<PAGE>
================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934.
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998.
Commission file number: 333-51097
COVAD COMMUNICATIONS GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0461529
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
2330 CENTRAL EXPRESSWAY
SANTA CLARA, CALIFORNIA 95050
(Address of principal executive
offices) (Zip Code)
(408) 844-7500
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
---- ----
As of September 1, 1998, 11,568,142 shares of the Registrants Common Stock,
$0.001 par value, were issued and outstanding.
================================================================================
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
INDEX
<TABLE>
<CAPTION>
Page No.
--------
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements (Unaudited)
Consolidated Balance Sheets as of December 31, 1997 and June 30, 1998.............................. 3
Consolidated Statements of Operations for the Three and Six Months Ended June 30, 1997 and 1998.... 4
Consolidated Statements of Cash Flows for the Six Months Ended June 30, 1997 and 1998.............. 5
Notes to Consolidated Financial Statements......................................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.............. 11
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.................................................................................. 16
Item 2. Changes in Securities.............................................................................. 16
Item 3. Defaults Upon Senior Securities.................................................................... 16
Item 4. Submission of Matters to a Vote of Securities Holders.............................................. 17
Item 5. Other Information.................................................................................. 17
Item 6. Exhibits and Reports on Form 8-K................................................................... 17
SIGNATURES................................................................................................... 18
INDEX TO EXHIBITS............................................................................................ 19
FINANCIAL DATA SCHEDULE...................................................................................... 20
</TABLE>
2
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN 000'S, EXCEPT SHARE AND PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
DECEMBER 31, JUNE 30,
1997 1998
(RESTATED1) (UNAUDITED)
------- --------
ASSETS
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents..................................................... $ 4,378 $121,885
Accounts receivable, net...................................................... 25 568
Unbilled revenue.............................................................. 4 279
Inventories................................................................... 43 208
Prepaid expenses.............................................................. 52 327
Other current assets.......................................................... 317 21
------- --------
TOTAL CURRENT ASSETS........................................................ 4,819 123,288
PROPERTY AND EQUIPMENT:
Networks and communication equipment.......................................... 2,185 13,005
Computer equipment............................................................ 600 2,111
Furniture and fixtures........................................................ 185 205
Leasehold improvements........................................................ 114 164
------- --------
3,084 15,485
Less accumulated depreciation and amortization................................ (70) (680)
------- --------
NET PROPERTY AND EQUIPMENT.................................................. 3,014 14,805
OTHER ASSETS:
Restricted cash............................................................... 210 210
Deposits...................................................................... 31 44
Deferred debt issuance costs (net)............................................ -- 8,194
------- --------
TOTAL OTHER ASSETS.......................................................... 241 8,448
------- --------
TOTAL ASSETS................................................................ $ 8,074 $146,541
======= ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable.............................................................. $ 651 $ 3,982
Unearned revenue.............................................................. 7 113
Accrued network costs......................................................... 58 557
Other accrued liabilities..................................................... 77 662
Current portion of capital lease obligations.................................. 229 245
------- --------
TOTAL CURRENT LIABILITIES................................................... 1,022 5,559
Long-term debt (net of discount)............................................... -- 132,467
Long-term capital lease obligations............................................ 554 450
------- --------
TOTAL LIABILITIES........................................................... 1,576 138,476
STOCKHOLDERS' EQUITY:
Convertible preferred stock (.001 par value):
Authorized shares 30,000,000
Issued and outstanding shares 17,750,001 and 18,246,162, respectively...... 18 18
Common stock (.001 par value):
Authorized shares 65,000,000
Issued and outstanding shares 11,361,204 and 11,479,767, respectively...... 11 11
Additional paid-in capital.................................................... 9,692 26,036
Deferred compensation......................................................... (611) (3,684)
Retained earnings (deficit)................................................... (2,612) (14,316)
------- --------
TOTAL STOCKHOLDERS' EQUITY..................................................... 6,498 8,065
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY..................................... $ 8,074 $146,541
======= ========
</TABLE>
- ----------------------------
1 See Note 4.
The accompanying notes are an integral part of these financial statements.
3
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN 000'S, EXCEPT SHARE AND PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
(UNAUDITED) (UNAUDITED)
------------------------ -------------------
1997 1998 1997 1998
------ ------- ------ --------
<S> <C> <C> <C> <C>
Revenues.............................................. $ -- $ 809 $ -- $ 995
Operating expenses:
Network and product costs............................ -- 758 -- 961
Sales, marketing, general and administrative......... 233 4,606 257 6,550
Amortization of deferred compensation................ -- 631 -- 858
Depreciation and amortization........................ -- 446 -- 610
------ ------- ------ --------
Total operating expenses............................. 233 6,441 257 8,979
------ ------- ------ --------
Income (loss) from operations......................... (233) (5,632) (257) (7,984)
Interest income (expense):
Interest income...................................... -- 1,712 -- 2,147
Interest expense..................................... -- (5,003) -- (5,867)
------ ------- ------ --------
Net interest......................................... -- (3,291) -- (3,720)
------ ------- ------ --------
Net income (loss)..................................... $ (233) $(8,923) $ (257) $(11,704)
====== ======= ====== ========
Basic and diluted net income (loss) per common share.. $(0.08) $ (1.66) $(0.09) $ (2.31)
Weighted average shares used in computing
net loss per share................................... 3,007,329 5,367,181 2,762,267 5,056,334
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN 000'S)
<TABLE>
<CAPTION>
SIX MONTHS ENDED JUNE 30,
(UNAUDITED)
--------------------
1997 1998
---- --------
<S> <C> <C>
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES $327 $(877)
INVESTING ACTIVITIES:
Purchase of restricted investment................................... -- --
Deposits............................................................ -- (13)
Purchase of property and equipment.................................. (199) (12,367)
---- -------
Net cash used in investing activities............................... (199) (12,380)
FINANCING ACTIVITIES:
Net proceeds from issuance of long-term debt and warrants........... -- 129,622
Principal payments under capital lease obligations.................. -- (122)
Proceeds from common stock issuance, net of repurchase.............. 45 64
Proceeds from preferred stock issuance.............................. 250 1,200
---- --------
Net cash provided by financing activities........................... 295 130,764
---- --------
Net increase in cash and cash equivalents........................... 423 117,507
Cash and cash equivalents at beginning of period.................... -- 4,378
---- --------
Cash and cash equivalents at end of year............................ $423 $121,885
==== ========
Supplemental disclosures of cash flow information:
Cash paid during the year for interest............................. $ -- $ 48
==== ========
Supplemental schedule of non-cash investing and
financing activities:
Equipment purchased through capital leases......................... $ -- $ 34
==== ========
Warrants issued for equity commitment............................... $ -- $ 2,928
==== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
JUNE 30, 1998
1. BASIS OF PRESENTATION
The consolidated financial statements of the Company include the accounts
of all of its wholly-owned subsidiaries. There were no intercompany accounts
and transactions which required elimination.
The financial statements at June 30, 1998 and three and six months ended
June 30, 1998 and 1997 are unaudited, but include all adjustments (consisting of
normal recurring adjustments) that the Company considers necessary for a fair
presentation of financial position and operating results. Operating results for
the three and six months ended June 30, 1998 and 1997 are not necessarily
indicative of results that may be expected for any future periods.
The consolidated financial statements contained herein should be read in
conjunction with the consolidated financial statements and notes thereto
included in the Company's annual financial statements included on Form S-1 filed
with the Securities and Exchange Commission ("SEC").
2. DEBT
On March 11, 1998, the Company completed a private placement (the "1998
Private Offering") through the issuance of 260,000 units (the "Units"), each
unit consisting of $1,000 in principal amount at maturity of 13 1/2% Senior
Discount Notes due 2008 (the "Notes") and one warrant, initially exercisable to
purchase 19.4376 shares of common stock, $0.001 par value, of the Company (the
"Unit Warrants"). Net proceeds from the 1998 Private Offering were
approximately $129.6 million, after transaction costs of approximately $5.5
million.
The principal amount of the Notes will accrete from the date of issuance at
the rate of 13 1/2% per annum through March 15, 2003, compounded semi-annually,
and thereafter bear interest at the rate of 13 1/2% per annum, payable semi-
annually, in arrears on March 15 and September 15 of each year, commencing on
September 15, 2003. The Notes are unsecured senior obligations of the Company
that will mature on March 15, 2008. The Notes will be redeemable at the option
of the Company at any time after March 15, 2003 plus accrued and unpaid interest
thereon, if any, to the redemption date.
The Notes were originally recorded at approximately $126.9 million, which
represents the $135.1 million in gross proceeds less the approximate $8.2
million value assigned to the Unit Warrants, which is included in additional
paid-in capital. The value assigned to the Unit Warrants, representing debt
discount, is being accreted over the life of the Notes. Additional debt
issuance costs were incurred through the issuance of warrants associated with
the commitment of equity by certain investors. The debt issuance costs are also
being amortized over the life of the Notes. For the six-month period ending
June 30, 1998, the accretion of the Notes, debt discount and amortization of
debt issuance costs was $5.8 million and is included in interest expense in the
accompanying consolidated financial statements.
6
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
3. STOCKHOLDERS' EQUITY
Stock Split:
The consolidated financial statements applicable to the prior periods
have been restated to reflect a two-for-one stock split and a three-for-two
stock split effective in May 1998 and August 1998, respectively, for common
stock ("Common Stock") and preferred stock ("Preferred Stock"). The company has
amended the authorized shares of Common Stock to 65,000,000 and Preferred Stock
to 30,000,000, of which 750,000 are designated Series A Preferred, 17,100,003
are designated Series B Preferred, 11,149,287 are designated Series C Preferred,
and 1,000,710 are undesignated.
Common Stock:
The number of shares of Common Stock authorized for issuance by the Company
is 65,000,000 shares with a par value of $.001 per share. Shares of Common
Stock outstanding at December 31, 1997 and June 30, 1998 were 11,361,204 and
11,479,767 shares, respectively, of which 7,033,107 and 5,900,250 shares,
respectively, remain subject to repurchase provisions which generally lapse over
a four year period from the date of issuance.
Convertible Preferred Stock:
Convertible preferred stock consists of the following:
<TABLE>
<CAPTION>
DECEMBER 31, JUNE 30,
1997 1998
------------ ----------
<S> <C> <C>
Authorized shares 30,000,000
Series A preferred stock (.001 par value);
Authorized shares 750,000
Issued and outstanding shares 750,000 at December 31, 1997
and June 30, 1998.......................................... $ 1 $ 1
Series B preferred stock (.001 par value);
Authorized shares 17,100,003
Issued and outstanding shares 17,000,001 at December 31,
1997 and 17,100,003 at June 30, 1998....................... $17 $17
Series C preferred stock (.001 par value);
Authorized shares 11,149,287
Issued and outstanding shares None at December 31, 1997 and
396,159 at June 30, 1998...................................... -- --
--------- ----------
$18 $18
========= ==========
</TABLE>
Equity Commitment
On February 20, 1998, the Company entered into a Series C Preferred Stock
and Warrant Subscription Agreement (the "Subscription Agreement") with certain
of its investors (the "Series C Investors") pursuant to which the Series C
Investors have unconditionally agreed to purchase an aggregate of 5,764,143
shares of Series C Preferred Stock and warrants to purchase an aggregate of
4,729,500 shares of Series C Preferred Stock (the "Series C Warrants") for an
aggregate purchase price of $16.0 million at a date to be determined by the
Company but no later than March 11, 1999. The Company either has agreed to call
the Equity Commitment or to complete an alternate equity financing of at least
$16.0 million by March 11, 1999. In consideration of this commitment, the
Company has issued to the Series C Investors warrants to purchase an aggregate
of 1,694,148 shares of the Company's Common Stock at a purchase price of $0.0033
per share (the "Common Warrants").
7
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
On April 24, 1998, the Subscription Agreement was amended pursuant to an
Assignment and Assumption Agreement between the Company, the Series C Investors,
and a director of the Company whereby the Series C Investors assigned to the
director of the Company their obligation to purchase 36,015 shares of Series C
Preferred Stock and 29,559 Series C Warrants for an aggregate purchase price of
$100,000. On the same date, the director purchased 36,015 shares of Series C
Preferred Stock. As a result of this amendment, the aggregate obligation of the
Series C Investors to purchase Series C Preferred Stock and Series C Warrants
was reduced from 5,764,143 shares to 5,728,128 shares, and from 4,729,500 shares
to 4,699,941 shares, respectively, for an aggregate purchase price of $15.9
million, reduced from $16.0 million.
The Series C Warrants issuable in connection with the closing of the Equity
Commitment will have five-year terms, have an exercise price of $2.7767 per
share of Series C Preferred Stock (subject to adjustment in certain events), are
immediately exercisable and contain a net exercise provision. The Common
Warrants issued upon the signing of the Subscription Agreement have five-year
terms (but must be exercised prior to the closing of an initial public offering
of equity securities by the Company), have exercise prices of $0.0033 per share,
are immediately exercisable and contain net exercise provisions.
The Stock Purchase
On March 11, 1998, an investor in the Company purchased 360,144 shares of
Series C Preferred Stock and Series C Warrants to purchase an aggregate of
295,500 shares of Series C Preferred Stock for an aggregate purchase price of
$1,000,000; provided, that the Company does not have any obligation to issue
such Series C Warrants to this investor until such time as the Equity Commitment
is called. In connection with its agreement to purchase such Series C Preferred
Stock and Series C Warrants, the Company issued to this investor Common Warrants
to purchase an aggregate of 105,852 shares of Common Stock at a purchase price
of $0.0033 per share.
Preferred Stock Attributes
The holders of Series A, Series B and Series C are entitled to receive in
any fiscal year, dividends at the rate of $0.167 per share, $0.04 per share and
$0.2233 per share, respectively, payable in preference and priority to any
payment of dividends on Common Stock. The rights to such dividends are
cumulative and accrue to the holders to the extent they are not declared or paid
and are payable only in the event of a liquidation, dissolution or winding up of
the Company, or other liquidity event (as defined in the Certificate of
Incorporation). The cumulative dividends at December 31, 1997 for Series A and
Series B were $6,250 and $312,000, respectively, none of which has been declared
or paid.
Subject to certain adjustments as set forth in the Certificate of
Incorporation, each share of Series A, Series B and Series C is convertible into
one share of Common Stock. Each share of Series A, Series B and Series C is
entitled to the number of votes equal to the number of shares of Common Stock in
which such shares of Series A, Series B and Series C respectively, could be
converted.
In the event of any liquidation or dissolution or winding up of the
Company, either voluntary or involuntary, the holders of Series A, Series B and
Series C are entitled to receive, in addition to the cumulated and unpaid
dividends, $0.3333, $0.50 and $2.7767 per share, respectively (the "Initial
Preference"), until with respect to Series A and Series B only, a "Liquidation
Preference Threshold" is met based on a formula as set forth in the Certificate
of Incorporation. After payment of these preferences, any remaining amounts are
distributed to the holders of Series A, Series B, Series C and Common Stock on a
pro rata basis based on the number of shares of Common Stock held by each holder
on an as-converted basis. If the "Liquidation Preference Threshold" is met, the
Initial Preference is eliminated with respect to Series A and Series B only.
8
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
4. STOCK OPTIONS
In 1997, the Company adopted the Covad Communications Group, Inc. 1997
Stock Plan (the "Plan"). The Plan provides for the grant of stock purchase
rights and options to purchase shares of Common Stock to employees and
consultants from time to time as determined by the Board of Directors. The
options expire from two to eight years after the date of grant. As of June 30,
1998 the Plan has reserved 8,270,250 shares of the Company's Common Stock for
sale and issuance under the Plan at prices to be determined by the Board of
Directors.
The following table summarizes stock option activity for the six month
period ending June 30, 1998:
<TABLE>
<CAPTION>
NUMBER OF
SHARES OF OPTION PRICE
COMMON STOCK PER SHARE
-------- -------------
<S> <C> <C>
Balance as of December 31, 1997.................... 3,804,750 $0.033-$0.05
Granted............................................ 3,405,150 $0.10 -$0.667
Exercised.......................................... (22,563) $0.033-$0.05
Forfeited.......................................... (145,237) $0.05 -$0.667
-------- -------------
Balance as of June 30, 1998........................ 7,042,100 $0.033-$0.667
========= =============
</TABLE>
The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees," ("APB 25") and related
interpretations in accounting for its employee stock options and the disclosure
only provisions of SFAS No. 123, "Accounting and Disclosure of Stock-Based
Compensation," ("SFAS 123"). Under APB 25, compensation expense is recognized
based on the amount by which the fair value of the underlying common stock
exceeds the exercise price of stock options at the date of grant. As a result
of the Company's reassessment during 1998 of the fair values per share of its
common stock, the Company has restated its financial statements for the year
ended December 31, 1997 to record deferred compensation of $906,000 as a result
of granting stock options and issuing restricted stock with exercise or issue
prices per share below the revised fair value per share of the Company's common
stock at the date of grant or issuance. This amount was recorded as reduction
of stockholders' equity and is being amortized as a charge to operations over
the vesting period of the applicable options. Such amortization was $295,000
for the year ended December 31, 1997. During the six months ended June 30,
1998, the Company recorded additional deferred compensation of approximately
$3.9 million. Amortization of deferred compensation during this same period was
$858,000.
5. LEGAL PROCEEDINGS
On March 11, 1998, the Company initiated an arbitration proceeding against
Pacific Bell before the American Arbitration Association seeking damages and
equitable relief from Pacific Bell regarding its collocation practices that have
led to the denial of physical collocation space for the installation of the
Company's equipment in multiple central offices in California. On May 8, 1998,
the Company filed a complaint in Federal Court against Pacific Bell seeking
damages and equitable relief from Pacific Bell regarding its collocation
practices, failures to timely and properly deliver transmission and local loop
facilities, position on local shop spectral interference issues, as well as
other practices. This lawsuit is pending in federal court. However, Pacific
Bell has, during the course of this litigation, found physical collocation space
in numerous central offices for which it had previously denied the Company such
space.
9
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
The Company also litigated U.S. West collocation practices before the
American Arbitration Association in Seattle, Washington. In addition, on August
28, 1998, U.S. West filed a lawsuit and sought a preliminary injunction against
the Company and one of its employees in Federal Court in connection with the
departure of such employee from U.S. West to the Company and the potential
improper disclosure of U.S. West's alleged trade secrets to the Company.
6. YEAR 2000 COMPLIANT
The Company is engaged in the development of information systems to manage
various aspects of the Company's operations. Management believes these
information systems are in compliance with year 2000 requirements, although
there can be no assurance in this regard.
7. SUBSEQUENT EVENT
Filing of Registration Statement
On September 21, 1998, the Company filed Form S-1 with the Securities Exchange
Commission in accordance with the Securities Act of 1933. The Company intends
to sell securities to the public at some point in the future.
10
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion of the financial condition and results of
operations of the Company should be read in conjunction with the Company's
Consolidated Financial Statements and the related Notes thereto included
elsewhere in this Form 10-Q. This discussion contains forward-looking
statements that involve risks and uncertainties. The Company's 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
herein and in the Company's Registration Statement on Form S-1. The Company
disclaims any obligation to update information contained in any forward-looking
statement. See "-Forward Looking Statements"
OVERVIEW
Covad Communications Group, Inc. is a leading packet-based competitive
local exchange carrier ("CLEC") that provides dedicated high-speed digital
communication services using digital subscriber line ("DSL") technology to
enterprise customers and Internet service providers ("ISPs"). The Company
introduced its services in the San Francisco Bay Area in December 1997. The
Company launched its services in the Los Angeles, New York and Boston
metropolitan areas in August 1998 and expects to introduce its services in the
Seattle and Washington, D.C. metropolitan areas in the first quarter of 1999.
In March 1998, the Company raised approximately $135 million through the
issuance of its 13 1/2% Senior Discount Notes due 2008 (the "Senior Discount
Notes") to fund the deployment of its networks in these initial six regions.
During 1998, the Company expanded its network in the San Francisco Bay Area and
increased its sales and marketing efforts in that region which resulted in
higher revenue in each successive month in 1998. In connection with the
Company's expansion within existing regions and into new regions, it expects to
significantly increase its capital expenditures, as well as its sales and
marketing expenditures, to deploy its networks and support additional
subscribers in those regions. Accordingly, the Company expects to incur
substantial and increasing net losses for at least the next several years.
The Company derives revenue from (i) monthly recurring service charges for
connections from the end-user to the Company's facilities and for backhaul
services from the Company's facilities to the enterprise or ISP customer, (ii)
service activation, installation and other non-recurring charges and (iii) the
sale of customer premise equipment ("CPE") which the Company provides to its
customers due to the general unavailability of CPE through retail channels. The
Company expects prices for the major components of both recurring and non-
recurring charges to decrease each year. The Company believes its revenues from
the sale of CPE will decline over time as CPE becomes more generally available.
The Company expects that the prices it charges to customers for CPE will
decrease each year.
The Company's network and product costs include costs of recurring and
nonrecurring circuit fees charged to the Company by incumbent local exchange
companies ("ILECs") and other CLECs, including installation, activation, monthly
line costs, maintenance and repair of circuits between and among the Company's
digital subscriber line access multiplexers ("DSLAMs") and its regional data
centers ("RDCs"), customer backhaul, and subscriber lines. Other costs the
Company incurs include those for materials used by the Company in installation
and the servicing of customers and end-users, and the cost of CPE. As the
Company's end-user base grows, the largest element of network and product cost
is expected to be the ILECs' charges for the Company's leased copper lines.
11
<PAGE>
RESULTS OF OPERATIONS
The Company's operations from inception in October 1996 to December 1997
were limited principally to the development of the technology and activities
related to the commencement of its business operations. As a result, the
Company's revenues and expenditures prior to such period are not indicative of
anticipated revenues which may be attained or expenditures which may be incurred
by the Company in future periods. In particular, the Company's expenditure
levels during the year ended December 31, 1997 do not reflect the issuance of
the Senior Discount Notes in March 1998 and the related interest and
amortization charges, which the Company expects will be approximately $16.0
million during the year ending December 31, 1998 and will increase annually
thereafter up to $36.9 million for the year ending December 31, 2004 and to
remain at that level through the maturity of of the Senior Discount Notes in
March 2008. The Company did not have any revenue until the fourth quarter of
1997. As a result, any comparison of the three and six month period ended June
30, 1998 with the three and six month period ended June 30, 1997 is not
meaningful.
Revenues
Revenues were not generated until the fourth quarter of 1997. For the
three and six month periods ending June 30, 1998, revenues were $809,000 and
$995,000, respectively. During the six months ending June 30, 1998, revenues
increased each month as a result of the Company expanding its network in the San
Francisco Bay Area and the Company increasing its sales and marketing efforts in
that region. The Company expects revenues to increase in future periods as the
Company expands its network within its existing regions, deploys networks in new
regions and increases its sales and marketing efforts in all of its target
regions.
Network and Product Costs
Total network and product costs were approximately $758,000 and $961,000
for the three and six months ended June 30, 1998, respectively. This increase
is attributable to the expansion of the Company's network and increased orders
resulting from the Company's sales and marketing efforts. The Company expects
aggregate line costs to increase significantly in future periods due to
increased sales activity and expected revenue growth.
Sales, Marketing, General and Administrative Expenses
Sales, marketing, general and administrative expenses consist primarily of
salaries, expenses for the development of the Company's business, the
development of corporate identification, promotional and advertising materials,
expenses for the establishment of its management team, and sales commissions.
These expenses increased from $233,000 and $257,000 for the three and six months
ended June 30, 1997, respectively, to $4.6 million and $6.6 million for the
three and six months ended June 30, 1998, respectively. This increase is
attributable to increased headcount in all areas as the Company expanded its
sales and marketing efforts, expanded the deployment of its network and built
operational infrastructure. Sales, marketing, general and administrative
expenses are expected to significantly increase as the Company continues to
expand its business.
12
<PAGE>
Deferred Compensation
Through June 30, 1998, the Company had recorded a total of $4.8 million of
deferred compensation, with an unamortized balance of $3.7 million on its
balance sheet as of June 30, 1998. This deferred compensation arose as a result
of the granting of stock options to employees with exercise prices per share
subsequently determined to be below the fair values per share for accounting
purposes of the Company's Common Stock at the dates of grant. The deferred
compensation is being amortized over the vesting period of the applicable
options, and resulted in a charge to operations of $631,000 and $858,000 during
the three and six months ended June 30, 1998, respectively. As a result of
additional stock option grants through July 1998, the Company will record
additional deferred compensation on its balance sheet of approximately $4.1
million. The total charge to operations during the year ending December 31,
1998 for amortization of the deferred compensation associated with the options
granted through July 31, 1998 will approximate $3.8 million.
Depreciation and Amortization
Depreciation and amortization includes: (i) depreciation of network
infrastructure equipment, (ii) depreciation of information systems, furniture
and fixtures, (iii) amortization of improvements to COs, RDC and NOC facilities
and corporate facilities and (iv) amortization of capitalized software costs.
Depreciation and amortization was approximately $446,000 and $610,000 for the
three and six months ended June 30, 1998, respectively. The Company expects
depreciation and amortization to increase significantly as the Company increases
its capital expenditures to expand its network.
Interest Income and Expense
Net interest income and expense consists primarily of interest income on
the Company's cash balance and interest expense associated with the Company's
debt. Interest income for the three and six months ended June 30, 1998, was
approximately $1.7 million and $2.1 million, respectively, resulting primarily
from investing the proceeds from the Company's Senior Discount Notes. Interest
expense for the three and six months ended June 30, 1998, was approximately $5.0
million and $5.9 million, respectively, and consisted primarily of interest on
the Senior Discount Notes and capital lease obligations. The Company expects
interest expense to increase significantly as a result of the issuance of the
Senior Discount Notes. The Senior Discount Notes accrete to $260 million by
March 15, 2003, and as a result, the Company expects that annual interest
charges (which includes amortization of debt discount and debt issuance costs)
relating to the accretion of the Senior Discount Notes will be approximately
$16.0 million during the year ending December 31, 1998, will increase to
approximately $22.3 million for the year ending December 31, 1999 and will
increase to approximately $32.7 million for the year ending December 31, 2002.
Thereafter, the Company expects that interest expense attributable to the Senior
Discount Notes (including amortization of debt discount, debt issuance costs and
capitalized financing costs) will increase to approximately $36.9 million for
the year ending December 31, 2004 and will remain at that level through maturity
of the Senior Discount Notes in March 2008.
Income Taxes
Income taxes consist of federal, state and local taxes, when applicable.
The Company expects significant consolidated net losses for the foreseeable
future which should generate net operating loss ("NOL") carryforwards. However,
utilization of NOLs is subject to substantial annual limitations. In addition,
income taxes may be payable during this time due to operating income in certain
tax jurisdictions. Once the Company achieves operating profits and the NOLs
have been exhausted or have expired, the Company may experience significant tax
expense. The Company recognized no provision for taxes as it operated at a loss
throughout 1997 and through the six months ended June 30, 1998.
13
<PAGE>
Certain Pro Forma Financial Information
Giving pro forma effect to the issuance of the Senior Discount Notes as if
it had been consummated on January 1, 1997 and the related interest and
amortization charges relating to the Senior Discount Notes accruing from such
date through June 30, 1998, the Company's interest expense would have been
approximately $20.3 million and $11.1 million, net loss would have been
approximately $22.9 million and $17.0 million, and net loss per Common Share
would have been $(7.00) and $(3.36) for the year ended December 31, 1997 and the
six months ended June 30, 1998, respectively. For purposes of such pro forma
calculation, the Company has assumed (i) no correlating additional interest
income attributable to interest earned on the cash proceeds of the issuance of
the Senior Discount Notes and (ii) no application of the use of proceeds from
such issuance for the Company's corporate purposes. Therefore, the interest and
amortization charges relating to the Senior Discount Notes would have had a
significant adverse effect on the Company's net loss and net loss per share had
the issuance occurred on January 1, 1997.
LIQUIDITY AND CAPITAL RESOURCES
The Company's operations have required substantial capital investment for
the procurement, design and construction of the Company's CO collocation cages,
the purchase of telecommunications equipment and the design and development of
the Company's networks. Capital expenditures were approximately $12.4 million
for the first six months of 1998. The Company expects that its capital
expenditures will be substantially higher in future periods in connection with
the purchase of infrastructure equipment necessary for the development and
expansion of its network and the development of new markets.
Since inception, the Company has financed its operations primarily through
private placements of $10.1 million of equity securities, $865,000 of lease
financings and $129.6 million in net proceeds raised from the issuance of the
Senior Discount Notes. As of June 30, 1998, the Company had an accumulated
deficit of $14.3 million, and cash and cash equivalents of $121.9 million.
Net cash used in the Company's operating activities was approximately
$877,000 for the six months ended June 30, 1998. The net cash used for
operating activities during this period was primarily due to net losses and
increases in current assets, offset by noncash expenses, increases in accounts
payable and accrued liabilities. Net cash used by the Company for acquisitions
of property and equipment was $12.4 million during the six months ended June 30,
1998. Net cash provided by financing activities for the six months ended June
30, 1998 was $130.8 million which primarily related to the issuance of the
Senior Discount Notes (including amounts attributable to the related warrants to
purchase Common Stock) and Series C Preferred Stock.
The Company expects to experience substantial negative cash flow from
operating activities and negative free cash flow before financing activities for
at least the next several years due to continued development, commercial
deployment and expansion of its networks. The Company's future cash
requirements for developing, deploying and enhancing its networks and operating
its business, as well as the Company's revenues, will depend on a number of
factors including (i) the number of regions entered, the timing of entry and
services offered; (ii) network development schedules and associated costs due to
issues including the physical requirements of the CO collocation process; (iii)
the rate at which customers and subscribers purchase the Company's services and
the pricing of such services; (iv) the level of marketing required to acquire
and retain customers and to attain a competitive position in the marketplace;
and (v) the rate at which the Company invests in engineering and development and
intellectual property with respect to existing and future technology.
14
<PAGE>
YEAR 2000 ISSUES
Many currently installed computer systems and software products are coded
to accept only two-digit entries in the date code field and cannot distinguish
21st century dates from 20th century dates. These date code fields will need to
distinguish 21st century dates from 20th century dates and, as a result, many
companies' software and computer systems may need to be upgraded or replaced in
order to comply with such "Year 2000" requirements. The Company has reviewed
its internally developed information technology systems and programs and
believes that its systems are Year 2000 compliant and that there are no
significant Year 2000 issues within the Company's systems or services. The
Company has not reviewed its non-information technology systems for Year 2000
issues relating to embedded microprocessors. To the extent that such issues
exist, these systems may need to be replaced or upgraded to become Year 2000
compliant. The Company believes that its non-information technology systems
will not present any significant Year 2000 issues, although there can be no
assurance in this regard. In addition, the Company utilizes third-party
equipment and software that may not be Year 2000 compliant. Failure of such
third-party equipment or software to operate properly with regard to the year
2000 and thereafter could require the Company to incur unanticipated expenses to
remedy any problems, which could have a material adverse effect on the Company's
business, prospects, operating results and financial condition. Furthermore,
the purchasing patterns of the Company's enterprise and ISP customers may be
affected by Year 2000 issues as companies expend significant resources to
correct their current systems for Year 2000 compliance. These expenditures may
result in reduced funds available for the Company's services, which could have a
material adverse effect on the Company's business, prospects, operating results
and financial condition. The Company, to date, has not made any assessment of
the Year 2000 risks associated with its third-party equipment or software or
with its enterprise and ISP customers and has not made any contingency plans to
address such risks. However, the Company may devise a Year 2000 contingency
plan in the future.
FORWARD LOOKING STATEMENTS
The statements contained in this Report that are not historical facts are
"forward-looking statements" (as such term is defined in Section 27A of the
Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934),
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. These forward-
looking statements, such as the Company's plans to expand its existing network
or to commence service in new areas, estimates regarding the timing of launching
its service in new regions, statements regarding development of the Company's
business, future operating results, the Company's anticipated capital
expenditures, the effect of regulatory reform and regulatory litigation, and
other statements contained in this Report regarding matters that are not
historical facts, are only estimates or predictions and cannot be relied upon.
No assurance can be given that future results will be achieved; actual events or
results may differ materially as a result of risks facing the company or actual
results differing from the assumptions underlying such statements. Such risks
and assumptions include, but are not limited to, the Company's ability to
successfully market its services to current and new customers, generate customer
demand for its services in the particular regions where it plans to market
services, achieve acceptable pricing for its services, respond to increasing
competition, manage growth of the Company's operations, access regions and
negotiate suitable interconnection agreements with ILECs, all in a timely
manner, at reasonable costs and on satisfactory terms and conditions, as well as
regulatory, legislative, and judicial developments that could cause actual
results to vary materially from the future results indicated, expressed or
implied in such forward-looking statements. All written and oral forward-
looking statements made in connection with this Report which are attributable to
the company or persons acting on its behalf are expressly qualified in their
entirety by the "Risk Factors" and other cautionary statements included in the
Company's Registration Statement on Form S-1 (Commission File No. 333-63899).
The company disclaims any obligation to update information contained in any
forward-looking statement.
15
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is engaged in negotiations, arbitration and litigation
proceedings with several ILECs concerning their denial of physical collocation
space to the Company in certain central offices ("COs"). For example, the
Company has filed a suit against Pacific Bell in Federal Court on this issue on
antitrust and other grounds. Since commencement of the suit, Pacific Bell has
found space for the Company in numerous COs where Pacific Bell had previously
denied the Company space. In addition, the Company is asserting breach of
contract claims against Pacific Bell and U S WEST Communications, Inc. on
collocations issues in American Arbitration Association proceedings in
California and Washington. Failure to resolve these controversies and obtain
space in COs without undue delay or expense could have a material adverse effect
on the Company's business, prospects, operating results and financial condition.
In addition, on August 28, 1998, U S WEST communications sued the company and
one of its employees and sought a preliminary injunction in federal court in
connection with such employee's departure from U S WEST Communications to join
the Company and the potential improper disclosure of U S WEST Communications'
alleged trade secrets to the Company. The Company is not currently engaged in
any other legal proceedings that it believes could have a material adverse
effect on the Company's business, prospects, operating results and financial
condition. The Company is, however, subject to state commission, FCC and court
decisions as they relate to the interpretation and implementation of the
Telecommunications Act of 1996, the interpretation of CLEC interconnection
agreements in general and the Company's interconnection agreements in
particular. In some cases, the Company may be deemed to be bound by the results
of ongoing proceedings of these bodies or the legal outcomes of other contested
interconnection agreements that are similar to the Company's agreements. The
results of any of these proceedings could have a material adverse effect on the
Company's business, prospects, operating results and financial condition.
ITEM 2. CHANGES IN SECURITIES
During the three months ended June 30, 1998, the Company has issued and
sold unregistered securities as follows:
(1) An aggregate of 36,015 shares of Series C Preferred Stock was
issued in a private placement in April 1998 to Mr. Hawk. The consideration
received for such shares was $100,001.65.
(2) An aggregate of 96,000 shares of Common Stock was issued in a
private placement pursuant to a Restricted Stock Purchase Agreement in
April 1998 to Mr. Hawk. The consideration received for such shares was
$64,000.
No underwriters were used in connection with these sales and issuances.
The sales and issuances of these securities were exempt from registration under
the Securities Act pursuant to Rule 701 promulgated thereunder on the basis that
these options were offered and sold either pursuant to a written compensatory
benefit plan or pursuant to written contracts relating to consideration, as
provided by Rule 701, or pursuant to Section 4(2) thereof on the basis that the
transactions did not involve a public offering.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
16
<PAGE>
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the three months ended June 30, 1998, the Company's stockholders took
the following actions by written consent:
(1) By written consent dated May 18, 1998, the stockholders of the Company
approved (a) the amendment and restatement of the Company's Certificate of
Incorporation to, among other things, effect a two-for-one stock split and
increase the authorized Common Stock and Preferred Stock of the Company, and (b)
the amendment of the Company's 1997 Stock Plan to increase the number of shares
available for options thereunder by 5,700,000 post-split shares. Such action
was taken by holders of more than a majority of the Company's outstanding Common
Stock and Preferred Stock.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a. Exhibits:
Exhibit Number Description of Exhibit
- -------------- ----------------------
3.1 Amended and Restated Certificate of Incorporation as filed with
the Delaware Secretary of State on May 20, 1998 (incorporated
herein by reference to Exhibit 3.1 to the Company's Registration
Statement on Form S-4 (File No. 333-51097))
4.1 Amended and Restated Stockholders Rights Agreement dated March
11, 1998 among the Company and certain of its stockholders, as
amended by Amendment No. 1 to the Amended and Restated
Stockholders Rights Agreement among the Company and certain of
its stockholders dated as of April 24, 1998 (incorporated by
reference to Exhibit 4.6 to the Company's Registration Statement
on Form S-1 (File No 333-63899))
10.1 Series C Preferred Stock and Warrant Subscription Agreement
dated as of February 20, 1998 among the Company, 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 Company, Warburg, Crosspoint and Robert Hawk
(incorporated by reference to Exhibit 10.5 to the Company's
Registration Statement on Form S-1 (File No 333-63899))
10.2 1997 Stock Plan and related form of option agreement, as amended
(incorporated by reference to Exhibit 10.4 to the Company's
Registration Statement on Form S-4 (File No. 333-51097))
27.1 Financial Data Schedule
b. Reports on Form 8-K
There have been no reports on Form 8-K filed during the quarter ended
June 30, 1998.
17
<PAGE>
SIGNATURES
Pursuant to the requirements 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.
Date: September 25, 1998 By: /s/ Timothy Laehy
-------------------------------------
Timothy Laehy
Chief Financial Officer and Vice President,
Finance (Principal Financial and Accounting
Officer)
18
<PAGE>
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT PAGE
- --------------- -------
<S> <C>
3.1 Amended and Restated Certificate of Incorporation as filed with
the Delaware Secretary of State on May 20, 1998 (incorporated
herein by reference to Exhibit 3.1 to the Company's Registration
Statement on Form S-4 (File No. 333-51097))
4.1 Amended and Restated Stockholders Rights Agreement dated March
11, 1998 among the Company and certain of its stockholders, as
amended by Amendment No. 1 to the Amended and Restated
Stockholders Rights Agreement among the Company and certain of
its stockholders dated as of April 24, 1998 (incorporated by
reference to Exhibit 4.6 to the Company's Registration Statement
on Form S-1 (File No 333-63899))
10.1 Series C Preferred Stock and Warrant Subscription Agreement
dated as of February 20, 1998 among the Company, 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 Company, Warburg, Crosspoint and Robert Hawk
(incorporated by reference to Exhibit 10.5 to the Company's
Registration Statement on Form S-1 (File No 333-63899))
10.2 1997 Stock Plan and related form of option agreement, as amended
(incorporated by reference to Exhibit 10.4 to the Company's
Registration Statement on Form S-4 (File No. 333-51097))
27.1 Financial Data Schedule 20
</TABLE>
19
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 121,885
<SECURITIES> 0
<RECEIVABLES> 568
<ALLOWANCES> 0
<INVENTORY> 208
<CURRENT-ASSETS> 123,288
<PP&E> 15,485
<DEPRECIATION> 680
<TOTAL-ASSETS> 146,541
<CURRENT-LIABILITIES> 5,559
<BONDS> 132,467
0
18
<COMMON> 11
<OTHER-SE> 8,036
<TOTAL-LIABILITY-AND-EQUITY> 146,541
<SALES> 995
<TOTAL-REVENUES> 995
<CGS> 961
<TOTAL-COSTS> 8,979
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 5,867
<INCOME-PRETAX> (11,704)
<INCOME-TAX> 0
<INCOME-CONTINUING> (11,704)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (11,704)
<EPS-PRIMARY> (2.31)
<EPS-DILUTED> (2.31)
</TABLE>
