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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 MARCH 31, 2000
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)
4250 BURTON DRIVE 95054
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 May 12, 2000, 150,938,167 shares of the Registrants Common Stock,
$0.001 par value, were issued and outstanding.
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COVAD COMMUNICATIONS GROUP, INC.
INDEX
<TABLE>
<CAPTION>
PAGE NO.
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements (Unaudited)
Consolidated Balance Sheets as of December 31, 1999 and
March 31, 2000 (unaudited)........................................................................3
Consolidated Statements of Operations for the Three Months Ended
March 31, 1999 and 2000 (unaudited)...............................................................4
Condensed Consolidated Statements of Cash Flows for the Three Months Ended
March 31, 1999 and 2000 (unaudited)...............................................................5
Notes to Consolidated Financial Statements (unaudited)..............................................6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................. 11
PART II. OTHER INFORMATION
Item 1. Legal Proceedings..................................................................................18
Item 2. Changes in Securities..............................................................................19
Item 5. Other Information..................................................................................19
Item 6. Exhibits and Reports on Form 8-K.................................................................. 19
SIGNATURES...........................................................................................................20
INDEX TO EXHIBITS....................................................................................................21
</TABLE>
2
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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>
MARCH 31, DECEMBER 31,
2000 1999
(UNAUDITED) (NOTE 1)
---------- ----------
ASSETS
CURRENT ASSETS:
<S> <C> <C>
Cash and cash equivalents................................................................. $ 589,145 $216,038
Accounts receivable, net.................................................................. 18,351 15,393
Short term investments.................................................................... 473,644 551,319
Unbilled revenue.......................................................................... 7,774 5,419
Inventories............................................................................... 13,162 8,547
Prepaid expenses.......................................................................... 12,053 6,048
Other current assets...................................................................... 5,317 1,219
---------- ----------
Total current assets................................................................. 1,119,446 803,983
PROPERTY AND EQUIPMENT:
Networks and communication equipment...................................................... 312,707 233,260
Computer equipment........................................................................ 37,107 24,057
Furniture and fixtures.................................................................... 7,615 4,383
Leasehold improvements.................................................................... 17,524 6,884
Land...................................................................................... 1,195 1,120
---------- ----------
376,148 269,704
Less accumulated depreciation and amortization............................................ (46,989) (32,162)
---------- ----------
Net property and equipment........................................................... 329,159 237,542
OTHER ASSETS:
Restricted cash........................................................................... 51,476 63,308
Deposits.................................................................................. 1,509 1,131
Deferred debt issuance costs (net)........................................................ 23,569 12,369
Deferred charge (net)..................................................................... 18,438 20,529
Goodwill (net)............................................................................ 395,248 --
Other long term assets.................................................................... 8,608 8,744
---------- ----------
Total other assets................................................................... 498,848 106,081
---------- ----------
Total assets......................................................................... $1,947,453 $1,147,606
========== ==========
<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
<S> <C> <C>
Accounts payable.......................................................................... $ 77,451 $ 41,126
Unearned revenue.......................................................................... 8,754 5,238
Accrued network costs..................................................................... 7,492 8,798
Other accrued liabilities................................................................. 45,167 27,104
Current portion of capital lease obligations.............................................. 210 268
---------- ----------
Total current liabilities............................................................ 139,074 82,534
Long-term debt (net of discount).......................................................... 805,619 374,737
Long-term capital lease obligations....................................................... 35 44
Other Long-term liabilities............................................................... 17,900 --
---------- ----------
Total liabilities.................................................................. 962,628 457,315
STOCKHOLDERS' EQUITY:
Preferred stock ($0.001 par value):
Authorized shares--5,000,000 at March 31, 2000 and 5,000,000 at December 31, 1999
Issued and outstanding shares--0 at March 31, 2000 and 0 at December 31, 1999 ......... -- --
Common stock ($0.001 par value):
Authorized shares--190,000,000 at March 31, 2000 and 190,000,000 at December 31, 1999,
Issued and outstanding shares--148,028,308 at March 31, 2000 and 132,331,316 at
December 31, 1999...................................................................... 132 82
Common stock - Class B ($0.001 par value):
Authorized shares--10,000,000 March 31, 2000 and 10,000,000 at December 31, 1999
Issued and outstanding shares--1,594,794 at March 31, 2000 and 6,379,177 at
December 31, 1999 ..................................................................... 6 6
Additional paid-in capital................................................................ 1,252,793 851,589
Deferred compensation..................................................................... (7,414) (6,513)
Accumulated other comprehensive income.................................................... 92,663 91,257
Accumulated deficit....................................................................... (353,355) (246,130)
---------- ----------
Total stockholders' equity ............................................................ 984,825 690,291
---------- ----------
Total liabilities and stockholders' equity ............................................ $1,947,453 $1,147,606
========== ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
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COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN 000'S, EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
------------------------
2000 1999
----------- ----------
<S> <C> <C>
Revenues.................................................................. $ 41,807 $ 5,596
Operating expenses:
Network and product costs............................................ 31,349 4,960
Sales, marketing, general and administrative......................... 89,171 18,113
Amortization of deferred compensation................................ 1,186 1,653
Depreciation and amortization........................................ 20,782 4,647
----------- ----------
Total operating expenses........................................ 142,488 29,373
----------- ----------
Loss from operations...................................................... (100,681) (23,777)
Interest income (expense):
Interest income...................................................... 13,828 3,509
Interest expense..................................................... (21,371) (8,636)
----------- ----------
Net interest income (expense)........................................ (7,543) (5,127)
----------- ----------
Other income 999 --
----------- ----------
Net loss $ (107,225) $ (28,904)
----------- ----------
Preferred dividends.................................................. -- (1,146)
Net loss available to common stockholders................................. $ (107,225) $ (30,050)
=========== ==========
Basic and diluted net loss per common stock share......................... $ (0.73) $ (0.37)
=========== ==========
Weighted average shares used in computing basic and diluted net loss per
share..................................................................... 146,967,581 80,432,965
=========== ==========
</TABLE>
4
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COVAD COMMUNICATIONS GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN 000'S)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
---------------------
2000 1999
--------- ---------
<S> <C> <C>
NET CASH USED IN OPERATING ACTIVITIES..................................... $ (17,044) $ (15,254)
INVESTING ACTIVITIES:
Purchase of restricted investments........................................ -- (74,103)
Redemption of restricted investments...................................... 13,438 --
Sale of investments....................................................... 79,081 --
Deposits.................................................................. (378) (11)
Other long-term assets.................................................... (784) (6,132)
Purchase of property and equipment........................................ (110,652) (42,802)
Cash acquired through acquisitions........................................ 3,948 --
Acquisition of business, net of cash acquired............................. (14,903) --
--------- ---------
Net cash used in investing activities .................................... (30,250) (123,048)
FINANCING ACTIVITIES:
Net proceeds from issuance of long-term debt.............................. 413,269 205,094
Principal payments under capital lease obligations........................ (67) (65)
Proceeds from common stock issuance, net of offering costs................ 7,199 150,703
Proceeds from preferred stock issuance.................................... -- 60,000
Preferred Dividends....................................................... -- (77)
--------- ---------
Net cash provided by financing activities................................. 420,401 415,655
--------- ---------
Net increase in cash and cash equivalents ................................ 373,107 277,353
Cash and cash equivalents at beginning of period.......................... 216,038 64,450
--------- ---------
Cash and cash equivalents at end of period................................ $ 589,145 $ 341,803
========= =========
Supplemental disclosures of cash flow information:
Cash paid during the period for interest............................. $ 13,257 $ --
========= =========
Supplemental schedule of non-cash investing and financing activities:
Common Stock Issued for preferred dividends.......................... $ -- $ --
========= =========
Issuance of Common Stock for acquisition of business................. $ 391,968 $ --
========= =========
</TABLE>
5
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COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
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 March 31, 2000 and for the three
month period ended March 31, 1999 are unaudited, but include all adjustments
(consisting only of normal recurring adjustments) that the Company considers
necessary for a fair presentation of financial position and operating results.
Operating results for the three month periods ended March 31, 2000 and 1999 are
not necessarily indicative of results that may be expected for any future
periods.
The consolidated balance sheet at December 31, 1999 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 1999 Annual Report on Form 10-K.
LOSS PER SHARE
Basic loss per share is computed by dividing loss applicable to common
stockholders 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 loss 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. The diluted
earnings per share amount is the same as basic loss per share, which has not
been reported because the Company has a net loss and the impact of the assumed
exercise of the stock options and warrants is not dilutive.
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, a three-for-two stock split
effective May 1999, and a three-for-two stock split effective April 2000.
6
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The following table presents the calculation of basic and diluted net loss
per share (in thousands, except share and per share amounts):
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
------------------------
2000 1999
----------- ----------
<S> <C> <C>
Net loss............................................................. $ (107,225) $ (28,904)
Preferred dividends................................................ -- (1,146)
----------- ----------
Net loss available to common stockholders............................ $ (107,225) $ (30,050)
Basic and diluted:
Weighted average shares of common stock outstanding............... 151,996,934 90,269,528
Less: Weighted average shares subject to repurchase............. 5,029,353 9,836,562
Weighted average shares used in computing basic and diluted net loss ----------- ----------
per share............................................................ 146,967,581 80,432,966
=========== ==========
Basic and diluted net loss per share................................. $ (0.73) $ (0.37)
=========== ==========
</TABLE>
2. COMPREHENSIVE INCOME
Comprehensive income for the three months ended March 31, 2000 and 1999
was as follows (in thousands):
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
--------------------
2000 1999
--------- --------
<S> <C> <C>
Net loss............................................................. $(107,225) $(28,904)
Unrealized holding gains, net of tax effect........................ 92,663 --
--------- --------
Comprehensive income................................................. $ (14,562) $(28,904)
========= ========
</TABLE>
3. SHORT-TERM INVESTMENTS
At March 31, 2000, all of the Company's investments were classified as
available for sale. Investments were also classified as short-term, as their
maturing date was less than one year from the balance sheet date. Management
determines the appropriate classification of investments at the time of purchase
and re-evaluates such designation at the end of each period. Unrealized gains
and losses on short-term investments as of March 31, 2000 and December 31, 1999,
are included as a separate component of stockholders' equity, net of any related
tax effect. The amount of realized gains or losses for the three months ended
March 31, 2000 and March 31, 1999 was not significant.
The following table summarizes the Company's investments:
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED
MARCH 31, 2000 COST GAINS LOSSES FAIR VALUE
- -------------------------------------- --------- ---------- ---------- ----------
(AMOUNTS IN $000'S)
<S> <C> <C> <C> <C>
Commercial paper...................... $ 133,870 $ -- $ (10) $ 133,860
Corporate notes....................... 8,340 -- (24) 8,316
U.S. Treasury & Agency notes.......... 182,142 -- (9) 182,133
Equity securities..................... 55,113 94,222 -- 149,335
--------- ---------- ---------- ----------
Total available for sale securities... $ 379,465 $ 94,222 $ (43) $ 473,644
========= ========== ========== ==========
</TABLE>
7
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<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED
DECEMBER 31, 1999 COST GAINS LOSSES FAIR VALUE
- -------------------------------------- --------- ---------- ---------- ----------
(AMOUNTS IN $000'S)
<S> <C> <C> <C> <C>
Commercial paper...................... $ 373,007 $ 125 $ -- $ 373,132
Corporate notes....................... 53,767 -- (596) 53,171
Equity securities..................... 32,200 92,816 -- 125,016
--------- ---------- ---------- ----------
Total available for sale securities... $ 458,974 $ 92,941 $ (596) $ 551,319
========= ========== ========== ==========
</TABLE>
The company had a net unrealized loss of $844,000 and $918,000 on long
term U.S. Treasury investments, at March 31, 2000 and December 31, 1999,
respectively, classified as restricted cash on the accompanying consolidated
balance sheet. The Company also had unrealized losses on cash and cash
equivalents which were not significant at March 31, 2000 or at December 31,
1999.
4. ACQUISITIONS
On March 20, 2000, the Company completed the acquisition of
LaserLink.net, a leading provider of branded Internet access, based in Media,
Pennsylvania in a transaction to be accounted for as a purchase. The Company
anticipates that this acquisition will allow the Company to provide a turnkey
broadband access solution to companies and affinity groups who want to offer
broadband Internet services to their customers, members, or affiliates.
LaserLink.net currently provides a similar service using dial-up access.
The amounts allocated to purchased research and development were
determined through established valuation techniques in the high technology
Internet industry and were expensed upon acquisition, because technological
feasibility had not been established and no future alternative uses existed. The
values assigned to purchased in-process technology were determined by
identifying the on-going research projects for which technological feasibility
had not been achieved and assessing the state of completion of the research and
development effort. The state of completion was determined by estimating the
costs and time incurred to date relative to those costs and time to be incurred
to develop the purchased in-process technology into commercially viable
products, estimating the resulting net cash flows only from the percentage of
research and development efforts complete at the date of acquisition, and
discounting the net cash flows back to their present value. The discount rate
included a factor that took into account the uncertainty surrounding the
successful development of the purchased in-process technology projects.
To determine the values of purchased technology, the expected future cash
flows of the existing developed technologies were discounted taking into account
the characteristics and applications of the product.
To determine the value of the customer base, the expected future cash
flows from customer payments were discounted back to their present value taking
into account, the length of contracts, payment terms, expected life cycle of a
customer relationship, and the level of internet usage.
To determine the values of the acquired workforce, it was concluded all
employees would require significant cost to replace and train. Then each
employee's partially burdened cost (salary, benefits, facilities), the cost the
train the employee, and the recruiting costs (locating, interviewing, and
hiring) were estimated. These costs were then aggregated and tax-affected to
estimate the value of the assembled workforce.
Amounts allocated to purchased technology, goodwill and other intangible
assets for the business acquisitions that follow are being amortized on a
straight-line basis over a period of five years.
8
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The purchase consideration consisted of approximately 4.3 million shares
of Common Stock with a value of $392.0 million, liabilities assumed of $3.6
million and $15.5 million in acquisitions costs. The purchase consideration of
the acquired assets and assumed liabilities were allocated based on fair values
as follows (in thousands):
Purchased in-process research and
development charged to operations............ $ 3,726
Assets acquired................................ 8,738
Purchased technology........................... 10,798
Customer base.................................. 28,552
Acquired workforce............................. 1,141
Goodwill....................................... 358,105
--------
Total purchase consideration................... $411,060
========
The pro forma results of operations for the three months ended March 31,
2000 and 1999, for Laser Link were not significant.
5. DEBT
On January 28, 2000, the Company completed a private placement of $425.0
million aggregate principal amount of the Company's 12% senior notes (the "2000
notes') due 2010 and are redeemable at the option of the Company any time after
February 15, 2005 at stated redemption prices plus accrued and unpaid interest
thereon.
Net proceeds from the 2000 Notes were approximately $413.3 million, after
discounts, commissions and other transaction costs of approximately $11.7
million. The discount and debt issuance costs are being amortized over the life
of the 2000 Notes. For the three months ended March 31, 2000, the amortization
of debt discount and debt issuance costs was $205,000.
6. 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 20,182,500 shares of
the Company's common stock at a price of $8.00 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, 41,053,865 shares of Common Stock and 6,379,177 shares of
Class B Common Stock (which are convertible into 14,353,148 shares of Common
Stock) were issued upon the conversion of Preferred Stock, 133,587 shares of
Common Stock were issued for cumulative but unpaid dividends on series A and
series B Preferred Stock and 4,049,039 shares of Common Stock were issued upon
the exercise of common warrants.
SECONDARY OFFERING:
9
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On June 23, 1999, the Company completed a public offering of 12,937,500
split adjusted 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 22,425,000
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.
10
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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, 1999 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 provider of broadband communications services to Internet
service provider, enterprise and telecommunications carrier, and other
customers. Since March 1998, we have raised $1,594.3 million of gross proceeds
from debt and equity financings to fund the deployment and expansion of our
network to date. As of March 31, 2000, we offered our services in 62
metropolitan statistical areas. We plan to build our networks and offer our
services in a total of 100 metropolitan statistical areas nationwide. As of
March 31, 2000, our networks passed 35 million homes and businesses, and we had
installed 93,000 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:
o monthly recurring service charges for connections from the end-user to
our facilities and for backhaul services from our facilities to
Internet service provider or enterprise customer;
o service order set-up and other non-recurring charges; and
o 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:
o 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 in the near future the largest
element of network and product cost will be the traditional telephone
companies' charge for our leased copper wires; and
11
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o Other costs. Other costs that we incur include those for materials in
installation and the servicing of customers and end-users, and the cost
of customer premise equipment.
The development and expansion of our business will require significant
expenditures. The principal capital expenditures incurred during the buildup
phase of any metropolitan statistical area involve the procurement, design and
construction of our central office cages, end-user DSL line cards, and
expenditures for other elements of our network design. Currently, the average
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 January 28, 2000, the Company completed a private placement of $425.0
million aggregate principal amount of the Company's 12% senior notes (the "2000
notes") due 2010. The 2000 notes are unsecured senior obligations of the Company
maturing on February 15, 2010 and are redeemable at the option of the Company
any time after February 15, 2005 at stated redemption prices plus accrued and
unpaid interest thereon. Net proceeds from the 2000 notes were approximately
$413.3 million, after discounts, commissions and other transaction costs of
approximately $11.7 million. The discount and debt issuance costs are being
amortized over the life of the 2000 notes.
On March 20, 2000, the Company completed the acquisition of LaserLink.net,
a leading provider of branded Internet access, based in Media, Pennsylvania in a
transaction to be accounted for as a purchase. Under the acquisition agreement,
the Company issued 6.5 million shares of Common Stock for all LaserLink.net
outstanding shares, plus assumption of all outstanding debt. The Company
anticipates that this acquisition will allow the Company to provide a turnkey
broadband access solution to companies and affinity groups who want to offer
broadband internet services to their customers, members, or affiliates.
LaserLink.net currently provides a similar service using dial-up access. The
total consideration related to the acquisition was $411.1 million. The company
recorded $398.6 million in goodwill related to the acquisition, which will be
amortized over a 5-year life on a straight-line basis. The company also recorded
a non-cash write-off of in process technology required for $3.7 million related
to the acquisition.
Staff Accounting Bulletin entitled SAB 101 "Revenue Recognition in
Financial Statements," was issued in December 1999 by the Securities and
Exchange Commission. SAB 101 provides that, in certain circumstances, revenues,
which are received in the first month of a contract, might have to be recognized
over an extended period of time, instead of in the first month of the contract.
Due to complications surrounding the implementation of SAB 101, in March
2000 the SEC deferred the implementation date of certain provisions of SAB 101
until the quarter ended June 30, 2000, with retroactive application to
transactions entered into during the quarter ended March 31, 2000. This
extension will allow the Company and other companies impacted by
12
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this Bulletin adequate time to fully understand the broader implications of SAB
101 and to respond accordingly. The Company believes that based on the current
guidelines, its revenue recognition policy is in accordance with generally
accepted accounting principles.
On February 15, 2000 the Company's Board of Directors adopted a
Stockholder Rights Protection Plan under which stockholders received one right
for each share of our Common Stock or Class B Common Stock owned by them. The
rights become exercisable, in most circumstances, upon the accumulation by a
person or group of 15% or more of our outstanding shares of Common Stock. Each
right entitles the holder to purchase from the Company, as provided by the
Stockholder Protection Rights Agreement, one one-thousandth of a share of
Participating Preferred Stock, par value $.001 per share, for $400.00, subject
to adjustment.
On March 7, 2000, the Company announced a 3-for-2 stock split, which was
effectuated through a stock dividend. Our Common Stock began trading on a
split-adjusted basis on April 3, 2000.
RESULTS OF OPERATIONS
REVENUES
We recorded revenues of $41.8 million for the three months ended March 31,
2000 compared to $5.6 million for the three months ended March 31, 1999. This
increase is attributable to growth in the number of customers and end-users
resulting from our increased sales and marketing efforts and the expansion of
our 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 $31.3 million for the three
months ended March 31, 2000 and $5.0 million for the three months ended March
31, 1999. This increase is attributable to the expansion of our networks and
increased orders resulting from our sales and marketing efforts. We expect
network and product costs to increase significantly in future periods due to
increased sales activity and expected revenue growth.
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 $89.2 million for the three
months ended March 31, 2000 and $18.1 million for the three months ended March
31, 1999. This increase is attributable to growth in headcount in all areas of
our company, continued expansion of our sales and marketing efforts, deployment
of our networks and building of our operating infrastructure. Sales, marketing,
general and administrative expenses are expected to increase significantly as we
continue to expand our business.
DEFERRED COMPENSATION
Through March 31, 2000, we recorded a total of approximately $17.7 million
of deferred compensation, with an unamortized balance of approximately $7.4
million on our March 31, 2000 consolidated balance sheet. This deferred
compensation is a result of us granting stock options to our employees, certain
of our directors, and
13
<PAGE>
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 $1.2 million for the three months ended March 31, 2000 and $1.7 million for
the three months ended March 31, 1999.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization includes:
o depreciation of network costs and related equipment;
o depreciation of information systems, furniture and fixtures;
o amortization of improvements to central offices, regional data centers
and network operations center facilities and corporate facilities;
o amortization of capitalized software costs; and
o amortization of intangible assets, including goodwill.
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 and $1.9 million during the three months ended March
31, 2000 and 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 $20.8 million for the
three months ended March 31, 2000 and $4.6 million for the three months ended
March 31, 1999. This increase was due to the increase in equipment and
facilities placed in service throughout the period as well as amortization of
intangible assets. We expect depreciation and amortization to increase
significantly as we increase our capital expenditures to expand our networks.
NET INTEREST INCOME AND EXPENSE
Net interest income and expense consists primarily of interest income on
our cash balance and interest expense associated with our debt. Net interest
expense for the three months ended March 31, 2000, was $7.5 million. Net
interest expense during this period consisted primarily of interest expense on
the 1998 notes, the 1999 notes, and the 2000 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, the 1999 notes, and the
2000 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
months ended March 31, 1999, was $5.1 million. Net interest expense during this
period 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.
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 $110.7 million for the three months
ended March 31, 2000. We expect that our capital expenditures will be
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.
14
<PAGE>
From our inception through March 31, 2000, 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, $205.0 million in net
proceeds raised from the issuance of the 1999 notes, $568.8 million in net
proceeds raised from our public offering on November 3, 1999 and $413.3 million
in net proceeds from the issuance of the 2000 notes. As of March 31, 2000, we
had an accumulated deficit of $353.4 million, and cash, cash equivalents, and
short-term investments of $1,062.8 million.
Net cash used in our operating activities was $17.0 million for the three
months ended March 31, 2000. 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 $30.3 million for the
three months ended March 31, 2000. The net cash used for investing activities
during this period was primarily due to purchases of property and equipment, the
acquisition of Laser Link, and a $23 million equity investment was made with a
strategic partner.
Net cash provided by financing activities for the three months ended March
31, 2000 was $420.4 million, which primarily related to the net proceeds of
$413.3 million from the issuance of the 2000 notes with an aggregate principal
amount of $425.0 million.
We believe that our current cash, cash equivalents and short-term
investments, including the proceeds received from our recently completed
issuance of 12% senior notes (2000 notes), will be sufficient to meet our
anticipated cash needs for working capital and capital expenditures through at
least mid-2001.
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:
o the number of regions entered, the timing of entry and services
offered;
o network development schedules and associated costs;
o the rate at which customers and end-users purchase our services and the
pricing of such services;
o the level of marketing required to acquire and retain customers and to
attain a competitive position in the marketplace;
o the rate at which we invest in engineering and development and
intellectual property with respect to existing and future technology;
o existing and future technology; and
o 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.
15
<PAGE>
YEAR 2000 ISSUES
Many currently installed computer systems and software products are coded
to accept only two-digit entries in the date code field and cannot distinguish
21st century dates from 20th century dates. These date code fields will need to
distinguish 21st century dates from 20th century dates and, as a result, many
companies' software and computer systems may need to be upgraded or replaced in
order to comply with such "Year 2000" requirements.
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.
To date, we have not experienced any problems in complying with Year 2000
requirements, nor have we experienced or expect to experience any operational
difficulties related to Year 2000 issues.
FORWARD-LOOKING STATEMENTS
The statements contained in this Report on Form 10-K that are not
historical facts are "forward- looking statements" (as such term is defined in
Section 27A of the Securities Act and Section 21E of the Exchange Act), which
can be identified by the use of forward-looking terminology such as "estimates,"
"projects," "anticipates," "expects," "intends," "believes," or the negative
thereof or other variations thereon or comparable terminology, or by discussions
of strategy that involve risks and uncertainties. Examples of such
forward-looking statements include but are not limited to:
o our plans to expand our existing networks or to commence service in new
metropolitan statistical areas;
o estimates regarding the timing of launching our service in new
metropolitan statistical areas;
o expectations regarding the time frames, rates, terms and conditions for
implementing line sharing;
o expectations regarding the extent to which enterprise customers roll
out our service;
o expectations regarding our relationships with our strategic partners
and other potential third parties;
o expectations as to pricing for our services in the future;
o expectations as to the impact of our TeleSurfer service offerings on
our margins;
o the possibility that we may obtain significantly increased sales
volumes;
o the impact of our national advertising campaign on brand recognition
and operating results;
o the plans to make strategic investments and acquisitions and the affect
of such investments and acquisitions;
o estimates of future operating results;
16
<PAGE>
o plans to develop and commercialize value-added services;
o our anticipated capital expenditures;
o plans to enter into business arrangements with broadband-related
service providers;
o expectations regarding the commencement of our voice service; and
o the effect of regulatory reform and regulatory litigation; 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 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:
o successfully market our services to current and new customers;
o generate customer demand for our services in the particular regions
where we plan to market services;
o achieve favorable pricing for our services;
o respond to increasing competition;
o manage growth of our operations;
o access regions and negotiate suitable interconnection agreements with
the traditional telephone companies, all in a timely manner, at
reasonable costs and on satisfactory terms and conditions consistent
with regulatory, legislative and judicial developments; and
o implement new network capabilities and new service offerings.
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 Report on Form 10-K for the year ended
December 31, 1999. We disclaim any obligation to update information contained in
any forward-looking statement.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to financial market risk, including changes in interest rates
and marketable equity security prices, relates primarily to our investment
portfolio and outstanding debt obligations. We typically do not attempt to
reduce or eliminate our market exposure on our investment securities because a
substantial majority of our investments are in fixed-rate, short-term
securities. We do not have any derivative instruments. The fair value of our
investments portfolio or related income would not be significantly impacted by
either a 100 basis point increase or decrease in interest rates due mainly to
the fixed-rate, short-term nature of the substantial majority of our investment
portfolio. In addition, substantially all of our outstanding indebtedness at
March 31, 2000 including our 1998 notes, our 1999 notes, and our 2000 notes is
fixed-rate debt.
17
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is 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 the Company 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, the Company is currently involved in
commercial arbitration proceedings with Pacific Bell over these issues. The
Company has also filed a lawsuit against Pacific Bell and certain of its
affiliates, including SBC Communications, in federal court. The Company is
pursuing a variety of contract, tort, and antitrust and other claims, such as
violations of the Telecommunications Act, in these proceedings. In November
1998, the Company prevailed in its commercial arbitration proceeding against
Pacific Bell. The arbitration panel found that Pacific Bell breached its
interconnection agreement with the Company and failed to act in good faith on
multiple counts. The arbitration panel ruled in favor of awarding the Company
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 the Company's claim for additional damages.
The Company also filed a lawsuit against Bell Atlantic and its affiliates
in federal court and is pursuing antitrust and other claims in this lawsuit. In
addition, Bell Atlantic has separately filed suit against the Company asserting
infringement of a patent issued to them in September 1998 entitled "Variable
Rate and Variable Mode Transmission System." However, on February 18, 2000 the
court issued a summary judgment ruling holding that the Company had not
infringed Bell Atlantic's patent. The Company anticipates that Bell Atlantic may
appeal this decision and, while the Company expects that it would prevail on an
appeal, the outcome of such an appeal is uncertain.
A former employee of the Company has filed a complaint against the Company
in California Superior Court, alleging that he was terminated wrongfully and is
entitled to commissions and other amounts arising from his employment. The
Company believes this employee resigned and it does not owe him any money, but
litigation is unpredictable and there is no guarantee the Company will prevail.
Another group of former employees has filed a complaint against the Company in
California Superior Court, alleging that they were terminated wrongfully and are
entitled to stock options, appreciation on stock options, and other amounts
arising out of their employment. The Company believes it does not owe these
employees any money, but there is no guarantee the Company will prevail. Failure
to resolve these various legal disputes and controversies without excessive
delay and cost and in a manner that is favorable, could significantly harm the
business.
The Company is not currently engaged in any other legal proceedings that
it believes could have a material adverse effect on the Company business,
prospects, operating results and financial condition. The Company is 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
the Company interconnection agreements in particular. In some cases, the Company
may be deemed to be bound by the results of ongoing proceedings of these bodies
or the legal outcomes of other contested interconnection agreements that are
similar to our agreements. The results of any of these proceedings could harm
the business.
18
<PAGE>
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
ITEM 5. OTHER INFORMATION
NONE
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a. Exhibits:
EXHIBIT NUMBER DESCRIPTION OF EXHIBIT
- -------------- ----------------------
27.1 Financial Data Schedules for the three months ended
March 31, 2000.
- --------------
b. Reports on Form 8-K
Form 8-K filed on February 7, 2000.
Form 8-K filed on February 22, 2000.
Form 8-K filed on March 9, 2000.
Form 8-K filed on March 23, 2000.
19
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
COVAD COMMUNICATIONS GROUP, INC.
Date: May 15, 2000 By: /s/ Timothy P. Laehy
-----------------------
Timothy P. Laehy
Chief Financial Officer
(Principal Financial and
Accounting Officer)
20
<PAGE>
INDEX TO EXHIBITS
EXHIBIT NUMBER DESCRIPTION OF EXHIBIT
- -------------- ----------------------
27.1 Financial Data Schedules for the three months ended
March 31, 2000.
- --------------
21
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