<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 MARCH 31, 1999.
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 95050
Santa Clara, California
(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 April 30, 1999, 69,907,823 split-adjusted 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> <C>
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements (Unaudited)
Consolidated Balance Sheets as of
December 31, 1998 and March 31, 1999............................................... 3
Consolidated Statements of Operations for the Three Months Ended
March 31, 1998 and 1999............................................................ 4
Consolidated Statements of Cash Flows for the Three Months Ended
March 31, 1998 and 1999............................................................ 5
Notes to Consolidated Financial Statements........................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations... 9
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.................................................................... 16
Item 2. Changes in Securities................................................................ 16
Item 3. Defaults Upon Senior Securities...................................................... 17
Item 4. Submission of Matters to a Vote of Securities Holders................................ 18
Item 5. Other Information.................................................................... 20
Item 6. Exhibits and Reports on Form 8-K..................................................... 21
SIGNATURES........................................................................................ 22
INDEX TO EXHIBITS................................................................................. 23
</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, March 31,
1998 1999
(Note 1) (unaudited)
--------------------------
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents................................................................ $64,450 $341,803
Accounts receivable, net ................................................................ 1,933 3,629
Unbilled revenue......................................................................... 663 1,642
Inventories.............................................................................. 946 3,316
Prepaid expenses......................................................................... 1,183 3,424
Other current assets..................................................................... 514 985
---------- ---------
Total current assets................................................................... 69,689 354,799
Property and equipment:
Networks and communication equipment..................................................... 55,189 95,785
Computer equipment....................................................................... 4,426 6,508
Furniture and fixtures................................................................... 1,119 1,266
Leasehold improvements................................................................... 1,887 1,864
---------- ---------
62,621 105,423
Less accumulated depreciation and amortization........................................... (3,476) (6,227)
---------- ---------
Net property and equipment............................................................. 59,145 99,196
Other assets:
Restricted investments................................................................... 225 74,740
Deposits................................................................................. 337 348
Deferred debt issuance costs (net)....................................................... 8,112 13,307
Deferred charge (net).................................................................... - 26,805
Other long term assets................................................................... 1,911 8,043
---------- ---------
Total other assets..................................................................... 10,585 123,243
---------- ---------
Total assets........................................................................... $139,419 $577,238
========== =========
LIABILITIES AND STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
Current liabilities:
Accounts payable......................................................................... $14,975 $18,240
Unearned revenue......................................................................... 551 1,079
Accrued network costs.................................................................... 1,866 1,972
Other accrued liabilities................................................................ 3,854 10,114
Current portion of capital lease obligations............................................. 263 273
---------- ---------
Total current liabilities.............................................................. 21,509 31,678
Long-term debt (net of discount)......................................................... 142,300 357,950
Long-term capital lease obligations...................................................... 316 241
---------- ---------
Total liabilities...................................................................... 164,125 389,869
Stockholders' equity (net capital deficiency):
Convertible preferred stock ($0.001 par value):
Authorized shares--30,000,000 and 0 at December 31, 1998 and March 31, 1999,
respectively
Issued and outstanding shares--18,246,162 and 0 at December 31, 1998 and March 31, 1999,
respectively........................................................................... 18 -
Preferred stock ($0.001 par value):
Authorized shares--0 and 5,000,000 at December 31, 1998 and March 31, 1999, respectively
Issued and outstanding shares--0 at December 31, 1998 and March 31, 1999, respectively.. - -
Common stock ($0.001 par value):
Authorized shares--65,000,000 and 190,000,000 at December 31, 1998 and March 31, 1999,
respectively
Issued and outstanding shares--17,660,995 and 63,427,407 at December 31, 1998 and
March 31, 1999, respectively........................................................... 18 63
Common stock Class B ($0.001 par value):
Authorized shares--0 and 10,000,000 at December 31, 1998 and March 31, 1999, respectively
Issued and outstanding shares--0 and 6,379,177 at December 31, 1998 and March 31, 1999,
respectively........................................................................... - 6
Additional paid-in capital............................................................... 30,679 270,672
Deferred compensation.................................................................... (4,688) (3,735)
Accumulated deficit...................................................................... (50,733) (79,637)
---------- ---------
Total stockholders' equity (net capital deficiency)..................................... (24,706) 187,369
---------- ---------
Total liabilities and stockholders' equity (net capital deficiency)..................... $139,419 $577,238
========== =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
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COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in 000's, except share and per share amounts)
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended
March 31,
-------------------------
1998 1999
------------ ------------
<S> <C> <C>
Revenues.................................................................. $ 186 $ 5,596
Operating expenses:
Network and product costs............................................... 203 4,960
Sales, marketing, general and administrative............................ 1,944 18,113
Amortization of deferred compensation................................... 227 1,653
Depreciation and amortization........................................... 164 4,647
------------ ------------
Total operating expenses............................................. 2,538 29,373
------------ ------------
Income (loss) from operations............................................. (2,352) (23,777)
Interest income (expense):
Interest income......................................................... 435 3,509
Interest expense........................................................ (864) (8,636)
------------ ------------
Net interest income (expense)........................................... (429) (5,127)
------------ ------------
Net income (loss)......................................................... $ (2,781) $ (28,904)
============ ============
Basic and diluted net income (loss) per common share...................... $ (0.39) $ (0.56)
============ ============
Weighted average shares used in computing basic and diluted
net loss per share...................................................... 7,118,160 53,621,977
============ ============
</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)
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended
March 31,
-------------------------
1998 1999
------------ -----------
<S> <C> <C>
Net cash provided by (used in) operating activities....................................... $ 521 $ (15,254)
Investing activities:
Purchase of restricted investments........................................................ - (74,103)
Deposits.................................................................................. - (11)
Other long-term assets.................................................................... - (6,132)
Purchase of property and equipment........................................................ (3,802) (42,802)
------------ -----------
Net cash used in investing activities..................................................... (3,802) (123,048)
Financing activities:
Net proceeds from issuance of long-term debt and warrants................................. 129,622 -
Net proceeds from issuance of long-term debt.............................................. - 205,094
Principal payments under capital lease obligations........................................ (61) (65)
Proceeds from common stock issuance, net of offering costs................................ - 150,703
Proceeds from preferred stock issuance.................................................... 1,100 60,000
Preferred dividends....................................................................... - (77)
------------ -----------
Net cash provided by financing activities................................................. 130,661 415,655
------------ -----------
Net increase in cash and cash equivalents................................................. 127,380 277,353
Cash and cash equivalents at beginning of period.......................................... 4,378 64,450
------------ -----------
Cash and cash equivalents at end of period................................................ $131,758 $ 341,803
============ ===========
Supplemental disclosures of cash flow information:
Cash paid during the period for interest................................................ $ 24 $ 31
============ ===========
Supplemental schedule of non-cash investing and financing activities:
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)
1. Summary of Significant Accounting Policies
A. Basis of Presentation
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements.
Actual results may differ from those estimates. 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 March 31, 1999 and for the three month period
ended March 31, 1998 and 1999 are unaudited, but include all adjustments
(consisting only of normal recurring adjustments) that the Company considers
necessary for a fair presentation of financial position and operating results.
Operating results for the three month periods ended March 31, 1998 and 1999 are
not necessarily indicative of results that may be expected for any future
periods.
The balance sheet at December 31, 1998 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by generally accepted accounting principles for
complete financial statements.
The information included in this report should be read in conjunction
with the Company's audited consolidated financial statements and notes thereto
included in the Company's 1998 Annual Report on Form 10-K.
B. Earnings (Loss) Per Share
Basic earnings per share is computed by dividing income or loss applicable to
common shareholders by the weighted average number of shares of the Company's
common stock ("Common Stock"), after giving consideration to shares subject to
repurchase, outstanding during the period.
Diluted earnings per share is determined in the same manner as basic earnings
per share except that the number of shares is increased assuming exercise of
dilutive stock options and warrants using the treasury stock method and
conversion of the Company's convertible preferred stock ("Preferred Stock"). In
addition, income or loss is adjusted for dividends and other transactions
relating to preferred shares for which conversion is assumed. The diluted
earnings per share amount has not been reported because the Company has a net
loss and the impact of the assumed exercise of the stock options and warrants
and the assumed preferred stock conversion is not dilutive.
Under the Company's Certificate of Incorporation, all outstanding Preferred
Stock converted into Common Stock on a one-for-one basis upon the completion of
the Company's initial public offering of Common Stock (see note 3).
The consolidated financial statements applicable to the prior periods have
been restated to reflect a two-for-one stock split effective May 1998, a three-
for-two stock split effective August 1998, and a three-for-two stock split
effective May 1999.
6
<PAGE>
The following table presents the calculation of basic and diluted net income
(loss) per share (in thousands, except share and per share amounts):
<TABLE>
<CAPTION>
Three Months Ended
March 31,
-------------------------------
1998 1999
-------------------------------
<S> <C> <C>
Net loss.............................................................. $(2,781) $(28,904)
Preferred dividends................................................. -- (1,146)
-------------- --------------
Net loss available to common stockholders............................. $(2,781) $(30,050)
Basic and diluted:
Weighted average shares of common stock outstanding.................. 17,045,556 60,179,685
Less: Weighted average shares subject to repurchase................. 9,927,396 6,557,708
-------------- --------------
Weighted average shares used in computing basic and diluted net
income (loss) per share.............................................. 7,118,160 53,621,977
============== ==============
Basic and diluted net income (loss) per share......................... $(0.39) $(0.56)
============== ==============
</TABLE>
2. Debt
On February 18, 1999, the Company completed a private placement (the "1999
Notes") of $215 million aggregate principal amount of our 12 1/2% senior notes
due 2009. Net proceeds from the 1999 Notes were approximately $205.1 million,
after discounts, commissions and other transaction costs of approximately $9.9
million.
The 1999 Notes will bear interest at a fixed annual rate of 12 1/2%, to be
paid in cash every six months on February 15 and August 15, beginning August 15,
1999. Approximately $74.1 million of the net proceeds was used to purchase
government securities representing sufficient funds to pay the first six
scheduled interest payments on the 1999 Notes. This reserve, along with earned
interest, is recorded as restricted investments on the accompanying balance
sheet.
The 1999 Notes are unsecured senior obligations of the Company that will
mature on February 15, 2009. After February 15, 2004, the Company may redeem
all or a part of these 1999 Notes upon not less than 30 days nor more than 60
days' notice, at the redemption prices (expressed as percentages of principal
amount) which decline to 100% after February 15, 2007, plus accrued and unpaid
interest theron.
The 1999 Notes were originally recorded at approximately $210.5 million,
which represents the $215.0 million in gross proceeds less the discount of
approximately $4.5 million. This discount is being amortized over the life of
the 1999 Notes. Debt issuance costs of approximately $5.5 million were incurred
and are also being amortized over the life of the 1999 Notes. For the three
months ended March 31, 1999, the amortization of debt discount and debt issuance
costs was $56,000 and $68,000, respectively.
7
<PAGE>
3. Stockholders' Equity
Covad Communications Group, Inc.
Strategic Investment:
In January 1999, the Company entered into strategic relationships with AT&T
Corp. ("AT&T"), NEXTLINK Communications, Inc. ("NEXTLINK") and Qwest
Communications Corporation ("QCC"). As part of these strategic relationships,
the Company received equity investments of $25 million from AT&T's venture
capital arm and two affiliated funds, $20 million from NEXTLINK and $15 million
from QCC's wholly owned subsidiary, U.S. Telesource, Inc. (as used herein,
"Qwest" refers to QCC or its subsidiary, as applicable). AT&T, NEXTLINK and
Qwest each received shares of preferred stock which was converted into Class B
Common Stock upon the Company's initial public offering ("IPO"). The Company
recorded intangible assets of $28.7 million associated with these transactions
which will be amortized over periods of three to six years. Furthermore, AT&T,
NEXTLINK and Qwest each entered into commercial agreements with the Company
providing for the purchase, marketing and resale of the Company's services,
the purchase by the Company of fiber optic transport bandwidth and collocation
of network equipment.
Initial Public Offering:
On January 27, 1999, the Company completed the IPO of 13,455,000 split-
adjusted shares of the Company's Common Stock at a split-adjusted price of
$12.00 per share. Net proceeds to the Company from the IPO were $150.2 million
after deducting underwriting discounts and commissions and estimated offering
expenses payable by the Company. As a result of the IPO, 27,369,243 split-
adjusted shares of Common Stock and 6,379,177 shares of Class B Common Stock
(which are convertible into 9,568,765 split-adjusted shares of Common Stock)
were issued upon the conversion of Preferred Stock, 89,058 split-adjusted shares
of Common Stock were issued for cumulative but unpaid dividends on series A and
series B Preferred Stock and 2,699,626 split-adjusted shares of Common Stock
were issued upon the exercise of common warrants.
4. Subsequent Events
On April 22, 1999, the Company completed an offer to exchange all outstanding
12 1/2% Senior Notes due February 15, 2009 for 12 1/2% Senior Notes due February
15, 2009, which have been registered under the Securities Act of 1933. The
consolidated financial statements applicable to the prior period have been
restated to reflect a three-for-two stock split effective in May 1999 for Common
Stock.
8
<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 consolidated
financial statements and the related notes thereto included elsewhere in this
Form 10-Q and the consolidated audited financial statements and notes thereto
and Management's Discussion and Analysis of Financial Condition and Results of
Operations for the year ended December 31, 1998 included in the Company's
Annual Report on Form 10-K. This discussion contains forward-looking
statements the accuracy of which involves risks and uncertainties. Our actual
results could differ materially from those anticipated in the forward-looking
statements for many reasons including, but not limited to, those discussed
herein and in our Registration Statement on Form S-4. We disclaim any
obligation to update information contained in any forward-looking statement.
See "Forward Looking Statements"
Overview
We are a leading high-speed Internet and network access provider offering
digital subscriber line ("DSL") services to Internet service provider and
enterprise customers. Since March 1998, we have raised $569.0 million of gross
proceeds from debt and equity financings to fund the deployment and expansion of
our networks. To date, we have introduced our services in the San Francisco Bay
Area and the Los Angeles, New York, Boston, Washington D.C., Seattle,
Philadelphia, Sacramento, Baltimore, Chicago and San Diego metropolitan areas.
We plan to build our networks and offer our services in 22 metropolitan regions
nationwide representing 51 metropolitan statistical areas.
In connection with our expansion within existing regions and into new
regions, we expect to significantly increase our capital expenditures, as well
as our sales and marketing expenditures, to deploy our networks and support
additional end-users in those regions. Accordingly, we expect to incur
substantial and increasing net losses for at least the next several years.
We derive revenue from:
. monthly recurring service charges for connections from the end-user to
our facilities and for backhaul services from our facilities to the
Internet service provider or enterprise customer;
. service order set-up and other non-recurring charges; and
. the sale of customer premise equipment that we provide to our customers
due to the general unavailability of customer premise equipment through
retail channels.
We expect prices for the major components of both recurring and non-
recurring revenues to decrease each year in part due to the effects of
competitive pricing and future volume discounts. We believe our revenues from
the sale of customer premise equipment will decline over time as customer
premise equipment becomes more generally available. We expect that the prices we
charge to customers for customer premise equipment will decrease each year.
The following factors comprise our network and service costs:
. Monthly non-recurring and recurring circuit fees. We pay traditional
telephone companies and other competitive telecommunications companies
non-recurring and recurring fees for services including installation,
activation, monthly line costs, maintenance and repair of circuits
between and among our digital subscriber line access multiplexers and our
regional data centers, customer backhaul, and end-user lines. As our
end-user base grows, we expect that the largest element of network and
product cost will be the traditional telephone companies' charge for our
leased copper lines; and
. Other costs. Other costs that we incur include those for materials in
installation and the servicing of customers and end-users, and the cost
of customer premise equipment.
9
<PAGE>
The development and expansion of our business will require significant
expenditures. The principal capital expenditures incurred during the buildup
phase of any region involve the procurement, design and construction of our
central office cages, end-user DSL line cards, and expenditures for other
elements of our network design, which includes a regional data center in each
region. Currently, the average capital cost to deploy our facilities in a
central office, excluding end-user line cards, is approximately $85,000 per
central office facility. This cost may vary in the future due to the quantity
and type of equipment we initially deploy in a central office facility as well
as regulatory limitations imposed on the traditional phone companies relative to
pricing of central office space. Following the buildout of our central office
space, the major portion of our capital expenditures is the purchase of DSL line
cards to support incremental end-users. We expect that the average cost of such
line cards will decline over the next several years. Network expenditures will
continue to increase with the number of end-users. However, once an operating
region is fully built out, a substantial majority of the regional capital
expenditures will be tied to incremental customer and end-user growth. In
addition to developing our networks, we will use our capital for marketing our
services, acquiring Internet service provider and enterprise customers, and
funding our customer care and field service operations.
Recent Developments
On April 20, 1999, we launched our TeleSurfer and TeleSurfer Pro service
for the consumer Internet market. The monthly recurring charges for such
services are significantly lower than those for our business grade TeleSpeed
services. As a result, our profit margins on such consumer services are
expected to be lower than our business grade services. However, the market for
consumer services is very large and we could potentially obtain significantly
increased volumes. Moreover, consumer grade services will leverage our existing
network infrastructure. Our overall margins will depend on the mix and volume
of business and consumer customers, of which consumer grade services could
comprise a significant percentage.
Results of Operations
Revenues
We recorded revenues of $186,000 for the three months ended March 31, 1998
and $5.6 million for the three months ended March 31, 1999. This increase is
attributable to growth in the number of customers and end-users resulting from
our increased sales and marketing efforts and the expansion of our network in
the San Francisco Bay Area and the Los Angeles metropolitan area and to a lesser
extent in the New York, Boston, Washington, D.C., Seattle, Philadelphia and
Sacramento metropolitan areas. We expect revenues to increase in future periods
as we expand our network within our existing regions, deploy networks in new
regions and increase our sales and marketing efforts in all of our regions.
Network and Product Costs
We recorded network and product costs of $203,000 for the three months
ended March 31, 1998 and $5.0 million for the three months ended March 31, 1999.
This increase is attributable to the expansion of our networks and increased
orders resulting from our sales and marketing efforts. We expect network and
product costs to increase significantly in future periods due to increased sales
activity and expected revenue growth.
10
<PAGE>
Sales, Marketing, General and Administrative Expenses
Sales, marketing, general and administrative expenses consist primarily of
salaries, expenses for the development of our business, the development of
corporate identification, promotional and advertising materials, expenses for
the establishment of our management team, and sales commissions. These expenses
increased from $1.9 million for the three months ended March 31, 1998 to $18.1
million for the three months ended March 31, 1999. This increase is
attributable to growth in headcount in all areas of our company, continued
expansion of our sales and marketing efforts, deployment of our networks and
building of our operating infrastructure. Sales, marketing, general and
administrative expenses are expected to increase significantly as we continue to
expand our business.
Deferred Compensation
Through March 31, 1999, we recorded a total of approximately $9.7 million
of deferred compensation, with an unamortized balance of approximately $3.7
million on our March 31, 1999 balance sheet. This deferred compensation is a
result of us granting stock options to our employees with exercise prices per
share subsequently determined to be below the fair values per share for
accounting purposes of our common stock at the dates of grant. We are amortizing
the deferred compensation over the vesting period of the applicable option.
Amortization of deferred compensation was $227,000 during the three months ended
March 31, 1998 and $1.7 million during the three months ended March 31, 1999.
Depreciation and Amortization
Depreciation and amortization includes: (i) depreciation of network costs
and related equipment, (ii) depreciation of information systems, furniture and
fixtures, (iii) amortization of improvements to central offices, regional data
centers and network operations center facilities and corporate facilities, (iv)
amortization of capitalized software costs and (v) amortization of intangible
assets.
During the three months ended March 31, 1999, we recorded intangible assets
of $28.7 million from the issuance of preferred stock to AT&T Ventures, NEXTLINK
and Qwest. Amortization of these assets was $1.9 million during the three
months ended March 31, 1999. Annual amortization of these assets will be
approximately $8.4 million in each of the years in the three year period ending
December 31, 2001, decreasing to approximately $1.2 million per year for each
subsequent year through the year ending December 31, 2004.
Depreciation and amortization was approximately $164,000 for the three
months ended March 31, 1998 and $4.6 million for the three months ended March
31, 1999. This increase was due to the increase in equipment and facilities
placed in service throughout the period as well as amortization of intangible
assets. We expect depreciation and amortization to increase significantly as we
increase our capital expenditures to expand our networks.
Net Interest Income and Expense
Net interest income and expense consists primarily of interest income on
our cash balance and interest expense associated with our debt. For the three
months ended March 31, 1998, net interest expense was $429,000, and was
primarily attributable to the interest expense on the 1998 notes and capital
lease obligations, partially offset by interest income earned primarily from the
investment of the proceeds raised from the issuance of the 1998 notes. Net
interest expense for the three months ended March 31, 1999 was $5.1 million and
consisted primarily of interest expense on the 1998 notes and the 1999 notes and
capital lease obligations partially offset by interest income earned primarily
from the investment of the proceeds raised from the
11
<PAGE>
issuance of the 1998 notes and the 1999 notes as well as our initial public
offering and our issuance of preferred stock to AT&T Ventures, NEXTLINK and
Qwest. We expect interest expense to increase significantly over time, primarily
because the 1998 notes accrete to $260 million by March 15, 2003.
Liquidity and Capital Resources
Our operations have required substantial capital investment for the
procurement, design and construction of our central office cages, the purchase
of telecommunications equipment and the design and development of our networks.
Capital expenditures were approximately $42.8 million for the three months ended
March 31, 1999. We expect that our capital expenditures will be substantially
higher in future periods in connection with the purchase of infrastructure
equipment necessary for the development and expansion of our networks and the
development of new regions.
From our inception through March 31, 1999, we financed our operations
primarily through private placements of $10.6 million of equity securities,
$129.3 million in net proceeds raised from the issuance of the 1998 notes,
$150.2 million in net proceeds raised form our initial public offering, $60.0
million in net proceeds raised from strategic investors and $205.1 million in
net proceeds raised from the issuance of the 1999 notes. As of March 31, 1999,
we had an accumulated deficit of $79.6 million, and cash and cash equivalents of
$341.8 million.
Net cash used in our operating activities was $15.3 million for the three
months ended March 31, 1999. The net cash used for operating activities during
this period was primarily due to net losses and increases in current assets,
offset by non-cash expenses and increases in accounts payable and accrued
liabilities. Net cash used in our investing activities was $123.0 million for
the three months ended March 31, 1999. The net cash used for investing
activities during this period was primarily due to purchases of property and
equipment and the purchase of $74.1 million of restricted investments which were
pledged as collateral for the payment of the first six scheduled interest
payments on the 1999 notes.
Net cash provided by financing activities for the three months ended March
31, 1999 was $415.7 million which primarily related to the following:
. Equity investments of $25 million from AT&T Ventures, $20 million from
NEXTLINK and $15 million from Qwest, representing an aggregate equity
investment of $60 million.
. Net proceeds of $150.2 million form our initial public offering of
13,455,000 split-adjusted shares of our common stock at a split-adjusted
initial public offering price of $12.00 per share.
. Net proceeds of $205.1 million from the issuance of the 1999 notes with
an aggregate principal amount of $215.0 million.
12
<PAGE>
We expect to experience substantial negative cash flow from operating
activities and negative cash flow before financing activities for at least the
next several years due to continued development, commercial deployment and
expansion of our networks. We may also make investments in 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 number of regions entered, the timing of entry and services offered;
. network development schedules and associated costs;
. the rate at which customers and end-users purchase our services and the
pricing of such services;
. 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 and development and
intellectual property with respect to existing and future technology; and
. unanticipated opportunities.
Accordingly, we cannot predict when or to what extent we may be required to
raise additional capital for developing, deploying and enhancing our networks
and operating our business. We may incur additional indebtedness if such
indebtedness becomes available on favorable terms to finance the continued
development, commercial deployment and expansion of our networks and for funding
operating losses or to take advantage of unanticipated opportunities. If we are
unable to obtain required additional capital or are required to obtain it on
terms less satisfactory than we desire, we may be required to delay the
expansion of our business or take or forego actions, any or all of which could
harm our business.
In addition, we may wish to selectively pursue possible acquisitions of
businesses, technologies or products complementary to ours in the future in
order to expand our geographic presence and achieve operating efficiencies.
There can be no assurance that we will have sufficient liquidity, or be able to
obtain additional debt or equity financing on favorable terms or at all, in
order to finance such an acquisition. However, no acquisitions are currently
contemplated.
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. We have reviewed our
internally developed information technology systems and programs and believe
that our systems are Year 2000 compliant and that there are no significant Year
2000 issues within our systems or services. We have not reviewed our 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. We believe that our
non-information technology systems will not present any significant Year 2000
issues, although there can be no assurance in this regard. In addition, we
utilize third-party equipment and software and interact with traditional
telephone companies that have equipment and software that may not be Year 2000
compliant. Failure of such third-party or traditional telephone company
equipment or software to operate properly with regard to the year 2000 and
thereafter could require us to incur unanticipated expenses to remedy any
problems, which could have a material adverse effect on our business, prospects,
operating results and financial condition.
Furthermore, the purchasing patterns of our Internet service provider and
enterprise customers may be
13
<PAGE>
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 our services, which could have a material
adverse effect on our business, prospects, operating results and financial
condition.
We have not made any assessment of the Year 2000 risks associated with our
third-party or traditional phone company equipment or software or with our
Internet service provider and enterprise customers. We have not determined the
risks associated with the reasonably likely worst-case scenario and have not
made any contingency plans to address such risks. However, we intend to devise
a Year 2000 contingency plan prior to December 31, 1999.
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. Examples of such
forward-looking statements include:
. our plans to expand our existing networks or to commence service in new
regions;
. the market opportunity presented by our target regions;
. estimates regarding the timing of launching our service in new regions;
. expectations regarding the extent to which enterprise customers roll out
our service;
. expectations regarding our relationships with AT&T, NEXTLINK, Qwest and
other potential third parties;
. expectations as to pricing for our services in the future;
. statements regarding development of our business;
. expectations as to the impact of our TeleSurfer service offerings on our
margins;
. the possibility that we may obtain significantly increased sales
volumes;
. the estimates of future operating results;
. our anticipated capital expenditures;
. the effect of regulatory reform and regulatory litigation; and
. other statements contained in this Form 10-Q 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:
. successfully market our services to current and new customers;
. generate customer demand for our services in the particular regions where
we plan to market services;
. 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 phone 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-Q which are attributable to us or persons acting on our
behalf are expressly qualified in their entirety by the "Risk Factors" and
other cautionary statements included in our Registration Statement on Form S-4
(Commission File No. 333-75955). We disclaim any obligation to update
information contained in any forward-looking statement.
14
<PAGE>
Quantitative and Qualitative Disclosures about Market Risk
Our exposure to financial market risk, including changes in interest
rates 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 investments portfolio or related income would not be
significantly impacted by either a 100 basis point increase or decrease in
interest rates due mainly to the fixed-rate, short-term nature of the
substantial majority of our investment portfolio. In addition, substantially
all of our outstanding indebtedness at March 31, 1999 including our 1998 notes
and our 1999 notes, is fixed-rate debt.
15
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
We are engaged in a variety of negotiations, arbitrations and regulatory
and court proceedings with multiple traditional telephone companies. These
negotiations, arbitrations and proceedings concern the traditional telephone
companies' denial of physical central office space to us in certain central
offices, the cost and delivery of central office spaces, the delivery of
transmission facilities and telephone lines, billing issues and other
operational issues. For example, we are currently involved in commercial
arbitration proceedings with Pacific Bell over these issues. We have also filed
a lawsuit against Pacific Bell and its affiliates, including Southwestern Bell
Telephone Company, in federal court. We are pursuing a variety of contract,
tort, antitrust and other claims, such as violations of the Telecommunications
Act, in these proceedings. In November 1998, we prevailed in our commercial
arbitration proceeding against Pacific Bell. The arbitration panel found that
Pacific Bell breached its interconnection agreement with us and failed to act in
good faith on multiple counts. The arbitration panel ruled in favor of awarding
us direct damages, as well as attorneys' fees and costs of the arbitration.
Pacific Bell is currently attempting to have the decision vacated. We have also
filed a lawsuit against Bell Atlantic and its affiliates in federal court. We
are pursuing antitrust and other claims in this lawsuit. In addition, Bell
Atlantic has separately filed suit against us asserting at least one patent
infringement claim. Failure to resolve the various legal disputes and
controversies between us and the various traditional telephone companies without
excessive delay and cost and in a manner that is favorable to us could 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 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.
Item 2. Changes in Securities and Use of Proceeds
Recent Sales of Unregistered Securities
During the three month period ended March 31, 1999, we have issued and sold
unregistered securities as follows:
(1) An aggregate of 2,701,049 shares of Series C-1 Preferred Stock and
2,083,334 shares of Series D-1 Preferred Stock were issued in a private
placement in January 1999 to four investors. The consideration received for
such shares was $45 million.
(2) An aggregate of 900,349 shares of Series C-1 Preferred Stock and
694,445 shares of Series D-1 Preferred Stock were issued in a private
placement in January 1999 to an investor. The consideration received for
such shares was $15 million.
(3) In February 1999, we issued $215 million aggregate principal
amount of 12 1/2% Senior Notes due 2009 to Bear, Stearns & Co. Inc., BT
Alex. Brown Incorporated, Donaldson, Lufkin &
16
<PAGE>
Jenrette Securities Corporation and Goldman, Sachs & Co., as initial
purchasers, for resale to qualified institutional buyers. The initial
purchasers received commissions of $5,106,250 for acting as such in
connection with the transaction.
No underwriters were used in connection with these sales and issuances
except for the issuance of the securities described in (3) above. The sales and
issuances of these securities were exempt from registration under the Securities
Act of 1933 pursuant to Section 4(2) under the Act on the basis that the
transactions did not involve a public offering. In connection with the resale
by the initial purchasers of the securities described in (3) above, such resales
were exempt from registration under the Act pursuant to Rule 144A thereunder.
Report of Offering of Securities and Use of Proceeds Therefrom
In January 1999, we commenced and completed a firm commitment underwritten
initial public offering of 13,455,000 split-adjusted shares of our common stock,
including 1,755,000 split-adjusted shares related to the underwriter's over-
allotment option, at a split-adjusted price of $12.00 per share. The shares were
registered with the Securities and Exchange Commission pursuant to a
registration statement on Form S-1 (No. 333-63899), which was declared effective
on January 21, 1998. The public offering was underwritten by a syndicate of
underwriters led by Bear, Stearns & Co. Inc., BT Alex. Brown Incorporated,
Donaldson, Lufkin & Jenrette Securities Corporation and Goldman, Sachs & Co., as
their representatives. After deducting underwriting discounts and commissions of
$10.0 million and expenses of $1.2 million, we received net proceeds of $150.2
million.
As of March 31, 1999, we had invested the net proceeds from our initial
public offering in short- and long-term investments in order to meet
anticipated cash needs for future working capital. We invested our available
cash principally in high-quality corporate issuers and in debt instruments of
the U.S. Government and its agencies. The use of proceeds from the offering
does not represent a material change in the use of proceeds described in the
Registration Statement. None of the net proceeds of the offering were paid
directly or indirectly to any director, officer, general partner of Covad or
their associates, persons owning 10 percent or more of any class of equity
securities of Covad, or an affiliate of Covad.
Item 3. Defaults Upon Senior Securities
None.
17
<PAGE>
Item 4. Submission of Matters to a Vote of Security Holders
The Company held its Annual Meeting of Stockholders on January 19, 1999. At
the meeting the following matters were voted upon, and the number of votes cast
for or against, as well as the number of abstentions, as to each such
matter, along with a separate tabulation with respect to each nominee for
office, is set forth below:
1. A proposal to elect eight directors to serve until the next Annual
Meeting of Stockholders or until their successors are duly elected and
qualified.
<TABLE>
<CAPTION>
Nominee For Against Abstain
------- --- ------- -------
<S> <C> <C> <C>
Robert Hawk 27,457,559 - 11,637
---------- ---------- ------
Robert Knowling, Jr. 27,457,559 - 11,637
---------- ---------- ------
Henry Kressel 27,457,559 - 11,637
---------- ---------- ------
Joseph Landy 27,457,559 - 11,637
---------- ---------- ------
Daniel Lynch 27,457,559 - 11,637
---------- ---------- ------
Frank Marshall 27,457,559 - 11,637
---------- ---------- ------
Charles McMinn 27,457,559 - 11,637
---------- ---------- ------
Richard Shapero 27,457,559 - 11,637
---------- ---------- ------
</TABLE>
2. A proposal to approve an amendment and restatement of the Company's
Amended and Restated Certificate of Incorporation (the "Restated
Certificate") effective upon the closing of the Company's initial
public offering (the "IPO"). The Restated Certificate (i) increased
the Common Stock authorized for issuance to 150,000,000 shares, (ii)
deleted all references to the then-existing series of Preferred Stock,
(iii) authorized one class of undesignated Preferred Stock, and (iv)
established a classified board of directors with the following classes
and terms:
(a) two Class I directors, to hold office until the date of
the Annual Meeting of Stockholders in 2000 and thereafter
for 3-year terms;
(b) three Class II directors, to hold office until the date
of the Annual Meeting of Stockholders in 2001 and
thereafter for 3-year terms;
(c) three Class III directors, to hold office until the date
of the Annual Meeting of Stockholders in 2002 and
thereafter for 3-year terms.
<TABLE>
<CAPTION>
For Against Abstain
--- ------- -------
<S> <C> <C> <C>
Preferred Stock: 15,886,017 -- --
------------- --------------- ---------------
Common Stock: 11,571,542 -- 11,637
------------- --------------- ---------------
</TABLE>
18
<PAGE>
3. A proposal to approve an amendment and restatement of the Company's
Bylaws (the "Amended Bylaws") effective upon the closing of the IPO.
The Amended Bylaws (i) eliminated the right of the stockholders to
call a special meeting, (ii) required specific procedures and advance
notice for director nominations by stockholders and stockholder
proposals and (iii) provided for a classified Board of Directors
consistent with the Restated Certificate.
<TABLE>
<CAPTION>
For Against Abstain
--- ------- -------
<S> <C> <C> <C>
Preferred Stock: 15,886,017 -- --
------------- --------------- ---------------
</TABLE>
4. A proposal to approve (i) an amendment to the Company's 1997 Stock
Plan to increase the number of shares available for issuance
thereunder by 1,550,092 to 15,520,342 and (ii) a further amendment to
the Company's 1997 Stock Plan effective upon the closing of the IPO,
which further amendments (A) provided for annual increases in the
number of shares available for issuance under the plan beginning in
the year 2000 equal to the lesser of 3% of the outstanding shares or
an amount determined by the Board of Directors, and (B) provided for
other technical changes necessary to comply with regulations
applicable to public companies.
<TABLE>
<CAPTION>
For Against Abstain
--- ------- -------
<S> <C> <C> <C>
Preferred Stock: 27,339,670 46,873 2,991,077
------------- --------------- ---------------
</TABLE>
5. A proposal to approve the adoption of the Company's 1998 Employee
Stock Purchase Plan and the reservation of 1,000,000 shares of Common
Stock for issuance thereunder, plus annual increases beginning in the
year 2000 equal to the lesser of (i) 2% of the outstanding shares or
(ii) an amount determined by the Board of Directors.
<TABLE>
<CAPTION>
For Against Abstain
--- ------- -------
<S> <C> <C> <C>
Preferred Stock: 27,391,931 -- 2.985,689
------------- --------------- ---------------
</TABLE>
6. A proposal to approve the Company's exceeding the 30% limit for
outstanding options of the Company as set forth in Section 260.140.45
and related sections of the California Code of Regulations.
<TABLE>
<CAPTION>
For Against Abstain
--- ------- -------
<S> <C> <C> <C>
Preferred Stock: 27,334,653 47,672 2,995,295
------------- --------------- ---------------
</TABLE>
19
<PAGE>
7. A proposal to ratify the appointment of Ernst & Young LLP as
independent public accountants of the Company for the fiscal year
ending December 31, 1999.
<TABLE>
<CAPTION>
For Against Abstain
--- ------- -------
<S> <C> <C> <C>
Preferred Stock: 27,365,762 -- 3,011,858
------------- --------------- ---------------
</TABLE>
In January 1999, a majority of the holders of the Company's outstanding Common
Stock and Preferred Stock approved by written consent a further amendment to the
Restated Certificate effective upon the closing of the Company's IPO to increase
the Common Stock authorized for issuance to 200,000,000 shares.
Item 5. Other Information
None.
20
<PAGE>
Item 6. Exhibits and Reports on Form 8-K
<TABLE>
<CAPTION>
a. Exhibits:
Exhibit Number Description of Exhibit
- -------------- ----------------------
<S> <C>
3.1* Amended and Restated Certificate of Incorporation of the Company, as currently in
effect.
3.2* Bylaws, as currently in effect.
4.1* Amended and Restated Stockholders Rights Agreement dated January 19, 1999.
4.2** Indenture dated as of February 18, 1999 among the Company and The Bank of New
York, including form of 12 1/2% Senior Note Due 2009.
4.3** Registration Rights Agreement dated as of February 18, 1999 among the Company and
Bear, Stearns & Co. Inc., BT Alex. Brown Incorporated, Donaldson, Lufkin &
Jenrette Securities Corporation and Goldman, Sachs & Co.
4.4** Specimen 12 1/2% Senior Note Due 2009.
10.1* 1998 Employee Stock Purchase Plan and related agreements, as currently in effect.
10.2* 1997 Stock Plan and related option agreement, as currently in effect.
10.3* C-1 Preferred Stock Purchase Agreement dated as of January 19, 1999 between the
Company and U.S. Telesource, Inc.
10.4* Series D-1 Preferred Stock Purchase Agreement dated as of January 19, 1999 between
the Company and U.S. Telesource, Inc.
27.1 Financial Data Schedules for the three months ended March 31, 1999.
</TABLE>
- ----------------
* Incorporated by reference to the corresponding exhibit filed with our
registration statement on Form S-1 (No. 333-63899).
** Incorporated by reference to the corresponding exhibit filed with our
registration statement on Form S-4 (No. 333-75955).
b. Reports on Form 8-K
There have been no reports on Form 8-K filed during the quarter ended
March 31, 1999.
21
<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: May 14, 1999 By: /s/ Timothy P. Laehy
--------------------------------------
Timothy P. Laehy
Chief Financial Officer and Vice President,
Finance (Principal Financial and Accounting
Officer)
22
<PAGE>
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Exhibit Number Description of Exhibit
- -------------- ----------------------
<C> <S>
3.1* Amended and Restated Certificate of Incorporation of the Company, as currently in
effect.
3.2* Bylaws, as currently in effect.
4.1* Amended and Restated Stockholders Rights Agreement dated January 19, 1999.
4.2** Indenture dated as of February 18, 1999 among the Company and The Bank of New
York, including form of 12 1/2% Senior Note Due 2009.
4.3** Registration Rights Agreement dated as of February 18, 1999 among the Company and
Bear, Stearns & Co. Inc., BT Alex. Brown Incorporated, Donaldson, Lufkin &
Jenrette Securities Corporation and Goldman, Sachs & Co.
4.4** Specimen 12 1/2% Senior Note Due 2009.
10.1* 1998 Employee Stock Purchase Plan and related agreements, as currently in effect.
10.2* 1997 Stock Plan and related option agreement, as currently in effect.
10.3* C-1 Preferred Stock Purchase Agreement dated as of January 19, 1999 between the
Company and U.S. Telesource, Inc.
10.4* Series D-1 Preferred Stock Purchase Agreement dated as of January 19, 1999 between
the Company and U.S. Telesource, Inc.
27.1 Financial Data Schedules for the three months ended March 31, 1999.
</TABLE>
- ------------------------
* Incorporated by reference to the corresponding exhibit filed with our
registration statement on Form S-1 (No. 333-63899).
** Incorporated by reference to the corresponding exhibit filed with our
registration statement on Form S-4 (No. 333-75955).
23
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> MAR-31-1999
<CASH> 341,803
<SECURITIES> 0
<RECEIVABLES> 4,504
<ALLOWANCES> 875
<INVENTORY> 3,316
<CURRENT-ASSETS> 354,799
<PP&E> 105,423
<DEPRECIATION> 6,227
<TOTAL-ASSETS> 577,238
<CURRENT-LIABILITIES> 31,678
<BONDS> 357,950
0
0
<COMMON> 69
<OTHER-SE> 187,300
<TOTAL-LIABILITY-AND-EQUITY> 577,238
<SALES> 5,596
<TOTAL-REVENUES> 5,596
<CGS> 4,960
<TOTAL-COSTS> 4,960
<OTHER-EXPENSES> 24,413
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 8,636
<INCOME-PRETAX> (28,904)
<INCOME-TAX> 0
<INCOME-CONTINUING> (28,904)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (28,904)
<EPS-PRIMARY> (0.56)
<EPS-DILUTED> (0.56)
</TABLE>
