<PAGE> 1
THE INFORMATION IN THIS PRELIMINARY PROSPECTUS IS NOT COMPLETE AND MAY BE
CHANGED. UNDERWRITERS MAY NOT CONFIRM SALES OF THESE SECURITIES UNTIL THE
REGISTRATION STATEMENT FILED WITH THE SECURITIES AND EXCHANGE COMMISSION IS
EFFECTIVE. THIS PRELIMINARY PROSPECTUS IS NOT AN OFFER TO SELL THESE SECURITIES
AND WE ARE NOT SOLICITING OFFERS TO BUY THESE SECURITIES IN ANY STATE WHERE THE
OFFER OR SALE IS NOT PERMITTED.
Filed Pursuant to Rule 424(a)
Registration No. 333-88757
SUBJECT TO COMPLETION, DATED OCTOBER 15, 1999
PRELIMINARY PROSPECTUS
13,000,000 SHARES
LOGO
COMMON STOCK
-------------------------
This is a public offering of 13,000,000 shares of common stock of Covad
Communications Group, Inc. We are selling 11,405,000 shares of common stock
offered under this prospectus. The selling stockholders identified in the
prospectus are selling an additional 1,595,000 shares. We will not receive any
proceeds from the shares of common stock sold by the selling stockholders.
Our common stock is traded on the Nasdaq National Market under the symbol
"COVD." On October 14, 1999, the last reported sale price for our common stock
on the Nasdaq National Market was $41.75 per share.
SEE "RISK FACTORS" BEGINNING ON PAGE 5 TO READ ABOUT CERTAIN RISKS THAT YOU
SHOULD CONSIDER BEFORE BUYING SHARES OF OUR COMMON STOCK.
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY OTHER REGULATORY BODY HAS
APPROVED OR DISAPPROVED THESE SECURITIES OR PASSED UPON THE ADEQUACY OR ACCURACY
OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
-------------------------
<TABLE>
<CAPTION>
PER
SHARE TOTAL
------ --------
<S> <C> <C>
Public offering price....................................... $ $
Underwriting discounts and commissions...................... $ $
Proceeds, before expenses, to us............................ $ $
Proceeds, before expenses, to the selling stockholders...... $ $
</TABLE>
-------------------------
The underwriters may, under certain circumstances, purchase up to an additional
1,950,000 shares of common stock from us at the public offering price less the
underwriting discount.
The underwriters are severally underwriting the shares being offered. The
underwriters expect to deliver the shares against payment in New York, New York
on , 1999.
-------------------------
BEAR, STEARNS & CO. INC. MORGAN STANLEY DEAN WITTER
CREDIT SUISSE FIRST BOSTON
DEUTSCHE BANC ALEX. BROWN
DONALDSON, LUFKIN & JENRETTE
GOLDMAN, SACHS & CO.
UTENDAHL CAPITAL PARTNERS, L.P.
-------------------------
The date of this prospectus is , 1999
<PAGE> 2
PROSPECTUS SUMMARY
This summary highlights information contained elsewhere in this prospectus.
You should read the entire prospectus, including "Risk Factors" beginning on
page 5, carefully before investing in our common stock.
COVAD COMMUNICATIONS GROUP, INC.
OUR COMPANY
We are a leading provider of broadband communications services to Internet
service provider, enterprise and telecommunications carrier customers. These
services include a range of high-speed, high-capacity Internet and network
access services using digital subscriber line (DSL) technology, and related
value-added services. Internet service providers purchase our services in order
to provide high-speed Internet access to their business and consumer end-users.
Enterprise customers purchase our services directly or indirectly from us to
provide employees with high-speed remote access to the enterprise's local area
networks (RLAN access), which improves employee productivity and reduces network
connection costs. Telecommunications carrier customers purchase our services for
resale to their Internet service provider affiliates, Internet users and
enterprise customers.
We believe we have the nation's largest DSL network with 880 operational
central offices passing over 25 million homes and businesses. As of September
30, 1999, we had installed 31,000 DSL-based high-speed access lines and received
orders for our services from 295 Internet service provider, enterprise and
telecommunications carrier customers, including AT&T, Concentric Network,
Flashcom, MindSpring, Oracle, Prodigy, PSINet, Qwest, Stanford University, Sun
Microsystems, UUNET and Verio.
We had planned to deploy our services in 51 metropolitan statistical areas
by the end of the first quarter 2000. By August 1999 we had begun offering our
services in each of these 51 metropolitan statistical areas, and in September
1999, we announced plans to roll out our services in 49 additional metropolitan
statistical areas. When this build-out is completed, which we expect to be by
the end of 2000, our network will pass a total of 46 million homes and
businesses, representing 40% of homes and 45% of businesses in the United
States.
We plan to continue to pursue rapid network expansion and installation of
high-speed access lines, and to develop a variety of services that are enhanced
or enabled by our broadband network, such as voice over DSL and e-commerce
applications. We expect to leverage our network by entering into business
arrangements with broadband-related service providers in order to bring a
variety of value-added service offerings to our customers and their end-users.
OUR MARKET OPPORTUNITY
We believe that we have a substantial business opportunity for the
following reasons:
- There is a growing market demand for broadband communications services.
- Broadband communications services are enabling new applications for
businesses and consumers.
- DSL is a cost-effective technology for broadband communications.
- The current regulatory environment facilitates the provision of
competitive broadband communications service offerings.
OUR COMPETITIVE STRENGTHS
We offer an attractive value proposition compared to alternative
technologies. For business Internet users, our high-end services offer
bandwidth comparable to that offered by T1 and frame relay circuits (which are
up to 25 times the speed of most analog modems) at a substantially lower cost
than traditional T1 service. For the RLAN market, our mid-range services are
three to six times the speed of ISDN lines
1
<PAGE> 3
and up to ten times the speed of most analog modems at monthly rates similar to
or lower than those for heavily-used ISDN lines. For consumer Internet users,
our consumer services are comparably priced to other services, such as cable
modem services, but offer significant advantages in security, network
performance and speed.
We have leveraged our first-mover advantage to rapidly expand our network
and grow our number of installed lines. We were the first to widely roll out
DSL services on a commercial basis, making DSL service available for purchase in
the San Francisco Bay Area in December 1997. We believe that we have leveraged
our first-mover advantage to rapidly expand our network into our targeted
metropolitan regions and grow our number of line installations.
Our services are widely available, continuously connected and secure. Our
strategy of providing blanket coverage in each region we serve is designed to
ensure that our services are available to the vast majority of our customers'
end-users. Our networks provide a 24-hour continuous connection, unlike ISDN
lines and analog modems which require customers to dial-up each time for
Internet or RLAN access. Also, because we use dedicated connections from each
end-user to the Internet service provider or enterprise network, our customers
can reduce the risk of unauthorized access.
Our management team has extensive industry experience. Our management team
includes individuals with extensive experience in the data communications,
telecommunications and personal computer industries. In July 1998, we hired as
our Chief Executive Officer Robert Knowling, Jr., who formerly served as the
Executive Vice President of Operations and Technologies at U S WEST
Communications and as Vice President of Network Operations at Ameritech. Mr.
Knowling also serves as our President and the Chairman of our board of
directors.
OUR BUSINESS STRATEGY
Our objective is to become the leading nationwide provider of broadband
services and a critical element in the proliferation of e-commerce and other
applications that are enabled or enhanced by broadband communications. The key
elements of our strategy to achieve this objective are to:
- expand our network and roll out our service rapidly in our targeted
metropolitan statistical areas;
- provide pervasive coverage in each of our 100 targeted metropolitan
statistical areas;
- establish and maintain sales and marketing relationships with leading
Internet service providers, telecommunications carriers and DSL
resellers;
- develop a high level of national brand recognition for our name;
- develop and commercialize additional value-added services such as voice
over DSL; and
- take advantage of new regulatory developments to facilitate the
deployment of our network.
2
<PAGE> 4
THE OFFERING
The following information is based on 82,933,005 shares of our common stock
outstanding as of September 30, 1999. This number includes:
- 9,568,765 shares of common stock issuable upon conversion of 6,379,177
shares of our non-voting class B common stock held by our strategic
investors; and
- 445,000 shares of common stock subject to outstanding options held by
selling stockholders that are expected to be exercised prior to the date
of this offering at a weighted average exercise price of $2.12 per share.
This number excludes:
- 17,110,191 shares of common stock subject to outstanding options at a
weighted average exercise price of $11.09 as of September 30, 1999;
- 1,709,468 shares of common stock reserved for future issuance under our
1997 Stock Plan and 1,500,000 shares of common stock reserved for future
issuance under our 1998 Employee Stock Purchase Plan as of September 30,
1999; and
- 272,904 shares of common stock issuable upon exercise of warrants issued
in connection with our 1998 notes at an exercise price of $0.0022 per
share.
Common stock offered by us...................... 11,405,000 shares
Common stock offered by the selling
stockholders.................................... 1,595,000 shares
Common stock to be outstanding after this
offering........................................ 94,338,005 shares
Use of proceeds................................. We will use the proceeds from
this offering to expand our
network, for sales and
marketing activities, to
support possible strategic
investments and acquisitions
and for working capital and
general corporate purposes.
Nasdaq National Market symbol................... COVD
Unless we indicate otherwise, the information in this prospectus assumes
the underwriters will not exercise their over-allotment option.
-------------------------
The address of our principal executive office is 2330 Central Expressway,
Santa Clara, California 95050, and our telephone number is (408) 844-7500.
"Covad(TM)," "TeleSpeed(R)," "TeleSurfer(SM)," "The Speed to Work(SM),"
"The Internet As It Should Be(SM)" and the Covad logos, names and marks are some
of our trademarks and servicemarks. This prospectus contains other product
names, trade names and trademarks of ours and of other organizations.
3
<PAGE> 5
SUMMARY CONSOLIDATED FINANCIAL DATA
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, SIX MONTHS ENDED JUNE 30,
------------------------ -------------------------
1997 1998 1998 1999
---------- ---------- ---------- -----------
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenues........................................... $ 26 $ 5,326 $ 995 $ 16,429
Operating expenses:
Network and product costs........................ 54 4,562 961 15,525
Sales, marketing, general and administrative..... 2,374 31,043 6,550 43,089
Amortization of deferred compensation............ 295 3,997 858 2,887
Depreciation and amortization.................... 70 3,406 610 13,318
---------- ---------- ---------- -----------
Total operating expenses.................. 2,793 43,008 8,979 74,819
---------- ---------- ---------- -----------
Income (loss) from operations...................... (2,767) (37,682) (7,984) (58,390)
Net interest income (expense).................... 155 (10,439) (3,720) (12,366)
---------- ---------- ---------- -----------
Net income (loss).................................. (2,612) (48,121) (11,704) (70,756)
---------- ---------- ---------- -----------
Preferred dividends................................ -- -- -- (1,146)
---------- ---------- ---------- -----------
Net income (loss) available to common
stockholders..................................... $ (2,612) $ (48,121) $ (11,704) $ (71,902)
========== ========== ========== ===========
Net income (loss) per common share(1).............. $ (0.53) $ (5.62) $ (1.54) $ (1.18)
Weighted average shares used in computing net
income (loss) per share(1)....................... 4,907,319 8,562,802 7,584,501 60,930,856
OTHER FINANCIAL DATA:
EBITDA(2).......................................... $ (2,402) $ (30,154) $ (6,516) $ (42,185)
CONSOLIDATED CASH FLOW DATA:
Provided by (used in) operating activities......... $ (1,895) $ (9,054) $ (877) $ (27,721)
Provided by (used in) investing activities......... (2,494) (61,252) (12,380) (194,446)
Provided by (used in) financing activities......... 8,767 130,378 130,764 415,188
</TABLE>
<TABLE>
<CAPTION>
AS OF AS OF JUNE 30, 1999
DECEMBER 31, ----------------------------
1998 ACTUAL AS ADJUSTED(3)
------------ ---------- --------------
(UNAUDITED)
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents................................... $ 64,450 $ 257,471 $ 719,578
Net property and equipment.................................. 59,145 143,562 143,562
Total assets................................................ 139,419 593,816 1,055,923
Long-term obligations, including current portion............ 142,879 363,856 363,856
Total stockholders' equity (net capital deficiency)......... (24,706) 172,004 634,111
</TABLE>
<TABLE>
<CAPTION>
AS OF DECEMBER 31, AS OF JUNE 30,
------------------------ -------------------------
1997 1998 1998 1999
---------- ---------- ---------- -----------
<S> <C> <C> <C> <C>
OTHER OPERATING DATA:
Homes and businesses passed........................ 278,000 6,000,000 1,300,000 15,400,000
Lines installed.................................... 26 3,900 700 16,700
</TABLE>
- ---------------
(1) Data reflects a two-for-one stock split effective May 1998, a three-for-two
stock split effective August 1998 and a three-for-two split of our common
stock effective May 1999.
(2) EBITDA consists of net loss excluding net interest, taxes, depreciation and
amortization, non-cash stock-based compensation expense and other
non-operating income or expenses. We have provided EBITDA because it is a
measure of financial performance commonly used in the telecommunications
industry as well as to enhance an understanding of our operating results.
EBITDA should not be construed as either:
- an alternative to operating income (as determined in accordance with
generally accepted accounting principles) as an indicator of our operating
performance, or
- an alternative to cash flows from operating activities (as determined in
accordance with generally accepted accounting principles) as a measure of
liquidity.
EBITDA as calculated by us may be calculated differently than EBITDA for other
companies. See our consolidated financial statements and the related notes
thereto contained elsewhere in this prospectus.
(3) The as adjusted balance sheet data reflects the receipt of:
- $461.2 million of net proceeds from the sale of shares of common stock by
us in this offering; and
- $943,000 of proceeds from the issuance of 445,000 shares of common stock
subject to outstanding options held by selling stockholders that are
expected to be exercised prior to the date of this offering at a weighted
average exercise price of $2.12 per share.
4
<PAGE> 6
RISK FACTORS
An investment in our common stock involves a high degree of risk. You
should carefully consider the following factors before deciding to purchase
shares of our common stock. This prospectus contains forward-looking statements
that involve risks and uncertainties. We use words such as "anticipates,"
"believes," "plans," "expects," "future," "intends" and similar expressions to
identify forward-looking statements. Our actual results could differ materially
from those anticipated in the forward-looking statements as a result of certain
factors, including the risks described below and elsewhere in this prospectus.
We disclaim any obligation to update information contained in any
forward-looking statement.
RISKS RELATED TO COVAD
OUR BUSINESS IS DIFFICULT TO EVALUATE BECAUSE WE HAVE A LIMITED OPERATING
HISTORY
We were incorporated in October 1996 and introduced our services
commercially in the San Francisco Bay Area in December 1997. Because of our
limited operating history, you have limited operating and financial data upon
which to evaluate our business. You should consider that we have the risks of an
early stage company in a new and rapidly evolving market. To overcome these
risks, we must:
- rapidly expand the geographic coverage of our services;
- attract and retain customers within our existing and in new metropolitan
statistical areas;
- increase awareness of our services;
- respond to competitive developments;
- continue to attract, retain and motivate qualified persons;
- continue to upgrade our technologies in response to competition and
market factors;
- manage our traditional telephone company suppliers;
- rapidly install high-speed access lines;
- effectively manage the growth of our operations; and
- deliver additional value-added services to our customers.
WE HAVE A HISTORY OF LOSSES AND EXPECT INCREASING LOSSES IN THE FUTURE
We have incurred substantial losses and experienced negative cash flow each
fiscal quarter since our inception. As of June 30, 1999, we had an accumulated
deficit of approximately $121.5 million. We intend to increase our capital
expenditures and operating expenses in order to expand our business. As a
result, we expect to incur substantial additional net losses and substantial
negative cash flow for at least the next several years.
In addition, we expect our net losses to increase in the future due to the
interest and amortization charges related to the 13 1/2% Senior Discount Notes
due 2008 issued in March 1998 and the 12 1/2% Senior Notes due 2009 issued in
February 1999, and the amortization charges related to our issuance of preferred
stock to AT&T Ventures and two affiliated funds ("AT&T Ventures"), NEXTLINK and
Qwest in January 1999. For example:
- Interest and amortization charges relating to the 1998 notes were
approximately $16.0 million during the year ended December 31, 1998.
These charges will increase each year until the year ending December 31,
2004, during which period the interest and amortization charges will be
approximately $36.9 million. This increase is due to the accretion of the
1998 notes to $260 million through March 2003.
5
<PAGE> 7
- Interest and amortization charges relating to the 1999 notes will be
approximately $24.0 million during the year ending December 31, 1999 and
will increase slightly each year to approximately $28.3 million during
the year ending December 31, 2008.
- We recorded intangible assets of $28.7 million associated with the
issuance of our preferred stock to AT&T Ventures, NEXTLINK and Qwest.
These amounts will result in an annual amortization charge of
approximately $8.4 million in each of the years in the three year period
ending December 31, 2001.
OUR OPERATING RESULTS ARE LIKELY TO FLUCTUATE IN FUTURE PERIODS AND, THEREFORE,
ARE DIFFICULT TO PREDICT
Our annual and quarterly operating results are likely to fluctuate
significantly in the future as a result of numerous factors, many of which are
outside of our control. These factors include:
- the timing and willingness of traditional telephone companies to provide
us with central office space and the prices, terms and conditions on
which they make available the space to us;
- the amount and timing of capital expenditures and other costs relating to
the expansion of our networks and the marketing of our services;
- delays in the commencement of operations in new regions and the
generation of revenue because certain network elements have lead times
that are controlled by traditional telephone companies and other third
parties;
- the ability to develop and commercialize new services by us or our
competitors;
- the ability to deploy on a timely basis our services to adequately
satisfy end-user demand;
- our ability to successfully operate our networks;
- the rate at which customers subscribe to our services;
- decreases in the prices for our services due to competition, volume-based
pricing and other factors;
- our ability to retain Internet service provider, enterprise and
telecommunications carrier customers and end-user churn rates;
- the mix of line orders between consumer end-users and business end-users
(which typically have higher margins);
- the success of our relationships with AT&T, NEXTLINK, Qwest and WebMD and
other potential third parties in generating significant end-user demand;
- the development and operation of our billing and collection systems and
other operational systems and processes;
- the rendering of accurate and verifiable bills by our traditional
telephone company suppliers and resolution of billing disputes;
- the incorporation of enhancements, upgrades and new software and hardware
products into our network and operational processes that may cause
unanticipated disruptions; and
- the interpretation and enforcement of regulatory developments and court
rulings concerning the 1996 Telecommunications Act, interconnection
agreements and the anti-trust laws.
As a result, it is likely that in some future quarters our operating
results will be below the expectations of securities analysts and investors. If
this happens, the trading price of our common stock would likely decline.
6
<PAGE> 8
WE CANNOT PREDICT WHETHER WE WILL BE SUCCESSFUL BECAUSE OUR BUSINESS STRATEGY IS
LARGELY UNPROVEN
We believe that we were the first competitive telecommunications company to
widely provide high-speed Internet and network access using DSL technology. To
date, our business strategy remains largely unproven. To be successful, we must
develop and market services that achieve broad commercial acceptance by Internet
service provider, enterprise and telecommunications carrier customers in our
targeted metropolitan statistical areas. Because our business and the demand for
high-speed digital communications services are in the early stages of
development, we are uncertain whether our services will achieve broad commercial
acceptance.
WE MAY EXPERIENCE DECREASING PRICES FOR OUR SERVICES, WHICH MAY IMPAIR OUR
ABILITY TO ACHIEVE PROFITABILITY OR POSITIVE CASH FLOW
We may experience decreasing prices for our services due to competition,
volume-based pricing, an increase in the proportion of our revenues generated by
our consumer services and other factors. Currently, we charge higher prices for
some of our services than some of our competitors do for their similar services.
As a result, we cannot assure you that our customers and their end-user
customers will select our services over those of our competitors. In addition,
prices for digital communications services in general have fallen historically,
and we expect this trend to continue. We have provided and expect in the future
to provide price discounts to customers that commit to sell our services to a
large number of their end-user customers. Our consumer grade services have lower
prices than our business grade services. As a result, expected increases in the
percentage of our revenues which we derive from our consumer services will
likely reduce our overall profit margins. We also expect to reduce prices
periodically in the future to respond to competition and to generate increased
sales volume. As a result, we cannot predict whether demand for our services
will exist at prices that enable us to achieve profitability or positive cash
flow.
OUR BUSINESS WILL SUFFER IF OUR INTERNET SERVICE PROVIDERS, TELECOMMUNICATIONS
CARRIERS AND OTHER THIRD PARTIES ARE NOT SUCCESSFUL IN MARKETING AND SELLING OUR
SERVICES
We market our Internet access services through Internet service providers
and telecommunications carriers for resale to their business and consumer
end-users. To date, a limited number of Internet service providers have
accounted for the significant majority of our revenues. As a result, a
significant reduction in the number of end-users provided by one or more of our
key Internet service providers could result in a material decrease in our
revenues for a given period. We expect that our Internet service provider
customers and telecommunications carriers will account for the majority of our
future market penetration and revenue growth. Our agreements with our customers
are generally non-exclusive. Many of our customers also resell services offered
by our competitors. In addition, a number of our customers have committed to
provide large numbers of end-users in exchange for price discounts. If our
customers do not meet their volume commitments or otherwise do not sell our
services to as many end users as we expect, our business will suffer.
In addition, we entered into commercial agreements with each of AT&T,
NEXTLINK and Qwest and more recently with WebMD. Our agreements with AT&T,
NEXTLINK and Qwest provide for the purchase and resale of our services,
primarily to their small business and enterprise customers. Our agreement with
WebMD provides that we will be WebMD's preferred provider of broadband
connectivity offering physician subscribers web-based multimedia and
communication services designed to enhance their practices. To date, these
relationships have not generated significant line orders. We cannot predict the
number of line orders that AT&T, NEXTLINK, Qwest or WebMD will generate, if any,
or whether line orders will be below our expectations. In addition, these and
future relationships we may establish with other third parties may not result in
significant line orders or revenues.
7
<PAGE> 9
OUR FAILURE TO MANAGE OUR GROWTH EFFECTIVELY MAY DELAY OUR NETWORK EXPANSION AND
SERVICE ROLLOUT
Our strategy is to significantly expand our networks within our existing
metropolitan statistical areas and to deploy our networks in substantially all
of our 100 targeted metropolitan statistical areas by the end of 2000. The
execution of this strategy involves:
- obtaining the required government authorizations;
- identifying, accessing and initiating service in key central offices
within existing and target regions;
- designing, maintaining and upgrading adequate operational support,
billing and collection systems;
- obtaining central office space and maintaining connections between
central offices;
- obtaining phone lines and electronic ordering facilities from our
traditional telephone company suppliers on a timely basis; and
- entering into and renewing interconnection agreements with the
appropriate traditional telephone companies on satisfactory terms and
conditions.
To accomplish this strategy, we must, among other things:
- market to and acquire a substantial number of customers and end-users;
- continue to implement and improve our operational, financial and
management information systems, including our client ordering,
provisioning, dispatch, trouble ticketing and other operational systems
as well as our billing, accounts receivable and payable tracking,
collection, fixed assets and other financial management systems;
- hire and train additional qualified management and technical personnel;
- manage and resolve any disputes which may arise with our traditional
telephone company suppliers;
- establish and maintain relationships with third parties to market and
sell our services, install network equipment and provide field service;
and
- continue to expand and upgrade our network infrastructure.
We may be unable to do these things successfully. As a result, we may be
unable to deploy our networks as scheduled or achieve the operational growth
necessary to achieve our business strategy.
Our growth has placed, and is expected to continue to place, significant
demands on our management and operational resources. We expect to continue to
significantly increase our employee base to support the deployment of our
networks. We also expect to implement system upgrades, new software systems and
other enhancements, which could cause disruption and dislocation in our
business. If we are successful in implementing our marketing strategy, we may
have difficulty responding to demand for our services and technical support in a
timely manner and in accordance with our customers' expectations. We expect
these demands to require the addition of new management personnel and the
increased outsourcing of company functions to third parties. We may be unable to
do this successfully, in which case we could experience a reduction in the
growth of our line orders and therefore our revenues.
REJECTIONS OF OUR APPLICATIONS FOR CENTRAL OFFICE SPACE BY TRADITIONAL TELEPHONE
COMPANIES ARE LIKELY TO DELAY THE EXPANSION OF OUR NETWORKS AND THE ROLLOUT OF
OUR SERVICES
We must secure physical space from traditional telephone companies for our
equipment in their central offices in order to provide our services in our
targeted metropolitan statistical areas. In the past, we have experienced
rejections of our applications to secure this space in many central offices, and
we continue to receive rejections in some central offices.
We expect that as we proceed with our deployment, we will face additional
rejections of our applications for central office space in our other targeted
metropolitan statistical areas. These rejections have in the past resulted, and
could in the future result, in delays and increased expenses in the rollout of
8
<PAGE> 10
our services in our targeted metropolitan statistical areas, including delays
and expenses associated with engaging in legal proceedings with the traditional
telephone companies. This has harmed our business and is likely to continue to
harm our business in future periods.
We face other challenges in dealing with the traditional telephone
companies:
- there may be real limitations on the availability of central office space
in certain central offices;
- they frequently claim lack of available facilities when asked by us to
provide connections between central offices and telephone wires to
end-users;
- they frequently fail to promise delivery of, and actually deliver,
properly connected telephone wires to our end-users on time;
- they frequently do not cooperate in providing us with relevant telephone
wire information such as the length of the wire;
- they frequently do not deploy and provide us with integrated software
systems that allow us to seamlessly place large volumes of orders for
telephone lines; and
- they frequently do not cooperate in maintaining and resolving problems
relating to delivery of telephone lines.
We are engaged in a variety of negotiations, regulatory disputes and legal
actions to resolve these situations. We may be unable to resolve these matters
successfully.
The Federal Communications Commission (FCC) has been reviewing the policies
and practices of the traditional telephone companies with the goal of
facilitating the efforts of competitive telecommunications companies to obtain
central office space and telephone wires more easily and on more favorable
terms. On March 31, 1999, the FCC adopted rules to make it easier and less
expensive for competitive telecommunications companies to obtain central office
space and to require traditional telephone companies to make new alternative
arrangements for obtaining central office space. However, the FCC's new rules
have not been uniformly implemented in a timely manner and may not ultimately
enhance our ability to obtain central office space.
CHARGES FOR UNBUNDLED NETWORK ELEMENTS ARE OUTSIDE OF OUR CONTROL BECAUSE THEY
ARE PROPOSED BY THE TRADITIONAL TELEPHONE COMPANIES AND ARE SUBJECT TO COSTLY
REGULATORY APPROVAL PROCESSES.
Traditional telephone companies provide the unbundled DSL-capable lines or
telephone wires that connect each end-user to our equipment located in the
central offices. The 1996 Telecommunications Act generally requires that charges
for these unbundled network elements be cost-based and nondiscriminatory. The
nonrecurring and recurring monthly charges for DSL-capable lines (telephone
wires) that we require vary greatly. These rates are subject to the approval of
the state regulatory commissions. The rate approval processes for DSL-capable
lines and other unbundled network elements typically involve a lengthy review of
the rates proposed by the traditional telephone companies in each state. The
ultimate rates approved typically depend on the traditional telephone company's
initial rate proposals and the policies of the state public utility commission.
These rate approval proceedings are time-consuming and expensive. Consequently,
we are subject to the risk that the non-recurring and recurring charges for
DSL-capable lines and other unbundled network elements will increase based on
rates proposed by the traditional telephone companies and approved by state
regulatory commissions from time to time, which would harm our operating
results.
9
<PAGE> 11
THE FAILURE OF TRADITIONAL TELEPHONE COMPANIES TO ADEQUATELY PROVIDE
TRANSMISSION FACILITIES AND PROVISION TELEPHONE WIRES IS LIKELY TO IMPAIR OUR
ABILITY TO INSTALL LINES AND ADVERSELY AFFECT OUR GROWTH RATE
We interconnect with and use traditional telephone companies' networks to
service our customers. This presents a number of challenges because we depend on
traditional telephone companies:
- to use their technology and capabilities to meet certain
telecommunications needs of our customers and to maintain our service
standards;
- to cooperate with us for the provision and maintenance of transmission
facilities; and
- to provide the services and network components that we order, for which
they depend significantly on unionized labor. Labor issues have in the
past and may in the future hurt the telephone companies' performance.
Our dependence on the traditional telephone companies has caused and could
continue to cause us to encounter delays in establishing our networks and
providing higher speed DSL services. We rely on the traditional telephone
companies to provision telephone wires to our customers and end-users. We must
establish efficient procedures for ordering, provisioning, maintaining and
repairing large volumes of DSL-capable lines from the traditional telephone
companies. We must also establish satisfactory electronic billing and payment
arrangements with the traditional telephone companies. We may not be able to do
these things in a manner that will allow us to retain and grow our customer and
end-user base. It has been and continues to be our experience that, at any given
time, one or more of those companies will be failing to deliver the central
office space, transmission facilities, telephone wires or other elements,
features and functions that our business requires. For example, the traditional
telephone companies currently are significantly impairing our ability to
efficiently install our services, and this has adversely affected the growth in
the volume of orders we receive. The failure of the traditional telephone
companies to consistently and adequately deliver operable telephone wires to us
on time has significantly contributed to an increase in the backlog of
uninstalled orders. The continued inadequate performance of the traditional
telephone companies could slow the growth in our revenues and reduce the growth
in orders placed by our customers, which could materially harm our business.
WE DEPEND ON THE TRADITIONAL TELEPHONE COMPANIES FOR THE QUALITY AND
AVAILABILITY OF THE TELEPHONE WIRES THAT WE USE
We depend significantly on the quality and availability of the traditional
telephone companies' telephone wires and the traditional telephone companies'
maintenance of such wires. We may not be able to obtain the telephone wires and
the services we require from the traditional telephone companies at satisfactory
quality levels, rates, terms and conditions. Our inability to do so could delay
the expansion of our networks and degrade the quality of our services to our
customers.
OUR BUSINESS WILL SUFFER IF OUR INTERCONNECTION AGREEMENTS ARE NOT RENEWED OR IF
THEY ARE RENEWED OR MODIFIED ON UNFAVORABLE TERMS
We are required to enter into and implement interconnection agreements in
each of our targeted metropolitan statistical areas with the appropriate
traditional telephone companies in order to provide service in those regions. We
have not yet entered into all of the interconnection agreements we require to
complete our 100 metropolitan statistical area buildout. We may be unable to
timely enter into these agreements, which is prerequisite for us to provide
service in those areas. Many of our existing interconnection agreements have a
maximum term of three years. Therefore, we will have to renegotiate these
agreements with the traditional telephone companies when they expire. We may not
succeed in extending or renegotiating them on favorable terms or at all.
Additionally, disputes have arisen and will continue to arise in the future
as a result of differences in interpretations of the interconnection agreements.
For example, we are in litigation proceedings with certain of the traditional
telephone companies. These disputes have delayed our deployment of our networks,
and resolution of the litigated matters will take time and cause us ongoing
expenditure of money
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and management time. They may have also negatively affected our service to our
customers and our ability to enter into additional interconnection agreements
with the traditional telephone companies in other states. In addition, the
interconnection agreements are subject to state commission, FCC and judicial
oversight. These government authorities may modify the terms of the
interconnection agreements in a way that harms our business.
THE MARKETS WE FACE ARE HIGHLY COMPETITIVE AND WE MAY NOT BE ABLE TO COMPETE
EFFECTIVELY, ESPECIALLY
AGAINST ESTABLISHED INDUSTRY COMPETITORS WITH SIGNIFICANTLY GREATER FINANCIAL
RESOURCES
The markets we face for business and consumer Internet access and RLAN
access services are intensely competitive. We expect that these markets will
become increasingly competitive in the future. In addition, the traditional
telephone companies dominate the current market and have a monopoly on telephone
wires. We pose a competitive risk to the traditional telephone companies and, as
both our competitors and our suppliers, they have the ability and the motivation
to harm our business. We also face competition from cable modem service
providers, competitive telecommunications companies, traditional and new
national long distance carriers, Internet service providers, on-line service
providers and wireless and satellite service providers. Many of these
competitors have longer operating histories, greater name recognition, better
strategic relationships and significantly greater financial, technical or
marketing resources than we do. As a result, these competitors:
- may be able to develop and adopt new or emerging technologies and respond
to changes in customer requirements or devote greater resources to the
development, promotion and sale of their products and services more
effectively than we can;
- may form new alliances and rapidly acquire significant market share; and
- may be able to undertake more extensive marketing campaigns, adopt more
aggressive pricing policies and devote substantially more resources to
developing high-speed digital services.
The intense competition from our competitors, including the traditional
telephone companies, the cable modem service providers and the competitive
telecommunications companies could harm our business.
The traditional telephone companies represent the dominant competition in
all of our target service areas. We expect this competition to intensify. For
example, they have an established brand name and reputation for high quality in
their service areas, possess sufficient capital to deploy DSL equipment rapidly,
have their own telephone wires and can bundle digital data services with their
existing analog voice services to achieve economies of scale in serving
customers. Certain of the traditional telephone companies have aggressively
priced their consumer DSL services as low as $19-$29 per month, placing pricing
pressure on our TeleSurfer services. While we may be allowed to provide our data
services over the same telephone wires that they provide analog voice services,
we may be unable to obtain this ability. Even if we do obtain this ability,
there is no assurance that we will be permitted to provide our services in this
manner without running into operational or technical obstacles; including those
created by the traditional telephone companies. Further, they can offer service
to end-users from certain central offices where we are unable to secure central
office space and offer service. Accordingly, we may be unable to compete
successfully against the traditional telephone companies.
Cable modem service providers such as Excite@Home and MediaOne (and their
respective cable partners) are deploying high-speed Internet access services
over cable networks. Where deployed, these networks provide similar and in some
cases higher-speed Internet access and RLAN access than we provide. They also
offer these services at lower price points than our TeleSurfer services. As a
result, competition with the cable modem service providers may have a
significant negative effect on our ability to secure customers and may create
downward pressure on the prices we can charge for our services.
Many competitive telecommunications companies offer high-speed data
services using a business strategy similar to ours. Some of these competitors
have begun offering DSL-based access services and others are likely to do so in
the future. In addition, some competitive telecommunications companies have
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extensive fiber networks in many metropolitan areas primarily providing
high-speed digital and voice circuits to large corporations, and have
interconnection agreements with traditional telephone companies pursuant to
which they have acquired central office space in many of our markets. Further,
certain of our customers have made investments in our competitors. As a result
of these factors, we may be unsuccessful in generating a significant number of
new customers or retaining existing customers.
OUR LEVERAGE IS SUBSTANTIAL AND WILL INCREASE, MAKING IT MORE DIFFICULT TO
RESPOND TO CHANGING BUSINESS CONDITIONS
As of June 30, 1999, we had approximately $363.9 million of long-term
obligations (including current portion), which consists primarily of the 1998
notes and the 1999 notes. Because the 1998 notes accrete to $260 million through
March 2003, we will become increasingly leveraged until then, whether or not we
incur new indebtedness in the future. We may also incur additional indebtedness
in the future, subject to certain restrictions contained in the indentures
governing the 1998 notes and the 1999 notes, to finance the continued
development, commercial deployment and expansion of our networks and for funding
operating losses or to take advantage of unanticipated opportunities. The degree
to which we are leveraged could have important consequences to you. For example,
it could:
- materially limit or impair our ability to obtain additional financing or
refinancing in the future for working capital, capital expenditures,
acquisitions, general corporate purposes or other purposes;
- require us to dedicate a substantial portion of our cash flow to the
payment of principal and interest on our indebtedness, which reduces the
availability of cash flow to fund working capital, capital expenditures,
acquisitions, general corporate purposes or other purposes;
- limit our ability to redeem the 1998 notes and the 1999 notes in the
event of a change of control; and
- increase our vulnerability to economic downturns, limit our ability to
withstand competitive pressures and reduce our flexibility in responding
to changing business and economic conditions.
WE WILL REQUIRE A SIGNIFICANT AMOUNT OF CASH TO SERVICE OUR INDEBTEDNESS; OUR
ABILITY TO GENERATE
CASH DEPENDS ON MANY FACTORS BEYOND OUR CONTROL
We expect to continue to generate substantial net losses and negative cash
flow for at least the next several years. We may be unable to maintain a level
of cash flow from operations sufficient to permit us to pay the principal and
interest on our current indebtedness and the 1999 notes, and any additional
indebtedness we may incur. The 1998 notes accrete to $260 million through March
2003 and we must begin paying cash interest on those notes in September 2003. In
addition, we began paying cash interest on the 1999 notes in August 1999. We
have set aside approximately $74.1 million in government securities in a pledge
account to fund the first three years of interest payments on the 1999 notes.
Our ability to make scheduled payments with respect to indebtedness will
depend upon, among other things:
- our ability to achieve significant and sustained growth in cash flow;
- the rate and success of the commercial deployment of our networks;
- successful operation of our networks;
- the market acceptance, customer demand, rate of utilization and pricing
for our services;
- our ability to successfully complete development, upgrades and
enhancements of our networks; and
- our ability to complete additional financings, as necessary.
Each of these factors is affected by economic, financial, competitive and
other factors, many of which are beyond our control. If we are unable to
generate sufficient cash flow to service our indebtedness, we may have to reduce
or delay network deployments, restructure or refinance our indebtedness or seek
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additional equity capital, strategies that may not enable us to service and
repay our indebtedness. Any failure to satisfy our obligations with respect to
the 1998 notes or the 1999 notes at or before maturity would be a default under
the related indenture and could cause a default under agreements governing our
other indebtedness. If such defaults occur, the holders of the indebtedness
would have enforcement rights, including the right to accelerate payment of the
entire amount of the debt and the right to commence an involuntary bankruptcy
proceeding against us.
OUR INTELLECTUAL PROPERTY PROTECTION MAY BE INADEQUATE TO PROTECT OUR
PROPRIETARY RIGHTS, AND WE MAY BE SUBJECT TO INFRINGEMENT CLAIMS
We regard certain aspects of our products, services and technology as
proprietary. We attempt to protect them with patents, copyrights, trademarks,
trade secret laws, restrictions on disclosure and other methods. These methods
may not be sufficient to protect our technology. We also generally enter into
confidentiality or license agreements with our employees and consultants, and
generally control access to and distribution of our documentation and other
proprietary information. Despite these precautions, it may be possible for a
third party to copy or otherwise obtain and use our products, services or
technology without authorization, or to develop similar technology
independently.
Currently we have a number of patent applications. We intend to prepare
additional applications and to seek patent protection for our systems and
services. These patents may not be issued to us. If issued, they may not protect
our intellectual property from competition. Competitors could seek to design
around or invalidate these patents.
Effective patent, copyright, trademark and trade secret protection may be
unavailable or limited in certain foreign countries. The global nature of the
Internet makes it virtually impossible to control the ultimate destination of
our proprietary information. The steps that we have taken may not prevent
misappropriation or infringement of our technology. Litigation may be necessary
in the future to enforce our intellectual property rights, to protect our trade
secrets or to determine the validity and scope of the proprietary rights of
others. Such litigation could result in substantial costs and diversion of
resources and could harm our business.
In addition, we may be sued by others with respect to infringement of their
intellectual property rights. We were recently sued by Bell Atlantic for an
alleged infringement of a patent issued to them in September 1998 entitled
"Variable Rate and Variable Mode Transmission System." We believe that we do not
infringe the Bell Atlantic patent and have defenses to infringement and
liability. However, litigation is inherently unpredictable and there is no
guarantee that we will prevail. An unfavorable outcome in this, or in any other
lawsuit that may be brought against us, could limit our ability to provide all
our services and require us to pay damages, which could significantly harm our
business.
WE WILL NEED ADDITIONAL FUNDS IN THE FUTURE IN ORDER TO CONTINUE TO GROW OUR
BUSINESS
We believe our current capital resources combined with the proceeds of this
offering will be sufficient for our funding and working capital requirements for
the deployment and operation of our networks at least through the end of 2000.
Thereafter, we will be required to raise additional capital through the issuance
of debt or equity financings. We may choose to raise additional capital sooner,
depending on market conditions. The actual amount and timing of our future
capital requirements will depend upon a number of factors, including:
- the number of geographies targeted and entered and the timing of entry
and services offered;
- network deployment 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 each region we enter;
- the rate at which we invest in engineering and development and
intellectual property with respect to existing and future technology; and
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- investment opportunities in complementary businesses, acquisitions or
other opportunities.
You may be diluted by our future capital raising transactions. We also may
be unsuccessful in raising sufficient capital at all or on terms that we
consider acceptable. If this happens, our ability to continue to expand our
business or respond to competitive developments would be impaired.
In addition, our indentures contain covenants that restrict our business
activities and our ability to raise additional funds. As a result, we may not be
able to undertake certain activities which management believes are in our best
interest to develop our business. We also may be unable to raise as much
additional funding through the issuance of debt securities as we may need in the
future. This could require us to raise funding through the issuance of equity
securities or amend our indentures, which we may be unable to do on acceptable
terms.
THE SCALABILITY AND SPEED OF OUR NETWORKS REMAIN LARGELY UNPROVEN
To date, we have deployed our networks in a total of 51 metropolitan
statistical areas, most of which have been deployed only in the last several
months. As a result, the ability of our DSL networks and operational support
systems to connect and manage a substantial number of online end-users at high
speeds is still unknown. Consequently, there remains a risk that we may not be
able to scale our network and operational support systems up to our expected
end-user numbers while achieving superior performance. Peak digital data
transmission speeds currently offered across our DSL networks are 1.5 megabits
per second downstream. However, the actual data transmission speeds over our
networks could be significantly slower and will depend on a variety of factors,
including:
- the type of DSL technology deployed;
- the distance an end-user is located from a central office;
- the configuration of the telecommunications line being used;
- quality of the telephone wires provisioned by traditional telephone
companies; and
- our operational support systems which manage our networks.
As a result, our networks may be unable to achieve and maintain the highest
possible digital transmission speed. Our failure to achieve or maintain
high-speed digital transmissions would significantly reduce customer and
end-user demand for our services.
INTERFERENCE IN THE TRADITIONAL TELEPHONE COMPANIES' COPPER PLANT COULD DEGRADE
THE PERFORMANCE OF OUR SERVICES
Certain tests indicate that some types of DSL technology may cause
interference with and be interfered with by other signals present in a
traditional telephone company's copper plant, usually with lines in close
proximity. If present, this interference could cause degradation of performance
of our services or render us unable to offer our services on selected lines. The
amount and extent of such interference will depend on the condition of the
traditional telephone company's copper plant and the number and distribution of
DSL and other signals in such plant and cannot now be ascertained. When
interference occurs, it is difficult to detect. The procedures to resolve
interference issues between competitive telecommunications companies and
traditional telephone companies are still being developed and may not be
effective. In the past we have agreed to interference resolution procedures with
certain traditional telephone companies. However, we may be unable to
successfully negotiate similar procedures with other traditional telephone
companies in future interconnection agreements or in renewals of existing
interconnection agreements. In addition, the failure of the traditional
telephone companies to take timely action to resolve interference issues could
harm the provision of our services. If our TeleSpeed and TeleSurfer services
cause widespread network degradation or are perceived to cause that type of
interference, actions by the traditional telephone companies or state or federal
regulators could harm our reputation, brand image, service quality, customer
satisfaction and retention, and overall business. Moreover, ostensible
interference concerns have in the past been, continue to currently and may in
the
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future be used by the traditional telephone companies as a pretext to delay the
deployment of our services and otherwise harm our business.
A SYSTEM FAILURE COULD DELAY OR INTERRUPT SERVICE TO OUR CUSTOMERS
Our operations depend upon our ability to support our highly complex
network infrastructure and avoid damage from fires, earthquakes, floods, power
losses, excessive sustained or peak user demand, telecommunications failures,
network software flaws, transmission cable cuts and similar events. The
occurrence of a natural disaster or other unanticipated problem at our network
operations center or any of our regional data centers could cause interruptions
in our services. Additionally, failure of a traditional telephone company or
other service provider, such as competitive telecommunications companies, to
provide communications capacity that we require, as a result of a natural
disaster, operational disruption or any other reason, could cause interruptions
in our services. Any damage or failure that causes interruptions in our
operations could harm our business.
A BREACH OF NETWORK SECURITY COULD DELAY OR INTERRUPT SERVICE TO OUR CUSTOMERS
Our networks may be vulnerable to unauthorized access, computer viruses and
other disruptive problems. Internet service provider, telecommunications carrier
and corporate networks have in the past experienced, and may in the future
experience, interruptions in service as a result of accidental or intentional
actions of Internet users, current and former employees and others. Unauthorized
access could also potentially jeopardize the security of confidential
information stored in the computer systems of our customers and the customers'
end-users. This might result in liability to our customers and also might deter
potential customers. We intend to implement security measures that are standard
within the telecommunications industry and newly developed security measures. We
have not done so yet and may not implement such measures in a timely manner. If
and when implemented, such measures may be circumvented. Eliminating computer
viruses and alleviating other security problems may require interruptions,
delays or cessation of service to our customers and such customers' end-users,
which could harm our business.
WE DEPEND ON A LIMITED NUMBER OF THIRD PARTIES FOR EQUIPMENT SUPPLY AND
INSTALLATION
We rely on outside parties to manufacture our network equipment. This
equipment includes:
- digital subscriber line access multiplexers;
- customer premise equipment modems;
- network routing and switching hardware;
- network management software;
- systems management software; and
- database management software.
As we sign additional service contracts, we will need to increase
significantly the amount of manufacturing and other services supplied by third
parties in order to meet our contractual commitments. For example, we have a
service arrangement with Lucent Technologies Inc. to increase our ability to
install our central office facilities and associated equipment. We have in the
past experienced supply problems with certain of our vendors. These vendors may
not be able to meet our needs in a satisfactory and timely manner in the future.
In addition, we may not be able to obtain additional vendors when and if needed.
We have identified alternative suppliers for technologies that we consider
critical. However, it could take us a significant period of time to establish
relationships with alternative suppliers for critical technologies and
substitute their technologies into our networks.
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Our reliance on third-party vendors involves a number of additional risks,
including:
- the absence of guaranteed capacity; and
- reduced control over delivery schedules, quality assurance, production
yields and costs.
The loss of any of our relationships with these suppliers could harm our
business.
OUR SUCCESS DEPENDS ON OUR RETENTION OF CERTAIN KEY PERSONNEL, OUR ABILITY TO
HIRE ADDITIONAL KEY PERSONNEL AND THE MAINTENANCE OF GOOD LABOR RELATIONS
We depend on the performance of our executive officers and key employees.
In particular, our senior management has significant experience in the data
communications, telecommunications and personal computer industries, and the
loss of any of them could negatively affect our ability to execute our business
strategy. Additionally, we do not have "key person" life insurance policies on
any of our employees.
Our future success also depends on our continuing ability to identify,
hire, train and retain other highly qualified technical, sales, marketing and
managerial personnel in connection with our expansion within our existing
regions and the deployment and marketing of our networks into targeted regions.
Competition for such qualified personnel is intense. This is particularly the
case in software development, network engineering and product management. We
also may be unable to attract, assimilate or retain other highly qualified
technical, operations, sales, marketing and managerial personnel. Our business
will be harmed if we cannot attract the necessary technical, sales, marketing
and managerial personnel. In addition, in the event that our employees unionize,
we could incur higher ongoing labor costs and disruptions in our operations in
the event of a strike or other work stoppage.
WE MAY MAKE ACQUISITIONS OF COMPLEMENTARY TECHNOLOGIES OR BUSINESSES IN THE
FUTURE, WHICH MAY DISRUPT OUR BUSINESS AND BE DILUTIVE TO OUR EXISTING
STOCKHOLDERS
We intend to consider acquisitions of businesses and technologies in the
future on an opportunistic basis. Acquisitions of businesses and technologies
involve numerous risks, including the diversion of management attention,
difficulties in assimilating the acquired operations, loss of key employees from
the acquired company, and difficulties in transitioning key customer
relationships. In addition, these acquisitions may result in dilutive issuances
of equity securities, the incurrence of additional debt, large one-time expenses
and the creation of goodwill or other intangible assets that result in
significant amortization expense. Any of these factors could materially harm our
business or our operating results in a given period or could cause our stock
price to decline.
OUR FAILURE AND THE FAILURE OF THIRD PARTIES TO BE YEAR 2000 COMPLIANT COULD
NEGATIVELY IMPACT OUR BUSINESS
Many currently installed computer systems and software products are coded
to accept only two-digit entries in the date code filed and cannot distinguish
21st century dates from 20th century dates. These date code fields will need to
distinguish 21st century dates form 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 not 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
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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 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 are currently assessing the Year 2000 risks associated with our
third-party and traditional telephone company equipment and software and with
our Internet service provider, enterprise and telecommunication carrier
customers. We are evaluating the risks associated with the reasonably likely
worst-case scenario, but we 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.
RISKS RELATED TO OUR INDUSTRY
THE BROADBAND COMMUNICATIONS INDUSTRY IS UNDERGOING RAPID TECHNOLOGICAL CHANGES,
AND NEW TECHNOLOGIES MAY BE SUPERIOR TO THE TECHNOLOGY WE USE
The broadband communications industry is subject to rapid and significant
technological change, including continuing developments in DSL technology, which
does not presently have widely accepted standards, and alternative technologies
for providing broadband communications such as cable modem technology. As a
consequence:
- we will rely on third parties, including some of our competitors and
potential competitors, to develop and provide us with access to
communications and networking technology;
- our success will depend on our ability to anticipate or adapt to new
technology on a timely basis; and
- we expect that new products and technologies will emerge that may be
superior to, or may not be compatible with, our products and
technologies.
If we fail to adapt successfully to technological changes or fail to obtain
access to important technologies, our business will suffer.
OUR STRATEGY DEPENDS ON GROWTH IN DEMAND FOR DSL-BASED SERVICES
The demand for high-speed Internet and RLAN access is in the early stages
of development. As a result, we cannot predict the rate at which this demand
will grow, if at all, or whether new or increased competition will result in
satisfying all demand. Various providers of high-speed digital communications
services are testing products from various suppliers for various applications.
We do not know whether DSL will offer the same or more attractive
price-performance characteristics. Critical issues concerning commercial use of
DSL for Internet and RLAN access, including security, reliability, ease and cost
of access and quality of service, remain unresolved and may impact the growth of
such services. If the demand for our services grows more slowly than we
anticipate or is satisfied by competitors, our ability to achieve revenue growth
and positive cash flow will be harmed.
WE MUST COMPLY WITH FEDERAL AND STATE TAX AND OTHER SURCHARGES ON OUR SERVICES,
THE LEVELS OF WHICH ARE UNCERTAIN
Telecommunications providers pay a variety of surcharges and fees on their
gross revenues from interstate services and intrastate services. Interstate
surcharges include Federal Universal Service Fees, Common Carrier Regulatory
Fees and TRS Fund fees. In addition, state regulators impose similar surcharges
and fees on intrastate services. The division of our services between interstate
services and intrastate services is a matter of interpretation and may in the
future be contested by the FCC or relevant state commission authorities. A
change in the characterization of their jurisdictions could cause our
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payment obligations pursuant to the relevant surcharges to increase. In
addition, pursuant to periodic revisions by state and federal regulators of the
applicable surcharges, we may be subject to increases in the surcharges and fees
currently paid.
OUR SERVICES ARE SUBJECT TO GOVERNMENT REGULATION, AND CHANGES IN CURRENT OR
FUTURE LAWS OR REGULATIONS COULD ADVERSELY AFFECT OUR BUSINESS
Our services are subject to federal, state and local government regulation.
The 1996 Telecommunications Act, which became effective in February 1996,
introduced widespread changes in the regulation of the telecommunications
industry, including the digital access services segment in which we operate. The
1996 Telecommunications Act eliminates many of the pre-existing legal barriers
to competition in the telecommunications services business and sets basic
criteria for relationships between telecommunications providers.
Among other things, the 1996 Telecommunications Act removes barriers to
entry in the local exchange telephone market by preempting state and local laws
that restrict competition by providing competitors interconnection, access to
unbundled network elements and retail services at wholesale rates. The FCC's
primary rules interpreting the 1996 Telecommunications Act, which were issued on
August 8, 1996, have been reviewed by the U.S. Court of Appeals for the Eighth
Circuit, which has overruled certain of the FCC's rules. However, the U.S.
Supreme Court overruled the Eighth Circuit in January of 1999 and upheld the FCC
rules. We have entered into competitive interconnection agreements using the
federal guidelines established in the FCC's interconnection order. In addition,
the FCC's pricing method for unbundled network elements is under review at the
Eighth Circuit. Any unfavorable decisions by the Eighth Circuit, the FCC or
state telecommunications regulatory commissions could harm our business.
In August 1998, the FCC proposed new rules that would allow traditional
telephone companies to provide their own DSL services free from traditional
telephone company regulation through a separate affiliate. The provision of DSL
services by an affiliate of an traditional telephone company not subject to such
regulation could harm our business.
Changes to current regulations, the adoption of new regulations by the FCC
or state regulatory authorities, court decisions or legislative initiatives,
such as changes to the 1996 Telecommunications Act, could harm our business. For
further details of the government regulation to which we are subject see
"Business -- Government Regulation."
RISKS RELATED TO THIS OFFERING
OUR PRINCIPAL STOCKHOLDERS AND MANAGEMENT OWN A SIGNIFICANT PERCENTAGE OF OUR
CAPITAL STOCK, AND WILL BE ABLE TO EXERCISE SIGNIFICANT INFLUENCE OVER OUR
AFFAIRS
After the completion of this offering, our executive officers, directors
and principal stockholders will continue to beneficially own a significant
percentage of our outstanding common stock. Accordingly, these stockholders:
- will be able to significantly influence the composition of the our board
of directors;
- will significantly influence all matters requiring stockholder approval;
and
- will continue to have significant influence over our affairs.
This concentration of ownership could have the effect of delaying or
preventing a change in control of us or otherwise discouraging a potential
acquirer from attempting to obtain control of us. This in turn could have a
negative effect on the market price of our common stock. It could also prevent
our stockholders from realizing a premium over the market prices for their
shares of common stock.
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OUR STOCK PRICE COULD FLUCTUATE WIDELY IN RESPONSE TO VARIOUS FACTORS, MANY OF
WHICH ARE BEYOND OUR CONTROL
The trading price of our common stock has been and is likely to continue to
be highly volatile. Our stock price could fluctuate widely in response to
factors such as the following:
- actual or anticipated variations in quarterly operating results;
- announcements of new products or services by us or our competitors or new
competing technologies;
- the addition or loss of Internet service providers or enterprise
customers or end-users;
- changes in financial estimates or recommendations by securities analysts;
- conditions or trends in the telecommunications industry, including
regulatory developments;
- growth of the Internet and on-line commerce industries;
- announcements by us of significant acquisitions, strategic partnerships,
joint ventures or capital commitments;
- additions or departures of key personnel;
- future equity or debt offerings or our announcements of such offerings;
- general market and general economic conditions; and
- other events or factors, many of which are beyond our control.
In addition, in recent years the stock market in general, and the Nasdaq
National Market and the market for Internet and technology companies in
particular, have experienced extreme price and volume fluctuations. These
fluctuations have often been unrelated or disproportionate to the operating
performance of these companies. These market and industry factors may materially
and adversely affect our stock price, regardless of our operating performance.
FUTURE SALES OF OUR COMMON STOCK MAY DEPRESS OUR STOCK PRICE
Sales of a substantial number of shares of our common stock in the public
market, or the appearance that such shares are available for sale, could
adversely affect the market price for our common stock. Upon completion of this
offering (based upon shares outstanding as of September 30, 1999), we will have
94,338,005 shares of common stock outstanding (including common stock to be
issued upon conversion of our class B common stock and shares that will be
issued upon exercise of outstanding options by the selling stockholders prior to
the consummation of this offering). More than half of these shares are not
currently publicly traded but are available for immediate resale to the public,
subject to certain volume limitations under the securities laws and lock-up
agreements entered into in connection with this offering. The 13,981,567 shares
that will still be held by our selling stockholders after completion of this
offering are subject to a 90-day lock-up agreement and will be available for
public resale on , 2000, the 91st day after the date of this
prospectus. The 9,568,765 shares of common stock issuable upon conversion of our
class B common stock will be available for resale to the public on January 7,
2000.
In addition to the shares that are currently outstanding, we have 272,904
shares underlying warrants issued in connection with our 1998 notes. To the
extent that the warrant holders effect a "cashless" exercise of these warrants,
the underlying shares will be eligible for immediate sale in the public markets.
We also have 23,280,513 shares of our common stock reserved for issuance
pursuant to options under our 1997 Stock Plan, of which 17,110,191 shares were
subject to outstanding options at September 30, 1999. We have also reserved
1,500,000 shares of common stock for issuance under our 1998 Employee Stock
Purchase Plan. Shares underlying vested options are eligible for immediate
resale in the public market, unless such shares are held by our selling
stockholders in which case the shares will be eligible for
19
<PAGE> 21
sale in the public market at the expiration of the 90-day lock-up agreement
entered into in connection with this offering.
Furthermore, a significant portion of our stockholders have certain
registration rights with respect to their shares, including the holders of our
class B common stock with respect to the 9,568,765 shares of common stock
issuable upon conversion of their class B common stock. The class B common stock
is convertible into common stock beginning January 2000. In addition, the
holders of the 272,904 shares underlying warrants issued in connection with our
1998 notes have certain registration rights with respect to their shares. If
these or other holders exercise their registration rights and cause a large
number of shares to be registered and sold in the public market, such sales
could have a material adverse effect on the market price for our common stock.
Bear, Stearns & Co. Inc. may, in its sole discretion and at any time
without notice, release all or any portion of the securities subject to lock-up
agreements.
CERTAIN PROVISIONS OF OUR CHARTER AND BYLAWS AND DELAWARE LAW COULD DELAY OR
PREVENT A CHANGE OF CONTROL OF COVAD
Our board of directors has the authority to issue up to 5,000,000 shares of
preferred stock and to determine the price, rights, preferences, privileges and
restrictions, including voting rights, of those shares without any further vote
or action by the stockholders. The issuance of preferred stock, while providing
desirable flexibility in connection with possible acquisitions and other
corporate purposes, could have the effect of making it more difficult for a
third party to acquire a majority of our outstanding voting stock. Our charter
and bylaws provide for:
- a classified board of directors;
- limitations on the ability of stockholders to call special meetings and
act by written consent;
- the lack of cumulative voting for directors; and
- procedures for advance notification of stockholder nominations and
proposals.
These provisions, as well as Section 203 under the Delaware General
Corporation Law, could discourage potential acquisition proposals and could
delay or prevent a change of control. The indentures relating to the 1998 notes
and the 1999 notes provide that, in the event of certain changes in control,
each holder of the notes will have the right to require us to repurchase such
holder's notes at a premium over the aggregate principal amount or the accreted
value, as the case may be, of such debt. The provisions in the charter, bylaws
and indentures could have the effect of discouraging others from making tender
offers for our shares and, as a consequence, they also may inhibit increases in
the market price of our shares that could result from actual or rumored takeover
attempts. Such provisions also may have the effect of preventing changes in our
management.
OUR MANAGEMENT MAY NOT USE THE PROCEEDS OF THIS OFFERING EFFECTIVELY
Our management will retain broad discretion over the use of the net
proceeds of this offering. Accordingly, it is possible that our management may
allocate the proceeds differently than investors in this offering would have
preferred, or that we will fail to maximize our return on the proceeds.
20
<PAGE> 22
USE OF PROCEEDS
The net proceeds to us from the sale of shares of common stock by us in
this offering are estimated to be approximately $461.2 million ($540.1 million
if the underwriters' over-allotment option is exercised in full) after deducting
estimated underwriting discounts and commissions and estimated offering
expenses. For purposes of estimating our net proceeds, we are assuming that the
public offering price will be $41.75, the last reported sale price of our common
stock on October 14, 1999. We will not receive any of the proceeds from the sale
of shares of common stock by the selling stockholders.
We anticipate that the net proceeds we receive from this offering will be
used:
- to fund capital expenditures to be incurred in the deployment of our
network in existing and new regions,
- for expenses associated with our continued development and sales and
marketing activities,
- to fund operating losses,
- to support possible strategic investments and strategic acquisitions, and
- for working capital and other general corporate purposes.
The amounts that we actually expend will vary depending upon a number of
factors, including future revenue growth, capital expenditures and the amount of
cash generated by our operations. Additionally, if we determine it would be in
our best interest, we may increase or decrease the number, selection and timing
of entry of our targeted regions. Accordingly, our management will retain broad
discretion in the allocation of such net proceeds. We may also use a portion of
the net proceeds of this offering to pursue possible strategic investments in or
acquisitions of businesses, technologies or products complementary to ours in
the future. We actively investigate strategic investments and have also
considered in the past, and will consider in the future, acquisitions. We
presently have no understandings, commitments or agreements with respect to any
acquisitions or any material investments. Pending use of such net proceeds for
the above purposes, we intend to invest such funds in short-term,
interest-bearing, investment-grade securities.
DIVIDEND POLICY
We have not paid any cash dividends since our inception. We currently
anticipate that we will retain all of our future earnings for use in the
expansion and operation of our business. Thus, we do not anticipate paying any
cash dividends on our capital stock in the foreseeable future. In addition, the
terms of the indentures relating to the 1998 notes and the 1999 notes restrict
our ability to pay dividends on our capital stock.
PRICE RANGE OF OUR COMMON STOCK
Our common stock has been traded on the Nasdaq National Market under the
symbol "COVD" since January 22, 1999, the date of our initial public offering.
Prior to January 22, 1999, there was no public market for our common stock. The
following table sets forth, for the periods indicated, the high and low daily
closing sales prices for our common stock as reported by the Nasdaq National
Market.
<TABLE>
<CAPTION>
HIGH LOW
------ ------
<S> <C> <C>
FISCAL YEAR ENDED DECEMBER 31, 1999:
First Quarter............................................. $47.50 $27.00
Second Quarter............................................ $72.38 $39.56
Third Quarter............................................. $67.50 $37.31
Fourth Quarter (through October 14, 1999)................. $44.63 $37.88
</TABLE>
On October 14, 1999, the last reported sale price for our common stock on
the Nasdaq National Market was $41.75 per share. As of October 14, 1999, there
were 336 holders of record of our common stock, and there were five holders of
record of our class B common stock.
21
<PAGE> 23
CAPITALIZATION
The following table sets forth (i) our capitalization as of June 30, 1999,
and (ii) our capitalization as of June 30, 1999 on an as adjusted basis to
reflect the issue of the common stock to be sold in this offering and receipt of
the estimated net proceeds from the sale thereof after deducting estimated
underwriting discounts and commissions and estimated offering expenses payable
by us, and assuming a public offering price of $41.75, the last reported sale
price of our common stock on October 14, 1999.
<TABLE>
<CAPTION>
AS OF JUNE 30, 1999
------------------------------
ACTUAL AS ADJUSTED
------------ --------------
(DOLLARS IN THOUSANDS, EXCEPT
PER SHARE AMOUNTS)
<S> <C> <C>
Cash and cash equivalents(1)................................ $ 257,471 $ 719,578
Pledged securities(2)....................................... 75,406 75,406
--------- ---------
Total cash, cash equivalents and pledged
securities........................................... 332,877 794,984
========= =========
LONG-TERM OBLIGATIONS:
Capital lease obligations (including current portion)....... 450 450
13 1/2% Senior Discount Notes due 2008, net(3).............. 152,710 152,710
12 1/2% Senior Notes due 2009, net(4)....................... 210,696 210,696
--------- ---------
Total long-term obligations (including current
portion)............................................. 363,856 363,856
STOCKHOLDERS' EQUITY:
Preferred Stock, $0.001 par value; 5,000,000 shares
authorized, no shares issued and outstanding actual and as
adjusted.................................................. -- --
Common Stock, $0.001 par value; 190,000,000 shares
authorized, 71,136,940 shares issued and outstanding
actual; 82,986,940 shares issued and outstanding as
adjusted(5)(6)............................................ 72 84
Common Stock -- Class B, $0.001 par value; 10,000,000 shares
authorized, 6,379,177 shares issued and outstanding actual
and as adjusted(7)........................................ 6 6
Additional paid-in capital.................................. 271,325 733,420
Deferred compensation....................................... (3,548) (3,548)
Accumulated other comprehensive income...................... 25,638 25,638
Accumulated deficit......................................... (121,489) (121,489)
--------- ---------
Total stockholders' equity........................... 172,004 634,111
--------- ---------
Total capitalization............................... $ 535,860 $ 997,967
========= =========
</TABLE>
- ---------------
(1) Includes:
- $461.2 million of net proceeds from the sale of shares of common stock by
us in this offering; and
- $943,000 of proceeds from the issuance of 445,000 shares of common stock
subject to outstanding options held by selling stockholders that are
expected to be exercised prior to the date of this offering at a weighted
average exercise price of $2.12 per share.
(2) Represents the portion of the net proceeds from the issuance of the 1999
notes used to purchase government securities to be held in a pledge account.
Amount includes accrued interest on the securities.
(3) The 1998 notes accrete in value through March 15, 2003 at a rate of 13 1/2%
per annum, compounded semi-annually. No cash interest will be payable on the
1998 notes prior to that date. An additional unamortized debt discount of
$7.5 million at June 30, 1999, which represents the unamortized value
ascribed to the warrants issued in connection with the 1998 notes, is being
amortized to interest expense over the term of the 1998 notes.
(4) The 1999 notes are presented net of unamortized debt discount of
approximately $4.3 million at June 30, 1999, which represents the
unamortized additional original issue discount to be amortized to interest
expense over the term of the 1999 notes.
(5) Excludes:
- an aggregate of 17,819,010 shares subject to outstanding options at June
30, 1999 at a weighted average exercise price of $5.82 per share,
22
<PAGE> 24
- an aggregate of 2,585,554 shares of common stock reserved for future
issuance under our 1997 Stock Plan,
- an aggregate of 1,500,000 shares of common stock reserved for issuance
under our 1998 Employee Stock Purchase Plan,
- 272,904 shares of common stock issuable upon exercise of warrants issued
in connection with our 1998 notes at an exercise price of $0.0022 per
share, and
- 200,277 shares of common stock that were issued to a consultant on July
20, 1999 upon exercise of a warrant at an exercise price of $0.6667 per
share.
(6) Includes 445,000 shares of common stock subject to outstanding options held
by selling stockholders that are expected to be exercised prior to the date
of this offering at a weighted average exercise price of $2.12 per share.
(7) Beginning in January 2000, the 6,379,177 shares of class B common stock will
be convertible into 9,568,765 shares of common stock.
23
<PAGE> 25
DILUTION
As of June 30, 1999 we had a pro forma net tangible book value of
approximately $135.2 million, or $1.67 per share of our common stock based on
81,150,705 shares of our common stock outstanding. This number of shares
includes:
- 9,568,765 shares of common stock issuable upon conversion of 6,379,177
shares of our non-voting Class B common stock held by our strategic
investors; and
- 445,000 shares of common stock subject to outstanding options held by
selling stockholders that are expected to be exercised prior to the date
of this offering at a weighted average exercise price of $2.12 per share.
This number of shares excludes:
- 17,819,010 shares of common stock subject to outstanding options at June
30, 1999 at a weighted average exercise price of $5.82 per share,
- an aggregate of 2,585,554 shares of common stock reserved for future
issuance under our 1997 Stock Plan,
- an aggregate of 1,500,000 shares of common stock reserved for future
issuance under our 1998 Employee Stock Purchase Plan,
- 272,904 shares of common stock issuable upon the exercise of warrants
issued in connection with our 1998 notes at a weighted average exercise
price of $0.0022 per share and
- 200,277 shares of common stock that were issued to a consultant on July
20, 1999 upon exercise of a warrant at a weighted average exercise price
of $0.0667 per share.
Pro forma net tangible book value per share represents the amount of our
pro forma total tangible assets reduced by our total liabilities, divided by the
pro forma number of shares of our common stock outstanding. Dilution in pro
forma net tangible book value per share represents the difference between the
amount per share paid by purchasers of shares of our common stock in this
offering and the as adjusted pro forma net tangible book value per share of our
common stock as of June 30, 1999.
We will not receive any proceeds from the sale of shares of common stock by
the selling stockholders in this offering. After giving effect to this offering
resulting in estimated net proceeds to us of approximately $461.2 million (after
deducting estimated underwriting discounts and commissions and offering expenses
payable by us), our as adjusted pro forma net tangible book value at June 30,
1999 would have been $596.4 million or $6.44 per share. This represents an
immediate increase in pro forma net tangible book value of $4.77 per share to
existing stockholders and an immediate dilution in pro forma net tangible book
value of $35.31 per share to new investors purchasing shares at the assumed
public offering price of $41.75, the last reported sale price of our common
stock on October 14, 1999. The following table illustrates this per share
dilution:
<TABLE>
<S> <C> <C>
Assumed public offering price per share.............. $41.75
Pro forma net tangible book value per share as
of June 30, 1999............................... $1.67
Increase per share attributable to new
investors...................................... $4.77
-----
As adjusted pro forma net tangible book value per
share after the offering............................ $ 6.44
------
Dilution per share to new investors.................. $35.31
======
</TABLE>
24
<PAGE> 26
SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data as of and for the years
ended December 31, 1997 and December 31, 1998 has been derived from our audited
consolidated financial statements and the related notes, which are included
elsewhere in this prospectus. The consolidated financial data as of and for the
six months ended June 30, 1998 and June 30, 1999 were derived from our unaudited
financial statements which, except for the consolidated balance sheet as of June
30, 1998, are included elsewhere in this prospectus. These unaudited financial
statements include, in the opinion of management, all adjustments, consisting
only of normal, recurring adjustments, necessary for a fair presentation set
forth therein. You should read the following selected consolidated financial
data together with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and our consolidated financial statements and the
related notes included elsewhere in this prospectus.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, SIX MONTHS ENDED JUNE 30,
----------------------- --------------------------
1997 1998 1998 1999
---------- ---------- ----------- ------------
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenues....................................... $ 26 $ 5,326 $ 995 $ 16,429
Operating expenses:
Network and product costs.................... 54 4,562 961 15,525
Sales, marketing, general and
administrative............................ 2,374 31,043 6,550 43,089
Amortization of deferred compensation........ 295 3,997 858 2,887
Depreciation and amortization................ 70 3,406 610 13,318
---------- ---------- ---------- -----------
Total operating expenses............. 2,793 43,008 8,979 74,819
---------- ---------- ---------- -----------
Income (loss) from operations.................. (2,767) (37,682) (7,984) (58,390)
Net interest income (expense)................ 155 (10,439) (3,720) (12,366)
---------- ---------- ---------- -----------
Net income (loss).............................. (2,612) (48,121) (11,704) (70,756)
========== ========== ========== ===========
Preferred dividends............................ -- -- -- (1,146)
---------- ---------- ---------- -----------
Net income (loss) available to common
stockholders................................. $ (2,612) $ (48,121) $ (11,704) $ (71,902)
---------- ---------- ---------- -----------
Net income (loss) per common share(1).......... $ (0.53) $ (5.62) $ (1.54) $ (1.18)
Weighted average shares used in computing net
income (loss) per share(1)................... 4,907,319 8,562,802 7,584,501 60,930,856
OTHER FINANCIAL DATA:
EBITDA(2)...................................... $ (2,402) $ (30,154) $ (6,516) $ (42,185)
CONSOLIDATED CASH FLOW DATA:
Provided by (used in) operating activities..... $ (1,895) $ (9,054) $ (877) $ (27,721)
Provided by (used in) investing activities..... (2,494) (61,252) (12,380) (194,446)
Provided by (used in) financing activities..... 8,767 130,378 130,764 415,188
</TABLE>
<TABLE>
<CAPTION>
AS OF JUNE 30, 1999
----------------------
AS OF AS
DECEMBER 31, 1998 ACTUAL ADJUSTED(3)
----------------- -------- -----------
(UNAUDITED)
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents............................... $ 64,450 $257,471 $ 719,578
Net property and equipment.............................. 59,145 143,562 143,562
Total assets............................................ 139,419 593,816 1,055,923
Long-term obligations, including current portion........ 142,879 363,856 363,856
Total stockholders' equity (net capital deficiency)..... (24,706) 172,004 634,111
</TABLE>
25
<PAGE> 27
<TABLE>
<CAPTION>
AS OF JUNE
AS OF DECEMBER 31, 30,
---------------------------- -----------
1997 1998 1998
----------------- -------- -----------
<S> <C> <C> <C>
OTHER OPERATING DATA:
Homes and businesses passed............................. 278,000 6,000,000 1,300,000
Lines installed......................................... 26 3,900 700
</TABLE>
- ---------------
(1) Data reflects a two-for-one stock split effective May 1998, a three-for-two
stock split effective August 1998 and a three-for-two split of our common
stock effective May 1999.
(2) EBITDA consists of net loss excluding net interest, taxes, depreciation and
amortization, non-cash stock-based compensation expense and other
non-operating income or expenses. We have provided EBITDA because it is a
measure of financial performance commonly used in the telecommunications
industry as well as to enhance an understanding of our operating results.
EBITDA should not be construed as either:
- an alternative to operating income (as determined in accordance with
generally accepted accounting principles) as an indicator of our
operating performance, or
- an alternative to cash flows from operating activities (as determined in
accordance with generally accepted accounting principles) as a measure of
liquidity.
EBITDA as calculated by us may be calculated differently than EBITDA for other
companies. See our consolidated financial statements and the related notes
thereto contained elsewhere in this prospectus.
(3) The as adjusted balance sheet data reflects the receipt of:
- $461.2 million of net proceeds from the sale of shares of common stock by
us in this offering; and
- $943,000 of proceeds from the issuance of 445,000 shares of common stock
subject to outstanding options held by selling stockholders that are
expected to be exercised prior to the date of this offering at a weighted
average exercise price of $2.12 per share.
26
<PAGE> 28
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of our financial condition and results of
operations should be read in conjunction with the consolidated financial
statements and the related notes thereto included elsewhere in this prospectus.
This discussion contains forward-looking statements the accuracy of which
involves risks and uncertainties. Our actual results could differ materially
from those anticipated in the forward-looking statements for many reasons
including, but not limited to, those discussed in "Risk Factors" and elsewhere
in this prospectus. We disclaim any obligation to update information contained
in any forward-looking statement. See "-- Forward Looking Statements."
OVERVIEW
We are a leading provider of broadband communications services to Internet
service provider, enterprise and telecommunications carrier 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
offer our services in 51 metropolitan statistical areas. We plan to build our
networks and offer our services in a total of 100 metropolitan statistical areas
nationwide. As of September 30, 1999, our networks passed 25 million homes and
businesses, and we had installed 31,000 end-user lines.
In connection with our expansion within existing metropolitan statistical
areas and into new metropolitan statistical areas, 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' charges for our
leased telephone wires; 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.
The development and expansion of our business will require significant
expenditures. The principal capital expenditures incurred during the buildup
phase of any metropolitan statistical area 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. 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
27
<PAGE> 29
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, including cageless physical collocation. 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,
enterprise, and telecommunication carrier customers, and funding our customer
care and field service operations.
In connection with rolling out service on a national basis we have
commenced a branding campaign to differentiate our service offerings in the
marketplace. As a result, we expect our selling, general and administrative
expenses to increase significantly in future periods as we implement increased
marketing efforts as part of the campaign.
RESULTS OF OPERATIONS
Three Months and Six Months Ended June 30, 1999 Compared to Three Months and
Six Months Ended June 30, 1998
Revenues
We recorded revenues of $10.8 million for the three months ended June 30,
1999 compared to $809,000 for the three months ended June 30, 1998. Revenue was
$16.4 million for the six months ended June 30, 1999 compared to $995,000 for
the six months ended June 30, 1998. 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 national network. 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 $10.6 million for the three months
ended June 30, 1999 and $758,000 for the three months ended June 30, 1998.
Network and product costs were $15.5 million for the six months ended June 30,
1999 and $961,000 for the six months ended June 30, 1998. 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.
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. Sales,
marketing, general and administrative expenses were $25.0 million for the three
months ended June 30, 1999 and $4.6 million for the three months ended June 30,
1998. Sales, marketing, general and administrative expenses were $43.1 million
for the six months ended June 30, 1999 and $6.6 million for the six months ended
June 30, 1998. 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 and build brand awareness of our
business.
28
<PAGE> 30
Deferred Compensation
Through June 30, 1999, we recorded a total of $10.7 million of deferred
compensation, with an unamortized balance of $3.5 million on our June 30, 1999
balance sheet. This deferred compensation is a result of us granting stock
options to our employees, certain of our directors, and certain contractors with
exercise prices per share 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 using a
graded vesting method. Amortization of deferred compensation was $1.2 million
for the three months ended June 30, 1999 and $631,000 for the three months ended
June 30, 1998. Amortization of deferred compensation was $2.9 million for the
six months ended June 30, 1999 and $858,000 for the six months ended June 30,
1998.
Depreciation and Amortization
Depreciation and amortization includes:
- depreciation of network costs and related equipment;
- depreciation of information systems, furniture and fixtures;
- amortization of improvements to central offices, regional data centers
and network operations center facilities and corporate facilities;
- amortization of capitalized software costs; and
- amortization of intangible assets.
In January 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 $2.1 million and $4.0 million during the three and six
months ended June 30, 1999, respectively. 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 $8.7 million for the three months ended
June 30, 1999 and $446,000 for the three months ended June 30, 1998.
Depreciation and amortization was $13.3 million for the six months ended June
30, 1999 and $610,000 for the six months ended June 30, 1998. 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. Net interest
expense for the three and six months ended June 30, 1999, was $7.2 million and
$12.4 million, respectively. Net interest expense during these periods 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 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. Net interest expense for the three
and six months ended June 30, 1998, was $3.3 million and $3.7 million,
respectively. Net interest expense during these periods consisted primarily of
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. We expect interest expense to
increase significantly over time, primarily because the 1998 notes accrete to
$260 million by March 15, 2003.
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<PAGE> 31
Income Taxes
Income taxes consist of federal, state and local taxes, when applicable. We
expect significant consolidated net losses for the foreseeable future which
should generate net operating loss carryforwards. However, our ability to use
net operating losses may be subject to annual limitations. In addition, income
taxes may be payable during this time due to operating income in certain tax
jurisdictions. In the future, if we achieve operating profits and the net
operating losses have been exhausted or have expired, we may experience
significant tax expense. We recognized no provision for taxes because we
operated at a loss for the years ended December 31, 1997 and December 31, 1998
and the three and six months ended March 31, 1999 and June 30, 1999.
Year Ended December 31, 1998 Compared to Year Ended December 31, 1997
Revenues
We recorded revenues of $26,000 for the year ended December 31, 1997 and
$5.3 million for the year ended December 31, 1998. 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 networks in the San
Francisco Bay Area and to a lesser extent in the Los Angeles, New York and
Boston metropolitan areas.
Network and Product Costs
We recorded network and product costs of $54,000 for the year ended
December 31, 1997 and $4.6 million for the year ended December 31, 1998. This
increase is attributable to the expansion of our networks and increased orders
resulting from our sales and marketing efforts.
Sales, Marketing, General and Administrative Expenses
Sales, marketing, general and administrative expenses increased from $2.4
million for the year ended December 31, 1997 to $31.0 million for the year ended
December 31, 1998. This increase is attributable to growth in headcount in all
areas of our company as we expanded our sales and marketing efforts, expanded
the deployment of our networks and built our operating infrastructure.
Deferred Compensation
Through December 31, 1998, we recorded a total of $9.0 million of deferred
compensation, with an unamortized balance of $4.7 million on our December 31,
1998 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 using a graded vesting method.
Amortization of deferred compensation was $295,000 during the year ended
December 31, 1997 and $4.0 million during the year ended December 31, 1998.
Depreciation and Amortization
Depreciation and amortization was $70,000 for the year ended December 31,
1997 and $3.4 million for the year ended December 31, 1998. The increase was due
to the increase in equipment and facilities placed in service throughout the
period.
Net Interest Income and Expense
For the year ended December 31, 1997, net interest income was $155,000, and
was primarily attributable to the interest income earned from the proceeds
raised in our preferred stock financing in July 1997. Interest income was $4.8
million for the year ending December 31, 1998. This interest income was earned
primarily from the investment of the proceeds raised in the issuance of our 1998
discount notes in
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March 1998. Interest expense for the year ended December 31, 1998 was $15.2
million and consisted primarily of interest on the 1998 discount notes and
capital lease obligations.
Income Taxes
For the years ended December 31, 1997 and December 31, 1998 we recognized
no provision for taxes because we operated at a loss for both years.
QUARTERLY FINANCIAL INFORMATION
The following table sets forth certain consolidated statements of
operations data for our most recent eight quarters. This information has been
derived from our unaudited consolidated financial statements. In our opinion,
this unaudited information has been prepared on the same basis as the annual
consolidated financial statements and includes all adjustments (consisting only
of normal recurring adjustments) necessary for a fair presentation of the
information for the quarters presented. This information should be read in
conjunction with the consolidated financial statements and related notes
included elsewhere in this prospectus. The operating results for any quarter are
not necessarily indicative of results for any future period.
<TABLE>
<CAPTION>
THREE MONTHS ENDED
-------------------------------------------------------------------
SEPTEMBER 30, DECEMBER 31, MARCH 31, JUNE 30, SEPTEMBER 30,
1997 1997 1998 1998 1998
------------- ------------ --------- -------- -------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Revenues.................... $ -- $ 26 $ 186 $ 809 $ 1,565
Operating expenses:
Network and product
costs................... 10 44 203 758 1,355
Sales, marketing, general
and administrative...... 783 1,334 1,944 4,606 10,681
Amortization of deferred
compensation............ 134 161 227 631 1,837
Depreciation and
amortization............ -- 70 164 446 738
----- ------- ------- ------- --------
Total operating
expenses.............. 927 1,609 2,538 6,441 14,611
----- ------- ------- ------- --------
Income (loss) from
operations................ (927) (1,583) (2,352) (5,632) (13,046)
Net interest income
(expense)................. 80 75 (429) (3,291) (3,511)
----- ------- ------- ------- --------
Net income (loss)....... $(847) $(1,508) $(2,781) $(8,923) $(16,557)
===== ======= ======= ======= ========
<CAPTION>
THREE MONTHS ENDED
-----------------------------------
DECEMBER 31, MARCH 31, JUNE 30,
1998 1999 1999
------------ --------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Revenues.................... $ 2,766 $ 5,596 $ 10,833
Operating expenses:
Network and product
costs................... 2,246 4,960 10,565
Sales, marketing, general
and administrative...... 13,812 18,113 24,976
Amortization of deferred
compensation............ 1,302 1,653 1,234
Depreciation and
amortization............ 2,058 4,647 8,671
-------- -------- --------
Total operating
expenses.............. 19,418 29,373 45,446
-------- -------- --------
Income (loss) from
operations................ (16,652) (23,777) (34,613)
Net interest income
(expense)................. (3,208) (5,127) (7,239)
-------- -------- --------
Net income (loss)....... $(19,860) $(28,904) $(41,852)
======== ======== ========
</TABLE>
We have generated increasing revenues in each of the last eight quarters,
reflecting increases in the number of customers and end-users. Our network and
product costs have increased in every quarter, reflecting costs associated with
customer and end-user growth and the deployment of our networks in existing and
new regions. Our selling, marketing, general and administrative expenses have
increased in every quarter and reflect sales and marketing costs associated with
the acquisition of customers and end-users, including sales commissions, and the
development of regional and corporate infrastructure. Depreciation and
amortization has increased in each quarter, primarily reflecting the purchase of
equipment associated with the deployment of our networks. We have experienced
increasing net losses on a quarterly basis as we increased operating expenses
and increased depreciation as a result of increased capital expenditures, and we
expect to sustain increasing quarterly losses for at least the next several
years. See "Risk Factors -- We have a history of losses and expect increasing
losses in the future."
Our annual and quarterly operating results may fluctuate significantly in
the future as a result of numerous factors. Factors that may affect our
operating results include:
- the timing and ability of traditional telephone companies to provide us
with central office space;
- the rate at which traditional telephone companies can provide us
telephone wires over which we sell our service;
- the rate at which customers subscribe to our services;
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<PAGE> 33
- decreases in the prices for our services due to competition, volume-based
pricing and other factors;
- our ability to retain Internet service provider, enterprise and
telecommunications carrier customers and end-user churn rates;
- the success of our relationships with strategic partners, and other
potential third parties in generating significant subscriber demand;
- the ability to deploy on a timely basis our services to adequately
satisfy end-user demand;
- delays in the commencement of operations in new regions and the
generation of revenue because certain network elements have lead times
that are controlled by traditional telephone companies and other third
parties;
- the mix of line orders between consumer end-users and business end-users
(which typically have higher margins);
- the amount and timing of capital expenditures and other costs relating to
the expansion of our networks;
- the ability to develop and commercialize new services by us or our
competitors;
- the impact of regulatory developments, including interpretations of the
1996 Telecommunications Act; and
- our ability to successfully operate our networks.
Many of these factors are outside of our control. In addition, we plan to
increase operating expenses to fund operations, sales, marketing, general and
administrative activities and infrastructure, including increased expenses
associated with our relationships with strategic partners. If these expenses are
not accompanied by an increase in revenues, we could experience a material
adverse effect on our business, prospects, operating results and financial
condition and our ability to service and repay our indebtedness. See "Risk
Factors -- Our operating results are likely to fluctuate in future periods and,
therefore, are difficult to predict."
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 $93.7 million for the six months ended
June 30, 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. We have also recently begun a branding campaign to
increase recognition of our name under which we expect to incur substantial
additional expenses over the next 12 months.
From our inception through June 30, 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 from 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 June 30, 1999, we
had an accumulated deficit of $121.5 million, and cash and cash equivalents of
$257.5 million.
Net cash used in our operating activities was $27.7 million for the six
months ended June 30, 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 $194.4 million for
the six months ended June 30, 1999. The net cash used for investing activities
during this period was primarily due to purchases of property and equipment, the
purchase of $74.1 million of restricted investments which were pledged as
collateral for the
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payment of the first six scheduled interest payments on the 1999 notes, and an
aggregate $20 million equity investment made in WebMD, Inc. and Efficient
Networks, Inc.
Net cash provided by financing activities for the six months ended June 30,
1999 was $415.2 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 from 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.
Net cash provided by financing activities was partially offset by an
estimated $680,000 in offering costs applicable to our secondary offering of
7,500,000 shares in June 1999 for which we received no proceeds.
Upon completion of this offering, we believe that our current cash, cash
equivalents and short-term investments will be sufficient to meet our
anticipated cash needs for working capital and capital expenditures through at
least the end of 2000.
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 and acquisitions of
businesses that are complementary to ours to support the growth of our business.
Our future cash requirements for developing, deploying and enhancing our
networks and operating our business, as well as our revenues, will depend on a
number of factors including:
- the 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.
We will be required to raise additional capital, the timing and amount of
which we cannot predict. We expect to raise additional capital through debt or
equity financings, depending on market conditions, 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 or
investments in businesses, technologies or products complementary to ours in the
future in order to expand our geographic presence and achieve operating
efficiencies. We may not have sufficient liquidity, or we may be unable to
obtain additional debt or equity financing on favorable terms or at all, in
order to finance such an acquisition or investment.
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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 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 are currently assessing the Year 2000 risks associated with our
third-party and traditional telephone company equipment and software and with
our Internet service provider, enterprise and telecommunication carrier
customers. We are evaluating the risks associated with the reasonably likely
worst-case scenario, but we 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 prospectus that are not historical facts
are "forward-looking statements" (as such term is defined in Section 27A of the
Securities Act and Section 21E of the Exchange Act), which can be identified by
the use of forward-looking terminology such as "estimates," "projects,"
"anticipates," "expects," "intends," "believes," or the negative thereof or
other variations thereon or comparable terminology, or by discussions of
strategy that involve risks and uncertainties. Examples of such forward-looking
statements include but are not limited to:
- our plans to expand our existing networks or to commence service in new
metropolitan statistical areas;
- estimates regarding the timing of launching our service in new
metropolitan statistical areas;
- expectations regarding the extent to which enterprise customers roll out
our service;
- expectations regarding our relationships with our strategic partners and
other potential third parties;
- expectations as to pricing for our services in the future;
- expectations as to the impact of our TeleSurfer service offerings on our
margins;
- the possibility that we may obtain significantly increased sales volumes;
- the impact of our national advertising campaign on brand recognition and
operating results;
- plans to make strategic investments and acquisitions and the affect of
such investments and acquisitions;
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<PAGE> 36
- estimates of future operating results;
- plans to develop and commercialize value-added services;
- our anticipated capital expenditures;
- plans to enter into business arrangements with broadband-related service
providers;
- expectations regarding the commencement of our voice service;
- the effect of regulatory reform and regulatory litigation; and
- other statements contained in this prospectus 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 telephone companies, all in a timely manner, at reasonable
costs and on satisfactory terms and conditions consistent with
regulatory, legislative and judicial developments.
All written and oral forward-looking statements made in connection with
this prospectus 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 this prospectus. We disclaim any obligation to update
information contained in any forward-looking statement.
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
June 30, 1999 including our 1998 notes and our 1999 notes, is fixed-rate debt.
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BUSINESS
The following discussion contains forward-looking statements that involve
risks and uncertainties. Actual results could differ materially from those
anticipated in the forward-looking statements as a result of certain factors
including, but not limited to, those discussed in "Risk Factors" and elsewhere
in this prospectus. We disclaim any obligation to update information contained
in any forward-looking statement. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Forward Looking Statements."
OVERVIEW
We are a leading provider of broadband communications services to Internet
service provider, enterprise and telecommunications carrier customers. These
services include a range of high-speed, high-capacity Internet and network
access services using digital subscriber line (DSL) technology, and related
value-added services. Internet service providers purchase our services in order
to provide high-speed Internet access to their business and consumer end-users.
Enterprise customers purchase our services directly or indirectly from us to
provide employees with high-speed remote access to the enterprise's local area
networks (RLAN access), which improves employee productivity and reduces network
connection costs. Telecommunications carrier customers purchase our services for
resale to their Internet service provider affiliates, Internet users and
enterprise customers.
We believe we have the nation's largest DSL network with 880 operational
central offices passing over 25 million homes and businesses. As of September
30, 1999, we had installed 31,000 DSL-based high-speed access lines and received
orders for our services from 295 Internet service provider, enterprise and
telecommunications carrier customers, including AT&T, Concentric Network,
Flashcom, MindSpring, Oracle, Prodigy, PSINet, Qwest, Stanford University, Sun
Microsystems, UUNET and Verio.
We had planned to deploy our services in 51 metropolitan statistical areas
by the end of the first quarter 2000. By August 1999 we had begun offering our
services in each of these 51 metropolitan statistical areas, and in September
1999, we announced our plans to roll out our service in 49 additional
metropolitan statistical areas. When this build-out is completed, which we
expect to be by the end of 2000, our network will pass a total of 46 million
homes and businesses, representing 40% of homes and 45% of businesses in the
United States.
We plan to continue to pursue rapid network expansion and installation of
high-speed access lines, and to develop a variety of services that are enhanced
or enabled by our broadband network, such as voice over DSL and e-commerce
applications. We expect to leverage our expanding network by entering into
business arrangements with broadband-related service providers in order to bring
a variety of value-added service offerings to our customers and their end-users.
INDUSTRY BACKGROUND
Growing Market Demand for Broadband Communications Services
High-speed connectivity has become important to small- and medium-sized
businesses and consumers due to the dramatic increase in Internet usage.
According to International Data Corporation, the number of Internet users
worldwide reached approximately 142 million in 1998 and is forecasted to grow to
approximately 502 million by 2003. The popularity of the Internet with consumers
has driven the rapid proliferation of the Internet as a commercial medium.
Businesses are increasingly establishing Web sites and corporate intranets and
extranets to expand their customer reach and improve their communications
efficiency. Consumers are increasingly using the Internet to carry out commerce
transactions. International Data Corporation also estimates that the value of
goods and services sold worldwide via the Internet will increase from $50
billion in 1998 to over $1.3 trillion in 2003. Accordingly, to remain
competitive, small-and medium-sized businesses increasingly need high-speed
Internet connections to maintain complex Web sites, access critical business
information and communicate more effectively with employees, customers
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and business partners. Broadband connections are also becoming increasingly
important to businesses and consumers as on-line consumer transactions and
e-commerce become more widespread.
The demand for broadband communications services for RLAN access is also
growing rapidly. Over the past ten years, high-speed local area networks have
become increasingly important to enterprises to enable employees to share
information, send e-mail, search databases and conduct business. We believe that
a large majority of personal computers used in enterprises are connected to
local area networks. Enterprises are now seeking to extend this same high-speed
connectivity to employees accessing the local area networks from home to improve
employee productivity and reduce operating costs. The number of home office
households on the Internet grew from 12.0 million at the end of 1997 to an
estimated 19.7 million by the end of 1999 and is expected to grow to 30.2
million households by 2002. Only 3.7% of these users currently access the
Internet through a broadband connection of any type.
As use of the Internet, intranets and extranets increases, we expect the
market size for both small-and medium-sized business and consumer Internet and
RLAN access to continue to grow rapidly causing the demand for broadband
communications services to also grow rapidly. However, the full potential of
Internet and local area network applications cannot be realized without removing
the performance bottlenecks of the existing public switched telephone network.
Increases in telecommunications bandwidth have significantly lagged improvements
in microprocessor performance over the last ten years. Since 1988,
microprocessor performance has improved nearly 80-fold, while the fastest
consumer modem connection has improved from 9.6 kilobits per second to 56.6
kilobits per second, a factor of six. According to industry analysts, there are
nearly 40 million personal computers in U.S. homes today, and most of them can
only connect to the Internet or their corporate local area network by low-speed
analog lines. Higher speed connections are available, including:
- Integrated Services Digital Networks -- An ISDN provides standard
interfaces for digital communication networks and is capable of carrying
data, voice, and video over digital circuits. ISDN protocols are used
worldwide for connections to public ISDN networks or to attach ISDN
devices to compatible PBX systems.
- T1 Line and Fractional T1 -- These are telephone industry terms for a
digital transmission link with a capacity of 1.544 megabits per second or
portions thereof.
- Frame Relay -- A high-speed packet-switched data communications protocol.
While these services have recently experienced dramatic growth in the U.S.,
they are frequently expensive and complex to order, install and maintain.
Emergence of DSL Technology
DSL technology emerged in the 1990s and is commercially available today to
address the performance bottlenecks of the public switched telephone network.
DSL equipment, when deployed at each end of standard copper telephone lines,
increases the data carrying capacity of these lines from analog modem speeds of
56.6 kilobits per second for the fastest consumer modems and ISDN speeds of 128
kilobits per second to DSL speeds of up to 6 megabits per second depending on
the length and condition of the copper line. Recent advances in semiconductor
technology and digital signal processing algorithms and falling equipment prices
have made the widespread deployment of DSL technology more economical over time.
We anticipate that equipment prices will continue to fall as a result of
continued advances in semiconductor technologies and increases in equipment
production volumes.
Because DSL technology reuses the existing copper plant, it is
significantly less expensive to deploy on a broad scale than alternative
technologies, such as cable modems, wireless data and satellite data. As a
result, a significant portion of the investment in a DSL network is
success-based, requiring a comparatively lower initial fixed investment.
Subsequent variable investments in DSL technology are directly related to the
number of paying customers.
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Impact of Regulatory Developments
The passage of the 1996 Telecommunications Act created a legal framework
for competitive telecommunications companies to provide local analog and digital
communications services in competition with the traditional telephone companies.
The 1996 Telecommunications Act eliminated a substantial barrier to entry for
competitive telecommunications companies by enabling them to leverage the
existing infrastructure built by the traditional telephone companies, which
required a $200 billion investment by these telephone companies and their
ratepayers, rather than constructing a competing infrastructure at significant
cost. The 1996 Telecommunications Act requires traditional telephone companies,
among other things:
- to allow competitive telecommunications companies to lease telephone
wires on a line by line basis;
- to provide central office space for the competitive telecommunications
companies' DSL and other equipment used to connect to the leased
telephone wires;
- to lease access on their inter-central office fiber backbone to link the
competitive telecommunications companies' equipment; and
- to allow competitive telecommunications companies to use their
operational support systems to place orders and access their databases.
The 1996 Telecommunications Act, as interpreted by the FCC, in particular
emphasized the need for competition-driven innovations in the deployment of
advanced telecommunications services, such as DSL services.
OUR COMPETITIVE STRENGTHS
We were formed to capitalize on the substantial business opportunity
created by the growing demand for Internet and network access, the commercial
availability of low cost DSL technology and the passage of the 1996
Telecommunications Act. Key aspects of our solution to provide broadband
communications services include:
- an attractive value proposition that provides high-speed connections at
similar or lower prices than alternative high-speed technologies
currently available to customers;
- a rapid network deployment and service rollout with significant increases
in line installations to date;
- a widely available, continuously connected, secure network that
facilitates deployment of Internet and intranet applications; and
- a management team experienced in the data communications,
telecommunications and personal computer industries.
Attractive Value Proposition. We offer higher bandwidth digital
connections than alternative services at similar or lower prices that do not
vary with usage. For business Internet users, our high-end services offer
bandwidth comparable to that offered by T1 and frame relay circuits at
approximately 25% of the cost. For the RLAN market, our mid-range services are
three to six times the speed of ISDN and up to ten times the speed of analog
modems at monthly rates similar to or lower than those for heavily used ISDN
lines. We believe that many of our enterprise customers can justify deploying
lines to their employees if productivity improves by only a few hours per month
based on increases in the number of hours worked and decreases in commute time
and time spent waiting for information. For consumer Internet users, our
consumer services are comparably priced to current cable modem services. Unlike
cable modems, the speed of our service does not decrease when more users are
added.
We have leveraged our first-mover advantage to rapidly expand our networks
and grow our number of lines installed. We were the first to widely roll out
DSL services on a commercial basis, making DSL service available for purchase in
the San Francisco Bay Area in December 1997. We believe that we have
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leveraged our first-mover advantage to rapidly expand our networks into our
targeted metropolitan regions and grow our number of line installations. We
believe we have the nation's largest DSL network with 880 operational central
offices passing over 25 million homes and businesses. As of September 30, 1999,
we had installed a total of 31,000 lines nationwide.
Widely Available, Always-Connected, Secure Network. Our strategy of
providing blanket coverage in each region we serve is designed to ensure that
our services are available to the vast majority of our customers' end-users. Our
network provides 24-hour, always-on connectivity, unlike ISDN lines and analog
modems which require customers to dial-up each time for Internet or RLAN access.
Also, because we use dedicated connections from each end-user to the Internet
service provider or enterprise network, our customers can reduce the risk of
unauthorized access. These factors are important to our customers because any
Internet service they market to their end-users must actually be available for
them to purchase and be secure enough to not risk their own reputation or
business with any security lapses.
Experienced Management Team. Our management team includes individuals with
extensive experience in the data communications, telecommunications and personal
computer industries, including Robert Knowling, Jr., Chairman of the Board,
President and Chief Executive Officer (former Executive Vice President of
Operations and Technology at U S WEST Communications), Catherine Hemmer, Chief
Operations Officer (former Vice President, Network Reliability and Operations at
U S WEST Communications, Inc., former General Manager, Network Provisioning at
Ameritech Corporation and former Vice President, Network Services at MFS),
Robert Roblin, Executive Vice President, Sales and Marketing (former Executive
Vice President of Marketing at Adobe Systems, Inc. and former Vice President and
General Manager of Marketing, Consumer Division at IBM Corporation), Timothy
Laehy, Chief Financial Officer (former Vice President of Corporate Finance and
Treasurer of Leasing Solutions, Inc.), Rex Cardinale, Chief Technology Officer
and Vice President of Engineering (former General Manager of the cc:Mail
division of Lotus Development Corporation), Robert Davenport, III, Executive
Vice President, Business Development (former Senior Vice President and Chief
Operating Officer of Tele-Communication, Inc.'s Internet Services subsidiary
TCI.NET), Joseph Devich, Executive Vice President, Corporate Services (former
Vice President, Operations and Technologies Staff of US WEST Communications),
Charles Haas, Senior Vice President of Sales Development, and Dhruv Khanna,
Executive Vice President, General Counsel and Secretary, and Jane Marvin, Senior
Vice President of Human Resources (former Vice President of Human Resources for
the General Business Services unit of Ameritech Corporation).
BUSINESS STRATEGY
Our objective is to become the leading nationwide provider of broadband
services and a critical element in the proliferation of e-commerce and other
applications that are enabled or enhanced by broadband communications. The key
elements of our strategy to achieve this objective are as follows:
Expand our Network and Roll Out Service Rapidly in Our Targeted
Metropolitan Statistical Areas. To date, we have introduced our services in 51
of the top metropolitan statistical areas nationwide. We have recently announced
our plan to expand our services to a total of 100 metropolitan statistical areas
by the end of 2000. In the aggregate, these 100 metropolitan statistical areas
cover 40% of homes and 50% of businesses in the United States. In addition, we
have recently begun to assess the regulatory and competitive environments in
other countries.
Provide Pervasive Coverage in Each Metropolitan Statistical Area. We are
pursuing a blanket coverage strategy of providing service in a substantial
majority of the central offices in each region that we enter since our Internet
service provider customers desire to market their Internet access services on a
region-wide basis. Blanket coverage is also important to our enterprise
customers since most of them desire to offer RLAN access to all employees
regardless of where they reside. In addition, we believe our presence in 100
metropolitan statistical areas will allow us to better serve our Internet
service provider, enterprise and telecommunications carrier customers which are
increasingly seeking a single supplier in multiple metropolitan areas.
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Establish and Maintain Sales and Marketing Relationships with Leading
Internet Service Providers, Telecommunications Carriers and DSL Resellers. We
principally target Internet service providers, telecommunications carriers and
DSL resellers that can offer their end-users cost and performance advantages for
Internet access using our services. We do not provide Internet access directly
to any of our customers. Instead, we provide connections to Internet service
providers, which in turn offer high-speed Internet access using our networks. In
this way, we:
- carry the traffic of multiple Internet service providers and
telecommunications carriers in any region, increasing our volume and
reducing our costs;
- leverage our selling efforts through the sales and support staff of these
Internet service providers and telecommunications carriers;
- offer Internet service providers and telecommunications carriers a
transport alternative, since the traditional telephone company typically
provides its own Internet access services in competition with Internet
service providers; and
- provide Internet service providers and telecommunications carriers a
high-speed service offering to compete with cable-based Internet access.
Develop a National Brand. We believe that we can enhance our competitive
position and increase demand for our services by actively developing a positive
brand and image for our company and our services through a combination of
television, print and radio advertisements on both a national and regional
basis. In October 1999, we commenced a significant advertising campaign in
pursuit of this strategy.
Develop and Commercialize Value-Added Services. We intend to introduce
value-added services to our customers and leverage the value of the network
access we offer today. Offering services such as voice over DSL, among others,
will allow for us to bundle service offerings to our customers and improve the
quality of content delivery to their end users. We believe this is an important
part of our strategy and will allow us to build upon our success to date in
adding and retaining subscribers.
Enter Into Business Arrangements With Network and Broadband-Related Service
Providers. We believe that the pace of deployment of our network can be
increased by entering into business arrangements with other network service
providers some of which may be located outside of the United States. We also
believe our network deployment will enable the delivery of a variety of
broadband-related services and content that are desired by our customers. We
expect to make these services available to our customers through entering into
business arrangements with leading providers of broadband-related services or
content.
Take Advantage of New Regulatory Developments. Both the FCC and the
Minnesota Public Utilities Commission have indicated that they may mandate "line
sharing" in certain circumstances. This would allow us to provide our service
over the same telephone wire used by the traditional telephone companies to
provide analog voice services. In addition, some of the Ameritech/SBC merger
conditions adopted by the FCC in October 1999 also contain provisions on line
sharing and provide for reductions in loop costs in certain circumstances. In
many cases, line sharing would allow us to provision our assymetric services on
the same telephone wire as the existing local phone companies' voice service.
Currently, we provision our DSL services over a separate additional telephone
wire. Assymetric and standard telephone service can exist on a single line and
most, if not all of the traditional telephone companies provision their own
assymetric services on the same line as existing voice services.
We see line sharing as an extremely important opportunity for us for three
primary reasons. First, line sharing should significantly reduce the monthly
recurring charges we incur for telephone wires. Second, line sharing should
reduce the time it takes traditional telephone companies to deliver telephone
wires because the telephone wire will already exist. Third, line sharing should
resolve lack of telephone wire problems that we have encountered when ordering
telephone wires in some areas of the country.
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OUR SERVICE OFFERINGS
We offer six business grade services under the TeleSpeed brand to connect
our customers' end-users to our regional data centers and two consumer grade
service offerings called TeleSurfer and TeleSurfer Pro. We also offer business
consumers Virtual Private Network (VPN) technology over DSL. In addition,
Internet service provider and enterprise customers may purchase backhaul
services from us to connect their facilities to our regional data centers.
TeleSpeed Services
Our TeleSpeed services connect individual end-users on conventional
telephone wires to our DSL equipment in their serving central office and from
there to our network serving that metropolitan area. A traditional telephone
company's infrastructure consists of numerous central offices which are
connected by a fiber optic backbone to a regional office that routes local and
long distance traffic. Each central office collects the individual telephone
wires from end-users' premises in the neighborhood.
The particular TeleSpeed service available to an end-user depends on the
user's distance to the central office. We believe that substantially all of our
potential end-users in our target markets generally can be served with one of
our services. We estimate that approximately 70% of end-users are within 18,000
feet of a central office and can be served by at least our TeleSpeed 384
service. We also believe at least a majority of potential end-users will be able
to obtain our highest speed service offering. However, the specific number of
potential end-users for the higher speeds will vary by central office and by
region and will be affected by line quality. The chart below compares the
performance and markets for each of our intraregional end-user services as of
September 30, 1999.
<TABLE>
<CAPTION>
SPEED TO SPEED FROM RANGE*
INTRAREGIONAL SERVICES END-USER END-USER (FEET) MARKET/USAGE
---------------------- -------- ---------- ------ -----------------------
<S> <C> <C> <C> <C>
TeleSpeed 144..................... 144 Kbps 144 Kbps 35,000 ISDN replacement
TeleSpeed 192..................... 192 Kbps 192 Kbps 18,000 Business Internet, RLAN
TeleSpeed 384..................... 384 Kbps 384 Kbps 18,000 Business Internet, RLAN
TeleSpeed 768..................... 768 Kbps 768 Kbps 13,500 Business Internet
TeleSpeed 1.1..................... 1.1 Mbps 1.1 Mbps 12,000 Business Internet
TeleSpeed 1.5..................... 1.5 Mbps 384 Kbps 15,000 High-speed Web access
</TABLE>
- ---------------
* Estimated maximum distance from the end-user to the central office.
Prices for our end-user services may vary depending upon the performance
level of the service. For example, our TeleSpeed 144 and 192 services are our
lowest priced end-user services and our TeleSpeed 1.1 and 1.5 services are our
highest priced end-user services. Our prices also vary across regions and for
high volume customers that are eligible for volume discounts. See "Risk
Factors -- We may experience decreasing prices for our services, which may
impair our ability to achieve profitability or positive cash flow" for a
discussion of the risks associated with our ability to sustain current price
levels in the future.
TeleSpeed 144. Our TeleSpeed 144 service operates at up to 144 kilobits
per second in each direction, which is similar to the performance of an ISDN
line. This service, which can use existing ISDN equipment at the end-user site,
is targeted at the ISDN replacement market where its per month flat rate can
compare favorably to ISDN services from the traditional telephone company when
per-minute usage charges apply. It is also the service that we offer on
telephone wires that are either too long to carry our higher speed services or
are served by digital loop carrier systems or similar equipment where a
continuous copper connection is not available from the end-user site to the
central office.
TeleSpeed 192. This service provides one and a half to three times the
performance of ISDN lines at similar or lower price points to heavily-used ISDN
lines.
TeleSpeed 384. This service provides three to six times the performance of
ISDN lines at similar price points to heavily-used ISDN lines.
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TeleSpeed 768. This service provides one-half the bandwidth of a T1 data
circuit at substantially less than one-half of the monthly price that we
estimate is typical for T1 service. The target market for the TeleSpeed 768
service is small businesses needing moderate speed access to the Internet but
who have previously been unable to afford the price of such service. The service
also competes favorably from a price/performance standpoint with traditional
fractional T1 and frame relay services for these same customers.
TeleSpeed 1.1. This service provides over two-thirds the bandwidth of a T1
data circuit at substantially less than one-half of the monthly price that we
estimate is typical for T1 service. The target market for the TeleSpeed 1.1
service is small businesses needing T1-level access to the Internet which have
previously been unable to afford the price of such service. The service also
competes favorably from a price/performance standpoint with traditional
fractional T1 and frame relay services for these same customers.
TeleSpeed 1.5. TeleSpeed 1.5 is an asymmetric service, i.e., with
different speeds to and from the end-user. This service is intended for
end-users who consume more bandwidth than they generate, and is especially
useful for accessing Web sites. The service also provides the highest
performance of any TeleSpeed service to stream video or other multimedia content
to end-user locations.
TeleSpeed Remote. TeleSpeed Remote provides high-speed network access for
end-users located in remote regions to their corporate networks. This service is
targeted at businesses that want high-speed remote office connections at a lower
cost than ISDN or frame-relay services. For example, this service can provide a
corporation's employees located in Boston high-speed access to their corporate
network located in San Francisco.
TeleSurfer Services
<TABLE>
<CAPTION>
SPEED TO SPEED FROM RANGE*
INTRAREGIONAL SERVICES END-USER END-USER (FEET) MARKET/USAGE
---------------------- -------- ---------- ------ ------------
<S> <C> <C> <C> <C>
TeleSurfer.................................... 384 Kbps 128 Kbps 12,000 Consumer
TeleSurfer Pro................................ 768 Kbps 384 Kbps 12,000 Consumer
</TABLE>
- ---------------
* Estimated maximum distance from the end-user to the central office.
TeleSurfer. This consumer grade service is an asymmetric service, offering
384 kilobits per second downstream and 128 kilobits per second upstream. This
service is the base consumer service. The target market for this service is
consumers using either dial-up analog or ISDN connections for web browsers.
TeleSurfer Pro. This is a premium consumer grade asymmetric service,
offering 768 kilobits per second downstream and 386 kilobits per second
upstream. The target market for this service is consumers using either dial-up
analog or ISDN connections for web browsers.
VPN Over DSL
In August 1999 we introduced our VPN over DSL service. This service uses
the public Internet backbone or a private data network, combined with DSL
connections, as a channel for sharing information and applications within a
closed circle of users in different locations. We offer two levels of VPN over
DSL service.
Covad Branch Office. This service is available for remote or branch
offices that require high-speed inter-office connectivity across multiple
locations.
Covad Teleworker. This service is available for telecommuters and other
remote users who secure access to their corporate network and the Internet from
home.
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Other Services
We also provide a DS3 backhaul service from our regional network to an
Internet service provider or enterprise customer site. This service aggregates
all individual end-users in a metropolitan area and transmits the packet
information to the customer on a single high-speed line. The service utilizes an
asynchronous transfer mode protocol that efficiently handles the high data rates
involved and operates at up to 45 megabits per second. In addition to monthly
service charges, we impose non-recurring order setup charges for Internet
service provider and RLAN end-users for our DS3 backhaul service. Customers must
also purchase a DSL modem from us or a third party for each end-user of our
services.
CUSTOMERS
We offer our services to Internet service providers, enterprises,
telecommunications carriers and other DSL resellers. According to Claritas,
Inc., a leading provider of diagnostic databases, there are over 169,000
businesses in the U.S. with over 100 employees, of which we estimate
approximately 85,000 are in our 100 targeted metropolitan statistical areas. As
of September 30, 1999, we had installed 31,000 DSL lines and received orders for
our services from 295 Internet service provider, enterprise and
telecommunications carrier customers. The following is a list of selected
Internet service provider, enterprise and telecommunications carrier customers:
<TABLE>
<CAPTION>
SELECTED INTERNET SERVICE PROVIDER CUSTOMERS SELECTED ENTERPRISE CUSTOMERS SELECTED TELECOMMUNICATIONS CARRIERS
- -------------------------------------------- ----------------------------- ------------------------------------
<S> <C> <C>
Concentric Network Corporation Apple Computer AT&T
Flashcom Inktomi GST Telecommunications
MindSpring Intel RCN Corporation
PSINet Oracle Corporation e.spire
Prodigy Stanford University Qwest
UUNET Sun Microsystems
Verio WebTV
</TABLE>
Our agreements with Internet service providers and other DSL resellers
generally have terms of one year and are nonexclusive. We do not require the
Internet service providers to generate a minimum number of end-users and
generally grant volume discounts based on order volume.
Our practice with respect to our enterprise customers has been to enter
into an arrangement for a negotiated price to install the service initially to a
small number of end-users. An enterprise customer decides whether to implement a
broad rollout of our services after evaluating the results of this initial phase
of deployment. To date, an enterprise customer's initial phase of deployment and
its decision to roll out our service to additional end users has taken at least
six months, and has generally taken longer than we originally expected. As of
September 30, 1999, a substantial majority of our enterprise customers had not
yet rolled out our services broadly to their employees. We will not receive
significant revenue from an enterprise customer until and unless these rollouts
occur. During the lengthy sales cycle for an enterprise customer, we incur
significant expenses in advance of the receipt of revenues.
We also enter into customer agreements with telecommunications carriers,
including competitive telecommunications companies and interexchange carriers.
Under these agreements our telecommunication carrier customers typically resell
our services to their new and existing customers. These carriers currently
market our Internet and RLAN services primarily to small, medium and enterprise
businesses that purchase voice services from them.
SALES AND MARKETING
Business and Consumer Internet. For the business and consumer Internet
access markets, we sell our service to Internet service providers and
telecommunications carriers that combine our lines with their Internet access
services and resell the combination to their existing and new end-users. We
address these markets through sales and marketing personnel dedicated to the
Internet service provider sales channel. We supplement our sales efforts to
Internet service providers through training programs and marketing
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programs that include promotions and sales incentives designed to encourage the
Internet service providers to sell our services instead of those of our
competitors. As of September 30, 1999, we had more than 225 Internet service
provider and telecommunications carrier customers with their own sales personnel
marketing Internet services.
Remote Local Area Network. We market our RLAN services to businesses
through a direct sales force, augmented by marketing programs with value-added
resellers and interexchange carriers. The direct sales force is organized by
region. The sales force is directed to deal directly with the chief information
officer and the telecommunications manager responsible for remote access within
an enterprise. We augment our sales efforts to RLAN customers through
partnerships with value-added resellers, including systems integrators that can
offer our TeleSpeed service as part of a complete work-at-home solution to
businesses.
Third-Party Relationships. A key element of our strategy is to enter into
relationships with leading telecommunications companies, including competitive
telecommunications carriers and interexchange carriers, pursuant to which those
companies resell our TeleSpeed and TeleSurfer services to their customers. For
example, we have entered into commercial agreements with each of AT&T, GST,
Qwest and RCN providing for the purchase and resale of our services, primarily
to their small business and enterprise customers. In addition, in May 1999 we
entered into a strategic relationship with WebMD in which we will be WebMD's
preferred provider of broadband connectivity offering physician subscribers
web-based multimedia and communication services designed to enhance their
practices. We believe that these indirect sales channels will enable us to
penetrate our target markets more rapidly and eventually will generate the
majority of sales of our services.
Branding and Marketing Programs. We have recently commenced a branding and
advertising effort to educate the market about our broadband service offerings
and increase recognition of our brand. This program, which utilizes television,
print and radio advertisings on both a national and regional basis, is intended
to inform the market about the availability of Covad service, differentiate the
products and services offered by Covad and simplify the process through which
these products and services are ordered today.
We are also pursuing several types of joint marketing arrangements with our
Internet service provider, telecommunications carrier customers and other DSL
resellers. In addition, certain of our equipment suppliers have promoted our
services through seminars to corporate information technology managers in the
San Francisco Bay Area. We also support our sales efforts with marketing efforts
that include advertising programs through radio and other popular media,
attendance at trade shows and presentations at industry conferences. See "Risk
Factors -- Our business will suffer if our Internet service providers,
telecommunications carriers and other third parties are not successful in the
marketing and sale of our services."
SERVICE DEPLOYMENT AND OPERATIONS
Internet service providers, telecommunications carriers and corporate
information technology managers typically have had to assemble their digital
communications connections using multiple service and equipment suppliers,
leading to additional work, cost and coordination problems. With our services,
we emphasize a one-stop service solution for our customers. This service
solution includes:
- extending our networks to customers and end-users with various needs and
configuration requirements;
- end-user premise wiring and DSL modem configuration;
- ongoing network monitoring, customer reporting;
- customer service and technical support; and
- operational support system.
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Extending our Networks to Customers and End-Users. We work with our
Internet service provider, enterprise and telecommunications carrier customers
to extend our networks to each customer premise and each end-user premise by
ordering circuits from the traditional telephone company or a competitive
telecommunications company, interconnecting the customers and end-users to our
networks, testing the circuits, configuring customer routers or switches and
end-user routers and monitoring the circuits from the network operations center.
End-User Premises Wiring and DSL Modem Configuration. We use our own and
subcontracted field service crews and trucks to perform any required inside
wiring and to configure DSL modems at each end-user site.
Network Monitoring. We monitor our networks from our network operations
center, which helps us to identify and correct network problems. We have also
developed network capability to provide Internet service provider, enterprise
and telecommunications carrier customers direct monitoring access of their
end-users for more efficient monitoring of their own network performance.
Customer Reporting. We communicate regularly with our customers about the
status of their end-users. We also operate a toll-free customer care help line.
Additionally, we provide Web-based tools to allow individual Internet service
providers and enterprise information technology managers and telecommunications
carriers to monitor their end-users directly, to place orders for new end-users,
to enter trouble tickets on end-user lines and to communicate with us on an
ongoing basis.
Customer Service and Technical Support. We provide 24X7 on-line support to
our Internet service provider customers and enterprise information technology
managers. The Internet service provider and information technology manager and
telecommunications carriers serve as the initial contact for service and
technical support, and we provide the second level of support.
Operational Support System. We have developed what we believe to be the
industry-leading operational support system for DSL networks. Our operational
support system is based on web interfaces and is highly automated. These
features allow us to scale our businesses rapidly because they eliminate many
manual processes such as line testing, network path configuration, equipment
configuration, order taking and verification, billing and telephone wire
supplier management.
NETWORK ARCHITECTURE AND TECHNOLOGY
The key design principles of our network attempt to provide the following
attributes which we believe are important requirements of our existing and
potential customers:
Robust Network Security. Modem access to enterprise networks presents
significant security risks, since any telephone can be used to attempt to access
such a network simply by dialing the telephone number. As a result, enterprises
expend significant effort and resources to prevent unauthorized access.
Enterprises also typically limit remote access users to reading e-mail or other
non-sensitive applications. Our networks are designed to ensure secure
availability of all internal applications and information for remote locations.
Our permanent virtual circuit network architecture connects individual end-users
at fixed locations to a single enterprise, which reduces the possibility of
unauthorized access and allows our customers to safely transmit sensitive
information and applications over our TeleSpeed lines.
Consistent and Scalable Performance. We believe that eventually public
packet networks will evolve to replace the over 40 million modems currently
connected to circuit switched networks that have been deployed in the U.S. As
such, we designed our networks for scalability and consistent performance to all
users as the networks grow. We have designed a "star topology" network similar
to the most popular local area network networking architecture currently used in
high performance enterprise networks. In this model, new capacity is added
automatically as each new user receives a new line. We also use asynchronous
transfer mode equipment in our networks that implements packet switching
directly in silicon circuits rather than slower router-based designs that
implement switching in router software.
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Intelligent End-to-End Network Management. Because the customers' and
end-users' lines are continuously connected, they can also always be monitored.
We have visibility from the Internet service provider or enterprise site across
the network and into the end-user's home or business. Because our networks are
centrally managed, we can identify and dynamically enhance network quality,
service and performance and address network problems promptly.
Flexibility. We have designed our networks to be flexible in handling
various types of network traffic, starting with data, but able to accommodate
voice and video. This flexibility will allow us to offer or enter into
arrangements with other entities to offer not only value-added services such as
voice over DSL, but also control the prioritization of content delivery within
our national network.
The primary components of our networks are the network operations center,
our high-speed private metropolitan networks, central office spaces, including
digital subscriber line access multiplexers (DSLAMs), copper telephone lines and
DSL modems.
Network Operations Center. Our entire network is managed from the network
operations center. We provide end-to-end network management using advanced
network management tools on a 24X7 basis, which enhances our ability to address
performance or connectivity issues before they affect the end-user experience.
From the network operations center, we can monitor the equipment and circuits in
each metropolitan network (including the asynchronous transfer mode equipment),
each central office (including DSLAMs) and potentially individual end-user lines
(including the DSL modems). Currently, the network operations center is located
in the San Francisco Bay Area. We are currently in the process of building a
second network operations center on the East Coast.
Private Metropolitan Network. We operate our own private metropolitan
network in each region that we enter. The network consists of high-speed
asynchronous transfer mode communications circuits that we lease to connect our
asynchronous transfer mode hubs, our equipment in individual central offices and
our Internet service provider, enterprise and telecommunications carrier
customers. This network operates at a speed of 45 to 155 megabits per second.
Central Office Spaces. Through our interconnection agreements with the
traditional telephone companies, we seek to secure space in every central office
where we intend to offer service. These central office spaces are designed to
offer the same high reliability and availability standards as the traditional
telephone company's other central office space. We require access to these
spaces for our equipment and for persons employed by, or under contract with,
us. We place DSLAMs in our central office spaces to provide the high-speed DSL
signals on each copper line to our end-users. We expect to deploy up to 80
central office spaces in any metropolitan area that we enter. As of September
30, 1999, we had 880 central office spaces operational. In addition, we have a
significant number of additional spaces under construction as well as other
spaces on order from various traditional telephone companies. In December 1998,
we entered into a professional service arrangement with Lucent Technologies to
augment and accelerate our ability to deploy our central office facilities.
Telephone Wires. We lease the telephone wires running to end-users from
the traditional telephone companies under terms specified in our interconnection
agreements. We lease lines that, in numerous cases, must be specially
conditioned by the traditional telephone companies to carry digital signals,
usually at an additional charge relative to that for voice grade telephone
wires. The price we are obligated to pay for these lines currently varies from
$4 to $43 per month per line with additional one-time charges in some cases for
installation, modification or removal of lines.
DSL Modems and On-Site Connection. We buy our DSL modems from our
suppliers for resale to our Internet service provider or enterprise customers
for use by their end-users. We configure and install these modems along with any
required on-site wiring needed to connect the modem to the copper line leased
from the traditional telephone company. For the most part, the DSL modem and
DSLAM equipment used must come from the same vendor for all services, since
there are not yet interoperability standards for the equipment used in our
higher-speed services.
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We are also pursuing a program of ongoing network development. Our service
development and engineering efforts focus on the design and development of new
technologies and services to increase the speed, efficiency, reliability and
security of our networks and to facilitate the development of network
applications by third parties that will increase the use of our networks. See
"Risk Factors -- The scalability and speed of our networks remain largely
unproven."
COMPETITION
The markets for business and consumer Internet access and network access
services are intensely competitive. We expect that these markets will become
increasingly competitive in the future. The principal bases of competition in
our markets include:
- price/performance;
- breadth of service availability;
- reliability of service;
- network security;
- ease of access and use;
- content bundling;
- customer support;
- brand recognition;
- operating experience;
- relationships with Internet service providers and other third parties;
and
- capital resources.
We face competition from traditional telephone companies, cable modem
service providers, competitive telecommunications companies, traditional and new
national long distance carriers, Internet service providers, on-line service
providers and wireless and satellite service providers.
Traditional Telephone Companies. All of the largest traditional telephone
companies in our target markets have begun offering DSL services or have
announced their intention to provide DSL services in the near term. As a result,
the traditional telephone companies represent strong competition in all of our
target service areas, and we expect this competition to intensify. The
traditional telephone companies have an established brand name and reputation
for high quality in their service areas, possess sufficient capital to deploy
DSL equipment rapidly, own the telephone wires themselves and can bundle digital
data services with their existing voice services to achieve economies of scale
in serving their customers. Certain of the traditional telephone companies have
aggressively priced their consumer DSL services as low as $19 - $29 per month,
placing pricing pressure on our TeleSurfer services. The traditional telephone
companies are also in a position to offer service from central offices where we
are unable to secure space and offer service because of asserted or actual space
restrictions.
Cable Modem Service Providers. Cable modem service providers such as AT&T,
Excite@Home, Road Runner and MediaOne (and their respective cable partners) are
deploying high-speed Internet access services over hybrid fiber coaxial cable
networks. Hybrid fiber coaxial cable is a combination of fiber optic coaxial
cable, and has become the primary architecture utilized by cable operators in
recent and ongoing upgrades of their systems. Where deployed, these networks
provide similar and in some cases higher-speed Internet access than we provide.
They also offer these services at lower price points than our TeleSurfer
services. We believe the cable modem service providers face a number of
challenges that providers of DSL services do not face. For example, different
regions within a metropolitan area may be served by different cable modem
service providers, making it more difficult to offer the blanket coverage
required by potential business customers. Also, much of the current cable
infrastructure in the U.S. must be upgraded to support cable modems, a process
which we believe is significantly more expensive and time-consuming than the
deployment of DSL-based networks.
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Competitive Telecommunications Companies. Many competitive
telecommunications companies such as NorthPoint Communications, Rhythms
NetConnections and Network Access Solutions offer high-speed digital services
using a business strategy similar to ours. Some of these competitors have begun
offering DSL-based access services and others are likely to do so in the future.
Companies such as Teleport Communications Group, Inc. (acquired by AT&T), Brooks
Fiber Properties, Inc. (acquired by MCI WorldCom), MFS (acquired by MCI
WorldCom) and NEXTLINK Communications have extensive fiber networks in many
metropolitan areas, primarily providing high-speed digital and voice circuits to
large corporations. They also have interconnection agreements with the
traditional telephone companies pursuant to which they have acquired central
office space in many markets targeted by us. Further, certain of our customers
have made investments in our competitors.
National Long Distance Carriers. Interexchange carriers, such as AT&T,
Sprint, MCI WorldCom and Qwest, have deployed large-scale Internet access
networks and ATM networks, sell connectivity to businesses and residential
customers, and have high brand recognition. They also have interconnection
agreements with many of the traditional telephone companies and a number of
spaces in central offices from which they are currently offering or could begin
to offer competitive DSL services.
Internet Service Providers. Internet service providers such as BBN
(acquired by GTE), UUNET Technologies (acquired by MCI WorldCom), EarthLink
Network, Concentric Network Corporation, MindSpring Enterprises, Netcom On-Line
Communication Services and PSINet provide Internet access to residential and
business customers, generally using the existing public switched telephone
network at integrated services digital network speeds or below. Some Internet
service providers such as UUNET Technologies in California and New York,
HarvardNet Inc. and InterAccess have begun offering DSL-based services. To the
extent we are not able to recruit Internet service providers as customers for
our service, Internet service providers could become competitive DSL service
providers.
On-line Service Providers. On-line service providers include companies
such as AOL, Excite@Home, Compuserve (acquired by AOL), MSN (a subsidiary of
Microsoft Corp.) and WebTV (a subsidiary of Microsoft Corp.) that provide, over
the Internet and on proprietary online services, content and applications
ranging from news and sports to consumer video conferencing. These services are
designed for broad consumer access over telecommunications-based transmission
media, which enable the provision of digital services to the significant number
of consumers who have personal computers with modems. In addition, they provide
Internet connectivity, ease-of-use and consistency of environment. Many of these
on-line service providers have developed their own access networks for modem
connections. If these on-line service providers were to extend their access
networks to DSL or other high-speed service technologies, they would become
competitors of ours.
Wireless and Satellite Data Service Providers. Wireless and satellite data
service providers are developing wireless and satellite-based Internet
connectivity. We may face competition from terrestrial wireless services,
including two Gigahertz (Ghz) and 28 Ghz wireless cable systems (Multi-channel
Microwave Distribution System (MMDS) and Local Multi-channel Distribution System
(LMDS)), and 18 Ghz and 39 Ghz point-to-point microwave systems. For example,
the FCC is currently considering new rules to permit MMDS licensees to use their
systems to offer two-way services, including high-speed data, rather than solely
to provide one-way video services. The FCC also recently auctioned spectrum for
LMDS services in all markets. This spectrum is expected to be used for wireless
cable and telephony services, including high-speed digital services. In
addition, companies such as Teligent Inc., Advanced Radio Telecom Corp. and
WinStar Communications, Inc., hold point-to-point microwave licenses to provide
fixed wireless services such as voice, data and videoconferencing.
We also may face competition from satellite-based systems. Motorola
Satellite Systems, Inc., Hughes Communications (a subsidiary of General Motors
Corporation), Teledesic and others have filed applications with the FCC for
global satellite networks which can be used to provide broadband voice and data
services, and the FCC has authorized several of these applicants to operate
their proposed networks.
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INTERCONNECTION AGREEMENTS WITH TRADITIONAL TELEPHONE COMPANIES
A critical aspect of our business is our interconnection agreements with
the traditional telephone companies. These agreements cover a number of aspects
including:
- the price we pay to lease access to the traditional telephone company's
telephone wires;
- the special conditioning the traditional telephone company provides on
certain of these lines to enable the transmission of digital signals;
- the price and terms of central office space for our equipment in the
traditional telephone company's central offices;
- the price we pay and access we have to the traditional telephone
company's transport facilities;
- the operational support systems and interfaces that we can use to place
orders, report network problems and monitor the traditional telephone
company's response to our requests;
- the dispute resolution process that we use to resolve disagreements on
the terms of the interconnection contract; and
- the term of the interconnection agreement, its transferability to
successors, its liability limits and other general aspects of the
traditional telephone company relationship.
As of September 30, 1999, we have entered into interconnection agreements
with or otherwise obtained interconnection rights from the different major
traditional telephone companies in all the states covering our existing 51
metropolitan statistical areas. Traditional telephone companies do not in many
cases agree to our requested provisions in interconnection agreements and we
have not consistently prevailed in obtaining all of our desired provisions in
such agreements either voluntarily or through the interconnection arbitration
process. We cannot be sure that we will be able to continue to sign
interconnection agreements with existing or other traditional telephone
companies. We are currently negotiating agreements with several traditional
telephone companies in order to expand our services into 100 targeted
metropolitan statistical areas. The traditional telephone companies are also
permitting competitive telecommunications companies to adopt previously signed
interconnection agreements. In certain instances, we have adopted the
interconnection agreement of another competitive telecommunications company.
Other competitive telecommunications companies have also adopted the same or
modified versions of our interconnection agreements, and may continue to do so
in the future.
Many of our interconnection agreements have a term of three years. We will
have to renegotiate these agreements when they expire. Although we expect to
renew the interconnection agreements that require renewal and believe the 1996
Telecommunications Act and the agreements themselves limit the ability of
traditional telephone companies not to renew such agreements, we may not succeed
in extending or renegotiating our interconnection agreements on favorable terms.
Additionally, disputes have arisen and will likely arise in the future as a
result of differences in interpretations of the interconnection agreements. For
example, we are in litigation proceedings with certain of the traditional
telephone companies. These disputes have delayed our deployment of our networks.
They have also adversely affected our service to our customers and our ability
to enter into additional interconnection agreements with the traditional
telephone companies in other states. Finally, the interconnection agreements are
subject to state commission, FCC and judicial oversight. These government
authorities may modify the terms of the interconnection agreements in a way that
hurts our business.
GOVERNMENT REGULATION
Overview. Our services are subject to a variety of federal regulations.
With respect to certain activities and for certain purposes, we have submitted
our operations to the jurisdiction of state and local authorities who may also
assert more extensive jurisdiction over our facilities and services. The FCC has
jurisdiction over all of our services and facilities to the extent that we
provide interstate and international services. To the extent we provide
identifiable intrastate services, our services and facilities are subject to
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state regulations. In addition, local municipal government authorities also
assert jurisdiction over our facilities and operations. The jurisdictional reach
of the various federal, state and local authorities is subject to ongoing
controversy and judicial review, and we cannot predict the outcome of such
review.
Federal Regulation. We must comply with the requirements of the
Communications Act of 1934, as amended by the 1996 Telecommunications Act, as
well as the FCC's regulations under the statute. The 1996 Telecommunications Act
eliminates many of the pre-existing legal barriers to competition in the
telecommunications and video programming communications businesses, preempts
many of the state barriers to local telecommunications service competition that
previously existed in state and local laws and regulations, and sets basic
standards for relationships between telecommunications providers. The law
delegates to the FCC and the states broad regulatory and administrative
authority to implement the 1996 Telecommunications Act.
Among other things, the 1996 Telecommunications Act removes barriers to
entry in the local telecommunications market. It does this by preempting certain
state and local laws that are barriers to competition and by requiring
traditional telephone companies to provide nondiscriminatory access and
interconnection to potential competitors, such as cable operators, wireless
telecommunications providers, interexchange carriers and competitive
telecommunications companies such as us.
Regulations promulgated by the FCC under the 1996 Telecommunications Act
specify in greater detail the requirements of the 1996 Telecommunications Act
imposed on the traditional telephone companies to open their networks to
competition by providing competitors interconnection, central office space,
access to unbundled network elements, retail services at wholesale rates and
nondiscriminatory access to telephone poles, ducts, conduits, and rights-of-way.
The requirements enable companies such as us to interconnect with the
traditional telephone companies in order to provide local telephone exchange
services and to use portions of the traditional telephone companies' existing
networks to offer new and innovative services such as our TeleSpeed and
TeleSurfer services. In January 1999, the U.S. Supreme Court ruled on challenges
to the FCC regulations. Although the U.S. Supreme Court upheld most of the FCC's
authority and its regulations, it required the FCC to reexamine and redefine
which unbundled networks elements the traditional telephone companies must
offer. The FCC is expected to issue its revised list of unbundled network
elements in October 1999.
The 1996 Telecommunications Act also allows the regional bell operating
companies (RBOCs), which are the traditional telephone companies created by
AT&T's divestiture of its local exchange business, to enter the long distance
market within their own local service regions upon meeting certain requirements.
The remaining RBOCs include BellSouth, Bell Atlantic Corporation, Ameritech
Corporation, U S WEST Communications, Inc. and SBC Communications, Inc. The
timing of the various RBOCs' entry into their respective in-region long distance
service businesses is extremely uncertain. On September 29, 1999, Bell Atlantic
filed its application for FCC approval to provide in-region long distance
services in New York state. The FCC is expected to act on the application before
the end of 1999. It is uncertain whether the FCC will grant Bell Atlantic's
application. If the FCC grants Bell Atlantic's application, it is likely to
thereafter grant similar applications by Bell Atlantic and the other RBOCs in
other states. The timing of the various RBOCs' in-region long distance entry
will likely affect the level of cooperation we receive from each of the RBOCs.
The approval of such entry will likely adversely affect the level of
cooperation.
In addition, the 1996 Telecommunications Act provides relief from the
earnings restrictions and price controls that have governed the local telephone
business for many years. Traditional telephone company tariff filings at the FCC
have been subjected to increasingly less regulatory review. However, precisely
when and to what extent the traditional telephone companies will secure pricing
flexibility or other regulatory freedom for their services is uncertain. For
example, under the 1996 Telecommunications Act, the FCC is considering
eliminating certain regulations that apply to the traditional telephone
companies' provision of services that are competitive with ours. The timing and
the extent of regulatory freedom and pricing flexibility and regulatory freedom
granted to the traditional telephone companies will affect the competition we
face from the traditional telephone companies' competitive services.
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Further, the 1996 Telecommunications Act provides the FCC with the
authority to forbear from regulating entities such as us who are classified as
"non-dominant" carriers. The FCC has exercised its forbearance authority. As a
result, we are not obligated to obtain prior certificate approval from the FCC
for our interstate services or file tariffs for such services. We have
determined not to file tariffs for our interstate services. We provide our
interstate services to our customers on the basis of contracts rather than
tariffs. We believe that it is unlikely that the FCC will require us to file
tariffs for our interstate services in the future.
On March 18, 1999, the FCC announced that it was adopting rules to make it
easier and less expensive for competitive telecommunications companies to obtain
central office space and to require traditional telephone companies to make new
alternative arrangements for obtaining central office space. New entrants will
be able to locate all equipment necessary for interconnection, whether or not
such equipment has a switching function. The FCC's rules have not been uniformly
implemented. In the same announcement, the FCC provided notice of proposed
rule-making to determine whether carriers should be able to provide asymmetric
DSL over the same line over which traditional telephone companies provide voice
service. The notice sought comments on the operational, pricing, legal and
policy ramifications of mandating such line sharing at the federal level. If
adopted, these rules could materially lower the price we pay to lease access to
the traditional telephone company's telephone wires. While we believe that these
rules would be advantageous to us, the FCC may decide not to establish such
rules, and the traditional telephone companies may balk at or thwart the
implementation of such rules even if the FCC establishes them.
Any changes in applicable federal law and regulations, in particular,
changes in its interconnection agreements with traditional telephone companies,
the prospective entry of the RBOCs into the in-region long distance business and
grant of regulatory freedom and pricing flexibility to the traditional telephone
companies, could harm our business.
State Regulation. To the extent we provide identifiable intrastate
services or have otherwise submitted ourselves to the jurisdiction of the
relevant state telecommunications regulatory commissions, we are subject to such
jurisdiction. In addition, certain states have required prior state
certification as a prerequisite for processing and deciding an arbitration
petition for interconnection under the 1996 Telecommunications Act. As of
September 30, 1999, we were authorized under state law to operate as a
competitive local exchange carrier in 28 states, and intend to obtain
authorization in the other states necessary to cover our 100 targeted
metropolitan statistical areas. We have pending arbitration proceedings in
different states for interconnection arrangements with the relevant traditional
telephone companies. We have concluded arbitration proceedings in a number of
states by entering into interconnection agreements with the relevant traditional
telephone companies. We have filed tariffs in certain states for intrastate
services as required by state law or regulation. We are also subject to periodic
financial and other reporting requirements of these states with respect to our
intrastate services.
The different state commissions have various proceedings to determine the
rates, charges and terms and conditions for unbundled network elements
(unbundled network elements are the various portions of a traditional telephone
company's network that a competitive telecommunications company can lease for
purposes of building a facilities-based competitive network, including telephone
wires, central office collocation space, inter-office transport, operational
support systems, local switching and rights of way), as well as the discount for
wholesale services that we purchase from the relevant traditional telephone
company. The rates set forth in our interconnection agreements are interim rates
and will be prospectively, and, in some cases, retroactively, affected by the
permanent rates set by the various state commissions for such unbundled network
elements as unbundled loops and interoffice transport. We have participated in
unbundled network element rate proceedings in several states in an effort to
reduce these rates. If any state commission decides to increase unbundled
network element rates our operating results could suffer.
The applicability of the various state regulations on our business and
compliance requirements will be further affected by the extent to which our
services are determined to be intrastate services. Jurisdictional determinations
of our services as intrastate services could harm our business.
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Local Government Regulation. We may be required to obtain various permits
and authorizations from municipalities in which we operate our own facilities.
The issue of whether actions of local governments over the activities of
telecommunications carriers, including requiring payment of franchise fees or
other surcharges, pose barriers to entry for competitive telecommunications
companies which may be preempted by the FCC is the subject of litigation.
Although we rely primarily on the unbundled network elements of the traditional
telephone companies, in certain instances we deploy our own facilities,
including fiber optic cables, and therefore may need to obtain certain municipal
permits or other authorizations. The actions of municipal governments in
imposing conditions on the grant of permits or other authorizations or their
failure to act in granting such permits or other authorizations could harm our
business.
The foregoing does not purport to describe all present and proposed
federal, state and local regulations and legislation affecting the
telecommunications industry. Other existing federal regulations are currently
the subject of judicial proceedings, legislative hearings and administrative
proposals, which could change, in varying degrees, the manner in which
communications companies operate in the U.S. The ultimate outcome of these
proceedings, and the ultimate impact of the 1996 Telecommunications Act or any
final regulations adopted pursuant to the 1996 Telecommunications Act or our
business cannot be determined at this time but may well be adverse to our
interests. We cannot predict the impact, if any, that future regulation or
regulatory changes may have on our business and we can give you no assurance
that such future regulation or regulatory changes will not harm our business.
See "Risk Factors -- Rejections of our applications for central office space by
traditional telephone companies are likely to delay the expansion of our
networks and the rollout of our services" and "-- Our services are subject to
government regulation, and changes in current or future laws or regulations
could adversely affect our business."
INTELLECTUAL PROPERTY
We regard certain aspects of our products, services and technology as
proprietary and attempt to protect them with patents, copyrights, trademarks,
trade secret laws, restrictions on disclosure and other methods. These methods
may not be sufficient to protect our technology. We also generally enter into
confidentiality or license agreements with our employees and consultants, and
generally control access to and distribution of our documentation and other
proprietary information. Despite these precautions, it may be possible for a
third party to copy or otherwise obtain and use our products, services or
technology without authorization, or to develop similar technology
independently.
Currently we have a number of patent applications and intend to prepare
additional applications and to seek patent protection for our systems and
services to the extent possible. These patents may not be issued to us, and if
issued, they may not protect our intellectual property from competition which
could seek to design around or invalidate these patents.
Further, effective patent, copyright, trademark and trade secret protection
may be unavailable or limited in certain foreign countries. The global nature of
the Internet makes it virtually impossible to control the ultimate destination
of our proprietary information. Steps taken by us may not prevent
misappropriation or infringement of our technology. In addition, litigation may
be necessary in the future to enforce our intellectual property rights to
protect our trade secrets or to determine the validity and scope of the
proprietary rights of others. Such litigation could result in substantial costs
and diversion of resources.
In addition, we may be sued by others with respect to infringement of their
intellectual property rights. We were recently sued by Bell Atlantic for an
alleged infringement of a patent issued to them in September 1998 entitled
"Variable Rate and Variable Mode Transmission System." We believe that we do not
infringe the Bell Atlantic patent and have defenses to infringement and
liabilities. However, litigation is inherently unpredictable and there is no
guarantee that we will prevail. Such lawsuits, including the Bell Atlantic suit,
could significantly harm our business.
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EMPLOYEES
As of September 30, 1999, we had 680 employees, excluding temporary
personnel and consultants. None of our employees are represented by a labor
union, and we consider our relations with our employees to be good. Our ability
to achieve our financial and operational objectives depends in large part upon
the continued service of our senior management and key technical, sales,
marketing and managerial personnel, and our continuing ability to attract and
retain highly qualified technical, sales, marketing and managerial personnel.
Competition for such qualified personnel is intense, particularly in software
development, network engineering and product management. In addition, in the
event that our employees unionize, we could incur higher ongoing labor costs and
disruptions in our operations in the event of a strike or other work stoppage.
PROPERTIES
We are headquartered in Santa Clara, California in facilities consisting of
approximately 62,000 square feet pursuant to a lease that will expire on or
before July 14, 2002. We also lease office space in many of the metropolitan
statistical areas in which we conduct operations. In addition, our San Francisco
Bay Area regional data center consists of approximately 2,000 square feet and is
located in San Jose, California, which we occupy under a ten-year lease with two
five-year renewal options. Currently, and until we finish building our west
coast network operations center, we utilize a portion of the San Francisco Bay
Area regional data center space to facilitate this operation. We are currently
planning to build a second network operations center on the east coast. We also
lease central office space from the traditional telephone company in each region
that we operate or plan to operate under the terms of our interconnection
agreements and obligations imposed by state public utilities commissions and the
FCC. While the terms of these leases are perpetual, the productive use of our
central office space is subject to the terms of our interconnection agreements
which expire on or before March 2001. We will increase our central office space
as we expand our network in the San Francisco Bay Area and other regions.
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. Meanwhile,
the arbitration panel is evaluating our claim for additional damages. 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 infringement of a patent
issued to them in September 1998 entitled "Variable Rate and Variable Mode
Transmission System." We believe that we do not infringe the Bell Atlantic
patent and have defenses to infringement and liability. However, litigation is
inherently unpredictable and there is no guarantee that we will prevail. Failure
to resolve these 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 significantly harm our business.
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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.
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MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
Our directors and executive officers, and their respective ages as of
September 30, 1999, are as follows:
<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
Robert Knowling, Jr....................... 44 Chairman of the Board, President and Chief
Executive Officer
Timothy Laehy............................. 43 Chief Financial Officer
Robert Davenport, III..................... 40 Executive Vice President, Business
Development
Catherine Hemmer.......................... 41 Chief Operations Officer
Robert Roblin............................. 47 Executive Vice President, Sales and
Marketing
Joseph Devich............................. 42 Executive Vice President, Corporate
Services
Dhruv Khanna.............................. 39 Executive Vice President, General Counsel
and Secretary
Jane Marvin............................... 40 Senior Vice President, Human Resources
Terry Moya................................ 41 Senior Vice President, External Affairs
Robert Hawk............................... 59 Director
Henry Kressel............................. 65 Director
Joseph Landy.............................. 38 Director
Daniel Lynch.............................. 58 Director
Frank Marshall............................ 52 Director
Charles McMinn............................ 47 Director
Rich Shapero.............................. 51 Director
</TABLE>
ROBERT KNOWLING, JR. has been our President, Chief Executive Officer and a
member of our board of directors since July 1998. As of September 1999, he also
became Chairman of the Board of Directors. From October 1997 through July 1998,
Mr. Knowling served as the Executive Vice President of Operations and
Technologies at U S WEST Communications, Inc. In this capacity, Mr. Knowling was
responsible for planning, delivering and maintaining high-quality
telecommunications services for more than 25 million customers in 14 western and
midwestern states. From March 1996 through September 1997, he served as Vice
President of Network Operations at U S WEST Communications, Inc. From November
1994 through March 1996, he served as Vice President of Network Operations for
Ameritech Corporation. Mr. Knowling began his career in 1977 at Indiana Bell
where he progressed through a variety of assignments in operations, engineering
and marketing. When Indiana Bell became a part of Ameritech Corporation, Mr.
Knowling assumed positions of increasing responsibility in marketing, product
development, large business marketing and network operations, including service
on Ameritech Corporation's re-engineering breakthrough development team. As lead
architect of the Ameritech Corporation transformation, Mr. Knowling reported
directly to the Chairman.
TIMOTHY LAEHY joined us in August 1997. He served as our Chief Financial
Officer, Treasurer and Vice President, Finance until February 1999 and has
served as our Chief Financial Officer since that date. Prior to joining us, Mr.
Laehy served as Vice President, Corporate Finance and Treasurer of Leasing
Solutions, Inc., a computer equipment leasing company, from February 1991 to
August 1997. From 1990 to 1991, Mr. Laehy served as a senior associate with
Recovery Equity Partners, a private venture capital investment fund. From 1985
to 1990, he served in various capacities at Guarantee Acceptance Capital
Corporation, an investment bank, Liberty Mutual Insurance Company and Union
Carbide Corporation.
ROBERT R. DAVENPORT, III joined us in January 1999. He served as our Vice
President, Business Development until February 1999 and has served as our
Executive Vice President, Business Development since that date. Prior to joining
us, Mr. Davenport was Senior Vice President and Chief Operating Officer
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at Tele-Communications, Inc.'s Internet Services subsidiary, TCI.NET from 1997
to 1999. Between 1995 and 1997, Mr. Davenport was with Tele-Communications,
Inc., as Vice President, Finance and Development for the Telephony Services
subsidiary. From 1992 to 1995, he was Managing Partner of RD Partners, LLC, a
private investment firm focused on leveraged equity investments.
CATHERINE HEMMER joined us in August 1998. She served as our Vice
President, Operations until February 1999 and served as our President, Network
Services from February 1999 to September 1999. Since September 1999, she has
served as Chief Operating Officer. From 1996 to August 1998, she was Vice
President, Network Reliability and Operations at U S WEST Communications, Inc.
From 1995 to 1996, she served as General Manager, Network provisioning at
Ameritech Services, Inc., a telecommunications company. From 1988 to 1995, she
served in various capacities, including Vice President, Network Services, at MFS
Telecom, Inc. From 1987 to 1988, she served as Senior Manager, Management
Information Systems at Chicago Fiber Optic Corporation d/b/a Metropolitan Fiber
Systems of Chicago, Inc., a start-up venture developing a market niche for fiber
optic local access networks.
ROBERT ROBLIN joined us in November 1998. He served as our Vice President,
Marketing until February 1999 and has served as our Executive Vice President,
Sales and Marketing since that date. Prior to joining us, he was Executive Vice
President of Marketing at Adobe Systems, Inc. from 1996 to November 1998. From
1994 to 1996, Mr. Roblin served as Vice President and General Manager of
Marketing of the Consumer Division of IBM Corporation. Between 1992 and 1994,
Mr. Roblin was the Vice President of Marketing of Pensoft, a start-up pen-based
software company that produced a database-driven personal information manager.
JOSEPH DEVICH joined us in August 1998. He served as Vice President and
General Manager of our Western Region until February 1999 and served as
President and General Manager of the Western Region from February 1999 to
September 1999. Since September 1999, he has served as Executive Vice President,
Corporate Services. Prior to joining us, from November 1996 to August 1998, Mr.
Devich was Vice President, Operations and Technologies Staff of U S WEST
Communications, where he served on the strategic leadership council and was
responsible for leading staff support functions, methodical and procedural
process support, results reporting and analysis, systems planning and
integration, customer value analysis, disaster recovery/business continuity
planning, network security, supplier management and operations strategy
planning. From August 1986 to November 1996, Mr. Devich worked in several
capacities at Ameritech Corporation, including Manager of Product
Management -- Technical Support, and Director in the areas of customer support
in the large business market, service reliability within custom business
services, process improvement of network operations and network provisioning.
DHRUV KHANNA is one of our founders. He served as our Vice President,
General Counsel and Secretary from October 1996 until February 1999 and has
served as our Executive Vice President, General Counsel and Secretary since that
date. He was an in-house counsel for Intel's communications products division
and its Senior Telecommunications Attorney between 1993 and 1996. Between 1987
and 1993, Mr. Khanna was an associate at Morrison & Foerster where his clients
included Teleport Communications Group (now AT&T), McCaw Cellular
Communications, Inc. (now AT&T Wireless), and Southern Pacific Telecom (now
Qwest). Mr. Khanna has extensive experience with regulatory matters, litigation
and business transactions involving the RBOCs and other telecommunications
companies. While at Intel, he helped shape the computer industry's positions on
the Telecommunications Act of 1996 and the FCC's rules implementing the 1996
Act.
JANE MARVIN joined us in April 1999 as our Senior Vice President, Human
Resources. Prior to joining us, from August 1995 to April 1999, Ms. Marvin was
Vice President, Human Resources for the General Business, Small Business and
Enhanced Business Services units and Director, Leadership and Executive
Development of Ameritech Corporation. In these capacities, she re-engineered and
streamlined multiple HR processes and drove corporate-wide change initiatives.
From 1991 to 1995, Ms. Marvin was Human Resources Director with the Pepsi Cola
Company, a division of Pepsico Inc., where she improved business processes in
the areas of recruitment, selection, training, and compensation. From 1988 to
1991,
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Ms. Marvin worked in progressively broader HR leadership roles at Data General
Corporation, a provider of enterprise hardware and software solutions.
TERRY MOYA joined us in July 1999 as our Senior Vice President, External
Affairs. Prior to joining us, from January 1999 to July 1999, Terry served as
Vice President & Chief Financial Officer, Capital Management, Network/Operations
and Technologies at U S WEST Communications, Inc. From August 1998 to January
1999, Terry served as Vice President, Operations for U S WEST Communications,
Inc., where he managed over $2 billion in capital expenditures and over $320
million in engineering and construction transaction costs. From February 1997 to
August 1998, Terry served as Vice President, Construction, Operations and
Technologies and led the outside plant construction contracting organization for
U S WEST Communications, Inc. From August 1992 to February 1997, Terry spent
time in over a half dozen foreign countries establishing and improving several
different lines of business for U S WEST Communications, Inc. These countries
include Poland, Russia, the Czech Republic, Hungary, Brazil and the United
Kingdom. Prior to August 1992, Terry was at KPMG Peat Marwick in New Orleans.
ROBERT HAWK has served as a member of our board of directors since April
1998. Mr. Hawk is President of Hawk Communications and recently retired as
President and Chief Executive Officer of U S WEST Multimedia Communications,
Inc., where he headed the cable, data and telephony communications business from
May 1996 to April 1997. He was president of the Carrier Division of U S West
Communications, a regional telecommunications service provider, from September
1990 to May 1996. Prior to that time, Mr. Hawk was Vice President of Marketing
and Strategic Planning for CXC Corporation. Prior to joining CXC Corporation,
Mr. Hawk was director of Advanced Systems Development for AT&T/American Bell. He
currently serves on the boards of PairGain Technologies, COM21, Concord
Communications, Radcom, Efficient Networks and several privately held companies.
HENRY KRESSEL has served as a member of our board of directors since July
1997. Dr. Kressel has been with E.M. Warburg, Pincus & Co., LLC since 1983 and
is currently a managing director of the firm. He is also a partner of Warburg,
Pincus & Co., the general partner of Warburg, Pincus Investors, L.P. Prior to
that time, he served as Staff Vice President of the RCA Corporation responsible
for research and development of optoelectronics, semiconductors and related
software and technologies. Dr. Kressel serves as a director of Earthweb, Inc.,
Level One Communications, Inc., IA Corporation, NOVA Corporation, Inc. and
several privately held companies.
JOSEPH LANDY has served as a member of our board of directors since July
1997. Mr. Landy has been with E.M. Warburg, Pincus & Co., LLC since 1985 and is
currently a managing director of the firm. Throughout his career at E.M.
Warburg, Pincus & Co., LLC, Mr. Landy has focused primarily on investments in
information technology and specialty semiconductors. Mr. Landy is a director of
Indus International, Inc. and Level One Communications, Inc. and several
privately held companies.
DANIEL LYNCH has served as a member of our board of directors since April
1997. Mr. Lynch is also a founder of CyberCash, Inc. and has served on its board
of directors since August 1994. From December 1990 to December 1995, he served
as chairman of the board of directors of Softbank Forums, a provider of
education and conference services for the information technology industry. Mr.
Lynch founded Interop Company in 1986, which is now a division of ZD Comdex and
Forums. Mr. Lynch is a member of the Association for Computing Machinery and the
Internet Society. He is also a member of the Board of Trustees of the Santa Fe
Institute, the Bionomics Institute and CommerceNet. He previously served as
Director of the Information Processing Division for the Information Sciences
Institute in Marina del Rey, where he led the Arpanet team that made the
transition from the original NCP protocols to the current TCP/IP based
protocols. He has served as a member of the board of directors of Exodus
Communications since January 1998. Mr. Lynch previously served as a member of
the board of directors at UUNET Technologies from April 1994 until August 1996.
FRANK MARSHALL has served as a member of our board of directors since
October 1997. Mr. Marshall currently serves on the board of directors of
PMC-Sierra Inc. and several private companies. Mr. Marshall also serves on the
technical advisory board of several high technology private companies. He is a
member of the InterWest Partners Advisory Committee and a Venture Partner at
Sequoia Capital. From 1992 to
57
<PAGE> 59
1997, Mr. Marshall served as Vice President of Engineering and Vice President
and General Manager, Core Business Unit of Cisco Systems Inc. From 1982 to 1992,
he served as Senior Vice President, Engineering at Convex Computer Corporation.
CHARLES MCMINN is one of our founders and served as the Chairman of our
board of directors until September 1999. He served as our President and Chief
Executive Officer from October 1996 to July 1998 and as a director until
November 1999. From July 1995 to October 1996, and from August 1993 to June
1994, Mr. McMinn managed his own consulting firm, Cefac Consulting, which
focused on strategic development for information technology and communications
businesses. From June 1994 to November 1995, he served as Principal, Strategy
Discipline, at Gemini Consulting. From August 1992 to June 1993, he served as
President and Chief Executive Officer of Visioneer Communications, Inc. and from
October 1985 to June 1992 was a general partner at InterWest Partners, a venture
capital firm. Mr. McMinn has resigned from all of his positions with us
effective November 1, 1999.
RICH SHAPERO has served as a member of our board of directors since July
1997. Mr. Shapero has been a general partner of Crosspoint Venture Partners,
L.P., a venture capital investment firm, since April 1993. From January 1991 to
June 1992, he served as Chief Operating Officer of Shiva Corporation, a computer
network company. Previously, he was a Vice President of Sun Microsystems, Senior
Director of Marketing at AST, and held marketing and sales positions at
Informatics General Corporation and UNIVAC's Communications Division. Mr.
Shapero serves as a member of the board of directors of Sagent Technology, Inc.
and several privately held companies.
58
<PAGE> 60
SELLING STOCKHOLDERS
The following table sets forth information known to us with respect to the
beneficial ownership of our common stock held by each selling stockholder as of
September 30, 1999, and as adjusted to reflect the sale of common stock offered
by such stockholder. As of September 30, 1999, there were 72,919,240 shares of
common stock outstanding, which excludes 6,379,177 outstanding shares of our
non-voting class B common stock which are convertible into 9,568,765 shares of
common stock beginning January 2000. Beneficial ownership is determined in
accordance with the rules of the SEC. The number of shares beneficially owned by
a person includes shares of common stock subject to options held by that person
that are currently exercisable or exercisable within 60 days of September 30,
1999. Such shares issuable pursuant to such options are deemed outstanding for
computing the percentage ownership of the person holding such options but are
not deemed outstanding for the purposes of computing the percentage ownership of
any other person.
<TABLE>
<CAPTION>
OWNERSHIP
PRIOR TO THE OFFERING OWNERSHIP AFTER OFFERING
----------------------- SHARES -------------------------
NUMBER BEING NUMBER
BENEFICIAL OWNER OF SHARES PERCENTAGE OFFERED OF SHARES PERCENTAGE
---------------- ---------- ---------- --------- ---------- -----------
<S> <C> <C> <C> <C> <C>
Robert Davenport III(1)(2).............. 62,500 * 20,000 42,500 *
Joseph Devich(1)(3)..................... 72,774 * 10,000 62,774 *
Robert Grant(4)......................... 120,546 * 25,000 95,546 *
Charles Haas(5)......................... 4,490,578 6.2% 300,000 4,190,578 4.9%
Catherine Hemmer(1)(6).................. 91,190 * 33,000 58,190 *
John Hemmer(7).......................... 47,577 * 17,000 30,577 *
Dhruv Khanna(1)(8)...................... 4,540,579 6.2 300,000 4,240,579 5.0
Robert Knowling, Jr.(1)(9).............. 1,042,500 1.4 300,000 742,500 *
Timothy Laehy(1)........................ 472,500 * 50,000 422,500 *
Keith Markley(10)....................... 52,500 * 5,000 47,500 *
Charles McMinn(1)(11)................... 4,355,136 6.0 500,000 3,855,136 4.6
Robert Roblin(1)(12).................... 93,750 * 10,000 83,750 *
Thomas Wagner(13)....................... 40,625 * 25,000 15,625 *
---------
Total......................... 1,595,000
</TABLE>
- ---------------
(1) See "Management -- Directors and Executive Officers" for a description of
the selling stockholder's affiliation with us during the past three years.
(2) Consists of 62,500 shares of common stock subject to options exercisable
within 60 days of September 30, 1999.
(3) Consists of 72,774 shares of common stock subject to options exercisable
within 60 days of September 30, 1999.
(4) Includes 60,546 shares of common stock subject to options exercisable
within 60 days of September 30, 1999. Mr. Grant is employed by us as Senior
Vice President, Sales -- Western Region.
(5) Includes 180,000 shares of common stock held by a limited partnership of
which Mr. Haas is a general partner and a limited partner. Mr. Haas
disclaims beneficial ownership of the shares of common stock held by such
limited partnership except to the extent of his pecuniary interest therein.
Mr. Haas is employed by us as Senior Vice President of Sales Development.
(6) Consists of 91,190 shares of common stock subject to options exercisable
within 60 days of September 30, 1999.
(7) Consists of 47,577 shares of common stock subject to options exercisable
within 60 days of September 30, 1999. Mr. Hemmer is employed by us as
Senior Vice President, Network Deployment.
59
<PAGE> 61
(8) Includes 562,500 shares of common stock held by a limited partnership of
which Mr. Khanna is a general partner and a limited partner. Mr. Khanna
disclaims beneficial ownership of the shares of common stock held by such
limited partnership except to the extent of his pecuniary interest therein.
(9) Consists of 1,042,500 shares of common stock subject to options exercisable
within 60 days of September 30, 1999.
(10) Consists of 52,500 shares of common stock subject to options exercisable
within 60 days of September 30, 1999. Mr. Markley is employed by us as
Senior Vice President, Sales -- Eastern Region.
(11) Includes 712,500 shares of common stock held by a trust for the benefit of
two members of Mr. McMinn's immediate family, who also serve as
co-trustees. Mr. McMinn disclaims beneficial ownership of the shares of
common stock held by such trust.
(12) Consists of 93,750 shares of common stock subject to options exercisable
within 60 days of September 30, 1999.
(13) Consists of 40,625 shares of common stock subject to options exercisable
within 60 days of September 30, 1999. Mr. Wagner is employed by us as
Senior Vice President, Sales -- Central Region.
60
<PAGE> 62
UNDERWRITING
The underwriters named below have severally agreed, subject to the terms
and conditions of the underwriting agreement, to purchase from us the number of
shares of common stock set forth opposite their names below:
<TABLE>
<CAPTION>
UNDERWRITERS NUMBER OF SHARES
------------ ----------------
<S> <C>
Bear, Stearns & Co. Inc.....................................
Morgan Stanley Dean Witter Incorporated.....................
-----------
Credit Suisse First Boston Corporation......................
-----------
Deutsche Bank Securities Inc................................
-----------
Donaldson, Lufkin & Jenrette Securities Corporation.........
-----------
Goldman, Sachs & Co.........................................
-----------
Utendahl Capital Partners, L.P..............................
-----------
Total............................................. 13,000,000
===========
</TABLE>
Subject to the terms and conditions of the underwriting agreement, the
underwriters have agreed to purchase all of the shares of common stock being
sold pursuant to the underwriting agreement if any of such shares are purchased
(excluding shares covered by the over-allotment option).
The underwriters have advised us that they propose to offer the common
stock to the public initially at the public offering price set forth on the
cover page of this prospectus and to certain dealers at such price less a
concession of not more than $ per share. Additionally, the underwriters may
allow, and such dealers may reallow, a discount of not more than $ per share
on sales to certain other dealers. After the public offering of the shares, the
offering price and other selling terms may be changed by the underwriters.
We have granted the underwriters an option to purchase up to 1,950,000
additional shares of common stock at the public offering price, less the
underwriting discount set forth on the cover page of this prospectus, solely to
cover over-allotments, if any. This option may be exercised in whole or in part
at any time within 30 days after the date of this prospectus. To the extent that
the underwriters exercise this option, each underwriter will have a firm
commitment, subject to certain conditions, to purchase a number of shares of
common stock proportionate to such underwriter's purchase obligations set forth
in the foregoing table.
The following table shows the per share and total underwriting discounts
and commissions to be paid to the underwriters by us and the selling
stockholders. Such amounts are shown assuming both no exercise and full exercise
of the underwriters option to purchase additional shares.
<TABLE>
<CAPTION>
NO EXERCISE FULL EXERCISE
----------- -------------
<S> <C> <C>
Per share................................................... $ $
Total............................................. $ $
</TABLE>
The offering of the shares is made for delivery, when, as and if accepted
by the underwriters and subject to prior sale and to withdrawal, cancellation or
modification of the offering without notice. The underwriters reserve the right
to reject an order for the purchase of shares in whole or in part.
The selling stockholders, who own in the aggregate 13,981,567 shares of
common stock, have agreed that they will not, without the prior written consent
of Bear, Stearns & Co. Inc., directly or indirectly, offer, sell, contract to
sell, grant any option to purchase, pledge or otherwise dispose of, or, in any
manner, transfer all or a portion of the economic consequences associated with
the ownership of any shares of common stock or any securities convertible into
or exercisable or exchangeable for common stock beneficially owned by them
during the 90-day period following the date of this prospectus.
We have agreed that we will not, without the prior written consent of Bear,
Stearns & Co. Inc., directly or indirectly, offer, sell, contract to sell, grant
any option to purchase, pledge or otherwise dispose (or announce any offer,
sale, contract to sell, grant of an option to purchase, pledge or other
disposition)
61
<PAGE> 63
of any shares of common stock or any securities convertible into or exercisable
into or exchangeable for shares of common stock during the 90-day period
following the date of this prospectus, except that we may issue shares of common
stock and options to purchase common stock under our stock option and stock
purchase plans and upon exercise of warrants issued and outstanding on the date
of this prospectus, and may issue stock in connection with strategic
relationships and in connection with acquisitions of businesses, technologies or
products complementary to those of our company, so long as the recipients of
such stock agree to be bound by a lock-up agreement for the remainder of the
90-day lock-up period.
We and the selling stockholders have agreed to indemnify the underwriters
against certain civil liabilities, including liabilities under the Securities
Act and to contribute to payments the underwriters may be required to make in
respect thereof.
The underwriters have advised us that, pursuant to Regulation M promulgated
under the Securities Exchange Act, certain persons participating in the offering
may engage in transactions, including stabilizing bids, syndicate covering
transactions or the imposition of penalty bids, which may have the effect of
stabilizing or maintaining the market price of our common stock at a level above
that which might otherwise prevail in the open market. A "stabilizing bid" is a
bid for or the purchase of the common stock on behalf of the underwriters for
the purpose of pegging, fixing or maintaining the price of the common stock. A
"syndicate covering transaction" is the bid for or the purchase of the common
stock on behalf of the underwriters to reduce a short position created in
connection with the offering. The underwriters may also cover all or a portion
of such short position by exercising the over-allotment option. A "penalty bid"
is an arrangement permitting the underwriters to reclaim the selling concession
otherwise accruing to an underwriter or syndicate member in connection with the
offering if the common stock originally sold by such underwriter or syndicate
member is purchased by the underwriters in a syndicate covering transaction and
has therefore not been effectively placed by such underwriter or syndicate
member. The underwriters have advised us such transactions may be effected on
the Nasdaq National Market or otherwise and, if commenced, may be discontinued
at any time.
We estimate that the total expenses of this offering, excluding
underwriting discounts and commissions, will be approximately $ .
Bear, Stearns & Co. Inc. and Deutsche Bank Securities Inc. acted as initial
purchasers of our 1998 senior discount notes in March 1998, for which Bear,
Stearns & Co. Inc. and Deutsche Banc Securities Inc. received usual and
customary fees.
Bear, Stearns & Co. Inc., Deutsche Bank Securities Inc., Donaldson, Lufkin
& Jenrette Securities Corporation and Goldman, Sachs & Co. participated as
underwriters in our initial public offering in January 1999, for which they
received usual and customary fees.
Bear, Stearns & Co. Inc., Deutsche Bank Securities Inc., Donaldson, Lufkin
& Jenrette Securities Corporation and Goldman, Sachs & Co. acted as initial
purchasers of our 1999 notes in February 1999, for which they received usual and
customary fees.
Bear, Stearns & Co. Inc., Morgan Stanley & Co. Incorporated, Credit Suisse
First Boston Corporation, Deutsche Bank Securities Inc. and Donaldson, Lufkin &
Jenrette Securities Corporation participated as underwriters in our initial
public offering in June 1999, for which they received usual and customary fees.
62
<PAGE> 64
WHERE YOU CAN FIND MORE INFORMATION
We have filed with the Securities and Exchange Commission a registration
statement on Form S-3, of which this prospectus is a part, under the Securities
Act with respect to the shares of common stock offered hereby. This prospectus
does not contain all of the information included in the registration statement.
Statements contained in this prospectus concerning the provisions of any
document are not necessarily complete. You should refer to the copy of these
documents filed as an exhibit to the registration statement or otherwise filed
by us with the SEC for a more complete understanding of the matter involved.
Each statement concerning these documents is qualified in its entirety by such
reference.
We are also subject to the informational requirements of the Securities
Exchange Act of 1934. In accordance with the Exchange Act, we file reports,
proxy statements and other information with the SEC. The registration statement,
including the attached exhibits and schedules, may be inspected and copied at
the public reference facilities maintained by the SEC, Room 1024, Judiciary
Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549 and at the regional
offices of the Commission located at Seven World Trade Center, New York, New
York 10048, and 500 West Madison Street, Chicago, Illinois 60661. Please call
the SEC at 1-800-SEC-0330 for further information about the public reference
rooms. The SEC maintains a Web site that contains reports, proxy and information
statements and other information regarding registrants that file electronically
with the SEC. Copies of the registration statement and the reports, proxy and
information statements and other information that we file with the SEC may be
obtained from the SEC's Internet address at http://www.sec.gov.
The SEC allows us to "incorporate by reference" into the prospectus the
information we have filed with them. The information incorporated by reference
is an important part of this prospectus and the information that we file
subsequently with the SEC will automatically update this prospectus. The
information incorporated by reference is considered to be part of this
prospectus. We incorporate by reference the documents listed below and any
filings we make with the SEC under Sections 13(a), 13(c), 14 or 15(d) of the
Securities Exchange Act of 1934, as amended, after the initial filing of this
registration statement that contains this prospectus and prior to the time that
we sell all the securities offered by this prospectus:
- our Annual Report on Form 10-K for the fiscal year ended December 31,
1998;
- our Quarterly Report on Form 10-Q for the quarter ended March 31, 1999;
- our Quarterly Report on Form 10-Q for the quarter ended June 30, 1999;
and
- the description of our Common Stock contained in our Registration
Statement on Form 8-A filed on January 19, 1999 under Section 12 of the
Exchange Act, including any amendment or report updating such
description.
You may request a copy of these documents, at no cost, by writing or
telephoning us at the following address:
Covad Communications Group, Inc.
Attention: Investor Relations
2330 Central Expressway
Santa Clara, California 95050
(408) 844-7500
63
<PAGE> 65
LEGAL MATTERS
The validity of the common stock offered hereby will be passed upon for us
by Wilson Sonsini Goodrich & Rosati, P.C., Palo Alto, California. Certain
attorneys at Wilson Sonsini Goodrich & Rosati, P.C. hold an aggregate of 4,375
shares of our common stock. Certain legal matters in connection with the
offering will be passed upon for the underwriters by Simpson Thacher & Bartlett,
New York, New York.
EXPERTS
Our consolidated financial statements as of December 31, 1997 and 1998 and
for the years then ended included in this prospectus have been audited by Ernst
& Young LLP, independent auditors, as stated in their report appearing herein,
and have been so included in reliance upon the report of such firm given upon
their authority as experts in accounting and auditing.
64
<PAGE> 66
COVAD COMMUNICATIONS GROUP, INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Annual Financial Statements
Report of Ernst & Young LLP, Independent Auditors......... F-2
Consolidated Balance Sheets at December 31, 1997 and
1998................................................... F-3
Consolidated Statements of Operations for the years ended
December 31, 1997 and 1998............................. F-4
Consolidated Statements of Stockholders' Equity (Net
Capital Deficiency) for the years ended December 31,
1997 and 1998.......................................... F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 1997 and 1998............................. F-6
Notes to Consolidated Financial Statements................ F-7
Interim Financial Statements (Unaudited)
Consolidated Balance Sheet at June 30, 1999............... F-18
Consolidated Statements of Operations for the six months
ended June 30, 1998 and 1999........................... F-19
Consolidated Statement of Stockholders' Equity (Net
Capital Deficiency) for the six months ended June 30,
1999................................................... F-20
Consolidated Statements of Cash Flows for the six months
ended June 30, 1998 and 1999........................... F-21
Notes to Consolidated Financial Statements................ F-22
</TABLE>
F-1
<PAGE> 67
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders of
Covad Communications Group, Inc.
We have audited the accompanying consolidated balance sheets of Covad
Communications Group, Inc. as of December 31, 1997 and 1998, and the related
consolidated statements of operations, stockholders' equity (net capital
deficiency), and cash flows for the years then ended. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Covad
Communications Group, Inc. as of December 31, 1997 and 1998, and the
consolidated results of its operations and its cash flows for the years then
ended in conformity with generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
San Jose, California
February 15, 1999, except for the fourth
paragraph of Note 1.J. as to which the
date is May 4, 1999
F-2
<PAGE> 68
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN 000'S, EXCEPT SHARE AND PER SHARE AMOUNTS)
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------
1997 1998
------- --------
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents................................... $ 4,378 $ 64,450
Accounts receivable, net of allowance for uncollectibles of
$220 in 1998.............................................. 25 1,933
Unbilled revenue............................................ 4 663
Inventories................................................. 43 946
Prepaid expenses............................................ 52 1,183
Other current assets........................................ 317 514
------- --------
Total current assets............................... 4,819 69,689
PROPERTY AND EQUIPMENT:
Networks and communication equipment........................ 2,185 55,189
Computer equipment.......................................... 600 4,426
Furniture and fixtures...................................... 185 1,119
Leasehold improvements...................................... 114 1,887
------- --------
3,084 62,621
Less accumulated depreciation and amortization.............. (70) (3,476)
------- --------
Net property and equipment......................... 3,014 59,145
OTHER ASSETS:
Restricted cash............................................. 210 225
Deposits.................................................... 31 337
Deferred debt issuance costs (net).......................... -- 8,112
Other long term assets...................................... -- 1,911
------- --------
Total other assets................................. 241 10,585
------- --------
Total assets....................................... $ 8,074 $139,419
======= ========
LIABILITIES AND STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
CURRENT LIABILITIES:
Accounts payable............................................ $ 651 $ 14,975
Unearned revenue............................................ 7 551
Accrued network costs....................................... 58 1,866
Other accrued liabilities................................... 77 3,854
Current portion of capital lease obligations................ 229 263
------- --------
Total current liabilities.......................... 1,022 21,509
Long-term debt (net of discount)............................ -- 142,300
Long-term capital lease obligations......................... 554 316
------- --------
Total liabilities.................................. 1,576 164,125
STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY):
Convertible preferred stock ($0.001 par value):
Authorized shares -- 30,000,000
Issued and outstanding shares -- 17,750,001 and 18,246,162
at December 31, 1997 and
December 31, 1998, respectively......................... 18 18
Common stock ($0.001 par value):
Authorized shares -- 65,000,000
Issued and outstanding shares -- 17,041,806 and 17,660,995
at December 31, 1997 and December 31, 1998,
respectively............................................ 17 18
Additional paid-in capital.................................. 9,686 30,679
Deferred compensation....................................... (611) (4,688)
Accumulated deficit......................................... (2,612) (50,733)
------- --------
Total stockholders' equity (net capital
deficiency)....................................... 6,498 (24,706)
------- --------
Total liabilities and stockholders' equity (net capital
deficiency)............................................. $ 8,074 $139,419
======= ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-3
<PAGE> 69
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN 000'S, EXCEPT SHARE AND PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
------------------------
1997 1998
---------- ----------
<S> <C> <C>
Revenues.................................................... $ 26 $ 5,326
Operating expenses:
Network and product costs................................. 54 4,562
Sales, marketing, general and administrative.............. 2,374 31,043
Amortization of deferred compensation..................... 295 3,997
Depreciation and amortization............................. 70 3,406
---------- ----------
Total operating expenses.......................... 2,793 43,008
---------- ----------
Income (loss) from operations............................... (2,767) (37,682)
Interest income (expense):
Interest income........................................ 167 4,778
Interest expense....................................... (12) (15,217)
---------- ----------
Net interest income (expense).......................... 155 (10,439)
---------- ----------
Net income (loss)........................................... $ (2,612) $ (48,121)
========== ==========
Net income (loss) per common share.......................... $ (0.53) $ (5.62)
Weighted average shares used in computing net loss per
share..................................................... 4,907,319 8,562,802
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-4
<PAGE> 70
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(NET CAPITAL DEFICIENCY)
(AMOUNTS IN 000'S, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
CONVERTIBLE
PREFERRED STOCK COMMON STOCK ADDITIONAL
------------------- ------------------- PAID-IN DEFERRED ACCUMULATED
SHARES AMOUNT SHARES AMOUNT CAPITAL COMPENSATION DEFICIT
---------- ------ ---------- ------ ---------- ------------ -----------------
<S> <C> <C> <C> <C> <C> <C> <C>
Initial issuance of
common stock........... -- $-- 18,000,000 $18 $ 32 $ -- $ --
Repurchase of common
stock.................. -- -- (3,615,444) (4) (6) -- --
Issuance of common
stock.................. -- -- 2,657,250 3 65 -- --
Issuance of Series A
Preferred Stock........ 750,000 1 -- -- 249 -- --
Issuance of Series B
Preferred Stock (net of
$43 of financing
costs)................. 17,000,001 17 -- -- 8,440 -- --
Deferred compensation.... -- -- -- -- 906 (906) --
Amortization of deferred
compensation........... -- -- -- -- -- 295 --
Net loss................. -- -- -- -- -- -- (2,612)
---------- --- ---------- --- ------- ------- --------
Balance at December 31,
1997................... 17,750,001 18 17,041,806 17 9,686 (611) (2,612)
Issuance of common
stock.................. -- -- 619,189 1 570 -- --
Issuance of Series B
Preferred Stock........ 100,002 -- -- -- 100 -- --
Issuance of Series C
Preferred Stock........ 396,159 -- -- -- 1,100 -- --
Issuance of common stock
warrants as part of
debt offering issuance
costs.................. -- -- -- -- 2,928 -- --
Issuance of common stock
warrants pursuant to
debt offering.......... -- -- -- -- 8,221 -- --
Deferred compensation.... -- -- -- -- 8,074 (8,074) --
Amortization of deferred
compensation........... -- -- -- -- -- 3,997 --
Net loss................. -- -- -- -- -- -- (48,121)
---------- --- ---------- --- ------- ------- --------
Balance at December 31,
1998................... 18,246,162 $18 17,660,995 $18 $30,679 $(4,688) $(50,733)
========== === ========== === ======= ======= ========
<CAPTION>
TOTAL STOCKHOLDERS'
EQUITY (NET CAPITAL
DEFICIENCY)
-------------------
<S> <C>
Initial issuance of
common stock........... $ 50
Repurchase of common
stock.................. (10)
Issuance of common
stock.................. 68
Issuance of Series A
Preferred Stock........ 250
Issuance of Series B
Preferred Stock (net of
$43 of financing
costs)................. 8,457
Deferred compensation.... --
Amortization of deferred
compensation........... 295
Net loss................. (2,612)
--------
Balance at December 31,
1997................... 6,498
Issuance of common
stock.................. 571
Issuance of Series B
Preferred Stock........ 100
Issuance of Series C
Preferred Stock........ 1,100
Issuance of common stock
warrants as part of
debt offering issuance
costs.................. 2,928
Issuance of common stock
warrants pursuant to
debt offering.......... 8,221
Deferred compensation.... --
Amortization of deferred
compensation........... 3,997
Net loss................. (48,121)
--------
Balance at December 31,
1998................... $(24,706)
========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-5
<PAGE> 71
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN 000'S)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------
1997 1998
--------- ----------
<S> <C> <C>
OPERATING ACTIVITIES:
Net loss.................................................... $(2,612) $(48,121)
Reconciliation of net loss to net cash used in operating
activities:
Depreciation and amortization............................. 70 3,406
Amortization of deferred compensation..................... 295 3,997
Accreted interest and amortization of debt discount and
deferred debt issuance costs........................... -- 16,009
Net changes in current assets and liabilities:
Accounts receivable.................................... (25) (1,908)
Inventories............................................ (43) (903)
Other current assets................................... (373) (1,987)
Accounts payable....................................... 651 14,324
Unearned revenue....................................... 7 544
Other current liabilities.............................. 135 5,585
------- --------
Net cash used in operating activities....................... (1,895) (9,054)
INVESTING ACTIVITIES:
Purchase of restricted cash................................. (210) (15)
Deposits.................................................... (31) (306)
Other long-term assets...................................... -- (1,428)
Purchase of property and equipment.......................... (2,253) (59,503)
------- --------
Net cash used in investing activities....................... (2,494) (61,252)
FINANCING ACTIVITIES:
Net proceeds from issuance of long-term debt and warrants... -- 129,328
Principal payments under capital lease obligations.......... (48) (238)
Proceeds from common stock issuance, net of repurchase...... 108 571
Proceeds from preferred stock issuance...................... 8,707 1,200
Offering costs related to common stock offering............. -- (483)
------- --------
Net cash provided by financing activities................... 8,767 130,378
------- --------
Net increase in cash and cash equivalents................... 4,378 60,072
Cash and cash equivalents at beginning of year.............. -- 4,378
------- --------
Cash and cash equivalents at end of year.................... $ 4,378 $ 64,450
======= ========
Supplemental disclosures of cash flow information:
Cash paid during the year for interest................. $ 9 $ 99
======= ========
Supplemental schedule of non-cash investing and financing
activities:
Equipment purchased through capital leases............. $ 831 $ 34
======= ========
Warrants issued for equity commitment.................. -- $ 2,928
======= ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-6
<PAGE> 72
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION AND NATURE OF OPERATIONS
Covad Communications Group, Inc (the "Company") is a high-speed Internet
and network access provider offering Digital Subscriber Line ("DSL") services to
Internet Service Provider ("ISP") and enterprise customers. ISPs purchase the
Company's services in order to provide high-speed Internet access to their
business and consumer end-users. Enterprise customers purchase the Company's
services to provide employees with remote access to their Local Area Networks to
improve employee productivity and reduce operating costs. The Company's services
are provided over standard copper telephone lines at considerably faster speeds
than available through a standard modem.
The Company's operations are subject to significant risks and uncertainties
including competitive, financial, developmental, operational, growth and
expansion, technological, regulatory, and other risks associated with an
emerging business.
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 accompanying statements of operations, stockholders' equity, and cash
flows for the year ended December 31, 1997 include $50,000 received during 1996
upon issuance of the initial capital stock of the Company and $2,000 expended in
1996 for general and administrative expenses. Due to the insignificance of
balances at December 31, 1996 and activity for the period from inception through
December 31, 1996, financial statements for 1996 have not been presented.
B. Revenue Recognition
Revenue related to installation of service and sale of customer premise
equipment is recognized when equipment is delivered and installation is
completed. Revenue from monthly recurring service is recognized in the month the
service is provided. Recognized revenue for which the customer has not been
billed is recorded as unbilled revenue until the period such billings are
provided. Amounts billed in advance of providing services are recorded as
unearned revenue until the period such services are provided. For the year ended
December 31, 1998, one customer accounted for approximately 17% of the Company's
revenue. For the year ended December 31, 1998, no other customer accounted for
more than 10% of the Company's revenue.
C. Cash and Cash Equivalents
All highly liquid investments with a maturity of three months or less from
the date of original issuance are considered to be cash equivalents.
D. Restricted Cash
As of December 31, 1997 and December 31, 1998, the Company had $210,000 and
$225,000, respectively, in commercial deposits held in the Company's name but
restricted as security for certain of the Company's capital lease arrangements.
F-7
<PAGE> 73
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
E. Inventories
Inventories are stated at the lower of cost or market and consist primarily
of customer premise equipment. Costs are based on the first-in first-out method.
F. Property and Equipment
Property and equipment are recorded at cost and depreciated using the
straight-line method over the following estimated useful lives:
<TABLE>
<S> <C>
Leasehold improvements..................................... 15 years or life of the lease
Electronic communication equipment......................... 2 to 5 years
Furniture and fixtures..................................... 3 to 7 years
Computer equipment......................................... 3 years
Office equipment........................................... 2 to 5 years
Computer software.......................................... 2 to 7 years
</TABLE>
The Company capitalizes costs associated with the design, deployment and
expansion of the Company's network including internally and externally developed
software. Capitalized external software costs include the actual costs to
purchase software from vendors. Capitalized internal software costs generally
include personnel and related costs incurred in the enhancement and
implementation of purchased software packages. Capitalized internal labor costs
for the years ending December 31, 1997 and December 31, 1998 were $139,000 and
$3,063,000, respectively. Capitalized interest cost for the year ending December
31, 1998 was $900,000.
G. Equipment Under Capital Leases
The Company leases certain of its equipment and other fixed assets under
capital lease agreements. The assets and liabilities under capital leases are
recorded at the lesser of the present value of aggregate future minimum lease
payments, including estimated bargain purchase options, or the fair value of the
assets under lease, whichever is less. Assets under capital lease are amortized
over the lease term or useful life of the assets.
H. Income Taxes
Due to the Company's overall loss position, there is no provision for
income taxes for 1997 or 1998. The reconciliation of income tax computed at the
US federal statutory rate to income tax expense is as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------
1997 1998
--------- ------------
<S> <C> <C>
Federal at 34%, statutory................................. $(757,000) $(16,363,000)
Non deductible interest................................... -- 911,000
Losses with no current benefit............................ 757,000 15,436,000
Other..................................................... -- 16,000
--------- ------------
Provision................................................. $ -- $ --
========= ============
</TABLE>
As of December 31, 1998, the Company had federal and state net operating
loss carryforwards of approximately $40,000,000. The net operating loss and
credit carryforwards will expire at various dates beginning in 2005 through
2018, if not utilized.
The utilization of the net operating loss is subject to a substantial
annual limitation due to the "change in ownership" provisions of the Internal
Revenue Code of 1986 and similar state provisions. The
F-8
<PAGE> 74
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
annual limitation may result in the expiration of net operating losses and
credits before utilization. Significant components of the Company's deferred tax
assets and liabilities for federal and state income taxes are as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------
1997 1998
--------- -----------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards......................... $ 820,000 $16,000,000
Depreciation............................................. -- 1,000,000
Other.................................................... -- 1,500,000
--------- -----------
Net deferred tax assets.................................. 820,000 18,500,000
Valuation allowance........................................ (820,000) (18,500,000)
--------- -----------
Net deferred tax assets.................................... -- --
========= ===========
</TABLE>
The net valuation allowance increased by $17,680,000 during the year ended
December 31, 1998.
I. Fair Value of Financial Instruments
Statement of Financial Accounting Standards ("SFAS") No. 107, "Disclosures
About Fair Value of Financial Instruments," as amended by SFAS No. 119,
"Disclosures About Derivative Financial Instruments and Fair Value of Financial
Instruments," requires disclosure of fair value information about financial
instruments whether or not recognized in the balance sheet, for which it is
practicable to estimate that value. In cases where quoted market prices are not
available for identical or comparable financial instruments, fair values are
based on estimates using the present value of estimated cash flows or other
valuation techniques. The resulting fair values can be significantly affected by
the assumptions used, including the discount rate and estimates as to the
amounts and timing of future cash flows.
The following methods and assumptions were used to estimate the fair value
for financial instruments:
Cash and cash equivalents. The carrying amount approximates fair value.
Borrowings. The fair values of borrowings, including long-term debt,
capital lease obligations and other obligations, were estimated based on quoted
market prices, where available, or by discounting the future cash flows using
estimated borrowing rates at which similar types of borrowing arrangements with
the same remaining maturities could be obtained by the Company. For all
borrowings outstanding at December 31, 1997 and December 31, 1998, fair value
approximates recorded value.
J. 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.
F-9
<PAGE> 75
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 on January 27, 1999 (see
note 9).
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 split of the
Company's Common Stock effective May 1999.
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>
YEAR ENDED
DECEMBER 31,
--------------------------
1997 1998
----------- -----------
<S> <C> <C>
Net income (loss)......................................... $ (2,612) $ (48,121)
Basic and diluted:
Weighted average shares of common stock outstanding..... 16,531,903 17,257,960
Less: Weighted average shares subject to repurchase..... 11,624,584 8,695,158
----------- -----------
Weighted average shares used in computing basic and
diluted net income (loss) per share..................... 4,907,319 8,562,802
=========== ===========
Basic and diluted net income (loss) per share............. $ (0.53) $ (5.62)
=========== ===========
</TABLE>
K. Concentration of Credit Risk
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash and cash equivalents
and accounts receivable. The Company's cash and investment policies limit
investments to short-term, investment grade instruments. Concentrations of
credit risk with respect to accounts receivable are limited due to the large
number of customers comprising the Company's customer base. In addition, the
Company typically offers its customers credit terms. The Company performs
ongoing credit evaluations of its customers' financial condition and generally
does not require collateral.
L. Key Suppliers
The Company is dependant on limited source suppliers for certain equipment
used to provide its services. The Company has generally been able to obtain an
adequate supply of equipment. In addition, the Company believes that there are
alternative suppliers for the equipment used to provide its service. However, an
extended interruption in the supply of equipment currently obtained from limited
source suppliers could adversely affect the Company's business and results of
operations.
M. Accounts Receivable Allowance:
The Company established a reserve for uncollectible accounts receivable in
the amount of $220,000 at December 31, 1998. No significant charges were made
against this reserve as of December 31, 1998.
N. Recently Issued Accounting Pronouncements:
In June 1997, the Financial Accounting Standards Board issued Statement No.
131, "Disclosures About Segments of an Enterprise and Related Information"
("SFAS 131"), which establishes standards for the way that public business
enterprises report information about operating segments in quarterly and annual
financial statements. SFAS 131 changes segment reporting from an industry
segment basis to an operating segment basis defined based on how the business is
managed. The Company operates in only one
F-10
<PAGE> 76
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
segment, high-speed digital communications services, and hence, separate segment
reporting is not applicable.
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 29.1564 shares of common stock, $0.001 par value, of the Company (the
"Unit Warrants"). Net proceeds from the 1998 Private Offering were approximately
$129.3 million, after transaction costs of approximately $5.8 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 amortized over the life of the Notes. Debt issuance costs
were incurred through the issuance of additional warrants associated with the
commitment of equity by certain investors. The debt issuance costs are also
being amortized over the life of the Notes. For the year ended December 31,
1998, the accretion of the Notes and the amortization of debt discount and debt
issuance costs was $16 million, of which $15.1 million is included in interest
expense and $900,000 is capitalized in property, plant and equipment.
The Unit Warrants have ten year terms, have exercise prices of $0.0022 per
share (subject to adjustment in certain events), contain net exercise provisions
and are currently exercisable.
3. CAPITAL LEASES
The Company has entered into capital lease arrangements to finance the
acquisition of certain operating assets, two of which have bargain purchase
options. The principal value of these leases totaled $831,000 and $865,000 as of
December 31, 1997 and December 31, 1998, respectively, and was equivalent to the
fair value of the assets leased.
Future minimum lease payments under capital leases are as follows:
<TABLE>
<CAPTION>
YEAR ENDING DECEMBER 31,
------------------------
<S> <C>
1999...................................................... 335,000
2000...................................................... 294,000
2001...................................................... 44,000
2002...................................................... 4,000
2003...................................................... --
Thereafter.................................................. --
---------
677,000
Less amount representing interest........................... (98,000)
Less current portion........................................ (263,000)
---------
Total long-term portion..................................... $ 316,000
=========
</TABLE>
F-11
<PAGE> 77
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Accumulated amortization for equipment under capital leases is reflected in
accumulated depreciation and amortization for property and equipment.
4. OPERATING LEASES
The Company leases vehicles, equipment, and office space under various
operating leases. Future minimum lease payments by year under operating leases
are as follows:
<TABLE>
<CAPTION>
YEAR ENDING DECEMBER 31,
------------------------
<S> <C>
1999...................................................... 2,656,000
2000...................................................... 2,105,000
2001...................................................... 2,159,000
2002...................................................... 1,436,000
2003...................................................... 506,000
Thereafter................................................ 351,000
----------
Total............................................. $9,213,000
==========
</TABLE>
Rental expense on operating leases totaled $131,000 and $1,507,000 for the
year ended December 31, 1997 and December 31, 1998, respectively.
5. STOCKHOLDERS' EQUITY
COVAD COMMUNICATIONS GROUP, INC.
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 December 31, 1998, were 17,041,806 and
17,660,995 shares, respectively, of which 10,549,660 and 7,159,624 shares,
respectively, remain subject to repurchase provisions which generally lapse over
a four year period from the date of issuance.
Common Stock reserved for future issuance as of December 31, 1998 is as
follows:
<TABLE>
<S> <C>
Convertible preferred stock................................. 27,369,243
Outstanding and reserved options............................ 22,960,264
Outstanding warrants........................................ 10,483,146
----------
Total............................................. 60,812,653
==========
</TABLE>
F-12
<PAGE> 78
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Convertible Preferred Stock:
Convertible preferred stock consists of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
------------
1997 1998
---- ----
<S> <C> <C>
Authorized shares -- 30,000,000
Series A preferred stock ($0.001 par value):
Authorized shares -- 750,000
Issued and outstanding shares -- 750,000 at December 31,
1997 and December 31, 1998............................. $ 1 $ 1
Series B preferred stock ($0.001 par value):
Authorized shares -- 17,100,003
Issued and outstanding shares -- 17,000,001 at December
31, 1997 and 17,100,003 at December 31, 1998........... 17 17
Series C preferred stock ($0.001 par value):
Authorized shares -- 11,149,287
Issued and outstanding shares -- None at December 31, 1997
and 396,159 at December 31, 1998....................... -- --
--- ---
$18 $18
=== ===
</TABLE>
In January 1999, all of the outstanding convertible Preferred Stock
converted into Common Stock (see Note 9).
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 2,541,222 shares of the Company's Common Stock at a purchase price of $0.0022
per share (the "Common Warrants"). In January 1999, the Company completed an
alternative equity financing and, as a result, the Equity Commitment will not be
called (see Note 9).
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.
F-13
<PAGE> 79
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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
$1.0 million; 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 158,778 shares of Common Stock at a purchase price
of $0.0022 per share.
Preferred Stock Dividends
The holders of Series A, Series B and Series C were entitled to receive in
any fiscal year, dividends at the rate of $0.0167 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 were
cumulative and accrue to the holders to the extent they were not declared or
paid and were payable, in cash or Common Stock, only in the event of a
liquidation, dissolution or winding up of the Company, or other liquidity event
(as defined in the Certificate of Incorporation). The cumulative dividends at
December 31, 1997 and December 31, 1998 for Preferred Stock were $318,250 and
$1,084,740, respectively, none of which has been declared or paid.
6. 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 December
31, 1998 the Plan has reserved 23,280,513 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 is a summary of the status of stock options outstanding at
December 31, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------- --------------------------
WEIGHTED- WEIGHTED- WEIGHTED-
NUMBER OF AVERAGE LIFE AVERAGE NUMBER OF AVERAGE
EXERCISE PRICE RANGE SHARES REMAINING EXERCISE PRICE SHARES EXERCISE PRICE
-------------------- ----------- ------------ -------------- --------- --------------
<S> <C> <C> <C> <C> <C>
$0.022 - $0.445...................... 9,754,542 6.4 years $0.1783 2,663,751 $0.1115
$0.667 - $1.085...................... 4,173,748 7.5 years $0.7692 70,305 $1.0847
$3.83................................ 2,158,203 7.6 years $3.8333 6,558 $3.8333
$4.92 - $5.29........................ 1,967,941 7.7 years $5.1827 12,099 $5.1155
$5.44................................ 293,252 7.9 years $5.4400 750 $5.4400
</TABLE>
F-14
<PAGE> 80
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The following table summarizes stock option activity for the year ended
December 31, 1997 and December 31, 1998:
<TABLE>
<CAPTION>
NUMBER OF SHARES OPTION PRICE
OF COMMON STOCK PER SHARE
---------------- ---------------
<S> <C> <C>
Balance as of December 31, 1996..................... -- N/A
Granted........................................... 5,765,625 $0.022 - $0.033
Exercised......................................... (9,000) $0.022
Forfeited......................................... (49,500) $0.022 - $0.033
---------- ---------------
Balance as of December 31, 1997..................... 5,707,125 $0.022 - $0.033
Granted........................................... 14,038,467 $0.067 - $5.44
Exercised......................................... (311,248) $0.022 - $0.445
Forfeited......................................... (1,086,658) $0.022 - $5.29
---------- ---------------
Balance as of December 31, 1998..................... 18,347,686 $0.022 - $5.44
========== ===============
</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. During the
year ended December 31, 1997, the Company recorded 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 a reduction of stockholders' equity and is being amortized as a
charge to operations over the vesting period of the applicable options using a
graded vesting method. Such amortization was $295,000 for the year ended
December 31, 1997. During the year ended December 31, 1998, the Company recorded
additional deferred compensation of approximately $8.1 million. Amortization of
deferred compensation during this same period was approximately $4.0 million.
Stock-Based Compensation
Pro forma information regarding results of operations and loss per share is
required by SFAS 123 as if the Company had accounted for its stock-based awards
under the fair value method of SFAS 123. The fair value of the Company's
stock-based awards to employees has been estimated using the minimum value
option pricing model which does not consider stock price volatility. Because the
Company does not have actively traded equity securities, volatility is not
considered in determining the fair value of stock-based awards to employees.
For the year ended December 31, 1997 and December 31, 1998, the fair value
of the Company's stock-based awards to employees was estimated using the
following weighted average assumptions:
<TABLE>
<CAPTION>
1997 1998
---- ----
<S> <C> <C>
Expected life of options in years........................... 4.0 4.0
Risk-free interest rate..................................... 7.0 % 7.0%
Expected dividend yield..................................... 0.00% 0.00%
</TABLE>
F-15
<PAGE> 81
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The weighted average fair value of stock options granted during the years
ended December 31, 1997 and December 31, 1998 was $0.17 and $1.37 per share,
respectively. For pro forma purposes, the estimated fair value of the Company's
stock-based awards to employees is amortized over the options' vesting period
which would result in an increase in net loss of approximately $12,000 and $1.7
million for the years ended December 31, 1997 and 1998, respectively. The result
of applying SFAS 123 to the Company's option grants was not material to the
results of operations or loss per share for the year ended December 31, 1997 and
would have increased the net loss per share by $0.20 per share for the year
ended December 31, 1998.
7. RELATED PARTY TRANSACTIONS
The Company purchases equipment from a supplier which is partially owned by
an investor in the Company. Purchases from this supplier totaled $85,000 and
$5.8 million for the years ending December 31, 1997 and December 31, 1998,
respectively.
8. LEGAL PROCEEDINGS
The Company is engaged in a variety of negotiations, arbitrations and
regulatory and court proceedings with incumbent local exchange carriers
("ILECs"). These negotiations, arbitrations and proceedings concern the ILECs'
denial of physical collocation space to the Company in certain central offices,
the cost and delivery of collocation spaces, the delivery of transmission
facilities and telephone lines, billing issues, alleged patent infringements and
other operational issues. Failure to resolve any of these matters without undue
delay or expense could have a material adverse effect on the Company's business,
prospects, operating results and financial condition. 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 competitive local
exchange carrier 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.
9. SUBSEQUENT EVENTS
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). The Company intends to
record intangible assets of $28.7 million associated with these transactions.
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. In addition, the equity
investments by AT&T, NEXTLINK and Qwest satisfied the conditions of an alternate
equity financing and thus the Equity Commitment will not be called.
On January 27, 1999, the Company completed the Initial Public Offering
("IPO") of 13,455,000 split-adjusted shares of Common Stock at a split-adjusted
initial public offering 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, all
F-16
<PAGE> 82
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
shares of Preferred Stock, including shares issued in the above-mentioned
strategic transactions, were converted into Common Stock, all cumulative but
unpaid dividends on Series A and Series B were paid in Common Stock and the
Common Warrants were exercised.
On February 11, 1999 the Company issued 12 1/2% Senior Notes due February
15, 2009 through a private placement. Interest is due and payable in cash on
February 15 and August 15 of each year, beginning on August 15, 1999. Net
proceeds to the Company were approximately $205.1 million after discounts,
commissions and other transaction costs of approximately $9.9 million.
Approximately $74.1 million of the net proceeds will be used to purchase pledged
securities representing sufficient funds to pay the first six scheduled interest
payments on the notes.
F-17
<PAGE> 83
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN 000'S, EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
ASSETS
<TABLE>
<CAPTION>
JUNE 30, 1999
-------------
<S> <C>
CURRENT ASSETS:
Cash and cash equivalents................................... $ 257,471
Accounts receivable, net.................................... 6,637
Short term investments...................................... 45,638
Unbilled revenue............................................ 2,334
Inventories................................................. 9,470
Prepaid expenses............................................ 4,310
Other current assets........................................ 2,218
---------
Total current assets...................................... 328,078
PROPERTY AND EQUIPMENT:
Networks and communication equipment........................ 143,184
Computer equipment.......................................... 9,639
Furniture and fixtures...................................... 1,469
Leasehold improvements...................................... 2,077
---------
156,369
Less accumulated depreciation and amortization.............. (12,807)
---------
Net property and equipment................................ 143,562
OTHER ASSETS:
Restricted investments...................................... 75,631
Deposits.................................................... 628
Deferred debt issuance costs (net).......................... 12,989
Deferred charge (net)....................................... 24,713
Other long term assets...................................... 8,215
---------
Total other assets........................................ 122,176
---------
Total assets.............................................. $ 593,816
=========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable............................................ $ 31,900
Unearned revenue............................................ 1,702
Accrued network costs....................................... 4,797
Other accrued liabilities................................... 19,557
Current portion of capital lease obligations................ 284
---------
Total current liabilities................................. 58,240
Long-term debt (net of discount)............................ 363,406
Long-term capital lease obligations......................... 166
---------
Total liabilities......................................... 421,812
STOCKHOLDERS' EQUITY:
Preferred stock ($0.001 par value):
Authorized shares -- 5,000,000............................
Issued and outstanding shares -- none..................... --
Common stock ($0.001 par value):
Authorized shares -- 190,000,000..........................
Issued and outstanding shares -- 71,136,940............... 72
Common stock -- Class B ($0.001 par value):
Authorized shares -- 10,000,000...........................
Issued and outstanding shares -- 6,379,177................ 6
Additional paid-in capital.................................. 271,325
Deferred compensation....................................... (3,548)
Accumulated other comprehensive income...................... 25,638
Accumulated deficit......................................... (121,489)
---------
Total stockholders' equity................................ 172,004
---------
Total liabilities and stockholders' equity................ $ 593,816
=========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-18
<PAGE> 84
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN 000'S, EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------ ------------------------
1998 1999 1998 1999
---------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
Revenues...................................... $ 809 $ 10,833 $ 995 $ 16,429
Operating expenses:
Network and product costs................... 758 10,565 961 15,525
Sales, marketing, general and
administrative........................... 4,606 24,976 6,550 43,089
Amortization of deferred compensation....... 631 1,234 858 2,887
Depreciation and amortization............... 446 8,671 610 13,318
---------- ----------- ---------- -----------
Total operating expenses............ 6,441 45,446 8,979 74,819
---------- ----------- ---------- -----------
Income (loss) from operations................. (5,632) (34,613) (7,984) (58,390)
Interest income (expense):
Interest income............................. 1,712 4,585 2,147 8,094
Interest expense............................ (5,003) (11,824) (5,867) (20,460)
---------- ----------- ---------- -----------
Net interest income (expense)............... (3,291) (7,239) (3,720) (12,366)
---------- ----------- ---------- -----------
Net income (loss)............................. (8,923) (41,852) (11,704) (70,756)
---------- ----------- ---------- -----------
Preferred dividends........................... -- -- -- (1,146)
---------- ----------- ---------- -----------
Net income (loss) available to common
stockholders................................ $ (8,923) $ (41,852) $ (11,704) $ (71,902)
========== =========== ========== ===========
Basic and diluted net income (loss) per common
share....................................... $ (1.11) $ (0.61) $ (1.54) $ (1.18)
========== =========== ========== ===========
Weighted average shares used in computing
basic and diluted net loss per share........ 8,050,771 68,157,273 7,584,501 60,930,856
========== =========== ========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-19
<PAGE> 85
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(NET CAPITAL DEFICIENCY)
(AMOUNTS IN 000'S, EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
CONVERTIBLE ACCUMULATED
PREFERRED STOCK COMMON STOCK ADDITIONAL OTHER
-------------------- -------------------- PAID-IN DEFERRED COMPREHENSIVE
SHARES AMOUNT SHARES AMOUNT CAPITAL COMPENSATION INCOME
----------- ------ ----------- ------ ---------- ------------ -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1998...... 18,246,162 $ 18 17,660,995 $18 $ 30,679 $ (4,688) $ --
Issuance of common stock (net of
$11,926 of financing costs)..... -- -- 16,010,701 16 150,296 -- --
Issuance of series C1 and D1
preferred stock................. 6,379,177 6 -- -- 59,994 -- --
Deferred charge related to
issuance of series C1 and D1
preferred stock................. -- -- -- -- 28,700 -- --
Issuance of common stock upon
exercise of common warrants..... -- -- 10,006,943 11 (5) -- --
Conversion of Series A, series B,
and series C preferred stock.... (18,246,162) (18) 27,369,243 27 (9) -- --
Conversion of series C1 and D1
preferred stock................. (6,379,177) (6) 6,379,177 6 -- -- --
Preferred dividend................ -- -- 89,058 -- (77) -- --
Deferred compensation............. -- -- -- -- 1,747 (1,747) --
Amortization of deferred
compensation.................... -- -- -- -- -- 2,887 --
Unrealized gains on investments... -- -- -- -- -- -- 25,638
Net loss.......................... -- -- -- -- -- -- --
----------- ---- ----------- --- -------- -------- --------
Balance at June 30, 1999.......... -- $ -- 77,516,117 $78 $271,325 $ (3,548) $ 25,638
=========== ==== =========== === ======== ======== ========
<CAPTION>
TOTAL
STOCKHOLDERS'
EQUITY (NET
ACCUMULATED CAPITAL
DEFICIT DEFICIENCY)
----------- -------------
<S> <C> <C>
Balance at December 31, 1998...... $ (50,733) $(24,706)
Issuance of common stock (net of
$11,926 of financing costs)..... -- 150,312
Issuance of series C1 and D1
preferred stock................. -- 60,000
Deferred charge related to
issuance of series C1 and D1
preferred stock................. -- 28,700
Issuance of common stock upon
exercise of common warrants..... -- 6
Conversion of Series A, series B,
and series C preferred stock.... -- --
Conversion of series C1 and D1
preferred stock................. -- --
Preferred dividend................ -- (77)
Deferred compensation............. -- --
Amortization of deferred
compensation.................... -- 2,887
Unrealized gains on investments... -- 25,638
Net loss.......................... (70,756) (70,756)
--------- --------
Balance at June 30, 1999.......... $(121,489) $172,004
========= ========
</TABLE>
F-20
<PAGE> 86
COVAD COMMUNICATIONS GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN 000'S)
(UNAUDITED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30,
---------------------
1998 1999
-------- ---------
<S> <C> <C>
Net cash used in operating activities....................... $ (877) $ (27,721)
INVESTING ACTIVITIES:
Purchase of restricted investments.......................... -- (74,103)
Purchase of investments..................................... -- (20,000)
Deposits.................................................... (13) (291)
Other long-term assets...................................... -- (6,304)
Purchase of property and equipment.......................... (12,367) (93,748)
-------- ---------
Net cash used in investing activities....................... (12,380) (194,446)
FINANCING ACTIVITIES:
Net proceeds from issuance of long-term debt and warrants... 129,622 --
Net proceeds from issuance of long-term debt................ -- 205,076
Principal payments under capital lease obligations.......... (122) (129)
Proceeds from common stock issuance, net of offering
costs..................................................... 64 150,318
Proceeds from preferred stock issuance...................... 1,200 60,000
Preferred dividends......................................... -- (77)
Net cash provided by financing activities................... 130,764 415,188
-------- ---------
Net increase in cash and cash equivalents................... 117,507 193,021
Cash and cash equivalents at beginning of period............ 4,378 64,450
Cash and cash equivalents at end of period.................. $121,885 $ 257,471
======== =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Interest paid............................................... $ 48 $ 43
======== =========
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING
ACTIVITIES:
Equipment purchased through capital leases.................. $ 34 $ --
======== =========
Warrants issued for equity commitment....................... $ 2,928 $ --
======== =========
Common stock issued for preferred dividends................. $ -- $ 1,069
======== =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-21
<PAGE> 87
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 June 30, 1999 and for the three and six month
periods ended June 30, 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 and six month periods ended June 30, 1998 and
1999 are not necessarily indicative of results that may be expected for any
future periods.
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 5).
The consolidated financial statements 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.
The following table presents the calculation of basic and diluted net
income (loss) per share (in thousands, except share and per share amounts):
F-22
<PAGE> 88
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------- -------------------------
1998 1999 1998 1999
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Net loss.................................... $ (8,923) $ (41,852) $ (11,704) $ (70,756)
Preferred dividends....................... -- -- -- (1,146)
----------- ----------- ----------- -----------
Net loss available to common stockholders... $ (8,923) $ (41,852) $ (11,704) $ (71,902)
Basic and diluted:
Weighted average shares of common stock
outstanding............................ 17,202,646 73,808,148 17,196,137 67,032,023
Less: Weighted average shares subject to
repurchase............................. 9,151,875 5,650,875 9,611,636 6,101,167
Weighted average shares used in computing
basic and diluted net income (loss) per
share..................................... 8,050,771 68,157,273 7,584,501 60,930,856
=========== =========== =========== ===========
Basic and diluted net income (loss) per
share..................................... $ (1.11) $ (0.61) $ (1.54) $ (1.18)
=========== =========== =========== ===========
</TABLE>
2. COMPREHENSIVE INCOME
Comprehensive income for the three and six months ended June 30, 1998 and
1999 was as follows (in thousands):
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- -------------------
1998 1999 1998 1999
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Net loss.............................................. $ (8,923) $(41,852) $(11,704) $(70,756)
Unrealized holding gains (losses)................... -- 25,638 -- 25,638
-------- -------- -------- --------
Comprehensive income.................................. $ (8,923) $(16,214) $(11,704) $(45,118)
======== ======== ======== ========
</TABLE>
3. SHORT-TERM INVESTMENTS
Short-term investments at June 30, 1999 consisted of the following (in
thousands):
<TABLE>
<S> <C>
Equity position in WebMD, Inc............................... $15,000
Equity position in Efficient Networks, Inc.................. 5,000
Unrealized holding gains.................................... 25,638
-------
$45,638
=======
</TABLE>
The cost of these investments is reflected on the consolidated balance
sheet along with their related unrealized holding gain or loss in order to
approximate fair market value.
4. DEBT
On February 18, 1999, the Company completed a private placement (the "1999
Notes") of $215 million aggregate principal amount of the Company's 12 1/2%
senior notes due 2009. The 1999 Notes are unsecured senior obligations of the
Company maturing on February 15, 2009 and are redeemable at the option of the
Company any time after February 14, 2004 at stated redemption prices plus
accrued and unpaid interest thereon.
Net proceeds from the 1999 Notes were approximately $205.1 million, after
discounts, commissions and other transaction costs of approximately $9.9
million. The discount and debt issuance costs are being
F-23
<PAGE> 89
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
amortized over the life of the 1999 Notes. For the six months ended June 30,
1999 the amortization of debt discount and debt issuance costs was $166,000 and
$190,000, respectively.
Concurrently with the closing of the offering, 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.
On June 1, 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.
5. 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 ("Qwest"). As part of these strategic relationships,
the Company received equity investments totaling approximately $60 million. The
Company recorded intangible assets of $28.7 million associated with these
transactions which will be amortized over periods of three to six years.
Initial Public Offering:
On January 27, 1999, the Company completed an initial public offering of
13,455,000 shares of the Company's Common Stock at a price of $12.00 per share.
Net proceeds to the Company were $150.2 million after deducting underwriting
discounts and commissions and estimated offering expenses payable by the
Company. As a result of the offering, 27,369,243 shares of Common Stock and
6,379,177 shares of Class B Common Stock (which are convertible into 9,568,765
shares of Common Stock) were issued upon the conversion of Preferred Stock,
89,058 shares of Common Stock were issued for cumulative but unpaid dividends on
series A and series B Preferred Stock and 2,699,626 shares of Common Stock were
issued upon the exercise of common warrants.
Secondary Offering:
On June 23, 1999, the Company completed a public offering of 8,625,000
shares of Common Stock sold by certain stockholders of the Company. The Company
did not sell any shares in this offering. Accordingly, there were no net
proceeds to the Company from this offering. The Company incurred estimated
offering expenses of $680,000.
F-24
<PAGE> 90
Description of Inside Front Cover Page of Covad Prospectus:
The graphic on the inside front cover page depicts a map of the United
States with blue dots showing the locations of the metropolitan statistical
areas in which Covad currently offers service (Phase I Deployment) and red dots
showing the locations of the metropolitan statistical areas in which Covad plans
to offer service (Phase II Expansion). Above the map is the Covad logo and the
statement, "The Internet as it should be." Below the map is a label which reads
"The Covad National Broadband Network" followed by a statement saying "Covad
estimates that by the end of 2000, its network will pass over 40% of all homes
and over 45% of all businesses in the United States."
Description of Inside Back Cover Page of Covad Prospectus:
At the top of the inside back cover page, there are two photographs of
screen shots of Covad's national television commercial showing a humorous
depiction of a yoga instructor losing patience waiting for his computer to
connect to the internet. The graphic at the bottom of the inside back cover page
shows a picture of a computer screen with the home page of the Company's new web
site on it. The column on the left of the home page contains the following
language: "Welcome to Covad We make internet access remarkably fast, convenient
and easy for you to use. We're the leading national provider of DSL services,
with a digital network that continues to expand rapidly. In fact, more that 350
qualified ISP partners across the U.S. offer Covad DSL. So ask for it by name."
Below this language is a box containing a sample description of a promotional
offer to customers. The rest of the home page reads as follows: "LEARN before
you buy Explore life in the online fast lane to discover how a Covad DSL
connection can save you time and help you get the most from the Internet. SELECT
a Service Research, compare and choose the best Covad Internet connection for
your home or business needs. SHOP SMART with Covad Special Values No time to
find a custom Internet access solution? Connect quickly with special value
packages through our select ISP partners." Below these words, in smaller type,
is the following statement: "Sign up for the Covad Connection Newsletter" and
beneath this statement is a box containing the letters [email protected] and
a button with the word "subscribe." A picture appears on the right side of the
computer screen depicting several bicycle riders, one of whom has his arms
extended above his head in victory.
<PAGE> 91
- ------------------------------------------------------
- ------------------------------------------------------
YOU SHOULD RELY ONLY ON THE INFORMATION CONTAINED OR INCORPORATED BY
REFERENCE IN THIS PROSPECTUS. WE HAVE NOT AUTHORIZED ANYONE TO PROVIDE YOU WITH
DIFFERENT OR ADDITIONAL INFORMATION. THIS PROSPECTUS IS NOT AN OFFER TO SELL NOR
IS IT SEEKING AN OFFER TO BUY SHARES OF OUR COMMON STOCK IN ANY JURISDICTION
WHERE THE OFFER OR SALE IS NOT PERMITTED. THE INFORMATION CONTAINED OR
INCORPORATED BY REFERENCE IN THIS PROSPECTUS IS CORRECT ONLY AS OF THE DATE OF
THIS PROSPECTUS, REGARDLESS OF THE TIME OF THE DELIVERY OF THIS PROSPECTUS OR
ANY SALE OF OUR COMMON STOCK.
------------------------------
TABLE OF CONTENTS
------------------------------
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
PROSPECTUS SUMMARY................. 1
RISK FACTORS....................... 5
USE OF PROCEEDS.................... 21
DIVIDEND POLICY.................... 21
PRICE RANGE OF OUR COMMON STOCK.... 21
CAPITALIZATION..................... 22
DILUTION........................... 24
SELECTED CONSOLIDATED FINANCIAL
DATA............................. 25
MANAGEMENT'S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS........ 27
BUSINESS........................... 36
MANAGEMENT......................... 55
SELLING STOCKHOLDERS............... 59
UNDERWRITING....................... 61
WHERE YOU CAN FIND MORE
INFORMATION...................... 63
LEGAL MATTERS...................... 64
EXPERTS............................ 64
INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS....................... F-1
</TABLE>
- ------------------------------------------------------
- ------------------------------------------------------
- ------------------------------------------------------
- ------------------------------------------------------
13,000,000 SHARES
LOGO
COMMON STOCK
-------------------------
PROSPECTUS
-------------------------
BEAR, STEARNS & CO. INC.
MORGAN STANLEY DEAN WITTER
---------------------------------------------
CREDIT SUISSE FIRST BOSTON
DEUTSCHE BANC ALEX. BROWN
DONALDSON, LUFKIN & JENRETTE
GOLDMAN, SACHS & CO.
UTENDAHL CAPITAL PARTNERS, L.P.
, 1999
- ------------------------------------------------------
- ------------------------------------------------------
