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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934.
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1999.
Commission file number: 000-25271
COVAD COMMUNICATIONS GROUP, INC.
(Exact name of registrant as specified in its charter)
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<S> <C>
Delaware 77-0461529
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
2330 Central Expressway
Santa Clara, California 95050
(Address of principal executive offices)
(Zip Code)
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(408) 844-7500
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
----- -----
As of August 2, 1999, 71,741,225 shares of the Registrants Common Stock,
$0.001 par value, were issued and outstanding.
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COVAD COMMUNICATIONS GROUP, INC.
INDEX
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<CAPTION>
Page No.
--------
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PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements (Unaudited)
Consolidated Balance Sheets as of
December 31, 1998 and June 30, 1999................................................ 3
Consolidated Statements of Operations for the Three and Six Months Ended
June 30, 1998 and 1999............................................................. 4
Condensed Consolidated Statements of Cash Flows for the Six Months Ended
June 30, 1998 and 1999............................................................. 5
Notes to Consolidated Financial Statements........................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.... 9
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.................................................................... 15
Item 2. Changes in Securities................................................................ 15
Item 6. Exhibits and Reports on Form 8-K..................................................... 16
SIGNATURES......................................................................................... 17
INDEX TO EXHIBITS.................................................................................. 18
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PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Amounts in 000's, except share and per share amounts)
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<CAPTION>
June 30, December 31
1999 1998
(unaudited) (note 1)
-----------------------------
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ASSETS
Current assets:
Cash and cash equivalents.............................................................................. $ 257,471 $ 64,450
Accounts receivable, net............................................................................... 6,637 1,933
Short term investments................................................................................. 45,638 -
Unbilled revenue....................................................................................... 2,334 663
Inventories............................................................................................ 9,470 946
Prepaid expenses....................................................................................... 4,310 1,183
Other current assets................................................................................... 2,218 514
--------- ---------
Total current assets................................................................................. 328,078 69,689
Property and equipment:
Networks and communication equipment................................................................... 143,184 55,189
Computer equipment..................................................................................... 9,639 4,426
Furniture and fixtures................................................................................. 1,469 1,119
Leasehold improvements................................................................................. 2,077 1,887
--------- ---------
156,369 62,621
Less accumulated depreciation and amortization......................................................... (12,807) (3,476)
--------- ---------
Net property and equipment........................................................................... 143,562 59,145
Other assets:
Restricted investments................................................................................. 75,631 225
Deposits............................................................................................... 628 337
Deferred debt issuance costs (net)..................................................................... 12,989 8,112
Deferred charge (net).................................................................................. 24,713 -
Other long term assets................................................................................. 8,215 1,911
--------- ---------
Total other assets................................................................................... 122,176 10,585
--------- ---------
Total assets......................................................................................... $ 593,816 $ 139,419
========= =========
</TABLE>
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<S> <C> <C>
LIABILITIES AND STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
Current liabilities:
Accounts payable....................................................................................... $ 31,900 $ 14,975
Unearned revenue....................................................................................... 1,702 551
Accrued network costs.................................................................................. 4,797 1,866
Other accrued liabilities.............................................................................. 19,557 3,854
Current portion of capital lease obligations........................................................... 284 263
--------- ---------
Total current liabilities............................................................................ 58,240 21,509
Long-term debt (net of discount)....................................................................... 363,406 142,300
Long-term capital lease obligations.................................................................... 166 316
--------- ---------
Total liabilities.................................................................................... 421,812 164,125
Stockholders' equity (net capital deficiency):
Convertible preferred stock ($0.001 par value):
Authorized shares--0 at June 30, 1999 and 30,000,000 at December 31, 1998, respectively
Issued and outstanding shares--0 and 18,246,162 at June 30, 1999 and December 31, 1998, respectively. - 18
Preferred stock ($0.001 par value):
Authorized shares--5,000,000 and 0 at June 30, 1999 and December 31, 1998, respectively
Issued and outstanding shares--0 at June 30, 1999 and December 31, 1998, respectively................ - -
Common stock ($0.001 par value):
Authorized shares--190,000,000 and 65,000,000 at June 30, 1999 and December 31, 1998, respectively
Issued and outstanding shares--71,136,940 and 17,660,995 at June 30, 1999 and December 31, 1998,
respectively......................................................................................... 72 18
Common stock Class B ($0.001 par value):
Authorized shares-- 10,000,000 and 0 at June 30, 1999 and December 31, 1998, respectively
Issued and outstanding shares-- 6,379,177 and 0 at June 30, 1999 and December 31, 1998, respectively.. 6 -
Additional paid-in capital............................................................................. 271,325 30,679
Deferred compensation.................................................................................. (3,548) (4,688)
Accumulated other comprehensive income................................................................. 25,638 -
Accumulated deficit.................................................................................... (121,489) (50,733)
--------- ---------
Total stockholders' equity (net capital deficiency).................................................. 172,004 (24,706)
--------- ---------
Total liabilities and stockholders' equity (net capital deficiency).................................. $ 593,816 $ 139,419
========= =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
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COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in 000's, except share and per share amounts)
(unaudited)
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<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------------------------------
1999 1998 1999 1998
---------- --------- ---------- ---------
<S> <C> <C> <C> <C>
Revenues.................................................... $ 10,833 $ 809 $ 16,429 $ 995
Operating expenses:
Network and product costs.............................. 10,565 758 15,525 961
Sales, marketing, general and administrative........... 24,976 4,606 43,089 6,550
Amortization of deferred compensation.................. 1,234 631 2,887 858
Depreciation and amortization.......................... 8,671 446 13,318 610
---------- --------- ---------- ---------
Total operating expenses.......................... 45,446 6,441 74,819 8,979
---------- --------- ---------- ---------
Income (loss) from operations............................... (34,613) (5,632) (58,390) (7,984)
Interest income (expense):
Interest income........................................ 4,585 1,712 8,094 2,147
Interest expense....................................... (11,824) (5,003) (20,460) (5,867)
---------- --------- ---------- ---------
Net interest income (expense).......................... (7,239) (3,291) (12,366) (3,720)
---------- --------- ---------- ---------
Net income (loss)........................................... $ (41,852) $ (8,923) $ (70,756) $ (11,704)
========== ========= ========== =========
Basic and diluted net income (loss) per common share........ $ (0.61) $ (1.11) $ (1.18) $ (1.54)
========== ========= ========== =========
Weighted average shares used in computing basic and diluted
net loss per share......................................... 68,157,273 8,050,771 60,930,856 7,584,501
========== ========= ========== =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
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COVAD COMMUNICATIONS GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in 000's)
(unaudited)
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<CAPTION>
Six Months Ended
June 30,
1999 1998
--------- ---------
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Net cash provided by (used in) operating activities............................................ $ (27,721) $ (877)
Investing activities:
Purchase of restricted investments............................................................. (74,103) --
Purchase of investments........................................................................ (20,000) --
Deposits....................................................................................... (291) (13)
Other long-term assets......................................................................... (6,304) --
Purchase of property and equipment............................................................. (93,748) (12,367)
--------- ---------
Net cash used in investing activities.......................................................... (194,446) (12,380)
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............................................. (129) (122)
Proceeds from common stock issuance, net of offering costs..................................... 150,318 64
Proceeds from preferred stock issuance......................................................... 60,000 1,200
Preferred dividends............................................................................ (77) --
--------- ---------
Net cash provided by financing activities...................................................... 415,188 130,764
--------- ---------
Net increase in cash and cash equivalents...................................................... 193,021 117,507
Cash and cash equivalents at beginning of period............................................... 64,450 4,378
--------- ---------
Cash and cash equivalents at end of period..................................................... $ 257,471 $ 121,885
========= =========
Supplemental disclosures of cash flow information:
Cash paid during the period for interest..................................................... $ 43 $ 48
========= =========
Supplemental schedule of non-cash investing and financing activities:
Equipment purchased through capital leases................................................... $ -- $ 34
========= =========
Warrants issued for equity commitment.......................................................... $ -- $ 2,928
========= =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
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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, 1999 and 1998 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, 1999 and
1998 are not necessarily indicative of results that may be expected for any
future periods.
The balance sheet at December 31, 1998 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements.
The information included in this report should be read in conjunction with
the Company's audited consolidated financial statements and notes thereto
included in the Company's 1998 Annual Report on Form 10-K.
B. Earnings (Loss) Per Share
Basic earnings per share is computed by dividing income or loss applicable to
common shareholders by the weighted average number of shares of the Company's
common stock ("Common Stock"), after giving consideration to shares subject to
repurchase, outstanding during the period.
Diluted earnings per share is determined in the same manner as basic earnings
per share except that the number of shares is increased assuming exercise of
dilutive stock options and warrants using the treasury stock method and
conversion of the Company's convertible preferred stock ("Preferred Stock"). In
addition, income or loss is adjusted for dividends and other transactions
relating to preferred shares for which conversion is assumed. The diluted
earnings per share amount has not been reported because the Company has a net
loss and the impact of the assumed exercise of the stock options and warrants
and the assumed preferred stock conversion is not dilutive.
Under the Company's Certificate of Incorporation, all outstanding Preferred
Stock converted into Common Stock on a one-for-one basis upon the completion of
the Company's initial public offering of Common Stock (see note 5).
The consolidated financial statements applicable to the prior periods have
been restated to reflect a two-for-one stock split effective May 1998, a three-
for-two stock split effective August 1998, and a three-for-two stock split
effective May 1999.
6
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The following table presents the calculation of basic and diluted net income
(loss) per share (in thousands, except share and per share amounts):
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------------------------------------------
1999 1998 1999 1998
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Net loss..................................... $ (41,852) $ (8,923) $ (70,756) $ (11,704)
Preferred dividends........................ -- -- (1,146) --
---------- ---------- ---------- ----------
Net loss available to common stockholders.... $ (41,852) $ (8,923) $ (71,902) $ (11,704)
Basic and diluted:
Weighted average shares of common stock
outstanding................................ 73,808,148 17,202,646 67,032,023 17,196,137
Less: Weighted average shares subject
to repurchase........................... 5,650,875 9,151,875 6,101,167 9,611,636
---------- ---------- ---------- ----------
Weighted average shares used in computing
basic and diluted net income (loss) per
share....................................... 68,157,273 8,050,771 60,930,856 7,584,501
========== ========== ========== ==========
Basic and diluted net income (loss) per share $(0.61) $ (1.11) $ (1.18) $ (1.54)
========== ========= ========== ==========
</TABLE>
2. Comprehensive Income
Comprehensive income for the three and six months ended June 30, 1999 and
1998 was as follows (in thousands):
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<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
----------------------------------------------------------------
1999 1998 1999 1998
--------- -------- --------- ---------
<S> <C> <C> <C> <C>
Net loss..................................... $ (41,852) $ (8,923) $ (70,756) $ (11,704)
Unrealized holding gains (losses).......... 25,638 -- 25,638 --
--------- -------- --------- ---------
Comprehensive income......................... $ (16,214) $ (8,923) $ (45,118) $ (11,704)
========= ======== ========= =========
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3. Short-Term Investments
Short-term investments at June 30, 1999 consisted of the following (in
thousands):
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<S> <C>
Equity position in WebMD, Inc......................... $15,000
Equity position in Efficient Networks, Inc............ 5,000
Unrealized holding gains (losses)..................... 25,638
-------
$45,638
=======
</TABLE>
The costs of these investments are reflected on the 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
7
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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 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 ("Quest"). 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 the IPO of 13,455,000 split-
adjusted shares of the Company's common stock at a split-adjusted price of
$12.00 per share. Net proceeds to the Company from the IPO were $150.2 million
after deducting underwriting discounts and commissions and estimated offering
expenses payable by the Company. As a result of the IPO, 27,369,243 split-
adjusted shares of Common Stock and 6,379,177 shares of Class B Common Stock
(which are convertible into 9,568,765 split-adjusted shares of Common Stock)
were issued upon the conversion of Preferred Stock, 89,058 split-adjusted shares
of Common Stock were issued for cumulative but unpaid dividends on series A and
series B Preferred Stock and 2,699,626 split-adjusted shares of Common Stock
were issued upon the exercise of common warrants.
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 is expected to incur estimated
offering expenses of $680,000.
8
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Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion of the financial condition and results of
operations of the Company should be read in conjunction with the consolidated
financial statements and the related notes thereto included elsewhere in this
Form 10-Q and the consolidated audited financial statements and notes thereto
and Management's Discussion and Analysis of Financial Condition and Results of
Operations for the year ended December 31, 1998 included in the Company's Annual
Report on Form 10-K. This discussion contains forward-looking statements the
accuracy of which involves risks and uncertainties. Our actual results could
differ materially from those anticipated in the forward-looking statements for
many reasons including, but not limited to, those discussed herein and in our
Registration Statement on Form S-1 (SEC File No. 333-78827). We disclaim any
obligation to update information contained in any forward-looking statement or
in the reasons why such forward-looking statements may differ materially from
actual results, which reasons speak as of their dates. See "Forward Looking
Statements"
Overview
We are a leading high-speed Internet and network access provider offering
digital subscriber line ("DSL") services to Internet service provider and
enterprise customers. Since March 1998, we have raised $569.0 million of gross
proceeds from debt and equity financings to fund the deployment and expansion
of our networks. Currently, we offer our services in 21 major metropolitan
areas and plan to build our networks and offer our services in one additional
metropolitan area representing a total of 51 metropolitan statistical areas
nationwide.
In connection with our expansion within existing regions and into new
regions, we expect to significantly increase our capital expenditures, as well
as our sales and marketing expenditures, to deploy our networks and support
additional end-users in those regions. Accordingly, we expect to incur
substantial and increasing net losses for at least the next several years.
We derive revenue from:
. monthly recurring service charges for connections from the end-user to
our facilities and for backhaul services from our facilities to the
Internet service provider or enterprise customer;
. service order set-up and other non-recurring charges; and
. the sale of customer premise equipment that we provide to our customers
due to the general unavailability of customer premise equipment through
retail channels.
We expect prices for the major components of both recurring and non-
recurring revenues to decrease each year in part due to the effects of
competitive pricing and future volume discounts. We believe our revenues from
the sale of customer premise equipment will decline over time, as prices for
such equipment decrease and customer premise equipment becomes more generally
available.
The following factors comprise our network and service costs:
. Monthly non-recurring and recurring circuit fees. We pay traditional
telephone companies and other competitive telecommunications companies
non-recurring and recurring fees for services including installation,
activation, monthly line costs, maintenance and repair of circuits
between and among our digital subscriber line access multiplexers and our
regional data centers, customer backhaul, and end-user lines. As our
end-user base grows, we expect that the largest element of network and
product cost will be the traditional telephone companies' charge for our
leased copper lines; and
. Other costs. Other costs that we incur include those for materials in
installation and the servicing of customers and end-users, and the cost
of customer premise equipment.
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The development and expansion of our business will require significant
expenditures. The principal capital expenditures incurred during the buildup
phase of any region involve the procurement, design and construction of our
central office cages, end-user DSL line cards, and expenditures for other
elements of our network design, which includes a regional data center in each
region. Following the buildout of our central office space, the major portion
of our capital expenditures is success-based, used to purchase DSL line cards
to support incremental end-users. We expect that the average cost of such line
cards will decline over the next several years. Network expenditures will
continue to increase with the number of end-users. However, once an operating
region is fully built out, a substantial majority of the regional capital
expenditures will be tied to incremental customer and end-user growth. In
addition to developing our networks, we will use our capital for marketing our
services, acquiring Internet service provider and enterprise customers, and
funding our customer care and field service operations.
Results of Operations
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 our business.
Deferred Compensation
Through June 30, 1999, we recorded a total of approximately $10.7 million
of deferred compensation, with an unamortized balance of approximately $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
10
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stock at the dates of grant. We are amortizing the deferred compensation over
the vesting period of the applicable option. Amortization of deferred
compensation was $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 approximately $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 approximately $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
$12.3 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.
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
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of infrastructure equipment necessary for the development and expansion of our
networks and the development of new regions.
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 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.
We expect to experience substantial negative cash flow from operating
activities and negative cash flow before financing activities for at least the
next several years due to continued development, commercial deployment and
expansion of our networks. We may also make investments in businesses that are
complementary to ours to support the growth of our business. Our future cash
requirements for developing, deploying and enhancing our networks and operating
our business, as well as our revenues, will depend on a number of factors
including:
. the number of regions entered, the timing of entry and services offered;
. network development schedules and associated costs;
. the rate at which customers and end-users purchase our services and the
pricing of such services;
. the level of marketing required to acquire and retain customers and to
attain a competitive position in the marketplace;
. the rate at which we invest in engineering and development and
intellectual property with respect to existing and future technology; and
. unanticipated opportunities.
Accordingly, we will be required to raise additional capital, the timing
and amount of which we cannot predict. As a result, 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
12
<PAGE>
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.
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 have not made any assessment of the Year 2000 risks associated with our
third-party or traditional telephone company equipment or software or with our
Internet service provider and enterprise customers. We have not determined the
risks associated with the reasonably likely worst-case scenario and have not
made any contingency plans to address such risks. However, we intend to devise
a Year 2000 contingency plan prior to December 31, 1999.
Forward Looking Statements
The statements contained in this report that are not historical facts are
"forward-looking statements" (as such term is defined in Section 27A of the
Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934),
which can be identified by the use of forward-looking terminology such as
"estimates," "projects," "anticipates," "expects," "intends," "believes," or the
negative thereof or other variations thereon or comparable terminology, or by
discussions of strategy that involve risks and uncertainties. Examples of such
forward-looking statements include:
. our plans to expand our existing networks or to commence service in new
regions;
. expectations as to pricing for our services in the future;
. statements regarding development of our business;
. the possibility that we may obtain significantly increased sales
volumes;
13
<PAGE>
. the estimates of future operating results;
. our anticipated capital expenditures; and
. other statements contained in this Form 10-Q regarding matters that are
not historical facts.
These statements are only estimates or predictions and cannot be relied upon.
We can give you no assurance that future results will be achieved. Actual
events or results may differ materially as a result of risks facing us or actual
results differing from the assumptions underlying such statements. Such risks
and assumptions that could cause actual results to vary materially from the
future results indicated, expressed or implied in such forward-looking
statements include our ability to:
. successfully market our services to current and new customers;
. generate customer demand for our services in the particular regions where
we plan to market services;
. achieve favorable pricing for our services;
. respond to increasing competition;
. manage growth of our operations; and
. access regions and negotiate suitable interconnection agreements with the
traditional phone companies, all in a timely manner, at reasonable costs
and on satisfactory terms and conditions consistent with regulatory,
legislative and judicial developments.
All written and oral forward-looking statements made in connection with this
report on Form 10-Q which are attributable to us or persons acting on our behalf
are expressly qualified in their entirety by the "Risk Factors" and other
cautionary statements included in our Registration Statement on Form S-1
(Commission File No. 333-78827). We disclaim any obligation to update
information contained in any forward-looking statement or in the reasons why
such forward-looking statements may differ materially from actual results, which
reasons speak as of their dates.
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.
14
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
We are engaged in a variety of negotiations, arbitrations and regulatory
and court proceedings with multiple traditional telephone companies. These
negotiations, arbitrations and proceedings concern the traditional telephone
companies' denial of physical central office space to us in certain central
offices, the cost and delivery of central office spaces, the delivery of
transmission facilities and telephone lines, billing issues and other
operational issues. For example, we are currently involved in commercial
arbitration proceedings with Pacific Bell over these issues. We have also filed
a lawsuit against Pacific Bell and its affiliates, including Southwestern Bell
Telephone Company, in federal court. We are pursuing a variety of contract,
tort, antitrust and other claims, such as violations of the Telecommunications
Act, in these proceedings. In November 1998, we prevailed in our commercial
arbitration proceeding against Pacific Bell. The arbitration panel found that
Pacific Bell breached its interconnection agreement with us and failed to act in
good faith on multiple counts. The arbitration panel ruled in favor of awarding
us direct damages, as well as attorneys' fees and costs of the arbitration.
Pacific Bell is currently attempting to have the decision vacated. We have also
filed a lawsuit against Bell Atlantic and its affiliates in federal court. We
are pursuing antitrust and other claims in this lawsuit. In addition, Bell
Atlantic has separately filed suit against us asserting at least one patent
infringement claim. Failure to resolve the various legal disputes and
controversies between us and the various traditional telephone companies without
excessive delay and cost and in a manner that is favorable to us could harm our
business.
We are not currently engaged in any other legal proceedings that we believe
could have a material adverse effect on our business, prospects, operating
results and financial condition. We are, however, subject to state commission,
FCC and court decisions as they relate to the interpretation and implementation
of the 1996 Telecommunications Act, the interpretation of competitive
telecommunications company interconnection agreements in general and our
interconnection agreements in particular. In some cases, we may be deemed to be
bound by the results of ongoing proceedings of these bodies or the legal
outcomes of other contested interconnection agreements that are similar to our
agreements. The results of any of these proceedings could harm our business.
Item 2. Changes in Securities and Use of Proceeds
In June 1999, we issued 7,307,317 shares of common stock upon the exercise
of warrants that were issued in connection with the offering of our 1998 notes.
The issuance of these shares was pursuant to the "net exercise" of the warrants
and, therefore, we received no cash proceeds from the issuance of the shares.
The shares were issued in reliance on an exemption from registration under the
Securities Act provided by Section 4(2) of such act and the rules and regulation
promulgated thereunder.
Of these shares, 7,088,654 were sold by the holders in a registered public
offering under the Securities Act that was underwritten by a syndicate of
underwriters led by Bear, Stearns & Co. Inc, Morgan Stanley & Co. Incorporated,
Credit Suisse First Boston Corporation, Deutsche Bank Securities Inc.,
Donaldson, Lufkin & Jenrette Securities Corporation and Wit Capital Corporation.
In January 1999, we commenced and completed a firm commitment underwritten
initial public offering of 13,455,000 split-adjusted shares of our common stock,
including 1,755,000 split-adjusted shares related to the
15
<PAGE>
underwriter's over-allotment option, at a split-adjusted price of $12.00 per
share. The shares were registered with the Securities and Exchange Commission
pursuant to a registration statement on Form S-1 (No. 333-63899), which was
declared effective on January 21, 1999. The public offering was underwritten by
a syndicate of underwriters led by Bear, Stearns & Co. Inc., BT Alex. Brown
Incorporated, Donaldson, Lufkin & Jenrette Securities Corporation and Goldman,
Sachs & Co., as their representatives. After deducting underwriting discounts
and commissions of $10.0 million and expenses of $1.2 million, we received net
proceeds of $150.2 million.
As of June 30, 1999, we had invested the net proceeds from our initial
public offering in short- and long-term investments in order to meet anticipated
cash needs for future working capital. We invested our available cash
principally in high-quality corporate issuers and in debt instruments of the
U.S. Government and its agencies. The use of proceeds from the offering does not
represent a material change in the use of proceeds described in the Registration
Statement. None of the net proceeds of the offering were paid directly or
indirectly to any director, officer, general partner of Covad or their
associates, persons owning 10 percent or more of any class of equity securities
of Covad, or an affiliate of Covad.
Item 6. Exhibits and Reports on Form 8-K
a. Exhibits:
<TABLE>
<CAPTION>
Exhibit Number Description of Exhibit
- -------------- ----------------------
<S> <C>
10.1 Note secured by Deed of Trust dated May 24, 1999 issued by Robert Davenport in
favor of Covad Communications Group, Inc.
27.1 Financial Data Schedules for the six months ended June 30, 1999.
</TABLE>
b. Reports on Form 8-K
There have been no reports on Form 8-K filed during the quarter ended
June 30, 1999.
16
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
COVAD COMMUNICATIONS GROUP, INC.
Date: August 16, 1999 By: /s/ Timothy P. Laehy
---------------------
Timothy P. Laehy
Chief Financial Officer and Vice President,
Finance (Principal Financial and Accounting
Officer)
17
<PAGE>
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Exhibit Number Description of Exhibit
- -------------- ----------------------
<S> <C>
10.1 Note secured by Deed of Trust dated May 24, 1999 issued by Robert Davenport in
favor of Covad Communications Group, Inc.
27.1 Financial Data Schedules for the six months ended June 30, 1999.
</TABLE>
18
<PAGE>
EXHIBIT 10.1
COVAD COMMUNICATIONS GROUP, INC.
-------------------------------
NOTE SECURED BY DEED OF TRUST
-----------------------------
$600,000.00 May 24, 1999
Santa Clara, California
FOR VALUE RECEIVED, Robert Davenport, III ("Mr. Davenport" or "Maker")
promises to pay to the order of Covad Communications Group, Inc. (the
"Company"), at its corporate offices at 2330 Central Expressway, Building B,
Santa Clara, California 95050, the principal sum of six hundred thousand dollars
($600,000.00), together with any accrued interest thereon, upon the terms and
conditions specified below.
1. Principal. The principal balance of this Note shall become due and
---------
payable in four (4) consecutive equal annual installments on each anniversary of
January 20, 1999, with the last such installment becoming due on January 20,
2003.
2. Interest. No interest shall accrue under the Note while the
--------
Maker continues his employment with the Company.
3. Special Forgiveness. For purposes of this special forgiveness
-------------------
provision, the special prepayment provision under Section 5, the acceleration
provisions of Section 7 and the employment requirements of Section 8 hereof, the
principal amount of this Note shall be forgiven by the Company in a series of
four (4) successive equal annual installments upon Mr. Davenport's completion of
each year of employment with the Company measured from January 20, 1999, Mr.
Davenport's date of hire.
In the event that, within twelve (12) months following the
effectiveness of a Change in Control (as defined below), Mr. Davenport either
(i) is terminated from his employment without Cause (as defined below) or (ii)
resigns from his employment for Good Reason (as defined below), any remaining
unpaid and unforgiven amount of principal shall be forgiven in full on an
accelerated basis at the time of such termination or resignation. In the case
of any resignation for Good Reason under this Note, the Maker must specify in
reasonable detail the basis for such resignation for Good Reason and give the
Company at least twenty (20) business days in which to correct the circumstances
prompting the resignation for Good Reason.
For purposes of applying the provisions of this Note, the following
definitions shall be in effect:
"Cause" shall mean (i) the repeated failure of the Maker to perform
the duties of that Maker's position with the Company in any substantial
respect following thirty (30) days prior notification in writing, (ii) the
Maker's conviction of a felony (other than a traffic violation) or of other
criminal conduct involving fraud, theft or any other act exhibiting serious
moral turpitude or (iii) any willful conduct by the Maker which has a
material adverse effect on the Company. A termination for any other reason
shall be considered a termination "without Cause."
<PAGE>
"Change in Control" shall mean (i) a merger or consolidation in which
securities possessing more than fifty percent (50%) of the total combined
voting power of the Company's outstanding securities are transferred to a
person or persons different from the persons holding those securities
immediately prior to such transaction; or (ii) the sale, transfer or other
disposition of all or substantially all of the assets of the Company in
complete liquidation or dissolution of the Company.
"Good Reason" shall mean (i) any reduction in the Maker's base salary,
unless such reduction is pursuant to a change in the Company's compensation
policies generally; (ii) a material adverse change in the nature of the
Maker's job duties; or (iii) a relocation of the Maker's base office,
without the Maker's consent, to an office that is more than fifty (50)
miles from the Maker's base office as of the date of this Note. A
resignation by either Maker under any other circumstances shall be
considered a resignation "without Good Reason."
4. Payment. Payment shall be made in lawful tender of the United
-------
States and shall be applied first to the payment of all accrued and unpaid
interest and then to the payment of principal. Prepayment of the principal
balance of this Note may be made in whole or in part at any time without
penalty.
5. Special Prepayment Provision. On the earlier of the date Mr.
---------------------------- -------
Davenport (i) is terminated from his employment for Cause or (ii) resigns from
his employment without Good Reason, any remaining unpaid and unforgiven amount
of principal shall become immediately due and payable.
6. Security; Full Recourse. The proceeds of the loan evidenced by
-----------------------
this Note shall be applied solely to the purchase of the Maker's principal
residence in the City of Oakland, County of Alameda, State of California.
Payment of this Note shall be secured by a Deed of Trust on such principal
residence, as such property is more particularly described in Exhibit "A" to the
Deed of Trust, a copy of which Deed is attached hereto as Exhibit A. However,
the Maker shall remain personally liable for payment of this Note, and assets of
the Maker, in addition to the collateral under the Deed of Trust, may be applied
to the satisfaction of the Maker's obligations hereunder.
7. Events of Acceleration. If any of the following events shall
----------------------
occur and be continuing, then the Company may, at its option and without notice
to the Maker or any other person, declare the entire outstanding principal
balance of this Note, together with any other sums the Maker may owe to the
Company under or in connection with this Note or otherwise, together with
accrued interest thereon, immediately due and payable:
A. the Maker's failure to pay when due any principal or interest
hereunder, including the Maker's failure to pay any amounts due
under Section 5 hereof, and such default is continuing for a
period of ten (10) or more days after notice thereof from the
Company to the Makers; or
B. the sale, transfer, mortgage, assignment, encumbrance or lease,
whether voluntarily or involuntarily or by operation of law or
otherwise, of the
2
<PAGE>
property covered by the Deed of Trust, or any portion thereof or
interest therein, without the prior written consent of the
Company; or
C. the insolvency of the Maker, the commission of any act of
bankruptcy by the Maker, the execution by the Maker of a general
assignment for the benefit of creditors, the filing by or
against the Maker of any petition in bankruptcy or any petition
for relief under the provisions of the federal bankruptcy act or
any other state or federal law for the relief of debtors and the
continuation of such petition without dismissal for a period of
thirty (30) days or more, the appointment of a receiver or
trustee to take possession of any property or assets of the
Maker, or the attachment of or execution against any property or
assets of the Maker; or
D. the occurrence of any event of default under the Deed of Trust
securing this Note or any obligation secured thereby.
8. Employment Requirement. The benefits of the interest
----------------------
arrangements under this Note are not transferable by the Maker and are
conditioned on the future performance of substantial services by the Maker.
Upon Mr. Davenport's cessation of employment with the Company,
interest shall accrue on any unpaid and unforgiven principal balance at the
minimum per annum rate, compounded semi-annually, required to avoid the
imputation of compensation income to the Maker under the Federal tax laws.
For purposes of applying the provisions of this Note, the Maker shall
be considered to remain in the Company's employ for so long as the Maker renders
services as a full-time employee of the Company, any successor entity of the
Company or one or more subsidiaries of the Company in which the Company has at
least a fifty percent (50%) direct or indirect ownership interest.
9. Certification. The Maker certifies that the Maker reasonably
-------------
expects to be entitled to and will itemize deductions for Federal income tax
purposes for each year the Note is outstanding.
10. Collection. If action is instituted to collect this Note, the
----------
Maker promises to pay all costs and expenses (including reasonable attorney
fees) incurred in connection with such action.
11. Waiver. No previous waiver and no failure or delay by the
------
Company in acting with respect to the terms of this Note or the Deed of Trust
shall constitute a waiver of any breach, default, or failure of condition under
this Note, the Deed of Trust or the obligations secured thereby. A waiver of any
term of this Note, the Deed of Trust or of any of the obligations secured
thereby must be made in writing and shall be limited to the express terms of
such waiver.
The Maker waives presentment, demand, notice of dishonor, notice of
default or delinquency, notice of acceleration, notice of protest and
nonpayment, notice of costs, expenses
3
<PAGE>
or losses and interest thereon, notice of interest on interest, and diligence in
taking any action to collect any sums owing under this Note or in proceeding
against any of the rights or interests in or to properties securing payment of
this Note.
12. Conflicting Agreements. In the event of any inconsistencies
----------------------
between the terms of this Note and the terms of any other document related to
the loan evidenced by the Note, the terms of this Note shall prevail.
13. Governing Law. This Note shall be construed in accordance with
-------------
the laws of the State of California without resort to that State's conflict-of-
laws rules.
14. Due on Sale. If the Maker sells, conveys or alienates the
-----------
property covered by the Deed of Trust, or any part thereof, or any interest
therein, or shall be divested of his title or any interest therein in any manner
or way, whether voluntarily or involuntarily, without the written consent of the
Company being first obtained, then the Company shall have the right, at its
option, except as prohibited by law, to declare an indebtedness or obligations
secured hereby, irrespective of the maturity date specified in any note
evidencing the same, immediately due and payable. Consent to one such
transaction shall not be deemed to be a waiver of the right to require such
consent to future successive transactions.
MAKER
/s/ Robert Davenport, III
-------------------------
ROBERT DAVENPORT, III
4
<PAGE>
EXHIBIT A
DEED OF TRUST
5
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<RESTATED>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> JUN-30-1999
<CASH> 257,471
<SECURITIES> 45,638
<RECEIVABLES> 7,877
<ALLOWANCES> 1,240
<INVENTORY> 9,470
<CURRENT-ASSETS> 328,078
<PP&E> 156,369
<DEPRECIATION> 12,807
<TOTAL-ASSETS> 593,816
<CURRENT-LIABILITIES> 58,240
<BONDS> 363,406
0
0
<COMMON> 78
<OTHER-SE> 171,926
<TOTAL-LIABILITY-AND-EQUITY> 593,816
<SALES> 16,429
<TOTAL-REVENUES> 16,429
<CGS> 15,525
<TOTAL-COSTS> 15,525
<OTHER-EXPENSES> 59,294
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 20,460
<INCOME-PRETAX> (70,756)
<INCOME-TAX> 0
<INCOME-CONTINUING> (70,756)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (70,756)
<EPS-BASIC> (1.18)
<EPS-DILUTED> (1.18)
</TABLE>
