10, we tentatively settled
certain securities litigation in connection with our emergence from
Chapter 11 bankruptcy in 2001. However, the final settlement of such
litigation is still subject to court approval.
. As more fully described in Notes 1 and 5, property and equipment and
intangible assets are recorded at cost, subject to adjustments for
impairment. Property and equipment and intangible assets are depreciated
or amortized using the straight-line method over their estimated useful
lives, certain of which were significantly revised in 2001, as more fully
described in Note 1. In assessing the recoverability of our property and
equipment and intangible assets, we must make assumptions regarding
estimated future cash flows and other factors to determine the fair value
of the respective assets. If these estimates and assumptions change in
the future, we may be required to record additional impairment charges
relating to our property and equipment and intangible assets. See further
discussion below concerning the pending adoption of SFAS Nos. 142 and 144
and our framework for evaluating the impairment of long-lived assets in
periods ending after December 31, 2001.
. As more fully described in Notes 2, 3 and 10, we are a party to a variety
of legal proceedings, as either plaintiff or defendant, and are engaged
in other disputes that arise in the ordinary course of business. We are
required to assess the likelihood of any adverse judgments or outcomes to
these matters, as well as potential ranges of probable losses for certain
of these matters. The determination of the liabilities required, if any,
for loss contingencies is made after careful analysis of each individual
issue. However, it is reasonably possible that certain of the liabilities
reflected in our consolidated balance sheets associated with various loss
contingencies could change in the near term due to new developments or
changes in settlement strategies.
. As more fully described in Note 10, we are currently analyzing the
applicability of certain transaction-based taxes to sales of our products
and services. This analysis includes discussions with authorities of
jurisdictions in which we do business to determine the extent of our
transaction-based tax liabilities. We believe that such negotiations will
be concluded without a material adverse effect on our consolidated
financial position and results of operations. However, it is reasonably
possible that our estimates of our transaction-based tax liabilities
could change in the near term.
. As more fully described in Notes 1 and 12, we account for income taxes
using the liability method, under which deferred tax assets and
liabilities are determined based on differences between the financial
reporting and tax bases of our assets and liabilities. We record a
valuation allowance on our deferred tax assets to arrive at an amount
that is more likely than not to be realized. In the future, should we
determine that we are able to realize all or part of our deferred tax
assets, which presently are fully reserved, an adjustment to our deferred
tax assets would increase income in the period in which the determination
was made.
Recent Accounting Pronouncements
On January 1, 2001, we adopted statement of Financial Accounting Standards
("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging
Activities," as amended. SFAS No. 133 standardizes the accounting for
derivatives and hedging activities and requires that all derivatives be
recognized in the statement of financial position as either assets or
liabilities at fair value. Changes in the fair value of derivatives that do not
meet the hedge accounting criteria are required to be reported in operations.
The adoption of SFAS No. 133 had no effect on our consolidated financial
statements as of and for the year ended December 31, 2001.
60
During the fourth quarter of 2000, retroactive to January 1, 2000, we
changed our method of accounting for up-front fees associated with service
activation and the related incremental direct costs in accordance with the SEC
Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial
Statements." The cumulative effect of the change in accounting principle
resulted in a charge to operations of $9,249, which is included in net loss for
the year ended December 31, 2000. For the years ended December 31, 2001 and
2000, we recognized $11,661 and $18,661, respectively, in revenue that was
included in the cumulative effect adjustment as of January 1, 2000. The effect
of that revenue during 2001 and 2000 was to decrease our net loss by $3,067 and
$4,624, respectively.
In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other
Intangibles Assets." SFAS No. 141 eliminates the pooling-of-interests method of
accounting for business combinations, except for qualifying business
combinations that were initiated prior to July 1, 2001. Under SFAS No. 142,
goodwill and indefinite-lived intangible assets are no longer amortized, but
are reviewed annually, or more frequently if impairment indicators arise, for
impairment. We are required to adopt SFAS No. 142 on January 1, 2002. We do not
believe the adoption of SFAS Nos. 141 and 142 will have a material effect on
our consolidated financial statements because we do not presently have any
indefinite-lived intangible assets.
In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations." SFAS No. 143 requires that the fair value of a
liability for an asset retirement obligation be recognized in the period in
which it is incurred if a reasonable estimate of fair value can be made. The
associated asset retirement costs are capitalized as part of the carrying
amount of the long-lived asset. We are required to adopt SFAS No. 143 on
January 1, 2003, and we do not believe the adoption of SFAS No. 143 will have a
material effect on our consolidated financial statements.
In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," which supersedes SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to be Disposed Of," and provides a single accounting model for long-lived
assets to be disposed of. We are required to adopt SFAS No. 144 on January 1,
2002, and we do not believe the adoption of SFAS No. 144 will have a material
effect on our consolidated financial statements.
In April 2001, the FASB's Emerging Issues Task Force ("EITF") reached a
consensus regarding the provision in EITF Issue 00-25, "Vendor Income Statement
Characterization of Consideration from a Vendor to a Retailer," dealing with
consideration from a vendor to a reseller under cooperative advertising and
other arrangements. This provision of EITF Issue 00-25 states that
consideration from a vendor to a reseller of the vendor's products or services
is presumed to be a reduction of the selling price of the vendor's products or
services, unless the vendor (i) receives an identifiable benefit in return for
the consideration and (ii) can reasonably estimate the fair value of the
benefit received. If the amount of consideration paid by the vendor exceeds the
estimated fair value of the benefit received, the excess amount is to be
recorded by the vendor as a reduction of revenues. We are required to adopt
this provision of EITF Issue 00-25 on January 1, 2002, and we do not believe
the adoption of this new guidance will have a material effect on our
consolidated financial statements.
61
Quarterly Financial Information (Unaudited)
The Company's 2001 and 2000 unaudited consolidated quarterly financial
information, is as follows (in thousands):
Three months ended
---------------------------------------------
March 31 June 30 September 30 December 31
--------- --------- ------------ -----------
2001:
Revenues, net......................................... $ 71,245 $ 87,099 $ 84,784 $ 89,468
Network and product costs............................. $ 135,162 $ 121,444 $ 103,290 $ 96,690
Sales, marketing, general and administrative.......... $ 62,827 $ 59,268 $ 46,601 $ 36,501
Provision for restructuring expenses.................. $ 14,805 $ 2,942 $ (130) $ (3,253)
Provision for long-lived asset impairment............. -- $ 2,230 $ (241) $ 9,999
Loss from operations.................................. $(174,712) $(141,847) $(108,070) $ (112,251)
Loss before extraordinary item........................ $(198,535) $(175,462) $(139,749) $ (175,223)
Extraordinary item.................................... -- -- -- $1,033,727
Net income (loss)..................................... $(198,535) $(175,462) $(139,749) $ 858,504
Basic and diluted per share amounts:
Loss before extraordinary item..................... $ (1.15) $ (1.01) $ (0.79) $ (0.96)
Extraordinary item................................. -- -- -- $ 5.65
Net income (loss).................................. $ (1.15) $ (1.01) $ (0.79) $ 4.69
2000:
Revenues, net......................................... $ 20,750 $ 43,244 $ 39,523 $ 55,219
Network and product costs............................. $ 66,008 $ 88,891 $ 129,818 $ 145,581
Sales, marketing, general and administrative.......... $ 52,757 $ 64,917 $ 89,311 $ 87,861
Provision for restructuring expenses.................. -- -- -- $ 4,988
Provision for long-lived asset impairment............. -- -- -- $ 589,388
Loss from operations.................................. $(118,311) $(152,720) $(229,046) $ (854,115)
Loss before cumulative effect of accounting change.... $(127,010) $(153,021) $(246,344) $ (907,512)
Cumulative effect of accounting change................ $ (9,249) -- -- --
Net loss.............................................. $(136,259) $(153,021) $(246,344) $ (907,512)
Basic and diluted per share amounts:
Loss before cumulative effect of accounting change. $ (0.87) $ (1.00) $ (1.58) $ (5.40)
Cumulative effect of accounting change............. $ (0.06) -- -- --
Net loss........................................... $ (0.93) $ (1.00) $ (1.58) $ (5.40)
During the fourth quarter of 2000, retroactive to January 1, 2000, we
adopted SAB No. 101, which requires up-front revenues to be deferred. Also, as
a result of the adoption of SAB No. 101, retroactive to January 1, 2000, we now
treat the incremental direct costs of DSL service activation as deferred
charges in amounts that are no greater than the up-front fees that are deferred.
For the three-month periods ended March 31, June 30, September 30 and
December 31, 2000, we recognized approximately $4,770, $4,738, $4,645 and
$4,508 of revenues, respectively, that were included in the SAB No. 101
cumulative effect adjustment as of January 1, 2000. The effect of that revenue
during those periods was to decrease net loss by approximately $1,156 during
each of those periods.
For the three-month periods ended March 31, June 30, September 30 and
December 31, 2001, we recognized approximately $4,264, $3,679, $2,697, and
$1,021 of revenues, respectively, that were included in the SAB No. 101
cumulative effect adjustment as of January 1, 2000. The effect of that revenue
during those periods was to decrease net loss by approximately $1,140, $949,
$688 and $290 during each of those periods, respectively.
62
In the fourth quarter of 2001, we determined that certain communications
equipment was obsolete based on its discontinued use in our network. We also
made the decision to sell (subject to certain approvals) our Manassas,
Virginia, facility including land, building and certain furniture and fixtures.
In March 2002, we entered into a non-binding agreement with a third party to
sell this property for less than the current book value. Accordingly, we
recorded a write-down of this property and equipment for $9,999 during the
fourth quarter of 2001.
We recorded litigation-related expenses of $31,160 for the year ended 2001,
including a cash payment of $5,359 and a non-cash charge of $25,801 for the
value of 9,328,334 shares of common stock that either have been issued or are
expected to be issued. Of these shares, 2,000,000 have been issued during the
fourth quarter of 2001, and 6,495,844 are expected to be distributed upon the
approval of the MOU described in "Part I. Item 3 Legal Proceedings." We will
adjust this charge in subsequent quarters based on our stock price until such
time as the final distribution of certain shares is made. We recognized $4,000
of these charges in the second quarter ended June 30, 2001, $1,907 in the third
quarter ended September 30, 2001 and $25,253 in the fourth quarter ended
December 31, 2001, respectively.
Included in the network and product costs for the fourth quarter of 2001 is
a recovery of $5,570 from disputed collocation claims.
Our network and product costs have decreased in every quarter for the year
ended December 31, 2001, reflecting the impact of cost reduction measures and
efforts to rationalize our network. Our selling, marketing, general and
administrative expenses have decreased on a relative basis (excluding
bankruptcy-related expenses recorded during the fourth quarter of 2001) in most
quarters and reflect the impact of our restructuring efforts and cost control
measures including a reduction in workforce and the consolidation of office
space. We have experienced decreasing losses from operations on a quarterly
basis during the year ended December 31, 2001, as we increased revenues and
decreased operating expenses with depreciation and amortization remaining
relatively flat as a result of decreased capital expenditures. We expect to
sustain quarterly losses for at least the next few years. See "Item 1.
Business--Risk Factors--We have a history of losses and expect losses in the
future." Our annual and quarterly operating results may fluctuate significantly
in the future as a result of numerous factors, including the factors described
in "Part I. Item 1. Business--Risk Factors." Factors that may affect our
operating results include:
. the financial difficulties experienced by our customers;
. our ability to collect "past-due" receivables from customers;
. receipt of timely payment from our customers;
. the financial condition of our customers;
. our ability to attract and retain Internet service provider, enterprise
and telecommunications carrier customers and limit end-user churn rates;
. the rate at which customers subscribe to our services;
. the rate at which traditional telephone companies can provide us access
to facilities over which we sell our service;
. the ability to order or deploy our services on a timely basis to
adequately satisfy end-user demand;
. our ability to successfully operate our network;
. decreases in the prices for our services due to competition, volume-based
pricing and other factors;
. the success of our relationships with strategic partners, and other
potential third parties in generating significant subscriber demand;
. the mix of line orders between consumer end-users and business end-users
(which typically have higher margins) as well as the mix between our
Wholesale and Direct channels;
63
. the ability to develop and commercialize new services by us or our
competitors;
. the amount and timing of capital expenditures and other costs relating to
the expansion of our network, our network capacity and new service
offerings;
. the impact of regulatory developments, including interpretations of the
1996 Telecommunications Act;
. delays in the commencement of operations in new regions and the
generation of revenue because certain network elements have lead times
that are controlled by traditional telephone companies and other third
parties;
. our ability to raise additional capital as may be required in the future;
and
. the absence of an adverse result in litigation against us.
Many of these factors are outside of our control. See "Item 1.
Business--Risk Factors--Our operating results are likely to fluctuate in future
periods and may fail to meet the expectations of securities analysts and
investors."
Liquidity and Capital Resources
Our operations have required substantial capital investment for the
procurement, design and construction of our central office cages, the design,
creation, implementation and maintenance of our OSS, the purchase of
telecommunications equipment and the design and development of our networks.
Capital expenditures were $23,672 for the year ending December 31, 2001. We
expect that our capital expenditures related to the purchase of infrastructure
equipment necessary for the development and expansion of our networks and the
development of new regions will be less in future periods while capital
expenditures related to the addition of subscribers in existing regions will
increase proportionately in relation to the number of new subscribers that we
add.
From our inception through December 31, 2001, we financed our operations
primarily through private placements of $220,600 of equity securities,
$1,282,000 in net proceeds raised from the issuance of notes (including our
recent agreement with SBC for a $50,000 note payable), a $75,000 collateralized
deposit, and $719,000 in net proceeds raised from public equity offerings. As
of December 31, 2001, we had an accumulated deficit of $1,344,508, and cash,
cash equivalents, and short-term investments of $283,863. In addition, we had
stockholders' equity as of December 31, 2001 of $259,829.
Net cash used in our operating activities was $455,199 for the year ended
December 31, 2001. The net cash used for operating activities during this
period was primarily due to the net losses before extraordinary item of
$688,969, offset by $150,839 for depreciation and amortization, $25,801 for
non-cash litigation-related expenses, $20,845 for the accretion of debt
discount and amortization of deferred debt issuance costs and $42,856 of
non-cash reorganization expenses.
Net cash provided by our investing activities was $258,238 for the year
ended December 31, 2001. The net cash provided by investing activities during
this period was primarily due to net proceeds received from the sale and
maturities of investments of $876,935, offset by purchases of short-term
investments of $638,096.
Net cash used in our financing activities for the year ended December 31,
2001 was $153,669, which primarily related to the payment of $271,708 for the
extinguishment of approximately $1,324,000 of book amount of debt, offset by
$125,000 in net proceeds from our agreements with SBC for a note payable due in
2005 and a collateralized deposit.
We recently entered into a non-binding letter of intent to sell our
Manassas, VA, facility for $14,000. The sale is conditioned upon (1) the buyers
completion of its due diligence and (2) the negotiation and signing of
definitive agreements relating to the sale.
As of December 31, 2001, we had $207,810 in cash and cash equivalents and
$76,053 in short-term investments. We expect to experience negative cash flow
from operating and investing activities at least into the
64
second half of 2003 due to continued development, commercial deployment and
addition of new end-users to our networks. We may also make investments in and
acquisitions of businesses that are complementary to ours to support the growth
of our business. Our future cash requirements for developing, deploying and
enhancing our networks and operating our business, as well as our revenues,
will depend on a number of factors including:
. the rate at which customers and end-users purchase and pay for our
services and the pricing of such services;
. the financial condition of our customers;
. the level of marketing required to acquire and retain customers and to
attain a competitive position in the marketplace;
. the rate at which we invest in engineering, development and intellectual
property with respect to existing and future technology;
. the operational costs that we incur to install, maintain and repair
end-user lines and our network as a whole;
. pending litigation;
. existing and future technology;
. unanticipated opportunities;
. network development schedules and associated costs; and
. the number of regions entered, the timing of entry and services offered.
In addition, we may wish to selectively pursue possible acquisitions of, or
investments in businesses, technologies or products complementary to ours in
order to expand our geographic presence, broaden our product and service
offerings, and achieve operating efficiencies. We may not have sufficient
liquidity, or we may be unable to obtain additional financing on favorable
terms or at all, in order to finance such an acquisition or investment.
Our contractual debt and lease obligations for the next five years, and
thereafter are as follows (amounts in thousands):
2002 2003-2004 2005-2006 Thereafter Total
------ --------- --------- ---------- -------
Note payable to SBC.................... $ -- $ -- $50,000 $ -- $50,000
Capital leases......................... $ -- $ -- $ -- $ -- $ --
Office leases.......................... 5,540 9,226 5,742 1,829 22,337
Other operating leases................. 2,371 1,575 5 -- 3,951
------ ------- ------- ------ -------
Total contractual cash obligations.. $7,922 $10,801 $55,747 $1,829 $76,299
====== ======= ======= ====== =======
Our business plan includes certain discretionary spending in 2002 that is
predicated on certain revenue growth assumptions. If necessary, we will curtail
this discretionary spending so that we can continue as a going concern at least
through January 1, 2003 using only our unrestricted cash, cash equivalent and
short-term investment balances in existence as of December 31, 2001.
Additionally, based on the advice of our legal counsel, we believe it is more
likely than not that certain securities litigation described in Note 10 to our
2001 consolidated financial statements will ultimately be settled in accordance
with the terms of the memorandum of understanding ("MOU") executed by us and
the plaintiffs in such securities litigation dated August 10, 2001. Therefore,
we do not believe that the ultimate settlement of this securities litigation
will have a material adverse effect on our ability to continue as a going
concern at least through January 1, 2003. However, in the event (1) the MOU is
not ultimately approved by the United States District Court and (2) the
settlement of the aforementioned securities litigation ultimately requires us
to disburse additional cash to the plaintiffs in such litigation, we will
reduce other discretionary spending so that we can continue as a going concern
at least through January 1, 2003 using only our unrestricted cash, cash
equivalent and short-term investment balances in
65
existence as of December 31, 2001. We do not believe the curtailment of our
discretionary spending, if necessary, will have a material adverse effect on
the overall execution of our business plan.
We believe that our current cash, cash equivalents and short-term
investments will be sufficient to meet our anticipated cash needs for working
capital and capital expenditures to reach cash flow positive operations, which
we currently anticipate will be in the second half of 2003. An adverse
business, legal, regulatory or legislative development may require us to raise
additional financing. If necessary, we will develop a contingency plan to
address any material adverse developments. We also recognize that we may be
required to raise additional capital, at times and in amounts, which are
uncertain, especially under the current capital market conditions. If we are
unable to acquire additional capital or are required to raise it on terms that
are less satisfactory than we desire, it will have a material adverse effect on
our financial condition which could require a restructuring, sale or
liquidation of our company.
Forward-Looking Statements
We include certain estimates, projections, and other forward-looking
statements in our reports, in presentations to analysts and others, and in
other publicly available material. Future performance cannot be ensured. Actual
results may differ materially from those in forward-looking statements. The
statements contained in this Report on Form 10-K that are not historical facts
are "forward-looking statements" (as such term is defined in Section 27A of the
Securities Act and Section 21E of the Exchange Act), which can be identified by
the use of forward-looking terminology such as "estimates," "projects,"
"anticipates," "expects," "intends," "believes," or the negative thereof or
other variations thereon or comparable terminology, or by discussions of
strategy that involve risks and uncertainties. Examples of such forward-looking
statements include but are not limited to:
. expectations regarding our ability to become cash-flow positive;
. expectations regarding the extent to which customers roll out our service;
. expectations regarding our relationships with our strategic partners and
other potential third parties;
. expectations as to pricing for our services in the future;
. expectations as to the impact of our service offerings on our margins;
. the possibility that we may obtain significantly increased sales volumes;
. the impact of advertising on brand recognition and operating results;
. plans to make strategic investments and acquisitions and the affect of
such investments and acquisitions;
. estimates and expectations of future operating results, including
expectations regarding when we anticipate operating on a cash flow basis,
the adequacy of our cash reserves, our monthly burn rate and the number
of installed lines;
. expectations regarding the time frames, rates, terms and conditions for
utilizing "line sharing;"
. plans to develop and commercialize value-added services;
. our anticipated capital expenditures;
. plans to enter into business arrangements with broadband-related service
providers;
. expectations regarding the development and commencement of our voice
services;
. our plans to expand our existing networks or to commence service in new
metropolitan statistical areas;
. estimates regarding the timing of launching our service in new
metropolitan statistical areas;
. the effect of regulatory reform and litigation;
66
. the effect of litigation currently pending; and
. other statements contained in this Report on Form 10-K regarding matters
that are not historical facts.
These statements are only estimates or predictions and cannot be relied
upon. We can give you no assurance that future results will be achieved. Actual
events or results may differ materially as a result of risks facing us or
actual results differing from the assumptions underlying such statements. Such
risks and assumptions that could cause actual results to vary materially from
the future results indicated, expressed or implied in such forward-looking
statements include our ability to:
. collect receivables from customers;
. retain end-users that are serviced by delinquent customers;
. successfully market our services to current and new customers;
. generate customer demand for our services;
. successfully defend our company against litigation;
. successfully reduce our operating costs and overhead in light of the
financial circumstances of many of our customers while continuing to
provide good customer service;
. successfully continue to increase the number of business-grade lines;
. achieve favorable pricing for our services;
. respond to increasing competition;
. manage growth of our operations; and
. access regions and negotiate suitable interconnection agreements with the
traditional telephone companies, all in a timely manner, at reasonable
costs and on satisfactory terms and conditions consistent with
regulatory, legislative and judicial developments.
All written and oral forward-looking statements made in connection with this
Report on Form 10-K which are attributable to us or persons acting on our
behalf are expressly qualified in their entirety by the "Part I. Item 1.
Business--Risk Factors" and other cautionary statements included in this Report
on Form 10-K. We disclaim any obligation to update information contained in any
forward-looking statement.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to financial market risk, including changes in interest and
marketable equity security prices, relates primarily to our investment
portfolio and outstanding debt obligations. We typically do not attempt to
reduce or eliminate our market exposure on our investment securities because a
substantial majority of our investments are in fixed-rate, short-term
securities. We do not have any derivative instruments. The fair value of our
investment portfolio or related income would not be significantly impacted by
either a 100 basis point increase or decrease in interest rates due mainly to
the fixed-rate, short-term nature of the substantial majority of our investment
portfolio. In addition, all of our outstanding indebtedness as of December 31,
2001 is fixed-rate debt.
67
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
FINANCIAL STATEMENTS
INDEX
(a) The following documents are filed as part of this Form 10-K:
(1) Financial Statements. The following Financial Statements of Covad
Communications Group, Inc. and Report of Independent Auditors are filed as
part of this report.
Report of Ernst & Young LLP, Independent Auditors
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders' Equity (Deficit)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
68
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Covad Communications Group, Inc.
We have audited the accompanying consolidated balance sheets of Covad
Communications Group, Inc. as of December 31, 2001 and 2000, and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the three years in the period ended December 31, 2001. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Covad
Communications Group, Inc. at December 31, 2001 and 2000, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 2001, in conformity with accounting principles
generally accepted in the United States.
As discussed in Note 4 to the consolidated financial statements, in 2000 the
Company changed its method of accounting for revenue recognition and related
incremental direct costs in accordance with guidance contained in SEC Staff
Accounting Bulletin No. 101, Revenue Recognition in Financial Statements.
/s/ ERNST & YOUNG LLP
Walnut Creek, California
March 21, 2002
69
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share and per share amounts)
December 31,
------------------------
2001 2000
----------- -----------
ASSETS
Current assets:
Cash and cash equivalents.......................................................................... $ 207,810 $ 558,440
Short-term investments............................................................................. 76,053 311,394
Restricted cash and investments.................................................................... 9,203 27,748
Accounts receivable, net of allowances of $8,483 at December 31, 2001 ($15,034 at December 31,
2000)............................................................................................. 23,245 26,877
Unbilled revenues.................................................................................. 4,964 7,246
Other receivables.................................................................................. 3,885 6,389
Inventories........................................................................................ 7,249 14,221
Prepaid expenses and other current assets.......................................................... 6,689 5,884
----------- -----------
Total current assets........................................................................... 339,098 958,199
Property and equipment, net........................................................................ 215,804 338,409
Collocation fees, net of accumulated amortization of $18,131 at December 31, 2001 ($7,871 at
December 31, 2000)................................................................................ 53,464 74,888
Restricted investments............................................................................. -- 12,722
Investments in unconsolidated affiliates........................................................... 4,874 30,347
Deferred costs of service activation............................................................... 57,962 52,831
Deferred debt issuance costs....................................................................... -- 36,890
Other long-term assets............................................................................. 3,966 7,199
----------- -----------
Total assets................................................................................... $ 675,168 $ 1,511,485
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current Liabilities:
Accounts payable................................................................................... $ 15,842 $ 72,896
Accrued compensation............................................................................... 16,268 15,685
Current portion of long-term debt.................................................................. -- 43,735
Current portion of capital lease obligations....................................................... 11 2,566
Accrued collocation and network service fees....................................................... 40,839 39,910
Accrued transaction-based taxes.................................................................... 31,263 21,381
Accrued interest................................................................................... 183 38,706
Accrued market development funds and customer incentives........................................... 636 13,860
Unresolved claims related to bankruptcy proceedings................................................ 22,200 --
Accrued restructuring expenses..................................................................... -- 3,980
Other accrued liabilities.......................................................................... 9,200 27,137
----------- -----------
Total current liabilities...................................................................... 136,442 279,856
Long-term debt, net of discount of $10,227 at December 31, 2000 (none at December 31, 2001)........ 50,000 1,324,704
Long-term portion of capital lease obligations..................................................... -- 3,668
Collateralized customer deposit.................................................................... 75,000 --
Deferred gain resulting from deconsolidation of subsidiary......................................... 55,200 --
Unearned revenues.................................................................................. 98,697 85,920
----------- -----------
Total liabilities.............................................................................. 415,339 1,694,148
Commitments and contingencies
Stockholders' Equity (Deficit):
Preferred stock, $0.001 par value; 5,000,000 shares authorized; no shares issued and outstanding at
December 31, 2001 and 2000........................................................................ -- --
Common Stock, $0.001 par value; 590,000,000 shares authorized; 216,542,210 shares issued and
outstanding at December 31, 2001 (171,937,452 shares issued and outstanding at December 31,
2000)............................................................................................. 216 172
Additional paid-in capital......................................................................... 1,606,737 1,509,365
Deferred stock-based compensation.................................................................. (257) (3,067)
Notes receivable from stockholders................................................................. -- (423)
Accumulated other comprehensive income (loss)...................................................... (2,359) 556
Accumulated deficit................................................................................ (1,344,508) (1,689,266)
----------- -----------
Total stockholders' equity (deficit)........................................................... 259,829 (182,663)
----------- -----------
Total liabilities and stockholders' equity (deficit)........................................... $ 675,168 $ 1,511,485
=========== ===========
See accompanying notes.
70
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except share and per share amounts)
Year ended December 31,
----------------------------------------
2001 2000 1999
------------ ------------ ------------
Revenues, net.................................................................. $ 332,596 $ 158,736 $ 66,488
Operating expenses:
Network and product costs................................................... 456,586 430,298 101,445
Sales, marketing, general and administrative................................ 205,197 294,846 96,086
Provision for bad debts (bad debt recoveries)............................... (658) 11,257 2,956
Depreciation and amortization of property and equipment..................... 137,920 91,205 27,888
Amortization of intangible assets........................................... 12,919 87,220 9,714
Provision for restructuring expenses........................................ 14,364 4,988 --
Provision for long-lived asset impairment................................... 11,988 589,388 --
Litigation-related expenses, net............................................ 31,160 -- --
Write-off of in-process research and developments costs..................... -- 3,726 --
------------ ------------ ------------
Total operating expenses................................................ 869,476 1,512,928 238,089
------------ ------------ ------------
Loss from operations........................................................... (536,880) (1,354,192) (171,601)
Other income (expense):
Interest income............................................................. 24,593 52,901 20,676
Realized gain on short-term investments..................................... 5,909 13,466 --
Other than temporary losses on short-term investments....................... (1,311) (11,579) --
Provision for impairment of investments in unconsolidated affiliates........ (10,069) (17,826) --
Equity in losses of unconsolidated affiliates............................... (13,769) (6,452) --
Gain on disposal of investment in unconsolidated affiliate.................. 178 -- --
Interest expense (contractual interest expense was $142,356 during the year
ended December 31, 2001).................................................. (92,782) (109,863) (44,472)
Miscellaneous expense, net.................................................. (2,218) (342) --
Reorganization expenses, net................................................ (62,620) -- --
------------ ------------ ------------
Other income (expense), net................................................. (152,089) (79,695) (23,796)
------------ ------------ ------------
Loss before extraordinary item and cumulative effect of change in accounting
principle.................................................................... (688,969) (1,433,887) (195,397)
Extraordinary item--gain on extinguishment of debt............................. 1,033,727 -- --
Cumulative effect of change in accounting principle............................ -- (9,249) --
------------ ------------ ------------
Net income (loss).............................................................. 344,758 (1,443,136) (195,397)
Preferred dividends............................................................ -- -- (1,146)
------------ ------------ ------------
Net income (loss) attributable to common stockholders.......................... $ 344,758 $ (1,443,136) $ (196,543)
============ ============ ============
Basic and diluted per share amounts:
Loss before extraordinary item and cumulative effect of change in
accounting principle...................................................... $ (3.89) $ (9.41) $ (1.83)
============ ============ ============
Extraordinary item.......................................................... $ 5.83 $ -- $ --
============ ============ ============
Cumulative effect of accounting change...................................... $ -- $ (0.06) $ --
============ ============ ============
Net income (loss)........................................................... $ 1.94 $ (9.47) $ (1.83)
============ ============ ============
Weighted average common shares used in computing basic and diluted per
share amounts............................................................. 177,347,193 152,358,589 107,647,812
============ ============ ============
Pro forma amounts assuming the accounting change is applied retroactively:
Net income (loss)........................................................... $ 344,758 $ (1,433,887) $ (204,646)
============ ============ ============
Net income (loss) attributable to common stockholders....................... $ 344,758 $ (1,433,887) $ (205,792)
============ ============ ============
Basic and diluted net income (loss) per common share........................ $ 1.94 $ (9.41) $ (1.91)
============ ============ ============
See accompanying notes.
71
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(Amounts in thousands, except share amounts)
Convertible
Preferred Stock Common Stock Additional Deferred
------------------ ------------------ Paid-In Stock-Based
Shares Amount Shares Amount Capital Compensation
----------- ------ ----------- ------ ---------- ------------
Balances at December 31, 1998.............................. 27,369,243 $ 18 26,491,494 $ 27 $ 30,670 $(4,688)
Issuance of common stock................................... -- -- 48,999,989 49 725,692 --
Issuance of common stock upon exercise of warrants......... -- -- 15,652,382 16 (11) --
Issuance of Series C and D preferred stock................. 9,568,766 6 -- -- 59,994 --
Deferred charge related to issuance of Series C and D
preferred stock........................................... -- -- -- -- 28,700 --
Conversion of Series A, Series B and Series C preferred
stock to common stock..................................... (27,369,243) (18) 41,053,864 41 (23) --
Conversion of Series C1 and D1 preferred stock............. (9,568,766) (6) 6,379,177 6 -- --
Preferred dividends........................................ -- -- 133,587 -- (77) --
Conversion of convertible preferred stock.................. -- -- -- -- -- --
Deferred stock-based compensation.......................... -- -- -- -- 6,593 (6,593)
Amortization of deferred stock-based compensation.......... -- -- -- -- -- 4,768
Unrealized gains on investments............................ -- -- -- -- -- --
Net loss................................................... -- -- -- -- -- --
----------- ---- ----------- ---- ---------- -------
Balances at December 31, 1999.............................. -- -- 138,710,493 139 851,538 (6,513)
Issuance of common stock................................... -- -- 18,101,646 18 155,385 --
Issuance of common stock upon exercise of options.......... -- -- 5,461,935 5 12,080 --
Issuance of common stock for acquisitions of businesses.... -- -- 11,097,753 11 480,645 (407)
Repurchase of common stock................................. -- -- (1,434,375) (1) -- --
Recognition of warrants.................................... -- -- -- -- 9,089 --
Assumption of notes receivable from stockholders in
connection with business acquisitions..................... -- -- -- -- -- --
Deferred stock-based compensation.......................... -- -- -- -- 628 (628)
Amortization of deferred stock-based compensation.......... -- -- -- -- -- 4,481
Unrealized losses on available-for-sale securities......... -- -- -- -- -- --
Foreign currency translation............................... -- -- -- -- -- --
Net loss................................................... -- -- -- -- -- --
----------- ---- ----------- ---- ---------- -------
Balances at December 31, 2000.............................. -- -- 171,937,452 172 1,509,365 (3,067)
Issuance of common stock................................... -- -- 1,010,000 1 579 --
Issuance of common stock upon exercise of options.......... -- -- 4,100,977 4 2,109 --
Repurchase of common stock................................. -- -- (67,500) -- (172) --
Issuance of common stock upon emergence from
Chapter 11 bankruptcy..................................... -- -- 37,292,800 37 93,568 --
Deconsolidation of subsidiary.............................. -- -- -- -- -- --
Stock-based compensation................................... -- -- -- -- 439 --
Issuance of common stock for business acquisition.......... -- -- 2,268,481 2 2,062 --
Reversal of deferred stock-based compensation.............. -- -- -- -- (1,213) 1,213
Amortization of deferred stock-based compensation.......... -- -- -- -- -- 1,597
Unrealized losses on available-for-sale securities......... -- -- -- -- -- --
Foreign currency translation............................... -- -- -- -- -- --
Net income................................................. -- -- -- -- -- --
----------- ---- ----------- ---- ---------- -------
Balances at December 31, 2001.............................. -- $ -- 216,542,210 $216 $1,606,737 $ (257)
=========== ==== =========== ==== ========== =======
Notes Accumulated Total
Receivable Other Stockholders'
From Comprehensive Accumulated Equity
Stockholders Income (Loss) Deficit (Deficit)
------------ ------------- ----------- -------------
Balances at December 31, 1998.............................. $ -- $ -- $ (50,733) $ (24,706)
Issuance of common stock................................... -- -- -- 725,741
Issuance of common stock upon exercise of warrants......... -- -- -- 5
Issuance of Series C and D preferred stock................. -- -- -- 60,000
Deferred charge related to issuance of Series C and D
preferred stock........................................... -- -- -- 28,700
Conversion of Series A, Series B and Series C preferred
stock to common stock..................................... -- -- -- --
Conversion of Series C1 and D1 preferred stock............. -- -- -- --
Preferred dividends........................................ -- -- -- (77)
Conversion of convertible preferred stock.................. -- -- -- --
Deferred stock-based compensation.......................... -- -- -- --
Amortization of deferred stock-based compensation.......... -- -- -- 4,768
Unrealized gains on investments............................ -- 91,257 -- 91,257
Net loss................................................... -- -- (195,397) (195,397)
----- -------- ----------- -----------
Balances at December 31, 1999.............................. -- 91,257 (246,130) 690,291
Issuance of common stock................................... -- -- -- 155,403
Issuance of common stock upon exercise of options.......... -- -- -- 12,085
Issuance of common stock for acquisitions of businesses.... -- -- -- 480,249
Repurchase of common stock................................. -- -- (1)
Recognition of warrants.................................... -- -- -- 9,089
Assumption of notes receivable from stockholders in
connection with business acquisitions..................... (423) -- -- (423)
Deferred stock-based compensation.......................... -- -- -- --
Amortization of deferred stock-based compensation.......... -- -- -- 4,481
Unrealized losses on available-for-sale securities......... -- (88,985) -- (88,985)
Foreign currency translation............................... -- (1,716) -- (1,716)
Net loss................................................... -- -- (1,443,136) (1,443,136)
----- -------- ----------- -----------
Balances at December 31, 2000.............................. (423) 556 (1,689,266) (182,663)
Issuance of common stock................................... -- -- -- 580
Issuance of common stock upon exercise of options.......... -- -- -- 2,113
Repurchase of common stock................................. -- -- -- (172)
Issuance of common stock upon emergence from
Chapter 11 bankruptcy..................................... -- -- -- 93,605
Deconsolidation of subsidiary.............................. 423 -- -- 423
Stock-based compensation................................... -- -- -- 439
Issuance of common stock for business acquisition.......... -- -- -- 2,064
Reversal of deferred stock-based compensation.............. -- -- -- --
Amortization of deferred stock-based compensation.......... -- -- -- 1,597
Unrealized losses on available-for-sale securities......... -- (2,327) -- (2,327)
Foreign currency translation............................... -- (588) -- (588)
Net income................................................. -- -- 344,758 344,758
----- -------- ----------- -----------
Balances at December 31, 2001.............................. $ -- $ (2,359) $(1,344,508) $ 259,829
===== ======== =========== ===========
See accompanying notes.
72
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
Year ended December 31,
-----------------------------------
2001 2000 1999
----------- ----------- ---------
Operating Activities:
Net income (loss)....................................................................... $ 344,758 $(1,443,136) $(195,397)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Provision for bad debts (bad debt recoveries)........................................ (658) 11,257 2,956
Depreciation and amortization........................................................ 150,839 178,425 37,602
Loss on disposition of equipment..................................................... 2,679 524 358
Non-cash reorganization expenses..................................................... 42,856 -- --
Non-cash litigation-related expenses................................................. 25,801 -- --
Provision for long-lived asset impairment............................................ 11,988 589,388 --
Write-off of in-process research and development costs............................... -- 3,726 --
Amortization of deferred stock-based compensation.................................... 1,597 4,481 4,768
Other stock-based compensation....................................................... 439 9,089 --
Accretion of interest on investments................................................. (7,136) (25,093) (6,240)
Accretion of debt discount and amortization of deferred debt issuance costs.......... 20,845 27,826 20,269
Other than temporary losses on short-term investments................................ 1,311 11,579 --
Provision for impairment of investments in unconsolidated affiliates................. 10,069 17,826 --
Equity in losses of unconsolidated affiliates........................................ 13,769 6,452 --
Gain on disposal of investment in unconsolidated affiliates.......................... (178) -- --
Extraordinary item................................................................... (1,033,727) -- --
Cumulative effect of change in accounting principle.................................. -- 9,249 --
Net changes in operating assets and liabilities:
Restricted cash.................................................................. (9,103) (635) (565)
Accounts receivable.............................................................. 532 (18,932) (16,416)
Unbilled revenue................................................................. 2,282 (1,827) (4,756)
Inventories...................................................................... 6,748 (5,662) (7,601)
Prepaid expenses and other current assets........................................ 3,163 3,534 (5,005)
Deferred costs of service activation............................................. (5,131) (52,831) --
Accounts payable................................................................. (53,652) 41,047 5,815
Unresolved claims related to bankruptcy proceedings.............................. 22,200 -- --
Accrued restructuring expenses................................................... 2,024 4,988 --
Other current liabilities........................................................ (22,291) 51,773 50,518
Unearned revenue................................................................. 12,777 80,459 4,687
----------- ----------- ---------
Net cash used in operating activities......................................... (455,199) (496,493) (109,007)
Investing Activities:
Cash acquired through business acquisitions............................................. -- 4,330 --
Cash relinquished as a result of deconsolidating a subsidiary........................... (1,599) -- --
Purchase of short-term investments...................................................... (638,096) (613,307) (558,212)
Maturities of short-term investments.................................................... 547,477 679,615 104,390
Sale of short-term investments.......................................................... 329,458 92,917 --
Purchase of restricted investments...................................................... -- -- (73,435)
Redemption of restricted investments.................................................... 26,875 26,875 13,214
Purchase of restricted investments in connection with bankruptcy proceedings............ (257,202) -- --
Redemption of restricted investments in connection with bankruptcy proceedings.......... 270,698 -- --
Purchase of property and equipment...................................................... (15,732) (319,234) (174,054)
Proceeds from sale of property and equipment............................................ 1,280 -- --
Recovery of internal-use software costs................................................. 2,000 21,500 --
Payment of collocation fees............................................................. (7,940) (25,038) (34,132)
Acquisition of equity investments in unconsolidated affiliates.......................... -- (51,341) --
Proceeds from sale of investment in unconsolidated affiliate............................ 1,225 -- --
Purchase of other long-term assets...................................................... (206) (2,053) (7,627)
----------- ----------- ---------
Net cash provided by (used in) investing activities..................................... 258,238 (185,736) (729,856)
73
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS--(Continued)
(Amounts in thousands)
Year ended December 31,
-------------------------------
2001 2000 1999
--------- ---------- --------
Financing Activities:
Proceeds from collateralized customer deposit.......................... $ 75,000 $ -- $ --
Proceeds from issuance of long-term debt and warrants, net............. 50,000 897,619 205,049
Principal payments of long-term debt in connection with bankruptcy
proceedings.......................................................... (271,708) -- --
Other principal payments of long-term debt............................. (8,393) (5,457) --
Principal payments under capital lease obligations..................... (1,089) (2,347) (267)
Proceeds from common stock issuance, net of repurchase................. 2,521 167,487 725,746
Proceeds from preferred stock issuance................................. -- -- 60,000
Principal payments on short-term borrowings............................ -- (32,900) --
Payment of preferred dividends......................................... -- -- (77)
--------- ---------- --------
Net cash provided by (used in) financing activities.......... (153,669) 1,024,402 990,451
Effect of foreign currency translation on cash and cash equivalents.... -- 229 --
--------- ---------- --------
Net increase (decrease) in cash and cash equivalents................... (350,630) 342,402 151,588
Cash and cash equivalents at beginning of year......................... 558,440 216,038 64,450
--------- ---------- --------
Cash and cash equivalents at end of year..................... $ 207,810 $ 558,440 $216,038
========= ========== ========
Supplemental Disclosures of Cash Flow Information:
Cash paid during the year for interest, net of amounts capitalized
($2,490 and $2,757 in 2000 and 1999, respectively--none in 2001)..... $ 68,051 $ 77,816 $ 13,257
========= ========== ========
Supplemental Schedule of Non-Cash Investing and Financing Activities:
Common stock issued in lieu of preferred dividends..................... $ -- $ -- $ 1,069
========= ========== ========
Equipment purchased through capital leases............................. $ -- $ 955 $ --
========= ========== ========
See accompanying notes.
74
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2001, 2000 and 1999
(Amounts in thousands, except share and per share amounts)
1. Nature of Operations and Summary of Significant Accounting Policies
Organization, Business and Basis of Presentation
Organization and Business
Covad Communications Group, Inc. ("Covad") is a provider of high-speed
connectivity services. These services include a range of high-speed,
high-capacity Internet and network access services utilizing digital subscriber
line ("DSL") technology and related value-added services. Covad's high-speed
connectivity services are sold to businesses and consumers directly and
indirectly through Internet service providers ("ISPs"), enterprises,
telecommunications carriers and other customers. These services are sold
directly to business and consumer end-users through Covad's field sales force,
telephone sales and Covad's website. ISPs purchase Covad's services in order to
provide high-speed Internet access to their business and consumer end-users.
Branded virtual service providers purchase turnkey broadband or dial-up
services from the Company and sell these services to their existing customers
or affiliate groups. Enterprise customers purchase services directly or
indirectly from Covad to provide their employees with high-speed remote access
to the enterprise's local area network. Other telecommunications carriers
purchase Covad's services for resale to their ISP affiliates, Internet users
and enterprise customers.
Basis of Presentation
The consolidated financial statements include the accounts of Covad and its
wholly owned subsidiaries (collectively, the "Company"), except for the
accounts of BlueStar Communications Group, Inc. and its subsidiaries
(collectively, "BlueStar"), which have been excluded from the Company's
consolidated financial statements effective June 25, 2001 (Note 3). All
significant intercompany accounts and transactions have been eliminated in
consolidation.
The Company's business plan includes certain discretionary spending in 2002
that is predicated on certain revenue growth assumptions. If necessary,
management will curtail this discretionary spending so that the Company can
continue as a going concern at least through January 1, 2003 using only the
Company's unrestricted cash, cash equivalent and short-term investment balances
in existence as of December 31, 2001. Additionally, based on the advice of the
Company's legal counsel, management believes it is more likely than not that
certain securities litigation described in Note 10 will ultimately be settled
in accordance with the terms of the memorandum of understanding ("MOU")
executed by the Company and the plaintiffs in such securities litigation dated
August 10, 2001. Therefore, management does not believe that the ultimate
settlement of this securities litigation will have a material adverse effect on
the Company's ability to continue as a going concern at least through January
1, 2003. However, in the event (i) the MOU is not ultimately approved by the
United States District Court and (ii) the settlement of the aforementioned
securities litigation ultimately requires the Company to disburse additional
cash to the plaintiffs in such litigation, management will reduce other
discretionary spending so that the Company can continue as a going concern at
least through January 1, 2003 using only the Company's unrestricted cash, cash
equivalent and short-term investment balances in existence as of December 31,
2001. Management does not believe the curtailment of the Company's
discretionary spending, if necessary, will have a material adverse effect on
the overall execution of the Company's business plan.
75
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Summary of Significant Accounting Policies
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results may differ
materially from those estimates. The Company's critical accounting estimates
include (i) revenue recognition and the establishment of accounts receivable
allowances (Notes 1 and 4), (ii) inventory valuation (Note 1), (iii)
reorganization and restructuring liabilities (Notes 2 and 3), (iv) useful life
assignments and impairment evaluations associated with property and equipment
and intangible assets (Notes 1 and 5), (v) anticipated outcomes of legal
proceedings and other disputes (Notes 2, 3 and 10), (vi) transaction-based tax
liabilities (Note 10) and (vii) valuation allowances associated with deferred
tax assets (Note 12).
Cash Equivalents and Short-Term Investments
The Company considers all highly liquid investments with a maturity of three
months or less from the date of original issuance to be cash equivalents. As of
December 31, 2001 and 2000, cash equivalents consisted principally of money
market mutual funds. All of the Company's investments are classified as
available-for-sale and stated at their fair market values, which are determined
based on quoted market prices. The Company's short-term investments had
original maturities greater than three months, but less than one year, from the
balance sheet dates. Management determines the appropriate classification of
investments at the time of purchase and reevaluates such designation at the end
of each period. Unrealized gains and losses on available-for-sale securities
are included as a separate component of stockholders' equity (deficit).
Realized gains and losses on available-for-sale securities are determined based
on the specific identification of the cost of securities sold.
Short-term investments consisted of the following:
December 31, 2001
------------------------------------------
Gross Gross
Amortized Unrealized Unrealized
Cost Gains Losses Fair Value
--------- ---------- ---------- ----------
U.S. Government agency securities...... $ 30,019 $ 1 $(23) $ 29,997
Certificates of deposit................ 46,089 -- (33) 46,056
-------- ------ ---- --------
Total available-for-sale securities. $ 76,108 $ 1 $(56) $ 76,053
======== ====== ==== ========
December 31, 2000
------------------------------------------
Gross Gross
Amortized Unrealized Unrealized
Cost Gains Losses Fair Value
--------- ---------- ---------- ----------
U.S. Government agency securities...... $283,884 $ 239 $ (2) $284,121
Commercial paper and corporate notes... 14,935 -- (8) 14,927
Marketable equity securities........... 10,303 2,043 -- 12,346
-------- ------ ---- --------
Total available-for-sale securities. $309,122 $2,282 $(10) $311,394
======== ====== ==== ========
76
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Realized gains and losses resulting from the sale of available-for-sale
securities were as follows:
Year ended December 31,
-----------------------
2001 2000 1999
------ ------- ----
Gains. $6,373 $13,466 $ --
Losses (464) -- --
------ ------- ----
$5,909 $13,466 $ --
====== ======= ====
Restricted Cash and Investments
As of December 31, 2001 the Company held $9,203 in money market mutual funds
principally for the payment of unresolved bankruptcy claims (Note 2). As of
December 31, 2000 the Company held $39,036 in U.S. Treasury securities and
$1,434 in money market mutual funds for the payment of interest on the
Company's 1999 senior notes (Note 7) and other purposes.
Other Investments
Other investments consist primarily of strategic investments in publicly
held and private entities. Investments representing equity interests of less
than 20% in publicly held companies are accounted for as available-for-sale
securities at fair value as measured by quoted market prices. Investments in
privately held companies are accounted for under either the cost or equity
methods of accounting, depending on the Company's ability to significantly
influence these entities.
The Company performs periodic reviews of its investments for impairment.
Impairment write-downs create a new carrying value for both publicly and
privately held investments and the Company does not record subsequent increases
in fair value in excess of the new carrying value for privately held
investments accounted for under the cost or equity methods. The Company
recorded write-downs of $10,069 and $17,826 during the years ended December 31,
2001 and 2000, respectively, related to impairments of its privately held
investments. No impairment losses were recognized in 1999.
Concentrations of Credit Risk, Significant Customers, Key Suppliers and
Related Parties
Financial instruments that potentially subject the Company to concentrations
of credit risk consist principally of cash and cash equivalents, short-term
investments and restricted investments. The Company's cash and investment
policies limit cash equivalents, short-term investments and restricted
investments to short-term, investment grade instruments. Cash and cash
equivalents, short-term investments and restricted cash and investments are
held with various domestic and Canadian financial institutions with high credit
standing. The Company has not experienced any significant losses on its cash,
cash equivalents or restricted investments. However, during the years ended
December 31, 2001 and 2000, the Company recognized other than temporary losses
on certain available-for-sale securities aggregating $1,311 and $11,579,
respectively. No such losses were recognized in 1999.
The Company conducts business primarily with ISP, enterprise and
telecommunications carrier customers in the United States. As more fully
described in Note 4, the Company has concentrations of credit risk with a small
number of customers, and certain of the Company's ISP customers were
experiencing financial difficulties as of December 31, 2001 and 2000 and were
not current in their payments for the Company's services at those dates. The
Company performs ongoing credit evaluations of its customers' financial
condition and generally does not require collateral. An allowance is maintained
for estimated credit losses. During the years ended December 31,
77
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
2001, 2000 and 1999, the Company wrote-off certain accounts receivable balances
aggregating $10,371, $175, and $1,138, respectively, against the allowance for
credit losses.
The Company's former interim chief executive officer, who is also a member
of the Company's board of directors, is a minority stockholder and former
member of the board of directors of one of the Company's ISP customers,
InternetConnect, which filed for bankruptcy protection in 2001 (Note 15). The
Company recognized revenues of $5,601, $7,189, and $2,135 related to this
customer during the years ended December 31, 2001, 2000, and 1999,
respectively. Gross accounts receivable from this customer amounted to $1,375
as of December 31, 2000 (none as of December 31, 2001).
The Company is dependent on a limited number of suppliers for certain
equipment used to provide its services. The Company has generally been able to
obtain an adequate supply of such equipment. In addition, the Company believes
there are alternative suppliers for the equipment used to provide its services.
However, an extended interruption in the supply of equipment currently obtained
from its suppliers could adversely affect the Company's business and results of
operations.
The Company purchased equipment from a supplier that was partially owned by
a stockholder of the Company. Purchases from this supplier totaled $45,695 for
the year ended December 31, 1999. During 1999, an unrelated party acquired this
supplier. In addition, the Company acquired an equity interest in a new
supplier during 1999 and disposed of this interest in 2001. Purchases from this
new supplier totaled $13,928, $54,538 and $3,401 for the years ended December
31, 2001, 2000 and 1999, respectively.
The Company also purchased certain products from a company in which one of
the Company's directors and former interim chief executive officer serves as a
director. Purchases from this vendor totaled $33 in 2001. Purchases were not
made from this vendor in 2000 or 1999.
Inventories
Inventories, consisting primarily of customer premises equipment, are stated
at the lower of cost, determined using the "first-in, first-out" method, or
market.
Property and Equipment
Property and equipment are recorded at cost, subject to adjustments for
impairment, and depreciated or amortized using the straight-line method over
the following estimated useful lives:
Building............................... 10 years
Leasehold improvements................. 5 years or the term of the lease,
whichever is less
Computer equipment..................... 2 to 5 years
Computer software...................... 3 to 5 years
Furniture and fixtures................. 2 to 5 years
Networks and communication equipment... 2 to 5 years
The Company incurs significant costs associated with internal use software,
which consists principally of the Company's operational support systems ("OSS")
software and website. The Company charges to expense as incurred the costs of
research, including pre-development efforts related to determining
technological or product
78
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
alternatives, and costs incurred for training and maintenance. Software and web
site development costs, which include direct costs such as labor and
contractors, are capitalized when it is probable that the project will be
completed and the software or 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
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 $9,207, $6,394, and $3,253 during the years
ended December 31, 2001, 2000, and 1999, respectively. The Company accounts for
incidental sales of licenses to its OSS software on a cost recovery basis (Note
6).
The Company leases certain equipment under capital lease agreements. The
assets and liabilities under capital leases are recorded at the lesser of the
present value of the aggregate future minimum lease payments, including
estimated bargain purchase options, or the fair value of the assets under
lease. Assets under capital leases are amortized over the lesser of the lease
term or useful life of the assets. Amortization of assets under capital leases
is included in depreciation and amortization expense.
Collocation Fees
Collocation fees represent nonrecurring fees paid to other
telecommunications carriers for the perpetual right to use central office space
to house equipment owned or leased by the Company. Such nonrecurring fees are
capitalized as intangible assets and amortized 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.
Change in Accounting Estimate
Effective January 1, 2001, the Company reduced the remaining estimated
useful lives of all long-lived assets, excluding a building and leasehold
improvements, that previously had estimated useful lives in excess of five
years such that the residual balances and any subsequent additions are now
depreciated or amortized over five years using the straight-line method. This
change in accounting estimate increased the Company's loss before extraordinary
item by $14,006 ($.08 per share) and decreased net income by $14,006 ($.08 per
share) for the year ended December 31, 2001.
Impairment of Long-Lived Assets
The Company periodically evaluates potential impairments of its long-lived
assets, including intangibles. When the Company determines that the carrying
value of long-lived assets may not be recoverable based upon the existence of
one or more indicators of impairment, the Company evaluates the projected
undiscounted cash flows related to the assets. If these cash flows are less
than the carrying value of the assets, the Company measures the impairment
using discounted cash flows or other methods of determining fair value.
Long-lived assets to be disposed of are carried at the lower of cost or fair
value less estimated costs of disposal.
Stock-Based Compensation
The Company accounts for stock-based awards to employees using the intrinsic
value method.
Advertising Costs
The Company charges the costs of advertising to expense as incurred.
Advertising expense for the years ended December 31, 2001, 2000 and 1999 was
$16,467, $45,511 and $25,798, respectively.
79
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The Company makes market development funds ("MDF") available to certain
customers for the reimbursement of co-branded advertising expenses and other
purposes. To the extent that MDF is used by the Company's customers for
co-branded advertising, and the customers provide the Company with third-party
evidence of such co-branded advertising as prescribed by Company policy, such
amounts are charged to advertising expense as incurred. Other amounts payable
to customers relating to rebates and nonqualified MDF activities are charged to
revenues as incurred.
Income Taxes
The Company uses the liability method to account for income taxes. Under
this method, deferred tax assets and liabilities are determined based on
differences between financial reporting and tax bases of assets and
liabilities. Deferred tax assets and liabilities are measured using enacted tax
rates and laws that will be in effect when the differences are expected to
reverse.
Fair Values of Financial Instruments
The following methods and assumptions were used to estimate the fair values
of the Company's financial instruments:
Cash, Cash Equivalents, Short Term Investments and Restricted
Investments. The carrying amounts of these assets approximate their respective
fair values, which were determined based on quoted market prices.
Borrowings. The fair values of borrowings, including long-term debt 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 $50,011 as of
December 31, 2001, as compared to the aggregate carrying amount of $50,011 as
of such date. The aggregate fair value of the Company's long-term debt and
capital lease obligations was $972,045 as of December 31, 2000, as compared to
the aggregate carrying amount of $1,374,673 as of such date.
Foreign Currency
The functional currency of the Company's unconsolidated affiliates is the
local currency. The investments in these unconsolidated affiliates are
translated into U.S. dollars at year end exchange rates and the Company's
equity in the income or losses of these affiliates is translated at average
exchange rates prevailing during the year. Translation adjustments are included
in "Accumulated other comprehensive income (loss)," a separate component of
stockholders' equity (deficit).
Per Share Amounts
Basic per share amounts are computed by using the weighted average number of
shares of the Company's common stock, less the weighted average number of
common shares subject to repurchase, outstanding during the period.
Diluted per share amounts are determined in the same manner as basic per
share amounts, except that the number of weighted average common shares used in
the computations includes dilutive common shares subject to repurchase and is
increased assuming the (i) exercise of dilutive stock options and warrants
using the treasury stock method and (ii) conversion of dilutive convertible
debt instruments. However, diluted net income (loss) per share is the same as
basic net income (loss) per share in the periods presented in the accompanying
consolidated
80
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
statements of operations because loss from operations is the "control number"
in determining whether potential common shares are included in the calculation.
Consequently, the impact of (i) including common shares subject to repurchase,
(ii) the assumed exercise of outstanding stock options and warrants and (iii)
the assumed conversion of the 2000 convertible senior notes (Note 7) was not
dilutive to loss from operations.
The following table presents the calculation of weighted average common
shares used in the computations of basic and diluted per share amounts
presented in the accompanying consolidated statements of operations:
Year ended December 31,
-----------------------------------
2001 2000 1999
----------- ----------- -----------
Weighted average shares of common stock
outstanding............................... 177,489,090 155,944,344 115,675,656
Less weighted average shares of common stock
subject to repurchase..................... 141,897 3,585,755 8,027,844
----------- ----------- -----------
Weighted average common shares used in
computing basic per share amounts......... 177,347,193 152,358,589 107,647,812
=========== =========== ===========
Comprehensive Income (Loss)
Significant components of the Company's comprehensive income (loss) are as
follows:
Year ended December 31,
Cumulative --------------------------------
Amounts 2001 2000 1999
----------- -------- ----------- ---------
Net income (loss)...................... $(1,344,508) $344,758 $(1,443,136) $(195,397)
Unrealized gains (losses) on available-
for-sale securities.................. (55) (2,327) (88,985) 91,257
Foreign currency translation
adjustment........................... (2,304) (588) (1,716) --
----------- -------- ----------- ---------
Comprehensive income (loss)............ $(1,346,867) $341,843 $(1,533,837) $(104,140)
=========== ======== =========== =========
Recent Accounting Pronouncements
On January 1, 2001, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging
Activities," as amended. SFAS No. 133 standardizes the accounting for
derivatives and hedging activities and requires that all derivatives be
recognized in the statement of financial position as either assets or
liabilities at fair value. Changes in the fair value of derivatives that do not
meet the hedge accounting criteria are required to be reported in operations.
The adoption of SFAS No. 133 had no effect on the Company's consolidated
financial statements as of and for the year ended December 31, 2001.
In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other
Intangibles Assets." SFAS No. 141 eliminates the pooling-of-interests method of
accounting for business combinations, except for qualifying business
combinations that were initiated prior to July 1, 2001. Under SFAS No. 142,
goodwill and indefinite-lived intangible assets are no longer amortized, but
are reviewed annually, or more frequently if impairment indicators arise, for
impairment. The Company is required to adopt SFAS No. 142 on January 1, 2002.
The Company does not believe the adoption of SFAS Nos. 141 and 142 will have a
material effect on its consolidated financial statements because the Company
does not presently have any indefinite-lived intangible assets.
81
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations." SFAS No. 143 requires that the fair value of a
liability for an asset retirement obligation be recognized in the period in
which it is incurred if a reasonable estimate of fair value can be made. The
associated asset retirement costs are capitalized as part of the carrying
amount of the long-lived assets. The Company is required to adopt SFAS No. 143
on January 1, 2003, and it does not believe the adoption of SFAS No. 143 will
have a material effect on its consolidated financial statements.
In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," which supersedes SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to Be Disposed Of," and provides a single accounting model for long-lived
assets to be disposed of. The Company is required to adopt SFAS No. 144 on
January 1, 2002, and it does not believe the adoption of SFAS No. 144 will have
a material effect on its consolidated financial statements.
In April 2001, the FASB's Emerging Issues Task Force ("EITF") reached a
consensus regarding the provision in EITF Issue 00-25, "Vendor Income Statement
Characterization of Consideration from a Vendor to a Retailer," dealing with
consideration from a vendor to a reseller under cooperative advertising and
other arrangements. This provision of EITF Issue 00-25 states that
consideration from a vendor to a reseller of the vendor's products or services
is presumed to be a reduction of the selling price of the vendor's products or
services, unless the vendor (i) receives an identifiable benefit in return for
the consideration and (ii) can reasonably estimate the fair value of the
benefit received. If the amount of consideration paid by the vendor exceeds the
estimated fair value of the benefit received, the excess amount is to be
recorded by the vendor as a reduction of revenues. The Company is required to
adopt this provision of EITF Issue 00-25 on January 1, 2002, and it does not
believe the adoption of this new guidance will have a material effect on its
consolidated financial statements.
Reclassifications
Certain balances in the Company's 2000 and 1999 consolidated financial
statements have been reclassified to conform to the presentation in 2001.
2. Reorganization Under Bankruptcy Proceedings
On August 15, 2001 (the "Petition Date"), Covad, excluding its operating
subsidiaries, filed a voluntary petition (the "Petition") under Chapter 11 of
the United States Bankruptcy Code (the "Bankruptcy Code") for the purpose of
confirming its pre-negotiated First Amended Plan of Reorganization, as modified
on November 26, 2001 (the "Plan") with the majority holders (the "Noteholders")
of its senior notes (Note 7). The Petition was filed with the United States
Bankruptcy Court for the District of Delaware (the "Bankruptcy Court") and was
assigned Case No. 01-10167 (JJF). On December 13, 2001, the Bankruptcy Court
entered an order confirming the Plan and, on December 20, 2001 (the "Effective
Date"), the Plan was consummated and Covad emerged from bankruptcy. However,
the Bankruptcy Court still maintains jurisdiction over certain administrative
matters related to the implementation of the Plan, including the unresolved
claims described below.
82
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
On the Effective Date, the Company made the following distributions of cash
and shares of its common stock to certain claimants:
Common Stock
------------------------------------------------
Aggregate Fair Total
Claimant Cash Shares Market Value Consideration
- -------- -------- ---------- -------------- -------------
Noteholders....................... $271,708 35,292,800 $88,585 $360,293
Plaintiffs in litigation (Note 10) 5,793 2,000,000 5,020 10,813
Other claimants................... 1,900 -- -- 1,900
-------- ---------- ------- --------
$279,401 37,292,800 $93,605 $373,006
======== ========== ======= ========
The aforementioned distributions of cash and shares of the Company's common
stock resulted in the extinguishment of certain liabilities of Covad as of the
Effective Date and the recognition of an extraordinary gain and certain
litigation-related and other general and administrative expenses in the
accompanying consolidated statement of operations for the year ended December
31, 2001, as follows:
Extinguishment of senior notes:
Senior notes...................................................... $1,351,488
Accrued interest.................................................. 42,532
----------
1,394,020
Less consideration distributed to the Noteholders................. 360,293
----------
Extraordinary gain recognized................................. $1,033,727
==========
Settlement of litigation (Note 10):
Consideration distributed to the plaintiffs....................... $ 10,813
Less amounts accrued prior to the Effective Date.................. 6,820
----------
Additional litigation-related expenses recognized............. $ 3,993
==========
Other:
Consideration distributed to the claimants........................ $ 1,900
Less amounts accrued prior to the Effective Date.................. --
----------
Additional general and administrative expenses recognized..... $ 1,900
==========
There were unresolved claims related to Covad's Chapter 11 bankruptcy
proceedings aggregating $31,608 as of December 31, 2001. As of December 31,
2001, the Company has recorded these unresolved claims in its consolidated
balance sheet based on the amount of such claims allowed by the Bankruptcy
Court (adjusted for changes in the value of the Company's common stock after
December 20, 2001), unless the Company has persuasive evidence indicating that
a claim is duplicative with another allowed claim that was settled previously
or is otherwise in error. In these cases, the unresolved claim does not meet
the criteria for recognition in the Company's consolidated financial
statements. However, it is reasonably possible that the Company's unresolved
Chapter 11 bankruptcy claims could ultimately be settled for amounts that
differ from the aggregate liability for "Unresolved claims related to
bankruptcy proceedings" reflected in the accompanying consolidated balance
sheet as of December 31, 2001.
As of December 31, 2001, the Company had (i) placed $8,000 of cash in a
reserve fund (this balance is classified as "Restricted Cash and Investments"
in the accompanying consolidated balance sheet) and (ii) reserved 7,295,844
shares of common stock pending the resolution of the aforementioned disputed
claims.
83
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The holders of the Company's common stock issued prior to the Effective Date
of the Plan retained their existing equity interests, but were diluted through
the issuance of common stock to the claimants described above. As of the
Effective Date, and after the issuance of 37,292,800 shares of the Company's
common stock pursuant to the Plan as described above, there were 216,445,276
shares of the Company's common stock issued and outstanding. The holders of the
Company's common stock immediately before the Effective Date of the Plan held
more than 50% of the Company's voting shares (including shares reserved for
future issuance under the Plan) immediately after the Effective Date of the
Plan. Therefore, under AICPA Statement of Position ("SOP") 90-7, "Financial
Reporting by Entities in Reorganization Under the Bankruptcy Code," the Company
did not qualify for fresh-start reporting.
In accordance with SOP 90-7, expenses resulting from the restructuring are
reported separately as reorganization items. For the year ended December 31,
2001, the Company recognized expenses directly associated with Covad's Chapter
11 bankruptcy proceedings in the amount of $63,229. These reorganization
expenses consisted of (i) non-cash adjustments to unamortized debt issuance
costs and discounts and (ii) professional fees for legal and financial advisory
services. For the year ended December 31, 2001, the Company recognized interest
income in the amount of $609 on accumulated cash that Covad did not disburse as
a result of its Chapter 11 bankruptcy proceedings. Such interest income has
been offset against the aforementioned reorganization expenses in the Company's
2001 consolidated statement of operations.
Operating cash receipts and payments made by Covad resulting from the Plan
were as follows for the period from August 15, 2001 through December 20, 2001:
Cash receipts:
Interest received................ $ 2,650
--------
Total cash receipts.......... $ 2,650
========
Cash disbursements:
Interest paid.................... $ 1,509
Professional fees paid........... 16,003
Claims paid...................... 277,892
--------
Total cash disbursements..... $295,404
========
3. Other Restructuring Activities
BlueStar, which was acquired by the Company on September 22, 2000 in a
transaction accounted for as a purchase (Note 6), provided broadband
communications and Internet services to small and medium sized businesses in
smaller cities using a direct sales model. Continued losses at BlueStar, with
no near term possibility of improvement, caused the Company's board of
directors, to decide, on June 22, 2001, to cease the Company's funding of
BlueStar's operations. Subsequently, on June 25, 2001, BlueStar terminated all
of its 365 employees. However, 59 of BlueStar's former employees were
temporarily retained by the Company for varying periods through July 31, 2001
to assist with the migration of certain BlueStar end user lines to the
Company's network, as described below. In addition, the Company hired 69 of
BlueStar's former employees subsequent to June 25, 2001.
On June 24, 2001, the Company and BlueStar entered into a Purchase Agreement
("PA") under which the Company purchased the right to offer service to
BlueStar's customers, subject to BlueStar's right to seek higher offers. The
amount of consideration to be paid by the Company under the PA is contingent on
the number of end user lines that are successfully migrated from BlueStar to
the Company. However, the maximum amount payable
84
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
by the Company under the PA is $5,000. To facilitate this migration, the
Company and BlueStar entered into a Migration Agreement on July 12, 2001 that
required the Company to pay certain amounts contemplated in the PA directly to
certain former employees of BlueStar and certain BlueStar vendors, including
the Assignee, as defined below. The Company made payments aggregating $5,100 in
connection with BlueStar's cessation of operations during the year ended
December 31, 2001. Of this amount, $1,300 represents employee severance
benefits, $2,000 represents customer acquisition costs under the PA and $1,800
represents legal and other professional fees . Such (i) severance benefits and
professional fees and (ii) customer acquisition costs have been charged to
restructuring expenses and network and product costs, respectively, in the
Company's consolidated statement of operations for the year ended December 31,
2001.
On June 25, 2001, BlueStar made an irrevocable assignment for the benefit of
creditors ("ABC") of all its assets to an independent trustee (the "Assignee")
in the State of Tennessee. Immediately thereafter, the Assignee began an
orderly liquidation of BlueStar that is expected to occur over a period of
approximately one year. 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 board of directors to satisfy the liabilities of BlueStar.
Consequently, the liquidation of BlueStar's assets and the discharging of its
liabilities are currently under the sole control of the Assignee. On July 25,
2001, certain creditors of BlueStar filed an involuntary petition for relief
under Chapter 7 of the Bankruptcy Code, which was dismissed on October 11,
2001. Nevertheless, the control of BlueStar's assets no longer rests with the
Company. Therefore, the Company deconsolidated BlueStar effective June 25,
2001, which resulted in the recognition of a deferred gain in the amount of
$55,200 in the Company's consolidated balance sheet as of December 31, 2001.
Such deferred gain represents the difference between the carrying values of
BlueStar's assets (aggregating $7,900) and liabilities (aggregating $63,100) as
of June 25, 2001. The Company will recognize such deferred gain as an
extraordinary item when the liquidation of BlueStar is complete and its
liabilities have been discharged.
The following unaudited pro forma financial information presents the
consolidated results of operations of the Company as if the deconsolidation of
BlueStar had occurred on January 1, 2000 and does not purport to be indicative
of the results of operations that would have occurred had the deconsolidation
occurred on January 1, 2000, or the results that may occur in the future :
Year ended December 31,
----------------------
2001 2000
--------- -----------
Revenues............................................... $ 320,619 $ 152,948
Loss before extraordinary item and cumulative effect of
accounting charge.................................... $(646,647) $(1,406,527)
Net income (loss)...................................... $ 387,080 $(1,415,776)
Basic and diluted net income (loss) per share.......... $ 2.18 $ (9.29)
During the fourth quarter of 2000, the Company announced a comprehensive
restructuring plan that involved the following steps:
. raising revenue by reducing rebates and other incentives that the Company
provides to customers and reducing new line addition plans for 2001 to
improve margins and reduce subscriber payback times;
. closing approximately 200 under-performing or not fully built-out central
offices and holding the size of the Company's network at approximately
1,700 central offices;
. reducing the Company's workforce by 638 employees, which represented
approximately 21% of the Company's workforce;
85
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
. closing a facility in Alpharetta, Georgia and consolidating offices in
Manassas, Virginia, Santa Clara, California and Denver, Colorado.
. continued downsizing of the Company's international operations and
discontinuing plans to fund additional international expansion while
continuing to manage existing investments ( Note 6);
. enhancing productivity in the Company's operations to increase customer
satisfaction while reducing costs;
. restructuring the Company's direct sales and marketing channel; and
. evaluating and implementing other cost reduction strategies, including
salary freezes and reductions in travel, facilities and advertising
expenses.
In connection with this restructuring plan, the Company recorded a charge to
operations of $4,988 in the fourth quarter of 2000 relating to employee
severance benefits that met the requirements for accrual as of December 31,
2000. During the year ended December 31, 2001, the total workforce was reduced
by 638 employees and the Company paid $3,849 in severance benefits, which were
charged against the restructuring liability recorded as of December 31, 2000.
The Company recorded additional restructuring expenses aggregating $14,364
during the year ended December 31, 2001, of which $2,140 related to the
BlueStar shutdown. These expenses consist principally of collocation and
building lease termination costs that met the requirements for accrual in 2001.
During the year ended December 31, 2001, the Company paid collocation and
building lease termination costs of $12,355, which were charged against the
restructuring liabilities recorded during 2001. During the year ended December
31, 2001, the restructuring liability was also reduced by $131 based on revised
estimates of the Company's restructuring expenses. Management continues to
consider whether additional restructuring is necessary, and the Company may
incur additional charges to operations related to any further restructuring
activities in future periods.
4. Revenue Recognition and Change in Accounting Principle
Revenues from recurring service are recognized when (i) persuasive evidence
of an arrangement between the Company and the customer exists, (ii) service has
been provided to the customer, (iii) the price to the customer is fixed and
determinable and (iv) collectibility of the sales prices is reasonably assured.
Revenues earned for which the customer has not been billed are recorded as
"Unbilled revenues" in the consolidated balance sheets. Amounts billed in
advance of providing service are deferred and recorded as an element of the
consolidated balance sheet caption "Unearned revenues." Included in revenues
are Federal Universal Service Fund charges billed to customers aggregating
$13,277, $10,647 and $1,717 for the years ended December 31, 2001, 2000 and
1999, respectively.
The Company has over 150 wholesale customers. However, for the year ended
December 31, 2001, the Company's thirty largest wholesale customers
collectively comprised 88.5% of the Company's total wholesale revenues and
76.0% of the Company's total revenues. As of December 31, 2001, receivables
from these customers collectively comprised 79.9% of the Company's gross
accounts receivable balance.
For the year ended December 31, 2001, one wholesale customer (Earthlink,
Inc.) accounted for 17.5% of the Company's total revenues. As of December 31,
2001, receivables from this wholesale customer comprised 26.0% of the Company's
gross accounts receivable balance. For the year ended December 31, 1999,
two wholesale customers (Earthlink, Inc. and XO Communications) accounted for
14.0% and 13.0%, respectively, of the Company's total revenues. As of December
31, 1999, receivables from such wholesale
86
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
customers comprised 9.2% and 8.9%, respectively, of the Company's gross
accounts receivable balance. No individual customers accounted for more than
10% of the Company's total revenues in 2000.
A number of the Company's ISP customers are experiencing financial
difficulties. During the years ended December 31, 2001 and 2000, certain of
these financially distressed ISP customers either (i) were not current in their
payments for the Company's services or (ii) were essentially current in their
payments but, subsequent to the end of the reporting period, the financial
condition of such customers deteriorated significantly and certain of them have
filed for bankruptcy protection. Based on this information, the Company
determined that (i) the collectibility of revenues from these customers was not
reasonably assured or (ii) its ability to retain certain of the payments
received from the ISP customers who have filed for bankruptcy protection is
uncertain. Revenue related to customers that do not demonstrate the ability to
pay for services in a timely manner, but who have not filed for bankruptcy
protection, is recorded as revenue when cash for those services is received,
after the collection of all previous outstanding accounts receivable balances.
Payments received from financially distressed customers during a defined period
prior to their filing of petitions for bankruptcy protection are recorded in
the consolidated balance sheet caption "Unearned revenues" if the Company's
ability to retain these payments is uncertain.
A number of the Company's financially distressed ISP customers have filed
for bankruptcy protection. Revenues from these ISP customers accounted for
approximately 7.1%, 8.3% and 18.3% of the Company's total revenues for the
years ended December 31, 2001, 2000 and 1999, respectively. The Company
continues to attempt to migrate end users from certain of these financially
distressed ISP customers to the extent feasible.
During the years ended December 31, 2001 and 2000, the Company issued
billings to its financially distressed customers, including those that have
filed for bankruptcy protection, aggregating $74,928 and $45,278, respectively
(none in 1999). These billings were not recognized as revenues or accounts
receivable in the consolidated financial statements. However, the Company
ultimately recognized revenues from certain of these customers on a cash basis
(as described above) aggregating $29,003 and $2,814 during the years ended
December 31, 2001 and 2000, respectively (none in 1999).
The Company has obtained information indicating that some of its ISP
customers who (i) were essentially current in their payments for the Company's
services prior to December 31, 2001, and (ii) have subsequently paid all or
significant portions of the respective amounts recorded as accounts receivable
by the Company as of December 31, 2001, may become financially distressed.
Revenues from these customers accounted for approximately 14.2%, 13.9% and
25.5% of the Company's total net revenues for the years ended December 31,
2001, 2000, and 1999, respectively. If these customers are unable to
demonstrate their ability to pay for the Company's services in a timely manner,
in periods ending subsequent to December 31, 2001, revenue from these customers
will be recognized on a cash basis (as described above).
The Company has billing disputes with certain of its customers. These
disputes arise in the ordinary course of business in the telecommunications
industry and their impact on the Company's accounts receivable and revenues can
be reasonably estimated based on historical experience. Accordingly, the
Company maintains an allowance, through charges to revenues, based on its
estimate of the ultimate resolution of these disputes. During the years ended
December 31, 2001 and 2000, the Company wrote-off certain accounts receivable
balances aggregating $6,701 and $13,468, respectively, against the allowance
for customer disputes. The Company did not write-off any accounts receivable
balances against the allowance for customer disputes in 1999.
During the fourth quarter of 2000, retroactive to January 1, 2000, the
Company changed its method of accounting for up-front fees associated with
service activation and the related incremental direct costs in accordance with
SEC Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in Financial
87
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Statements." Previously, the Company had recognized up-front fees as revenues
upon activation of service. Under the new accounting method, which was adopted
retroactive to January 1, 2000, the Company now recognizes up-front fees
associated with service activation over the expected term of the customer
relationship, which is presently estimated to be 24 months, using the
straight-line method. Also as a result of the adoption of SAB No. 101,
retroactive to January 1, 2000, the Company now treats the incremental direct
costs of service activation (which consist principally of customer premises
equipment, service activation fees paid to other telecommunications companies
and sales commissions) as deferred charges in amounts that are no greater than
the up-front fees that are deferred, and such deferred incremental direct costs
are amortized to expense using the straight-line method over 24 months. The
cumulative effect of the change in accounting principle resulted in a charge to
operations of $9,249, which is included in net loss for the year ended December
31, 2000. The effect of the change in accounting principle on the year ended
December 31, 2000 was to increase loss before cumulative effect of change in
accounting principle by $51,550 ($0.33 per share). The pro forma amounts
presented in the consolidated statements of operations were calculated assuming
the accounting change was made retroactively to all prior periods presented.
For the years ended December 31, 2001 and 2000, the Company recognized
$11,661 and $18,661, respectively, in revenue that was included in the
cumulative effect adjustment as of January 1, 2000. The effect of that revenue
during 2001 and 2000 was to increase net income/decrease net loss by $3,067 and
$4,624, respectively.
5. Impairment of Long-Lived Assets
In connection with the 2000 financial statement closing process, the Company
identified indicators of possible impairment of its long-lived assets. Such
indicators included deterioration in the business climate for Internet and DSL
service companies, reduced levels of venture capital and other funding activity
for such businesses and changes in the Company's strategic plans.
The Company performed asset impairment tests at the enterprise-level, the
lowest level for which there are identifiable cash flows that are largely
independent of the cash flows of other groups of assets. The tests were
performed by comparing the expected aggregate undiscounted cash flows to the
carrying amounts of long-lived assets. Based on the results of these tests, the
Company determined that long-lived assets were impaired.
With the assistance of independent valuation experts, the Company then
determined the fair value of its long-lived assets. Fair value was determined
using the discounted cash flow method and the market comparison method. A
write-down of $589,388 was recorded in the fourth quarter of 2000, reflecting
the amount by which the carrying amount of certain long-lived assets exceed
their respective fair values. The write-down consisted of $390,641 for
goodwill, $92,395 for other intangible assets and $106,352 for certain property
and equipment. As described in Note 6, the Company recorded an additional
write-down of goodwill in the amount of $1,989 during 2001. Furthermore, during
the fourth quarter of 2001, the Company determined that (i) certain of its
communication equipment was obsolete based on its discontinued use in the
Company's network and (ii) it would sell (subject to the approval of the
Company's board of directors) its land, building and certain furniture and
fixtures located in Manassas, Virginia. In March 2002, the Company entered into
a non-binding letter of intent with a third party to sell the aforementioned
Manassas, Virginia property. Accordingly, a write-down of this property and
equipment in the amount of $9,999 was recognized by the Company during the
fourth quarter of 2001. No write-downs of long-lived assets were recorded by
the Company during 1999.
88
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Property and equipment consisted of the following:
December 31,
-----------------
2001 2000
-------- --------
Land.......................................... $ 891 $ 1,195
Building...................................... 17,257 18,226
Leasehold improvements........................ 8,433 11,360
Computer equipment............................ 46,440 45,147
Computer software............................. 34,751 39,727
Furniture and fixtures........................ 20,337 28,584
Networks and communication equipment.......... 332,668 290,661
-------- --------
460,777 434,900
Less accumulated depreciation and amortization 244,973 96,491
-------- --------
Property and equipment, net................ $215,804 $338,409
======== ========
6. Business Acquisitions and Equity Investments
Acquisition of Laser Link.net, Inc.
On March 20, 2000, the Company acquired Laser Link.net, Inc. ("Laser Link")
by issuing approximately 5,000,000 common shares in exchange for all of the
outstanding common shares of Laser Link. This transaction was accounted for as
a purchase. Accordingly, the Company's consolidated financial statements
include the results of operations of Laser Link for periods ending after the
date of acquisition. The common shares issued were valued for accounting
purposes using the average market price of $61.52 per share, which is based on
the average closing price around the announcement date (March 9, 2000) of the
transaction. The outstanding Laser Link stock options were converted into
options to purchase approximately 1,400,000 shares of the Company's common
stock at a fair value of $58.66 per share. In addition, the outstanding Laser
Link warrants were converted into warrants to purchase 15 shares of the
Company's common stock at a fair value of $61.52 per share. The value of the
options and warrants, as well as direct transaction costs, were included as
elements of the total purchase cost.
89
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The total purchase cost of the Laser Link acquisition has been allocated to
the assets and liabilities of Laser Link based upon estimates of their fair
values. The following tables depict the total purchase cost and the allocation
thereof:
Total purchase cost:
Value of common shares issued............... $308,429
Value of assumed Laser Link options......... 84,176
--------
392,605
Acquisition costs........................... 10,566
--------
Total purchase cost.................. $403,171
========
Purchase price allocation:
Tangible net assets acquired................ $ 691
Intangible assets acquired:
Developed and core technology........... 13,023
Customer base........................... 28,552
Assembled workforce..................... 1,140
In-process research and development..... 3,726
Goodwill................................ 356,039
--------
Total purchase consideration......... $403,171
========
The tangible assets of Laser Link acquired by the Company aggregating $9,078
consisted principally of cash, accounts receivable and property and equipment.
The liabilities of Laser Link assumed by the Company aggregating $8,387
consisted principally of a note payable (which was repaid prior to December 31,
2000), accounts payable and accrued expenses.
The customer base was valued using an income approach, which projects the
associated revenue, expenses and cash flows attributable to the customer base
over its estimated life of five years. These cash flows are discounted to their
present value. Through December 31, 2000, this intangible asset was being
amortized on a straight-line basis over its estimated useful life of five years
(Note 5).
The value of the assembled workforce was derived by estimating the costs to
replace the existing employees, including recruiting, hiring and training costs
for each category of employee. Through December 31, 2000, this intangible asset
was being amortized on a straight-line basis over its estimated useful life of
three years (Note 5).
A portion of the purchase price was allocated to developed and core
technology and in-process research and development ("IPRD"). Developed and core
technology and IPRD were identified and valued through extensive interviews,
analysis of data provided by Laser Link concerning developmental products,
their stage of development, the time and resources needed to complete them, if
applicable, their expected income generating ability, target markets and
associated risks. The relief from royalty method, which assumes that the value
of an asset equals the amount a third party would pay to use the asset and
capitalize on the related benefits of the assets, was the primary technique
utilized in valuing the developed and core technology and IPRD.
Where developmental projects had reached technological feasibility, they
were classified as developed and core technology and the value assigned to
developed technology was capitalized. Through December 31, 2000, the elements
of this intangible asset were being amortized on a straight-line basis over
their estimated useful lives, which ranged from one to four years (Note 5).
Where the developmental projects had not reached
90
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
technological feasibility and had no future alternative uses, they were
classified as IPRD. The value allocated to projects identified as IPRD was
charged to expense in 2000.
The nature of the efforts required to develop the purchased IPRD into
commercially viable products principally relate to the completion of all
planning, designing, prototyping, verification and testing activities that are
necessary to establish that the products can be produced to meet their design
specifications, including functions, features and technical performance
requirements.
In valuing the IPRD, the Company considered, among other factors, the
importance of each project to the overall development plan, the project
incremental cash flows from the projects when completed and any associated
risks. The projected incremental cash flows were discounted back to their
present value using a discount rate of 30%. This discount rate was determined
after consideration of the Company's weighted average cost of capital and the
weighted average return on assets. Associated risks include the inherent
difficulties and uncertainties in completing each project and thereby achieving
technological feasibility, anticipated levels of market acceptance and
penetration, market growth rates and risks related to the impact of potential
changes in future target markets.
The IPRD relates to internally developed proprietary software used in Laser
Link's virtual ISP business. This software has been designed with enhancements
and upgrades continually underway. With respect to the acquired in-process
technologies, the calculations of value were adjusted to reflect the value
creation efforts of Laser Link prior to the closing date. The percent complete
for the in-process technology was estimated to be 75% as of March 20, 2000.
Goodwill was determined based on the residual difference between the amount
paid and the values assigned to identified tangible and intangible assets and
liabilities. Through December 31, 2000, this intangible asset was being
amortized on a straight-line basis over its estimated useful life of five years
(Note 5).
The following unaudited pro forma financial information presents the
consolidated results of operations of the Company, excluding the charges for
IPRD and long-lived asset impairment, as if the acquisition of Laser Link had
occurred on January 1, 1999 and does not purport to be indicative of the
results of the operations that would have occurred had the acquisition been
made on January 1, 1999, or the results that may occur in the future:
Year ended December 31,
----------------------
2000 1999
--------- ---------
Revenues.......................................................... $ 164,176 $ 66,502
Loss before extraordinary item and cumulative effect of accounting
change.......................................................... $(858,011) $(276,177)
Net loss.......................................................... $(867,260) $(276,177)
Basic and diluted net loss per share.............................. $ (5.65) $ (2.54)
Acquisition of BlueStar
On September 22, 2000, the Company acquired BlueStar by issuing
approximately 6,100,000 shares of common stock (including 800,000 shares to be
held in escrow for a one year period pending the Company's verification of
certain representations and warranties made to it by BlueStar at the date of
the acquisition) in exchange for all of the outstanding preferred and common
shares of BlueStar. Two of the Company's stockholders and members of its board
of directors when the acquisition occurred were also stockholders of BlueStar,
and one was a member of the board of directors of BlueStar.
91
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
This transaction was accounted for as a purchase. Accordingly, the Company's
consolidated financial statements include the results of operations of BlueStar
for periods ending after the date of acquisition. However, as described in Note
3, the Company deconsolidated BlueStar effective June 25, 2001.
The common shares issued by the Company to BlueStar's stockholders were
valued for accounting purposes using the average market price of $14.23 per
share, which is based on the average closing price around the closing date of
the transaction. In addition, the outstanding BlueStar stock options and
warrants were converted into options to purchase approximately 225,000 shares
of the Company's common stock at a fair value of $6.55 per share. The value of
the options, as well as direct transaction costs, have been included as
elements of the total purchase cost.
Up to 5,000,000 additional common shares of the Company's common stock were
to be issued if BlueStar achieved certain specified levels of revenues and
earnings before interest, taxes, depreciation and amortization in 2001.
However, during April, 2001, the Company reached an agreement with the BlueStar
stockholders' representative to resolve this matter, as well as the matters
that caused 800,000 of the Company's common shares to be held in escrow as of
December 31, 2000, by providing the BlueStar stockholders with 2,532,850 (which
include 264,369 options and warrants which are held by the Company in the event
such options and warrants are exercised after the distribution date) of the
5,000,000 shares, in exchange for a release of all claims against the Company.
The 800,000 common shares held in escrow were ultimately returned to the
Company under this agreement. BlueStar's former stockholders received the
additional shares of the Company's common stock during 2001. Consequently, the
Company recorded additional goodwill of $1,989 in 2001. However, the Company
determined that such goodwill was impaired based on BlueStar's continued
operating losses, as described in Note 3. Therefore, such goodwill balance was
written-off through a charge to the provision for long-lived asset impairment
during the year ended December 31, 2001.
The total purchase cost of the BlueStar acquisition was allocated to the
assets and liabilities of BlueStar based upon estimates of their fair value.
The following tables depict the total purchase cost and the allocation thereof:
Total purchase cost:
Value of common shares issued....................... $ 86,579
Fair Value of assumed BlueStar options and warrants. 1,471
--------
88,050
Acquisition costs................................... 5,724
--------
Total purchase cost.......................... $ 93,774
========
Purchase price allocation:
Tangible net assets acquired........................ $(55,833)
Intangible assets acquired:
Customer base................................... 17,332
Assembled workforce............................. 11,491
Deferred stock-based compensation............... 407
Collocation agreements.......................... 24,013
Goodwill........................................ 96,364
--------
$ 93,774
========
The tangible assets of BlueStar acquired by the Company aggregating $64,753
consisted principally of accounts receivable, prepaid expenses and property and
equipment. The liabilities of BlueStar assumed by the
92
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Company aggregating $120,586 consisted principally of accounts payable, accrued
expenses, a short-term bridge loan (which was retired prior to December 31,
2000) and equipment financing arrangements.
The customer base was valued using an income approach, which projects the
associated revenue, expenses and cash flows attributable to the customer base
over its estimated life. These cash flows are discounted to their present value
using a rate of return that reflects the appropriate level of risk. Through
December 31, 2000, this intangible asset was being amortized on a straight-line
basis over its estimated useful life of three years (Note 5).
The value of the assembled workforce was derived by estimating the costs to
replace the existing employees, including recruiting, hiring and training costs
for each category of employee. Through December 31, 2000, this intangible asset
was being amortized on a straight-line basis over its estimated useful life of
three years (Note 5).
The value of the collocation agreements was calculated using the replacement
cost approach which estimates the value of the asset at replacement cost.
Through December 31, 2000, this intangible asset was being amortized to expense
over its estimated useful life of three years (Note 5).
Deferred stock-based compensation associated with unvested BlueStar stock
options at the date of acquisition was being amortized to expense over the
remainder of the vesting period (Note 5).
Goodwill was determined based on the residual difference between the amount
paid and the values assigned to identified tangible and intangible assets and
liabilities. Through December 31, 2000, this intangible asset was being
amortized on a straight-line basis over its estimated useful life of five years
(Note 5).
The following unaudited pro forma financial information presents the
consolidated results of operations of the Company, excluding the charge for
long-lived asset impairment, as if the acquisition of BlueStar had occurred on
January 1, 1999 and does not purport to be indicative of the results of
operations that would have occurred had the acquisition been made on January 1,
1999, or the results that may occur in the future:
Year ended December 31,
----------------------
2000 1999
--------- ---------
Revenues.......................................................... $ 164,635 $ 67,258
Loss before extraordinary item and cumulative effect of accounting
change.......................................................... $(924,242) $(251,636)
Net loss.......................................................... $(933,491) $(251,636)
Basic and diluted net loss per share.............................. $ (5.95) $ (2.21)
93
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Unconsolidated Investments in Affiliates
The following table lists the Company's unconsolidated investments in
affiliates as of December 31, 2001 and 2000:
Ownership Investment
Percentage Carrying Value
--------- Method of --------------
Entity Name Date of Investment(s) 2001 2000 Accounting 2001 2000
----------- --------------------- ---- ---- ---------- ------ -------
DishnetDSL Limited...... February 2000 6% 6% Equity $3,000 $17,603
ACCA Networks Co., Ltd.. August 2000 18% 42% Equity -- 9,195
Certive Corporation..... November 1999; May
2000 5% 5% Equity 1,874 2,418
Sequoia Capital X....... May-November 2000 -- 2% Equity -- 1,131
Loop Holdings Europe ApS September 2000 21% 21% Equity -- --
------ -------
$4,874 $30,347
====== =======
DishnetDSL Limited
In February 2000, the Company acquired a 6% American Depository Receipt
("ADR") equity interest in DishnetDSL Limited ("Dishnet"), a privately held,
Indian telecommunications company, in exchange for cash payments totaling
approximately $23,000, which the Company believed was representative of the
fair value of such investment based on significant concurrent investments in
Dishnet made by new, non-strategic investors. The difference between the cost
of the Company's equity investment in Dishnet and its proportional share of
Dishnet's net assets ($11,963 and $15,700 as of December 31, 2001 and 2000,
respectively) is being amortized using the straight-line method over a period
of five years. Concurrent with its purchase of the Dishnet ADRs, the Company
also acquired, without further consideration, (i) contingent warrants for the
purchase of up to 3,700,000 Dishnet ADRs at a price that is presently
indeterminate and (ii) a put option (the "Put Option") from a Dishnet
shareholder and another entity that entitles the Company to require these
entities to purchase the Dishnet ADRs owned by the Company at their original
purchase price for a specified period beginning in February 2002. Because of
the contingent nature of the Dishnet warrants and uncertainties concerning the
financial capacity of the makers of the Put Option, the Company ascribed no
separate value to these elements of the transaction. As a result of this
strategic investment, one employee of the Company became a member of the board
of directors of Dishnet. (The Company's chairman holds options to purchase
shares of Dishnet and is independently a member of the board of directors of
Dishnet).
In February 2002, the Company's board of directors approved an offer
involving (i) the sale of the Company's 6% ADR interest in Dishnet for $3,000
in cash, (ii) settlement of a claim alleging breach of contract by the Company
relating to the OSS license described below and (iii) relinquishment of the Put
Option by the Company. Completion of this transaction is conditioned on the
negotiation of definitive documents. Consequently, during 2001, the Company
wrote-down the carrying value of its Dishnet equity investment to its estimated
net realizable value through a charge to the provision for impairment of
unconsolidated equity investments in the amount of $10,069.
In February 2000, the Company also licensed its OSS software to Dishnet and
another entity for $28,000, $24,000 of which was received in cash on such date.
The Company also agreed to provide certain software support, customization and
training services to Dishnet and another entity relating to the OSS license up
to an aggregate cost of $2,500. Accordingly, the Company recorded $2,500 of the
OSS license proceeds received from Dishnet as a liability in February 2000. All
of the $2,500 customization liability has been offset by expenses
94
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
incurred in 2000 and 2001 by the Company to customize the OSS for Dishnet. The
remaining proceeds of $21,500 have been offset against the Company's
capitalized internal use software costs.
ACCA Networks Co., Ltd.
In August 2000, the Company acquired a 42% preferred equity interest in ACCA
Networks Co., Ltd. ("ACCA"), a privately held, Japanese telecommunications
Company, in exchange for cash payments aggregating approximately $11,700, which
the Company believes is representative of the fair value of such investment
based on significant concurrent investments in ACCA made by new, non-strategic
investors. The difference between the cost of the Company' equity investment in
ACCA and its proportional share of ACCA's net assets ($1,100 and $1,350 as of
December 31, 2001 and 2000, respectively) is being amortized using the
straight-line method over a period of five years. As a result of this strategic
investment, one employee of the Company is a member of the board of directors
of ACCA.
In addition, in August 2000, the Company also licensed its OSS software to
ACCA for $9,000, of which $2,000 and $2,000 was received in cash during 2001
and 2000, respectively. The remainder of $5,000 is due in December 2005. The
Company may also receive certain royalty payments from ACCA in the future under
terms of the OSS license agreement. The Company also agreed to provide certain
software support, customization and training services to ACCA relating to the
OSS license up to an aggregate cost of $2,000. Accordingly, the Company
recorded $2,000 of the OSS license proceeds received from ACCA as a liability
in August 2000, and the remainder of such proceeds will be recorded under the
cost recovery method when received as a reduction of the Company's capitalized
internal use software costs. All of the $2,000 customization liability has been
offset by expenses incurred in 2000 and 2001 by the Company to customize the
OSS for ACCA.
Certive Corporation
As of December 31, 2001, the Company holds a 5% preferred equity interest in
Certive Corporation ("Certive"), a privately held, development stage
application service provider. The Company's chairman is also the chairman and a
principal stockholder of Certive.
Sequoia Capital X
As of December 31, 2000, the Company held a 2% limited partnership interest
in Sequoia Capital X, a privately held venture capital partnership. The Company
sold its investment in Sequoia Capital X during 2001 for $1,225 in cash, which
resulted in the recognition of a gain in the amount of $178.
Loop Holdings Europe ApS
In September 2000, the Company acquired 100% of the capital stock of Loop
Holdings Europe ApS ("Loop Holdings"), which owns 70% (a 43% voting interest)
of the preferred stock of Loop Telecom, S.A. ("Loop Telecom"), a privately
held, Spanish telecommunications company. Consideration for the Company's
acquisition of the capital stock of Loop Holdings consisted of $15,000 in cash
and non-recourse notes payable aggregating $35,000. In March 2001, the Company
declined to make the first scheduled payment of $15,000 under the terms of the
non-recourse notes payable. As a result, the Company's indirect preferred
equity interest in Loop Telecom was diluted to 21% (a 21% voting interest) and
its obligations under the non-recourse notes payable were released.
Accordingly, in the accompanying consolidated balance sheet as of December 31,
2000, the Company has netted the non-recourse notes payable aggregating $35,000
against the equity investment balance and it has written-off its initial
$15,000 investment balance in Loop Holdings through a charge to operations in
2000 due to uncertainties concerning the recoverability of such investment.
95
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
On February 5, 2002, the Company, via Loop Holdings, sold its equity
interest in Loop Telecom to certain other shareholders of Loop Telecom for $360
in cash.
7. Long-Term Debt
The Company's long-term debt consisted of the following:
December 31,
------------------
2001 2000
------- ----------
1998 senior notes, extinguished in 2001 (Note 2)............ $ -- $ 188,347
1999 senior notes, extinguished in 2001 (Note 2)............ -- 211,357
2000 senior notes, extinguished in 2001 (Note 2)............ -- 425,000
2000 convertible senior notes, extinguished in 2001 (Note 2) -- 500,000
Note payable to SBC (Note 11), as described below........... 50,000 --
Other....................................................... -- 43,735
------- ----------
50,000 1,368,439
Less current portion........................................ -- 43,735
------- ----------
Total long-term debt..................................... $50,000 $1,324,704
======= ==========
Immediately prior to Covad's emergence from Chapter 11 bankruptcy on
December 20, 2001 (Note 2), the Company's new agreements with SBC became
effective (Note 11). One such agreement (the "Credit Agreement") involves a
term note payable that is collateralized by substantially all of the Company's
domestic assets. This note bears interest at 11%, which is payable quarterly
beginning in December 2003. The entire unpaid principal balance is payable in
December 2005. However, the Company has the right to prepay the principal
amount of the note, in whole or in part, at any time without penalty. In
addition, upon a "Change of Control," as defined in the Credit Agreement, of
the Company, SBC has the option to require all amounts due under the terms of
the Credit Agreement to be paid by the Company within 30 days of the Change of
Control. The Credit Agreement contains various restrictive covenants, which,
among other things, restrict the Company's ability to incur additional
indebtedness or permit liens to be placed on its assets.
During the year ended December 31, 2000, the Company recorded in its
Consolidated Balance Sheet, as part of the BlueStar acquisition (Note 6),
various other financing arrangements, principally to finance the acquisition,
build-out and maintenance of BlueStar's networks and communication equipment.
These financing arrangements bear interest rates ranging from 7.75% to 12.0%
and mature between August 2001 and July 2003. These financing arrangements were
classified as current liabilities in the Company's consolidated balance sheet
as of December 31, 2000. However, as described in Note 3, the Company
deconsolidated BlueStar effective June 25, 2001.
Aggregate scheduled future principal payments, absent any optional or
mandatory prepayments, of long-term debt are as follows:
Year ending December 31,
2002-2004............ $ --
2005................. 50,000
-------
Total............ $50,000
=======
96
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
8. Capital Leases
The Company has entered into capital lease arrangements to finance the
acquisition of certain equipment.
The capitalized costs and accumulated amortization related to assets under
capital leases were $133 and $133, respectively, as of December 31, 2001 (the
corresponding amounts were $8,214 and $2,298, respectively, as of December 31,
2000).
The Company did not have significant future minimum lease payments under
these capital leases as of December 31, 2001.
9. Operating Leases
The Company leases vehicles, equipment, and office space under various
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 respective
lease term. Future minimum lease payments by year under operating leases with
noncancelable terms in excess of one year, along with future minimum payments
to be received under noncancelable subleases, are as follows:
Gross Less Net
Lease Sublease Lease
Payments Payments Payments
Year ending December 31, -------- -------- --------
2002............ $ 7,911 $ 380 $ 7,531
2003............ 6,703 371 6,332
2004............ 4,098 309 3,789
2005............ 2,890 -- 2,890
2006............ 2,857 -- 2,857
Thereafter....... 1,829 -- 1,829
------- ------ -------
Total.......... $26,288 $1,060 $25,228
======= ====== =======
Rent expense, which is net of sublease income of $152 in 2001 (none in 2000
or 1999) associated with all operating leases totaled $15,421, $19,584, and
$4,302 for the years ended December 31, 2001, 2000, and 1999.
10. Contingencies
Litigation
Purchasers of the Company's common stock and purchasers of the convertible
senior notes the Company issued in September 2000 filed complaints 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 Northern District of California (the "District
Court"). The complaints have been consolidated and the lead plaintiff filed its
amended consolidated complaint. The amended consolidated complaint alleges
violations of federal securities laws on behalf of persons who purchased or
otherwise acquired the Company's securities, including those who purchased
common stock and those who purchased the Company's convertible senior notes
during the periods from April 19, 2000 to May 24, 2001. The relief sought
includes monetary damages and equitable relief. On August 10, 2001, the Company
signed a MOU with counsel for the lead plaintiffs in this litigation that
tentatively resolves the litigation. Under this agreement, the Company is to
contribute approximately 6,500,000 common shares. The Company's insurance
carriers would fund the cash
97
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
portion of the settlement. Final settlement is contingent on negotiation and
execution of a final agreement and approval by the United States District
Court. As described in Note 2, this settlement was approved by the Bankruptcy
Court on December 20, 2001. Additionally, management, based on the advice of
legal counsel, believes it is more likely than not that this settlement will
ultimately be approved by the District Court. Consequently, the Company
recorded a liability of approximately $18,590 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. The Company
will remeasure this liability in future periods, through the date of final
settlement of this litigation, based on changes in the underlying value of the
Company's common stock.
In addition, six purchasers of the convertible senior notes that the Company
issued in September 2000 have filed complaints against the Company and two
former officers in the Superior Court of the State of California for the County
of Santa Clara. The complaints have been consolidated. The complaints allege
fraud and deceit, negligence and violations of state securities laws. The
relief sought includes rescission of the plaintiffs' alleged purchases of
approximately $142,000 in aggregate principal amount of convertible notes and
unspecified damages, including punitive damages and attorneys' fees. However,
the Company believes the convertible notes were legally and validly issued. Two
of these purchasers allegedly holding $48,000 in aggregate principal amount of
the convertible notes have dismissed their complaints without prejudice.
Following the Company's filing for bankruptcy protection, these plaintiffs
removed these actions to Federal Court, seeking to amend their claims. After
the Federal Court vacated the hearing on plaintiffs' motion to amend,
plaintiffs filed a new complaint in Federal Court. The new complaint alleged
causes of action against present and formers directors and officers of the
Company and no longer named the Company as a defendant. On October 24, 2001,
Covad and two former officers reached a settlement in which the plaintiffs
agreed to release all of their claims against the Company and its past and
present directors and officers. The settlement created a settlement fund
consisting of a cash amount provided by the Company and its insurance carrier.
This litigation was settled on a final basis on December 20, 2001, upon the
payment of $2,600 to the plaintiffs by the Company, which is net of a payment
of $900 received by the Company from its insurers.
Several stockholders have filed complaints, 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 Company's
underwriters in the United States District Court for the Southern District of
New York. 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. The plaintiffs claim that the Company and
others failed to disclose the arrangements that some of the Company's
underwriters purportedly made with certain investors. The Company believes it
has strong defenses to these lawsuits and intends to contest them vigorously.
However, because these lawsuits are at an early stage, the Company is unable to
provide an evaluation of the ultimate outcome of the litigation.
Numerous former shareholders of Laser Link had threatened to file complaints
against the Company and two of its former officers. Under the Plan (Note 2),
the Company settled with a group of these former shareholders by paying $2,300
and issuing 2.0 million shares of the Company's common stock to these former
shareholders on December 20, 2001 (Note 2). The Company also settled the claims
of another former Laser Link shareholder on March 18, 2002, in exchange for a
payment by the Company of $640 and the issuance of 0.8 million shares of the
Company's common stock. Consequently, the Company recorded a liability of
$2,202 in its consolidated balance sheet as of December 31, 2001, through a
charge to litigation-related expenses during the fourth quarter of 2001.
A manufacturer of telecommunications hardware has filed a complaint against
the Company in the United States District Court for the District of Arizona,
alleging claims for false designation of origin, infringement and unfair
competition. The plaintiff is seeking an injunction to stop the Company from
using the COVAD
98
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
trademark, as well as an award of monetary damages. This action was stayed
pursuant to the automatic stay provisions of the Bankruptcy Code when the
Company filed its petition under Chapter 11. The Company does not believe that
these claims have any merit, but the outcome of this litigation cannot
presently be determined.
In April 1999, the Company filed a lawsuit against Bell Atlantic (now
Verizon) and its affiliates in the United States District Court for the
District of Columbia. The Company is pursuing antitrust and other claims in
this lawsuit. The Company also recently filed a lawsuit against BellSouth
Telecommunications and its subsidiaries in the United States District Court for
the Northern District of Georgia. The Company is pursing antitrust and other
claims in this lawsuit arising out of BellSouth's conduct as a supplier of
network facilities, including central office space, transmission facilities and
telephone lines. Both BellSouth and Verizon have asked the courts to dismiss
the Company's cases on the basis of the ruling of the Seventh Circuit in
Goldwasser v. Ameritech, which dismissed a consumer antitrust class action
against Ameritech. The Company opposed the BellSouth and Verizon motions. The
Georgia court recently granted in part BellSouth's motion and dismissed some of
the Company's antitrust claims and breach of contract claims. The Company
subsequently dismissed its remaining claims in order to appeal the court's
ruling in the Eleventh Circuit Courts of appeals. To date, the District of
Columbia court has not ruled on Bell Atlantic's motion. The Company cannot
predict the outcome of this motion.
On June 11, 2001, Verizon Communications filed a lawsuit against the Company
in the United States District Court for the Northern District of California.
Verizon is a supplier of telephone lines that the Company resells to its
customers. The Complaint claims that the Company falsified trouble ticket
reports with respect to the phone lines that Covad ordered and seeks
unspecified monetary damages and injunctive relief. The Complaint asserts
causes of action for negligent and intentional misrepresentation and violations
of the Lanham Act. This lawsuit is at an early stage, so the Company is unable
to provide an evaluation of the ultimate outcome.
In connection with his departure, Terry Moya, the Company's former Executive
Vice President, Corporate Development and External Affairs, has threatened
litigation against the Company for wrongful termination, breach of contract and
misrepresentation. The Company does not believe that his assertions have any
merit, but cannot predict the ultimate outcome of any potential litigation.
An unfavorable outcome in any of the pending legal proceedings described
above could have a material adverse effect on the Company's consolidated
financial position and results of operations.
The Company is also a party to a variety of other legal proceedings, as
either plaintiff or defendant, and is engaged in other disputes that arise in
the ordinary course of its business. The Company's management believes these
other matters will be resolved without a material adverse effect on the
Company's consolidated financial position and results of operations.
Other Contingencies
As of December 31, 2001, the Company had disputes with a number of
telecommunications companies concerning the balances owed to such
telecommunications carriers for collocation fees and certain network services.
In the opinion of management, such disputes will be resolved without a material
adverse effect on the Company's consolidated financial position and results of
operations. However, it is reasonably possible that management's estimates of
the Company's collocation fee and network service obligations, as reflected in
the accompanying consolidated balance sheets, could change in the near term. 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
99
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
reduction of network and product costs during the fourth quarter of 2001 and
(ii) Verizon's ultimate damage award or settlement, if any, pursuant to the
Company's antitrust lawsuit against Verizon will be reduced by $6.6 million. In
addition, the Company is engaged in a variety of negotiations, arbitrations and
regulatory proceedings with multiple telephone companies. These negotiations,
arbitrations and regulatory proceedings concern the traditional telephone
companies' denial of physical central office space to the Company in certain
central offices, the cost and delivery of central office space, the delivery of
transmission facilities and telephone lines and other operational issues. An
unfavorable outcome in any of these negotiations, arbitrations and regulatory
proceedings could have a material adverse effect on the Company's consolidated
financial position and results of operations.
As of December 31, 2001, management was analyzing the applicability of
certain transaction-based taxes to sales of the Company's products and
services. This analysis includes discussions with authorities of significant
jurisdictions in which the Company does business to determine the extent of the
Company's respective transaction-based tax liabilities. In the opinion of
management, such analysis will be concluded without a material adverse effect
on the Company's consolidated financial position and results of operations.
However, it is reasonably possible that management's estimates of the Company's
transaction-based tax liabilities, as reflected in the accompanying
consolidated balance sheets, could change in the near term.
11. Stockholders' Equity (Deficit)
Strategic Investors
In January 1999, the Company entered into strategic relationships with AT&T
Corp., NEXTLINK Communications, Inc. (now XO Communications) and Qwest
Communications Corporation. As part of these strategic relationships, the
Company received equity investments totaling approximately $60,000. The Company
recorded intangible assets of $28,700 associated with these transactions that
were being amortized over periods of three to six years using the straight-line
method. For the years ended December 31, 2000 and 1999, such amortization
expense totaled $8,300 and $8,200, respectively (none in 2001--Note 5).
On September 20, 2000, the Company entered into various agreements (the
"September 2000 Agreements") with SBC Communications, Inc. ("SBC"), including
(i) a six-year resale and marketing agreement under which SBC was to market and
resell the Company's DSL services (through December 31, 2000, the Company had
not provided any DSL services to SBC or recognized any revenues under this
arrangement), (ii) a stock purchase agreement whereby SBC acquired, on November
6, 2000, a minority ownership position of approximately 6% of the Company's
outstanding common stock in exchange for $150,000, and (iii) a settlement
agreement of the Company's pending legal matters with SBC and its affiliates
including performance standards and line-sharing arrangements governing the
future commercial relationship between the two entities in all 13 SBC states.
Effective December 20, 2001, immediately prior to Covad's emergence from
Chapter 11 bankruptcy (Note 2), the Company entered into a series of new
agreements with SBC, including (i) a $50,000 Credit Agreement (Note 7), (ii) a
10-year resale agreement (the "Resale Agreement") under which SBC, its
affiliates or special agents will resell the Company's DSL services (SBC made a
$75,000 noninterest-bearing prepayment, which is collateralized by
substantially of the Company's domestic assets, to the Company on December 20,
2001 under the terms of the Resale Agreement) and (iii) a termination and
mutual general release agreement (the "Termination Agreement") that resulted in
the cancellation of the September 2000 Agreements, except for the stock
purchase agreement and an interconnection and line-sharing agreement that
remains in effect. The Company received a payment of $10,000 from SBC on
December 20, 2001 under the terms of the Termination Agreement, which was
deferred and is being recognized as revenue on a straight-line basis over the
10-year term of the Resale Agreement.
100
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Common Stock
141,897 and 1,114,841 shares of the Company's common stock outstanding at
December 31, 2001 and December 31, 2000, respectively, were subject to
repurchase provisions which generally lapse over a four-year period from the
date of issuance.
Common stock reserved for future issuance as of December 31, 2001 was as
follows:
Bankruptcy claims (Note 2).. 7,295,844
Outstanding options......... 31,600,330
Options available for grant. 11,194,003
Employee stock purchase plan 6,503,927
Outstanding warrants........ 236,574
----------
Total.................... 56,830,678
==========
Notes Receivable from Stockholders
Notes receivable from stockholders consisted of full-recourse notes issued
to BlueStar by various employees in connection with the exercise of certain
stock options. Such notes are collateralized by shares of the Company's common
stock and bear interest at a fixed rate of 7%. Interest payments are due
annually from January 2001 through January 2004. All principal and accrued
interest on these notes is due at maturity, in January 2005, and management
believes that all such amounts are fully collectible. However, as described in
Note 3, the Company deconsolidated BlueStar effective June 25, 2001.
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, 2001, none of these rights
were exercisable.
Warrants
Warrants for the purchase of 236,574 shares of the Company's common stock
were outstanding as of December 31, 2001. Such warrants are exercisable at
prices ranging from $0.0015 to $48.44 per share during periods ending between
February 2003 and March 2008. All such warrants were vested as of December 31,
2001.
12. Income Taxes
The Company has made no provision for income taxes in any period presented
in the accompanying consolidated financial statements because it incurred
operating losses in each of these periods. In addition, the Company made no
provision for income taxes on the extraordinary gain resulting from the
extinguishment of debt in 2001 (Note 2) due to the relevant tax regulations
governing the treatment of debt extinguishment income in Chapter 11 bankruptcy
proceedings.
101
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
A reconciliation of income taxes computed at the federal statutory rate to
income tax expense (benefit) recorded in the Company's consolidated statements
of operations is as follows:
Year ended December 31,
------------------------------
2001 2000 1999
--------- --------- --------
Federal benefit at statutory rate............ $(241,139) $(505,098) $(66,435)
Nondeductible interest expense............... 878 1,189 2,050
Net operating losses with no current benefits 206,948 342,863 64,306
Goodwill..................................... -- 158,257 --
Deconsolidation of BlueStar.................. 23,915 -- --
Other........................................ 9,398 2,789 79
--------- --------- --------
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,
--------------------
2001 2000
--------- ---------
Deferred tax assets:
Net operating loss carryforwards......... $ 149,756 $ 297,903
Unearned revenue......................... 77,959 52,094
Accrued interest......................... -- 24,376
Unconsolidated investments in affiliates. 25,454 14,343
Depreciation and amortization............ 36,437 21,964
Other.................................... 2,907 36,490
--------- ---------
Total deferred tax assets............ 292,513 447,170
Valuation allowance...................... (292,513) (438,454)
--------- ---------
Net deferred tax assets.............. -- 8,716
Deferred tax liabilities................. -- (8,716)
--------- ---------
Net deferred taxes................... $ -- $ --
========= =========
Realization of the Company's deferred tax assets relating to net operating
loss carryforwards is dependent upon future earnings, the timing and amount of
which are uncertain. Accordingly, the Company's net deferred tax assets have
been fully offset by a valuation allowance. The valuation allowance increased
(decreased) by $(145,941), $411,672 and $8,282 during 2001, 2000, and 1999,
respectively.
As of December 31, 2001, the Company had net operating loss carryforwards
for federal income tax purposes of approximately $267,200, which will expire in
the year 2021, if not utilized. The Company's federal net operating loss
carryforwards were reduced by $950,000 as a result of the Company's Chapter 11
bankruptcy proceedings (Note 2). The Company also had net operating loss
carryforwards for state income tax purposes of approximately $937,600, which
begin to expire in 2004, if not utilized.
The tax benefits associated with employee stock options provided deferred
tax benefits of $116 for the year ended December 31, 2001. Such deferred tax
benefits have been offset by a valuation allowance and will be credited to
additional paid-in capital if realized. Deferred tax benefits related to the
Company's employee stock options in prior years were eliminated as a result of
the Company's Chapter 11 bankruptcy proceedings (Note 2).
102
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The utilization of the Company's net operating losses may be subject to a
substantial annual limitation due to the "change in ownership" provisions of
the Internal Revenue Code of 1986, as amended, and similar state provisions.
The annual limitation may result in the expiration of net operating losses and
tax credits before utilization.
13. Employee Benefit Plans
Defined Contribution Plan
The Company has a defined contribution retirement plan under Section 401(k)
of the Internal Revenue Code that covers substantially all employees. Eligible
employees may contribute amounts to the plan, via payroll withholding, subject
to certain limitations. The Company does not match contributions by plan
participants.
In connection with the Company's acquisition of Laser Link (Note 6) and
BlueStar (Notes 3 and 6), the Company merged Laser Link's and BlueStar's
defined contribution retirement plan under Section 401(k) of the Internal
Revenue Code into the Company's defined contribution retirement plan.
1998 Employee Stock Purchase Plan
In January 1999, the Company adopted the 1998 Employee Stock Purchase Plan.
The Company has reserved a total of 6,507,002 shares of common stock for
issuance under the plan. Eligible employees may purchase common stock at 85% of
the lesser of the fair market value of the Company's common stock on the first
day of the applicable twenty-four month offering period or the last day of the
applicable six month purchase period.
Stock Option Plans
The 1997 Stock Plan (the "Plan") provides for the grant of stock purchase
rights and options to purchase shares of common stock to employees and
consultants from time to time as determined by the Company's board of
directors. The options expire from two to eight years after the date of grant.
As of December 31, 2001, the Company has reserved 42,794,333 shares of the
Company's common stock under the Plan for sale and issuance at prices to be
determined by the Company's board of directors.
In connection with the Company's acquisition of Laser Link, the Company
assumed Laser Link's stock option plan. Laser Link's stock option plan provides
for the grant of options to purchase shares of common stock to employees and
consultants from time to time. The options expire up to ten years after the
date of grant. The Company assumed the Laser Link stock option plan at the time
it acquired Laser Link and it is no longer issuing options under the Laser Link
stock option plan. A maximum of 1,434,957 shares of the Company's Common Stock
will be available for issuance under the Laser Link Plan. The options granted
under the Laser Link plan are included in the data set forth below.
In connection with the Company's acquisition of BlueStar, the Company
assumed BlueStar's stock option plan. BlueStar's stock option plan provides for
the grant of options to purchase shares of common stock to employees and
consultants from time to time. The options expire up to ten years after the
date of grant. The Company assumed the BlueStar stock option plan at the time
it acquired BlueStar and it is no longer issuing options under the BlueStar
stock option plan. A maximum of 1,251,182 shares of the Company's Common Stock
will be available for issuance under the BlueStar stock option plan. The
options granted under the BlueStar stock option plan are included in the data
set forth below.
103
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following table summarizes stock option activity for the years ended
December 31, 2001, 2000, and 1999:
Number of
Shares of
Common Option Price
Stock Per Share
----------- --------------
Balance as of December 31, 1998 27,557,550 $0.022-$ 5.44
Granted..................... 8,774,658 $0.007-$ 44.67
Exercised................... (8,012,683) $0.007-$ 38.17
Cancelled................... (3,796,892) $0.147-$ 43.42
----------- --------------
Balance as of December 31, 1999 24,522,633 $0.007-$ 44.67
Granted and assumed......... 16,604,003 $0.001-$149.79
Exercised................... (5,461,935) $0.001-$ 66.58
Cancelled................... (7,930,326) $0.001-$ 64.75
----------- --------------
Balance as of December 31, 2000 27,734,375 $0.001-$149.79
Granted..................... 24,726,003 $0.350-$ 39.00
Exercised................... (4,100,977) $0.001-$ 2.56
Cancelled................... (16,759,071) $0.001-$149.79
----------- --------------
Balance as of December 31, 2001 31,600,330 $0.001-$149.79
=========== ==============
The following is a summary of the status of stock options outstanding at
December 31, 2001:
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
- -------------------- ---------- ---------------- ---------------- ---------- ----------------
$0.00-$6.63...... 24,823,856 6.9 $ 1.51 7,072,160 $ 1.84
$6.63-$13.25..... 627,052 5.6 $ 8.35 331,778 $ 7.97
$13.25-$19.88.... 950,439 6.2 $16.28 361,725 $16.78
$19.88-$26.50.... 301,003 6.2 $24.20 118,671 $24.47
$26.50-$33.13.... 1,721,530 5.3 $28.98 962,252 $28.99
$33.13-$39.75.... 526,420 4.6 $35.88 344,424 $35.76
$39.75-$46.38.... 490,118 5.3 $40.88 296,718 $40.84
$46.38-$53.00.... 577,777 6.2 $50.66 254,829 $50.66
$53.00-$59.63.... 767,429 6.1 $57.08 357,052 $57.08
$59.63-$149.79... 814,706 5.9 $65.77 372,650 $67.99
---------- --- ------ ---------- ------
31,600,330 6.6 $ 8.89 10,472,259 $12.95
========== === ====== ========== ======
During the year ended December 31, 2001, the Company reversed approximately
$1,213 of deferred stock-based compensation recorded in prior years due to the
termination of certain employees. During the years ended December 31, 2000 and
1999, the Company recorded deferred stock-based compensation of approximately
$628 and $6,593, respectively, as a result of granting stock options and
issuing restricted stock with exercise or purchase prices that were less than
the fair value of the Company's common stock at the date of grant or issuance.
These amounts are being amortized to operations over the vesting periods using
a graded vesting method. Amortization of deferred stock-based compensation for
the years ended December 31, 2001, 2000 and 1999 was approximately $1,597,
$4,481 and $4,768, respectively. Included in the amortization of deferred
stock-based compensation for the year ended December 31, 2000 are amounts
aggregating $724 relating to accelerated vesting provisions included in stock
options granted to certain employees in previous years. These accelerated
104
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
vesting provisions were triggered by the resignation of such employees during
2000. No similar amounts are included in the amortization of deferred
stock-based compensation in 2001 or 1999.
During the year ended December 31, 2001, the Company extended the exercise
period of options granted to certain former employees for the purchase of
244,550 shares of the Company's common stock. Consequently, the Company
recognized stock-based compensation expense of $253 in 2001, which represents
the difference between the exercise price of these options and the fair value
of the Company's common stock on the respective dates of the option award
modifications. The Company did not modify any stock-based awards in 2000 or
1999.
The Company grants options to consultants from time to time in exchange for
services performed for the Company. In general, these options vest over the
contractual period of the consulting arrangement. The Company granted options
to consultants to purchase 347,000 and 39,000 shares of the Company's common
stock in 2001 and 1999, respectively. No shares were granted to consultants in
2000. The fair value of these options is being amortized to expenses over the
vesting term of the options. The Company recorded expense of $186, and $534 for
the fair value of these options in 2001 and 1999, respectively. No expense was
recorded for options granted to consultants in 2000. As of December 31, 2001,
the fair value of the remaining unvested options to consultants is $643. These
charges are subject to adjustment based on the fair value of the 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
valuation model.
The Company uses the intrinsic value method in accounting for its employee
stock options because, as discussed below, the alternative fair value
accounting requires the use of option valuation models that were not developed
for use in valuing employee stock options. Under the intrinsic value method,
when the exercise price of the Company's employee stock options equals the
market price of the underlying stock on the date of grant, no compensation
expense is recognized.
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, 2001, 2000 and 1999, the fair value of the
Company's stock-based awards to employees was estimated using the following
weighted average assumptions:
2001 2000 1999
----- ----- -----
Expected life of options in years 4.0 4.0 4.0
Volatility....................... 169.2% 171.0% 123.5%
Risk-free interest rate.......... 3.5% 5.1% 7.0%
Expected dividend yield.......... 0.0% 0.0% 0.0%
The weighted average fair value of stock options granted during the years
ended December 31, 2001, 2000, and 1999 was $1.45, $29.02 and $9.79 per share,
respectively. For pro forma purposes, the estimated fair value of the Company's
stock-based awards to employees is amortized over the options' vesting period,
which would
105
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
result in a reduction in net income/an increase in net loss of approximately
$13,051, $206,900 and $35,200 for the years ended December 31, 2001, 2000 and
1999, respectively.
The result of applying the fair value method to the Company's option grants
would have reduced the net income per share/increased the net loss per share by
$.07 per share, $1.33 per share and $0.23 per share for the years ended
December 31, 2001, 2000 and 1999, respectively.
14. Business Segments
The Company disaggregates its business operations based upon differences in
services and marketing channels, even though the cash flows from these
operations are not largely independent of each other. The Company's wholesale
division ("Wholesale") is a provider of high-speed connectivity services, which
utilize DSL technology, to ISP, enterprise and telecommunications carrier
customers. The Company's direct division ("Direct") is a provider of high-speed
connectivity, Internet access and other services to individuals, small and
medium-sized businesses, corporations and other organizations. As described in
Note 3, on June 25, 2001, BlueStar, which was a component of Direct, made an
irrevocable assignment for the benefit of creditors of all its assets to an
independent trustee in the State of Tennessee and, accordingly, was not part of
the Company's operations during periods beginning after June 25, 2001.
Corporate operations represent general corporate expenses, headquarters
facilities and equipment, investments, and other nonrecurring and unusual items
not allocated to the segments. (In 1999, the Company's business was comprised
entirely of Wholesale DSL service operations.).
The accounting policies used in measuring segment assets and operating
results are the same as those described in Notes 1 and 4. The items discussed
in Notes 2, 3, 5 and 6 are not allocated to the segments and are included in
corporate operations. The Company evaluates performance of the segments based
on segment operating results, excluding nonrecurring and unusual items.
106
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Information about the Company's current business segments was as follows as
of and for the years ended December 31, 2001 and 2000 (the Company's 2000
segment information has been restated to conform to the Company's
organizational structure in 2001):
Total Corporate Intercompany Consolidated
Wholesale Direct Segments Operations Eliminations Total
--------- -------- --------- ---------- ------------ ------------
As of and for the year ended
December 31, 2001:
Domestic Internet and network
access revenues from
unaffiliated customers, net..... $ 285,707 $ 46,889 $ 332,596 $ -- $ -- $ 332,596
Intersegment revenues............. -- -- -- -- -- --
--------- -------- --------- ---------- ---- ----------
Total revenues, net.......... 285,707 46,889 332,596 -- -- 332,596
Operating expenses................ 484,818 90,651 575,469 116,816 -- 692,285
Depreciation and amortization..... 127,908 2,393 130,301 7,619 -- 137,920
Amortization of intangible
assets.......................... 12,919 -- 12,919 -- -- 12,919
Provision for restructuring
expenses........................ -- -- -- 14,364 -- 14,364
Provision for long-lived asset
impairment...................... -- -- -- 11,988 -- 11,988
--------- -------- --------- ---------- ---- ----------
Total operating expenses..... 625,645 93,044 718,689 150,787 -- 869,476
--------- -------- --------- ---------- ---- ----------
Loss from operations.............. (339,938) (46,155) (386,093) (150,787) -- (536,880)
--------- -------- --------- ---------- ---- ----------
Interest income................... 23,907 77 23,984 609 -- 24,593
Equity in losses of unconsolidated
affiliates...................... -- -- -- (13,769) -- (13,769)
Interest expense.................. (90,048) (2,734) (92,782) -- -- (92,782)
Other income (expense), net....... (6,644) (266) (6,910) (63,221) -- (70,131)
--------- -------- --------- ---------- ---- ----------
Total other income
(expense), net............. (72,785) (2,923) (75,708) (76,381) -- (152,089)
--------- -------- --------- ---------- ---- ----------
Loss before extraordinary item.... (412,723) (49,078) (461,801) (227,168) -- (688,969)
Extraordinary item................ -- -- -- 1,033,727 -- 1,033,727
--------- -------- --------- ---------- ---- ----------
Net income (loss)............ $(412,723) $(49,078) $(461,801) $ 806,559 $ $ 344,758
========= ======== ========= ========== ==== ==========
Assets............................ $ 656,200 $ 801 $ 657,001 $ 18,167 $ -- $ 675,168
Investments in unconsolidated
affiliates:
Domestic....................... $ -- $ -- $ -- $ 1,874 $ -- $ 1,874
International.................. $ -- $ -- $ -- $ 3,000 $ -- $ 3,000
Capital expenditures for property
and equipment................... $ 10,454 $ 614 $ 11,068 $ 4,664 $ -- $ 15,732
107
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Total Corporate Intercompany Consolidated
Wholesale Direct Segments Operations Eliminations Total
---------- -------- ---------- ---------- ------------ ------------
As of and for the year ended
December 31, 2000:
Domestic Internet and network
access revenues from
unaffiliated customers, net... $ 133,535 $ 25,201 $ 158,736 $ -- $ -- $ 158,736
Intersegment revenues........... -- -- -- -- -- --
---------- -------- ---------- --------- ---- -----------
Total revenues, net........ 133,535 25,201 158,736 -- -- 158,736
Operating expenses.............. 624,149 41,014 665,163 71,238 -- 736,401
Depreciation and amortization... 79,421 7,770 87,191 4,014 -- 91,205
Amortization of intangible
assets........................ -- -- -- 87,220 -- 87,220
Provision for restructuring
expenses...................... -- -- -- 4,988 -- 4,988
Provision for long-lived asset
impairment.................... -- -- -- 589,388 -- 589,388
Write-off of in-process research
and development costs......... -- -- -- 3,726 -- 3,726
---------- -------- ---------- --------- ---- -----------
Total operating
expenses................. 703,570 48,784 752,354 760,574 -- 1,512,928
---------- -------- ---------- --------- ---- -----------
Loss from operations............ (570,035) (23,583) (593,618) (760,574) -- (1,354,192)
---------- -------- ---------- --------- ---- -----------
Interest income................. 52,837 64 52,901 -- -- 52,901
Equity in losses of
unconsolidated affiliates..... -- -- -- (6,452) -- (6,452)
Interest expense................ (108,289) (1,574) (109,863) -- -- (109,863)
Other income (expense), net..... (16,294) 13 (16,281) -- -- (16,281)
---------- -------- ---------- --------- ---- -----------
Total other income
(expense), net........... (71,746) (1,497) (73,243) (6,452) -- (79,695)
---------- -------- ---------- --------- ---- -----------
Loss before cumulative effect of
change in accounting
principle..................... (641,781) (25,080) (666,861) (767,026) -- (1,433,887)
Cumulative effect of change in
accounting principle.......... (9,249) -- (9,249) -- -- (9,249)
---------- -------- ---------- --------- ---- -----------
Net loss................... $ (651,030) $(25,080) $ (676,110) $(767,026) $ -- $(1,443,136)
========== ======== ========== ========= ==== ===========
Assets.......................... $1,402,968 $ 51,790 $1,454,758 $ 56,727 $ -- $ 1,511,485
Investments in unconsolidated
affiliates:
Domestic..................... $ -- $ -- $ -- $ 3,549 $ -- $ 3,549
International................ $ -- $ -- $ -- $ 16,798 $ -- $ 16,798
Capital expenditures for
property and equipment........ $ 289,874 $ 6,485 $ 296,359 $ 22,875 $ -- $ 319,234
108
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
15. Subsequent Event
On January 4, 2002, the Company purchased substantially all of the assets of
InternetConnect (Note 1) in an auction supervised by the United States
Bankruptcy Court for the Central District of California. The purchase price for
the assets of InternetConnect was $7,350 in cash. The Company did not assume
any liabilities or obligations of InternetConnect. The assets purchased
included cash, accounts receivable, equipment and other assets and
approximately 9,250 lines, which include DSL and T1 broadband connections,
along with VPN customers. The majority of these lines are currently on the
Company's network.
Supplemental Data
The supplementary information required by Item 302 of Regulation S-K is in
"Part II. Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations."
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
109
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The current executive officers and directors of the Company, and their
respective ages as of March 1, 2002, are as follows:
Name Age Position
---- --- --------
Charles Hoffman.. 53 President and Chief Executive Officer
Patrick Bennett.. 54 Executive Vice President and General Manager, Covad Direct
Chuck Haas....... 42 Executive Vice President and General Manager, Covad Wholesale
P. Michael Hanley 44 Senior Vice President Organizational Transformation
Anjali Joshi..... 41 Executive Vice President, Engineering
Dhruv Khanna..... 42 Executive Vice President, Secretary, and General Counsel, Legal
and External Affairs
Mark A. Richman.. 42 Senior Vice President and Chief Financial Officer
Charles McMinn... 50 Chairman, Board of Directors
Frank J. Marshall 55 Vice-Chairman, Board of Directors
Helene Runtagh... 53 Director
Daniel Lynch..... 60 Director
Rich Shapero..... 53 Director
Larry Irving..... 45 Director
Robert Hawk...... 62 Director
Charles Hoffman has served as the Company's President and Chief Executive
Officer since June 2001. Mr. Hoffman previously served as President and Chief
Executive Officer of Rogers Wireless, Inc. from 1998 to 2001. From 1996 to 1998
he served as President, Northeast Region for Sprint PCS. Prior to that, he
spent 16 years at Southwestern Bell from 1980 to 1996 in various senior
positions, including regional manager, general manager and vice president and
general manager.
Patrick Bennett joined the Company in October 2001. He has served as the
Company's Executive Vice President and General Manager, Covad Direct since
January 2002. Prior to joining the Company, Mr. Bennett served as senior vice
president with TESSCO Technologies from March 2001 to October 2001. Before
that, Mr. Bennett was with Rogers Wireless where he served as its Executive
Vice President and Chief Operating Officer from December 1999 to March 2001 and
as its Senior Vice President, Sales, from April 1998 to December 1999. From
1996 to 1998, Mr. Bennett was an area vice president for Sprint PCS.
Charles Haas is a founder of the Company and has been serving as the
Company's Executive Vice President and General Manager, Covad Wholesale since
January 2002. He served as the Company's Vice President, Sales and Marketing
from May 1997 until November 1998 and has served in various other senior roles
with the Company. Mr. Haas has over fourteen years of sales and business
development experience with Intel where he held various positions from July
1982 to April 1997. At Intel Mr. Haas served as manager of corporate business
development, focusing on opportunities in the broadband computer communications
area, and played a principal in the development of the Company's Residential
Broadband strategy for telephone and satellite companies (DSL,
Fiber-to-the-Curb and satellite modems).
P. Michael Hanley has served as the Company's Senior Vice President,
Organizational Transformation, since February 2002. Mr. Hanley came to the
Company from Rogers Wireless, Inc. Canada's largest wireless communications
service provider, where he served as its Vice President, Organizational
Transformation from 1999 to 2001 and as its Vice President, Credit Operations
from 1996 to 1999. Prior to joining, Rogers Wireless, Mr. Hanley held
increasingly senior roles with Canadian Imperial Bank of Commerce from 1994 to
1996.
110
Anjali Joshi joined the Company in 1998 and has served as the Company's
Executive Vice President, Engineering since May 2001. She previously served as
the Company's Vice President, Network Engineering and Director, Network
Engineering. From 1994 to 1998, she served as a Technical Program Manager,
ATM/IP Network Implementation and Service Development for AT&T Interspan High
Speed Services. From 1990 to 1994, she was a Signaling Network
Technology/Architecture Planner for AT&T Bell Laboratories.
Dhruv Khanna is one of the Company's founders. He served as the Company's
Vice President, General Counsel and Secretary from October 1996 until February
1999. From February 1999 to January 2002, he served as the Company's Executive
Vice President, General Counsel and Secretary since that date. Since January
2002, he has served as the Company's Executive Vice President, Secretary, and
General Counsel, Legal and External Affairs. He was an in-house counsel for
Intel Corporation's communications products division and its Senior
Telecommunications Attorney between 1993 and 1996. Between 1987 and 1993, Mr.
Khanna was an associate at Morrison & Foerester, LLP, where his clients
included Teleport Communications Group (now AT&T Corp.), McCaw Cellular
Communications, Inc. (now AT&T Wireless), and Southern Pacific Telecom (now
Qwest Communications International, Inc.). Mr. Khanna has extensive experience
with regulatory matters, litigation and business transactions involving the
RBOCs and other telecommunications companies. While at Intel, he helped shape
the computer industry's positions on the Telecommunications Act of 1996 and the
FCC's rules implementing the 1996 Act.
Mark A. Richman joined the Company in September 2001 as its Senior Vice
President and Chief Financial Officer. Prior to joining the Company, Mr.
Richman served as Vice President and Chief Financial Officer of MainStreet
Networks from June 2000 to August 2001. From October 1996 to June 2000 Mr.
Richman served as vice president and corporate treasurer of Adecco S.A. and as
vice president of finance and administration for its subsidiary, Adecco U.S.
From February 1994 to October 1996, he was European finance director for
Merisel.
Charles McMinn is a founder of the Company and has been the Chairman of the
Board of Directors since October 2000. Mr. McMinn previously served as the
Company's Chairman of the Board of Directors from July 1998 to September 1999.
He served as the Company's President, Chief Executive Officer and as a member
of its Board of Directors from October 1996 to July 1998. Mr. McMinn has over
20 years of experience in creating, financing, operating and advising high
technology companies. From November of 1999 to October 2000, Mr. McMinn served
as Chief Executive Officer and is a founder of Certive Corporation and he is
still chairman of Certive's board of directors. From July 1995 to October 1996,
and from August 1993 to June 1994, Mr. McMinn managed his own consulting firm,
Cefac Consulting, which focused on strategic consulting for information
technology and communications businesses. From June 1994 to November 1995, he
served as Principal, Strategy Discipline, at Gemini Consulting. From August
1992 to June 1993, he served as President and Chief Executive Officer of
Visioneer Communications, Inc. and from October 1985 to June 1992 was a general
partner at InterWest Partners, a venture capital firm. Mr. McMinn began his
Silicon Valley career as the product manager for the 8086 microprocessor at
Intel.
Frank J. Marshall has served as a member of the Company's Board of Directors
since October 1997 and has served as Vice Chairman of the Board of Directors
since June 2001. Mr. Marshall also served as the Company's Interim Chief
Executive Officer from November 2000 to June 2001. Mr. Marshall currently
serves on the board of directors of PMC-Sierra, Inc., NetScreen Technologies
and several private companies. Mr. Marshall also serves on the technical
advisory board of several private high technology private companies. He is a
member of the InterWest Partners Advisory Committee. From 1992 to 1997, Mr.
Marshall served as Vice President of Engineering and Vice President and General
Manager, Core Business Unit of Cisco Systems, Inc. From 1982 to 1992, he served
as Senior Vice President, Engineering at Convex Computer Corporation.
Robert Hawk has served as a member of the Company's Board of Directors since
April 1998. Mr. Hawk is President of Hawk Communications and recently retired
as President and Chief Executive Officer of U S WEST Multimedia Communications,
a regional telecommunications service provider, where he headed the cable, data
and telephony communications business from May 1996 to April 1997. He was
president of the Carrier Division
111
of U S West Communications, Inc., from September 1990 to May 1996. Prior to
that time, Mr. Hawk was Vice President of Marketing and Strategic Planning for
CXC Corporation. Prior to joining CXC Corporation, Mr. Hawk was director of
Advanced Systems Development for AT&T/American Bell. He currently serves on the
boards of PairGain Technologies, Inc., COM21, Inc., Concord Communications,
Inc., Radcom, Ltd., Efficient Networks, Inc. and several privately held
companies.
Larry Irving has served as a member of the Company's Board of Directors
since April 2000. Mr. Irving is the President and CEO of the Irving Information
Group, a strategic consulting firm. Prior to founding the Irving Information
Group, Mr. Irving served for almost seven years as Assistant Secretary of
Commerce for Communications and Information, where he was a principal advisor
to the President, Vice President and Secretary of Commerce on domestic and
international communications and information policy issues, including the
development of policies related to the Internet and Electronic Commerce. He was
a point person in the Administration's successful efforts to reform the United
States' telecommunications law, which resulted in the passage of the
Telecommunications Act of 1996. Mr. Irving is widely credited with popularizing
the term "Digital Divide" and was the principal author of the landmark Federal
survey, Falling Through The Net, which tracked access to telecommunications and
information technologies, including computers and the Internet, across racial,
economic, and geographic lines. In recognition of his work to promote policies
and develop programs to ensure equitable access to advanced telecommunication
and information technologies, Irving was named one of the fifty most
influential persons in the "Year of the Internet" by Newsweek Magazine. Prior
to joining the Clinton-Gore Administration, Mr. Irving served ten years on
Capitol Hill, most recently as Senior Counsel to the U.S. House of
Representatives Subcommittee on Telecommunications and Finance. He also served
as Legislative Director, Counsel and Chief of Staff (acting) to the late
Congressman Mickey Leland (D-Texas). During the previous three years, Mr.
Irving was associated with the Washington, D.C. law firm of Hogan & Hartson,
specializing in communications law, antitrust law and commercial litigation.
Daniel Lynch has served as a member of the Company's Board of Directors
since April 1997. From December 1990 to December 1995, he served as chairman of
the board of directors of Softbank Forums, a provider of education and
conference services for the information technology industry. Mr. Lynch founded
Interop Company in 1986, which is now a division of the successor to Softbank
Forums, Key3Media Mr. Lynch is a member of the Association for Computing
Machinery and the Internet Society. He is also a member of the Board of
Trustees of the Santa Fe Institute and the Bionomics Institute. He previously
served as Director of the Information Processing Division for the Information
Sciences Institute in Marina del Rey, where he led the Arpanet team that made
the transition from the original NCP protocols to the current TCP/IP based
protocols. He has served as a member of the board of directors of Exodus
Communications since January 1998. Mr. Lynch previously served as a member of
the board of directors at UUNET Technologies, Inc., from April 1994 until
August 1996.
Hellene Runtagh has served as a member of the Company's Board of Directors
since November 1999. Ms. Runtagh served as Executive Vice President of
Universal Studios from January 1999 until January 2001. In this capacity, she
was responsible for overseeing the activities of the Universal Studios
Operations Group, Universal Studios Consumer Products Group, Universal Studios
Corporate Marketing and Sponsorships, and the Spencer Gift retail operations,
Universal Studios' worldwide information technology, and Seagram's global
sourcing and real estate operations. From February 1997 to January 1999, she
held the position of senior vice president of reengineering effort at
Universal. Previously, Ms. Runtagh spent 25 years at General Electric, where
she served as President and Chief Executive Officer of GE Information Services
from 1989 to 1996 and held general management roles with GE's capital and
software businesses.
Rich Shapero has served as a member of the Company's Board of Directors
since July 1997. Mr. Shapero is a managing partner of Crosspoint Venture
Partners, L.P., a venture capital investment firm and has been with that firm
since April 1993. From January 1991 to June 1992, he served as Chief Operating
Officer of Shiva Corporation, a computer network company. Previously, he was a
Vice President of Sun Microsystems, Inc., Senior Director of Marketing at AST
Research, Inc., and held marketing and sales positions at Informatics
112
General Corporation and UNIVAC's Communications Division. Mr. Shapero serves as
a member of the board of directors of several privately held companies.
See Part I. Item 3 "Legal Proceedings" for information relating to our
Chapter 11 proceeding in 2001.
Classified Board
The Board of Directors is divided into three classes. The term of office and
directors consisting of each class is as follows:
Class Directors Term of Office
- ----- --------- --------------
Class I............ Daniel Lynch . expires at the annual meeting of
Rich Shapero stockholders in 2003 and at each third
Larry Irving succeeding annual meeting thereafter
Class II........... Frank J. Marshall . expires at the annual meeting of
Hellene Runtagh stockholders in 2004 and at each third
succeeding annual meeting thereafter
Class III.......... Charles McMinn . expires at the annual meeting of
Robert Hawk stockholders in 2002 and at each third
succeeding annual meeting thereafter
The classification of directors has the effect of making it more difficult
to change the composition of the Board of Directors.
Board Committees
In April 1998, the Board of Directors established an Audit Committee and a
Compensation Committee.
The Audit Committee currently consists of three of the Company's outside
directors, Messrs. Lynch and Hawk and Ms. Runtagh. The Audit Committee's
primary responsibilities include:
. conducting a post-audit review of the financial statements and audit
findings;
. reviewing the Company's independent auditors' proposed audit scope and
approach; and
. reviewing, on a continuous basis, the adequacy of the Company's system of
internal accounting controls.
The Compensation Committee currently consists of two of the Company's
outside directors, Mr. Shapero and Ms. Runtagh. The primary responsibilities of
the Compensation Committee include:
. reviewing and determining the compensation policy for the Company's
executive officers and directors, and other employees as directed by the
Board of Directors;
. reviewing and determining all forms of compensation to be provided to the
Company's executive officers; and
. reviewing and making recommendations to the Company's Board of Directors
regarding general compensation goals and guidelines for the Company's
employees and the criteria by which bonuses to the Company's employees
are determined.
The Company also has a Pricing Committee and Management Compensation
Committee. The Pricing Committee currently consists of one outside director,
Mr. Irving and three inside directors, Messrs. McMinn, Marshall and Hoffman.
The function of the Pricing Committee is to set the price for the sale of the
Company's
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common stock to third-parties. The function of the Management Compensation
Committee, which consists solely of one inside director, Mr. Hoffman, is to
review and determine the compensation policy for employees other than the
Company's executive officers and directors and to review and determine all
forms of compensation for such employees.
Director Compensation
Except for grants of stock options subject to vesting and restricted stock
subject to repurchase, directors of the Company generally do not receive
compensation for services provided as a director or committee member. Periodic
stock options and restricted stock are granted as follows:
. All newly installed directors receive a stock option grant to purchase
60,000 shares of common stock and ongoing directors receive annual grants
of options to purchase 15,000 shares of our common stock;
. Members of our Audit Committee, other than the Chairperson, receive a one
time grant of options to purchase 10,000 shares of our common stock when
they are appointed to the Audit Committee and then receive annual grants
of options to purchase 5,000 shares of our common stock; and
. The Chairperson of our Audit Committee receives an option to purchase
10,000 shares of our common stock when appointed to the Audit Committee
and then receives annual grants of options to purchase 10,000 shares of
our common stock.
All of these grants of stock options or restricted stock subject to repurchase
are at the market price on the grant date and vest over a period of four years.
In January 2001, each of the members of the Board of Directors, other than Mr.
McMinn (who received a stock option grant to purchase 60,000 shares at the
market price on the grant date as a newly installed director), received a
one-time stock option grant to purchase 50,000 shares at the market price on
the grant date, vesting over four years.
The Company does not pay additional cash amounts for committee participation
or special assignments of the Board of Directors, except for reimbursement of
expenses in attending Board and committee meetings.
In April 2001, we provided Mr. McMinn and Mr. Marshall with stock option
grants to purchase 200,000 shares each. These options were priced at the
closing price of our stock on the NASDAQ National Market on the grant date.
One-half of these options were immediately vested and the remaining one-half
were scheduled to vest over the following six months. As a result of Mr.
Marshall's resignation as our Interim Chief Executive Officer in June 2001, the
option to purchase 50,000 of these 200,000 shares did not vest. In November
2001, Mr. Marshall was granted an additional option to purchase 50,000 shares
at the market price on the grant date. These options fully vested in December
2001.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16 of the Exchange Act requires our directors and certain of our
officers, and persons who own more than 10% of our common stock, to file
initial reports of ownership and reports of changes in ownership with the
Securities and Exchange Commission and the Nasdaq National Market. Such persons
are required by Securities and Exchange Commission regulation to furnish us
with copies of all Section 16(a) forms they file. Based solely on our review of
the copies of such forms furnished to us and written representations from these
officers and directors, we believe that all Section 16(a) filing requirements
were met during fiscal 2000, except the following forms which were filed late
by Anjali Joshi (Form 5 due February 15, 2002) and Frank Marshall (Form 5 due
February 15, 2002). Based solely upon representations from these officers and
directors, each of these late forms were filed in connection with single
transactions.
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ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth certain information with respect to
compensation awarded to, earned by or paid to each person who served as the
Company's Chief Executive Officer or was one of the Company's four other most
highly compensated executive officers (collectively, the "Named Executive
Officers") during the fiscal year ended December 31, 2001.
SUMMARY COMPENSATION TABLE
Long-Term Compensation
-----------------------------
Annual Compensation Restricted Securities
Fiscal --------------------- Stock Underlying All Other
Name and principal position Year Salary Bonus Awards ($) Options/SARs (#) Compensation
--------------------------- ------ -------- -------- ---------- ---------------- ------------
Charles E. Hoffman............... 2001 $257,617(19) $166,154 -- 2,500,000 $100,207(20)
President and Chief Executive 2000 $ -- $ -- -- -- $ --
Officer 1999 $ -- $ -- -- -- $ --
Frank J. Marshall................ 2001 $ 0 $ 0 -- 300,000 $ 0
Interim Chief Executive Officer 2000 $ 0(1) $ -- -- 60,000 $ --
And Director 1999 $ -- $ -- -- -- $ --
Catherine Hemmer(15)............. 2001 $350,000 $195,300 -- 250,000 $ 87,656(12)
Executive Vice President, 2000 $334,615 -- -- 175,000 $ 87,860(10)
Chief Operations Officer 1999 $180,769 $109,500 $882,500(5) -- $ 87,740(11)
Dhruv Khanna..................... 2001 $275,000 $153,450 -- 327,000 $ 152(9)
Executive Vice President, 2000 $263,462 -- -- 52,501 $ 270(9)
Human Resources, General
Counsel and Secretary 1999 $176.923 $ 85,000 -- -- $ 180(9)
Terry Moya(21)................... 2001 $250,000 $114,500 -- 352,000 $ 163(9)
Executive Vice President, 2000 $209,615 $ 88,919 -- 227,501 $ 240(9)
External Affairs and Corporate 1999 $ 70,673(3) $ 36,458 $526,200(6) 240,000 $ 40,065(13)
Development
Anjali Joshi..................... 2001 $232,692 $125,308 -- 325,000 $ 163(9)
Executive Vice President, 2000 $172,865 $ 30,000 -- 80,001 $ 176(9)
Engineering 1999 $120,000 $ -- -- -- $ 122(9)
Robert Davenport, III(14)........ 2001 $157,500 $ 43,346 -- 62,000 $150,083(8)
President, Covad 2000 $303,846 -- -- 152,500 $150,360(7)
Communications International 1999 $183,077(2) $ 91,667 -- 450,001 $ 171(9)
BV
John J. McDevitt(16)............. 2001 $215,174 $ 62,488 -- 50,000 $500,000(18)
Executive Vice President 2000 $124,000(4) $ -- -- 250,000 $ 50,126(17)
1999 $ -- $ -- -- -- $ ---
- --------
(1) On November 1, 2000, the Company announced the resignation of Mr.
Knowling. Frank J. Marshall was appointed to replace Mr. Knowling on an
interim basis.
(2) Pro rated based on an annual salary of $200,000 from hiring date of
January 20, 1999
(3) Pro rated based on an annual salary of $175,000 from hiring date of July
26, 1999.
(4) Pro rated based on an annual salary of $275,000 from hiring date of July
21, 2000.
(5) This value is based upon the closing price of $29.416 for 30,000 shares
granted on November 3, 1999 to Ms. Hemmer and Mr. Devich. Twenty-five
percent of these shares vest on the four consecutive anniversaries of the
grant date. As of December 29, 2000, twenty-five percent of these shares
were vested and each grant was valued at $49,686 based on a closing price
of $1.6562.
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(6) This value is based upon the closing price of $35.083 for 15,000 shares
granted on July 26, 1999 to Mr. Moya. Twenty-five percent of these shares
vest on the four consecutive anniversaries of the grant date. As of
December 29, 2000, twenty-five percent of these shares were vested and
valued at $24,843 based on a closing price of $1.6562.
(7) Includes scheduled loan forgiveness of $150,000 on a $600,000 note, which
was secured by Mr. Davenport's residence as well as, premium payments for
Mr. Davenport's term life insurance.
(8) Includes scheduled loan forgiveness of $150,000 on a $600,000 note, which
was secured by Mr. Davenport's residence as well as, premium payments for
Mr. Davenport's term life insurance.
(9) The dollar amount represents premium payments the Company made for these
executives' term life insurance policy.
(10) Includes scheduled loan forgiveness of $87,500 on a $350,000 note, which
was secured by Ms. Hemmer's residence as well as, premium payments for Ms.
Hemmer's term life insurance.
(11) Includes scheduled loan forgiveness of $87,500 on a $350,000 note, which
was secured by Ms. Hemmer's residence as well as, premium payments for Ms.
Hemmer's term life insurance.
(12) Includes scheduled loan forgiveness of $87,500 on a $350,000 note, which
was secured by Ms. Hemmer's residence as well as, premium payments for Ms.
Hemmer's term life insurance.
(13) Includes a payment of $40,000 as a sign-on bonus as well as $65 for term
life insurance premium.
(14) Mr. Davenport resigned from the Company in May 2001.
(15) Ms. Hemmer resigned from the Company in March 2002.
(16) Mr. McDevitt resigned from the Company in September 2001.
(17) Includes a payment of $50,000 as a sign-on bonus as well as $122 for term
life insurance premium.
(18) Includes scheduled loan forgiveness of $500,000 on a $500,000 note which
was secured by Mr. McDevitt's residence as well as premium payments for
Mr. McDevitt's term life insurance. Includes a payment of $100,055 as a
relocation bonus.
(19) Pro rated based on annual salary of $500,000 from hiring date of June 25,
2001.
(20) Includes a payment of $100,000 as a sign on bonus as well as $207 for term
life insurance.
(21) Mr. Moya left the Company in February 2002.
116
Option/SAR Grants In Last Fiscal Year
The following table sets forth information regarding stock options granted
to Named Executive Officers during the fiscal year ended December 31, 2001.
Individual Grants
-------------------------------------------------
Percent of Potential Realizable Value at
Number of Total Options Assumed Annual Rates Of
Securities Granted to Stock Price Appreciation
Underlying Employees in Exercise For Option Term ($)(3)
Options Fiscal Price Per Expiration -----------------------------
Name Granted (#)(1) 2000 (%)(2) Share Date 5% 10%
---- -------------- ------------- --------- ---------- ---------- ----------
Frank J. Marshall....... 50,000 0.2019% $2.5600 01/23/09 $ 61,114 $ 146,379
200,000 0.8076% $1.3000 04/17/09 $ 124,138 $ 297,333
50,000 0.2019% $0.8600 11/12/09 $ 20,531 $ 49,174
Charles E. Hoffman...... 2,500,000 10.0951% $0.8400 06/25/09 $1,002,656 $2,401,537
Robert Davenport, III(4) 62,000 0.2504% $2.5625 06/14/01 $ 75,856 $ 181,688
Catherine Hemmer(5)..... 150,000 0.6057% $2.5625 03/23/09 $ 183,522 $ 439,567
100,000 0.4038% $0.5600 09/11/09 $ 26,738 $ 64,041
Dhruv Khanna............ 127,000 0.5128% $2.5625 03/23/09 $ 155,382 $ 372,167
100,000 0.4038% $1.4300 05/04/09 $ 68,276 $ 163,533
100,000 0.4038% $0.5600 09/11/09 $ 26,738 $ 64,041
Terry Moya(7)........... 92,000 0.3715% $2.5625 03/23/09 $ 112,560 $ 269,601
180,000 0.7268% $1.4300 05/04/09 $ 122,897 $ 294,360
80,000 0.3230% $0.5600 09/11/09 $ 21,390 $ 51,233
Anjali Joshi............ 100,000 0.4038% $2.5625 03/23/09 $ 122,348 $ 293,045
125,000 0.5048% $1.4300 05/04/09 $ 85,345 $ 204,416
100,000 0.4038% $0.5600 09/11/09 $ 26,738 $ 64,041
John McDevitt(6)........ 50,000 0.2019% $2.5625 10/21/01 $ 61,174 $ 146,522
- --------
(1) The material terms of the option grants are as follows: (i) the options
consist of qualified and nonqualified stock options; (ii) all have an
exercise price equal to the fair market value on the date of grant; (iii)
grants generally have an 8-year term and become exercisable over a
four-year period (for example, grants of initial stock options to new
employees typically vest at a rate of 12.5% of the option shares on the
six-month anniversary of the grant date with the remainder vesting in 42
equal monthly installments); (iv) the options are not transferable and (v)
all options are otherwise subject to the terms and provisions of the
Company's 1997 Stock Plan. See "--1997 Stock Plan."
(2) Based on options covering an aggregate of 24,764,475 shares the Company
granted during 2001 pursuant to the Company's 1997 Stock Plan.
(3) These amounts represent hypothetical gains that could be achieved for the
options if exercised at the end of the option term. The potential
realizable values are calculated by assuming that the Company's common
stock appreciates at the annual rate shown, compounded annually, from the
date of grant until expiration of the granted options. The assumed 5% and
10% rates of stock price appreciation are mandated by the rules of the
Securities and Exchange Commission and do not represent the Company's
estimate or projection of future stock price growth.
(4) Mr. Davenport resigned from the Company in May 2001.
(5) Ms. Hemmer resigned from the Company in March 2002.
(6) Mr. McDevitt resigned from the Company in September 2001.
(7) Mr. Moya left the Company in February 2002.
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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, 2001 and the number and
year-end value of shares of the Company's common stock underlying the
unexercised options held by the Named Executive Officers. None of the Named
Executive Officers exercised or held stock appreciation rights during the year
ended December 31, 2001.
Number Of Securities
Underlying Unexercised Value Of Unexercised
Options At December 31, In-The-Money Options
Shares Value 2001 At December 31, 2001 ($)(2)
Acquired On Realized ------------------------- ---------------------------
Name Exercise (#) ($)(1) Exercisable Unexercisable Exercisable Unexercisable
---- ------------ -------- ----------- ------------- ----------- -------------
Frank J. Marshall....... 50,000 $ -- 200,000 50,000 $570,817 $ 78,000
Charles E Hoffman....... 312,500 2,187,500 $865,304 $4,418,750
Robert Davenport, III(3) $ -- 62,000 $ -- $ 18,445
Catherine Hemmer........ $ -- 59,373 190,627 $169,494 $ 244,448
Dhruv Khanna............ $ -- 87,935 239,065 $251,133 $ 327,280
Terry Moya.............. 3,750 $ 1,872 107,830 244,170 $307,806 $ 345,991
Anjali Joshi............ 15,500 $41,132 86,143 238,857 $246,010 $ 344,324
John J McDevitt......... $ -- 50,000 $ -- $ 14,875
- --------
(1) Value represents the fair market value at exercise minus the exercise price.
(2) Value represents the difference between the exercise price and the market
value (i.e., closing price) of common stock of $2.86 on December 31, 2001.
An option is "in-the-money" if the market value of the common stock exceeds
the exercise price.
(3) Mr. Davenport resigned from the Company in May 2001.
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 will receive
compensation in the form of a $500,000 annual base salary and a bonus of
$375,000 if he attains certain performance goals. Mr. Hoffman also received (i)
a signing bonus of $100,000, and (ii) stock options to purchase 2,500,000
shares of our common stock at an exercise price of $0.84 per share. Mr. Hoffman
has agreed to be bound by customary confidentiality provisions. In the event
that Mr. Hoffman is terminated without cause, we have agreed to pay his salary
for an additional year from his termination date, provided that he does not
become employed by one of our competitors.
In December 2000, we entered into written employment agreements with Mark
Perry, our former Executive Vice President and Chief Financial Officer, John
McDevitt, our former Executive Vice President, Sales and Marketing, Terry Moya,
our former Executive Vice President, External Affairs and Corporate Development
and Catherine Hemmer, our former Executive Vice President and Chief Operating
Officer. In May 2001, we entered into a similar written employment agreement
with Anjali Joshi, our Executive Vice President, Engineering. These agreements
have a 12-month term, except for Ms. Hemmer's and Mr. Moya's agreement, which
have 18-month terms. If we terminate any of these officers without cause (as
that term is defined in the agreement), or if an officer resigns for good
reason (as that term is defined in the agreement), we must continue to pay
their annual salary through the term of the agreement, plus a pro rated portion
of their bonus. In the event of a change of control (as that term is defined in
the agreement), these employment agreements are null and void.
In connection with their departure from the Company, Jane Marvin, our former
Executive Vice President, Human Resources, Joseph Devich, our former Executive
Vice President, Corporate Services, and Robert Davenport, the former President
and Chief Executive Officer of Covad International, each received six months of
salary continuation in lieu of any benefits under their employment agreement.
Mr. Davenport and Ms. Marvin's
118
salaries were terminated when the Company filed its petition under Chapter 11
of the United States Bankruptcy Code and they have both filed claims for these
amounts in the Company's bankruptcy proceeding. These claims have not been
resolved.
Mark Perry, our former Chief Financial Officer, will have his salary
continued for nine months after his departure and, in exchange for these
payments, Mr. Perry agreed to forego any rights under his employment agreement
and agreed to provide us with consulting services for three months after his
resignation.
In connection with her departure from the Company, Ms. Hemmer will receive a
lump sum payment of $120,000 in lieu of any benefits under her written
employment agreement. We will also forgive the remaining $87,500 that she owes
the Company as a result of a loan that was provided to her. We also extended
the exercise period for a portion of Ms. Hemmer's stock options (until July 31,
2002).
With respect to all options granted under the Company's 1997 Stock Plan, in
the event that the Company merges with or into another corporation resulting in
a change of control involving a shift in 50% or more of the voting power of the
Company's capital stock, or the sale of all or substantially all of the
Company's assets, the options will fully vest and become exercisable one year
after the change of control or earlier in the event the individual is
constructively terminated or terminated without cause or in the event the
successor corporation refuses to assume the options. See "--1997 Stock Plan."
We have also entered into restricted stock purchase agreements with certain
of the Company's officers and directors. The shares of the Company's common
stock issued pursuant to these restricted stock purchase agreements are subject
to the Company's right of repurchase which lapses in accordance with the
vesting schedule of the agreements. The agreements also include similar
provisions to the stock options, providing for accelerated vesting in the event
of a change of control. See "Certain Relationships and Related
Transactions--Issuance of Common Stock."
1997 Stock Plan
Structure
The 1997 Plan consists of three types of equity incentive programs: (i)
qualifying stock options ("Incentive Stock Options") intended to qualify within
the meaning of Section 422 of the Code; (ii) non-qualifying stock options (or
"Non-Statutory Stock Options") not intended to qualify within the meaning of
Section 422 of the Code; and (iii) stock purchase rights ("SPRs") for shares of
common stock.
Administration
The Plan is administered by the Company's Board of Directors or a committee
appointed by the Board of Directors and consisting of non-employee directors
within the meaning of Section 16(b) of the Exchange Act and outside directors
within the meaning of Section 162(m) of the Code (referred to as the
"Administrator"). Subject to the provisions of the Plan, the Administrator has
the authority, in its discretion: (i) to determine the fair market value of the
Company's common stock; (ii) to select the employees, directors or consultants
to whom options and SPRs may be granted under the Plan; (iii) to determine the
number of shares of common stock to be covered by each option and SPR granted
under the Plan; (iv) to approve forms of agreement for use under the Plan; (v)
to determine the terms and conditions of any option or SPR granted under the
Plan such as the exercise price, the time or times when options or SPRs may be
exercised (which may be based on performance criteria), any vesting
acceleration or waiver of forfeiture restrictions; (vi) to reduce the exercise
price of any option or SPR to the then current fair market value; (vii) to
institute an option exchange program; (viii) to construe and interpret the
terms of the Plan and awards granted pursuant to the Plan; (ix) to prescribe,
amend and rescind rules and regulations relating to the Plan; (x) to modify or
amend each option or SPR; (xi) to allow optionees to satisfy withholding tax
obligations by electing to have the Company withhold from the shares to be
issued upon exercise of an option or SPR that number of shares having a fair
market value equal to the amount required to be withheld; (xii) to
119
authorize any person to execute on behalf of the Company any instrument
required to effect the grant of an option or SPR previously granted by the
Administrator; and (xiii) to make all other determinations deemed necessary or
advisable for administering the Plan.
Eligibility
All employees, directors and consultants are eligible to participate in the
1997 Plan. Incentive Stock Options may be granted only to employees (including
officers and directors). Non-Statutory Stock Options and SPRs may be granted to
employees, directors and consultants. To the extent that the aggregate fair
market value of the shares with respect to which Incentive Stock Options are
exercisable for the first time by an optionee during any calendar year (under
all plans of the Company and any parent or subsidiary) exceed $100,000, such
options are treated as Non-Statutory Stock Options. No optionee may be granted,
in any fiscal year, options to purchase more than 4,500,000 shares (subject to
adjustment for future stock splits and dividends); provided that, in connection
with his or her initial service, an optionee may be granted options to purchase
up to an additional 2,000,000 shares that shall not count against such limit.
Securities Subject To The Plan
As of January 1, 2002, the number of shares of the Company's common stock
which are reserved for issuance under the Plan is 59,657,761 shares, plus an
annual increase on the first day of each fiscal year equal to the lesser of (i)
3% of the outstanding shares on such date or (ii) an amount determined by the
Company's Board of Directors, with the total annual increase being capped at
20,000,000 shares. In 2001, the 3% annual increase consisted of 5,308,123
shares plus 10,000,000 additional shares approved at the Company's Annual
Meeting held June 30, 2000 for the Year 2001.
These shares may be authorized, but unissued, or reacquired common stock. If
an option or SPR expires or becomes unexercisable without having been exercised
in full, or is surrendered pursuant to an option exchange program, the
unpurchased shares that were subject thereto may become available for future
grant or sale under the Plan.
Participation In The Plan
As of January 1, 2002, 31,600,330 shares of common stock were subject to
outstanding options and SPRs under the Plan, 49,681,484 options had been issued
under the Plan (net of cancelled options), and we can grant up to 9,976,277
additional options within the Plan's limits.
1998 Employee Stock Purchase Plan
The 1998 Employee Stock Purchase Plan was adopted by the Company's Board of
Directors in December 1998, and approved by the stockholders in January 1999.
As of January 1, 2001, a total of 8,626,749 shares of the Company's common
stock have been reserved for issuance under this plan, plus annual increases
equal to the lesser of (i) 2% of the outstanding shares on such date or (ii) an
amount determined by the Board of Directors. To date, 2,122,821 shares have
been issued under the 1998 Employee Stock Purchase Plan.
The 1998 Employee Stock Purchase Plan, which is intended to qualify under
Section 423 of the Internal Revenue Code of 1986, as amended (the "Code"),
contains consecutive, overlapping, twenty-four month offering periods. Each
offering period includes four six-month purchase periods. The offering periods
generally start on the first trading day on or after May 1 and November 1 of
each year, except for the first offering period which commenced on the first
trading day after the Company's initial public offering (January 22, 1999) and
ends on the last trading day on or before October 31, 2000.
Employees are eligible to participate if they are customarily employed by
the Company or any of the Company's participating subsidiaries for at least 30
hours per week and more than five months in any calendar
120
year. However, no employee may be granted a right to purchase stock under the
1998 Employee Stock Purchase Plan (i) to the extent that, immediately after the
grant of the right to purchase stock, the employee would own stock possessing
5% or more of the total combined voting power or value of all classes of the
Company's capital stock, or (ii) to the extent that his or her rights to
purchase stock under all the Company's employee stock purchase plans accrues at
a rate which exceeds $25,000 worth of stock for each calendar year. The 1998
Employee Stock Purchase Plan permits participants to purchase the Company's
common stock through payroll deductions of up to 12% of the participant's
"compensation." Compensation is defined as the participant's base straight time
gross earnings and commissions but excludes payments for overtime, shift
premium, incentive compensation, incentive payments, bonuses and other
compensation. The maximum number of shares a participant may purchase during a
single purchase period is 5,000 shares.
Amounts deducted and accumulated by the participant are used to purchase
shares of the Company's common stock at the end of each purchase period. The
price of stock purchased under the 1998 Employee Stock Purchase Plan is
generally 85% of the lower of the fair market value of the Company's common
stock (i) at the beginning of the offering period or (ii) at the end of the
purchase period. In the event the fair market value at the end of a purchase
period is less than the fair market value at the beginning of the offering
period, the participants will be withdrawn from the current offering period
following exercise and automatically re-enrolled in a new offering period. The
new offering period will use the lower fair market value as of the first date
of the new offering period to determine the purchase price for future purchase
periods. Participants may end their participation at any time during an
offering period, and they will be paid their payroll deductions to date.
Participation ends automatically upon termination of employment.
Laser Link.Net, Inc. 1997 Stock Plan
On March 20, 2000, pursuant to the Agreement and Plan of Merger dated as of
March 8, 2000, Laser Link.Net, Inc. was acquired in a merger of Lightsaber
Acquisition Co. ("Lightsaber"), the Company's wholly-owned subsidiary, with
Laser Link in which Lightsaber was the surviving entity (the "Merger"). As part
of the Merger, the Company agreed to assume the Laser Link.Net, Inc. 1997 Stock
Option Plan (the "Laser Link Plan") and each outstanding option under the Laser
Link Plan. As a result, the Company will issue shares of the Company's common
stock, subject to adjustment in the number of shares and exercise price of the
original options, upon exercise of outstanding stock options previously issued
under the Laser Link Plan. In the Merger, each share of Laser Link common stock
was converted into .173535 share of the Company's common stock (the "Exchange
Ratio").
Structure. The Laser Link Plan consists of two types of equity incentive
programs: (i) qualifying stock options ("Incentive Stock Options") intended to
qualify within the meaning of Section 422 of the Internal Revenue Code of 1986,
as amended (the "Code") and (ii) non-qualifying stock options (or
"Non-Statutory Stock Options") not intended to qualify within the meaning of
Section 422 of the Code.
Administration. The Laser Link Plan is administered by either the Company's
Board of Directors or an Option Committee consisting of outside directors
appointed by the Board of Directors (the "Administrator"). Subject to the
provisions of the Laser Link Plan, the Administrator has the authority, in its
discretion: (i) to select the employees, directors or consultants to whom
options may be granted under the Laser Link Plan; (ii) to determine the number
of shares of common stock to be covered by each option granted under the Laser
Link Plan; (iii) to determine the time or times at which options may be granted
and whether those options are Incentive Stock Options or Non-Statutory Stock
Options; (iv) to determine the price at which options are exercisable, the rate
of exercisability and the duration of each option; and (v) to prescribe, amend
and rescind rules and regulations relating to the Laser Link Plan.
Eligibility. All key employees, directors and important consultants are
eligible to participate in the Laser Link Plan. However, in view of the Merger,
it is anticipated that no further options will be granted under the Laser Link
Plan.
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Under the Laser Link Plan Incentive Stock Options may be granted only to
employees (including officers and directors who are employees). Non-Statutory
Stock Options may be granted to employees, directors and consultants of the
Company's. No optionholder may be granted options to purchase more than 90% of
the shares authorized for issuance under the Laser Link Plan.
Securities Subject to the Laser Link Plan. As of the date of the Merger,
10,000,000 shares of Laser Link's common stock, par value $0.01, were reserved
for issuance under the Laser Link Plan. After the Merger, based on the Exchange
Ratio, a maximum of 1,735,350 shares of the Company's common stock will be
available for issuance under the Laser Link Plan.
BlueStar Communications Group, Inc. 2000 Stock Incentive Plan
On September 25, 2000, pursuant to the Agreement and Plan of Merger dated as
of June 15, 2000, BlueStar Communications Group, Inc. ("BlueStar") was acquired
in a merger of Covad Acquisition Corp. ("CAC"), the Company's wholly owned
subsidiary, with BlueStar in which CAC was the surviving entity (the "Merger").
As part of the Merger, the Company agreed to assume the BlueStar Communications
Group, Inc. 2000 Stock Incentive Plan (the "BlueStar Plan") and each
outstanding option under the BlueStar Plan.
As a result, the Company will issue shares of the Company's common stock,
subject to adjustment in the number of shares and exercise price of the
original options, upon exercise of outstanding stock options previously issued
under the BlueStar Plan. In the Merger, each share of BlueStar common stock was
converted into .053 share of the Company's common stock (the "Exchange Ratio").
In light of the Exchange Ratio, there are 63,771 shares of the Company's common
stock subject to unexercised options under the BlueStar Plan.
In general, the BlueStar Plan consists of five types of equity incentive
programs: (i) the Discretionary Option Grant Program under which eligible
persons may, at the discretion of the Plan Administrator, be granted options to
purchase shares of common stock; (ii) the Salary Investment Option Grant
Program under which eligible employees may elect to have a portion of their
base salary invested each year in special options; (iii) the Stock Issuance
Program under which eligible persons may, at the discretion of the Plan
Administrator, be issued shares of common stock directly, either through the
immediate purchase of such shares or as a bonus for services rendered the
Company (or any parent or subsidiary); (iv) the Automatic Option Grant Program
under which eligible non-employee Board members shall automatically receive
options at periodic intervals to purchase shares of common stock; and (v) the
Director Fee Option Grant Program under which non-employee Board members may
elect to have all or any portion of their annual retainer fee otherwise payable
in cash applied to a special option grant.
The persons eligible to participate in the Discretionary Option Grant and
Stock Issuance Programs include (i) employees; (ii) non-employee members of the
Board of Directors or the board of directors of any parent or subsidiary; and
(iii) consultants and other independent advisors who provide services to the
Company (or any parent or subsidiary). Only employees who are Section 16
Insiders or other highly compensated individuals participate in the Salary
Investment Option Grant Program. Only non-employee Board members may
participate in the Automatic Option Grant and Director Fee Option Grant
Programs.
No one person participating in the BlueStar Plan may receive options,
separately exercisable stock appreciation rights and direct stock issuances for
more than 53,000 shares of common stock (in the aggregate) per calendar year.
The stock issuable under the BlueStar Plan includes shares of authorized but
unissued or reacquired common stock. The maximum number of shares of common
stock initially reserved for issuance over the term of the BlueStar Plan shall
not exceed 452,541 shares.
As of the date of the Merger, 7,027,077 shares of BlueStar's common stock,
par value $0.01, were reserved for issuance under existing options granted
under the BlueStar Plan. It is anticipated that no further options will be
granted or shares will be issued under the BlueStar Plan. While the BlueStar
Plan provides for automatic share
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increase each year through 2005 based on the outstanding common stock, the
Company does not intend to avail itself of this increased availability since it
anticipates that no further options will be granted under the BlueStar Plan.
Compensation Committee Interlocks and Insider Participation
Mr. Shapero 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. Mr. Shapero is affiliated with Crosspoint Venture Partners L.P., which
was a party along with the Company, to a Series C Preferred Stock and Warrant
Subscription Agreement dated February 23, 1998. Mr. Shapero was a shareholder
of BlueStar Communications, which we acquired in 2000 and was also on
BlueStar's Board of Directors. Mr. Shapero did not participate in Board matters
relating to our purchase of BlueStar. See "--Certain Relationships and Related
Transactions." Mr. McMinn is a member of the Board of Directors of DishnetDSL,
a DSL provider in India, and Certive Corporation. We are a minority investor in
both of these companies.
Limitation on Liability and Indemnification Matters
The Company's Amended and Restated Certificate of Incorporation limits the
liability of the Company's directors to the maximum extent permitted by
Delaware law, and the Company's Bylaws provide that the Company will indemnify
the Company's directors and officers and may indemnify the Company's other
employees and agents to the fullest extent permitted by law. We also entered
into agreements to indemnify the Company's directors and executive officers, in
addition to the indemnification provided for in the Company's Bylaws. The
Company's Board of Directors believes that these provisions and agreements are
necessary to attract and retain qualified directors and executive officers.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information regarding ownership of
the Company's common stock as of March 1, 2002 by:
(i) each Named Executive Officer;
(ii) each of the Company's directors;
(iii) all of the Company's executive officers and directors as a group;
and
(iv) all persons known to the Company to beneficially own 5% or more of
the Company's common stock.
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Share ownership in each case includes shares issuable upon exercise of
outstanding options and warrants that are exercisable within 60 days of March
1, 2002 as described in the footnotes below. Percentage ownership is calculated
pursuant to SEC Rule 13d-3(d)(1). Except as otherwise indicated, the address of
each of the persons in this table, other than the selling stockholders, is as
follows: c/o Covad Communications Group, Inc., 3420 Central Expressway, Santa
Clara, California 95051.
Shares Beneficially Owned
------------------------
Beneficial Owner Number Percentage
- ---------------- ---------- ----------
Charles McMinn(1)................................................... 3,611,809 1.60%
Rich Shapero(2)..................................................... 3,634,251 1.61%
Chuck Haas(3)....................................................... 5,437,114 2.41%
Dhruv Khanna(4)..................................................... 5,448,491 2.41%
Catherine Hemmer(5)................................................. 518,263 *
Robert Hawk(6)...................................................... 437,812 *
Daniel Lynch(7)..................................................... 607,207 *
Frank J. Marshall(8)................................................ 2,365,478 1.05%
Hellene Runtagh(9).................................................. 73,830 *
Larry Irving(10).................................................... 48,247 *
Terry Moya(11)...................................................... 387,665 *
Anjali Joshi (12)................................................... 265,426 *
Charles Hoffman (13)................................................ 520,833 *
All current executive officers and directors as a group (16 persons) 23,600,168 10.44%
- --------
* Represents beneficial ownership of less than 1% of the Company's
outstanding stock.
(1) Includes 668 shares of common stock subject to options exercisable within
60 days of March 1, 2002.
(2) Includes 4,374 shares of common stock subject to options exercisable
within 60 days of March 1, 2002.
(3) Includes 13,750 shares of common stock subject to options exercisable
within 60 days of March 1, 2002.
(4) Includes 15,814 shares of common stock subject to options exercisable
within 60 days of March 1, 2002.
(5) Includes 35,947 shares of common stock subject to options exercisable
within 60 days of March 1, 2002 as well as 15,141 shares of the Company's
common stock beneficially owned by Ms. Hemmer's husband, which may be
attributable to Ms. Hemmer.
(6) Includes 4,583 shares of common stock subject to options exercisable
within 60 days of March 1, 2002.
(7) Includes 4,791 shares of common stock subject to options exercisable
within 60 days of March 1, 2002.
(8) Includes 4,374 shares of common stock subject to options exercisable
within 60 days of March 1, 2002.
(9) Includes 6,666 shares of common stock subject to options exercisable
within 60 days of March 1, 2002.
(10) Includes 5,207 shares of common stock subject to options exercisable
within 60 days of March 1, 2002.
(11) Includes 29,980 shares of common stock subject to options exercisable
within 60 days of March 1, 2002.
(12) Includes 21,093 shares of common stock subject to options exercisable
within 60 days of March 2, 2002.
(13) Includes 104,167 shares of common stock subject to options exercisable
within 60 days of March 2, 2002.
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ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Series C Preferred Stock and Warrant Subscription Agreement
On February 20, 1998, we entered into a Series C Preferred Stock and Warrant
Subscription Agreement (the "Subscription Agreement") with Warburg, Pincus
Ventures, L.P. ("Warburg") & Crosspoint Venture Partners 1996 ("Crosspoint")
and Intel Corporation ("Intel"). Under this agreement, Warburg and Crosspoint
unconditionally agreed to purchase an aggregate of 8,646,214 shares of our
Series C Preferred Stock and warrants to purchase an aggregate of 7,094,250
shares of our Series C Preferred Stock for an aggregate purchase price of $16.0
million at a date that we were to determine but, in any event, not later than
March 11, 1999. We agreed to either call this commitment or complete an
alternate equity financing of at least $16.0 million by March 11, 1999. A
proposed alternate equity financing providing for a price per share greater
than or equal to $1.8511 and including securities that were equal in right
with, or more favorable to us than, our Series C Preferred Stock as set forth
in our Amended and Restated Certificate of Incorporation required unanimous
approval by a majority of our disinterested directors. In consideration of this
commitment, we issued to Warburg and Crosspoint warrants to purchase an
aggregate of 2,541,222 shares of our common stock at a purchase price of
$0.0022 per share. The parties agreed that the stock purchases by AT&T Ventures
and NEXTLINK Communications Inc. (now XO Communications) constituted an
alternate equity financing (see below). As a result, we did not issue and sell
our Series C Preferred Stock to Warburg and Crosspoint. Messrs. Henry Kressel
and Joseph Landy, two of our former directors, are affiliated with Warburg, and
Mr. Shapero, one of our current directors, is affiliated with Crosspoint.
On April 24, 1998, the Subscription Agreement was amended pursuant to an
Assignment and Assumption Agreement to which we were a party along with
Warburg, Crosspoint and Mr. Hawk. By the terms of this agreement, Warburg and
Crosspoint assigned to Mr. Hawk their obligation to purchase 54,022 shares of
our Series C Preferred Stock and 44,338 warrants to purchase Series C Preferred
Stock for an aggregate purchase price of $100,000. On the same date, Mr. Hawk
purchased 54,022 shares of our Series C Preferred Stock at a price per share of
$1.8511. As a result of this amendment, the aggregate obligation of Warburg and
Crosspoint to purchase our Series C Preferred Stock and warrants to purchase
Series C Preferred Stock was reduced from 8,646,214 shares to 8,592,192 shares
and from 7,094,250 shares to 7,049,911 shares, respectively, for an aggregate
purchase price of $15.9 million (reduced from $16.0 million). On the same date,
the Amended and Restated Stockholder Rights Agreement dated March 11, 1998 (the
"Stockholder Rights Agreement") was amended to add Mr. Hawk as a party.
The warrants to purchase our common stock issued upon the signing of the
Subscription Agreement had five-year terms (but had to be exercised prior to
the closing of our initial public offering), had purchase prices of $0.0015 per
share, were immediately exercisable and contained net exercise provisions.
Prior to our initial public offering, Warburg and Crosspoint exercised their
warrants to purchase Series C Preferred Stock for 3,048,907 and 762,364 shares
of our common stock.
On March 11, 1998, we amended the Stockholder Rights Agreement, to extend
the rights held by Warburg, Crosspoint, and Intel to our warrants to purchase
common stock, Series C Preferred Stock and warrants to purchase Series C
Preferred Stock issued or issuable to Warburg, Crosspoint and Intel pursuant to
the Subscription Agreement (see below).
The Intel Stock Purchase
As provided in the Subscription Agreement, Intel purchased 540,216 shares of
our Series C Preferred Stock and warrants to purchase 443,250 shares of our
Series C Preferred Stock for an aggregate purchase price of $1.0 million
concurrently with the issuance of our 1998 notes in March 1998. We did not have
any obligation to issue the warrants to purchase Series C Preferred Stock to
Intel until such time as Warburg and Crosspoint funded their respective
commitments under the Subscription Agreement. The parties agreed that our
initial public offering constituted an alternate equity financing and,
therefore, we did not issue the warrants to purchase
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Series C Preferred Stock to Intel. In connection with its agreement to purchase
such Series C Preferred Stock and warrants to purchase Series C Preferred
Stock, we issued to Intel warrants to purchase an aggregate of 238,167 shares
of our common stock at a purchase price of $0.0015 per share. Prior to our
initial public offering, Intel exercised its warrants for 238,167 shares of our
common stock.
Transactions in Connection with the Formation of the Delaware Holding Company
We were originally incorporated in California as Covad Communications
Company ("Covad California") in October 1996. In July 1997, we were
incorporated in Delaware as part of our strategy to operate through a holding
company structure and to conduct substantially all of our operations through
subsidiaries. To effect the holding company structure, in July 1997 we entered
into an Exchange Agreement with the existing holders of the common stock and
Series A Preferred Stock of Covad California to acquire all of such stock in
exchange for a like number of shares of our common and preferred stock, so that
after giving effect to the exchange Covad California became our wholly-owned
subsidiary. In addition, we entered into an Assumption Agreement pursuant to
which we assumed certain outstanding obligations of Covad California, including
a $500,000 demand note issued to Warburg and certain commitments to issue stock
options to two of our consultants.
In connection with the Exchange Agreement, Mr. McMinn, our Chairman of the
Board of Directors, and two of our current officers, Mr. Khanna and Mr. Haas,
each exchanged 6,750,000 shares of common stock of Covad California, originally
purchased for $.0019 per share, for a like number of our shares of common stock
pursuant to restricted stock purchase agreements. In addition, Mr. Lynch, one
of our directors, exchanged 324,000 shares of common stock of Covad California,
originally purchased for $0.148 per share, for a like number of our shares of
common stock pursuant to a restricted stock purchase agreement. The common
stock issued to Messrs. McMinn, Khanna, Haas and Lynch are generally subject to
vesting over a period of four years. This vesting is subject to acceleration
upon a change of control involving a merger, sale of all or substantially all
our assets or a shift in 50% or more of the voting power of our capital stock.
Our repurchase rights lapse one year after the change of control or earlier in
the event the individual is constructively terminated or terminated without
cause, or in the event the successor corporation refuses to assume the
agreements.
Issuance of Common Stock
On July 15, 1997, we issued 2,531,250 shares of our common stock to Mr. Rex
Cardinale, one of our former officers, for a purchase price of $0.148 per
share. On August 30,1997, we issued 776,250 shares of our common stock to Mr.
Laehy, one of our former officers, for a purchase price of $0.0222 per share.
On October 14, 1997, we issued 324,000 shares of our common stock to Mr.
Marshall, our Chief Executive Officer and one of our directors, for a purchase
price of $0.0222 per share. On April 24, 1998, we issued 216,000 shares of our
common stock to Mr. Hawk, one of our directors, for a purchase price of $0.296
per share. On August 28, 1998, we issued 90,000 shares of our common stock to
Mr. Hawk for a purchase price of $2.555 per share. The shares of our common
stock issued to Messrs. Cardinale, Laehy, Marshall, and Hawk were issued
pursuant to restricted stock purchase agreements which contain vesting and
change of control provisions similar to those contained in the above-described
restricted stock purchase agreements of Messrs. McMinn, Khanna, Haas and Lynch.
Issuance of Series A Preferred Stock
On June 30, 1997 Covad California issued 225,000 shares of Series A
Preferred Stock to each of Messrs. McMinn, Khanna and Haas and 450,000 shares
of Series A Preferred Stock to Mr. Lynch for a purchase price of $0.222 per
share. In July 1997, these shares were exchanged for a like number of our
shares of Series A Preferred Stock pursuant to the Exchange Agreement.
Issuance of Series B Preferred Stock
In July 1997, we sold an aggregate of 25,500,001 shares of our Series B
Preferred Stock, of which 18,000,000 shares were sold to Warburg, 4,500,000
shares were sold to Crosspoint and 3,000,001 shares were
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sold to Intel. The purchase price of our Series B Preferred Stock was $0.333
per share. A portion of the purchase price of the Series B Preferred Stock was
paid by cancellation of a $500,000 demand note issued to Warburg in June 1997.
Messrs. Kressel and Landy, each of whom formerly served as members of our Board
of Directors, are affiliated with Warburg. Mr. Shapero, who currently serves on
our Board of Directors, is affiliated with Crosspoint. On February 12, 1998, we
sold an additional 150,003 shares of Series B Preferred Stock at a purchase
price of $0.666 per share to Mr. Marshall.
The Strategic Investments and Relationships
In January 1999, we received equity investments from AT&T Ventures, NEXTLINK
Communications Inc. (now XO Communications) and Qwest Communications
International, Inc. AT&T Ventures purchased an aggregate of 2,250,874 shares of
our Series C-1 Preferred Stock at $1.8511 per share and an aggregate of
1,736,112 shares of our Series D-1 Preferred Stock at $12.00 per share. These
purchases represent an aggregate investment of $25 million, of which $11
million was invested by AT&T Venture Fund II, LP and $14 million was invested
by two affiliated funds. NEXTLINK Communications Inc. (now XO Communications)
purchased 1,800,699 shares of our Series C-1 Preferred Stock at $1.8511 per
share and 925,926 shares of our Series D-1 Preferred Stock at $12.00 per share,
representing an investment of $20 million. Qwest Communications International,
Inc. purchased 1,350,523 shares of our Series C-1 Preferred Stock at $1.8511
per share and 1,041,667 shares of our Series D-1 Preferred Stock at $12.00 per
share, representing an aggregate investment of $15 million. At the completion
of our initial public offering, our Series C-1 Preferred Stock converted into
our Class B common stock on a one-for-one basis. The Series D-1 Preferred Stock
also converted into our Class B common stock at that time on a one-for-one
basis. These strategic investors have agreed not to transfer any of our Series
C-1 Preferred Stock, Series D-1 Preferred Stock or Class B common stock to any
non-affiliated third party until January 2000. They have also each agreed not
to acquire more than 10% of our voting stock without our consent until January
2002. In addition, until January 2002, they have agreed to vote any voting
securities they hold as recommended by our Board of Directors. Since this time,
all of our Class B common stock has been converted into our common stock.
Concurrently with these strategic equity investments, we entered into
commercial agreements with AT&T Corp., NEXTLINK Communications Inc. (now XO
Communications) and Qwest Communications International, Inc. These agreements
provide for the purchase, marketing and resale of our services at volume
discounts, our purchase of fiber optic transport bandwidth at volume discounts,
collocation of network equipment and development of new DSL services. These
agreements have terms ranging from six months to several years subject to
earlier termination in certain circumstances. We cannot predict the number of
line orders that AT&T Corp., NEXTLINK Communications Inc. (now XO
Communications) or Qwest Communications International, Inc. will generate, if
any, whether line orders will be below our expectations or the expectations of,
AT&T Corp., NEXTLINK Communications Inc. (now XO Communications) or Qwest
Communications International, Inc. or whether AT&T Corp., NEXTLINK
Communications Inc. (now XO Communications) or Qwest Communications
International, Inc. will discontinue selling our services entirely.
On September 11, 2000, we entered into an agreement with SBC Communications,
Inc. in which SBC purchased 9,373,169 shares of our common stock for $150
million. SBC has agreed not to transfer any of our common stock until September
11, 2001, and, after that period, SBC agreed to offer us the first opportunity
to purchase shares that it intends to sell. We are not aware of any sales of
these shares by SBC. SBC also agreed for a period of five years to vote its
shares for the nominees to our Board of Directors either as recommended by the
Board of Directors or in the proportion to the votes cast by our other
shareholders, at SBC's choice. SBC also agreed that it would not acquire any
material number of additional shares of our common stock for a period of five
years without our prior consent.
Concurrently with this equity investment, we entered into the following
other agreements with SBC:
. A commercial agreement in which SBC will provide $600 million in resale
revenue to us over six years starting October 1, 2000, with approximately
$23 million of revenue in the first year and increasing
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revenue commitments each year during the life of the contract. Upon a
change of control as defined in the contract, SBC's aggregate revenue
commitment is reduced to $100 million during an initial period of the
contract, and is terminated after the initial period. This agreement also
provides incentives for SBC to sell business lines provided by us, and we
announced that SBC will begin marketing both symmetric business service
DSL and asymmetric consumer service DSL provided by Covad throughout the
United States.
. A settlement of pending legal matters, our antitrust suit against SBC and
Pacific Bell and our arbitrations against SBC affiliates, Southwestern
Bell and Pacific Bell, including Pacific Bell's claim for alleged past
due service fees. The settlement also resolves of several critical issues
in line sharing disputes in Texas, Kansas, Illinois, Michigan, Ohio,
Wisconsin, Indiana, Connecticut and California, plus key issues in
pending interconnection arbitration in Texas and Kansas.
. An agreement to continue joint OSS development to support SBC's resale of
our products, including the fully automatic loop ordering provisioning
process pioneered by us.
. In region agreements that include continued access to neighborhood
gateways utilized in SBC's recently announced "Project Pronto,"
competitively neutral terms and conditions for spectrum management and
agreements regarding the collocation of equipment in SBC central offices.
On November 13, 2001, we signed a loan agreement and restructured our resale
and marketing agreement with SBC Communications Inc. The new agreements include
four elements: a one-time $75 million prepayment, secured by all of our assets,
that SBC can use toward the purchase of our services during the next 10 years;
a $50 million four-year loan secured by all of our assets; a payment to Covad
of a $10 million restructuring fee in exchange for Covad eliminating SBC's
revenue commitments under the original resale and marketing agreement and the
elimination of a $15 million co-op-marketing fee we owed to SBC, which was
required in the previous resale and marketing agreement. These agreements with
SBC contain customary change of control provisions that would require us to
repay (1) any outstanding principal and interest on the loan; and (2) any
unused portion of the prepayment, if a change of control occurred.
BlueStar Acquisition
On September 25, 2000, we completed our acquisition of BlueStar
Communications Group, Inc. Our current Chairman of the Board of Directors,
Charles McMinn, was a member of BlueStar's Board of Directors and a BlueStar
shareholder when this acquisition occurred, however, he was not a member of our
Board of Directors at that time. Two of our directors, Robert Hawk and Richard
Shapero, were also shareholders of BlueStar when this acquisition took place
and Mr. Shapero was also a member of BlueStar's Board of Directors. Both Mr.
Shapero and Mr. Hawk did not participate in meetings of our Board of Directors
concerning the review and approval of the BlueStar acquisition.
In connection with our acquisition of BlueStar, we agreed to place
approximately 800,000 shares of our common stock in a third-party escrow
account. Up to 5,000,000 additional common shares of our common stock were to
be issued if BlueStar achieved certain specified levels of revenues and
earnings before interest, taxes, depreciation and amortization in 2001.
However, in April 2001, we reached an agreement with the BlueStar stockholders'
representative to resolve this matter, as well as the matters that caused
800,000 of the Company's common shares to be held in escrow as of December 31,
2000, by providing the BlueStar stockholders with 3,250,000 of the 5,000,000
shares, in exchange for a release of all claims against the Company. The
800,000 common shares held in escrow were ultimately returned to the Company
under this agreement. BlueStar's former stockholders received the additional
shares of the Company's common stock during 2001.
Equipment Lease Financing
In 1998, we incurred a total of $865,000 of equipment lease financing
obligations (including principal and interest) through a sale lease-back
transaction with Charter Financial, Inc. ("Charter Financial"). These leases
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were paid in full in 2000 and are no longer outstanding. Warburg, a principal
stockholder of us at the time this transaction was entered into, owns a
majority of the capital stock of Charter Financial. We believe that the terms
of the lease financing with Charter Financial were completed at rates similar
to those available from alternative providers. Our belief that the terms of the
sale lease-back arrangement are similar to those available from alternative
providers is based on the advice of our officers who reviewed at least two
alternative proposals and who reviewed and negotiated the terms of the
arrangement with Charter Financial.
Vendor Relationships
Crosspoint, who was one of our principal stockholders, previously owned
approximately 12% of the capital stock of Diamond Lane, one of our vendors.
Payments to Diamond Lane in 1998 and 1999 totaled approximately $52 million. We
believe that the terms of our transactions with Diamond Lane were completed at
rates similar to those available from alternative vendors. This belief is based
on our management team's experience in obtaining vendors and the fact that we
sought competitive bidders before entering into the relationship with Diamond
Lane. Diamond Lane was acquired by Nokia Communications, which continues to be
a significant supplier of our network equipment.
Frank Marshall, the Vice-Chairman of the Board of Directors and our Interim
Chief Executive Officer from November 2000 to June 2001, is also a director of
NetScreen Technologies, one of our vendors. Payments to NetScreen in 2001
totaled approximately $33 thousand. We believe that the terms of our
transactions with NetScreen were completed at rates similar to those available
from alternative vendors. This belief is based on our management team's
experience in obtaining vendors and the fact that we sought competitive bidders
before entering into the relationship with NetScreen.
Minority Investments
Mr. McMinn is a member of the Board of Directors of DishnetDSL, a DSL
provider in India, and holds options to purchase shares of that company. Mr.
McMinn is also on the Board of Directors and owns shares of Certive
Corporation. We are a minority investor in both of these companies. Our
investments in these companies were made when Mr. McMinn was not on our Board
of Directors.
Registration Rights
Certain holders of our common stock are entitled to registration rights.
Pursuant to the Stockholder Rights Agreement holders of 30,112,927 shares of
common stock and holders of 6,379,177 shares of Class B common stock
(collectively, the "Rights Holders") are entitled to certain rights with
respect to the registration under the Securities Act of the shares of common
stock held by them or issuable upon conversion of the Class B common stock.
Commencing January 2000, the Class B common stock became convertible into
common stock at the election of the holder. As of April 2000, all Class B
common stock had been so converted.
The Rights Holders are entitled to demand, "piggy-back" and S-3 registration
rights, subject to certain limitations and conditions. The number of securities
requested to be included in a registration involving the exercise of demand and
"piggy-back" rights are subject to a pro rata reduction based on the number of
shares of common stock held by each Rights Holder and any other security
holders exercising their respective registration rights to the extent that the
managing underwriter advises that the total number of securities requested to
be included in the underwriting is such as to materially and adversely affect
the success of the offering. The registration rights terminate as to any Rights
Holder at the later of (i) three years after our initial public offering or
(ii) such time as such Rights Holder may sell under Rule 144 in a three month
period all registrable securities then held by such Rights Holder.
Pursuant to the Warrant Registration Rights Agreement dated March 11, 1999,
between us and Bear, Stearns & Co. Inc. and BT Alex. Brown Incorporated (now
part of Deutsche Bank Alex Brown), holders of the warrants that were issued in
connection with our 1998 note offering in March 1998 are entitled to certain
129
registration rights with respect to the shares of common stock issuable upon
exercise of such warrants. The warrant holders are entitled to demand and
"piggy-back" registration rights, subject to certain limitations and
conditions. Like the Rights Holders, the number of securities that a warrant
holder may request to be included in a registration involving an exercise of
its demand or "piggy-back" rights is subject to a pro rata reduction. Such a
reduction will be based upon the number of shares held by each warrant holder
and any other security holders exercising their respective registration rights
to the extent that the managing underwriter advises us that the total number of
securities requested to be included in the underwriting is such as to
materially and adversely affect the success of the offering.
Employment Agreements
In 1998, we entered into a written employment agreement with Robert
Knowling, Jr., the former Chairman of the Board of Directors, President and
Chief Executive Officer, who resigned on November 1, 2000. Mr. Knowling will
continue to receive compensation in the form of a $500,000 annual base salary
for a period of two years and a $250,000 annual bonus for two years, so long as
Mr. Knowling does not become employed by one of our direct competitors. Mr.
Knowling received (i) a signing bonus of $1,500,000, one half of which was paid
when he began working for us, and the remaining half of which was paid once he
worked for us for one full year in July 1999, and (ii) stock options to
purchase 4,725,000 shares of our common stock at an exercise price of $0.45 per
share. Mr. Knowling has agreed to be bound by customary confidentiality
provisions. As provided in the agreement, in August 1998 we loaned Mr. Knowling
$500,000 pursuant to a Note Secured by Deed of Trust that bears no interest
during his employment. The loan has been forgiven in connection with his
resignation. See "Certain Relationships and Related Transactions--Employee
Loans."
In December 2000, we entered into written employment agreements with Mark
Perry, our former Executive Vice President and Chief Financial Officer, John
McDevitt, our former Executive Vice President, Sales and Marketing, Terry Moya,
our former Executive Vice President, External Affairs and Corporate Development
and Catherine Hemmer, our Executive Vice President and Chief Operating Officer.
The agreements with Messrs. Perry, Moya and McDevitt had 12-month terms. Ms.
Hemmer's agreement has an 18-month term. In May 2001, we entered into a similar
written employment agreement with Anjali Joshi, our Executive Vice President,
Engineering. If we terminate any of these officers without cause (as that term
is defined in the agreement), or if an officer resigns for good reason (as that
term is defined in the agreement), we must continue to pay their annual salary
through the term of the agreement, plus a pro rated portion of their bonus. In
the event of a change of control (as that term is defined in the agreement),
these employment agreements are null and void.
In connection with their departure from the Company, Jane Marvin, our former
Executive Vice President, Human Resources, Joseph Devich, our former Executive
Vice President, Corporate Services, and Robert Davenport, the former President
and Chief Executive Officer of Covad International, each received six months of
salary continuation in lieu of any benefits under their employment agreement.
Mr. Davenport and Ms. Marvin's salaries were terminated when the Company filed
its petition under Chapter 11 of the United States Bankruptcy Code and they
have both filed claims for these amounts in the Company's bankruptcy
proceeding. These claims have not been resolved.
Mark Perry, our former Chief Financial Officer, will have his salary
continued for nine months after his departure and, in exchange for these
payments, Mr. Perry agreed to forego any rights under his employment agreement
and agreed to provide us with consulting services for three months after his
resignation.
In connection with her departure from the Company, Ms. Hemmer will receive a
lump sum payment of $120,000 in lieu of any benefits under her written
employment agreement. We will also forgive the remaining $87,500 that she owes
the Company as a result of a loan that was provided to her. We also extended
the exercise period for a portion of Ms. Hemmer's stock options (until July 31,
2002).
We are in discussions with Mr. Moya concerning his departure and its impact
on his employment agreement (See "Part I. Item 3. "Legal Proceedings" for a
more detailed discussion).
130
With respect to all options granted under our 1997 Stock Plan, in the event
that we merge with or into another corporation resulting in a change of control
involving a shift in 50% or more of the voting power of our capital stock, or
the sale of all or substantially all of our assets, the options will fully vest
and become exercisable one year after the change of control or earlier in the
event the individual is constructively terminated or terminated without cause
or in the event the successor corporation refuses to assume the options. See
"--1997 Stock Plan."
We have also entered into restricted stock purchase agreements with certain
of the Company's officers and directors. The shares of our common stock issued
pursuant to these restricted stock purchase agreements are subject to the
Company's right of repurchase which lapses in accordance with the vesting
schedule of the agreements. The agreements also include similar provisions to
the stock options providing for accelerated vesting in the event of a change of
control. See "Certain Relationships and Related Transactions--Issuance of
Common Stock."
Employee Loans
In August 1998, we loaned Robert E. Knowling, Jr., our former Chairman of
the Board, President and Chief Executive Officer, pursuant to his employment
agreement, the principal amount of $500,000 pursuant to a Note Secured by Deed
of Trust, which was secured by Mr. Knowling's primary residence. As of November
1, 2000, the outstanding balance of $250,000 on this note was forgiven in
connection with Mr. Knowling's resignation from his position with the Company.
In August 1998, we loaned Joseph Devich, one of our former officers, the
principal amount of $200,000 pursuant to a Note Secured by Deed of Trust, which
was secured by the primary residence of Mr. Devich. This note had provisions
for forgiveness based upon the continued employment of Mr. Devich and was
subject to acceleration in certain events. No interest was charged on this
note. As of December 4, 2000, the outstanding balance of $100,000 on this note
was forgiven in connection with Mr. Devich's resignation from the Company.
In October 1998, we loaned Catherine Hemmer, our Executive Vice President
and Chief Operating Officer, and her husband, one of the Company's employees,
the principal amount of $600,000 pursuant to a Note Secured By Deed of Trust,
which was secured by the primary residence of the Hemmers. The outstanding
principal balance of this note becomes due in four equal annual installments
commencing August 10, 1999, with the last installment due on August 10, 2002.
No interest is charged on the note. This note has provisions for forgiveness
based upon continued employment of each of the Hemmers and is subject to
acceleration in certain events. The balance of this note of $93,750 was
forgiven in connection with Mr. And Ms. Hemmer's departures in March 2002.
In April 2000, we loaned Jane Marvin, one of our resigning officers, the
principal amount of $500,000 for the purchase of a primary residence. The loan
is secured by such primary residence. The remaining balance on the loan was due
within 120 days of Ms. Marvin's resignation. In addition, in December 1999, we
loaned Ms. Marvin $80,705 pursuant to a note secured by a pledge of shares of
our common stock. The entire principal balance of this note becomes due and
payable in one lump sum on the earlier to occur of December 2004 or the sale of
the pledged shares. Interest is payable on the note at a rate of 5.89% per
annum, compounded semiannually.
In May 1999, we loaned Robert Davenport, one of our resigning officers, the
principal amount of $600,000 for the purchase of a primary residence. The loan
is secured by such primary residence. No interest is charged on the note. The
remaining balance on this loan of $300,000 must be paid in full over the next
three years.
In August 2000, we loaned John McDevitt, one of our officers, the principal
amount of $100,000 pursuant to a note. The entire principal balance of the note
became due and payable in one lump sum in August 2001. Interest is payable on
the note at a rate of 6.60% per annum, compounded semiannually. In addition, in
January
131
2001, we loaned Mr. McDevitt $500,000 for the purchase of a primary residence.
The loan is secured by such primary residence. The principal balance of the
loan is due and payable in four equal annual installments beginning at the
first year anniversary of the commencement of Mr. McDevitt's employment. No
interest was charged on this loan. The outstanding balance of this note of
$500,000 was forgiven in accordance with its terms when Mr. McDevitt's
employment ended.
In October 2000, we loaned Terry Moya, one of our former officers, the
principal amount of $35,000 pursuant to a note secured by a pledge of shares of
our common stock. The entire principal balance of this note becomes due and
payable on the earlier to occur of October 2005 or the sale of the pledged
shares. Interest is payable at a rate of 6.60% per annum, compounded
semiannually. During 2001, this note became a non-recourse note when the market
price for our stock dropped below $0.50. We are in discussions with Mr. Moya
concerning his departure and its impact on this note (See "Part I. Item 3.
Legal Proceedings" for a more detailed disussion).
132
COVAD COMMUNICATIONS GROUP, INC.
GLOSSARY OF TERMS
Access Line--A circuit that connects a telephone end-user to the ILEC
Central Office.
Analog Modem--A telecommunications device that allows the communication of
digital information over analog telephone lines and through the public switched
telephone network by translating such information in a way that simulates and
uses only the bandwidth of normal voice transmissions.
Asynchronous Transfer Mode (ATM)--A standard packet-switching protocol that
segments digital information into 53-byte cells (each cell has a 5-byte
standard packet-switching header and 48 bytes of data) that are switched very
quickly throughout a network over virtual circuits. ATM is able to accommodate
multiple types of media (voice, video and data).
Bandwidth--Refers to the maximum amount of data that can be transferred
through a computer's backplane or communications channel in a given time. It is
usually measured in Hertz for analog communications and bits per second for
digital communication.
Central Office--ILEC facility where traditional telephone lines are
connected to a local loop and where our subscriber lines are joined to
switching equipment and connected to our network.
CLEC (Competitive Local Exchange Carrier)--Category of telephone service
provider (carrier) that offers services similar to those of the ILEC, as
allowed by recent changes in telecommunications law and regulation. A CLEC may
also provide other types of services such as long distance, Internet access and
entertainment.
Communications Act Of 1934--The federal legislation governing broadcast and
non-broadcast communications, including both wireless and wired telephone
service, and which established the FCC.
DSL (Digital Subscriber Line)--A technology which enables high-speed
transmission of digital data over traditional copper telephone lines.
FCC (Federal Communications Commission)--The U.S. government agency charged
with the oversight of communications originating in the United States and
crossing state lines.
Frame-Relay--A high-speed packet-switched data communications protocol used
across the interface between user devices (such as hosts and routers) and
network equipment (such as switching nodes).
HFC (Hybrid Fiber Coax)--A combination of fiber optic and coaxial cable,
which has become the primary architecture utilized by cable operators in recent
and ongoing upgrades of their systems. An HFC architecture generally utilizes
fiber optic wire between the head-end and the nodes and coaxial wire from nodes
to individual end-users.
ILEC (Incumbent Local Exchange Carrier)--The local exchange carrier that was
the monopoly carrier in a region, prior to the opening of local exchange
services to competition.
ILEC Collocation--A location serving as the interface point for a CLEC
network's interconnection to that of the ILEC. Collocation can be (i) physical,
in which the CLEC places and directly maintains equipment in the ILEC Central
Office, or (ii) virtual, in which the CLEC leases a facility, similar to that
which it might build, to effect a presence in the ILEC Central Office.
Interconnection (Co-Carrier) Agreement--A contract between an ILEC and a
CLEC for the interconnection of the two networks and CLEC access to ILEC UNEs.
These agreements set out the financial and operational aspects of such
interconnection and access.
133
ISP (Internet Service Provider)--A vendor that provides subscribers access
to the Internet.
ISDN (Integrated Services Digital Network)--ISDN provides standard
interfaces for digital communication networks and is capable of carrying data,
voice, and video over digital circuits. ISDN protocols are used worldwide for
connections to public ISDN networks or to attach ISDN devices to ISDN-capable
Private Branch Exchange systems (ISPBXs). Developed by the International
Telecommunications Union, ISDN includes two user-to-network interfaces: basic
rate interface (BRI) and primary rate interface (PRI). An ISDN interface
contains one signaling channel (D-channel) and a number of information channels
("bearer" or B channels). The D-channel is used for call setup, control, and
call clearing on the B-channels. It also transports feature information while
calls are in progress. The B-channels carry the voice, data, or video
information.
IXC (Interexchange Carrier)--Facilities-based long distance/interLATA
carriers (e.g., AT&T, MCI WorldCom and Sprint), who also provide intraLATA toll
service and may operate as CLECs.
KBPS (Kilobits Per Second)--One thousand bits per second.
LATA (Local Access And Transport Area)--A geographic area inside of which a
local telephone company can offer switched telecommunications services,
including long distance (known as toll). There are 196 LATAs in the United
States.
MBPS (Megabits Per Second)--One million bits per second.
RBOCS (Regional Bell Operating Companies)--ILECs created by AT&T's
divestiture of its local exchange business. The remaining RBOCs include
BellSouth, Verizon Communications, Qwest Communications, Inc. and SBC
Communications, Inc.
T1--This is a Bell system term for a digital transmission link with a
capacity of 1.544 Mbps.
UNES (Unbundled Network Elements)--The various portions of an ILEC's network
that a CLEC can lease for purposes of building a facilities-based competitive
network, including copper lines, Central Office collocation space, inter-office
transport, operational support systems, local switching and rights of way.
134
PART IV
ITEM 14. FINANCIAL STATEMENT SCHEDULES, REPORTS ON FORM 8-K AND EXHIBITS
(a) The following documents are filed as part of this Form 10-K:
(1) Financial Statements. The following Financial Statements of Covad
Communications Group, Inc. and Report of Independent Auditors are filed as
part of this report.
Report of Ernst & Young LLP, Independent Auditors
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders' Equity (Deficit)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules. Financial statement schedules not
filed herein are omitted because of the absence of conditions under which
they are required or because the information called for is shown in the
consolidated financial statements and notes thereto.
(3) Exhibits. The Exhibits listed below and on the accompanying Index to
Exhibits immediately following the signature page hereto are filed as part
of, or incorporated by reference into, this Report on Form 10-K.
EXHIBIT INDEX
Exhibit
Number Description
- ------ -----------
2.1(14) Plan: First Amended Plan of Reorganization, as Modified, of Covad Communications Group, Inc.
dated November 26, 2001.
2.2(15) Order Pursuant to (S) 1129 of the Bankruptcy Code Confirming the Debtor's First Amended Chapter
11 Plan of Reorganization, as Modified (Docket No. 214).
2.3(3) Agreement and Plan of Merger Among Covad Communications Group, Inc., LightSaber
Acquisition Co. and Laser Link.Net, Inc., dated as of March 8, 2000.
2.4(8) Agreement and Plan of Merger and Registration among Covad Communications Group, Inc., Covad
Acquisition Corp. and BlueStar Communications Group, Inc., dated as of June 15, 2000.
2.5(10) Acquisition Agreement, dated as of September 8, 2000, among Covad Communications Group,
Inc., Greenway Holdings Ltd., Loop Holdings Europe APS, Loop Telecom, S.A. and the
shareholders of Loop Telecom, S.A.
2.6(16) Shareholders' Agreement, dated as of September 12, 2000, among Loop Holdings Europe APS,
Loop Telecom, S.A., Covad Communications Group, Inc. and the other shareholders of Loop
Telecom, S.A.
3.1(12) Amended and Restated Certificate of Incorporation.
3.2(17) Certificate of Amendment of Certificate of Incorporation of the Registrant filed on July 14, 2000.
3.3 Certificate of Amendment of Certificate of Incorporation of the Registrant filed on December 20,
2001.
3.4(18) Bylaws, as currently in effect.
4.1(1) Indenture dated as of March 11, 1998 between the Registrant and The Bank of New York.
4.4(1) Warrant Registration Rights Agreement dated as of March 11, 1998 among the Registrant and Bear,
Stearns & Co., Inc. and BT Alex. Brown Incorporated.
135
Exhibit
Number Description
------ -----------
4.5(1) Specimen 131/2% Senior Note Due 2008.
4.6(1) Amended and Restated Stockholders Rights Agreement dated January 19, 1999 among the
Registrant and certain of its stockholders.
4.7(2) Indenture dated as of February 18, 1999 among the Registrant and The Bank of New York.
4.8(2) Registration Rights Agreement dated as of February 18, 1999 among the Registrant and the Initial
Purchasers.
4.9(2) Specimen 121/2% Senior Note Due 2009.
4.10(7) Indenture dated as of January 28, 2000, between the Registrant and United States Trust Company
of New York.
4.11(7) Registration Rights Agreement dated as of January 28, 2000, between the Registrant and Bear,
Stearns & Co., Inc.
4.12(7) Specimen 12% Senior Note Due 2010.
4.13(4) Stockholder Protection Rights Agreement dated February 15, 2000.
4.14(13) Amended and Restated Stockholder Protection Rights Agreement, dated as of November 1,
2001Stock Restriction Agreement among Covad Communications and certain stockholders of
BlueStar.
4.16(9) Indenture, dated as of September 25, 2000, between the Company and United States Trust
Company of New York.
4.17(9) Specimen 6% Convertible Senior Note.
10.1(2) Form of Indemnification Agreement entered into between the Registrant and each of the
Registrant's executive officers and directors.
10.2 1998 Employee Stock Purchase Plan and related agreements, as currently in effect.
10.3 1997 Stock Plan and related option agreement, as currently in effect.
10.5(2) Series C Preferred Stock and Warrant Subscription Agreement dated as of February 20, 1998
among the Registrant, Warburg, Pincus Ventures, L.P., Crosspoint Venture Partners 1996 and
Intel Corporation, as amended by the Assignment and Assumption Agreement and First
Amendment to the Series C Preferred Stock and Warrant Subscription Agreement dated as of
April 24, 1998 among the Registrant, Warburg, Crosspoint and Robert Hawk.
10.10(2) Form of Warrant to purchase Common Stock issued by the Registrant on February 20, 1998 to
Warburg, Pincus Ventures, L.P., Crosspoint Ventures Partners 1996 and Intel Corporation.
10.13(5) Series C-1 Preferred Stock Purchase Agreement dated as of December 30, 1998 among the
Registrant, AT&T Venture Fund II, LP and two affiliated funds.
10.14(5) Series D-1 Preferred Stock Purchase Agreement dated as of December 30, 1998 among the
Registrant, AT&T Venture Fund II, LP and two affiliated funds.
10.15(5) Series C-1 Preferred Stock Purchase Agreement dated as of December 30, 1998 between the
Registrant and NEXTLINK Communications, Inc.
10.16(5) Series D-1 Preferred Stock Purchase Agreement dated as of December 30, 1998 between the
Registrant and NEXTLINK Communications, Inc.
10.17(5) Series C-1 Preferred Stock Purchase Agreement dated as of January 19, 1998 between the
Registrant and U.S. Telesource, Inc.
10.18(5) Series D-1 Preferred Stock Purchase Agreement dated as of January 19, 1998 between the
Registrant and U.S. Telesource, Inc.
136
Exhibit
Number Description
------ -----------
10.21(9) Resale Registration Rights Agreement, among the Company, Bear, Stearns & Co., Inc., Morgan
Stanley & Co. Incorporated, Credit Suisse First Boston Corporation, Deutsche Bank Securities,
Inc. and Goldman, Sachs & Co.
10.22(11) Stock Purchase Agreement between SBC Communications Inc. and Covad Communications
Group, Inc., dated September 10, 2000.
10.23(11) Resale and Marketing Agreement between SBC Communications Inc. and Covad
Communications Group, Inc., dated September 10, 2000.
10.24(19) Credit Agreement dated as of November 12, 2001 by and between Covad Communications Group,
Inc. and SBC Communications Inc.
10.25(20) Resale Agreement dated as of November 12, 2001 by and among SBC Communications Inc.,
Covad Communications Group, Inc., Covad Communications Company, DIECA
Communications Company and Laser Link.net, Inc.
10.26(21) Term Loan Note dated December 20, 2001 made by Covad Communications Group, Inc. in favor
of SBC Communications Inc.
10.27(22) Deed of Trust, Assignment of Leases and Rents, Security Agreement and Financing Statement
dated effective as of December 20, 2001 made by DIECA Communications, Inc. in favor of
Title Associates of Virginia, Inc., for the benefit of SBC Communications Inc.
10.28(23) Pledge Agreement dated as of December 20, 2001 made by Covad Communications Group, Inc. to
SBC Communications Inc.
10.29(24) Pledge Agreement dated as of December 20, 2001 made by Covad Communications Group, Inc. to
SBC Communications Inc.
10.30(25) Security Agreement dated as of December 20, 2001 made by Covad Communications Company in
favor of SBC Communications Inc.
10.31(26) Intellectual Property Security Agreement dated as of December 20, 2001 made by Covad
Communications Company in favor of SBC Communications Inc.
10.32(27) Subsidiary Guaranty dated as of December 20, 2001 made by Covad Communications Company
in favor of and for the benefit of SBC Communications Inc.
10.33(28) Capital Markets Debt Subordination Provisions.
10.34(29) General Unsecured Debt Subordination Agreement.
10.35(8) Stockholders Agreement among Covad Communications and certain stockholders of BlueStar.
21.1(30) Subsidiaries of the Registrant.
23.1 Consent of Ernst & Young LLP, Independent Auditors.
24.1 Power of Attorney (incorporated in the signature page herein).
- --------
(1) Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-4 (No. 333-51097) as originally
filed on April 27, 1998 and as subsequently amended.
(2) Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-4 (No. 333-75955) as originally
filed on April 4, 1999 and as subsequently amended.
(3) Incorporated by reference to Exhibit 2.1 filed with our current report on
Form 8-K as originally filed on March 23, 2000 and as subsequently amended.
(4) Incorporated by reference to Exhibit 4.1 filed with our current report on
Form 8-A as originally filed on February 22, 2000 and as subsequently
amended.
(5) Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-1 (File No. 333-63899) as
originally filed on September 21, 1998 and as subsequently amended.
137
(6) Intentionally deleted.
(7) Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-4 (No. 333-30360) as originally
filed on February 14, 2000 and as subsequently amended.
(8) Incorporated by reference to Exhibit 2.2 filed with our registration
statement on Form S-4 (No. 333-43494) as originally filed on August 10,
2000 and as subsequently amended.
(9) Incorporated by reference to exhibit of corresponding number filed with
our current report on Form 8-K as originally filed on September 27, 2000
and as subsequently amended.
(10) Incorporated by reference to Exhibit 2.3 filed with our current report on
Form 8-K as originally filed on September 27, 2000 and as subsequently
amended.
(11) Incorporated by reference to the exhibit of corresponding number filed
with our current report on Form 8-K as originally filed on September 12,
2000 and as subsequently amended.
(12) Incorporated by reference to Exhibit 3.2 filed with our registration
statement on Form S-1/A (No. 333-38688) as originally filed on July 17,
2000 and as subsequently amended.
(13) Incorporated by reference to Exhibit 4.1 filed with our current report on
Form 8-K as originally filed on December 14, 2001.
(14) Incorporated by reference to the exhibit of corresponding number filed
with our current report on Form 8-K as originally filed on December 28,
2001.
(15) Incorporated by reference to Exhibit 99.12 filed with our current report
on Form 8-K as originally filed on December 28, 2001.
(16) Incorporated by reference to Exhibit 2.4 filed with our current report on
Form 8-K as originally filed on September 27, 2000 and as subsequently
amended.
(17) Incorporated by reference to Exhibit 3.5 filed with our current report on
Form 8-K as originally filed on July 17, 2000 and as subsequently amended.
(18) Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-1/A (No. 333-38688) as
originally filed on July 17, 2000 and as subsequently amended.
(19) Incorporated by reference to Exhibit 99.1 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(20) Incorporated by reference to Exhibit 99.2 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(21) Incorporated by reference to Exhibit 99.3 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(22) Incorporated by reference to Exhibit 99.4 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(23) Incorporated by reference to Exhibit 99.5 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(24) Incorporated by reference to Exhibit 99.6 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(25) Incorporated by reference to Exhibit 99.7 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(26) Incorporated by reference to Exhibit 99.8 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(27) Incorporated by reference to Exhibit 99.9 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(28) Incorporated by reference to Exhibit 99.10 filed with our current report
on Form 8-K as originally filed on December 28, 2001.
(29) Incorporated by reference to Exhibit 99.11 filed with our current report
on Form 8-K as originally filed on December 28, 2001.
(30) Incorporated by reference to the exhibit of corresponding number filed
with our report on 10-K as filed on May 24, 2001
138
(b) Reports on Form 8-K
The following items were reported on Form 8-K by the Company during the
fiscal quarter ended December 31, 2001.
The Company filed a Current Report on Form 8-K on November 9, 2001,
attaching its Disclosure Statement in Support of First Amended Plan of
Reorganization (including all exhibits thereto).
The Company filed a Current Report on Form 8-K on December 14, 2001,
attaching its Amended and Restated Stockholder Protection Rights Agreement with
Mellon Investor Services LLC.
The Company filed a Current Report on Form 8-K on December 28, 2001,
announcing the confirmation of its First Amended Plan of Reorganization, as
Modified, and the consummation of its agreements with SBC Communications Inc.
139
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
COVAD COMMUNICATIONS GROUP, INC.
By: /s/ MARK RICHMAN
------------------------------
Mark Richman
Senior Vice President and
Chief Financial Officer
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Charles E. Hoffman and/or Mark A. Richman and
either of them, jointly and severally, his attorneys-in-fact, each with full
power of substitution, for him in any and all capacities, to sign any and all
amendments to this Report on Form 10-K, and to file the same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each of said
attorneys-in-fact, or his substitute or substitutes, may do or cause to be done
by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant on March 28, 2002 in the capacities indicated.
Signature Title
--------- -----
/s/ CHARLES E. HOFFMAN Chief Executive Officer and
- ----------------------------- Director
(Charles E. Hoffman) (Principal Executive
Officer)
/s/ MARK RICHMAN Senior Vice President and
- ----------------------------- Chief Financial Officer
(Mark Richman) (Principal Financial and
Accounting Officer)
/s/ CHARLES MCMINN Chairman of the Board of
- ----------------------------- Directors
(Charles McMinn)
/s/ FRANK MARSHALL Vice-Chairman of the Board of
- ----------------------------- Directors
(Frank Marshall)
/s/ ROBERT HAWK Director
- -----------------------------
(Robert Hawk)
/s/ HELLENE RUNTAGH Director
- -----------------------------
(Hellene Runtagh)
/s/ LARRY IRVING Director
- -----------------------------
(Larry Irving)
/s/ DANIEL LYNCH Director
- -----------------------------
(Daniel Lynch)
/s/ RICH SHAPERO Director
- -----------------------------
(Rich Shapero)
140
EXHIBIT INDEX
Exhibit
Number Description
------ -----------
2.1(14) Plan: First Amended Plan of Reorganization, as Modified, of Covad Communications Group, Inc.
dated November 26, 2001.
2.2(15) Order Pursuant to (S) 1129 of the Bankruptcy Code Confirming the Debtor's First Amended
Chapter 11 Plan of Reorganization, as Modified (Docket No. 214).
2.3(3) Agreement and Plan of Merger Among Covad Communications Group, Inc., LightSaber
Acquisition Co. and Laser Link.Net, Inc., dated as of March 8, 2000.
2.4(8) Agreement and Plan of Merger and Registration among Covad Communications Group, Inc.,
Covad Acquisition Corp. and BlueStar Communications Group, Inc., dated as of June 15, 2000.
2.5(10) Acquisition Agreement, dated as of September 8, 2000, among Covad Communications Group,
Inc., Greenway Holdings Ltd., Loop Holdings Europe APS, Loop Telecom, S.A. and the
shareholders of Loop Telecom, S.A.
2.6(16) Shareholders' Agreement, dated as of September 12, 2000, among Loop Holdings Europe APS,
Loop Telecom, S.A., Covad Communications Group, Inc. and the other shareholders of Loop
Telecom, S.A.
3.1(12) Amended and Restated Certificate of Incorporation.
3.2(17) Certificate of Amendment of Certificate of Incorporation of the Registrant filed on July 14, 2000.
3.3 Certificate of Amendment of Certificate of Incorporation of the Registrant filed on December 20,
2001.
3.4(18) Bylaws, as currently in effect.
4.1(1) Indenture dated as of March 11, 1998 between the Registrant and The Bank of New York.
4.4(1) Warrant Registration Rights Agreement dated as of March 11, 1998 among the Registrant and
Bear, Stearns & Co., Inc. and BT Alex. Brown Incorporated.
4.5(1) Specimen 131/2% Senior Note Due 2008.
4.6(1) Amended and Restated Stockholders Rights Agreement dated January 19, 1999 among the
Registrant and certain of its stockholders.
4.7(2) Indenture dated as of February 18, 1999 among the Registrant and The Bank of New York.
4.8(2) Registration Rights Agreement dated as of February 18, 1999 among the Registrant and the Initial
Purchasers.
4.9(2) Specimen 121/2% Senior Note Due 2009.
4.10(7) Indenture dated as of January 28, 2000, between the Registrant and United States Trust Company
of New York.
4.11(7) Registration Rights Agreement dated as of January 28, 2000, between the Registrant and Bear,
Stearns & Co., Inc.
4.12(7) Specimen 12% Senior Note Due 2010.
4.13(4) Stockholder Protection Rights Agreement dated February 15, 2000.
4.14(13) Amended and Restated Stockholder Protection Rights Agreement, dated as of November 1,
2001Stock Restriction Agreement among Covad Communications and certain stockholders of
BlueStar.
4.16(9) Indenture, dated as of September 25, 2000, between the Company and United States Trust
Company of New York.
4.17(9) Specimen 6% Convertible Senior Note.
1
Exhibit
Number Description
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10.1(2) Form of Indemnification Agreement entered into between the Registrant and each of the
Registrant's executive officers and directors.
10.2 1998 Employee Stock Purchase Plan and related agreements, as currently in effect.
10.3 1997 Stock Plan and related option agreement, as currently in effect.
10.5(2) Series C Preferred Stock and Warrant Subscription Agreement dated as of February 20, 1998
among the Registrant, Warburg, Pincus Ventures, L.P., Crosspoint Venture Partners 1996 and
Intel Corporation, as amended by the Assignment and Assumption Agreement and First
Amendment to the Series C Preferred Stock and Warrant Subscription Agreement dated as of
April 24, 1998 among the Registrant, Warburg, Crosspoint and Robert Hawk.
10.10(2) Form of Warrant to purchase Common Stock issued by the Registrant on February 20, 1998 to
Warburg, Pincus Ventures, L.P., Crosspoint Ventures Partners 1996 and Intel Corporation.
10.13(5) Series C-1 Preferred Stock Purchase Agreement dated as of December 30, 1998 among the
Registrant, AT&T Venture Fund II, LP and two affiliated funds.
10.14(5) Series D-1 Preferred Stock Purchase Agreement dated as of December 30, 1998 among the
Registrant, AT&T Venture Fund II, LP and two affiliated funds.
10.15(5) Series C-1 Preferred Stock Purchase Agreement dated as of December 30, 1998 between the
Registrant and NEXTLINK Communications, Inc.
10.16(5) Series D-1 Preferred Stock Purchase Agreement dated as of December 30, 1998 between the
Registrant and NEXTLINK Communications, Inc.
10.17(5) Series C-1 Preferred Stock Purchase Agreement dated as of January 19, 1998 between the
Registrant and U.S. Telesource, Inc.
10.18(5) Series D-1 Preferred Stock Purchase Agreement dated as of January 19, 1998 between the
Registrant and U.S. Telesource, Inc.
10.21(9) Resale Registration Rights Agreement, among the Company, Bear, Stearns & Co., Inc., Morgan
Stanley & Co. Incorporated, Credit Suisse First Boston Corporation, Deutsche Bank Securities,
Inc. and Goldman, Sachs & Co.
10.22(11) Stock Purchase Agreement between SBC Communications Inc. and Covad Communications
Group, Inc., dated September 10, 2000.
10.23(11) Resale and Marketing Agreement between SBC Communications Inc. and Covad
Communications Group, Inc., dated September 10, 2000.
10.24(19) Credit Agreement dated as of November 12, 2001 by and between Covad Communications Group,
Inc. and SBC Communications Inc.
10.25(20) Resale Agreement dated as of November 12, 2001 by and among SBC Communications Inc.,
Covad Communications Group, Inc., Covad Communications Company, DIECA
Communications Company and Laser Link.net, Inc.
10.26(21) Term Loan Note dated December 20, 2001 made by Covad Communications Group, Inc. in favor
of SBC Communications Inc.
10.27(22) Deed of Trust, Assignment of Leases and Rents, Security Agreement and Financing Statement
dated effective as of December 20, 2001 made by DIECA Communications, Inc. in favor of
Title Associates of Virginia, Inc., for the benefit of SBC Communications Inc.
10.28(23) Pledge Agreement dated as of December 20, 2001 made by Covad Communications Group, Inc. to
SBC Communications Inc.
10.29(24) Pledge Agreement dated as of December 20, 2001 made by Covad Communications Group, Inc. to
SBC Communications Inc.
2
Exhibit
Number Description
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10.30(25) Security Agreement dated as of December 20, 2001 made by Covad Communications Company in
favor of SBC Communications Inc.
10.31(26) Intellectual Property Security Agreement dated as of December 20, 2001 made by Covad
Communications Company in favor of SBC Communications Inc.
10.32(27) Subsidiary Guaranty dated as of December 20, 2001 made by Covad Communications Company
in favor of and for the benefit of SBC Communications Inc.
10.33(28) Capital Markets Debt Subordination Provisions.
10.34(29) General Unsecured Debt Subordination Agreement.
10.35(8) Stockholders Agreement among Covad Communications and certain stockholders of BlueStar.
21.1(30) Subsidiaries of the Registrant.
23.1 Consent of Ernst & Young LLP, Independent Auditors.
24.1 Power of Attorney (incorporated in the signature page herein).
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(1) Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-4 (No. 333-51097) as originally
filed on April 27, 1998 and as subsequently amended.
(2) Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-4 (No. 333-75955) as originally
filed on April 4, 1999 and as subsequently amended.
(3) Incorporated by reference to Exhibit 2.1 filed with our current report on
Form 8-K as originally filed on March 23, 2000 and as subsequently amended.
(4) Incorporated by reference to Exhibit 4.1 filed with our current report on
Form 8-A as originally filed on February 22, 2000 and as subsequently
amended.
(5) Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-1 (File No. 333-63899) as
originally filed on September 21, 1998 and as subsequently amended.
(6) Intentionally deleted.
(7) Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-4 (No. 333-30360) as originally
filed on February 14, 2000 and as subsequently amended.
(8) Incorporated by reference to Exhibit 2.2 filed with our registration
statement on Form S-4 (No. 333-43494) as originally filed on August 10,
2000 and as subsequently amended.
(9) Incorporated by reference to exhibit of corresponding number filed with
our current report on Form 8-K as originally filed on September 27, 2000
and as subsequently amended.
(10) Incorporated by reference to Exhibit 2.3 filed with our current report on
Form 8-K as originally filed on September 27, 2000 and as subsequently
amended.
(11) Incorporated by reference to the exhibit of corresponding number filed
with our current report on Form 8-K as originally filed on September 12,
2000 and as subsequently amended.
(12) Incorporated by reference to Exhibit 3.2 filed with our registration
statement on Form S-1/A (No. 333-38688) as originally filed on July 17,
2000 and as subsequently amended.
(13) Incorporated by reference to Exhibit 4.1 filed with our current report on
Form 8-K as originally filed on December 14, 2001.
(14) Incorporated by reference to the exhibit of corresponding number filed
with our current report on Form 8-K as originally filed on December 28,
2001.
(15) Incorporated by reference to Exhibit 99.12 filed with our current report
on Form 8-K as originally filed on December 28, 2001.
(16) Incorporated by reference to Exhibit 2.4 filed with our current report on
Form 8-K as originally filed on September 27, 2000 and as subsequently
amended.
(17) Incorporated by reference to Exhibit 3.5 filed with our current report on
Form 8-K as originally filed on July 17, 2000 and as subsequently amended.
3
(18) Incorporated by reference to the exhibit of corresponding number filed
with our registration statement on Form S-1/A (No. 333-38688) as
originally filed on July 17, 2000 and as subsequently amended.
(19) Incorporated by reference to Exhibit 99.1 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(20) Incorporated by reference to Exhibit 99.2 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(21) Incorporated by reference to Exhibit 99.3 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(22) Incorporated by reference to Exhibit 99.4 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(23) Incorporated by reference to Exhibit 99.5 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(24) Incorporated by reference to Exhibit 99.6 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(25) Incorporated by reference to Exhibit 99.7 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(26) Incorporated by reference to Exhibit 99.8 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(27) Incorporated by reference to Exhibit 99.9 filed with our current report on
Form 8-K as originally filed on December 28, 2001.
(28) Incorporated by reference to Exhibit 99.10 filed with our current report
on Form 8-K as originally filed on December 28, 2001.
(29) Incorporated by reference to Exhibit 99.11 filed with our current report
on Form 8-K as originally filed on December 28, 2001.
(30) Incorporated by reference to the exhibit of corresponding number filed
with our report on 10-K as filed on May 24, 2001
4