DVW Covad Communications Grp.,

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

 

Form 10-K

 

 

Commission file number 001-32588

 

Covad Communications Group, Inc.

 

 

110 Rio Robles, San Jose, California 95134
(408) 952-6400

 

Securities registered pursuant to Section 12(b) of the Act:
None

 

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.001 per share
Stock Purchase Rights Pursuant To Rights Agreement

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  o      No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  o      No þ

 

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  þ      No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o      No þ

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was sold on June 29, 2007 as reported on the American Stock Exchange, was approximately $266 million. Shares of common equity held by each officer and director and by each person who owns 5% or more of the outstanding common equity have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.  Yes  þ      No  o

 

As of February 14, 2008 there were 299,118,331 shares outstanding of the Registrant’s Common Stock and no shares outstanding of the Registrant’s Class B Common Stock.

 

 

COVAD COMMUNICATIONS GROUP, INC.
For the Fiscal Year Ended December 31, 2007

 

TABLE OF CONTENTS

 

 

and we continue to experience churn among our existing end-users due to pricing pressures and other factors. As a result of these market conditions, we have added or increased our focus on the following:

 

 

We believe there is a substantial business opportunity to grow our sales of these services. While we believe we are favorably positioned to take advantage of this market opportunity, it is inherently difficult to predict with a high degree of certainty our ability to grow our sales of these services and whether our sales of these services will offset slowing sales of our stand-alone DSL services.

 

We were originally incorporated in California as Covad Communications Company in October 1996. In July 1997, we were incorporated in Delaware as Covad Communications Group, Inc., a holding company that conducts substantially all of its business through its operating wholly-owned subsidiaries.

 

On October 28, 2007, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) pursuant to which an affiliate of Platinum Equity, LLC, CCGI Holding Corporation, will acquire all of the outstanding shares of our common stock at a price of $1.02 per share through the merger (the “Merger”) of CCGI Merger Corporation, a wholly-owned subsidiary of CCGI Holding Corporation, with and into Covad. The transaction is subject to the approval of our stockholders and the satisfaction of customary closing conditions, including the approval of the Federal Communications Commission, or FCC, and state public utility commissions, or PUCs, in many of the states in which we operate and the absence of any material adverse effect on our company prior to the consummation of the Merger. These and other conditions are set forth in the Merger Agreement.

 

Additionally, on October 28, 2007, in connection with the proposed Merger, we and Mellon Investor Services, LLC entered into a Second Amendment to the Amended and Restated Stockholder Protection Rights Agreement (the “Rights Agreement Amendment”), which amends our Amended and Restated Stockholder Protection Rights Agreement, dated November 1, 2001, as amended (the “Rights Agreement”), to provide that CCGI Holding Corporation shall not be deemed an “Acquiring Person” under the Rights Agreement solely by virtue of the execution of the Merger Agreement or the consummation of the Merger.

 

If the Merger Agreement is terminated, under certain circumstances, we will be required to pay CCGI Holding Corporation a termination fee of $12,000. Upon consummation of the Merger, our company will become a wholly-owned subsidiary of CCGI Holding Corporation, and our stock will cease to be publicly traded. Accordingly, this annual report on Form 10-K should be read with the understanding that should the Merger be completed, Platinum Equity will have the power to control the conduct of our company’s business, and our company will no longer exist as a publicly traded company.

 

Industry Background

 

DSL technology first emerged in the 1990’s and is commercially available today to address performance bottlenecks of the public switched telephone network, or PSTN. DSL equipment, when deployed at each end of standard copper telephone lines, increases the data carrying capacity of copper telephone lines from analog modem speeds of up to 56.6 kilobits per second, for the fastest consumer modems, and Integrated Services Digital Network, or ISDN, speeds of up to 128 kilobits per second to DSL speeds of up to 15 megabits per second downstream and up to 3.0 megabits per second upstream, depending on the length and condition of the copper line. With certain products such as fixed wireless services, we can offer speeds of up to 100 megabits per second.

 

The passage of the 1996 Telecommunications Act created a legal framework for competitive telecommunications companies to provide local, analog and digital communications services in competition with the ILECs. The 1996 Telecommunications Act allowed these competitive telecommunications companies to use certain parts

of the existing infrastructure built by the ILECs rather than constructing a competing infrastructure at significant cost. Among other things, this infrastructure includes telephone lines and space in the ILECs central offices.

 

Fixed broadband wireless service has also emerged as an alternative to wireline services. Fixed wireless differs from mobile wireless service, such as cellular or wi-fi, because the location of the end user is fixed. Improvements in technology and wider acceptance of wireless services have reduced the cost to deploy fixed wireless services. In addition, the development of the WiMax standard is expected to facilitate broader deployments of these services.

 

Our Service Offerings

 

Our service offerings can be grouped into two main categories, data and voice services. We deliver these services through our broadband wireline and fixed wireless networks. Our direct customers can purchase our data services separately, while our voice services are typically offered in a bundle with our data services. Within our data suite of services, we offer a variety of business and consumer-grade broadband access services, email, Internet security, and hosting services. Our business-grade wireline data services are sold under the TeleSpeed, TeleSoho and TeleXtend brands for wireline services, and our business grade fixed wireless services are sold under our Covad Wireless (formerly referred to as NextWeb) brands for fixed wireless services. Our consumer-grade wireline services are sold under the TeleSurfer brand. In addition, resellers may purchase high-capacity network backhaul services from us to connect their facilities to our network and to provide direct technical support for their end-users. Our voice services are sold under the Covad ClearEdge brand. We also offer LPVA, which enables a wholesale partner to combine analog voice service with our consumer-grade data services.

 

The specific number of potential end-users who qualify for DSL service varies by central office and by region and is affected by line quality, distance and type of telephone loop facility deployed in a particular area. The specific number of potential end-users who qualify for fixed wireless services depends on distance from a base station, geography (such as to topology and the location of interfering buildings and trees) and the availability and characteristics of the type of wireless spectrum being used. Prices for our end-user services vary depending on the performance level of the service, the underlying technology used to deliver the service and our costs for offering a service. Our prices also vary for high volume customers that are eligible for volume discounts. See Part I, Item 1A. “Risk Factors — We may experience decreasing margins on the sale of our services, which may impair our ability to achieve profitability or positive cash flow” for a discussion of some of the risks associated with our ability to sustain current price levels in the future.”

 

TeleSpeed

 

We launched service in December 1997 with our TeleSpeed services. We provision TeleSpeed services via symmetric (download and upload speeds are equal) DSL, or SDSL, and ISDN DSL, or IDSL, technologies. These services are offered in a variety of speeds ranging from 144 kilobits to 1.5 megabits per second. TeleSpeed services are intended to connect individual end-users on previously unused conventional telephone lines to our DSL equipment in their serving central office and from there to our network serving that metropolitan statistical area. The particular TeleSpeed service available to an end-user depends in large part on the end-user’s distance to his or her respective central office. TeleSpeed services are offered with specific service levels of performance and repair times based on our service level agreements, or SLAs.

 

TeleSoho

 

We introduced our TeleSoho service in September 2001. We designed TeleSoho for the Small Office/Home Office, or SoHo, customer segment. The service is asymmetric (faster download than upload speeds), offering speeds up to 15.0 megabits per second downstream and up to 1.0 megabit per second upstream, and can be delivered to end-users using a self or professional installation. TeleSoho is provisioned with an asymmetric DSL, or ADSL, router capable of supporting multiple end-users and can support one fixed Internet Protocol, or IP, address. Line-sharing and self-installations reduce the monthly recurring cost and the up-front cost for installation of the service. TeleSoho services provisioned over a shared line do not include service level agreements.

 

In July 2004, we introduced second-line TeleSoho services, which we provision over a dedicated line, instead of a shared line. Our second-line TeleSoho services provide features and performance similar to our TeleSoho line-

shared services, but allow a customer to purchase the service without purchasing telephone service from the local telephone company. In addition, our second-line TeleSoho service includes service level commitments.

 

TeleXtend

 

We introduced our TeleXtend services in November 2001. These services allow end-users to connect to our network equipment in their local central offices over a DS-1 line, which may also be referred to as a T-1. The availability of TeleXtend services is not limited by distance from the servicing central office and is accompanied with service level agreements (SLAs) providing for our highest level of service. In May 2007, we began offering bonded T-1 services, which provide for symmetrical speeds of 3.0 megabits per second.

 

TeleSurfer

 

We introduced our TeleSurfer service in April 1999. TeleSurfer is designed for consumers. This service is asymmetric, offering speeds up to 1.5 megabits per second downstream and up to 128 kilobits per second upstream and uses dynamic IP addressing. We generally deliver this service to customers using a self-installation kit over a line-shared loop. Line-sharing and self-installations reduce the monthly recurring cost and the up-front cost for installation of the service. This service is not sold with SLAs.

 

In July 2004, we introduced second-line TeleSurfer services, which we provision over a dedicated telephone line. Our second-line TeleSurfer services provide features and performance similar to the TeleSurfer line-shared services, but allow a customer to purchase this service without purchasing telephone service from the local telephone company. Neither shared line nor second line TeleSurfer services are sold with service level agreements.

 

Fixed Broadband Wireless

 

Through our wholly-owned subsidiary, NextWeb, Inc., or NextWeb, which does business under the name Covad Wireless, we are currently offering business-grade fixed broadband wireless services to customers in the San Francisco Bay Area, Los Angeles, Orange County (California), Santa Barbara, Las Vegas and Chicago. This service is sold directly to end-users. We offer speeds of up to 9.0 megabits per second downstream and upstream using unlicensed spectrum and up to 100 megabits per second downstream and upstream using licensed spectrum that we lease from other companies that hold the spectrum licenses. Our fixed broadband wireless services are offered with specific service levels of performance and times for repairs based on our service level agreements. By offering fixed wireless broadband services, we expect that in the future we may be able to reduce our dependence on the ILECs for the network elements that we currently use to offer our services in the areas where we operate fixed wireless facilities. We also expect our recurring costs for fixed wireless end-users will be lower because in many cases we do not have to pay a monthly charge for a fixed wireless connection that is provisioned over our own network. In many cases we also can install fixed wireless services more quickly than we can install services that rely on network elements that we purchase from the ILECs. Finally, in some cases fixed wireless allows us to offer higher speed services than we can currently offer over our wireline network.

 

Voice over Internet Protocol for Businesses

 

In June 2004, we completed our acquisition of GoBeam, Inc., or GoBeam, and introduced our business-class VoIP services to small and medium-sized businesses. These services enable customers to use IP and Internet connections to make local and long distance telephone calls over our network instead of using the traditional PSTN. We sell two VoIP services, Covad ClearEdge Pro and Covad ClearEdge Integrated Access. Covad ClearEdge Pro is intended as a substitute for a small business’s telephone Private Branch Exchange, or PBX, system and includes call features such as “find me, follow me,” web conferencing, call forwarding, instant messaging and unified voicemail and fax services. It is a hosted voice service, eliminating the need for on premise voice switching equipment. For customers who want to keep their existing PBX system, Covad ClearEdge Integrated Access has some of the same features as our Covad ClearEdge Pro service, but it works with an end-user’s existing PBX system to deliver local, long distance and Internet services over one managed network connection, an alternative to using multiple connections.

We believe that our Covad ClearEdge Pro services provide cost advantages over PBX-based models because our customers do not need to purchase additional telephone line connections from other providers or install telephone switches at their premises. Customers of our Covad ClearEdge Pro services also can realize productivity improvements and reduce costs for in-house technical personnel, who typically are required to install and maintain a PBX-based telephone service.

 

While our VoIP services for businesses target a large market, we are continuing to enhance and expand our capability to market and sell these services through various channels. As a result, we will also continue to further enhance the internal systems and processes to support these new services, channels and additional customers.

 

Line Powered Voice Access

 

In January of 2006, EarthLink, Inc., or EarthLink, one of our wholesale customers, began offering a consumer-grade bundled voice and data service deployed over the telephone lines that we lease from the RBOCs to provide data services. We refer to the portion of this service we provide as line powered voice access, or LPVA. EarthLink adds local and long distance voice and related services to our LPVA service, which includes high-speed Internet access, using consumers’ existing wiring, telephone and computer equipment. Our LPVA service is intended to allow our partners to compete with the consumer voice and data bundles offered by the RBOCs and the cable companies. Our LPVA service is used as part of EarthLink’s voice and data bundle in twelve metropolitan areas.

 

In order to offer LPVA service, we have deployed new Digital Subscriber Line Access Multiplexers, or DSLAMs in the RBOCs central offices in these twelve major metropolitan areas. If we decide to offer LPVA service out of additional central offices, we will need to similarly deploy new equipment in those locations. We do not currently intend to offer this service through our Direct segment, whose voice needs we service with our VoIP services.

 

Asynchronous Transfer Mode, or ATM, Network Services

 

We also provide DS-3 and OC-3 circuit backhaul services to our wholesale customers that resell our wireline and fixed wireless services under their own brand names. These ATM network services backhaul data traffic from our regional network to a reseller’s site. ATM network services aggregates data traffic from individual end-users in a region and transmits the packets of information to the reseller over a single high-capacity connection. The service utilizes ATM protocol that operates at up to 45 megabits per second for DS-3 circuits and up to 155 megabits per second for OC-3 circuits.

 

Broadband Internet Access Service

 

Our Broadband Internet Access Service, or BIA, allows our resellers to sell broadband to their end-user customers without having to invest in network facilities. This service currently bundles IP services with our high-speed connectivity services to provide a complete connection to the Internet. The additional IP services include end-user authentication, authorization and accounting, IP address assignment and management, domain name service and IP routing and connectivity.

 

Value-Added Services

 

In addition to access and voice services, we offer value-added services to our wholesale and direct customers who purchase services directly from us. These services include:

 

Email and Web Hosting — These services allow small and medium-sized businesses to have a custom domain name, for example www.mybusiness.com, as well as business-class email and web hosting. All services come with anti-spam and anti-virus protection and easy-to-use website building tools and templates.

 

Security Services — We resell McAfee anti-virus software as well as Covad-branded firewall and VPN services to our direct customers.

Installation Services — We offer professional installation services to our wholesale and direct customers in connection with our services. In some cases our customer may request that we install additional equipment, services or software, such as a firewall or a virtual private network, for an additional fee.

 

Sales and Marketing

 

Wholesale

 

We sell our broadband services to ISPs, telecommunications carriers and other resellers. These resellers purchase our services on a wholesale basis and sell them under their own brand. We had approximately 440 resellers as of December 31, 2007. For 2007, our 30 largest resellers collectively accounted for 90.2% of our total wholesale net revenues and 57.0% of our total net revenues. For 2007, AT&T and EarthLink, two of our resellers, accounted for 12.3% and 11.3%, respectively, of our total net revenues. As of December 31, 2007, approximately 416,000 end-users purchased services through our resellers.

 

We offer our resellers a range of DSL, T-1, fixed wireless, and LPVA services that they in turn offer to their business and consumer customers. They can either combine our DSL and T-1 lines with their own Internet access services or purchase our BIA services and resell the combination to their customers. Our agreements with our resellers generally have terms of one to three years and are non-exclusive. We generally do not require these resellers to generate a minimum number of end-users or a minimum amount of revenue, but we grant volume discounts based on subscriber volume.

 

Strategic resellers with established brand names help us deliver our services to a larger number of end-users. The cost of acquiring a customer for broadband services is significant, so leveraging the brand of our resellers, their customer bases, and embedded direct and indirect sales channels helps us reduce this cost. We provide our resellers with sales and marketing support. We work jointly with our resellers to develop and fund marketing programs that are specific to their target markets, product offerings and sales objectives. We also work to improve our resellers’ cost of acquisition by assisting them with direct marketing, promotions, and incentive programs.

 

Direct

 

We also sell our services directly and indirectly to end-user customers. We sell VoIP, high-speed data and voice connectivity, fixed wireless broadband and related value-added services directly through our direct sales force, telephone sales and Web sales capabilities. We also sell our services indirectly via a variety of third parties such as dealers, sales agents, referral partners and affinity groups. Our approach to this market is to combine our national network with other features to deliver services to small offices, home offices and small and medium-sized businesses, as well as distributed enterprises. As of December 31, 2007, we had approximately 71,000 broadband lines, approximately 2,300 VoIP business customers with a combined total of approximately 4,000 VoIP sites, and approximately 3,600 fixed wireless broadband customers in service under our Covad brand.

 

Our marketing programs and communications to small and medium-sized businesses are primarily designed to increase brand awareness and encourage potential customers to contact our telesales center or visit our website. We use national and local marketing campaigns. We employ a wide variety of media, including on-line advertisements, direct mail, radio and print.

 

Our telesales and field sales teams also sell our services via outbound calling and “feet on the street” sales. Our telesales groups make outbound calls to individuals or organizations that have visited our website and to lists of pre-qualified businesses that match the profile of customers who have purchased services from us in the past. The field sales organization targets distributed and enterprise customers that purchase our services for distribution across their enterprise, such as connecting remote offices back to their corporate headquarters.

 

Our referral resources include sales agents, dealers and referral partners that receive one-time or recurring commissions in exchange for referring customers to us. In many cases, the sales agents, dealers and referral partners are telecommunications specialists that provide information technology, telecommunications, and networking services and products to business customers. By being part of our Alliance Network, our partners are able to complement their existing services and provide our broadband and VoIP services to their customers.

Network Architecture and Technology

 

We designed our network to provide the following attributes, which we believe are important requirements for our existing and potential customers:

 

Consistent and Scalable Performance  — We believe that packet networks will play an increasingly central role in the communications services market in the United States. With this in mind, we designed our network for scalability and consistent performance as we add new users and services. We have designed a nationwide network that is organized around our regional metropolitan areas and interconnected across the country. It is likely that our continued growth and the increasing amount of bandwidth required by our customers for applications like voice and video streaming will require that we continue to upgrade our equipment and purchase additional network capacity.

 

Intelligent End-to-End Network Management  — Because customers’ lines are continuously connected, we have visibility from the ISP or enterprise site across the network all the way down to the customer’s line, and for certain high-value customers, further down to their customer premise equipment, or CPE. Because our network is centrally managed, we can identify and improve network quality, service and performance.

 

Flexibility  — We have designed our network to be flexible in handling various types of network traffic, including data, voice, and potentially extending to video information in the future. This flexibility will allow us to carry not only value-added services such as VoIP, but will also allow us to control the prioritization of content delivery over our national network. We accomplish the prioritization and quality of service control using ATM technology, which allows us to support both non-real time and real-time applications and allocates bandwidth among customers.

 

Network Operations Centers  — Our entire network is managed from a network operations center located in the San Francisco Bay Area. We provide end-to-end network management using advanced network management tools on a 24x7 basis, which enhances our ability to address performance or connectivity issues.

 

Nationwide Broadband Access and Internet Connectivity  — We link each of our metropolitan areas together with leased high-speed private backbone network connections. Our Internet access points are strategically located at high-speed interconnection facilities across the country in order to increase the performance and decrease the latency of connections to the Internet for our customers.

 

Private Metropolitan Network  — We operate our own private metropolitan network in each region that we provide service. The network consists of high-speed communications circuits that we lease to connect our hubs, our equipment in individual central offices, our Internet access points, and our resellers and direct customers with multiple locations. We have leased fiber optic networks using Synchronous Optical Network, or SONET, technology in four of our major metropolitan areas. Our metropolitan networks operate at speeds of 45 megabits per second to 4.8 gigabits per second.

 

Central Office Spaces  — Through our interconnection agreements with the ILECs, we lease space in central offices where we offer service. We require access to these spaces for our equipment and for persons employed by or under contract with us. We place DSLAMs in our central office spaces to provide the high-speed DSL signals on each copper line to our end-users. As of December 31, 2007, we had 2,049 operational central offices.

 

Telephone Lines  — We lease the telephone lines running to end-users from the ILECs under terms specified in our interconnection agreements. We lease lines that, in many cases, must be specially conditioned by the ILECs to carry digital signals, usually at an additional charge relative to that for voice grade telephone lines. We also provide some of our services over telephone lines that already carry the voice service of an ILEC, known as line-sharing. Our continuing ability to use these line-shared telephone lines is dependent on our ability to maintain and enter into agreements with the three largest ILECs, the RBOCs, or to obtain favorable regulatory rulings.

 

Fixed Wireless Connections  — We sell fixed wireless broadband services directly to end users in the San Francisco Bay Area, Los Angeles, Orange County (California), Santa Barbara, Chicago and Las Vegas. We are evaluating whether we will offer the service in additional markets. We offer this service using a

combination of licensed and unlicensed wireless spectrum. The advantage of using licensed spectrum is that it is easier to prevent interference from other providers. Much of the licensed spectrum we use today is licensed directly by the FCC on a point-to-point basis. Additionally, some licensed spectrum we use is leased from third party license holders. For this reason, we incur additional operating expenses using licensed spectrum. In contrast, unlicensed spectrum requires less operating expense, but the management of the interference caused by other devices and service providers requires careful engineering. In order to offer our fixed wireless services we must deploy radios and antennas in the areas where we intend to offer the service. This usually means that we need to secure roof or antenna rights in these markets, which requires additional expenditures. Our fixed wireless service uses pre-WiMax equipment. WiMax is a set of specifications for wireless equipment and services that will encourage the interoperability of solutions from different suppliers. We currently plan to gradually upgrade our fixed wireless network to the WiMax standard when this equipment is available.

 

DSL Modems, Telecommunications Equipment and On-Site Connection  — We buy CPE from our suppliers for resale to our customers. In order to provide our business-class services to an end-user we currently have to configure and install CPE along with any required on-site wiring needed to connect the CPE to the copper line leased from the ILEC. Our fixed wireless services similarly require the deployment of CPE at the customer’s location. For our consumer access services, CPE is included in self-installation kits provided by us or our resellers. We ship the kits to end-users, who, in most cases, perform their own installation. Customers who purchase our VoIP services from us may also purchase office telephone equipment, such as telephones and conference speakerphones.

 

Competition

 

We face significant competition in the markets for business and consumer Internet access, network access, wireless broadband and voice services and we expect this competition to intensify. The principal bases of competition in our markets include price and performance, discounted rates for bundles of services, breadth of service availability, reliability of service, network security, and ease of access and use. We face competition from the following categories of companies:

 

 

Interconnection Agreements with the Regional Bell Operating Companies

 

A critical aspect of our business is our interconnection agreements with the three largest ILECs, the RBOCs.

 

These agreements cover a number of aspects including:

 

 

 

We have entered into interconnection agreements with or otherwise obtained interconnection rights from the three RBOCs in the states covering the metropolitan areas we serve. RBOCs often do not agree to our requested provisions in interconnection agreements. When we cannot agree, the 1996 Telecommunications Act provides for arbitration of interconnection agreement terms before state PUCs. We have not consistently prevailed in obtaining our desired provisions in such agreements.

 

Some of our interconnection agreements have a term of three years. Under our interconnection agreements, either party can request renegotiation prior to the agreement’s expiration if there is a change in law. We will also have to renew these agreements when they expire. Although we expect to renew the interconnection agreements that require renewal and believe the 1996 Telecommunications Act limits the ability of ILECs not to renew such agreements, we may not succeed in extending or renegotiating our interconnection agreements on favorable terms. Additionally, disputes have arisen and will likely arise in the future as a result of differences in interpretations of the interconnection agreements. In the past, these disputes have delayed our deployment of our network. Such disputes have also adversely affected our service to our customers and our ability to enter into additional interconnection agreements with the RBOCs in other states. Finally, the interconnection agreements are subject to state PUCs, FCC, and judicial oversight. These government authorities may modify the terms of the interconnection agreements in a way that adversely affects our business.

 

Government Regulation

 

Overview — Our services are subject to a variety of federal laws and regulations. With respect to certain activities and for certain purposes, we have also submitted our operations to the jurisdiction of state and local authorities who may also assert more extensive jurisdiction over our facilities and services. The FCC has jurisdiction over our facilities and services to the extent that we provide interstate and international communications services. To the extent we provide certain identifiable intrastate services, our services and facilities may be subject to a variety of state laws and regulations. Rates for the services and network elements we purchase from the RBOCs are, in many cases, determined by the applicable state PUCs. In addition, local municipal governments may assert jurisdiction over our facilities and operations, such as through government-owned rights of way and local zoning. The precise jurisdictional reach of the various federal, state and local authorities is uncertain because it is subject to ongoing controversy and judicial review.

 

Recent Developments — In June 2006, the United States Court of Appeals for the D.C. Circuit upheld the FCC’s order changing its rules regarding the obligations of ILECs to share their networks with competitive telecommunications companies like us. These rules include the following changes:

 

 

 

Implementation of these rules is governed by the interconnection agreements between ILECs and competitive carriers. The implementation and interpretation of the rules, including the dates that specific aspects of the new rules affect network elements, continue to be the subject of disputes in state PUCs and other venues.

 

The FCC decision mentioned above was a modification of the FCC’s previous Triennial Review order, which was issued in 2003, referred to as the Original Triennial Review Order. This order also represented a significant development for us because the FCC decided to phase out its rule requiring line-sharing pursuant to Section 251 of the 1996 Telecommunications Act over a three-year period. Line-sharing allows us to provision services using ADSL technology over the same telephone line that the ILEC is using to provide voice services. The phase-out period was handled in the following manner:

 

 

We have reached agreements that provide us with continued access to line-sharing with the three RBOCs (AT&T, Verizon and Qwest), accounting for approximately 100% of our line-shared customer base. Our agreements regarding line-sharing with AT&T, Verizon and Qwest expire in May of 2010, December of 2008 and October of 2007 (but subject to a currently effective evergreen clause), respectively. In the event that we do not obtain favorable regulatory rulings for line-sharing or enter into and maintain line-sharing agreements with the RBOCs, we will be required to purchase a separate telephone line in order to provide services to an end-user in the areas served by RBOCs. If this occurs we may stop selling stand-alone consumer-grade services to new customers, because the cost of a separate telephone line is significantly higher than what we currently pay for a shared line and requires us to

dispatch a technician to install the service. Our inability to acquire new line-shared customers would limit our growth and negatively impact our ability to sell consumer DSL services.

 

In the Original Triennial Review Order, and subsequent orders, the FCC also decided that ILECs are not required to allow us to access certain types of fiber and fiber-fed lines or the packet-switching functions of fiber-fed telephone lines to provision DSL services. In a subsequent order, released October 27, 2004, the FCC also granted the RBOCs forbearance from the obligation to provide access to the packet-switching functions of fiber-fed telephone lines under section 271 of the Telecommunications Act of 1996. This means that, unless we reach agreements with the RBOCs or obtain favorable regulatory rulings from the FCC or state regulators, we will continue to be unable to provide our most commonly-used services to end-users served by affected fiber-fed lines. Our inability to access fiber and fiber-fed packet-switching functions is significant for our business because it limits the addressable market for our DSL services, thereby limiting our growth. In addition, the RBOCs are increasing their deployment of fiber lines and fiber-fed remote terminal architectures, thereby limiting our addressable market.

 

The 1996 Telecommunications Act provided relief from the earnings restrictions and price controls that governed the local telephone business for many years. Since passage of the 1996 Telecommunications Act, the FCC has been less stringent in its review of tariff filings by the three largest ILECs, the RBOCs, including filings for DSL services. In particular, without substantive review of the cost support for the RBOCs’ DSL services, rates for those services may be below cost and may facilitate price squeezes, predatory pricing or other exclusionary strategies by ILECs that harm our business. In 2005, the FCC eliminated certain regulations that apply to the RBOCs provision of broadband Internet access services that are competitive with ours. This decision was upheld by the United States Court of Appeals for the D.C. Circuit in October 2007. The FCC determined that RBOC wireline broadband Internet access services are defined under the Communications Act as information services functionally integrated with a telecommunications component, and relieved RBOCs of related common carrier, tariffing, and non-discrimination obligations. The FCC also provided the RBOCs with flexibility to offer the transmission component of wireline broadband Internet access service to affiliated or unaffiliated ISPs on a common-carrier basis, a non-common carrier basis, or some combination of both. This classification of RBOC wireline broadband Internet access services does not impact competitive local exchange carriers, or CLECs, ability to access UNEs under section 251 of the 1996 Telecommunications Act and the FCC’s rules. In 2006 and 2007, through a series of decisions, the FCC eliminated certain regulations from several high-capacity broadband services for many major ILECs including Verizon, AT&T, Citizens, Embarq, and Frontier. This deregulation extends to certain dominant carrier and pricing rules for high-capacity broadband services. We expect that this additional regulatory freedom and any additional regulatory freedom granted to the RBOCs in this area will increase the competition we face from the RBOCs’ services and could reduce our access to ILEC facilities and services.

 

In late 2005, the U.S. Department of Justice (with certain limited divestiture conditions) and the FCC approved the mergers of SBC and AT&T and Verizon and MCI. The FCC’s orders approving the mergers also contained conditions favorable to competitive carriers. Such conditions include UNE and other service pricing freezes; recalculation of areas where the merged RBOCs are required to share their networks with competitive telecommunications companies; special access availability, pricing, and service quality monitoring; and Internet peering access and transparency. These conditions are limited and are of varying durations. The relevant conditions placed on Verizon are expected to terminate in 2008 and early 2009. Verizon may seek to increase the rates we pay it for network elements as these conditions expire. The relevant conditions placed on AT&T were extended significantly in duration due to the subsequent AT&T/BellSouth transaction discussed immediately below.

 

In December 2006, AT&T (the combined SBC/AT&T entity resulting from the 2005 merger) and BellSouth received all of the necessary approvals to transfer BellSouth’s licenses and authorizations to AT&T, pursuant to AT&T’s planned acquisition of BellSouth. The FCC’s approval of the acquisition was conditioned on terms intended to be favorable to competitive telecommunications companies. Such conditions include UNE and other service price freezes; recalculation of areas where the merged AT&T/BellSouth entity is required to share their networks with competitive telecommunications companies; special access availability, pricing, and service quality monitoring; Internet peering access and transparency; and limitations on the use of regulatory forbearance to erode the benefits of the conditions. Another condition requires that AT&T offer stand-alone, or “naked,” ADSL service to its retail customers for $20 a month, which is significantly lower than the price that our resellers charge for similar services. These conditions are limited and are of varying durations.

On December 4, 2007, the FCC acted on six petitions filed by Verizon seeking forbearance from the regulatory requirement to provide competitors access to lines and transport at cost-based rates in the Metropolitan Statistical Areas of Boston, New York, Philadelphia, Pittsburgh, Providence, and Virginia Beach by denying them in full. Verizon has since appealed the FCC’s decision to the U.S. Court of Appeals for the D.C. Circuit, where its appeal is pending. Qwest has similar petitions pending before the FCC for deregulation in the Denver, Minneapolis-St. Paul, Phoenix, and Seattle Metropolitan Statistical Areas. Ongoing access to these network elements at cost-based rates, particularly in Phoenix and Seattle markets, is essential to our ability to profitably offer our services. The FCC is required by statute to act on the Qwest petitions by April 2008 (with one extension to July 2008 possible).

 

Each of the FCC decisions in this area has been or will likely be challenged by various participants in the telecommunications industry. We expect that many of the components of these rules will be the subject of continuing litigation that could influence their ultimate impact. As such, it is not possible for us to predict the final effects of these rules with assurance.

 

Investors should review this discussion of the FCC’s recent rulemaking and the actual FCC orders carefully to understand the potentially significant effects that these proceedings may have on our ability to continue to engage in our business as we have in the past, as the FCC’s rulings create a number of uncertainties, risks, challenges and opportunities for us.

 

Federal and State VoIP Regulation  — As a result of the growing deployment of VoIP services, the FCC has taken action to extend to many VoIP services regulations applicable to traditional voice services. In 2005, the FCC required VoIP carriers interconnected with the PSTN, to provide enhanced 911, or E911, service to customers. Also in 2005, the FCC released rules requiring certain broadband Internet providers and VoIP carriers interconnected with the PSTN to accommodate wiretaps pursuant to the Communications Assistance for Law Enforcement Act, or CALEA. In 2006, the FCC extended the Federal Universal Service Fund, or FUSF, contribution obligations to VoIP providers that connect through the PSTN. The United States Court of Appeals for the D.C. Circuit upheld the FCC’s authority to impose FUSF contribution obligations on interconnected VoIP providers on June 1, 2007. Also in 2007, the FCC extended Telecommunications Relay Service, or TRS, disabilities access, customer proprietary network information, or CPNI, annual regulatory fee, and local number portability, or LNP, regulations on interconnected VoIP providers. These additional regulations further increase our regulatory duties and rights as a VoIP provider. There is regulatory uncertainty as to the imposition of access charges and other regulations, taxes, fees and surcharges on VoIP services. If the FCC chose to adopt such regulations, it could impact our ability to offer VoIP services in a cost-efficient manner.

 

The states PUCs are also conducting regulatory proceedings that could impact our rights and obligations with respect to VoIP. In 2004, the FCC determined that Internet telephony services like our VoIP service are not subject to traditional regulation by the state PUCs. On March 21, 2007, the United States Court of Appeals for the 8th Circuit upheld the FCC with regard to nomadic VoIP, but its decision did not clearly extend to fixed VoIP services such as the services we provide. Some states, most notably New York and Missouri, are currently attempting to exert jurisdiction over fixed VoIP.

 

Various state legislatures and municipalities have also passed or are currently considering legislation that would impose fees or taxes on our interconnected VoIP.

 

We cannot predict the outcome of these regulatory and legal proceedings or any similar petitions and regulatory proceedings pending before the FCC or state PUCs. Moreover, we cannot predict how their outcomes may affect our operations or whether the FCC or state PUCs or legislatures will impose additional requirements, regulations or charges upon our provision of VoIP services.

 

Other Federal Regulation — We must comply with the requirements of the Communications Act of 1934, as amended by the 1996 Telecommunications Act, as well as the FCC’s regulations under the statute. The 1996 Telecommunications Act eliminates many of the pre-existing legal barriers to competition in the telecommunications and video communications businesses, preempts many of the state barriers to local telecommunications service competition that previously existed in state and local laws and regulations, and sets basic standards for relationships between telecommunications providers. The law delegates to the FCC and the states broad regulatory and administrative authority to implement the 1996 Telecommunications Act.

Among other things, the 1996 Telecommunications Act removes barriers to entry in the local telecommunications market. It also requires that ILECs provide nondiscriminatory access and interconnection to potential competitors. Regulations promulgated by the FCC under the 1996 Telecommunications Act (such as those discussed above under the heading “Recent Developments”) specify in greater detail the requirements imposed on the ILECs to open their networks to competition by providing competitors interconnection, central office and remote terminal space, access to unbundled network elements, retail services at wholesale rates and nondiscriminatory access to telephone poles, ducts, conduits and rights-of-way. The requirements allow companies like us to interconnect with the ILECs.

 

Further, the 1996 Telecommunications Act provides the FCC with the authority to forbear from regulating entities such as us. The FCC has exercised its forbearance authority. As a result, we are not obligated to obtain prior approval from the FCC for our interstate services or file tariffs for such services. We generally do not file tariffs for our interstate services. We provide our interstate services to our customers on the basis of contracts rather than tariffs. We believe that it is unlikely that the FCC will require us to file tariffs for our interstate services in the future. We are, however, required to comply with certain obligations that attach to all telecommunications carriers. For example, we are required to make payments into the FUSF for some of our services. The FUSF is a federal fund to support various programs that ensure the availability of telecommunications services to, for example, schools, libraries, hospitals, and in high-cost regions of the country. We are required to pay a percentage of our interstate and international telecommunications and interconnected VoIP revenue to the FUSF, and we generally pass that percentage through to our customers. The amount we are required to pay into the FUSF varies depending on the breakdown between, for example, our telecommunications revenue and non-telecommunications, such as equipment sales and installation services, revenue. In addition, we are not required to pay into the FUSF for any revenues derived from information services. The FCC has a proceeding underway to reexamine its FUSF contribution rules, and the FCC and its FUSF collection agent periodically change the rules related to those contributions, including the percentage and time period of interstate telecommunications revenue that a carrier must contribute to the FUSF. To the extent those rules are changed, or new interpretations of those rules results in an increase in the FUSF contributions that we must make, we may be subject to increased liability for payments beyond what we have already contributed.

 

Other State Regulation — To the extent we provide identifiable intrastate services or have otherwise submitted ourselves to the jurisdiction of the relevant state telecommunications regulatory PUCs, we are subject to state jurisdiction. In addition, certain states have required prior state certification as a prerequisite for processing and deciding an arbitration petition for interconnection under the 1996 Telecommunications Act. We are authorized to operate as a CLEC in all of the states covering metropolitan statistical areas we serve. We file tariffs in certain states for intrastate services as required by state law or regulation. We are also subject to periodic financial and other reporting requirements of these states with respect to certain intrastate services. Jurisdictional determinations that some or all of our services are intrastate services could harm our business. In particular, we could be deemed liable for payments into state universal service funds, which require telecommunications carriers providing intrastate services to pay a percentage of their intrastate revenues to support state programs that ensure universal availability of telecommunications and related services. We do not believe that the services we offer on an interstate basis are subject to such state assessments, but a state commission or judicial decision to the contrary could subject us to liability for such payments.

 

Each state PUC has proceedings to determine the rates, charges and terms and conditions for collocation and unbundled network elements. Unbundled network elements are the various portions of an ILEC’s network that a competitive company can lease for purposes of building a facilities-based competitive network, including telephone lines, central office collocation space, inter-office transport, operational support systems, local switching and rights of way. The rates in many of our interconnection agreements are interim rates and will be prospectively, and, in some cases, retroactively, affected by the permanent rates set by the various state PUCs. We have participated in unbundled network element rate proceedings in several states in an effort to reduce these rates. If any state commission decides to increase unbundled network element rates our operating results would be adversely affected.

 

Local Government Regulation — We may be required to obtain various permits and authorizations from municipalities in which we operate our own facilities or otherwise provide services. The issue of whether actions of local governments with respect to activities of carriers, including requiring payment of franchise fees or other

surcharges, pose barriers to entry for competitive companies which may be preempted by the FCC is the subject of litigation. Although we rely primarily on the unbundled network elements of the ILECs, in certain instances we deploy our own facilities and, therefore, may need to obtain certain municipal permits or other authorizations. The actions of municipal governments in imposing conditions on the grant of permits or other authorizations or their failure to act in granting such permits or other authorizations could harm our business.

 

The foregoing does not purport to describe all present and proposed federal, state and local regulations and legislation affecting the telecommunications industry. Other existing federal regulations are currently the subject of judicial proceedings, legislative hearings and administrative proposals which could change, in varying degrees, the manner in which communications companies operate in the United States. The RBOCs have periodically introduced federal and state legislation to relieve them from some or all of their obligations to provide us with access to their networks. Some states legislatures have approved these proposals. It would be reasonable to expect that the RBOCs will seek additional state and federal legislation that, if enacted into law, would adversely affect our business.

 

The ultimate outcome of these proceedings and the ultimate impact of the 1996 Telecommunications Act or any final regulations adopted pursuant to the 1996 Telecommunications Act on our business cannot be determined at this time but may well be adverse to our interests. We cannot predict the impact, if any, that future regulation or regulatory changes may have on our business and we can give no assurance that such future regulation or regulatory changes will not harm our business. See Part I, Item 1A. — “Risk Factors — Our services are subject to government regulation, and changes in current or future laws or regulations could adversely affect our business” and Part I, Item 1A. — “Risk Factors — Charges for network elements are generally outside of our control because they are proposed by the ILECs and are subject to costly regulatory approval processes.

 

Significant Customers

 

We had approximately 440 wholesale customers as of December 31, 2007. For 2007, 2006 and 2005, our 30 largest wholesale customers in each such year collectively comprised 57.0%, 60.6% and 65.4% of our total net revenues, respectively. Two of our wholesale customers each individually accounted for more than 10% of our revenue:

 

 

Intellectual Property

 

We regard certain aspects of our products, services and technology as proprietary and attempt to protect them with patents, copyrights, trademarks, trade secret laws, restrictions on disclosure and other methods. These methods may not be sufficient to protect our technology. We also generally enter into confidentiality or license agreements with our employees and consultants, and generally control access to and distribution of our documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our products, services or technology without authorization, or to develop similar technology independently.

 

Currently we have twenty patents granted and a number of patent applications pending. We intend to seek additional patent protection for our systems and services to the extent possible. These patents may not be issued to us. Even if they are issued, they may not protect our intellectual property from competition. Competitors may design around or seek to invalidate these patents.

 

Further, effective patent, copyright, trademark and trade secret protection may be unavailable or limited in certain foreign countries. The global nature of the Internet makes it virtually impossible to control the ultimate destination of our proprietary information. Steps taken by us may not prevent misappropriation or infringement of our technology. Litigation may be necessary in the future to enforce our intellectual property rights to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Such litigation could result in

substantial costs and diversion of resources. In addition, others may sue us alleging infringement of their intellectual property rights.

 

A manufacturer of telecommunications hardware named “COVID” has filed an opposition to our trademark application for the mark “COVAD” and design.” Covid is also seeking to cancel our trademark registration for the “Covad” name. We do not believe that these challenges to our trademark application and granted trademark have merit. However, these proceedings are unpredictable and there is no guarantee we will prevail. If we do not succeed, it could limit our ability to provide our services under the “COVAD” name.

 

Employees

 

As of December 31, 2007, we had 775 employees. None of our employees are represented by a labor union, and we consider our relations with our employees to be good. Our ability to achieve our financial and operational objectives depends in large part upon the continued service of our senior management and key technical, sales, marketing, legal, finance, human resources and managerial personnel, and our continuing ability to attract and retain highly qualified technical, sales, marketing, legal, accounting and managerial personnel. Competition for such qualified personnel is intense, particularly in software development, network engineering and product management. In addition, in the event that our employees unionize, we could incur higher ongoing labor costs and disruptions in our operations in the event of a strike or other work stoppage.

 

Available Information

 

We make available free of charge on or through our Internet address located at www.covad.com our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file that material with, or furnish it to, the Securities and Exchange Commission, or SEC. Materials we file with the SEC may be read and copied at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, D.C. 20549. This information may also be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov. We will provide a copy of any of the foregoing documents to stockholders upon request. Requests should be sent to Covad Communications Group, Inc., 110 Rio Robles, San Jose, California, 95134, Attn: Investor Relations.

 

consummation of the merger. These and other conditions are set forth in the Merger Agreement. These conditions are set forth in the Merger Agreement which we filed, as an exhibit to the Current Report on Form 8-K, with the SEC on October 29, 2007 and are also described in the proxy materials we filed with SEC on Schedule 14A on January 14, 2008. We cannot ensure that each of the conditions to the consummation of the Merger set forth in the Merger Agreement will be satisfied.

 

The existence of the Merger Agreement could cause a material disruption to our business. For example, to the extent that our announcement of the acquisition creates uncertainty among customers or resellers such that they cancel orders or terminate their respective agreements with us, our results of operations and financial condition could be negatively affected.

 

If the Merger Agreement is terminated, under certain circumstances, we would be required to pay CCGI Holding Corporation a termination fee of $12,000. In addition to such adverse consequence and the possible adverse effects resulting from the announcement of the Merger Agreement, if the acquisition is not consummated we would expect to suffer a number of further consequences that may adversely affect our business, results of operations and stock price, including, but not limited to the following effects:

 

 

In addition, several lawsuits have been filed against our company and its directors seeking to enjoin or unwind the transaction described in the Merger Agreement, as described in more detail in Part II, Item 1, Legal Proceedings. We cannot assure you that we will prevail in these lawsuits.

 

We regularly evaluate the strategic value of our business operations and, where appropriate, invest further in certain business operations, and reduce investment in or divest other business operations.

 

We may choose to divest certain business operations based on our management’s assessment of their strategic value to our business. Decisions to eliminate or limit certain business operations have involved in the past, and could in the future involve, the expenditure of capital, consumption of management resources, realization of losses, transition and wind-up expenses, further reduction in workforce, impairment of the value of purchased assets and goodwill, facility consolidation and the elimination of revenues along with associated costs, any of which could cause our operating results to decline and may fail to yield the expected benefits. The Merger Agreement allows us to continue to conduct our business in the ordinary and usual course, consistent with past practices. This being the case, we may be unable to divest of business operations that we otherwise believe would be in our best interests without the approval of CCGI Holding Corporation.

Our services are subject to government regulation, and changes in current or future laws or regulations and the methods of enforcing the law and regulations could adversely affect our business.

 

Our services are subject to federal, state and local government regulations. In particular, the company and its resellers are dependent on certain provisions of the 1996 Telecommunications Act to procure certain facilities and services from the RBOCs that are necessary to provide our services. As a result, our business is highly dependent on rules and rulings from the FCC, legislative actions at both the state and federal level, and rulings from states PUCs.

 

Over the last several years the FCC has made substantial changes to the regulatory environment in which we operate. The FCC’s 2003 Triennial Review Order and its release of further changes to its network unbundling rules afterward, limited, and in some cases eliminated our access to some of the network elements that we use to operate our business. Where we no longer have regulated access to network elements, our costs are likely to increase as a result of these orders and we may be unable to profitably offer some of our services. We may be unable to adapt to the changed regulatory environment, in its current form, or to future changes, whether resulting from these orders or from subsequent action by Congress, state legislatures, the courts, the FCC, or other regulatory authorities.

 

In addition, the FCC’s 2003 Triennial Review Order and related subsequent orders provided that RBOC fiber-based facilities and packet-based facilities were no longer required to be unbundled and made available to competitive carriers like us. The RBOCs have each announced plans to aggressively deploy new fiber and packet-based facilities as replacements for the copper loop based facilities that we use to provide our services. This substitution of fiber and related phase-out of copper lines will reduce the portion of the market for data and voice services that we can reach utilizing our wireline network. While we are currently seeking federal and state regulation that would preserve RBOC copper for competitive use and are also pursuing alternative means of providing services where copper phase-out occurs, including commercial access agreements with the RBOCs and alternative means of providing services, such as fixed wireless, we may not be successful in these efforts, and there may be material adverse effects on our financial condition.

 

On December 4, 2007, the FCC acted on six petitions filed by Verizon seeking forbearance from the regulatory requirement to provide competitors access to lines and transport at cost-based rates in Boston, New York, Philadelphia, Pittsburgh, Providence, and Virginia Beach by denying them in full. Verizon has since appealed the FCC’s decision to the U.S. Court of Appeals for the D.C. Circuit, where its appeal is pending. Qwest has similar petitions pending before the FCC for deregulation in the Denver, Minneapolis-St. Paul, Phoenix, and Seattle Metropolitan Statistical Areas. Ongoing access to these network elements at cost-based rates, particularly in Phoenix and Seattle markets, is material to our ability to profitably offer our services. The FCC is required by statute to act on the Qwest petitions by April 2008 (with one extension to July 2008 possible). A court decision that overturns the FCC’s Verizon decision, or an FCC decision granting the Qwest petitions, in whole or in part, could significantly increase the costs of providing our services and have a material adverse effect on our financial results.

 

The FCC and various states have also increased their efforts to regulate VoIP services and have adopted new customer privacy rules for telecommunications companies. It is possible that these new regulations could significantly increase our costs of doing business.

 

Charges for network elements are generally outside of our control because they are proposed by the ILECs and are subject to costly regulatory approval processes.

 

ILECs provide the copper lines that connect the vast majority of our end-users to our equipment located in their central offices. The 1996 Telecommunications Act generally requires that charges for these unbundled network elements be cost-based and nondiscriminatory. Nonetheless, the nonrecurring and recurring monthly charges for copper lines that we require vary greatly. These rates are subject to negotiations between us and the ILECs and to the approval of the state PUCs. Consequently, we are subject to the risk that the non-recurring and recurring charges for lines and other unbundled network elements will increase based on higher rates proposed by the ILECs and approved by state PUCs from time to time, which would increase our operating expenses and reduce our ability to provide competitive products.

 

The impact of regulatory and judicial decisions on access to or the prices we pay to the ILECs for collocation and unbundled network elements is uncertain. There is a risk that ongoing access to collocation and unbundled

network elements will be reduced or eliminated in particular markets over time. There is also a risk that any new prices set by the regulators could be significantly higher than current prices. If we are denied access to collocation or network components or are required to pay higher prices to the ILECs for collocation and network components, it could materially increase our operating expenses and reduce our ability to provide competitive products.

 

Our business will be adversely affected if our interconnection agreements are not renewed or if they are modified on unfavorable terms.

 

We are required to enter into interconnection agreements covering each of the states we serve with the appropriate ILECs in order to provide service in those regions. Many of our existing interconnection agreements have a maximum term of three years. Therefore, we will have to renegotiate these agreements with the ILECs when they expire. A number of these agreements have expired and we are currently in the process of renegotiating them. We may not succeed in extending or renegotiating these interconnection agreements on favorable terms or at all.

 

As the FCC modifies changes and implements its rules related to unbundling and collocation, we generally have to renegotiate our interconnection agreements to implement those new or modified rules. For example, we are involved in a number of renegotiations of interconnection agreements to reflect the FCC’s recent decisions. We may be unable to renegotiate these agreements in a timely manner, or we may be forced to arbitrate and litigate in order to obtain agreement terms that fully comply with FCC rules.

 

Additionally, disputes have arisen and will likely continue to arise in the future as a result of different interpretations of the interconnection agreements. These disputes have delayed and could further delay the deployment of network capabilities and services, and resolution of any litigated matters will require ongoing expenditures and management time. In addition, the interconnection agreements are subject to state PUC, FCC and judicial oversight. These government authorities may modify the terms of the interconnection agreements in a way that reduces our access to, or increases the cost of, the network components that we purchase from the ILECs.

 

We depend on a limited number of customers for the preponderance of our revenues, and we are highly dependent on sales through our resellers.

 

The majority of our revenue comes from Internet service providers, telecommunications carriers and other customers who resell our Internet access and other services to their business and consumer end-users. Our agreements with our resellers are generally non-exclusive, and many of our customers also resell services offered by our competitors. Our agreements with our resellers generally do not contain purchase commitments. A limited number of resellers account for a significant portion of our revenues. Our top 30 resellers accounted for approximately 57.0% of our net revenues for 2007. We expect that our reseller customers will continue to account for a significant portion of our revenue and new end user additions.

 

If we were to lose one or more of our key resellers or if one or more of our key resellers stopped providing us with orders or removed end-users from our network, our revenue and line-growth could be materially adversely affected. Consolidations, mergers and acquisitions involving our key resellers have occurred in the past and may occur in the future. These consolidations, mergers and acquisitions may cause key resellers to stop providing us with orders or to remove end-users from our network. On January 31, 2005, one of our major resellers, AT&T Corp., was acquired by SBC, one of the largest RBOCs and also one of our larger resellers. The surviving company is now known as AT&T, Inc. In December 2006, AT&T acquired BellSouth. On January 6, 2006, another one of our resellers, MCI, was acquired by Verizon. The combined AT&T entity and Verizon (including MCI) are both our competitors and resellers of our services and account for a significant portion of our revenues.

 

The markets in which we operate are highly competitive, and we may not be able to compete effectively, especially against established industry competitors with significantly greater financial resources.

 

We face significant competition in the markets for business and consumer Internet access, network access and voice services and we expect this competition to intensify. We face competition from the RBOCs, cable modem service providers, competitive telecommunications companies, traditional and new national long distance carriers, Internet service providers, on-line service providers and wireless and satellite service providers. Many of these

competitors have longer operating histories, greater name recognition, better strategic relationships and significantly greater financial, technical or marketing resources than we do. As a result, these competitors may be able to:

 

 

The intense competition from our competitors, including the RBOCs, the cable modem service providers and the competitive telecommunications companies could harm our business.

 

The RBOCs represent the dominant competition in all of our target service areas, and we expect this competition to intensify. The RBOCs have established brand names and reputations for quality service, possess sufficient capital to deploy new DSL equipment and other competing products and services rapidly, have their own telephone lines and can bundle digital data services with their existing voice, wireless and other services to achieve economies of scale in serving customers. They can also offer service to end-users using fiber and fiber-fed lines that they are not required to make available to us. Certain RBOCs are aggressively pricing their consumer DSL service subscription fees below $15 per month when ordered as part of a bundle, which has slowed sales of consumer DSL services by our reseller partners and increased the rate of churn among our existing users. We believe that we pose a competitive risk to the RBOCs and, as both our competitors and our suppliers, they have the ability and the motivation to disadvantage our business. If we are unable to enter into and maintain our agreements with the RBOCs that provide us with access to line-sharing at reasonable rates, we will be unable to price our consumer services at a price that is competitive with the RBOCs.

 

Cable modem service providers, such as Cox Communications, Comcast, and Time Warner, and their respective cable company customers, have deployed high-speed Internet access services over coaxial cable networks. These networks provide similar, and in some cases, higher-speed data services than we provide. In addition, cable providers are bundling VoIP telephony and other services, such as video-on-demand, with their Internet access offerings. As a result, competition with the cable modem service providers may have a significant negative effect on our ability to secure customers and may create downward pressure on the prices we can charge for our services.

 

New competitors in the market for VoIP services and improvements in the quality of VoIP service provided by competitors over the public Internet could increase competition for our VoIP services.

 

Our business plan is based partly on our ability to provide local and long distance voice services at a lower rate than our competitors. We expect price competition to increase in the VoIP market due to increasing emphasis on VoIP by the local telephone companies and new entrants to the VoIP market. Because networks using VoIP technology can be deployed with less capital investment than traditional networks, there are lower barriers to entry in this market and it may be easier for new competitors to emerge. Increasing competition may cause us to lower our prices or may make it more difficult to attract and retain customers.

 

We believe that our VoIP service does not compete with providers who use the public Internet to transmit communications traffic, as these providers generally cannot provide the quality of service necessary for business-grade services. Future technology advances, however, may enable these providers to offer an improved quality of services to business customers over the Internet with lower costs than we incur by using a private network. This could also lead to increased price competition.

Failure to complete development, upgrades, testing and introduction of new services, including VoIP services, could affect our ability to compete in the industry.

 

We continuously develop, test and introduce new services that are delivered over our network. These new services are intended to allow us to address new segments of the communications marketplace and to compete for additional customers. In some cases, the introduction of new services requires the successful development of new technology. In addition, some of the equipment in our network will need to be replaced as it becomes obsolete and in order to accommodate the increasing bandwidth that our customers require. To the extent that upgrades of existing technology are required for the introduction of new services, the success of these upgrades may depend on the conclusion of contract negotiations with vendors and vendors meeting their obligations in a timely manner. In addition, new service offerings may not operate as intended and may not be widely accepted by customers. If we are not able to successfully complete the development and introduction of new services and enhancements to our existing services, including VoIP, LPVA, and fixed wireless services, in a timely manner, our business could be materially adversely affected.

 

We may need to raise additional capital under difficult financial market conditions, and our substantial leverage may negatively affect our operating results.

 

As of December 31, 2007, we had $46,316 in cash and cash equivalents, $19,640 in short-term investments, and $5,667 in restricted cash and cash equivalents. The sum of these balances amounted to $71,623. At December 31, 2007 we had outstanding bank loans and long-term debt aggregating $178,561. Included in our long-term debt is $125,000 in principal amount of our 3% Convertible Senior Debentures. The holders of these debentures have the right to require us to repurchase them for par value, plus accrued interest, in March 2009, and we currently expect them to exercise this right if the Merger is not completed before March 2009. If the Merger is not completed we expect that we will need to obtain external financing to enable us to repurchase the debentures. Adverse business, regulatory or legislative developments may also require us to raise additional financing, raise our prices or substantially decrease our cost structure.

 

Restrictive covenants in our EarthLink Convertible Notes and the Silicon Valley Bank senior secured credit facility may limit our ability to raise additional capital through sales of debt or equity securities, and our ability to raise capital may also be affected by the status of the credit and equity markets through which we may seek to access financing. As such, we may not be able to raise additional capital on terms that we find acceptable, or at all. If we are unable to acquire additional capital or are required to raise it on terms that are less satisfactory than we desire, our financial condition and results of operation would be adversely affected.

 

Our substantial leverage could have other negative consequences, including:

 

 

In order to become cash flow positive and to achieve profitability, we must add end-users and sell additional services to our existing end-users while minimizing the cost to upgrade and expand our network infrastructure.

 

We must increase the volume of Internet, data and voice transmission on our network in order to realize the anticipated cash flow, operating efficiencies and cost benefits of our network. If we do not add new customers and maintain our relationships with current customers, we may not be able to substantially increase traffic on our

network, which would adversely affect our ability to become profitable. To accomplish this strategy, we must, among other things:

 

 

Our growth has placed, and will continue to place, significant demands on our management and operations. Our customers are using increasing amounts of bandwidth as they use applications like VoIP and streaming video. We expect to replace equipment in our network as it becomes obsolete, implement system upgrades, new software releases and other enhancements which will require additional expenditures and may cause disruption and dislocation in our business. If we are successful in implementing our marketing strategy, we may have difficulty responding to demand for our services and technical support in a timely manner and in accordance with our customers’ expectations. We expect these demands may require increased outsourcing of our business functions to third parties. We may be unable to do this successfully, in which case we could experience an adverse effect on our financial performance.

 

Our end-user disconnection rate reduces our revenue and end-user growth.

 

We experience high disconnection or “churn” rates.   Our high end-user churn rate continues to impair the growth we need to cover the cost of maintaining our network. These disconnections occur as a result of several factors, including end-users who:

 

 

While we are working to address problems with the end-user experience, many of these factors are beyond our control. As a result, our churn rates may increase even if we improve the customer experience. In addition, promotions and rebates that we offer to our resellers and end-users are based on an assumption that a given end-user will maintain our service for a period of time. If our disconnection rate increases for more recently added end-users, we may not recoup the money we spend on these promotions and rebates.

 

We may experience decreasing margins on the sale of our services, which may impair our ability to achieve profitability or positive cash flow.

 

Prices for our services have steadily decreased since we first began operations. We expect we will continue to experience an overall price decrease for our services due to competition, volume-based pricing and other factors. We currently charge higher prices for some of our services than some of our competitors do for similar services. As a result, we cannot assure you that our customers will select our services over those of our competitors. In addition,

prices for digital communications services in general have fallen historically, and we expect this trend to continue. As a result of these factors, we cannot predict whether demand for our services will exist at prices that enable us to achieve profitability or positive cash flow.

 

If we detect material weaknesses in our internal controls over financial reporting under the requirements of the Sarbanes-Oxley Act, our business, reputation and stock price could be adversely affected.

 

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal control over financial reporting as of the end of each year, and to include a management report assessing the effectiveness of our internal control over financial reporting in our annual reports. Section 404, as updated, also requires our independent registered public accounting firm to annually attest to, and report on, the effectiveness of our internal control over financial reporting.

 

Although our management has determined, and our independent registered public accounting firm has attested, that our internal control over financial reporting was effective as of December 31, 2007, we cannot assure you that we or our independent registered public accounting firm will not identify a material weakness in our internal controls in the future. If our internal control over financial reporting is not considered adequate, we may experience a loss of public confidence, which could have an adverse effect on our business and our stock price.

 

Some of our resellers are facing financial difficulties, which makes it more difficult to predict our revenues.

 

Some of our reseller customers may experience financial difficulties, including bankruptcy. If a customer cannot provide us with reasonable assurance of payment, then we only recognize revenue when we collect cash for our services, assuming all other criteria for revenue recognition have been met, and only after we have collected all previous accounts receivable balances. Although we will continue to try to obtain payments from these customers, it is likely that one or more of these customers will not pay us for our services. With respect to resellers that are in bankruptcy proceedings, we similarly may not be able to collect sums owed to us by these customers and we also may be required to refund pre-petition amounts paid to us during the 90 days prior to the bankruptcy filing.

 

The existence of our direct business poses challenges and may cause our resellers to place fewer orders with us or may cause us to lose resellers.

 

Although the majority of our revenue comes from resellers who purchase our services, sales of services directly to end-user customers represent a significant and growing part of our business. As we expand our direct business, we face multiple challenges. These challenges include, but are not limited to, our ability to:

 

 

In addition, some of our existing resellers may perceive us as a potential or actual competitor. As a result, these resellers may stop or slow their purchases of our services.

 

The communications industry is undergoing rapid technological changes and new technologies may be superior to the technology we use.

 

The communications industry is subject to rapid and significant technological changes, including continuing developments in DSL and VoIP technology and alternative technologies for providing broadband and telephony communications, such as cable modem, satellite and wireless technology. In addition, much of the equipment in our

network has been in service for several years and may become inferior to new technologies. As a consequence, our success may depend on:

 

 

The investments required to address technological changes are difficult to predict and may exceed our available resources. If we fail to adapt successfully to technological changes or fail to obtain access to important technologies, our business will be adversely affected.

 

A system failure could delay or interrupt service to our customers, which could reduce demand for our services.

 

Our operations depend upon our ability to support our highly complex network infrastructure and avoid damage from fires, earthquakes, terrorist attacks, floods, power losses, excessive sustained or peak user demand, telecommunications failures, network software flaws, transmission cable cuts and similar events. The occurrence of a natural disaster or other unanticipated problem at our network operations center or any of our regional data centers could cause interruptions in our services. Similarly, if our third party providers fail to maintain their facilities properly or fail to respond quickly to network or other problems, our customers may experience interruptions in the service they obtain from us.

 

Our VoIP and LPVA services rely on Internet protocol, or IP, technology, which is different from, and much newer than, the legacy circuit-switch technology used by the traditional telephone companies and other providers of traditional communications services. Although we believe that IP technology is well-designed for the provision of a broad array of communications services to high numbers of users, we cannot assure that our IP-based network can handle increasingly higher volumes of voice and data traffic as we grow our business or as our customers’ usage increases, that it can adapt to future technological advancements, or that it will be reliable over long periods of time. We have experienced some interruptions in our VoIP service as a result of network and equipment issues as we enhance and improve this service. Any damage or failure that interrupts our operations negatively impacts our reputation and makes it more difficult to attract and retain customers.

 

Our use of fixed broadband wireless technology presents several challenges.

 

As a result of our acquisition of NextWeb and the assets of DataFlo in 2006, we now offer fixed broadband wireless service to a small portion of our customers. Fixed broadband wireless services are not as widely used as our DSL and T-1 services, which creates several unique challenges. First, there are fewer providers of equipment that we need to provide this service and the providers that exist are smaller than our traditional providers of network equipment. This may result in shortages of the equipment that we require or may cause us to pay more for this equipment. Our fixed wireless service uses pre-WiMax equipment. WiMax is a set of specifications for wireless equipment and services that will encourage the interoperability of solutions from different suppliers. We currently plan to gradually upgrade our fixed wireless network to the WiMax standard when this equipment is available, which will require additional capital expenditures.

 

Our use of unlicensed spectrum to provide fixed wireless service also presents unique challenges. Since the spectrum is unlicensed, there may be a large number of users of this spectrum in the areas where we offer our service. We carefully manage the interference caused by other devices and service providers, but this could become increasingly difficult as additional users of unlicensed spectrum emerge. If we are unsuccessful in managing this interference, our customers may become dissatisfied and stop purchasing our services.

A breach of network security could delay or interrupt service to our customers, which could reduce demand for our services.

 

Our network may be vulnerable to unauthorized access, computer viruses, worms and Trojan horses and other disruptions. Internet service providers, telecommunications carriers and corporate networks have in the past experienced, and may in the future experience, interruptions in service as a result of accidental or intentional actions of Internet users, current and former employees and others. Unauthorized access could also potentially jeopardize the security of confidential information stored in our computer systems, our end-users and our reseller’s end-users. This might result in liability to us and also might deter potential customers from purchasing or selling our services. While we attempt to implement and develop additional security measures we have not implemented all of the security measures commercially available, and we may not implement such measures in a timely manner or at all. Moreover, these measures, if and when implemented, may be circumvented, and eliminating computer viruses and alleviating other security problems may require interruptions, delays or cessation of service to our customers and our reseller’s customers, which could harm our business.

 

Our success depends on our retention of certain key personnel, our ability to hire additional key personnel and the maintenance of good labor relations.

 

We depend on the performance of our executive officers and key employees. In particular, our senior management has significant experience in the telecommunications industry and the loss of any of them could negatively affect our ability to execute our business strategy. Additionally, we do not have “key person” life insurance policies on any of our employees.

 

Our future success also depends on our continuing ability to identify, hire, train and retain other highly qualified technical, operations, sales, marketing, finance, legal, human resource, and managerial personnel as we add end-users to our network. Competition for qualified personnel is intense. Our reduced stock price, as well as our Merger Agreement with CCGI Holding Corporation, has greatly reduced or eliminated the value of stock options held by many of our employees, making it more difficult to retain employees in a competitive market. In addition, in the event that our employees unionize, we could incur higher ongoing labor costs and disruptions in our operations in the event of a strike or other work stoppage.

 

We depend on a limited number of third parties for equipment supply, software utilities, service and installation and if we are unable to obtain these items from these third parties we may not be able to deliver our services as required.

 

We rely on outside parties to manufacture our network equipment and provide certain network services. These services, software and equipment include:

 

 

 

We have in the past experienced supply problems with certain vendors. These vendors may not be able to meet our needs in a satisfactory and timely manner in the future, which may cause us to lose revenue. In addition, we may not be able to obtain additional vendors when needed.

 

Our reliance on third-party vendors involves additional risks, including:

 

 

Any of these events could have a material adverse impact on our business and operating results.

 

We use third-party vendors offshore for tasks that were previously done by our employees.

 

Since 2003 we have used offshore vendors to assist us with software development and certain customer support functions. Because we are using a third-party vendor to manage these day to day operations, we do not have as much control over the hiring and oversight of the vendors’ employees. In addition, the differences in time zones, languages and culture also present challenges. As a result, this arrangement may impair our ability to modify and improve our software and to develop new software in a timely manner. In addition, we have provided these vendors with access to our intellectual property. While we have taken certain contractual and procedural steps to protect our intellectual property, if any of the vendors or their employees improperly uses our intellectual property, it may be more difficult for us to assert our intellectual property rights because we may not be able to use United States courts to enforce our rights.

 

In outsourcing certain support functions to offshore vendors, we face similar challenges as with our software outsourcing arrangements. In addition, these vendors may have difficulties communicating with our customers and resolving non-standard customer issues. We also may experience difficulties integrating the vendor’s systems with our own.

 

Some of these offshore locations have experienced civil unrest and terrorism and have been involved in conflicts with neighboring countries. If some of these locations become engaged in armed hostilities, particularly if these hostilities are protracted or involved the threat of or use of weapons of mass destruction, our vendors’ operations could be adversely affected. While we have attempted to contractually protect ourselves against calamities, if our vendors’ operations are adversely affected, our customer service and software development efforts could be negatively impacted.

 

We have made and may make acquisitions of complementary technologies or businesses in the future, which may disrupt our business and be dilutive to our existing stockholders.

 

We intend to consider acquisitions of businesses and technologies in the future on an opportunistic basis. Acquisitions of businesses and technologies involve numerous risks, including the diversion of management attention, difficulties in assimilating the acquired operations, loss of key employees from the acquired company, and difficulties in transitioning key customer relationships. In addition, these acquisitions may result in dilutive issuances of equity securities, the incurrence of additional debt and large one-time expenditures. Any such acquisition may not provide the benefits originally anticipated, and there may be difficulty in integrating the service offerings and networks gained through acquisitions and strategic investments with our own. Although we attempt to minimize the risk of unexpected liabilities and contingencies associated with acquired businesses through planning,

investigation and negotiation, unexpected liabilities nevertheless may accompany such strategic investments and acquisitions.

 

In addition, the purchase price of an acquired business may exceed the current fair value of the net tangible assets of the acquired business. As a result, we would be required to record material amounts of goodwill and other intangible assets, which could result in significant impairment charges and amortization expense in future periods. These charges, in addition to the results of operations of such acquired businesses, could have a material adverse effect on our business, financial condition and results of operations. We cannot forecast the number, timing or size of future acquisitions, or the effect that any such acquisitions might have on our operating or financial results.

 

Under generally accepted accounting principles, we are required to review our intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of these assets may not be recoverable. In addition, we are required to review our goodwill on at least an annual basis. If presently unforeseen events or changes in circumstances arise which indicate that the carrying value of our goodwill or other intangible assets may not be recoverable, we will be required to perform impairment reviews of these assets, which have carrying values of $50,002 and $5,572 as of December 31, 2007. An impairment review could result in a write-down of all or a portion of these assets to their fair values. We perform an annual impairment review of our goodwill during the fourth quarter of each fiscal year or more frequently if we believe indicators of impairment exist. In light of the large carrying value associated with our goodwill and intangible assets, any write-down of these assets may result in a significant charge to our statement of operations in the period any impairment is determined and could cause our stock price to decline.

 

We must pay federal, state and local taxes and other surcharges on our services, the applicability and levels of which are uncertain.

 

Telecommunications providers pay a variety of surcharges and fees on their gross revenues from interstate and intrastate services. Interstate surcharges include FUSF and Common Carrier Regulatory Fees. In addition, state regulators impose similar surcharges and fees on intrastate services and the applicability of these surcharges and fees to our services is uncertain in many cases. The division of our services between interstate and intrastate services, and between services that are subject to surcharges and fees and those that are not, is a matter of interpretation and may in the future be contested by the FCC or state authorities. The FCC is currently considering the nature of Internet service provider-bound traffic and new interpretations or changes in the characterization of jurisdictions or service categories could cause our payment obligations, pursuant to the relevant surcharges, to increase or result in liabilities. For example, the FCC recently determined that, beginning in the fourth quarter of 2006, carriers will be required to collect FUSF on VoIP services, which will increase the amount that our customers pay for our service. In addition, periodic revisions by state and federal regulators of the applicable surcharges may increase the surcharges and fees we currently pay. In addition, we may be required to pay certain state taxes, including sales taxes, depending on the jurisdictional treatment of the services we offer. The amount of those taxes could be significant, depending on the extent to which the various states choose to tax our services.

 

The federal government and many states apply transaction-based taxes to the sales of our products and services and to our purchases of telecommunications services from various carriers. We are in discussions with federal and state tax authorities regarding the extent of our transaction-based tax liabilities. It is reasonably possible that our estimates of our transaction-based tax liabilities could materially change in the near term. We may or may not be able to recover some of those taxes from our customers.

 

We are a party to litigation and adverse results of such litigation matters could negatively impact our financial condition and results of operations.

 

We are a defendant in some of the litigation matters described in “Part I, Item 3. — “Legal Proceedings.” While we are vigorously defending these lawsuits, the total outcome of these litigation matters is inherently unpredictable, and there is no guarantee we will prevail. Adverse results in any of these actions could negatively impact our financial condition and results of operations and, in some circumstances result in a material adverse effect on us. In addition, defending such actions could result in substantial costs and diversion of resources that could adversely affect our financial condition, results of operations and cash flows.

Our intellectual property protection may be inadequate to protect our proprietary rights.

 

We regard certain aspects of our products, services and technology as proprietary. We attempt to protect them with patents, copyrights, trademarks, trade secret laws, restrictions on disclosure and other methods. These methods may not be sufficient to protect our technology. We also generally enter into confidentiality or license agreements with our employees and consultants, and generally control access to and distribution of our documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our products, services or technology without authorization, or to develop similar technology independently.

 

Currently, we have been issued twenty patents, and we have a number of additional patent applications pending. We intend to prepare additional applications and to seek patent protection for our systems and services. These patents may not be issued to us. If issued, they may not protect our intellectual property from competition. Competitors could design around or seek to invalidate these patents.

 

Effective patent, copyright, trademark and trade secret protection may be unavailable or limited in certain foreign countries. The global nature of the Internet makes it virtually impossible to control the ultimate destination of our proprietary information. The steps that we have taken may not prevent misappropriation or infringement of our technology. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Such litigation could result in substantial costs and diversion of resources and could harm our business.

 

Third parties may claim we infringe their intellectual property rights.

 

We periodically receive notices from others claiming we are infringing their intellectual property rights, principally patent rights. Given the rapid technological change in our industry and our continual development of new products and services, we may be subject to infringement claims in the future. We also may be unaware of filed patent applications and issued patents that could relate to our products and services. We expect the number of such claims will increase as the number of products and competitors in our industry segments grows, the functionality of products overlap, and the volume of issued patents and patent applications continues to increase. Responding to infringement claims, regardless of their validity, could:

 

 

If a successful claim is made against us and we fail to develop or license a substitute technology, our business, results of operations, financial condition or cash flows could be adversely affected.

 

The price of our common stock may continue to fluctuate significantly.

 

The market price for our common stock has been, and is likely to continue to be, highly volatile, which may result in losses to investors. We believe that a number of factors contribute to this fluctuation and may cause our stock price to decline in the future. While it is not possible to foresee all of the events that could adversely affect the price of our common stock or cause such price to remain volatile, the factors include:

 

 

 

The stock market has periodically experienced significant price and volume fluctuations that have particularly affected the market prices of common stock of technology companies. These changes have often been unrelated to the operating performance of particular companies. These broad market fluctuations may also negatively affect the market price of our common stock.

 

 

 

In June 2002, Dhruv Khanna was relieved of his duties as our General Counsel and Secretary. Shortly thereafter, Mr. Khanna alleged that, over a period of years, certain current and former directors and officers had breached their fiduciary duties to us by engaging in or approving actions that constituted waste and self-dealing, that certain current and former directors and officers had provided false representations to our auditors and that he had been relieved of his duties in retaliation for his being a purported whistleblower and because of racial or national origin discrimination. He threatened to file a shareholder derivative action against those current and former directors and officers, as well as a wrongful termination lawsuit. Mr. Khanna was placed on paid leave while his allegations were being investigated.

 

Our board of directors appointed a special investigative committee, which initially consisted of L. Dale Crandall and Hellene Runtagh, to investigate the allegations made by Mr. Khanna. Richard Jalkut was appointed to this committee shortly after he joined our board of directors. This committee retained an independent law firm to assist in its investigation. Based on this investigation, the committee concluded that Mr. Khanna’s allegations were without merit and that it would not be in our best interest to commence litigation based on these allegations. The committee considered, among other things, that many of Mr. Khanna’s allegations were not accurate, that certain allegations challenged business decisions lawfully made by management or the board, that the transactions challenged by Mr. Khanna in which any director had an interest were approved by a majority of disinterested directors in accordance with Delaware law, that the challenged director and officer representations to the auditors were true and accurate, and that Mr. Khanna was not relieved of his duties as a result of retaliation for alleged whistleblowing or racial or national origin discrimination. Mr. Khanna has disputed the committee’s work and the outcome of its investigation.

 

After the committee’s findings had been presented and analyzed, we concluded in January 2003 that it would not be appropriate to continue Mr. Khanna on paid leave status, and we determined that there was no suitable role for him in the business. Accordingly, he was terminated as an employee of the Company.

 

Based on the events mentioned above, in September 2003, Mr. Khanna filed a purported class action and a derivative lawsuit against our current and former directors (“defendants”) in the Court of Chancery of the State of Delaware in and for New Castle County. On August 3, 2004, Mr. Khanna amended his Complaint and two additional purported shareholders joined the lawsuit. In this action the plaintiffs seek recovery on behalf of the Company from the individual defendants for their purported breach of fiduciary duty. The plaintiffs also seek to invalidate our election of directors in 2002, 2003 and 2004 because they claim that our proxy statements were misleading. On May 9, 2006, the court dismissed several of the claims for breach of fiduciary duty as well as the claims relating to our proxy statements. The court also determined that Mr. Khanna could no longer serve as a plaintiff in this matter.

 

On September 27, 2007, the parties entered into a settlement in the Khanna lawsuit. On or about December 5, 2007, the settlement was approved by the Court. The order approving the settlement was not appealed, and the terms of the settlement became effective on or about January 5, 2008. Thereafter, we received a payment of approximately $6,250 from the individual defendants from which we paid plaintiffs’ counsel approximately $1,890 in fees and certain costs. The settlement has resulted in the dismissal of the lawsuit with prejudice.

 

On October 31, 2007, we and the members of our Board of Directors were named as defendants in a purported class action lawsuit brought by William Forte (“Plaintiff”) in the Superior Court of California, County of Santa Clara. Plaintiff alleges breach of fiduciary duty by defendants in connection with the transaction contemplated by the Agreement and Plan of Merger, dated as of October 28, 2007, by and among us, CCGI Holding Corporation and CCGI Merger Corporation, as more fully described in Note 1 to the consolidated financial statements. Plaintiff seeks certain equitable relief, including an injunction to prevent or unwind the transaction, attorney’s fees and other fees. This matter is in the early stages of litigation and we intend to vigorously defend ourseves in this matter.

 

On November 7, 2007, we, the members of our Board of Directors and Platinum Equity, LLC were named as defendants in a purported class action lawsuit brought by Feivel Gottlieb (Defined Benefit Pension Plan 2) (“Feivel Gottlieb”) in the Superior Court of California, County of Santa Clara. Feivel Gottlieb alleges breach of fiduciary duties by the individual defendants and the aiding and abetting of such breach by us and Platinum Equity, LLC in connection with the contemplated acquisition of our company. Feivel Gottlieb seeks certain equitable relief,

including an injunction to prevent the consummation of the transaction, attorney’s fees and other fees. This matter is in the early stages of litigation and we intend to vigorously defend ourselves in this matter.

 

On December 18, 2007, we, the members of our Board of Directors, Platinum Equity, LLC, CCGI Holding Corporation and CCGI Merger Corporation were named as defendants in a purported class action lawsuit brought by Robert Vilardi and Ellen Goldberg-Linzer in the Court of Chancery of the State of Delaware. Mr. Vilardi and Ms. Goldberg-Linzer allege breach of fiduciary duties by the individual defendants and the aiding and abetting of such breach by Platinum Equity, LLC, CCGI Holding Corporation and CCGI Merger Corporation in connection with the contemplated acquisition of our company. Mr. Vilardi and Ms. Goldberg-Linzer seek certain equitable relief, including an injunction to prevent the consummation of the transaction, attorney’s fees and other fees. This matter is in the early stages of litigation and we intend to vigorously defend ourselves in this matter.

 

On December 18, 2007, we, the members of our Board of Directors, Platinum Equity, LLC, CCGI Holding Corporation and CCGI Merger Corporation were named as defendants in a purported class action lawsuit brought by Lisa Swanson, IRA (“Swanson”) in the Court of Chancery of the State of Delaware. Swanson alleges breach of fiduciary duties by the individual defendants, breach of fiduciary duty by the unspecified “Covad defendants” and the aiding and abetting of such breach by the unspecified “Platinum Defendants” in connection with the contemplated acquisition of our company. Swanson seeks certain equitable relief, including an injunction to prevent the consummation of the transaction, attorney’s fees and other fees. This matter is in the early stages of litigation and we intend to vigorously defend ourselves in this matter.

 

On or about July 26, 2007, we entered into a settlement agreement with AT&T, Inc., which resulted in the dismissal of all pending state and FCC regulatory proceedings against BellSouth Telecommunications as well as a release of several claims between us and AT&T.

 

On October 9, 2007, we were named as a nominal defendant in a lawsuit brought by an alleged stockholder named Vanessa Simmonds in the United States, District Court, Western District of Washington, at Seattle. Ms. Simmonds named Bear Stearns Companies Inc. (“BSCI”) and the Goldman Sachs Group, Inc. (“GSGI”) as defendants alleging that BSCI and GSGI served as lead underwriters on the initial public offering of our common stock and violated Section 16(b) of the Securities Exchange Act of 1934 by engaging in certain prohibited transactions of our stock. Ms. Simmonds seeks various remedies, including disgorgement of all profits from the alleged transactions and recovery of attorneys’ fees. This matter is in the early stages of litigation and, to the extent that Ms. Simmonds may intend to pursue any claims against us, we intend to vigorously defend ourselves in those matters.

 

On or about June 30, 2006, Saturn Telecommunication Services (STS) filed a demand for arbitration against us seeking damages for Covad’s alleged failure to provide certain wholesale services to it. On or about February 9, 2007, STS amended the demand to include additional allegations and requests for relief. On December 10, 2007, the arbitrator in this matter issued an award of approximately $7,300 in STS’ favor. On December 12, 2007, STS filed a motion in the United States District Court, Southern District of Florida, to confirm the award. On January 21, 2008, Covad Communications Company moved to vacate the award. On February 7, 2008, the Court held a hearing on these two motions. The Court allowed the parties to submit additional briefing, which we filed on February 14, 2008. The Court indicated at the hearing that it would issue an order in approximately one month from the hearing date.

 

We are also a party to a variety of other pending or threatened legal proceedings as either plaintiff or defendant, and are engaged in business disputes that arise in the ordinary course of business. Failure to resolve these various legal disputes and controversies without excessive delay and cost and in a manner that is favorable to us could significantly harm our business. We do not believe the ultimate outcome of these matters will have a material impact on our consolidated financial position, results of operations, or cash flows. However, litigation is inherently unpredictable and there is no guarantee we will prevail or otherwise not be adversely affected.

 

We are subject to state PUC, FCC and other regulatory and court decisions as they relate to the interpretation and implementation of the 1996 Telecommunications Act. In addition, we are engaged in a variety of legal negotiations, arbitrations and regulatory and court proceedings with multiple ILECs. These negotiations, arbitrations and proceedings concern the telephone companies’ denial of central office space, the cost and delivery of

transmission facilities and telephone lines and central office spaces, billing issues and other operational issues. Other than the payment of legal fees and expenses, which are not quantifiable but are expected to be material, we do not believe that these matters will result in material liability to us and the potential gains are not quantifiable at this time. An unfavorable result in any of these negotiations, arbitrations and proceedings, however, could have a material adverse effect on our consolidated financial position, results of operations or cash flows if we are denied or charged higher rates for transmission lines or central office spaces.

 

PART II

 

 

The following selected unaudited financial data should be read in conjunction with Part II, Item 7 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8 — “Financial Statements and Supplementary Data” included in this Annual Report on Form 10-K.

 

 

(All dollar and share amounts are presented in thousands, except per share amounts)

 

The following discussion of Covad Communications Group, Inc. (“we”, “our”, “the Company”, “Covad”) financial condition and results of operations should be read in conjunction with the consolidated financial statements and the related notes thereto included elsewhere in this 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 in Part I, Item 1A. — “Risk Factors” and elsewhere in this Annual Report on Form 10-K. We disclaim any obligation to update information contained in any forward-looking statement. See — Forward-Looking Statements.”

 

Overview

 

Our Business

 

We provide voice and data communications products and services to consumers and businesses. We provide these services throughout the United States in approximately 235 major metropolitan areas in 44 states. Our products and services include high-speed, or broadband, data communications, Internet access connectivity, Voice over Internet Protocol telephony, or VoIP, fixed wireless broadband, and a variety of related services. We primarily use digital subscriber line, or DSL, and T-1 technologies to deliver our services. In order to provide our services we purchase network elements, such as telecommunication lines and central office facilities, from the traditional local telephone companies, which are often referred to as the incumbent local exchange carriers, or ILECs, and other carriers, and then combine these network elements with our own nationwide network facilities. We purchase the majority of these network elements from Verizon Communications, Inc., or Verizon, BellSouth Telecommunications, Inc., or BellSouth, AT&T, Inc. (formerly SBC Communications, Inc., or SBC), or AT&T, and Qwest Corporation, or Qwest, which are also known as the regional Bell operating companies, or RBOCs. As of December 31, 2007, we had approximately 487,000 broadband access end-users, approximately 2,300 VoIP business customers with a combined total of approximately 4,000 VoIP sites, and approximately 3,600 fixed wireless broadband subscribers.

 

We operate two business segments, Wholesale and Direct. Wholesale is a provider of high-speed data connectivity services to Internet service providers, or ISPs, and telecommunications carrier customers. We also offer line-powered voice access service, or LPVA, which enables a wholesale partner to combine analog voice service with our consumer-grade data services. As of December 31, 2007, Wholesale had approximately 416,000 DSL and T-1 lines in service, down from 443,000 lines as of December 31, 2006. The majority of our services are sold through our Wholesale segment.

 

Our Direct segment sells VoIP, high-speed data connectivity, fixed wireless broadband, and related value-added services. We sell our business-grade VoIP services primarily through our Direct segment. We sell our Direct services through multiple channels including telesales, field sales, affinity partner programs, and our website. Direct focuses on the small business market and also sells to enterprise customers that purchase our services for distribution across their enterprise. As of December 31, 2007, Direct had approximately 71,000 DSL and T-1 lines in service, down from 76,000 lines as of December 31, 2006. In addition, Direct provided service to approximately 2,300 VoIP business customers and approximately 3,600 fixed wireless broadband subscribers at the end of 2007.

 

Our total lines in service as of December 31, 2007 decreased by 32,000 lines, or 6.2% when compared to December 31, 2006 primarily as a result of a decrease in our consumer lines. However, our T-1 lines, which are typically higher revenue-producing lines, increased by 7,739, or 27.6%.

 

Since our inception, we have and continue to generate significant net and operating losses and negative operating cash flow, except for the year ended December 31, 2007 in which we generated positive cash flow from operations. Our cash reserves are limited and our business plan is based on assumptions that we believe are reasonable, but some of which are out of our control. If actual events differ from our assumptions, we may need to raise additional capital on terms that are less favorable than we desire, or we may not be able to raise or obtain additional liquidity.

Regulatory Environment

 

Recent decisions of the Federal Communication Commission, or FCC, as described in more detail in Part I, Item 1 — “Business — Government Regulation,” have created a number of uncertainties, challenges and potential opportunities for us. The final effect of these developments will be subject to further proceedings at the FCC and the reactions of the various participants in the telecommunications industry, and many of these components are, or likely will be, the subject of continuing litigation that could influence the decisions’ ultimate impact. As such, it is difficult for us to predict with a high degree of certainty the final effects of the FCC’s decisions.

 

Recent Event

 

On October 28, 2007, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) pursuant to which an affiliate of Platinum Equity, LLC, CCGI Holding Corporation, will acquire all of the outstanding shares of our common stock at a price of $1.02 per share through the merger (the “Merger”) of CCGI Merger Corporation, a wholly-owned subsidiary of CCGI Holding Corporation, with and into Covad. The transaction is subject to the approval of our stockholders and the satisfaction of customary closing conditions, including the approval of the FCC and state public utility commissions, or PUCs, in many of the states in which we operate and the absence of any material adverse effect on our company prior to the consummation of the Merger. These and other conditions are set forth in the Merger Agreement.

 

Additionally, on October 28, 2007, in connection with the proposed Merger, we and Mellon Investor Services, LLC entered into a Second Amendment to the Amended and Restated Stockholder Protection Rights Agreement (the “Rights Agreement Amendment”), which amends our Amended and Restated Stockholder Protection Rights Agreement, dated November 1, 2001, as amended (the “Rights Agreement”), to provide that CCGI Holding Corporation shall not be deemed an “Acquiring Person” under the Rights Agreement solely by virtue of the execution of the Merger Agreement or the consummation of the Merger.

 

If the Merger Agreement is terminated, under certain circumstances, we will be required to pay CCGI Holding Corporation a termination fee of $12,000. Upon consummation of the Merger, our company will become a wholly-owned subsidiary of CCGI Holding Corporation, and our stock will cease to be publicly traded. Accordingly, this annual report on Form 10-K should be read with the understanding that should the Merger be completed, Platinum Equity will have the power to control the conduct of our company’s business, and our company will no longer exist as a publicly traded company.

 

Our Opportunities and Challenges

 

Our business is subject to on-going changes in technologies, the competitive environment, particularly with regard to continued pricing pressure on our consumer-grade services and industry consolidation, federal and state regulations, and our resellers’ changing market strategies. We continue to experience churn among our existing end-users due to pricing pressures and other factors. As a result of these market conditions, we continue to prioritize and invest our resources towards selling:

 

 

We refer to these services as our Growth services. Our remaining services are our Legacy services, which are consumer ADSL, business symmetric DSL, or SDSL, frame relay and high-capacity transport circuits. While we believe we are favorably positioned to take advantage of market opportunities for our Growth services, it is difficult to predict with a high degree of certainty our ability to continue to grow our sales and the profit margins we will derive from these services.

In addition, some of our Growth services, such as VoIP and LPVA, require significant upfront expenditures to acquire and provision new customers. In most cases, there is a lag between the cash outlay for these expenditures and the timing of future sales. This lag negatively impacts our cash flow. Consequently, our ability to offset the continuing decline in sales of our Legacy services by sales of our Growth services may be adversely affected by our limited liquidity, which may hinder our ability to invest in and promote the sales of these Growth services

 

Given the facts above and the highly competitive, dynamic, and heavily regulated nature of our business environment, we face a complex array of factors that create challenges and opportunities for us. Key matters upon which we are focused at this time include the following:

 

Efficient use of cash  — As of December 31, 2007 our cash and cash equivalents, short-term investments in debt securities, and restricted cash and cash equivalents were $71,623. This balance was comprised of $46,316 of cash and cash equivalents, $19,640 in short-term investments in debt securities, and $5,667 in restricted cash and cash equivalents. For the year ended December 31, 2007, we recorded a net loss of $42,967 and generated cash flow from operations of $18,072. We continue to manage expenditures closely. Our ability to attain and sustain cash flow sufficiency will largely depend on the rate at which we can grow our revenues while controlling the expenditures necessary to generate and support increases in revenue.

 

Efficiently deliver broadband Internet access services  — Our stand-alone DSL services continue to face intense competition. Our competitors are aggressively pricing their broadband services, often as part of a bundled service offering that includes voice and video services. We believe these market conditions place pricing pressure on us and our resellers, reduce the number of orders for our services, and cause a higher level of churn among our consumer end-users. High churn rates negatively impact our business because even if we are successful in attracting new customers to replace those that we lose, there is a significant cost of acquisition associated with attracting and provisioning these new end users.

 

Respond to Changes in Telecommunications Regulations  — Federal, state and local government regulations affect our services. In particular, we rely upon provisions of the 1996 Telecommunications Act to procure certain facilities and services from the RBOCs that are necessary to provide our services. As a result, our business can be materially affected by changes in applicable rules and policies as a result of FCC decisions, legislative actions at both the state and federal levels, rulings from state PUCs, and court decisions. Such changes may reduce our access to network elements at regulated prices and increase our costs. We have changed our business in the past to respond to new regulatory developments and it is likely that we will need to make similar changes in the future.

 

Enter and maintain acceptable line-sharing terms with the RBOCs  — We currently support our consumer and small office/home office focused resellers through line-sharing. We currently generate 15.1% of our revenues from the sale of our line-shared services. Although the revenues we generate from line-sharing with the RBOCs may decline in future periods, we think this market will continue to be important to us. Since the RBOCs are the incumbent local telephone companies in almost all of the metropolitan areas where we offer our services, our ability to generate significant revenue from the sale of our line-shared DSL services will depend on whether we are able to enter into and maintain long-term agreements with the RBOCs, like our agreements with AT&T, Verizon and Qwest, or obtain favorable regulatory rulings that will allow us to share telephone lines for new customers on reasonable terms.

 

Expand and diversify our sources of revenue  — We continue to take steps to improve our prospects for revenue growth. We have diversified our revenue sources by adding new services such as voice, fixed wireless broadband and LPVA, as well as by adding new resellers.

 

New market opportunities  — We have recently developed several services, targeting both our wholesale and direct channels, which we believe will generate new revenues. For our direct channels, we continue to seek opportunities to enhance our existing services and offer additional services that are complementary to our broadband services, such as e-mail, security and web hosting. For wholesale channels, we have introduced Voice Optimized Access, or VOA, and LPVA. We believe that VOA is an ideal solution for companies that want to offer their VoIP solutions in connection with our services. LPVA is an alternative voice solution

targeted at residential customers who want to purchase voice services from a provider other than their local telephone company, but want the convenience of maintaining existing inside wiring and telephones.

 

We are in the early stages of offering these capabilities and continue to experience operational and competitive challenges as we expand and improve our capabilities. These new opportunities also require additional investment and in many cases will not contribute cash flow from operations in the near term. Our ability to succeed in providing these new services will depend on whether we offer a competitively-priced offering and continue to improve these services.

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our consolidated financial statements requires us to make estimates that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. We base our accounting estimates on historical experience and other factors that we believe to be reasonable under the circumstances. However, actual results may vary from these estimates under different assumptions or conditions. We have discussed the development and selection of critical accounting policies and estimates with our audit committee. The following is a summary of our critical accounting policies and estimates we make in preparing our consolidated financial statements:

 

 

 

 

Recent Accounting Pronouncements

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (SFAS 141(R)). The revised standard continues the movement toward the greater use of fair values in financial reporting. SFAS 141(R) will significantly change how business acquisitions are accounted for and will impact financial statements both on the acquisition date and in subsequent periods. SFAS 141(R) is effective for both public and private companies for fiscal years beginning on or after December 15, 2008. SFAS 141(R) will be applied prospectively. We are currently assessing the potential impact that the adoption of SFAS No. 141(R) will have on our consolidated financial statements.

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51” . SFAS 160 will change the accounting and reporting for minority interests, which will be recharacterized as non-controlling interests and classified as a component of equity. SFAS 160 is effective for both public and private companies for fiscal years beginning on or after December 15, 2008. SFAS 160 requires retroactive adoption of the presentation and disclosure requirements for existing minority interests. All other requirements of SFAS 160 shall be applied prospectively. We are currently assessing the potential impact that the adoption of SFAS No. 160 will have on our consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115.” SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years.

This statement permits an entity to choose to measure many financial instruments and certain other items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. We are evaluating if we will elect to measure these instruments and other items at fair value. If we elect to use the fair value method to measure financial assets and liabilities the effect would be material.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”), and expands disclosures about fair value measurements. Prior to SFAS 157, there were different definitions of fair value and limited guidance for applying those definitions in GAAP. In developing this Statement, the FASB considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. In February 2008, the FASB concluded that it should defer the effective date of SFAS 157 for one year for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. While the deferral provides some relief for us, we will still need to apply the recognition and disclosure requirements of SFAS 157 for financial assets and financial liabilities or for nonfinancial assets and nonfinancial liabilities that are remeasured at least annually. We are evaluating the effect that SFAS 157 will have on our consolidated financial statements upon adoption of the Statement.

 

Business Segment Information

 

We manage our business in segments that are based upon differences in customers, services and marketing channels, even though the assets and cash flows from these operations are not independent of each other. Our wholesale segment, or Wholesale, is a provider of high-speed connectivity services to ISPs and telecommunications carriers. Our direct segment, or Direct, is a provider of voice and data communication services, which include VoIP, high-speed Internet access, fixed wireless broadband, and other related services to individuals, small and medium-sized businesses, and other organizations. We report all other operations and activities as Corporate Operations. These operations and activities are primarily comprised of general corporate functions to support our revenue producing segments and include costs and expenses for headquarters facilities and equipment, depreciation and amortization, network capacity and non-recurring or unusual items not directly attributable or allocated to the segments, gains and losses on our investments, and income and expenses from our treasury and financing activities. We do not allocate such operating expenses and other income and expense items to our business segments because we believe these expenses and other income items are not directly managed or controlled by our business segments.

 

We measure our business segments’ profitability as income from operations, excluding certain operating expenses such as depreciation and amortization, and other income and expense items. Wholesale net revenues are primarily driven by products and services sold to large resellers, whereas Direct net revenues are primarily driven by products and services sold directly to end-users. Our business segments’ operating expenses are primarily comprised of network costs and labor and related non-labor expenses to provision services and to provide support to our customers. Our business segments’ network costs consist of end-user circuits, aggregation circuits, central office space, Internet transit charges, CPE and equipment maintenance. Operating expenses include labor and related non-labor expenses for customer care, dispatch, and repair and installation activities.

 

We allocate network costs to our business segments based on their consumption of circuit or equipment capacity. We allocate end-user circuit costs to a segment based on the products and services sold by such segment. Aggregation circuits are allocated based on actual capacity usage determined by the total number of customers in a segment utilizing those circuits. CPE cost is directly assigned to a business segment based on the number of installations performed by such segment. We allocate labor costs from our operations to our business segments based on resource consumption formulas, which are primarily based on installations, percentage of total lines in service and trouble tickets by segment. We allocate employee compensation for our sales forces directly to the business segments based on the customers they sell to and serve. We allocate advertising and promotions to the business segments based on the targeted customers of the advertising and promotions. Costs and expenses not allocated to the business segments, as described above, are recorded in the Company’s Corporate Operations.

Results of Operations for 2007, 2006 and 2005

 

Revenues, net

 

The primary component of our net revenues is earned monthly broadband subscription billings for DSL services. We also earn revenues from monthly subscription and usage billings related to our VoIP and fixed wireless broadband services, and monthly subscription billings for high-capacity T-1 circuits sold to our wholesale customers. Because we do not recognize revenues from billings to financially distressed customers until we receive payment and until our ability to keep the payment is reasonably assured, our reported revenues for the 2007, 2006 and 2005 have been impacted by whether we receive, and the timing of receipt of, payments from these customers. Our net revenues also include a ratable portion of service activation fees and revenue from equipment sales for which the up-front billings are deferred and recognized as revenue over the expected life of the relationship with the end-user, and FUSF charges billed to our customers. We record customer incentives and rebates that we offer to attract and retain customers as reductions to gross revenues. We regularly have billing and service disputes with our customers. These disputes arise in the ordinary course of business in the telecommunications industry, and we believe their impact on our accounts receivable and revenues can be reasonably estimated based on historical experience. In addition, certain revenues are subject to refund if an end-user terminates service within thirty days of the service activation. Accordingly, we maintain allowances, through charges to revenues, based on our estimate of the ultimate resolution of these disputes and future service cancellations.

 

Our net revenues of $484,207 for 2007 increased by $9,903, or 2.1%, over our net revenues of $474,304 for 2006. This increase was attributable to a $38,605 increase in broadband revenues primarily as a result of higher sales from our Growth services, a $14,876 increase in VoIP revenues primarily as a result of adding customers and stations, and a $3,558 increase in wireless broadband revenues as a result of the acquisitions of NextWeb in February 2006 and DataFlo in November 2006. These increases were partially offset by decreases in broadband revenues primarily as a result of a $35,672 decrease in sales as a result of having fewer subscribers for our Legacy services and $9,288 due to lower selling prices. In addition, our other revenues decreased by $2,174 primarily as a result of the sale of a software license related to our operational and support system software in 2006. At this time we do not anticipate additional revenue from the sale of our software.

 

Our net revenues of $474,304 for 2006 increased by $31,125, or 7.0%, over our net revenues of $443,179 for 2005. This increase was attributable to a $41,521 increase in broadband revenues primarily as a result of higher sales from our Growth services, a $14,994 increase in VoIP revenues primarily as a result of adding customers and stations, an $11,035 increase in fixed wireless broadband revenues as a result of the acquisitions of NextWeb and DataFlo, and a $343 increase in other revenues as a result of the sale of a software license related to our operational and support system software. These increases were offset by decreases in broadband revenues as a result of $13,518 from lower selling prices and $23,250 from a decrease in the number of lines from our Legacy services.

 

We expect to continue to experience increases in net revenues from the sales of our Growth services, subject to our ability to continue to finance further investments in this part of our business. We also expect to continue to experience competitive pricing pressure on our current Legacy services. As a result, we expect to continue to experience high levels of customer service terminations, particularly in our consumer DSL services, which may be greater than the number of new activations. We also expect customer rebates and incentives to continue to be an element of our sales and marketing programs and we also may reduce our prices in order to respond to competitive market conditions. It is possible that these conditions will cause our revenues to decline in future periods if we do not generate enough new sales from our Growth services.

 

Our Wholesale net revenues for 2007 decreased by $9,430, or 3.0%, when compared to 2006. This decrease was attributable to a $28,646 decrease in sales as a result of having fewer subscribers for our Legacy services and $4,937 due to lower selling prices. In addition, our other revenues decreased by $2,174 primarily as a result of the sale of a software license related to our operational and support system software during 2006. These decreases were offset by a $26,327 increase in broadband revenues primarily as a result of higher sales from our Growth services. Our Direct net revenues for 2007 increased by $19,333 or 12.2%, when compared to 2006. This increase was attributable to a $14,876 increase in VoIP revenues as a result of adding customers and stations, a $12,278 increase in broadband revenues as a result of higher sales from our Growth services, and a $3,558 increase in wireless broadband revenues as a result of the acquisitions of NextWeb in February 2006 and DataFlo in November 2006. These increases were offset by decreases in broadband revenues primarily as a result of a $7,028 decrease in sales as a result of having fewer subscribers for our Legacy services and $4,351 due to lower selling prices.

 

Our Wholesale net revenues for 2006 increased by $1,116, or 0.4%, when compared to 2005. This increase was attributable to a $25,641 increase in broadband revenues as a result of higher sales from our Growth services and a $343 increase in other revenues as a result of the sale of a software license related to our operational and support system software. These increases were partially offset by decreases in broadband revenues as a result of $10,149 from lower selling prices and $14,717 from a decrease in the number of lines from our Legacy services. Our Direct net revenues for 2006 increased by $30,009, or 23.3%, when compared to 2005. This increase was attributable to a $15,880 increase in broadband revenues as a result of higher sales from our Growth services, a $14,994 increase in VoIP revenues as a result of adding customers and stations, and an $11,035 increase in fixed wireless broadband revenues as a result of our acquisitions of NextWeb and DataFlo. These increases were partially offset by decreases in broadband revenues primarily as a result of $3,370 from lower selling prices and $8,532 from a decrease in the number of lines from our Legacy services.

 

As of December 31, 2007, we had approximately 440 wholesale customers. For 2007, 2006 and 2005, our 30 largest wholesale customers, in each such year, collectively accounted for 90.2%, 91.1% and 92.2%, respectively, of our total wholesale net revenues, and 57.0%, 60.6% and 65.4%, respectively, of our total net revenues. As of December 31, 2007 and 2006, receivables from these customers collectively accounted for 50.6% and 53.1%, respectively, of our gross accounts receivable balance.

 

For 2007 and 2006, two of our wholesale customers, AT&T and EarthLink, individually accounted for 12.3% and 11.3%, and 14.3% and 11.1%, respectively, of our total net revenues. AT&T’s percentage of 12.3% and 14.3% for 2007 and 2006, respectively, includes the net revenues for AT&T and SBC, which became one entity in 2005. For 2005, AT&T and EarthLink individually accounted for 16.3% and 14.6%, respectively, of our total net revenues. As of December 31, 2007 and 2006, accounts receivable from AT&T and EarthLink individually accounted for 4.1% and 14.0%, and 10.5% and 12.8%, respectively, of our gross accounts receivables. No other individual customer accounted for more than 10% of our total net revenues for 2007, 2006 and 2005.

 

On May 27, 2005, we entered into a strategic agreement with EarthLink to develop and deploy our LPVA services. As part of the agreement, EarthLink made a non-interest-bearing prepayment, which we agreed to use exclusively for expenditures related to the development and deployment of our LPVA services. Consequently, we classified the unused cash balance of the prepayment as restricted cash and cash equivalents. As of December 31, 2007 and 2006, proceeds associated with this prepayment were fully utilized towards expenditures related to the provision of the LPVA services. As of December 31, 2007, the remaining amount of the prepayment is classified as a current liability in collateralized and other customer deposits based on the amount of expected billings over the

next twelve months. As we provide the products and services described in the agreement to EarthLink, the resultant billings are recognized as revenue in accordance with our revenue recognition policy (which is described in Note 2, “Revenue Recognition,” to our consolidated financial statements) and are offset by the prepayment liability to the extent of EarthLink’s right to do so under the agreement. The amount of billings expected over the next twelve months is an estimate based on current projections of products and services EarthLink will purchase. The actual amount sold for this period may be greater or less than this estimated amount.

 

As of December 31, 2007, we had approximately 71,000 direct end-users compared to approximately 76,000 and 79,100 as of December 31, 2006 and 2005, respectively. As of December 31, 2007, we had approximately 2,300 VoIP business customers with a combined total of approximately 4,000 sites utilizing our VoIP services as compared to 1,623 VoIP business customers with a combined total of approximately 2,805 sites as of December 31, 2006. As of December 31, 2007, we had approximately 3,600 fixed wireless broadband subscribers compared to approximately 3,400 as of December 31, 2006.

 

Wholesaler Financial Difficulties

 

In 2007, 2006 and 2005, we issued billings to our financially distressed customers aggregating $2,353, $2,161 and $2,897, respectively, which were not recognized as revenues or accounts receivable in the accompanying consolidated financial statements at the time of such billings. However, in accordance with the revenue recognition policy described above, we recognized revenues from certain of these customers when cash was collected aggregating $2,154, $2,218 and $2,757 in 2007, 2006 and 2005, respectively. For 2007, 2006 and 2005, revenues from customers that filed for bankruptcy accounted for approximately 0.1%, 0.1% and 0.3%, respectively, of our total net revenues. As of December 31, 2007 and 2006, we had contractual receivables from our financially distressed customers totaling $521 and $470, respectively, which are not reflected in the accompanying consolidated balance sheet as of such date.

 

We have identified certain of our customers who were essentially current in their payments for our services prior to December 31, 2007, or have subsequently paid all or significant portions of the respective amounts that we recorded as accounts receivable as of December 31, 2007, that we believe may be at risk of becoming financially distressed. For 2007, 2006 and 2005, revenues from these customers collectively accounted for approximately 1.8%, 1.3% and 11.0%, respectively, of our total net revenues. As of December 31, 2007, receivables from these customers collectively accounted for 3.0% of our gross accounts receivable balance. If these customers are unable to demonstrate their ability to pay for our services in a timely manner in periods ending subsequent to 2007, revenue from such customers will only be recognized when cash is collected, as described above.

 

Operating Expenses

 

Operating expenses include cost of sales, benefit from transaction tax adjustment, selling, general and administrative expenses, provision for bad debts, depreciation and amortization of property and equipment, amortization of collocation fees and other intangibles, and provision for post-employment benefits.

 

Our total operating expenses were as follows:

 

 

Cost of sales (exclusive of depreciation and amortization)

 

Cost of sales consists primarily of the costs of provisioning and maintaining telecommunications circuits and central office spaces, equipment sold to our customers, labor and related expenses and other non-labor items to operate and maintain our network and related system infrastructure.

Our cost of sales was as follows:

 

 

Our cost of sales for 2007 increased by $18,402, or 5.6%, when compared to 2006. This increase was attributable to increases in network costs of $14,830, of which $6,029 relates to LPVA services, cost of equipment of $31, and labor and other related operating expenses of $4,637 as a result of the addition of broadband, VoIP and fixed wireless subscribers to our network. These increases were partially offset by a $584 decrease in employee compensation and related operating expenses as a result of a decrease in headcount and cost containment initiatives, a $629 increase in recoveries from billing disputes with our telecommunication vendors, and a $722 decrease in network costs as a result of reduced rates for some of our network elements. In 2007, we reduced our estimated liabilities for transaction-based, property, and employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our cost of sales and our net loss by $1,994, or $0.01 per share, for 2007. In addition, in 2007, we reduced our estimated liabilities of network costs as a result of a settlement with one of our vendors. This change in accounting estimate decreased our cost of sales and net loss by $2,747 or $0.01 per share, for 2007. In 2006, we reduced our estimated liabilities for transaction-based, property, and employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our cost of sales and our net loss by $5,553, or $0.02 per share, for 2006.

 

Our cost of sales for 2006 increased by $17,335, or 5.6%, when compared to 2005. This increase was attributable to increases in network costs of $18,230, of which approximately $3,792 relates to costs associated with the deployment of our LPVA services, and labor and other related operating expenses of $1,507 as a result of the addition of broadband business, VoIP and fixed wireless subscribers to our network. In addition, our network costs for 2006 increased by $5,908 as a result of regulatory rate adjustments to certain of our network elements and by $7,306 as a result of lower recoveries from billing disputes with our telecommunication vendors. Furthermore, our cost of sales for 2006 increased by $1,311 as a result of expensing the cost of employee stock-based compensation. These increases were partially offset by a $7,070 decrease in the cost of equipment sold as a result of fewer consumer installations and improved inventory management, a $6,882 decrease in employee compensation and related operating expenses as a result of a decrease in headcount and cost containment initiatives, and a $1,258 decrease in network costs as a result of the expiration of purchase commitment contracts with certain of our telecommunications vendors. In 2006, we reduced our estimated liabilities for transaction-based and property taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our cost of sales and our net loss by $5,553, or $0.02 per share, for 2006. In 2005 we reduced our estimated liabilities for property taxes, primarily as a result of lower property tax valuations and actual tax assessments on our network assets. This change in accounting estimate decreased our cost of sales and our net loss by approximately $3,830, or $0.01 per share, for 2005.

 

Some of our Growth services, such as VoIP and LPVA, require significant upfront costs to acquire and provision new customers, which creates a lag between the costs we incur in connection with these services and the amount of revenue we receive from these services. This has caused our cost of sales to increase at a rate that is higher than the rate that revenue has increased. We expect our cost of sales to increase in future periods as we anticipate we will add subscribers and services to our network. We also expect our network costs to increase as a result of the effect of the changes in the FCC rules released on February 4, 2005, which were upheld on June 16, 2006 by the United States Court of Appeals for the D.C. Circuit, regarding the obligations of ILECs to share their networks with competitive telecommunications companies like us. To offset some of the increased costs, we plan to continue to develop new cost-saving programs and improve our efficiency in delivering our services.

Our cost of sales was allocated as follows:

 

 

Our cost of sales for the Wholesale segment for 2007 increased by $5,195, or 2.8%, when compared to 2006. This increase was attributable to a $3,648 increase in labor and other operating expenses due to higher LPVA installations, and a $3,574 increase in network costs as a result of an increase in sales from other Growth services. These increases were offset by a $1,089 decrease in network costs due to reduced rates and increased recoveries from billing disputes with our telecommunication vendors, and a $213 decrease in employee compensation and related operating expenses as a result of a decrease in headcount and cost containment initiatives. In addition, in 2007, we reduced our estimated liabilities of network cost as a result of a settlement with one of our vendors. This change in accounting estimate decreased our cost of sales by $725, or $0.00 per share, for 2007. Our cost of sales for the Direct segment for 2007 increased by $10,233, or 10.8%, when compared to 2006. This increase was primarily attributable to an increase in network costs of $12,079 and cost of equipment of $31 as a result of the addition of broadband, VoIP and fixed wireless subscribers to our network. These increases were partially offset by a $1,156 decrease in labor and other operating expenses as a result of a decrease in headcount and cost containment initiatives, and a $340 decrease in network costs due to reduced rates and increased recoveries from billing disputes with our telecommunication vendors. In addition, we reduced our estimated liabilities of network cost as a result of a settlement with one of our vendors in 2007. This change in accounting estimate decreased our cost of sales by $415, or $0.00 per share, for 2007. Our cost of sales for Corporate Operations for 2007 increased by $2,974, or 6.2%, when compared to 2006. This increase was primarily attributable to a $2,145 increase in labor and other operating expenses as a result of adding capacity to our network. These increases were partially offset by an $823 decrease in network costs and a $405 decrease in employee compensation and related operating expenses as a result of a decrease in headcount and cost containment initiatives. In 2007, we reduced our estimated liabilities for transaction-based, property, and employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our Corporate Operations cost of sales by $1,994, or $0.01 per share, for 2007. In addition, we reduced our estimated liabilities of network cost as a result of a settlement with one of our vendors in 2007. This change in accounting estimate decreased our cost of sales by $1,607, or $0.01 per share, for 2007. In 2006, we reduced our estimated liabilities for transaction-based and property taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our cost of sales by $5,553, or $0.02 per share, for 2006.

 

Our cost of sales for the Wholesale segment for 2006 decreased by $7,579, or 3.9%, when compared to 2005. This decrease was attributable to a decrease in network costs of $4,079 and cost of equipment of $7,070 as a result of lower consumer installations and improved inventory management, and a $7,316 decrease in labor and other operating expenses due to a decrease in headcount and cost containment initiatives. These decreases were offset by a $10,360 increase in network costs due to regulatory rate adjustments and lower recoveries from billing disputes with our telecommunication vendors. Furthermore, cost of sales for the Wholesale segment increased by $526 as a result of expensing the cost of employee stock-based compensation. Our cost of sales for the Direct segment for 2006 increased by $12,963, or 15.9%, when compared to 2005. This increase was attributable to an increase in network costs of $12,092 as a result of the addition of broadband business, VoIP and fixed wireless subscribers to our network, $2,854 due to regulatory rate adjustments and lower recoveries from billing disputes with our telecommunication vendors, and $78 as a result of expensing the cost of employee stock-based compensation. These increases were partially offset by a $2,061 decrease in labor and other related operating expenses due to a decrease in headcount and cost containment initiatives. Our cost of sales for Corporate Operations for 2006 increased by $11,951, or 33.3%, when compared to 2005. This increase was primarily attributable to a $10,217

increase in network costs and a $4,002 increase in labor and other operating expenses as a result of adding capacity to our network, and an increase of $710 as a result of expensing the cost of employee stock-based compensation. These increases were partially offset by a $1,258 decrease in network costs as a result of the expiration of purchase commitment contracts with certain vendors. In 2006, we reduced our estimated liabilities for transaction-based and property taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our cost of sales by $5,553 for 2006. In 2005 we reduced our estimated liabilities for property taxes, primarily as a result of lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our cost of sales by approximately $3,830 for 2005.

 

Benefit from Federal Excise Tax Adjustment

 

In 2004, we stopped accruing Federal Excise Tax (“FET”) on the purchases of certain telecommunications services because we determined we were not subject to this tax. The determination was based on our revised interpretation of the applicability of the tax. That determination prospectively removed the “probable” condition required by SFAS 5 — “Accounting for Contingencies” to accrue a contingent liability. We did not reverse the liability of approximately $19,455 that was previously accrued, because the liability was properly recorded based upon our interpretation of the tax law at that time coupled with the guidance provided by SFAS 5. The criteria for reversing the liability for the tax is one of the following: (i) a ruling, either judicial or from the Internal Revenue Service (“IRS”), that we are not subject to the tax, (ii) a ruling, either judicial or from the IRS that a company with similar facts and circumstances to the Company is not subject to the tax, (iii) a settlement with the IRS on this matter or, (iv) the expiration of the applicable statute of limitations.

 

On May 25, 2006, the IRS issued Notice 2006-50 announcing that it will stop collecting FET on “long-distance” telephone service and that it will no longer litigate this issue with taxpayers. The FET is now applicable only to “local” telephone service. The services we purchased for which we accrued FET do not fall under the definition of local telephone service. Therefore, we have determined that (i) IRS Notice 2006-50 resolved the uncertainty around the applicability of the tax to those telecommunications services, and (ii) meets one of the criteria stated above for reversing the accrued liability of $19,455. Consequently, we reversed such liability in 2006. For 2006, the benefit decreased our net loss by $19,455, or $0.07 per share, respectively.

 

 

Our selling, general and administrative expenses for 2007 decreased by $16,171, or 12.7%, when compared to our selling, general and administrative expenses for 2006. This decrease was primarily attributable to a $5,054 decrease in marketing and related expenses, an $8,733 decrease in labor and other related operating expenses primarily as a result of a decrease in headcount and cost containment initiatives, and a $5,747 decrease in professional services primarily as a result of lower legal, consulting, contract labor and other services. These decreases were offset by $2,232 of expenses incurred in connection with the activities and efforts related to the Merger Agreement. In 2007, we reduced our estimated liabilities for employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes. This change in accounting estimate decreased our selling, general and administrative expnses, and our net loss by $215, or $0.00 per share, for 2007. In 2006, we reduced our estimated liabilities for employment-related taxes because we determined we do not owe some of these taxes as a result of the expiration of the statue of limitations. This change in accounting estimate decreased our selling, general and administrative expenses and our net loss by $1,346, or $0.00 per share, for 2006.

Our selling, general and administrative expenses for 2006 decreased by $31,423, or 19.8%, when compared to our selling, general and administrative expenses for 2005. This decrease was primarily attributable to an $11,424 decrease in marketing and related expenses, an $11,148 decrease in labor and other related operating expenses primarily as a result of a decrease in headcount and cost containment initiatives, and a $9,405 decrease in professional services primarily as a result of lower legal, consulting, contract labor and other services. These decreases were partially offset by a $1,934 increase in employee compensation as a result of expensing the cost of stock-based compensation. In addition, in 2006 we reduced our estimated liabilities for employment-related taxes because we determined we do not owe some of these taxes as a result of the expiration of the statue of limitations. These changes in accounting estimates decreased our selling, general and administrative expenses and our net loss by $1,346, or $0.00 per share, for 2006.

 

We expect to continue to consider cost reduction initiatives which may reduce our total selling, general and administrative expenses in future periods. We expect these benefits to reduce our selling, general and administrative expenses in 2008 when compared to 2007.

 

Our selling, general and administrative expenses were allocated as follows:

 

 

Our selling, general and administrative expenses for the Wholesale segment for 2007 decreased by $18, or 0.2%, when compared to 2006. This decrease was primarily attributable to lower marketing expenses as a result of cost containment initiatives. Our selling, general and administrative expenses for the Direct segment for 2007 decreased by $9,196, or 25.4%, when compared to 2006. This decrease was attributable to a $4,761 decrease in marketing expenses, and a $4,435 decrease in labor and other operating expenses due to a decrease in headcount and cost containment initiatives. Our selling, general and administrative expenses for Corporate Operations for 2007 decreased by $6,957, or 8.4%, when compared to 2006. This decrease was primarily attributable to a $5,747 decrease in professional services, and a $4,731 decrease in labor and other operating expenses as a result of cost containment initiatives. These decreases were partially offset by $2,232 of expenses incurred in connection with the activities and efforts related to the Merger Agreement. In 2007, we reduced our estimated liabilities for employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes. This change in accounting estimate decreased our selling, general and administrative expenses and our net loss by $215, or $0.00 per share, for 2007. In addition, in 2006, we reduced our estimated liabilities for employment-related taxes because we determined we do not owe some of these taxes. This change in accounting estimate decreased our selling, general and administrative expenses and our net loss by $1,346, or $0.00 per share, for 2006.

 

Our selling, general and administrative expenses for the Wholesale segment for 2006 decreased by $611, or 7.3%, when compared to 2005. This decrease was attributable to a $514 decrease in marketing expenses, and an $869 decrease in labor and other related operating expenses as a result of lower headcount and cost containment initiatives, offset by a $772 increase in employee compensation as a result of expensing the cost of stock-based compensation. Our selling, general and administrative expenses for the Direct segment for 2006 decreased by $13,755 or 27.5%, when compared to 2005. This decrease was primarily attributable to an $11,042 decrease in marketing expenses, and a $2,829 decrease in labor and other operating expenses due to a decrease in headcount and cost containment initiatives, offset by a $116 increase in employee compensation as a result of expensing the cost of stock-based compensation. Our selling, general and administrative expenses for Corporate Operations for 2006 decreased by $17,057, or 17.0%, when compared to 2005. This decrease was attributable to a $7,318 decrease in labor and other operating expenses as a result of a decrease in headcount and cost containment initiatives, and a $9,405 decrease in professional services. These decreases were partially offset by a $1,042 increase in employee compensation as a result of expensing the cost of stock-based compensation. In addition, in 2006 we reduced our

estimated liabilities for employment-related taxes because we determined we do not owe some of these taxes. This change in accounting estimate decreased our selling, general and administrative expenses by $1,346 for 2006.

 

Stock-Based Compensation

 

As a result of adopting SFAS No. 123R, our net loss for 2007 and 2006 includes $2,182 ($0.01 per share) and $3,245 ($0.01 per share), respectively, of stock-based compensation, of which $1,693 and $1,699, respectively, relates to our employee stock option plans, and $489 and $1,546, respectively, relates to our employee stock purchase plan. For 2007 and 2006, $904 and $1,311, respectively, of the total stock-based compensation was recorded in cost of sales and $1,278 and $1,934, respectively, in selling, general and administrative expenses. We did not recognize and do not expect to recognize in the near future, any tax benefit related to employee stock-based compensation cost as a result of the full valuation allowance on our net deferred tax assets and because of our net operating loss carryforwards. We did not capitalize any portion of our stock-based compensation cost for the year ended December 31, 2007. For the year ended December 31, 2006, we capitalized approximately $86 of our stock-based compensation cost. Refer to Note 13, “Stock-Based Compensation,” to our consolidated financial statements for additional information on our adoption of SFAS 123R.

 

On December 7, 2007, our Board of Directors approved an Amended and Restated 2003 ESPP that suspends additional offering periods following December 31, 2007. We reserve the right, without need for additional stockholder approval, to commence one or more offering periods under the ESPP at a later date.

 

Provision for Bad Debts

 

Our provision for bad debts was $476, $251 and $571 for 2007, 2006 and 2005, respectively. The increase in 2007, when compared to 2006, was primarily due to lower collections from certain voice customers. Our provision for bad debts for 2006 decreased by $320, when compared to 2005, as a result of improved collections of accounts receivable.

 

Depreciation and Amortization

 

Our depreciation and amortization of property and equipment, or depreciation, was $41,985, $34,876 and $49,813 for 2007, 2006 and 2005, respectively. Our depreciation for 2007 increased by $7,109, when compared to 2006, primarily due to the deployment of new equipment in connection with the LPVA build out in 2006, offset by certain historical assets becoming fully depreciated. Our depreciation for 2006 decreased by $14,937, when compared to 2005, this decrease was primarily due to historical assets becoming fully depreciated.

 

Our amortization of intangible assets, or amortization, was $9,284, $9,949 and $17,428 for 2007, 2006 and 2005, respectively. Our amortization for 2007 decreased by $665, when compared to 2006, this decrease was primarily due to historical assets becoming fully amortized. Our amortization for 2006 decreased by $7,479, when compared to 2005, this decrease was primarily due to historical assets becoming fully amortized. We expect amortization of intangible assets to decrease as certain assets become fully amortized.

 

We expect our depreciation and amortization to decrease in 2008 when compared to 2007 primarily as a result of historical assets becoming fully depreciated or amortized. As explained above, we do not allocate depreciation and amortization expense to our business segments.

 

Provision for Post-Employment Benefits

 

We reduced our workforce in 2007, 2006 and 2005 by approximately 82, 61 and 155 employees, respectively. These reductions represented approximately 8.5%, 5.8% and 13.6% of our workforce for 2007, 2006 and 2005, respectively. The reductions covered employees in the areas of sales and marketing, operations and corporate functions. In connection with the reductions in force, we recorded employee severance benefits of $1,652 for 2007, of which $1,419 was paid in 2007 and the remaining $233 was paid after December 31, 2007, $1,597 for 2006, of which $1,523 was paid in 2006 and the remaining $74 was paid after December 31, 2006, $3,640 for 2005, of which $1,910 was paid in 2005 and the remaining $1,730 was paid after December 31, 2005. For 2007 the expenses associated with the reductions in force were $602, $552 and $498 related to our Wholesale segment, our Direct

segment and our Corporate Operations, respectively. For 2006 the expenses associated with the reductions in force were $232, $479 and $886 related to our Wholesale segment, our Direct segment and our Corporate Operations, respectively. For 2005 the expenses associated with the reductions in force were $285, $397 and $2,958 related to our Wholesale segment, our Direct segment and our Corporate Operations, respectively. We continue to evaluate whether additional restructuring is necessary, and we may incur additional charges to operations related to any further restructuring activities in future periods, however at this time we cannot reasonably predict the probability or the impact of such event.

 

Provision for Arbitration Award

 

We recorded a charge of $7,338 for 2007 as a result of an arbitration award to one of our customers. We did not recognize similar charges for 2006 and 2005.

 

Other Income (Expense)

 

Net Interest Expense

 

Our net interest expense was $8,690, $5,624 and $863 for 2007, 2006 and 2005, respectively. Net interest expense for 2007 and 2006 consisted primarily of interest expense on our 3% convertible senior debentures due 2024 and our 12% senior secured convertible note issued in March 2006, less interest income earned on our cash, cash equivalents and short-term investments balances. Net interest expense for 2005 consisted primarily of interest expense on our 3% convertible senior debentures due 2024, less interest income earned on our cash, cash equivalents and short-term investments balances. We expect future net interest expense to be limited to interest on our 3% convertible senior debentures, our 12% senior secured convertible notes, and our credit facility, partially offset by interest earned on our cash balances. We may, however, seek additional debt financing in the future if it is available on terms that we believe are favorable. If we seek additional debt financing, our interest expense would increase.

 

Gain on Deconsolidation of Subsidiary

 

We recognized a gain of $53,963 in 2005 as a result of the deconsolidation of one of our subsidiaries. Refer to Note 3, under “Other Restructuring Activities” , to our consolidated financial statements for additional information on such gain. We did not recognize similar gains for 2007 or 2006.

 

Gain on Sale of Equity Securities

 

In August 2000, we made an equity investment in 10 shares of ACCA Networks Co., Ltd., or ACCA, a privately-held, Japanese telecommunications company. In March 2005, ACCA completed a public offering of its shares in Japan. We recorded a net realized gain of $28,844 in 2005 as a result of the sale of those shares. We did not recognize similar gains in 2007 or 2006.

 

Income Taxes

 

We made no provision for income taxes in any period presented in the accompanying consolidated financial statements because we incurred operating losses in each of these periods. As of December 31, 2007, we had net operating loss carryforwards for federal tax purposes of approximately $1,063,501 which will begin to expire in 2021, if not utilized. We also had aggregate net operating loss carryforwards for state income tax purposes of approximately $616,420 of which $9,734 will expire in 2008, $12,844 in 2009, and $593,842 through 2027, if not utilized. In addition, we had capital loss carryforwards for federal and state income tax purposes of approximately $16,452 which will begin to expire in 2008.

 

On February 16, 2006, we completed the acquisition of all of the outstanding shares of privately-held NextWeb. This transaction is further explained in Note 6 — “Business Acquisitions, Asset Acquisitions and Equity Investments,” to our consolidated financial statements. The acquisition was effectuated by merging one of our wholly-owned subsidiaries with and into NextWeb, with NextWeb surviving the merger as a wholly-owned subsidiary. The merger is intended to qualify as a tax-free reorganization. As a result of our acquisition, our net

operating loss carryforwards includes NextWeb’s existing, as of acquisition date, federal and state net operating loss carryforwards of $9,713 and $9,341 respectively. Tax benefits related to pre-acquisition losses of the acquired entity will be utilized first to reduce any associated intangibles and goodwill.

 

On June 8, 2004, we completed our acquisition of all of the outstanding shares of privately-held GoBeam. The acquisition was effectuated by merging one of our wholly-owned subsidiaries with and into GoBeam, with GoBeam surviving the merger as a wholly-owned subsidiary. The merger is intended to qualify as a tax-free reorganization. As a result of the acquisition, our net operating loss carryforwards includes GoBeam’s existing, as of acquisition date, federal and state net operating loss of $39,597 and $29,426 respectively. Tax benefits related to pre-acquisition losses of acquired entity will be utilized first to reduce any associated intangibles and goodwill.

 

On September 22, 2000, we acquired BlueStar in a transaction accounted for as a purchase. This transaction is further explained in Note 3 — “Restructuring and Post-Employment Benefits,” to our consolidated financial statements. We deconsolidated BlueStar effective June 25, 2001, which resulted in the recognition of a deferred gain in our consolidated balance sheet as of December 31, 2001. The total gain was recognized for tax purposes in 2001. On February 4, 2005, the Seventh Circuit Court for Davidson County, Tennessee ordered the Assignee in the assignment for the benefit of creditors, or ABC, to make a final distribution of funds of the estates to holders of allowed claims. Such final distribution has been made. As a result of the completion of the ABC, we recognized a deferred gain of $53,963 during 2005 and the related deferred tax asset was recognized in 2005.

 

In August 2000, we made an equity investment in 10 shares of ACCA. This transaction is further explained in Note 6 — “Business Acquisitions, Asset Acquisitions and Equity Investments,” to our consolidated financial statements. In March 2005, ACCA completed a public offering of its shares in Japan and we subsequently sold such investment, resulting in a capital gain. Proceeds in excess of tax basis resulted in a tax gain of $14,227 which was offset against our capital loss carryforward.

 

The utilization of our net operating loss could be subject to substantial annual limitation as a result of future events, such as an acquisition, which may be deemed as a “change in ownership” under the provisions of the Internal Revenue Code of 1986, as amended and similar state provisions. The annual limitation could result in the expiration of net operating losses and tax credits before utilization.

 

Realization of our deferred tax assets relating to net operating loss carryforwards and other temporary differences is dependent upon future earnings, the timing and amount of which are uncertain. Accordingly, our net deferred tax assets have been fully offset by a valuation allowance. The valuation allowance (decreased) increased by $8,488, $(13,836) and $6,339 in 2007, 2006 and 2005, respectively.

 

In June 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes.” FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” This Interpretation prescribes a recognition threshold and measurement attribute of tax positions taken or expected to be taken on a tax return. FIN No. 48 is effective for fiscal periods beginning after December 15, 2006. We adopted FIN No. 48 on January 1, 2007 and such adoption did not have an impact to our financial statements.

 

Related Party Transactions

 

We are a minority shareholder of Certive Corporation (“Certive”). Our chairman of the board of directors, Charles McMinn, is also a significant stockholder of Certive. During the first quarter of 2007, Certive changed its name to Cloud 9 Analytics, Inc.

 

A member of our board of directors, Richard Jalkut, is the President and CEO of TelePacific Communications, Inc., or TelePacific, one of our resellers. We recognized revenues from TelePacific of $160, $217 and $285 for 2007, 2006 and 2005, respectively. Accounts receivables from TelePacific were $24 and $15 as of December 31, 2007 and 2006, respectively. In August 2006, TelePacific acquired mPower Communications, or mPower, which is one of our vendors. We paid $573 and $524 to mPower in 2007 and 2006, respectively. Accounts payable to mPower were $41 and $51 as of December 31, 2007 and 2006, respectively.

L. Dale Crandall, one of our directors, is a director of BEA Systems, or BEA, one of our vendors. We paid $556, $1,094 and $993 to BEA in 2007, 2006 and 2005, respectively. There were no accounts payable to BEA as of December 31, 2007 or 2006. In 2007, L. Dale Crandall became a director of Serena Software, Inc., or Serena, another one of our vendors. We paid $27 to Serena in 2007. There were no accounts payable to Serena as of December 31, 2007.

 

Diana E. Leonard, one of our directors, is a Senior Vice President of Orange Business Services (part of the France Telecom Group), which is one of our wholesale customers. We recognized revenues from Orange Business Services of $755, $399 and $202 for 2007, 2006 and 2005, respectively. Accounts receivable from Orange Business Services were $87 and $28 as of December 31, 2007 and 2006, respectively.

 

Charles Hoffman, our CEO, is a director of Chordiant Software, or Chordiant, one of our vendors. We paid $255, $395 and $620 to Chordiant in 2007, 2006 and 2005, respectively. There were no accounts payable to Chordiant as of December 31, 2007 or 2006. Charles Hoffman is also a director of Synchronoss Technologies, or Synchronoss, one of our vendors. We paid $70 and $83 to Synchronoss in 2007 and 2006, respectively, none in 2005. Accounts payable to Synchronoss were $10 and $11 as of December 31, 2007 and 2006, respectively.

 

Mr. Lynch and Mr. McMinn paid our company approximately $430 as part of a $7,000 settlement in the Khanna, et al. v. McMinn, et al. derivative lawsuit. Both Mr. McMinn and Mr. Lynch have denied, and continue to deny liability in this matter, but agreed to this settlement to eliminate the burden, risk and expense of further litigation. A full copy of the settlement is attached as an exhibit to the Form 8-K that we filed on December 7, 2007.

 

We believe these transactions were negotiated on an arms-length basis and contain terms which are comparable to transactions that would likely be negotiated with unrelated parties.

 

expenses and other current assets due to the timing of payments to our vendors, partially offset by a $909 decrease in accounts payable and other current liabilities due to the timing of payments to our vendors, a $1,077 increase in other long-term assets, a $796 increase in inventories, and increase in deferred costs of $500.

 

Net cash used in our operating activities for 2006 decreased by $16,078 when compared to 2005. This decrease was attributable to an improvement in our net loss, adjusted for non-cash and non-operating items, of $46,667, offset by a $33,538 redemption of our collateralized deposit liability with AT&T, and the net change in our other operating assets and liabilities of $2,949. The net change in our operating assets and liabilities was primarily as a result of a $8,811 decrease in collateralized and other customer deposits as a result of applying such deposits towards accounts receivable balances, a $4,226 increase in accounts receivable due to growth, an increase in deferred costs of $3,508, and a $3,461 increase in prepaid expenses and other current assets due to the timing of payments to our vendors, partially offset by a $19,417 increase in accounts payable and other current liabilities due to the timing of payments to our vendors, a $1,018 increase in unearned revenues, and a $2,260 decrease in inventories due to lower sales of consumer lines and better inventory management.

 

We expect our cash from operating activities to improve in 2008, primarily as a result of our anticipated growth in our net revenues and the effect of cost reduction initiatives. These improvements will be partially offset by product, sales and marketing expenses which will primarily be used to promote our Growth services.

 

Investing Activities

 

Our investing activities consist primarily of purchases, maturities and sales of short-term investments in debt securities, capital expenditures for property and equipment and expenditures to acquire collocation facilities. Net cash used in our investing activities for 2007 decreased by $52,337 when compared to 2006. This decrease was primarily attributable to a $27,986 decrease in restricted cash and cash equivalents, a $20,369 decrease in equipment purchase primarily as a result of the completion of the build out of our LPVA services, and $4,193 from the net cash effect of our acquisitions of NextWeb and DataFlo, offset by $131 decrease in other long-term assets, and a $80 from the net cash effect of purchase, sale and maturity activities on our short-term investments in debt debentures.

 

Net cash used in our investing activities for 2006 increased by $76,436 when compared to 2005. This increase was primarily attributable to a $11,105 increase in restricted cash and cash equivalents primarily as a result of our commitment to use funds received from EarthLink exclusively for the expansion of our LPVA services, a $29,807 decrease in the proceeds from the sale of our equity securities, $25,097 from the net cash effect of purchase, sale and maturity activities on our short-term investments in debt securities, a $4,221 increase in equipment purchases as a result of expansion of LPVA services, $4,370 from the net cash effect of our acquisitions of NextWeb and DataFlo, and a $1,755 decrease in other long-term assets due to an increase in deferred charges.

 

We expect that in 2008 our expenditures related to the purchase of infrastructure equipment necessary for the development and expansion of our networks and the development of new regions will be relatively lower than in recent periods while incremental, or “success-based”, expenditures related to the addition of subscribers in existing regions will be driven by the number of new subscribers that we add to our network.

 

Financing Activities

 

Our financing activities consist primarily of proceeds from long-term debt, borrowings from our credit facility with SVB, the issuance of our common stock, including issuances under our employee stock-based compensation plans, and the repayment of long-term debt. Net cash provided by our financing activities for 2007 decreased by $57,014 when compared to 2006. This decrease was primarily attributable to our having received net proceeds from the sale of Notes and common stock during 2006, as described below.

 

These proceeds were partially offset by a $1,031 repayment of NextWeb’s long-term debt, $486 for payments of our capital lease obligations, and $651 in issuance costs related to our credit facility with SVB in 2007. On March 15 and September 15, 2007, we settled the semi-annual interest payment obligation on the above described convertible note with EarthLink. The interest obligation amounted to $5,221. As permitted by the Note, we settled the interest due by issuing additional notes with the same terms as the original note.

Net cash provided by our financing activities for 2006 increased by $55,561 when compared to 2005. This increase was primarily attributable to the $48,086 in proceeds, net of transaction and issuance costs, received from the sale of a 12% senior secured convertible note and our common stock to EarthLink in connection with the agreement for the expansion of our LPVA services (refer to Note 7, “Long-Term Debt and Credit Arrangements,” to our consolidated Financial Statements for a description of the EarthLink transaction), $18,300 of proceeds from draws on our credit facility, and a $2,472 increase in proceeds from the issuance of our common stock, primarily from the exercise of employee stock options, partially offset by a $13,231 repayment of NextWeb’s long-term debt and our credit facility with Wells Fargo Bank, and $651 in issuance costs related to our credit facility with SVB. On September 15, 2006, we settled the semi-annual interest payment obligation on the above described convertible note with EarthLink. The interest obligation amounted to $2,240. As permitted by the Note, we settled the interest due by issuing an additional note with the same terms as the original note.

 

We expect that for 2008 our net cash from financing activities will be primarily related to borrowings under and repayments of the revolving line of credit that we entered into with SVB in April 2006, as well as capital leases to finance the purchase of certain long-term network assets.

 

Liquidity

 

Although in 2007 we generated positive cash flow from operations, we have incurred losses and negative cash flows from operations for the last several years and have an accumulated deficit of $1,775,037 as of December 31, 2007. For 2007, we recorded a net loss of $42,967 and cash flow from operations of $18,072. As of December 31, 2007, we had $46,316 in cash and cash equivalents, $19,640 in short-term investments, and $5,667 in restricted cash and cash equivalents. The sum of these balances amounted to $71,623. In 2007, 2006 and 2005, we reduced our total workforce by approximately 8.5%, 5.8% and 13.6%, respectively, to improve our cost structure. In addition, we incurred expenditures in 2007, 2006 and 2005 to automate several of our business processes and make them more cost effective. Furthermore, as described above, in April 2006 we obtained a $50,000 revolving credit facility with SVB. As a result of these actions we expect that we will have sufficient liquidity to fund our operations through at least December 31, 2008. However, as of December 31, 2007, we had outstanding bank loans and long-term debt aggregating $178,561. Included in our long-term debt is $125,000 in principal amount of our 3% Convertible Senior Debentures. The holders of these debentures have the right to require us to repurchase them for par value, plus accrued interest, in March 2009, and we currently expect them to exercise this right if the Merger is not completed before March 2009.

 

If the Merger is not completed we expect that we will need to obtain external financing to enable us to repurchase the debentures. Adverse business, regulatory or legislative developments may also require us to raise additional financing, raise our prices or substantially decrease our cost structure.

 

Restrictive covenants in our EarthLink Convertible Notes and the Silicon Valley Bank senior secured credit facility may limit our ability to raise additional capital through sales of debt or equity securities, and our ability to raise capital may also be affected by the status of the credit and equity markets through which we may seek to access financing. As such, we may not be able to raise additional capital on terms that we find acceptable, or at all. If we are unable to raise additional capital or are required to raise it on terms that are less satisfactory than we desire, our financial condition and results of operation would be adversely affected.

 

On April 12, 2006, we redeemed our collateralized customer deposit liability with AT&T for $33,538. As a result of the redemption, the collateralized customer deposit liability and several of our agreements with AT&T, not including the resale agreement, have been terminated and AT&T has relinquished its related liens on our assets.

 

In conjunction with the redemption described above, on April 13, 2006, we entered into a Loan and Security Agreement (“Loan Agreement”) with SVB. The Loan Agreement provides for a revolving credit facility for up to $50,000, subject to specified borrowing base limitations. At our option, the revolving line bears an interest rate equal to SVB’s prime rate or LIBOR plus specified margins, and matures on April 19, 2009. As collateral for the loan under the Loan Agreement, we have granted security interests in substantially all of our real and personal property, other than intellectual property and equipment purchased with the proceeds received from the agreement with EarthLink. We have also provided a negative pledge on our intellectual property. As of December 31, 2007, we had an outstanding principal balance under the Loan Agreement of $9,896, of which $3,796 pertains to irrevocable letters of credit in favor of lessors

of equipment and facilities, which carried an interest rate of 7.25% plus a margin of 0.25%. Borrowings under the facility are limited by an amount of our eligible accounts receivable and cash. As of December 31, 2007, we had $35,458 of funds available under the credit facility as a result of borrowings, letters of credit, and the borrowing base limitations. As the available borrowing under the facility is limited, the amount available at any time may be substantially less than $50,000 and the facility could be unavailable in certain circumstances.

 

The Loan Agreement imposes various limitations on us, including without limitation, on our ability to: (i) transfer all or any part of our businesses or properties, merge or consolidate, or acquire all or substantially all of the capital stock or property of another company; (ii) engage in new business; (iii) incur additional indebtedness or liens with respect to any of our properties; (iv) pay dividends or make any other distribution on or purchase of, any of our capital stock; (v) make investments in other companies; (vi) make payments in respect of any subordinated debt; or (vii) make capital expenditures, measured on a consolidated basis, in excess of specified thresholds, subject to certain exceptions. The Loan Agreement also contains certain customary representations and warranties, covenants, notice and indemnification provisions, and events of default, including changes of control, cross-defaults to other debt, judgment defaults and material adverse changes to our business. In addition, the Loan Agreement requires us to maintain specified liquidity ratios and tangible net worth levels. As of December 31, 2007, we were in compliance with the above described limitations, covenants and conditions of the line of credit.

 

We expect to use additional cash resources primarily for sales and marketing activities to support our Growth services. The amount of this additional usage of cash will depend in part on our ability to control incremental selling, general and administrative expenses, the amount of capital expenditures required to grow the subscriber base, development of operating support systems and software, and our ability to generate demand for these services. In addition, we may wish to selectively pursue possible acquisitions of, or investments in businesses, technologies or products complementary to ours in order to expand our geographic presence, broaden our product and service offerings and achieve operating efficiencies. We may not have sufficient liquidity, or we may be unable to obtain additional financing on favorable terms or at all, in order to finance such an acquisition or investment.

 

Our cash requirements for 2008 and beyond for developing, deploying and enhancing our network and operating our business will depend on a number of factors including:

 

 

 

The 3% convertible senior debentures listed above mature on March 15, 2024. We may redeem some or all of the Debentures for cash at any time on or after March 20, 2009. Holders of the Debentures have the option to require us to purchase the Debentures in cash, in whole or in part, on March 15, 2009, 2014 and 2019, so we have included the principal amount of the Debentures in the 2009 column above. The holders of the Debentures will also have the ability to require us to purchase the Debentures in the event that we undergo a change in control. In each case, the redemption or purchase price would be at 100% of their principal amount, plus accrued and unpaid interest thereon.

 

Effective September 24, 2007, we entered into an agreement to lease an office in Washington, DC, to replace the current Washington DC office. Such lease ends on October 31, 2012. The lease is for a period of five years which commenced on October 22, 2007. This lease increases our total lease obligation by $474 and is reflected in office leases in the table above.

 

We lease certain vehicles, equipment and office facilities under various non-cancelable operating leases that expire at various dates through 2013. Our office leases generally require us to pay operating costs, including property taxes, insurance and maintenance, and contain scheduled rent increases and certain other rent escalation clauses. Rent expense is reflected in our consolidated financial statements on a straight-line basis over the terms of the respective leases.

 

As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities of financial partnerships, such as entities often referred to as structured finance or special purpose entities, or SPEs, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purpose. As of December 31, 2007, we were not involved in any SPE transactions.

 

Forward-Looking Statements

 

We include certain estimates, projections, and other forward-looking statements in our reports, in presentations to analysts and others, and in other publicly available material. Future performance cannot be ensured. Actual results may differ materially from those in 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,” “goals,” “plans,” “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:

 

 

 

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.

 

All written and oral forward-looking statements made in connection with this Report on Form 10-K which are attributable to us or persons acting on our behalf are expressly qualified in their entirety by the “Risk Factors” and other cautionary statements included in this Report on Form 10-K. We disclaim any obligation to update information contained in any forward-looking statement.

 

 

FINANCIAL STATEMENTS

 

INDEX

 

(a) The following documents are filed as part of this Form 10-K:

 

(1)  Financial Statements.   The following Financial Statements of Covad Communications Group, Inc. and Report of Independent Registered Public Accounting Firms are filed as part of this report.

 

Report of Independent Registered Public Accounting Firm

 

To the Board of Directors and Stockholders of

Covad Communications Group, Inc.

 

In our opinion, the consolidated financial statements listed in the accompanying index, present fairly, in all material respects, the financial position of Covad Communications Group, Inc. and its subsidiaries at December 31, 2007 and December 31, 2006, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Item 9A, Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

As discussed in Note 13 in Notes to Consolidated Financial Statements, the Company changed the manner in which it accounts for stock-based compensation in 2006.

 

As discussed in Note 1 in Notes to Consolidated Financial Statements, the Company’s ability to continue to meet its obligations and to achieve its intended business objectives is dependent upon, among other things, refinancing the 3% convertible senior debentures (the “debentures”) or raising additional capital in order to meet certain obligations which are callable by the holders in March 2009 related to the debentures. There can be no assurance that sufficient debt or equity financing will be available at all or, if available, that such financing will be at terms and conditions acceptable to the Company. Should the Company fail to refinance the debt or raise additional capital, it may not be able to achieve its longer term business objectives and may face other serious adverse consequences.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

 

San Jose, California

February 26, 2008

COVAD COMMUNICATIONS GROUP, INC.

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

The accompanying notes are an integral part of these consolidated financial statements.