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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 SEPTEMBER 30, 1999.
Commission file number: 000-25271
COVAD COMMUNICATIONS GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0461529
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
2330 CENTRAL EXPRESSWAY 95050
SANTA CLARA, CALIFORNIA
(Address of principal executive offices) (Zip Code)
(408) 844-7500
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1)has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2)has been subject to such
filing requirements for the past 90 days. Yes X No
---
As of November 9, 1999, 96,573,005 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.
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements (Unaudited)
Consolidated Balance Sheets as of September 30, 1999 and
December 31, 1998 and ........................................ 3
Consolidated Statements of Operations for the Three and Nine
Months Ended September 30, 1999 and 1998...................... 4
Condensed Consolidated Statements of Cash Flows for the Nine
Months Ended September 30, 1999 and 1998...................... 5
Notes to Consolidated Financial Statements...................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations........................................... 9
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................ 16
Item 2. Changes in Securities............................................ 17
Item 6. Exhibits and Reports on Form 8-K................................. 17
SIGNATURES................................................................... 18
INDEX TO EXHIBITS............................................................ 19
</TABLE>
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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)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
(UNAUDITED) (NOTE 1)
------------- ------------
ASSETS
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents ............................... $ 181,803 $ 64,450
Accounts receivable, net ................................ 10,996 1,933
Short term investments .................................. 36,698 --
Unbilled revenue ........................................ 3,935 663
Inventories ............................................. 7,753 946
Prepaid expenses ........................................ 4,924 1,183
Other current assets .................................... 2,138 514
--------- ---------
Total current assets ................................ 248,247 69,689
PROPERTY AND EQUIPMENT:
Networks and communication equipment .................... 187,321 55,189
Computer equipment ...................................... 15,616 4,426
Furniture and fixtures .................................. 2,206 1,119
Leasehold improvements .................................. 3,085 1,887
--------- ---------
208,228 62,621
Less accumulated depreciation and amortization .......... (20,852) (3,476)
--------- ---------
Net property and equipment .......................... 187,376 59,145
OTHER ASSETS:
Restricted investments .................................. 63,473 225
Deposits ................................................ 692 337
Deferred debt issuance costs (net) ...................... 12,693 8,112
Deferred charge (net) ................................... 22,622 --
Other long term assets .................................. 8,687 1,911
--------- ---------
Total other assets .................................. 108,167 10,585
--------- ---------
Total assets ........................................ $ 543,790 $ 139,419
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
CURRENT LIABILITIES:
Accounts payable ........................................ $ 36,880 $ 14,975
Unearned revenue ........................................ 3,195 551
Accrued network costs ................................... 8,895 1,866
Other accrued liabilities ............................... 13,691 3,854
Current portion of capital lease obligations ............ 294 263
--------- ---------
Total current liabilities ........................... 62,955 21,509
Long-term debt (net of discount) ........................ 368,922 142,300
Long-term capital lease obligations ..................... 88 316
--------- ---------
Total liabilities ................................... 431,965 164,125
STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY):
Convertible preferred stock ($0.001 par value):
Authorized shares--0 at September 30, 1999 and
30,000,000 at December 31, 1998,
Issued and outstanding shares--0 at September 30, 1999
and 18,246,162 at December 31, 1998 ................... -- 18
Preferred stock ($0.001 par value):
Authorized shares--5,000,000 at September 30, 1999 and
0 at December 31, 1998,
Issued and outstanding shares--0 at September 30, 1999
and 0 at December 31, 1998 ............................ -- --
Common stock ($0.001 par value):
Authorized shares--190,000,000 at September 30, 1999
and 65,000,000 at December 31, 1998,
Issued and outstanding shares--72,919,240 at September
30, 1999 and 17,660,995 at December 31,1998 ........... 73 18
Common stock--Class B ($0.001 par value):
Authorized shares--10,000,000 September 30, 1999 and 0
at December 31, 1998,
Issued and outstanding shares--6,379,177 at September
30, 1999 and 0 at December 31, 1998 ................... 6 --
Additional paid-in capital .............................. 274,092 30,679
Deferred compensation ................................... (3,450) (4,688)
Accumulated other comprehensive income .................. 16,698 --
Accumulated deficit...................................... (175,594) (50,733)
--------- ---------
Total stockholders' equity (net capital deficiency) ... 111,825 (24,706)
--------- ---------
Total liabilities and stockholders' equity (net capital
deficiency).......................................... $ 543,790 $ 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)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- ---------------------
1999 1998 1999 1998
---- ---- ---- ----
<S> <C> <C> <C> <C>
Revenues ................................ $ 19,141 $ 1,565 $ 35,570 $ 2,560
Operating expenses:
Network and product costs ........... 16,694 1,355 32,219 2,316
Sales, marketing, general and
administrative ................... 37,697 10,681 80,786 17,231
Amortization of deferred compensation 1,008 1,837 3,895 2,695
Depreciation and amortization ....... 10,593 738 23,911 1,348
------------ ------------ ------------ ------------
Total operating expenses ......... 65,992 14,611 140,811 23,590
------------ ------------ ------------ ------------
Income (loss) from operations ........... (46,851) (13,046) (105,241) (21,030)
Interest income (expense):
Interest income ..................... 4,770 1,526 12,864 3,673
Interest expense .................... (12,024) (5,037) (32,484) (10,904)
------------ ------------ ------------ ------------
Net interest income (expense) ....... (7,254) (3,511) (19,620) (7,231)
------------ ------------ ------------ ------------
Net income (loss) ...................... $ (54,105) $ (16,557) $ (124,861) $ (28,261)
------------ ------------ ------------ ------------
Preferred dividends ..................... -- -- (1,146) --
------------ ------------ ------------ ------------
Net income (loss) available to common
shareholders .......................... $ (54,105) $ (16,557) $ (126,007) $ (28,261)
============ ============ ============ ============
Basic and diluted net income (loss)
per common share ...................... $ (0.70) $ (1.84) $ (1.90) $ (3.51)
Weighted average shares used in computing
basic and diluted net loss per share .... 77,082,969 9,017,415 66,368,810 8,062,386
</TABLE>
The accompanying notes are an integral part of these financial statements.
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COVAD COMMUNICATIONS GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN 000'S)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------
1999 1998
----- -----
<S> <C> <C>
NET CASH USED IN OPERATING ACTIVITIES ............................ $ (65,721) $ (4,196)
INVESTING ACTIVITIES:
Purchase of restricted investments ............................... (74,353) (23)
Redemption of restricted investments ............................. 13,214 --
Purchase of investments .......................................... (20,000) --
Deposits ......................................................... (355) (251)
Other long-term assets ........................................... (6,776) (887)
Purchase of property and equipment ............................... (145,607) (32,303)
--------- ---------
Net cash used in investing activities ............................ (233,877) (33,464)
FINANCING ACTIVITIES:
Net proceeds from issuance of long-term debt and warrants ........ -- 129,328
Net proceeds from issuance of long-term debt ..................... 205,049 --
Principal payments under capital lease obligations ............... (197) (183)
Proceeds from common stock issuance, net of offering costs 152,176 13
Proceeds from preferred stock issuance ........................... 60,000 1,200
Preferred dividends .............................................. (77) --
------- -------
Net cash provided by financing activities ........................ 416,951 130,358
------- -------
Net increase in cash and cash equivalents ........................ 117,353 92,698
Cash and cash equivalents at beginning of period ................. 64,450 4,378
------ -----
Cash and cash equivalents at end of period ....................... $ 181,803 $ 97,076
========= =========
Supplemental disclosures of cash flow information:
Interest paid ................................................ $ 13,257 $ 78
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.
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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 consolidated financial statements at September 30, 1999 and for the
three and nine month periods ended September 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 nine month
periods ended September 30, 1999 and 1998 are not necessarily indicative of
results that may be expected for any future periods.
The consolidated balance sheet at December 31, 1998 has been derived from
the audited consolidated 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.
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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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------------------------------
1999 1998 1999 1998
---------------------------------------------------
<S> <C> <C> <C> <C>
Net loss ............................................... $ (54,105) $ (16,557) $ (124,861) $ (28,261)
Preferred dividends .................................. -- -- (1,146) --
------------ ------------ ----------- ----------
Net loss available to common stockholders .............. $ (54,105) $ (16,557) $ (126,007) $ (28,261)
Basic and diluted:
Weighted average shares of common stock
outstanding ........................................ 81,835,344 17,383,540 72,020,379 17,169,006
Less: Weighted average shares subject
to repurchase ...................................... 4,752,375 8,366,125 5,651,569 9,106,620
------------ ------------ ----------- ----------
Weighted average shares used in computing
basic and diluted net income (loss) per share .......... 77,082,969 9,017,415 66,368,810 8,062,386
Basic and diluted net income (loss) per share .......... $ (0.70) $ (1.84) $ (1.90) $ (3.51)
</TABLE>
2. COMPREHENSIVE INCOME
Comprehensive income for the three and nine months ended September 30, 1999
and 1998 was as follows (in thousands):
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------------------------------
1999 1998 1999 1998
---------------------------------------------------
<S> <C> <C> <C> <C>
Net loss............................................... $(54,105) $(16,557) $(124,861) $(28,261)
Unrealized holding gains (losses) .................. (8,940) -- 16,698 --
-------- -------- --------- --------
Comprehensive income .................................. $(63,045) $(16,557) $(108,163) $(28,261)
</TABLE>
3. SHORT-TERM INVESTMENTS
Short-term investments at September 30, 1999 consisted of the following (in
thousands):
Equity position in WebMD, Inc. ........................ $ 15,000
Equity position in Efficient Networks, Inc. ........... 5,000
Unrealized holding gains (losses) ..................... 16,698
------------
$ 36,698
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 of $215
million aggregate principal amount of the Company's 12 1/2% senior notes (the
"1999 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 theron.
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 nine months ended September 30, 1999, the
amortization of debt discount and debt issuance costs was $277,000 and $316,000,
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 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 incurred offering
expenses of approximately $600,000.
On November 3, 1999 the Company completed a public offering of 14,950,000
shares of common stock sold by the Company and certain stockholders of the
Company. The net proceeds to the Company from this offering are estimated to be
approximately $568.8 million after deducting underwriting discounts and
commissions and estimated offering expenses.
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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. 333-88757). 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 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. As of September
30, we offered 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 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. We expect that the prices we charge to customers for customer premise
equipment will decrease each year.
The following factors comprise our network and service costs: Monthly
non-recurring and recurring circuit fees - we pay traditional telephone
companies and other competitive telecommunications companies non-recurring and
recurring fees for services including installation, activation, monthly line
costs, maintenance and repair of circuits between and among our digital
subscriber line access multiplexers and our regional data centers, customer
backhaul, and end-user lines. As our end-user base grows, we expect that the
largest element of network and product cost will be the traditional telephone
companies' charge for our leased copper 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.
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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 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
cost to deploy our facilities in a central office, excluding end-user line
cards, is approximately $85,000 per central office facility. This cost may vary
in the future due to the quantity and type of equipment we initially deploy in a
central office facility as well as regulatory limitations imposed on the
traditional phone companies relative to pricing of central office space,
including cageless physical collocation. Following the buildout of our central
office space, the major portion of our capital expenditures is the purchase of
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.
RECENT DEVELOPMENTS
On November 3, 1999, we completed a public offering of 14,950,000 shares of
common stock at a price of $43.00 per share, 13,655,000 shares of which were
sold by the Company and the remaining 1,295,000 shares by certain stockholders
of the Company. We received proceeds of $568.8 million after deducting
underwriting commissions and expenses.
RESULTS OF OPERATIONS
REVENUES
We recorded revenues of $19.1 million for the three months ended September
30, 1999 compared to $1.6 million for the three months ended September 30, 1998.
Revenue was $35.6 million for the nine months ended September 30, 1999 compared
to $2.6 million for the nine months ended September 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 $16.7 million for the three
months ended September 30, 1999 and $1.4 million for the three months ended
September, 1998. Network and product costs were $32.2 million for the nine
months ended September 30, 1999 and $2.3 million for the nine months ended
September 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 $37.7 million for the three
months ended September 30, 1999 and $10.7 million for the three months ended
September 30, 1998. Sales, marketing, general and administrative expenses were
$80.8 million for the nine months ended September 30, 1999 and $17.2 million for
the nine months ended September 30, 1998.
10
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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 September 30, 1999, we recorded a total of approximately $11.6
million of deferred compensation, with an unamortized balance of approximately
$3.5 million on our September 30, 1999 consolidated balance sheet. 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 the graded vesting method. Amortization of
deferred compensation was $1.0 million for the three months ended September 30,
1999 and $1.8 million for the three months ended September 30, 1998.
Amortization of deferred compensation was $3.9 million for the nine months ended
September 30, 1999 and $2.7 million for the nine months ended September 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 $6.1 million during the three and nine
months ended September 30, 1999, respectively, and is included in depreciation
amortization on the accompanying consolidated statement of operations. 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 $10.6 million for the
three months ended September 30, 1999 and $738,000 for the three months ended
September 30, 1998. Depreciation and amortization was approximately $23.9
million for the nine months ended September 30, 1999 and $1.3 million for the
nine months ended September 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 nine months ended September 30, 1999, was $7.3 million
and $19.6 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 nine months ended September 30, 1998, was $3.5 million and $7.2
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.
11
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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 $145.6 million for the nine months ended
September 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 which we expect to incur
substantial additional expenses over the next 12 months.
From our inception through September 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 September 30,
1999, we had an accumulated deficit of $175.6 million, and cash and cash
equivalents of $181.8 million.
Net cash used in our operating activities was $65.7 million for the nine
months ended September 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 $233.9
million for the nine months ended September 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 nine months ended
September 30, 1999 was $417.0 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 $205.0 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 believe that our current cash, cash equivalents and short-term
investments, including the proceeds received from our recently completed
secondary offering in November 1999, 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:
12
<PAGE>
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.
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 or traditional telephone company equipment or software or with our
Internet service provider and enterprise 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.
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<PAGE>
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 MSA's; estimates regarding the timing of launching our service in
new MSA's expectations as to pricing for our services in the future;
the possibility that we may obtain significantly increased sales
volumes; the impact of our national advertising campaign on brand
recognition and operating results; the estimates of future operating
results; our anticipated capital expenditures; and other statements
contained in this report 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 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-3 (Commission File
No. 333-88757). We disclaim any obligation to update information contained in
any forward-looking statement.
14
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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
September 30, 1999 including our 1998 notes and our 1999 notes, is fixed-rate
debt.
15
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are engaged in a variety of negotiations, arbitrations and regulatory
and court proceedings with multiple traditional telephone companies. These
negotiations, arbitrations and proceedings concern the traditional telephone
companies' denial of physical central office space to us in certain central
offices, the cost and delivery of central office spaces, the delivery of
transmission facilities and telephone lines, billing issues and other
operational issues. For example, we are currently involved in commercial
arbitration proceedings with Pacific Bell over these issues. We have also filed
a lawsuit against Pacific Bell and its affiliates, including Southwestern Bell
Telephone Company, in federal court. We are pursuing a variety of contract,
tort, antitrust and other claims, such as violations of the Telecommunications
Act, in these proceedings. In November 1998, we prevailed in our commercial
arbitration proceeding against Pacific Bell. The arbitration panel found that
Pacific Bell breached its interconnection agreement with us and failed to act in
good faith on multiple counts. The arbitration panel ruled in favor of awarding
us direct damages, as well as attorneys' fees and costs of the arbitration.
Pacific Bell is currently attempting to have the decision vacated. Meanwhile,
the arbitration panel is evaluating our claim for additional damages. We have
also filed a lawsuit against Bell Atlantic and it 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 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.
16
<PAGE>
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 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 September 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:
Exhibit Number Description of Exhibit
- -------------- ----------------------
27.1 Financial Data Schedules for the nine months ended September
30, 1999.
- ------------
b. Reports on Form 8-K
There have been no reports on Form 8-K filed during the quarter ended
September 30, 1999.
17
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
COVAD COMMUNICATIONS GROUP, INC.
Date: November 4, 1999 BY: /s/ Timothy P. Laehy
----------------------------------
Timothy P. Laehy
Chief Financial Officer
(Principal Financial
and Accounting Officer)
18
<PAGE>
INDEX TO EXHIBITS
Exhibit Number Description of Exhibit
- -------------- ----------------------
27.1 Financial Data Schedules for the nine months ended September
30, 1999.
- --------------
19
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