Item 1. Business - Government Regulation, 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 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 execute cost-saving programs and improve the delivery of our services. In addition, we expect that certain elements of our cost of sales should benefit from the recent reductions in our workforce. We expect these benefits to improve our cost of sales by approximately $5,200 in 2006.
Our cost of sales was allocated as follows:
Our cost of sales for the Wholesale segment for 2005 increased by $16,606, or 9.4%, when compared to 2004. This increase was attributable to increases in network costs of $15,568, of which $4,549 was attributable to regulatory rate adjustments, equipment costs of $1,510 and labor and other related operating expenses of $362, as a result of adding subscribers to our network, offset by a decrease in incentive and stock-based compensation of $834, primarily as a result of reduced charges for our 2003 ESPP. Our cost of sales for the Direct segment for 2005 increased by $24,380, or 42.7%, when compared to 2004. This increase was attributable to increases in network
costs of $14,925, of which $1,652 was attributable to regulatory rate adjustments, and labor and other related operating expenses of $9,455 as a result of the addition of broadband and VoIP subscribers to our network and continued investment in our VoIP operations. Our cost of sales for Corporate Operations for 2005 increased by $3,981, or 12.5%, when compared to 2004. This increase was primarily attributable to an increase of $5,872 as a result of lower recoveries from billing disputes with our telecommunication vendors, a $4,247 increase in labor and other related operating expenses and an increase of $1,299 as a result of regulatory rate adjustments. These increases were partially offset by a decrease in network cost of approximately $8,140 of which $7,211 is a result of the expiration of purchase commitment contracts with certain vendors and a $517 decrease in incentive and stock-based compensation. In 2005 we reduced our estimated liabilities for transaction-based taxes and property taxes as a result of various settlements and the expiration of the relevant statute of limitations for such taxes. These changes in accounting estimates decreased our cost of sales and our net loss by $3,830, or $0.01 per share, for 2005. As previously reported, in 2004 we reduced our estimated liabilities for some elements of our network costs that were not yet billed by our suppliers. These changes in accounting estimates decreased our cost of sales and our net loss by approximately $1,185, $0.00 per share, for 2004. In addition, in 2004 we reduced our estimated liabilities of property, transaction-based and employment-related taxes due to the expiration of the prescribed statutory period for the corresponding tax returns and due to lower property tax valuations and assessments on our network assets. These changes in accounting estimates decreased our cost of sales and our net loss by approximately $3,846, or $0.02 per share, for 2004. On a comparative basis, these changes in accounting estimates in 2004 had the effect of increasing our cost of sales and decreasing our net income by $5,031, or 0.02 per share, for 2005.
Our cost of sales for the Wholesale segment for 2004 decreased by $32,219, or 15.4%, when compared to 2003. This decrease was attributable to (i) a decrease in network costs of $6,473, as a result of a decrease in installations and continued network cost management, (ii) a decrease in the cost of equipment sold of $3,134 due to lower installations and improved inventory management, (iii) a $8,787 decrease in amortization of network and product cost subject to deferral, (iv) a $7,871 decrease in salaries and incentives, and (v) a $2,318 decrease in stock-based compensation expenses related to our 2003 ESPP. In addition, in 2004 we changed our estimated liabilities for some elements of our network costs that are not yet billed by our suppliers and stopped accruing a transaction-based tax, as described above, which decreased our cost of sales by $3,636. Our cost of sales for the Direct segment for 2004 increased by $11,017, or 23.9%, when compared to 2003. This increase was attributable to (i) a $2,529 increase in network costs due to addition of broadband and VoIP subscribers to our network, (ii) a $2,306 increase in amortization of network and product costs subject to deferral; (iii) a $9,173 increase in contract labor and other services principally due to VoIP, partially offset by (i) a $2,991 decrease in the cost of equipment due to the migration expenses associated with the Qwest customer list acquisition that occurred during 2003. Our cost of sales for Corporate Operations for 2004 decreased by $748, or 2.3%, when compared to 2003. This decrease was primarily attributable to (i) a $1,438 decrease in stock-based compensation expenses related to our 2003 ESPP, and (ii) $2,135 from charges recorded in 2003 for employment-related taxes related to stock-based compensation provided to employees in prior periods, offset by (i) a $6,251 increase in transaction-based taxes due to tax settlements that occurred in 2003, (ii) a $47 increase in contract labor and other service expenses, and (iii) a $437 increase in network costs due to the addition of central office locations. In addition, we reduced our estimated liabilities for property taxes in 2004 by $3,946 as described above.
Selling, General and Administrative Expenses
Selling, general and administrative expenses consist primarily of salaries and related expenses, other non-labor items, and our promotional and advertising expenses.
Our selling, general and administrative expenses were as follows:
Our selling, general and administrative expenses for 2005, increased by $12,311, or 8.4%, when compared to 2004. This increase was attributable to increases in labor and other related operating expenses of $8,453 primarily as
a result of the growth in our broadband and VoIP services, an increase in professional services of $2,284 primarily as a result of expenditures associated with Sarbanes-Oxley, litigation and other corporate related activities, and an increase in marketing expenses of $1,290. These increases were offset by a $2,231 decrease in incentive and stock-based compensation that primarily resulted from a reduction in the variable accounting for our 2003 ESPP. As previously reported, in 2004 we reduced our estimated liabilities for property, transaction-based and employment-related taxes due to the expiration of the prescribed statutory period for the corresponding tax returns and due to lower property tax valuations and assessments on our network assets. These changes in accounting estimates decreased our selling, general and administrative expenses and our net loss by approximately $2,515, or $0.01 per share, for 2004. On a comparative basis, these changes in estimates in 2004 had the effect of increasing our selling, general and administrative expenses by $2,515, or $0.01 per share, for 2005.
Our selling, general and administrative expenses for 2004 increased by $6,160, or 4.4%, when compared to 2003. This increase was primarily attributable to a $17,305 increase in advertising expenses, which include marketing programs to promote our VoIP products, a $4,726 increase in professional services, primarily related to our implementation of the provisions of the Sarbanes-Oxley Act, offset by a $9,442 reduction in incentive and stock-based compensation expenses, of which $6,089 relates to our 2003 ESPP, and $3,800 from charges recorded in 2003 for employment-related taxes related to stock-based compensation provided to employees in prior periods. In addition, in 2004 we changed our estimated liabilities for property, transaction-based and employment-related taxes due to the expiration of the prescribed statutory period for the corresponding tax returns and due to lower property tax valuations and assessments on our network assets. These changes in accounting estimates decreased our selling, general and administrative expenses and our net loss by approximately $2,515, or $0.01 per share, for 2004.
We expect to decrease our total selling, general and administrative expenses primarily as a result of recently implemented cost reductions initiatives which included a substantial reduction in force. We expect these benefits to improve our selling, general and administrative expenses by approximately $11,200 in 2006.
Our selling, general and administrative expenses were allocated as follows:
Our selling, general and administrative expenses for the Wholesale segment for 2005 decreased by $695, or 7.7%, when compared to 2004. This decrease was primarily attributable to decreases in labor and other related operating expenses of $1,214 as a result of lower headcount and lower incentive and stock-based compensation expenses of $691, primarily as a result of reduced charges for our 2003 ESPP, offset by an increase in marketing expenses of $1,210. Our selling, general and administrative expenses for the Direct segment for 2005 increased by $13,079, or 35.5%, when compared to 2004. This increase was attributable to increases in labor and other operating expenses of $11,500, primarily as a result of the growth in our broadband and VoIP revenues, and higher marketing expenses of $1,789, offset by a decrease in incentive and stock-based compensation expenses of $210, as a result of reduced charges for our 2003 ESPP. Our selling, general and administrative expenses for Corporate Operations for 2005 decreased by $73, or 0.1%, when compared to 2004. This decrease was primarily attributable to decreases in marketing expenses of $1,709, incentive and stock-based compensation of $1,287 as a result of reduced charges for our 2003 ESPP, and labor and other operating expenses of $1,833, partially offset by an increase in professional services as a result of expenditures associated with Sarbanes-Oxley, litigation and other corporate related of $2,284. As previously reported, in 2004 we reduced our estimated liabilities for property, transaction-based and employment-related tax liabilities due to the expiration of the prescribed statutory period for the corresponding tax returns and due to lower property tax valuations and assessments on our network assets. These changes in accounting estimates decreased our selling, general and administrative expenses and our net loss by approximately $2,515, or
$0.01 per share, for 2004. On a comparative basis, these changes in estimates in 2004 had the effect of increasing our selling, general and administrative expenses by $2,515, or $0.01 per share, for 2005.
Our selling, general and administrative expenses for the Wholesale segment for 2004 decreased by $4,021, or 30.8%, when compared to 2003. This decrease was attributable to a $211 decrease in advertising expense, a $1,922 decrease in charges for our 2003 ESPP, and by a $1,888 decrease in labor and other operating expenses. Our selling, general and administrative expenses for the Direct segment for 2004 increased by $16,513, or 81.2%, when compared to 2003. This increase was attributable to a $17,540 increase in sales and advertising expenses, which include marketing programs to promote our VoIP products, offset by a $441 decrease in labor and other operating expenses, and a decrease in stock- based compensation of $586 related to our 2003 ESPP. Our selling, general and administrative expenses for Corporate Operations for 2004 decreased by $6,332, or 5.9%, when compared to 2003. This decrease was attributable to a $4,743 decrease in salaries, incentive and stock-based compensation expenses, of which $3,581 relates to our 2003 ESPP, and a $3,800 reduction from charges recorded in 2003 for employment-related taxes related to stock-based compensation provided to employees in prior periods, offset by $4,726 increase in professional and other services, primarily related to our implementation of the provisions of the Sarbanes-Oxley Act. In addition, in 2004 we reduced our estimated liabilities by $2,515 for property, transaction-based and employment-related taxes due to the expiration of the prescribed statutory period for the corresponding tax returns and due to lower property tax valuations and assessments on our fixed assets.
Provision for Bad Debts (Bad Debt Recoveries)
Our provision for bad debts (bad debt recoveries) was $571, $(2,035) and $99 for 2005, 2004 and 2003, respectively. Our bad debts for 2005 increased by $2,606 when compared to 2004. This increase was primarily attributable to the recovery in 2004 of amounts due to us from one of our wholesale customers that were previously written off. Our bad debts for 2004 decreased by $2,134 when compared to 2003. This decrease was primarily attributable to the recovery in 2004 of amounts due to us from one of our wholesale customers that were previously written off.
Depreciation and Amortization
Our depreciation and amortization of property and equipment, or depreciation, was $49,813, $56,825 and $56,559 for 2005, 2004 and 2003, respectively. Our depreciation for 2005 decreased by $7,012 when compared to 2004 primarily due to historical assets becoming fully depreciated. Our depreciation for 2004 increased by $266 when compared to 2003 primarily as a result of the expansion of our network during 2004, offset by certain historical assets becoming fully depreciated. We expect depreciation and amortization to decrease in future periods as historical assets continue to become fully depreciated. This decrease in depreciation will be partially offset as we add more broadband and VoIP end-users to our network and augment our network to support new services like LPVA and broadband wireless.
Our amortization of intangible assets, or amortization, was $17,428, $20,585 and $17,325 for 2005, 2004 and 2003, respectively. Our amortization for 2005 decreased by $3,157 when compared to 2004 primarily due to certain assets become fully amortized. Our amortization for 2004 increased by $3,260 when compared to 2003 primarily as a result of the resumption of our network build and augmentation in selected markets during such year, which increased collocation fee expenditures and related amortization expenses. In addition, amortization in 2004 increased as a result of the acquisition of certain customer lists during 2004 and 2003. We expect amortization of intangible assets to decrease as certain assets become fully amortized.
As explained above, we do not allocate depreciation and amortization expense to our business segments.
Provision for Restructuring and Post-Employment Benefits
We reduced our workforce in 2005, 2004 and 2003 by approximately 155, 77 and 113 employees, respectively. These reductions represented approximately 13.6%, 6.9% and 10.2% of our workforce for 2005, 2004 and 2003, 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 $3,640 for 2005, of which $1,910 was paid in 2005 and the remaining $1,730 was paid after December 31, 2005, $1,409 for 2004, of
which $426 was paid after December 31, 2004, and $1,235 for 2003, all of which was paid in 2003. 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. For 2004 the expenses associated with the reductions in force were $374, $281 and $754 related to our Wholesale segment, our Direct segment and our Corporate Operations, respectively. For 2003 the expenses associated with the reductions in force were $103, $349 and $783 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.
Other Income (Expense)
Net Interest Expense
Our net interest expense was $863, $2,259 and $3,421 for 2005, 2004 and 2003, respectively. Net interest expense during 2005 and 2004 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. Our interest expense for 2004 and 2003 included our 11% long-term note payable to SBC, which we repaid in March of 2004. We expect future net interest to be limited to the interest on our 3% convertible senior debentures due 2024 offset by interest income on our cash balances.
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 condensed consolidated financial statements for additional information on such gain. We did not recognize similar gains for 2004 and 2003.
Investment Gain and Losses
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 2004 and 2003.
Our losses and write-downs on investments for 2003 were $1,026. For 2003, our losses and write-downs on investments included impairment write-downs of equity investments of $747 and our equity in the losses of unconsolidated affiliates of $279. We did not record similar losses or write-downs on investments in 2005 and 2004.
Miscellaneous Income, net
Our miscellaneous income was $298, $1,498 and $6,715 for 2005, 2004 and 2003, respectively. The decrease in 2005 when compared to 2004 was primarily due to a $1,600 payment received as a result of a legal settlement in 2004. The decrease in 2004 when compared to 2003 resulted principally from $5,000 of royalty payments received from a license agreement on our OSS software in 2003.
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, 2005, we had net operating loss carryforwards for federal tax purposes of approximately $980,199, 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 $1,231,806, of which $34,484 will expire in 2006, $33,444 in 2007, and $1,163,878 through 2025, if not utilized. In addition, we had capital loss carryforwards for federal and state income tax purposes of approximately $8,955 which will begin to expire in 2007.
On June 8, 2004, we completed our acquisition of all of the outstanding shares of privately-held GoBeam. This transaction is further explained in Note 6 to our consolidated financial statements. 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 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 the current year.
In August 2000, we made an equity investment in 10 shares of ACCA. This transaction is further explained in Note 6 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 $18,069 which was offset against our capital loss carryforward.
The utilization of our net operating loss may be subject to substantial annual limitation due to the “change in ownership” provisions of the Internal Revenue Code of 1986, as amended, and similar state provisions. The annual limitation may 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 increased by $6,122, $34,259 and $39,071 in 2005, 2004 and 2003, respectively.
Related Party Transactions
A member of our board of directors, Richard Jalkut, is the President and CEO of TelePacific Communications (“TelePacific”), one of our resellers. We recognized revenues from TelePacific of $285, $369 and $611 for 2005, 2004 and 2003, respectively. Accounts receivables from TelePacific were $19 and $29 as of December 31, 2005 and 2004, respectively. L. Dale Crandall, one of our directors, is also a director of BEA Systems (“BEA”), one of our vendors. We paid $993, $890 and $2,232 to BEA in 2005, 2004 and 2003, respectively. Charles Hoffman, our CEO, is a director of Chordiant Software (“Chordiant”), one of our vendors. We paid $620 and $3,387 to Chordiant in 2005 and 2004, respectively. No amount was paid to this vendor in 2003.
We believe these transactions were negotiated on an arms-length basis which terms we believe are comparable to transactions that would likely be negotiated with unrelated parties.
Liquidity, Capital Resources and Contractual Cash Obligations
Over the last five years we have invested substantial capital for the procurement, design and construction of our central office collocation facilities, the design, creation, implementation and maintenance of our internally used software, the purchase of telecommunications equipment and the design, development and maintenance of our networks. We expect that in future periods our expenditures related to the purchase of infrastructure equipment necessary for the 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, and expenditures related to the offering of new services, will increase based on the number of new subscribers and types of new services that we add to our network. In addition, we may incur additional capital expenditures in conjunction with our anticipated deployment of LPVA and wireless broadband services.
Our cash and cash equivalents balance for 2005 decreased by $33,215. The change in cash and cash equivalents was as follows:
Operating Activities
Net cash used in our operating activities for 2005 increased by $44,408 when compared to 2004. This increase was attributable to an increase in our net loss, adjusted for non-cash and non-operating items, of $49,315 offset by the net change in our operating assets and liabilities of 4,907. The net change in our operating assets and liabilities was primarily as a result of a $5,700 increase in collateralized and other customer deposits principally resulting from a prepayment received from one of our wholesale customers, and an increase in unearned revenues of $3,470 primarily as a result of a payment received from ACCA for the licensing of our operating and support system software, partially offset by a $3,078 decrease in our accounts payable and other liabilities primarily due to the timing of payments to our vendors, and an increase in inventories of $1,346 primarily due to meet demand for our products. Net cash used in our operating activities for 2004 improved by $49,229 when compared to 2003. This improvement was attributable to a decrease in our net loss, adjusted for non-cash and non-operating items, of $48,144, and the net change in our operating assets and liabilities of $1,085, primarily as a result of the change in our unbilled revenues, driven by lower installations.
We expect our cash usage in our operating activities to improve in 2006, primarily as a result of our anticipated growth in our net revenues and the effect of our recent reduction in force and other cost reduction initiatives, and the completion of various initiatives during 2005 to improve our VoIP operations. These improvements will be partially offset by product, sales and marketing expenses to promote our broadband and VoIP services. As discussed above, SBC recently merged with AT&T Corp. As a result of the merger we expect that the utilization of the collaterized customer prepayment we hold from SBC will increase over the next twelve months due to the combined billings of the two entities. In May 2005, we entered into an agreement with SBC and AT&T Corp. to limit the monthly amount that the prepayment could be applied against actual billings. Consequently, as of December 31, 2005, we categorized the contractual amount to be utilized over the next twelve months as a current liability.
Investing Activities
Our investing activities consist primarily of purchases, maturities and sale of short-term investments in debt securities, capital expenditures for property and equipment and expenditures to acquire collocation facilities. Net cash provided by our investing activities for 2005 increased by $34,391 when compared to 2004. This increase was primarily attributable to $29,807 related to the proceeds from the sale of our equity holdings in ACCA, $5,550 net cash effect of purchases and maturity activities in our short-term investments, and $1,307 decrease in other long-term assets primarily due to a refund of a security deposit from one of our vendors, partially offset by a $3,329 increase in restricted cash and cash equivalents primarily resulting from the issuance of letters of credit. Net cash used in our investing activities for 2004 increased by $38,288 when compared to 2003. This increase was primarily attributable to the net cash effect of purchase and maturity activities on our short-term investments of $43,828, a decrease in cost recoveries from internal-use software of $7,345, offset by a decrease in capital expenditures for property and equipment and collocation fees of $12,388. We expect that in 2006 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 increase proportionately in relation to the number of new subscribers that we add to our network. In addition, as discussed above, we may incur additional capital expenditures in conjunction with our anticipated deployment of LPVA and wireless broadband services.
As discussed above under “Recent Developments,” we completed the acquisition of NextWeb on February 16, 2006. As a result of the merger, we will pay approximately $4,000 in cash during the first quarter of 2006 as part of the consideration of the purchase price.
Financing Activities
Our financing activities consist primarily of proceeds and repayments of long-term debt and proceeds from the issuance of our common stock under our employee stock-based compensation plans. Net cash provided by our financing activities for 2005 decreased by $75,328 when compared to 2004. This decrease was primarily attributable to the receipt of $119,961 of net proceeds from the issuance of our senior unsecured convertible bonds in 2004 and a $4,651 decrease in proceeds from the issuance of our common stock, partially offset by the $50,000 principal payment of our note to SBC, which was repaid in 2004. Net cash provided by our financing activities for 2004 increased by $70,229 when compared to 2003. This increase was primarily attributable to the net proceeds on the issuance of our senior unsecured convertible bonds of $119,961, offset by the principal repayment of our note to SBC of $50,000. We expect that in 2006 our cash from financing activities will be primarily related to the proceeds of issuance of common stock under our employee stock-based compensation plans.
Liquidity
We have incurred losses and negative cash flows from operations for the last several years and have an accumulated deficit of $1,718,121 as of December 31, 2005. For 2005, we recorded a net loss of $15,722 and negative cash flow from operations of $40,732. As of December 31, 2005, we had a total cash balance of $102,004. This balance was comprised of $84,291 in unrestricted cash and cash equivalents, $12,210 in unrestricted short-term investments, and $5,503 in restricted cash and cash equivalents. During the fourth quarter of 2005, we reduced our total workforce by approximately 13.6% to improve our cost structure. In addition, we incurred expenditures in 2005 to automate several of our business processes and make them more cost effective. As a result of these actions we expect that we will have sufficient liquidity to fund our operations at least through December 31, 2006. However, adverse business, legal, regulatory or legislative developments may require us to raise additional capital or obtain funds from debt financing, raise our prices or substantially decrease our cost structure. We also recognize that we may not be able to raise or obtain additional liquidity. If cash requirements from operations exceed available funds in the future and we are unable to raise additional capital or obtain additional liquidity, our financial condition will be adversely affected.
We expect to use additional cash resources primarily to increase sales and marketing activities as we continue to expand the offering of VoIP services. The amount of this additional usage of cash to expand the offering of our VoIP services will depend on our ability to control incremental selling, general and administrative expenses, the amount of capital expenditures that is required to grow the subscriber base, development of operating support systems and software, and our ability to generate demand for our VoIP 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 2006 and beyond for developing, deploying and enhancing our network and operating our business will depend on a number of factors including:
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further development of our VoIP capabilities, including systems and software to expand and improve our VoIP services;
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our continuing ability to obtain access to ILEC facilities, including telephone lines, remote terminals, interoffice transport and high-capacity circuits, all at reasonable prices;
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rates at which resellers and end-users purchase and pay for our services and the pricing of such services;
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financial condition of our customers;
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levels of marketing required to acquire and retain customers and to attain a competitive position in the marketplace;
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rates at which we invest in engineering, equipment, development and intellectual property with respect to existing and future technology;
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operational costs that we incur to install, maintain and repair end-user lines and our network as a whole;
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pending and any future litigation;
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existing and future technology, including wireless;
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unanticipated opportunities;
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network development schedules and associated costs; and
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number of regions entered and the timing of entry and services offered.
Contractual Cash Obligations
Our contractual debt, lease and purchase obligations as of December 31, 2005 for the next five years, and thereafter, were as follows:
We lease certain vehicles, equipment and office facilities under various non-cancelable operating leases that expire at various dates through 2011. 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.
Effective July 27, 2005, we entered into an amendment to our corporate headquarters facilities lease in San Jose, California. The amendment provides for us to lease an additional 47,114 square feet of space for a term of five years. The amendment increases our lease obligation by $2,961 over the five-year term and is reflected in “office leases” in the table above.
Effective August 1, 2005, we entered into an amendment to our facilities lease in Denver, Colorado, to extend the terms of the lease and to vacate 14,871 square feet of office space, effective August 1, 2005. The extension is for a period of 4.3 years which commences on April 1, 2007. This amendment increases our lease obligation by $2,710 and is reflected in “office leases” in the table above.
Effective June 9, 2005, we entered into an agreement to lease an office in Jersey City, New Jersey to replace the current Jersey City office. Such lease ends on September 30, 2005. The lease is for a period of five years which commences on October 1, 2005, and is reflected in “office leases” in the table above.
Effective March 31, 2005, we entered into an agreement to extend the terms of our office lease in Herndon, Virginia. The extension is for a period of five years which commences on August 1, 2005, and is reflected in “office leases” above.
In 2005, we entered into an agreement with Sylantro Systems Corporation to obtain discounted pricing on ComSuite Module licenses. For 2005 we had a minimum remaining aggregate purchase commitment of $2,250. There is no remaining commitment as of December 31, 2005.
In 2002, we entered into a three-year, non-exclusive agreement with MCI, for the right to provide certain network services to us. We had a monthly minimum usage requirement which began in June 2002. The agreement expired in May 2005 and we have no remaining aggregate purchase obligation for this particular agreement as of December 31, 2005. We entered into a new three-year, non-exclusive agreement with MCI in November 2005. We have a minimum purchase commitment of $13,200 with MCI that includes five commitment milestone periods between December 2005 and December 2007. Similarly, in 2002, we entered into a four-year, non-exclusive agreement with AT&T Corp. for the right to provide long distance services to us. We have an annual minimum usage requirement which began in April 2002. The agreement expires in March 2006 and we have a minimum remaining aggregate usage commitment of approximately $281 as of December 31, 2005.
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, 2005, 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 assured. 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:
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impact of the federal, state and local telecommunications regulations, decisions and related litigation, and our ability to obtain ILEC network elements and facilities at reasonable rates;
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continuing deployment of LPVA and our ability to bundle our data services with the voice services of Earthlink and other alternative voice providers;
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timing of our cash flows;
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extent to which customers purchase our services;
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relationships with our strategic partners and other potential third parties;
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pricing for our services in the future;
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plans regarding new financing arrangements;
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margins on our service offerings;
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possibilities that we will increase our revenues;
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plans to make strategic investments and acquisitions and the effect of such investments and acquisitions;
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estimates and expectations of future operating results, the adequacy of our cash reserves, and the number of anticipated installed lines;
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plans to increase sales of value-added services, like VoIP;
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anticipated capital expenditures;
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plans to enter into business arrangements with broadband-related service providers;
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regulatory changes;
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feasibility of alternative access solutions, like wireless;
•
effects of litigation currently pending; and
•
other statements contained in this Report on Form 10-K regarding matters that are not historical facts.
These statements are only estimates or predictions and cannot be relied upon. We can give you no assurance that future results will be achieved. Actual events or results may differ materially as a result of risks facing us or actual results differing from the assumptions underlying such statements.
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 “Part I. Item 1A.
ITEM 7A.
Quantitative and Qualitative Disclosures About Market Risk
(All dollar amounts are presented in thousands)
Our exposure to financial market risk, including changes in interest and marketable equity security prices, relates primarily to our investment portfolio and outstanding debt obligations. We typically do not attempt to reduce or eliminate our market exposure on our investment securities because the majority of our investments are in fixed-rate, short-term debt securities. We do not have any derivative instruments. The fair value of our investment portfolio or related income would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due mainly to the fixed-rate and short-term nature of our investment portfolio in debt securities. In addition, all of our outstanding indebtedness as of December 31, 2005 is fixed-rate debt.
The table below presents the carrying value and related weighted-average interest rates for our cash and cash equivalents, short-term investments in debt securities and restricted cash and cash equivalents as of December 31, 2005:
ITEM 8.
ITEM 8.
Financial Statements and Supplementary Data
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.
We have completed integrated audits of Covad Communications Group, Inc.’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005 in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements
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, 2005 and December 31, 2004, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes 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. We believe that our audits provide a reasonable basis for our opinion.
Internal control over financial reporting
Also, in our opinion, management’s assessment, included in “Management’s Report on Internal Control over Financial Reporting”, appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
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.
/s/ PricewaterhouseCoopers LLP
San Jose, California
February 24, 2006
Report of Ernst and Young LLP, Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Covad Communications Group, Inc.
We have audited the accompanying consolidated statements of operations, stockholders’ equity (deficit), and cash flows of Covad Communications Group, Inc. for the year ended December 31, 2003. These statements of operations, stockholders’ equity (deficit) and cash flows are the responsibility of the Company’s management. Our responsibility is to express an opinion on these statements of operations, stockholders’ equity (deficit) and cash flows based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the statements of operations, stockholders’ equity (deficit) and cash flows are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the statements of operations, stockholders’ equity (deficit) and cash flows. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall statements of operations, stockholders’ equity (deficit) and cash flows presentation. We believe that our audit of the statements of operations, stockholders’ equity (deficit) and cash flows provides a reasonable basis for our opinion.
In our opinion, the statements of operations, stockholders’ equity (deficit) and cash flows referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of Covad Communications, Inc. for the year ended December 31, 2003, in conformity with U.S. generally accepted accounting principles.
/s/ Ernst & Young LLP
San Francisco, California
February 12, 2004,
except for (i) the fourth and fifteenth
paragraphs of Note 13 and (ii)
Note 14, as to which the
dates are May 11, 2004 and
May 27, 2004, respectively
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
See accompanying notes.
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes.
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
See accompanying notes.
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2005, 2004 and 2003
(All dollar and share amounts are presented in thousands, except per share amounts)
1.
Nature of Operations and Summary of Significant Accounting Policies
Organization, Business and Basis of Presentation
Organization and Business
Covad Communications Group, Inc., together with the subsidiaries through which businesses are conducted (collectively “Covad” or “the Company”), provides voice and data communications products and services to consumers and businesses. The Company provides these services throughout the United States in approximately 235 major metropolitan areas in 44 states. The Company’s telecommunications network allows it to offer services to approximately 57 million homes and businesses. The Company’s products and services include high-speed, or broadband, data communications, Internet access connectivity, Voice over Internet Protocol telephony, or VoIP, and a variety of related services. The Company primarily uses digital subscriber line, or DSL, and DS-1, also referred to as T-1, technologies to deliver its services. In order to provide its services the Company purchases 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 telephone companies, or ILECs, and other telecommunication carriers, and then combine these network elements with its own nationwide network facilities. The Company purchases the majority of these network elements from Verizon Communications, Inc., or Verizon, BellSouth Telecommunications, Inc., or BellSouth, AT&T, Inc. (the new combined entity resulting from the merger of AT&T, Corp. and 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, 2005, the Company had approximately 567,200 broadband access end-users and 1,147 VoIP business customers with a combined total of approximately 40,600 VoIP stations.
The Company operates 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. As of December 31, 2005, Wholesale had approximately 488,100 DSL and T-1 lines in service. The Company’s Direct segment sells VoIP, high-speed data connectivity and related value-added services through multiple channels including telesales, field sales, affinity partner programs, and its website. Direct focuses on the small business market and also sells to enterprise customers that purchase the Company’s services for distribution across their enterprise. Direct ended 2005 with approximately 79,100 DSL and T-1 lines in service.
The Company has incurred losses and negative cash flows from operations for the last several years and has an accumulated deficit of $1,718,121 as of December 31, 2005. For 2005, the Company recorded a net loss of $15,722 and negative cash flow from operations of $40,732. As of December 31, 2005, the Company had a total cash balance of $102,004. This balance was comprised of $84,291 in unrestricted cash and cash equivalents, $12,210 in unrestricted short-term investments, and $5,503 in restricted cash and cash equivalents. During the fourth quarter of 2005, the Company reduced its total workforce by approximately 13.6% to improve its cost structure. In addition, the Company incurred expenditures in 2005 to automate several of its business processes and make them more cost effective. As a result of these actions the Company expects it will have sufficient liquidity to fund its operations at least through December 31, 2006. However, adverse business, legal, regulatory or legislative developments may require the Company to raise additional capital or obtain funds from debt financing, raise its prices or substantially decrease its cost structure. The Company also recognizes that it may not be able to raise or obtain additional liquidity. If cash requirements from operations exceed available funds in the future and the Company is unable to raise additional capital or obtain additional liquidity, its financial condition will be adversely affected.
Basis of Presentation
The consolidated financial statements include the accounts of Covad and its wholly owned subsidiaries, except for the accounts of BlueStar Communications Group, Inc. and its wholly owned subsidiaries, which have been
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
excluded from the Company’s consolidated financial statements effective June 25, 2001 (Note 3). All significant intercompany accounts and transactions have been eliminated in consolidation.
Adjustments
In 2003, a matter was identified related to prior financial reporting periods that necessitated the recording of additional expense. Such matter was related to the modification of stock options granted to certain employees in prior years. These modifications occurred upon the separation of such employees from the Company, principally during 2000. Accordingly, in 2003 the Company recorded additional stock-based compensation expense in the amount of $1,236 ($0.01 per share). Such amount is reflected in the Company’s selling, general and administrative expenses in 2003. The Company does not believe this amount is material to the periods in which it should have been recorded, nor does it believe it is material to its consolidated operating results for 2003. This adjustment is principally related to 2000, the impact of which would have been to increase selling, general and administrative expenses and net loss by $1,236 ($0.01 per share) for such year.
Summary of Significant Accounting Policies
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ materially from those estimates. The Company’s critical accounting estimates include (i) revenue recognition and the establishment of accounts receivable allowances (Notes 1 and 2), (ii) inventory valuation (Note 1), (iii) reorganization and restructuring liabilities (Note 3), (iv) useful life assignments and impairment evaluations associated with property and equipment and intangible assets (Notes 1, 4 and 5), (v) anticipated outcomes of legal proceedings and other disputes (Notes 2, and 10), (vi) transaction-based tax and employment-related tax liabilities (Note 10) and (vii) valuation allowances associated with deferred tax assets (Note 12).
Cash Equivalents and Short-Term Investments
The Company considers all highly liquid investments with a maturity of three months or less from the date of original purchase to be cash equivalents. As of December 31, 2005 and 2004, cash equivalents consisted principally of money market securities and mutual funds. All of the Company’s investments are classified as available-for-sale and stated at their fair market values, which are determined based on quoted market prices. The Company’s short-term investments had original maturities greater than three months, but less than one year, from the original maturity dates. The Company determines the appropriate classification of investments at the time of purchase and reevaluates such designation at the end of each period. Unrealized gains and losses on available-for-sale securities are included as a separate component of stockholders’ equity. Realized gains and losses on available-for-sale securities are determined based on the specific identification of the cost of securities sold.
Short-term investments consisted of the following:
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As of December 31, 2005, the contractual maturities of all available-for-sale debt securities are between January 15, 2006 and February 28, 2006.
Realized gains resulting from the sale of available-for-sale equity securities was as follows:
Restricted Cash and Cash Equivalents
As of December 31, 2005 and 2004, the Company held $5,503 and $2,533, respectively, in money market securities and mutual funds, which primarily (i) collateralize irrevocable letters of credit pertaining to certain operating lease commitments and purchases from vendors (Note 9) or (ii) are restricted for the payment of unresolved bankruptcy claims.
Other Investments
Other investments consist primarily of strategic investments in privately held entities. These investments in privately held companies are accounted for under either the cost or equity methods of accounting, depending on the Company’s ownership and ability to significantly influence these entities.
The Company performs periodic reviews, or when adverse conditions occur, of its investments for impairment. Impairment write-downs create a new carrying value for the investment and the Company does not record subsequent increases in fair value in excess of the new carrying value for these types of privately held investments accounted for under the cost or equity methods. The Company recorded a write-down of $747 during 2003 related to the impairment of a privately held investment. No similar impairments were recorded in 2005 and 2004.
Concentrations of Credit Risk, Significant Customer and, Key Suppliers
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, short-term investments and restricted cash and cash equivalents. The Company’s cash and investment policies limit cash equivalents, short-term investments and restricted cash and cash equivalents to short-term, investment grade instruments. Cash and cash equivalents, short-term investments and restricted cash and cash equivalents are held primarily with various domestic and international financial institutions with high credit ratings. The Company has not experienced any significant losses on its cash, cash equivalents or restricted cash and cash equivalents.
The Company conducts business primarily with ISPs, enterprise customers and telecommunications carrier customers in the United States. As more fully described in Note 2, the Company has concentrations of credit risk with a small number of customers, and certain of the Company’s customers were experiencing financial difficulties as of December 31, 2005, 2004 and 2003 and were not current in their payments for the Company’s services at those dates. The Company performs ongoing credit evaluations of its customers’ financial condition, account balance, and payment history, and generally does not require collateral. An allowance is maintained for estimated credit
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
losses and doubtful accounts, these allowances are derived by (i) specific facts and circumstances on the financial condition of individual customers, and (ii) credit loss history on the accounts receivable portfolio.
The Company is dependent on a limited number of suppliers for certain equipment used to provide its services. The Company has generally been able to obtain an adequate supply of such equipment. However, an extended interruption in the supply of equipment currently obtained from its suppliers could adversely affect the Company’s business and results of operations.
Related Parties
The Company is a minority shareholder of Certive Corporation (“Certive”). The Company’s chairman of the of board of directors, Charles McMinn, is also a significant stockholder of Certive (Note 6).
A member of the Company’s board of directors, Richard Jalkut, is the President and CEO of TelePacific Communications (“TelePacific”), one of the Company’s resellers. The Company recognized revenues from TelePacific of $285, $369 and $611 in 2005, 2004 and 2003, respectively. Accounts receivables from TelePacific were $19 and $29 as of December 31, 2005 and 2004, respectively. Another member of the Company’s board of directors, L. Dale Crandall, is a director of BEA Systems (“BEA”), one of the Company’s vendors. The Company paid $993, $890 and $2,232 to BEA in 2005, 2004 and 2003, respectively. Accounts payable to BEA was $400 as of December 31, 2005. Charles Hoffman, the Company’s CEO, is also a director of Chordiant Software (“Chordiant”), one of the Company’s vendors. The Company paid $620 and $3,387 to Chordiant in 2005 and 2004, respectively. No amount was paid to this vendor in 2003. There were no accounts payable to Chordiant as of December 31, 2005.
Inventories
Inventories, consisting primarily of customer premises equipment, are stated at the lower of cost, determined using the “first-in, first-out” method, or market. Shipping and handling costs incurred in conjunction with the sale of inventory are included as an element of cost of sales.
Property and Equipment
Property and equipment are recorded at cost, subject to adjustments for impairment, and depreciated or amortized using the straight-line method over the following estimated ranges of useful lives:
The Company incurs significant costs associated with internal-use software, which consists principally of software used to operate its operational support systems (“OSS”), network assets, and website. The Company charges pre-development, training and maintenance costs to expense as they are incurred. Software and website development costs, which include direct costs such as labor and contractors, are capitalized when they can be segregated from other non-capitalizable labor activities and when it is probable that the project will be completed and the software or website will be used as intended. Costs incurred for upgrades and enhancements to the Company’s software or website are capitalized when it is probable that such efforts will result in additional and significant functionality. Capitalized software and website costs are amortized to expense over the estimated useful life of the software or website. Amortization of internal-use software costs amounted to $6,046, $3,566 and $3,699 in 2005, 2004, and 2003, respectively. Unamortized balances of internal-use software costs were $24,020 and $19,241 as of December 31, 2005 and 2004, respectively. The Company accounts for incidental sales of licenses for
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
its OSS software on a cost recovery basis (Note 6). In 2004, the Company began recording royalty payments for licensing its OSS software as other revenue as the cost of the licensed software has been fully recovered.
The Company leased certain equipment under capital lease agreements. Assets and liabilities under capital leases are recorded at the lesser of the present value of the aggregate future minimum lease payments, including estimated bargain purchase options, or the fair value of the assets under lease. Assets under capital leases are amortized over the lease term or the useful life of the assets. Amortization of assets under capital leases is included in depreciation and amortization expense.
Collocation Fees and Other Intangible Assets
Collocation fees represent nonrecurring fees paid to other telecommunications carriers for the right to use central office space to house equipment owned or leased by the Company. Such nonrecurring fees are capitalized as intangible assets and amortized over five years using the straight-line method. The Company’s collocation agreements also require periodic recurring payments, which are charged to expense as incurred. All such collocation agreements are cancelable by the Company at any time.
Other intangible assets consist of a customer lists acquired from third parties (Note 6). Such customer lists are being amortized over a period of twenty-four to forty-eight months, representing a weighted-average life of thirty months, using the straight-line method.
As of December 31, 2005, the Company’s estimated annual amortization expenses associated with collocation fees and other intangible assets for the next five years were as follows:
Changes in Accounting Estimates
In 2005, the Company reduced its estimated liabilities for transaction-based taxes and property taxes as a result of settlements and the expiration of the relevant statute of limitations for such taxes. These changes in accounting estimates decreased the Company’s cost of sales and its net loss by $3,830 ($0.01 per share) in 2005. In addition, as discussed in Note 10, the Company reduced its estimated liabilities for network costs as a result of a settlement with Verizon.
In 2004, the Company reduced its estimated liabilities for property taxes, primarily caused by lower property valuations and assessments on its network assets. For 2004 this change in accounting estimate reduced the Company’s cost of sales by $1,824, its selling, general and administrative expenses by $544, and its net loss by $2,368 ($0.01 per share). In addition, in 2004, the Company stopped accruing a transaction-based tax because it determined it was not subject to this tax. The determination was based on the Company’s revised interpretation of the applicability of the tax. The Company believes that such determination prospectively removes the “probable” condition required by Statement of Financial Accounting Standard 5 (“SFAS 5”) to accrue a contingent liability. For 2004, this change in accounting estimate had the effect of reducing the Company’s cost of sales and its net loss, compared to the prior year period, by approximately $3,636 ($0.01 per share). The Company did not reverse the liability of approximately $19,455 that was accrued through 2004, because the Company believes that the liability was properly recorded based upon its interpretation of the tax law at that time coupled with the guidance provided by SFAS 5. The Company believes that the criteria for derecognizing the liability for the tax reflected in its consolidated balance sheet at the time the Company stopped accruing such tax, will be met when one of the following occurs: (i) a ruling, either judicial or from the Internal Revenue Service (“IRS”), that it is not subject to the
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
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. Furthermore, in 2004 the Company recorded a bad debt recovery in the amount of $1,600 as a result of a settlement of a previously written down account receivables balance from one of its wholesale customers. For 2004, this change in accounting estimate reduced the Company’s provision for bad debts and its net loss by $1,600 ($0.01 per share). In 2004, the Company also reduced its estimated transaction-based tax liabilities and employment related tax liabilities due to the expiration of the prescribed statutory period for the corresponding tax returns. For 2004, these changes in accounting estimates reduced the Company’s cost of sales by $2,023, its selling, general and administrative expenses by $1,971 and its net loss by $3,994 ($0.02 per share).
In 2003, the Company reduced its estimated liabilities for customer incentives based on the compilation of sufficient historical data with which to estimate sales incentives that will not ultimately be claimed by customers. For 2003, this change in accounting estimate increased the Company’s revenues by $2,355, and reduced its net loss by $2,750 ($0.01 per share).
Impairment of Long-lived Assets
The Company periodically evaluates potential impairments of its long-lived assets, including intangibles. When the Company determines that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more indicators of impairment, the Company evaluates the projected undiscounted cash flows related to the assets. If these cash flows are less than the carrying value of the assets, the Company measures the impairment using discounted cash flows or other methods of determining fair value.
Long-lived assets to be disposed of are carried at the lower of cost or fair value less estimated costs of disposal.
Stock-Based Compensation
The Company accounts for stock-based awards to (i) employees (including non-employee directors) using the intrinsic value method and (ii) non-employees using the fair value method.
Under the intrinsic value method, when the exercise price of the Company’s employee stock options equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense is recognized. The following table illustrates the pro forma effect on net loss and loss per share for 2005, 2004 and 2003 had the Company applied the fair value method to account for stock-based awards to employees:
The weighted-average grant date fair value of stock-based awards to employees was $1.16, $2.46 and $1.76 per share during for 2005, 2004 and 2003, respectively. Such weighted-average grant date fair values were estimated using the Black-Scholes option valuation model and the assumptions listed in Note 13 under the caption “Pro Forma Stock-Based Compensation Information.”
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
On December 19, 2005, the Compensation Committee (the “Committee”) of the board of directors of the Company approved the acceleration of vesting of unvested and “out-of-the-money” stock options with exercise prices equal to or greater than $1.34 per share previously awarded to its employees, including its executive officers, and directors, under the Company’s 1997 Stock Plan. The acceleration of vesting was effective for stock options outstanding as of December 20, 2005. The closing stock price on the American Stock Exchange at the effective date of the acceleration was $0.67. Options to purchase approximately 6,374 shares of common stock, or approximately 74% of the Company’s outstanding unvested options, of which options to purchase approximately 1,896 shares are held by the Company’s executive officers and directors, were subject to the acceleration. The weighted-average exercise price of the options subject to the acceleration was approximately $2.73.
The Committee also imposed a holding period that will require all executive officers and directors to refrain from selling shares acquired upon the exercise of these options until the dates on which the exercise would have been permitted under the option’s original vesting terms or, if earlier, the executive officer’s last day of employment or the director’s last day of service.
The purpose of the acceleration is to enable the Company to reduce compensation expense associated with these options in future periods on its consolidated statements of operations, upon adoption of FASB Statement No. 123R - Share-Based Payment in 2006. The pre-tax charges to be avoided amount to approximately $6,725, which is included in the pro-forma numbers above for 2005, over the course of the original vesting periods, which on average is approximately three years from the effective date of the acceleration. The Company also believes that because the options to be accelerated have exercise prices substantially in excess of the current market value of the Company’s common stock, the options have limited economic value and are not fully achieving their original objective of incentive compensation and employee retention. The vesting acceleration of these stock options did not result in a charge to fourth quarter results based on accounting principles generally accepted in the United States.
On December 8, 2005, the Committee approved an amendment to the 2003 Employee Stock Purchase Plan (“2003 ESPP”). The amendment (a) reduces each offering period to six-months (with a co-terminus exercise period) for all offering periods that commence on or after January 1, 2006, and (b) terminates all offering periods that commenced prior to January 1, 2006 on December 31, 2005. As a result of the termination of these offering periods, the Company reversed $1,465 of unamortized deferred compensation expense related to the 2003 ESSP. Such amount is included in the pro-forma numbers above for 2005. The amendment to the 2003 ESPP did not result in a charge to fourth quarter earnings based on accounting principles generally accepted in the United States.
Advertising Costs
The Company charges the costs of advertising to expense as incurred. Advertising expense for 2005, 2004 and 2003 was $26,245, $24,955 and $7,650, respectively.
The Company makes market development funds (“MDF”) available to certain customers for the reimbursement of co-branded advertising expenses and other purposes. To the extent that MDF is used by the Company’s customers for co-branded advertising and the customers provide the Company with third-party evidence of such co-branded advertising as required by its policy and the Company can reasonably estimate the fair value of its portion of the advertising, such amounts are charged to advertising expense as incurred. Other amounts payable to customers relating to rebates, customer incentives and nonqualified MDF activities are recorded as reductions of revenues as incurred.
Legal Costs
The Company accounts for legal costs expected to be incurred in connection with a loss contingency as incurred.
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Income Taxes
The Company uses the liability method to account for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.
Fair Values of Financial Instruments
The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments:
Cash, Cash Equivalents, Short-Term Investments and Restricted Cash and Cash Equivalents. The carrying amounts of these assets approximate their respective fair values, which were determined based on quoted market prices.
Borrowings. The fair values of borrowings, including long-term debt and capital lease obligations, are estimated based on quoted market prices, where available, or by discounting the future cash flows using estimated borrowing rates at which similar types of borrowing arrangements with the same remaining maturities could be obtained by the Company. The aggregate fair value of the Company’s long-term debt and capital lease obligations was $72,089 as of December 31, 2005, as compared to the aggregate carrying amount of $125,206 as of such date. The Company estimated the fair value of its debentures based on the last trade of 2005, which occurred on December 20. The aggregate fair value of the Company’s long-term debt and capital lease obligations was $98,753 as of December 31, 2004, as compared to the aggregate carrying amount of $125,734 as of such date.
Foreign Currency
The functional currency of the Company’s unconsolidated affiliates is the local currency. The investments in these unconsolidated affiliates are translated into U.S. dollars at year-end exchange rates, and the Company’s equity in the income or losses of these affiliates is translated at average exchange rates prevailing during the year. Translation adjustments are included in “Accumulated other comprehensive loss,” a separate component of stockholders’ deficit.
Net Loss Per Share
Basic net loss per share amounts are computed by using the weighted-average number of shares of the Company’s common stock during the period, less the weighted-average number of common shares subject to repurchase.
Diluted net loss per share amounts are determined in the same manner as basic net loss per share amounts, except that the number of weighted-average common shares used in the computations includes dilutive common shares subject to repurchase and is increased assuming the (i) exercise of dilutive stock options and warrants using the treasury stock method and (ii) conversion of dilutive convertible debt instruments. However, diluted net loss per share amounts are the same as basic net loss per share amounts in the periods presented in the accompanying consolidated statements of operations because the impact of (i) common shares subject to repurchase, (ii) the assumed exercise of outstanding stock options and warrants, and (iii) the assumed conversion of convertible debt instruments is not dilutive.
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table presents the calculation of weighted-average common shares used in the computations of basic and diluted net loss per share amounts presented in the accompanying consolidated statements of operations:
For 2005, 2004 and 2003, outstanding options and warrants were excluded from the calculation of diluted net loss per share, as the effect would be anti-dilutive. Total outstanding options and warrants to purchase common stock at December 31, 2005 were 24,973 and 6,514 shares at weighted-average exercise price of $4.96 and $2.85, respectively. Total outstanding options and warrants to purchase common stock at December 31, 2004 were 22,997 and 6,514 shares at weighted-average exercise price of $6.10 and $2.85, respectively. Total outstanding options and warrants to purchase common stock at December 31, 2003 were 21,677 and 6,512 shares at a weighted-average exercise price of $7.09 and $2.85, respectively.
For 2005, common stock issuable upon the assumed conversion of convertible debentures were excluded from the calculation of diluted net loss per share as the effect would be anti-dilutive. These debentures are convertible into 39,380 shares of the Company’s common stock.
Comprehensive Loss
Significant components of the Company’s comprehensive loss are as follows:
Goodwill
Goodwill is recorded when the consideration paid for an acquisition exceeds the fair value of net tangible and intangible assets acquired. Goodwill is measured and tested for impairment on an annual basis or more frequently if the Company believes indicators of impairment exist. The performance of the test involves a two-step process. The first step compares the fair value of the reporting unit to its carrying amount, including goodwill. The fair value of the reporting unit is determined by calculating the market capitalization of the reporting unit as derived from quoted market prices or other generally accepted valuation methods if quoted market prices are not available. A potential impairment exists if the fair value of the reporting unit is lower than its carrying amount. The second step of the process is only performed if a potential impairment exists, and it involves determining the difference between the fair values of the reporting unit’s net assets, other than goodwill, to the fair value of the reporting unit. If the difference is less than the net book value of goodwill, an impairment exists and is recorded.
The Company determines its reporting units, for purposes of testing for impairment, by determining (i) how the Company manages its operations, (ii) if a component of an operating unit constitutes a business for which discrete financial information is available and the Company management regularly reviews such financial information, and
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(iii) how an acquired entity, is integrated with the Company. Based on these criteria, the Company determined that its Wholesale and Direct segments are its reporting units.
On June 8, 2004, the Company completed its acquisition of all of the outstanding shares of privately-held GoBeam, Inc. (“GoBeam”), as described in Note 6, “Acquisition of GoBeam.” The Company integrated and manages the GoBeam business within its Direct segment. Accordingly, the recorded goodwill from the acquisition of GoBeam was allocated to the Direct segment for purposes of testing for impairment.
Collateralized and Other Customer Deposits
The Company entered into a 10-year resale agreement with SBC (SBC is now part of AT&T) in December 2001 under which SBC, its affiliates or special agents will resell the Company’s DSL services. Under the arrangement with SBC, the Company recognizes revenue consistent with its revenue recognition policy, which is described in Note 2, “Revenue Recognition,” to its consolidated financial statements. As part of the resale agreement, SBC made a $75,000 noninterest-bearing prepayment, which is collateralized by substantially all of the Company’s domestic assets. As the Company provides certain products and services to SBC, the resultant billings are recognized as revenue in accordance with the Company’s revenue recognition policy and are offset by the prepayment to the extent of SBC’s right to do so under the resale agreement. The total balance of the prepayment as of December 31, 2005 was $43,731. The Company categorizes a portion of the prepayment liability as a current liability, based upon the amount of expected billings over the next twelve months, with the remainder classified as long-term. The amount of billings expected over the next twelve months is an estimate based on the current quantity of products and services for which SBC is being billed. The actual amount to be sold during this period may be greater or lesser than this estimated amount. As noted above, SBC recently merged with AT&T Corp., one of the Company’s wholesale customers, forming a new combined entity under the name of AT&T, Inc. As a result of the merger the Company expects that the utilization of such prepayment will increase substantially over the next twelve months due to the combined billings of the two entities. In May 2005, the Company entered into an agreement with SBC and AT&T Corp. to limit the monthly amount that the prepayment could be applied against actual billings. Consequently, as of December 31, 2005, the Company categorized the contractual amount to be utilized over the next twelve months as a current liability.
In May 2005, the Company entered into a strategic agreement with EarthLink, Inc. (“EarthLink”) to develop and deploy the Company’s line-powered voice services. Under the arrangement with EarthLink, the Company recognizes revenue consistent with its revenue recognition policy, which is described in Note 2, “Revenue Recognition,” to its condensed consolidated financial statements. As part of the agreement, EarthLink made a non-interest-bearing prepayment, which the Company has agreed to use exclusively and solely for expenditures related to the development and deployment of its line-powered voice services. Consequently, the Company classified the unused cash balance of the prepayment as restricted cash and cash equivalents as of December 31, 2005. As the Company provides the products and services described in the agreement to EarthLink, the resultant billings are recognized as revenue in accordance with the Company’s revenue recognition policy and are offset by the prepayment to the extent of EarthLink’s right to do so under the agreement. The Company categorizes a portion of the prepayment liability as a current liability, based upon the amount of expected billings over the next twelve months, with the remainder classified as long-term. The amount of billings expected over the next twelve months is an estimate based on current projections of products and services EarthLink will purchase, and the actual amount sold during this period may be greater or lesser than this estimated amount.
Post-Employment Benefits
Post-employment benefits primarily consists of the Company’s severance plans. These plans are primarily designed to provide severance benefits to those eligible employees of the Company whose employment is terminated in connection with reductions in its workforce. The Company has not accrued for this employee
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benefit, other than for individuals that have been notified of termination, because it cannot reasonably determine the probability or the amount of such payments.
Recent Accounting Pronouncements
On June 1, 2005, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”), No. 154, “Accounting Changes and Error Corrections, a replacement of Accounting Principles Board (“APB”) Opinion No. 20 and FASB Statement No. 3.” SFAS 154 applies to all voluntary changes in accounting principle and also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. APB Opinion No. 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. When it is impracticable to determine the period-specific effects of an accounting change on one or more individual prior periods presented, SFAS 154 requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period rather than being reported in the statement of operations. When it is impracticable to determine the cumulative effect of applying a change in accounting principle to all prior periods, SFAS 154 requires that the new accounting principle be applied as if it were adopted prospectively from the earliest date practicable. SFAS 154 redefines restatement as the revising of previously issued financial statements to reflect the correction of an error. SFAS 154 also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS 154 applies to accounting changes and error corrections that are made in fiscal years beginning after December 15, 2005.
In March 2005, the FASB, issued Interpretation (“FIN”) No. 47, “Accounting for Conditional Asset Retirement Obligations - an interpretation of FASB Statement of Financial Accounting Standards, No. 143, “Accounting for Asset Retirement Obligations”. FIN 47 clarifies that the term conditional asset retirement obligation as used in SFAS 143, refers to an unconditional legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Thus, the timing and (or) method of settlement may be conditional on a future event. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The fair value of a liability for the conditional asset retirement obligation should be recognized when incurred, generally upon acquisition, construction, or development and (or) through the normal operation of the asset. Uncertainty about the timing and (or) method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists. SFAS 143 acknowledges that in some cases, sufficient information may not be available to reasonably estimate the fair value of an asset retirement obligation. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. The adoption of FIN 47 did not have a significant effect on the Company’s consolidated financial statements in 2005.
In December 2004, the FASB, issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The statement eliminates the ability to account for share-based compensation transactions using the intrinsic value method as prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and generally requires that such transactions be accounted for using a fair-value-based method and recognized as expenses in the Company’s
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consolidated statement of operations. The statement requires companies to assess the most appropriate model to calculate the value of the options. The Company currently uses the Black- Scholes option pricing model to value options and expects to continue to use such model. In addition, there are a number of other requirements under the new standard that will result in differing accounting treatment than currently required. These differences include, but are not limited to, the accounting for the tax benefit on employee stock options and for stock issued under the Company employee stock purchase plan. In addition to the appropriate fair value model to be used for valuing share-based payments, the Company will also be required to determine the transition method to be used at date of adoption. The allowed transition methods include prospective and retroactive adoption options. Under the retroactive options, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded beginning in the first quarter of 2006 for all employee stock option grants issued after December 31, 2005 and for all unvested stock options and restricted stock that existed at the end of 2005. The Company will adopt SFAS 123R utilizing the prospective method.
On April 14, 2005, the Securities and Exchange Commission, (“SEC”), announced the adoption of a new rule that amends the compliance dates for SFAS 123R. Under SFAS 123R, the Company would have been required to implement the standard as of the beginning of the first interim or annual period that begins after June 15, 2005. The SEC’s new rule allows the Company to implement SFAS 123R at the beginning of its next fiscal year. Consequently, the effective date of the new standard for the Company’s consolidated financial statements is its first quarter in 2006. The SEC’s new rule does not change the accounting required by SFAS 123R; it changes only the dates for compliance with the standard.
Upon adoption, this statement will have a significant impact on the Company’s consolidated financial statements as it will require the Company to expense the fair value of its stock option grants and stock purchases under its employee stock purchase plan rather than disclose the impact on its consolidated net income within its footnotes as is its current practice (see Note 1 of the notes of the consolidated financial statements contained herein). The amounts disclosed within the Company’s footnotes are not necessarily indicative of the amounts that will be expensed upon the adoption of SFAS 123R. Compensation expense calculated under SFAS 123R may differ materially from amounts currently disclosed within the Company’s footnotes based on changes in the fair value of its common stock, changes in the number of options granted or the terms of such options, the treatment of tax benefits and changes in interest rates or other factors. In addition, upon adoption of SFAS 123R, although the Company will continue to use its current model, it may choose different assumptions to value the compensation expense associated with employee stock options.
On March 29, 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107, which provides guidance on the interaction between SFAS 123R and certain SEC rules and regulations. SAB No. 107 provides guidance that may simplify some of SFAS 123R’s implementation challenges and enhance the information that investors receive.
In December 2004, the FASB issued SFAS No. 153 “Exchanges of Non-monetary Assets.” SFAS eliminates the exception from fair value measurement for non-monetary exchanges of similar productive assets in paragraph 21 (b) of APB Opinion 29, “Accounting for Non-monetary Transactions,” and replaces it with an exception for exchanges that do not have commercial substance. SFAS 153 specifies that a non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for fiscal periods beginning after June 15, 2005. The Company is currently evaluating the effect that the adoption of SFAS 153 will have on its consolidated statement of operations and financial condition.
In November 2004, the FASB issued SFAS No. 151 “Inventory Costs - an amendment of Accounting Research Bulletin No. 43, Chapter 4.” SFAS 151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,”, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material, or spoilage. Paragraph 5 of ARB 43, previously stated that under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and re-handling costs may be so abnormal as to require
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treatment as current period charges. SFAS 151 requires that such items be recognized as current period charges regardless of whether they meet the criterion of “so abnormal.” In addition, SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for fiscal periods beginning after June 15, 2005. The Company believes that the adoption of SFAS 151 will not have a material effect on its consolidated statement of operations and financial condition for fiscal periods beginning after June 15, 2005.
In March 2004, the FASB approved Emerging Issue Task Force, or EITF, Issue 03-6, “Participating Securities and the Two - Class Method under SFAS 128.” EITF Issue 03-6 supersedes the guidance in Topic No. D-95, “Effect of Participating Convertible Securities on the Computation of Basic Earnings per Share,” and requires the use of the two-class method of participating securities. The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. In addition, EITF Issue 03-6 addresses other forms of participating securities, including options, warrants, forwards and other contracts to issue an entity’s common stock, with the exception of stock-based compensation subject to the provisions of Opinion 25 and SFAS 123. The adoption of EITF Issue 03-6 did not have a significant effect on the Company’s consolidated statement of operations and financial condition in 2005.
Risks and Uncertainties
Future results of operations involve a number of risks and uncertainties. Factors that could affect future operating results and cash flows and cause actual results to vary materially from historical results include, but are not limited to:
•
changes in government policy, regulation and enforcement or adverse judicial or administrative interpretations and rulings or legislative action relating to regulations, enforcement and pricing, including, but not limited to, changes that affect the continued availability of the unbundled network elements of the local exchange carriers network and the costs associated therewith;
•
dependence on the availability and functionality of the networks of the incumbent local exchange carriers;
•
increased price competition in local and long distance services, including bundled services, and overall competition within the telecommunications industry; and
•
adverse determinations in certain litigation matters.
Negative developments in these areas could have a material effect on the Company’s business, financial condition and results of operations. In addition, the Company financial results could differ materially from those anticipated due to other risks and uncertainties.
2.
Revenue Recognition
Revenues from recurring service are recognized when (i) persuasive evidence of an arrangement between the Company and the customer exists, (ii) service has been provided to the customer, (iii) the price to the customer is fixed or determinable and (iv) collectibility of the sales prices is reasonably assured. If a customer is (i) experiencing financial difficulties and, (ii) is not current in making payments for the Company’s services or, (iii) is essentially current in making payments but, subsequent to the end of the reporting period, the financial condition of such customer deteriorates significantly or such customer files for bankruptcy protection, then, based on this information, the Company may determine that the collectibility of revenues from this customer is not reasonably assured or its ability to retain some or all of the payments received from a customer that has filed for bankruptcy protection is not reasonably assured. Accordingly, the Company classifies this group of customers as “financially distressed” for revenue recognition purposes. Revenues from financially distressed customers are recognized when cash for the services to those customers is collected, assuming all other criteria for revenue recognition have been met, but only
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
after the collection of all previous outstanding accounts receivable balances. Payments received from financially distressed customers during a defined period prior to their filing of petitions for bankruptcy protection are recorded in the consolidated balance sheets caption “Unearned revenues” if the Company’s ability to retain these payments is not reasonably assured.
Revenues earned for which the customer has not been billed are recorded as “Unbilled revenues” in the consolidated balance sheets. Amounts billed in advance of providing service are deferred and recorded as an element of the consolidated balance sheets caption “Unearned revenues.” Included in revenues are Federal Universal Service Fund (“FUSF”) charges billed to customers aggregating $6,680, $5,381 and $4,993 for 2005, 2004 and 2003, respectively. Shipping and handling charges billed to customers are included in the Company’s net revenues.
The Company recognizes up-front fees associated with service activation over the expected term of the customer relationships, which ranges from 24 to 48 months, using the straight-line method. The Company treats the incremental direct costs of service activation, which consist principally of customer premises equipment, service activation fees paid to other telecommunications companies and sales commissions, as deferred charges in amounts that are no greater than the up-front fees that are deferred. These deferred incremental direct costs are amortized to expense using the straight-line method over 24 to 48 months.
The Company has billing disputes with some of its customers. These disputes arise in the ordinary course of business in the telecommunications industry and their impact on the Company’s accounts receivable and revenues can be reasonably estimated based on historical experience. In addition, certain revenues are subject to refund if the end-user terminates service within 30 days of service activation. Accordingly, the Company maintains allowances, through charges to revenues, based on the Company’s estimates of (i) the ultimate resolution of the disputes and (ii) future service cancellations. The allowance for service credits and bad debts is calculated generally as a percentage, based on historical trends, of balances that meet certain criteria plus specific reserves for known disputes. As stated above, revenues from financially distressed customers are recognized when cash for the services to those customers is collected but only after the collection of all previous outstanding accounts receivable balances. Upon determining that a customer is financially distressed, the Company establishes an allowance, through a charge to bad debt expense, based on the outstanding balance of such customer.
Accounts receivable consisted of the following:
The Company’s accounts receivable valuation accounts were as follows:
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Significant Customers
The Company had over 410 wholesale customers as of December 31, 2005. For 2005, 2004 and 2003, the Company’s 30 largest wholesale customers in each such year collectively comprised 92.2%, 93.4% and 93.3% of the Company’s total wholesale net revenues, respectively, and 65.4%, 67.4% and 71.6% of the Company’s total net revenues, respectively. As of December 31, 2005 and 2004, receivables from these customers collectively comprised 56.3% and 65.1%, respectively, of the Company’s gross accounts receivable balance.
Two of the Company’s wholesale customers, AT&T and Earthlink, accounted for 16.3% and 14.6%, respectively, of the Company’s total net revenues for 2005. AT&T’s percentage of 16.3% for 2005 includes the revenues for AT&T Corp., SBC and AT&T. For 2004 and 2003 Earthlink and AT&T Corp. accounted for 16.9% and 13.8%, and 21.5% and 12.5%, respectively, of the Company’s total net revenues. Accounts receivable from Earthlink and AT&T Corp., Inc. totaled 15.3% and 10.2%, respectively, of the Company’s gross accounts receivables as of December 31, 2005. As of December 31, 2004, accounts receivable from Earthlink and AT&T, Corp. totaled 17.9% and 20.9%, respectively, of the Company’s gross accounts receivables. No other individual customer accounted for more than 10% of the Company’s total net revenues in 2005, 2004 and 2003.
Wholesaler Financial Difficulties
In 2005, 2004 and 2003, the Company issued billings to its financially distressed customers aggregating $2,897, $3,517 and $5,139, respectively, that 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, the Company recognized revenues from certain of these customers when cash was collected aggregating $2,757, $2,823 and $4,367 in 2005, 2004 and 2003, respectively. Revenues from customers that filed for bankruptcy accounted for approximately 0.3%, 0.3% and 1.3% of the Company’s total net revenues for 2005, 2004 and 2003, respectively. The Company had contractual receivables from its financially distressed customers totaling $666 and $1,317 as of December 31, 2005 and 2004, respectively, which are not reflected in the accompanying consolidated balance sheet as of such date. Although MCI filed for bankruptcy protection on July 21, 2002, the Company continued to recognize revenues from MCI on an accrual basis during 2002, 2003 and 2004 (MCI emerged from bankruptcy in April 2004) based on its specific facts and circumstances in relation to the revenue recognition criteria described above. Consequently, the amounts in this paragraph related to financially distressed customers exclude amounts pertaining to MCI.
The Company has identified certain of its customers who were essentially current in their payments for the Company’s services prior to December 31, 2005, or have subsequently paid all or significant portions of the respective amounts that the Company recorded as accounts receivable as of December 31, 2005, that the Company believes may be at risk of becoming financially distressed. Revenues from these customers accounted for approximately 11.0%, 7.7% and 11.6% of the Company’s total net revenues for 2005, 2004 and 2003, respectively. As of December 31, 2005, receivables from these customers comprised 13.8% of the Company’s gross accounts receivable balance. If these customers are unable to demonstrate their ability to pay for the Company’s services in a
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timely manner in periods ending subsequent to 2005, revenue from such customers will only be recognized when cash is collected, as described above.
3.
Restructuring
Reduction in Force
The Company reduced its workforce in 2005, 2004 and 2003 by approximately 155, 77 and 113 employees, respectively. These reductions represented approximately 13.6%, 6.9% and 10.2% of the Company’s workforce for 2005, 2004 and 2003, respectively. The reductions covered employees in the areas of sales and marketing, operations and corporate functions. In connection with the reductions in force, the Company recorded employee severance benefits of $3,640 for 2005, of which $1,910 was paid in 2005 and the remaining $1,730 was paid after December 31, 2005, $1,409 for 2004, of which $426 was paid after December 31, 2004, and $1,235 for 2003, all of which was paid in 2003. For 2005 the expenses associated with the reductions in force were $285, $397 and $2,958 related to the Company’s Wholesale segment, its Direct segment and its Corporate Operations, respectively. For 2004 the expenses associated with the reductions in force were $374, $281 and $754 related to the Company’s Wholesale segment, its Direct segment and its Corporate Operations, respectively. For 2003 the expenses associated with the reductions in force were $103, $349 and $783 related to the Company’s Wholesale segment, its Direct segment and its Corporate Operations, respectively. Management continues to evaluate whether additional restructuring is necessary, and the Company may incur additional restructuring charges in future periods.
Other Restructuring Activities
On September 22, 2000, the Company acquired BlueStar Communications Group, Inc. and its subsidiaries (collectively “BlueStar”), in a transaction accounted for as a purchase. BlueStar, a wholly owned subsidiary of the Company, provided broadband communications and Internet services to small and medium-sized businesses. Continued losses at BlueStar, caused the Company’s board of directors to decide, on June 22, 2001, to cease the Company’s funding of BlueStar’s operations.
On June 25, 2001, BlueStar made an irrevocable assignment for the benefit of creditors (“ABC”) of all its assets to an independent trustee (the “Assignee”) in the State of Tennessee. An ABC under Tennessee law is a non-judicial alternative to a plan of liquidation under Chapter 7 of the Bankruptcy Code. As a result of the ABC, BlueStar’s former assets were no longer controlled by BlueStar or the Company and could not be used by either BlueStar’s or the Company’s boards of directors to satisfy the liabilities of BlueStar. Consequently, the liquidation of BlueStar’s assets and the settlement of its liabilities was currently under the sole control of the Assignee. Consequently, the Company deconsolidated BlueStar effective June 25, 2001, which resulted in the recognition of a deferred gain in the amount of $55,200 in the Company’s consolidated balance sheet as of December 31, 2001. This deferred gain represented the difference between the carrying values of BlueStar’s assets (aggregating $7,900) and liabilities (aggregating $63,100) as of June 25, 2001. During 2003 and 2002, the deferred gain was reduced by $9 and $1,228, respectively, because certain BlueStar assets were inadvertently not deconsolidated on June 25, 2001. Therefore, the deconsolidation of BlueStar resulted in a deferred gain balance of $53,963 in the Company’s consolidated balance sheets as of December 31, 2004.
On February 4, 2005, the Seventh Circuit Court for Davidson County, Tennessee ordered the Assignee in the 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, the Company recognized the deferred gain of $53,963 during 2005.
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4.
Property and Equipment
Property and equipment consisted of the following:
5.
Collocation Fees and Other Intangibles Assets
Collocation fees and other intangibles assets consisted of the following:
6.
Business Acquisition, Asset Acquisitions and Equity Investments
Acquisition of GoBeam
On June 8, 2004, the Company completed its acquisition of all of the outstanding shares of privately-held GoBeam, a Delaware corporation based in Pleasanton, California, that provides VoIP solutions to small and medium-sized businesses. The Company acquired GoBeam to accelerate its plan to enter the VoIP market. As a result of the acquisition, the Company has added a VoIP offering to its current portfolio of products and services. These factors contributed to a purchase price that was in excess of the fair value of GoBeam’s net tangible and intangible assets acquired and, as a result, the Company recorded goodwill in connection with this transaction. The acquisition was effectuated by merging a wholly-owned subsidiary of the Company with and into GoBeam, with GoBeam surviving the merger as a wholly-owned subsidiary of the Company. The merger is intended to qualify as a tax-free reorganization.
As a result of the merger, the Company issued 18,724 shares of its common stock. Additionally, the Company has reserved 266 shares to cover shares issuable upon exercise of assumed GoBeam stock options and 3 shares to cover assumed warrants. Of the shares issued in conjunction with the merger, 2,216 shares were placed in an escrow account to cover GoBeam’s indemnification obligations under the merger agreement. The Company released the shares from escrow during 2005.
The Company accounted for the acquisition of GoBeam using the purchase method of accounting. Accordingly, the Company’s consolidated financial statements include the results of operations of GoBeam for periods ending after the date of acquisition. The Company valued the common share options and warrants issued, for
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accounting purposes, based on an average market price of $2.08 per share, which is based on the average closing price for a range of two trading days before and after the measurement date of the transaction, June 4, 2004. The outstanding GoBeam stock options were converted into options to purchase approximately 266 shares of the Company’s common stock. In addition, the outstanding GoBeam warrants were converted into warrants to purchase 3 shares of the Company’s common stock. The value of the options and warrants was determined using the Black-Scholes option pricing model with inputs of 1.284 for volatility, four-year expected life and a risk-free interest rate of 3.27%. The values of the options and assumed warrants, as well as direct acquisition costs, were included as elements of the total purchase cost.
The total purchase cost of the GoBeam acquisition has been allocated to the assets and liabilities of GoBeam based upon estimates of their fair values. The following tables set forth the total purchase cost and the allocation thereof:
The tangible assets of GoBeam acquired by the Company aggregating $1,723 consisted principally of cash, accounts receivable and property and equipment. The liabilities of GoBeam assumed by the Company aggregating $6,202 consisted principally of accounts payable and accrued expenses.
The customer relationships were valued using an income approach, which projects the associated revenue, expenses and cash flows attributable to the customer base. These cash flows are then discounted to their present value. Through December 31, 2005, this intangible asset was being amortized on a straight-line basis over a period of forty-eight months which represents the expected life of the customer relationships.
The internal use software was valued using the replacement cost approach. This approach estimates value based upon estimated cost to recreate the software with equivalent functionality. Through December 31, 2005, this intangible asset was being amortized on a straight-line basis over a period of sixty months.
Goodwill was determined based on the residual difference between the purchase cost and the values assigned to identified tangible and intangible assets and liabilities, and is not deductible for tax purposes. The Company tests for impairment of these assets on at least an annual basis.
The following unaudited pro forma financial information presents the consolidated results of operations of the Company as if the acquisition of GoBeam had occurred at the beginning of the periods presented. For 2004, net loss included GoBeam merger expenses of $4,247 (none in 2003). For 2003, net loss included a charge of $1,848 for cost associated with the exit of a real estate property lease (none in 2004). This financial information does not purport to
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be indicative of the results of the operations that would have occurred had the acquisition been made at the beginning of the periods presented, or the results that may occur in the future:
Upon closing of the acquisition of GoBeam, the Company effectively granted 337 shares of restricted common stock to certain employees of GoBeam. The restricted stock was valued on the date of issuance at $1.96 and vested over a period of two years. Accordingly the Company recorded deferred stock-based compensation of $660 in 2004. In 2004, as a result of the resignation of one of the Company executives, the Company reversed $289 of such deferred stock-based compensation and cancelled 148 shares of the restricted common stock. The remaining net deferred stock-based compensation balance of $371 at December 31, 2004 is being amortized on an accelerated basis over the vesting period consisted with the method described in FIN 28. For 2005 and 2004, the Company recognized $185 and $181, respectively, of stock-based compensation related to such amount.
As part of the acquisition of GoBeam the Company sold 834 shares for $1,781, or $2.13 per share, to pay for GoBeam’s merger expenses.
Acquisition of Qwest Customer List
On June 5, 2003, the Company purchased a customer list from Qwest Communications Corporation and Qwest Interprise America, Inc. (collectively, “Qwest”) pertaining to approximately 23,000 DSL subscribers who were not located in the states where Qwest provides local telephone services (substantially all of whom were not, indirectly, end-user customers of the Company as of June 5, 2003 under the then-existing wholesale DSL services agreement with Qwest). In exchange for the customer list, the Company paid $3,750 in cash and released Qwest from its obligations under the wholesale DSL services agreement. In addition, the Company agreed to pay Qwest an additional amount of up to $1,250 if certain numbers of these customers migrate to the Company’s network within a defined period, which has now elapsed. The additional level of successful migrations was not achieved and, consequently, the Company was not required to pay such additional amount to Qwest. The Company did not assume any liabilities or obligations of Qwest or hire any of Qwest’s employees. In addition, the Company does not believe the customer list acquired from Qwest constitutes a self-sustaining, integrated set of activities and assets that would constitute a business. Approximately 13,000 of these customers were migrated to the Company’s network as of December 31, 2003.
The Company recorded the $3,750 cash payment to Qwest for the customer list as an intangible asset, and such intangible asset was amortized on a straight-line basis to operations over a twenty-four month period, which was the Company’s estimate of the aggregate expected term of its customer relationships.
Unconsolidated Investments in Affiliates
The following table lists the Company’s unconsolidated investments in affiliates as of December 31, 2005 and 2004:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
ACCA Networks Co., Ltd.
In August 2000, the Company acquired a 42% preferred equity interest in ACCA Networks Co., Ltd. (“ACCA”), a privately held, Japanese telecommunications company, in exchange for cash payments aggregating approximately $11,700, which the Company believed was representative of the fair value of such investment based on significant concurrent investments in ACCA made by new, non-strategic investors. The difference between the cost of the Company’ equity investment in ACCA and its proportional share of ACCA’s net assets had been fully amortized as of December 31, 2001. As of December 31, 2004, the Company’s equity interest in ACCA was diluted to approximately 10% due to ACCA’s financings in 2002 and 2001. In March 2005, ACCA completed a public offering of its shares in Japan, which further diluted the Company’s equity interest to approximately 8%.
In addition, in August 2000, the Company also licensed its OSS software to ACCA for $9,000, of which $2,000 and $2,000 was received in cash during 2001 and 2000, respectively. The remainder of $5,000, which was scheduled to be received in 2005, was received in 2003 in accordance with an amendment to the August 2000 OSS software license agreement. The Company recorded the $5,000 payment received in 2003 as miscellaneous income, because the carrying value of the OSS software licensed to ACCA was fully recovered at that time. The Company may also receive certain on-going royalty payments from ACCA under terms of the amended OSS license agreement. Such payments amounted to $1,832, $2,124 and $2,345 in 2005, 2004 and 2003, respectively. As stated above, the OSS software licensed to ACCA had a net book value of zero at December 31, 2005. Beginning in 2004, the Company records royalty payments as other revenue. The term of the OSS license agreement and royalty payments expired at the end of 2005. In December 2005, the Company granted ACCA, effective January 1, 2006, a fully paid-up perpetual license to its OSS software for a one-time payment of $1,750. Such amount was received in December 2005 and recorded by the Company as unearned revenues. The Company will recognize this amount as revenue in 2006.
As stated above, in March 2005, ACCA completed a public offering of its shares in Japan. The Company sold its equity position, or 10 shares, in ACCA during 2005. As a result of the sale the Company recorded a net realized gain of $28,844 in 2005.
Certive Corporation
As of December 31, 2005 and 2004, the Company held a 0.01% and 2%, respectively, preferred equity interest in Certive Corporation (“Certive”), a privately held, development stage application service provider. The dilution of the Company’s equity interest in Certive resulted from Certive’s additional equity financing in 2005 and 2004. As stated in Note 1, the Company’s chairman of the board of directors is also a significant stockholder of Certive. During 2003, the Company determined that its investment in Certive was impaired due to Certive’s financial condition and market prospects. Accordingly, the Company wrote-off the remaining carrying value of its investment through a charge to operations of $747 in 2003.
7.
Credit Arrangements
On March 10, 2004, the Company completed a private placement of $125,000 in aggregate principal amount of 3% Convertible Senior Debentures (“Debentures”) due 2024, which are convertible into shares of the Company’s common stock at a conversion price of approximately $3.1742 per share, subject to certain adjustments. The Debentures mature on March 15, 2024. The Company 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 the Company to purchase the Debentures in cash, in whole or in part, on March 15, 2009, 2014 and 2019. The holders of the Debentures will also have the ability to require the Company to purchase the Debentures in the event that the Company undergoes 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. Net proceeds from the Debentures were approximately $119,961 after commission and other transaction costs. The Company incurred approximately $5,039 in transaction costs in conjunction with the placement of the Debentures. The debt issuance costs are being amortized to operations over
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
sixty months, the period through to the first date that holders have the option to require the Company to purchase the Debentures.
Under a registration rights agreement that the Company entered into in connection with the private placement of the Debentures, the Company agreed to file a registration statement on SEC Form S-3 to register the resale of the Debentures and the common stock issuable upon conversion of the Debentures. Since the registration statement was not declared by the agreed upon date, the Company was required to pay an interest penalty that accrued at a rate equal to 0.25% per year of the aggregate principal amount of the Debentures until January 4, 2005. The Company’s registration statement became effective on December 13, 2004.
As of December 31, 2005 and 2004, the Company had a $5,750 and $3,000, respectively, revolving line of credit with a bank that is available through May 2006. At the Company’s option, borrowings under this credit facility bear interest at a rate per annum equal to the prime rate, which was 7.25% at December 31, 2005. As of December 31, 2005 and 2004, the Company had issued irrevocable letters of credit aggregating $5,190 and $2,533, respectively, under this line of credit in favor of lessors of equipment and facilities and certain vendors. As of December 31, 2005 and 2004, the amount of revolving line of credit that was available was $373 and $306, respectively. There was no outstanding principal balance as of December 31, 2005 and 2004.
8.
Capital Leases
The capitalized costs and accumulated amortization related to assets under capital leases, primarily comprised of computer equipment and office equipment, were $1,693 and $1,487, respectively, as of December 31, 2005. The corresponding amounts were $1,120 and $386, respectively, as of December 31, 2004.
9.
Operating Leases, Commitments and Purchase Obligations
Operating Leases
The Company leases vehicles, equipment and office space under various non-cancelable operating leases. The facility leases generally require the Company to pay operating costs, including property taxes, insurance and maintenance, and contain scheduled rent increases and certain other rent escalation clauses. The Company recognizes rent expense on a straight-line basis over the terms of the respective leases. Future minimum lease payments by year under operating leases with non-cancelable terms in excess of one year, along with future minimum payments to be received under non-cancelable subleases, are as follows:
Commitments
Effective August 1, 2005, the Company entered into an agreement which extended the terms of its office lease in Denver, Colorado. The extension is for a period of 4.3 years which commences on April 1, 2007. This amendment increased the Company’s lease commitments by approximately $2,710.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Effective July 27, 2005, the Company entered into an agreement to lease additional space in San Jose, California. The lease is for a period of five years which commenced on October 24, 2005. The lease increased the Company’s lease commitments by approximately $2,961.
Effective June 9, 2005, the Company entered into an agreement to lease a new office in Jersey City, New Jersey, to replace the then existing office in that city, whose lease expired on September 30, 2005. The new lease is for a period of five years which commenced on October 1, 2005. The lease increased the Company’s lease commitments by approximately $979.
Effective March 31, 2005, the Company entered into an agreement which extended the terms of its office lease in Herndon, Virginia. The extension is for a period of five years which commenced on August 1, 2005. The extension of the lease increased the Company’s lease commitments by approximately $5,029.
Rent expense, which is net of sublease income of $56, $501 and $533 for 2005, 2004 and 2003, respectively, totaled $6,253, $6,571 and $7,874 for 2005, 2004 and 2003, respectively.
Purchase Obligations
In 2002, the Company entered into a three-year, non-exclusive agreement with MCI, for the right to provide certain network services to the Company. The Company had a monthly minimum usage requirement which began in June 2002. The agreement expired in May 2005 and the Company has no remaining aggregate purchase obligation for this particular agreement as of December 31, 2005. The Company entered into a new three-year, non-exclusive agreement with MCI in November 2005. The Company has a minimum purchase commitment of $13,200 with MCI that includes five commitment milestone periods between December 2005 and December 2007. Similarly, in 2002, the Company entered into a four-year, non-exclusive agreement with AT&T for the right to provide long distance services to the Company. The Company has an annual minimum usage requirement which began in April 2002. The agreement expires in March 2006 and the Company has a minimum remaining aggregate usage commitment of approximately $281 as of December 31, 2005.
Aggregate payments by year for the Company’s purchase obligations are as follows:
Cost of sales recognized pursuant to the aforementioned purchase obligations totaled $6,725, $8,000 and $1,292, for 2005, 2004 and 2003, respectively.
10.
Contingencies
Litigation
In April 1999, the Company filed a lawsuit against Bell Atlantic (now Verizon) and its affiliates in the United States District Court for the District of Columbia. The Company was pursuing antitrust and other claims in this lawsuit arising out of Verizon’s conduct as a supplier of network facilities, including central office space, transmission facilities and telephone lines. This lawsuit was settled in December of 2005.
In December 2000, the Company also filed a lawsuit against BellSouth Telecommunications and its subsidiaries in the United States District Court for the Northern District of Georgia. The Company was pursuing claims in this lawsuit that are similar to its claims against Verizon. The Company dismissed this lawsuit in October of 2005 and is instead pursuing remedies in state and FCC regulatory proceedings.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
On June 11, 2001, Verizon filed a lawsuit against the Company in the United States District Court for the Northern District of California. Verizon is a supplier of telephone lines that the Company uses to provide services to its customers. In its amended complaint, Verizon claimed that the Company falsified trouble ticket reports with respect to the telephone lines that the Company ordered and sought unspecified monetary damages (characterized as being in the “millions”) and injunctive relief. On November 13, 2002, the District Court entered summary judgment in favor of the Company and dismissed Verizon’s claims against the Company in their entirety. Verizon appealed the dismissal of its lawsuit and in July 2004 the Ninth Circuit Court of Appeals partially reversed the District Court’s decision and indicated that Verizon could attempt to pursue a claim against the Company for breach of contract. This lawsuit was settled in December of 2005.
Several stockholders have filed complaints in the United States District Court for the Southern District of New York, on behalf of themselves and purported classes of stockholders, against the Company and several former and current officers and directors in addition to some of the underwriters who handled the Company’s stock offerings. These lawsuits are so-called IPO allocation cases, challenging practices allegedly used by certain underwriters of public equity offerings during the late 1990s and 2000. On April 19, 2002, the plaintiffs amended their complaint and removed the Company as a defendant. Certain directors and officers are still named in the complaint. The plaintiffs claim that the Company and others failed to disclose the arrangements that some of these underwriters purportedly made with certain investors. The plaintiffs and the issuer defendants have reached a tentative agreement to settle the matter, and the Company believes the tentative settlement will not have a material adverse effect on its consolidated financial position or results of operations. That settlement, however, has not been finalized. If the settlement is not finalized, the Company believes these officers and directors have strong defenses to these lawsuits and intends to contest them vigorously. However, litigation is inherently unpredictable and there is no guarantee that these officers and directors will prevail.
In June 2002, Dhruv Khanna was relieved of his duties as the Company’s 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 the Company 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 the Company’s 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.
The Company’s board of directors appointed a special investigative committee, which initially consisted of Dale Crandall and Hellene Runtagh, to investigate the allegations made by Mr. Khanna. Richard Jalkut was appointed to this committee shortly after he joined the Company’s 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 the best interests of the Company 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, the Company concluded in January 2003 that it would not be appropriate to continue Mr. Khanna on paid leave status, and determined that there was no suitable role for him at the Company. 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 the Company’s current and former directors in the Court of Chancery of the State of
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
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 the Company’s election of directors in 2002, 2003 and 2004 because they claim that the Company’s proxy statements were misleading. The Company is unable to predict the outcome of this lawsuit.
The Company is also a party to a variety of other pending or threatened legal proceedings as either plaintiff or defendant, or is 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 the Company could significantly harm its business. The Company does not believe the ultimate outcome of these matters will have a material impact on its condensed consolidated financial position, results of operations and cash flows. However, litigation is inherently unpredictable and there is no guarantee the Company will prevail or otherwise not be adversely affected.
The Company is subject to state public utility commission (“PUC”), Federal Communications Commission (“FCC”) and other regulatory and court decisions as they relate to the interpretation and implementation of the 1996 Telecommunications Act. In addition, the Company is engaged in a variety of legal negotiations, arbitrations and regulatory and court proceedings with multiple telephone companies. 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, the Company does not believe that these matters will result in material liability to it 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 the Company’s condensed consolidated financial position, results of operations and cash flows if it is denied or charged higher rates for transmission lines or central office spaces.
Purchasers of the Company’s common stock and purchasers of the convertible senior notes the Company issued in September 2000 filed complaints on behalf of themselves and alleged classes of stockholders and holders of convertible notes against the Company and certain present and former officers of the Company in the United States District Court for the Northern District of California (the “District Court”) alleging violations of federal securities laws on behalf of persons who purchased or otherwise acquired the Company’s securities, including common stock and notes, during the period from April 19, 2000 to May 24, 2001. In 2001, the Company and the officer and director defendants agreed to settle the litigation. The settlement provided for the distribution to the plaintiffs of $16,500 in cash to be funded by the Company’s insurance carriers and 6,496 shares of the Company’s common stock. Consequently, the Company recorded a liability of approximately $18,578 in its consolidated balance sheet as of December 31, 2001 through a charge to litigation-related expenses for the year then ended in connection with this anticipated settlement. As a result of changes in the fair market value of the Company’s common stock, the Company decreased this liability to $6,950 as of December 31, 2002 through credits to litigation-related expenses in the amount of $11,628 for 2002. The settlement was subject to the approval of the District Court and, on December 18, 2002, the District Court issued its final judgment and dismissal order. One class member subsequently filed an appeal pertaining to the final judgment, but this appeal only related to the allocation of the settlement proceeds between the plaintiffs and their attorneys. On February 18, 2004, the Ninth Circuit affirmed the District Court’s final judgment. Consequently, on such date the Company considered the 6,496 shares validly issued and outstanding. The distribution of the shares was completed in April of 2004.
Other Contingencies
As of December 31, 2005, the Company had disputes with a number of telecommunications companies concerning the balances owed to such carriers for collocation fees and certain network services. The Company believes that such disputes will be resolved without a material adverse effect on its condensed consolidated financial position and results of operations. However, it is reasonably possible that the Company’s estimates of its collocation
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
fee and network service obligations, as reflected in the accompanying consolidated balance sheets, could change in the near term, and the effects could be material to the Company’s consolidated financial position and results of operations.
The Company had various billing disputes with Verizon. In December 2005, the Company and Verizon reached a comprehensive agreement that settled all pending litigation and claims, including the resolution of billing disagreements. As a result of the settlement agreement, the Company received certain billing credits and was relieved of certain accrued network costs liabilities. The Company changed its estimated liabilities for network costs as a result of this settlement. This change in accounting estimate reduced the Company’s cost of sales and its net loss by approximately $4,200 ($0.02 per share) in 2005. During 2003, the Company changed its estimated liabilities for network costs as a result of the resolution of various billing disputes with its vendors and the receipt of an invoice in December 2003 from a vendor for telecommunication services provided by such vendor primarily in 2000 and 2001. During 2004, the Company resolved approximately $1,900 related to the invoice received in 2003, which reduced the Company’s cost of sales. The remainder was resolved during 2005.
The Company performs on-going research and analysis of the applicability of certain transaction-based taxes to sales of its products and services and purchases of telecommunications circuits from various carriers. This research and analysis may include discussions with authorities of jurisdictions in which the Company does business and transaction-based tax experts to determine the extent of its transaction-based tax liabilities. It is the Company’s opinion that these activities will be concluded without a material adverse effect on its condensed consolidated financial position and results of operations. However, it is reasonably possible that the Company’s estimates of its transaction-based tax liabilities, as reflected in the accompanying condensed consolidated balance sheets, could change in the near term, and the effects could be material to the Company’s condensed consolidated financial position and results of operations. During 2003, the Company changed its estimated liabilities for transaction-based and property taxes based on settlement agreements reached with various states and local jurisdictions where the Company does business. These changes in accounting estimate reduced the Company’s net loss by $8,439 ($0.04 per share).
The Company recorded an estimated liability for employment-related taxes for stock-based compensation provided to employees through a charge to operations in the amount of $5,931 for 2003. In 2004, the Company determined that it does not owe a portion of this tax, approximately $3,079, and consequently, released the amount as a benefit to the statement of operations. In addition, during 2005, the Company determined that it does not owe an additional portion of this tax, approximately $419, and consequently, released the amount as a benefit to the statement of operations. It is the Company’s opinion that remaining liability will be resolved without a material adverse effect on its condensed consolidated financial position and results of operations. However, it is reasonably possible that the Company’s estimates of this tax liability, as reflected in the accompanying condensed consolidated balance sheets as of December 31, 2005, could change in the near term, and the effects could be material to the Company’s condensed consolidated financial position and results of operations.
Indemnification Agreements
From time to time, the Company enters into certain types of contracts that contingently require it to indemnify various parties against claims from third parties. These contracts primarily relate to: (i) certain real estate leases, under which the Company may be required to indemnify property owners for environmental and other liabilities, and other claims arising from the Company’s use of the applicable premises, (ii) certain agreements with the Company’s officers, directors and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationship, (iii) contracts under which the Company may be required to indemnify customers against third-party claims that a Company product infringes a patent, copyright or other intellectual property right and (iv) procurement or license agreements under which the Company may be required to indemnify licensors or vendors for certain claims that may be brought against them arising from the Company’s acts or omissions with respect to the supplied products or technology.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Generally, a maximum obligation under these contracts is not explicitly stated. Because the obligated amounts associated with these types of agreements are not explicitly stated, the overall maximum amount of the obligation cannot be reasonably estimated. During 2005, the Company recorded $546 of expenses as a result of an indemnification clause in a contract with one of its customers that is a defendant in a patent infringement dispute. The Company expects that it will continue to incur these expenses in future periods, but the probability and amount of this obligation cannot be reasonably estimated.
11.
Stockholders’ Equity
Strategic Investors
Effective December 20, 2001, immediately prior to Covad’s emergence from Chapter 11 bankruptcy, the Company entered into a series of agreements with SBC, including (i) a $50,000 Credit Agreement, which since then has been repaid, (ii) a 10-year resale agreement (the “Resale Agreement”) under which SBC, its affiliates or special agents will resell the Company’s DSL services, and (iii) a termination and mutual general release agreement (the “Termination Agreement”) that resulted in the cancellation of various agreements entered into in September 2000, except for the stock purchase agreement and an interconnection and line-sharing agreement that remains in effect. SBC made a $75,000 noninterest-bearing prepayment, which is collateralized by substantially all of the Company’s domestic assets, to the Company on December 20, 2001 under the terms of the Resale Agreement. The Company received a payment of $10,000 from SBC on December 20, 2001 under the terms of the Termination Agreement, which was deferred and is being recognized as revenue on a straight-line basis over the 10-year term of the Resale Agreement.
Common Stock
21 and 108 shares of the Company’s common stock outstanding at December 31, 2005 and 2004, respectively, were subject to repurchase provisions, which generally lapse over a two-year period from the date of issuance.
Common stock reserved for future issuance as of December 31, 2005 was as follows:
Stockholder Protection Rights Plan
On February 15, 2000, the Company’s board of directors adopted a Stockholder Protection Rights Plan under which stockholders received one right for each share of the Company’s common stock or Class B common stock owned by them. The rights become exercisable, in most circumstances, upon the accumulation by a person or group of 15% or more of the Company’s outstanding shares of common stock. Each right entitles the holder to purchase from the Company, as provided by the Stockholder Protection Rights Agreement, one one-thousandth of a share of participating preferred stock, par value $.001 per share, for $400 per share, subject to adjustment. As of December 31, 2005 and 2004, none of these rights were exercisable.
Warrants
On January 1, 2003, in conjunction with an amendment to an agreement with AT&T Corp., the Company granted AT&T Corp. three warrants to purchase shares of the Company’s common stock as follows: 1,000 shares for
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
$0.94 per share; 1,000 shares for $3.00 per share; and 1,000 shares for $5.00 per share. Such warrants were immediately exercisable, fully vested and nonforfeitable at the date of grant. Accordingly, the measurement date for these warrants was the date of grant. The aggregate fair value of such warrants of $2,640 was recorded as a deferred customer incentive in 2003 and is being recognized as a reduction of revenues on a straight-line basis over the three-year term of the agreement because the Company believes that future revenues from AT&T Corp. will exceed the fair value of the warrants described above. The aggregate fair value was determined using the Black-Scholes option valuation model with the following facts and assumptions: closing price of the Company’s common stock on December 31, 2002 of $0.94 per share; expected life of seven years (which is also the contractual life of the warrants); dividend yield of zero; volatility of 1.52; and a risk-free interest rate of 3.36%. None of these warrants were exercised during 2005, 2004 or 2003, or had expired as of December 31, 2005. As of December 31, 2005 and 2004 the carrying amount of the warrants was $0 and $660, respectively.
On September 4, 2002, in conjunction with the execution of a five-year agreement with America Online, Inc. (“AOL”), a wholesale customer, the Company granted AOL three warrants to purchase 1,500 shares of the Company’s common stock for $1.06 per share, 1,000 shares of the Company’s common stock for $3.00 per share and 1,000 shares of the Company’s common stock for $5.00 per share. Such warrants were immediately exercisable, fully vested and nonforfeitable at the date of grant. Accordingly, the measurement date for these warrants was the date of grant. The aggregate fair value of such warrants of $3,790, which was determined using the Black-Scholes option valuation model with the following facts and assumptions: closing price of the Company’s common stock on September 4, 2002 of $1.14 per share; expected life of seven years (which is also the contractual life of the warrants); dividend yield of zero; volatility of 1.56; and a risk-free interest rate of 3.63%, was recorded as a deferred customer incentive in 2002 and is being recognized as a reduction of revenues on a straight-line basis over the five-year term of the agreement because the Company believes that future revenues from AOL will exceed the fair value of the warrants described above. None of these warrants were exercised during 2005, 2004 or 2003, or had expired as of December 31, 2005. As of December 31, 2005 and 2004 the carrying amount of the warrants was $1,264 and $2,023, respectively.
Other warrants for the purchase of 14 shares of the Company’s common stock were outstanding as of December 31, 2005. Such warrants are exercisable at a purchase price ranging from $0.01 to $2.13 per share and fully vested as of December 31, 2005. Unless exercised, all such warrants will expire during periods ending between October 2007 and March 2008.
12.
Income Taxes
The Company has made no provision for income taxes in any period presented in the accompanying consolidated financial statements because it incurred operating losses in each of these periods.
The difference between the income tax benefits computed at the federal statutory rate of 35% and the Company’s actual income tax benefits for 2005, 2004 and 2003 are as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities for federal and state income taxes are as follows:
Realization of the Company’s 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, the Company’s net deferred tax assets have been fully offset by a valuation allowance. The valuation allowance increased by $6,122, $34,259 and $39,071 during 2005, 2004 and 2003, respectively.
As of December 31, 2005, the Company had net operating loss carryforwards for federal income tax purposes of $980,199, which will expire beginning in 2021, if not utilized. The Company also had aggregate net operating loss carryforwards for state income tax of approximately $1,231,806, of which $34,484 will expire in 2006, $33,444 will expire in 2007, and $1,163,878 will expire thereafter, if not utilized. In addition, the Company had capital loss carryforwards for both federal and state income tax purposes of approximately $8,955, which begin to expire in 2007, if not utilized.
On June 8, 2004, the Company completed its acquisition of all of the outstanding shares of privately-held GoBeam (Note 6). The acquisition was effectuated by merging a wholly-owned subsidiary of the Company with and into GoBeam, with GoBeam surviving the merger as a wholly-owned subsidiary of the Company. The merger is intended to qualify as a tax-free reorganization. As a result of its acquisition, the Company’s net operating loss carryforwards includes GoBeam’s existing, as of acquisition date, federal and state net operating loss carryforwards of $39,597 and $29,426, respectively. Tax benefits related to pre-acquisition losses of the acquired entity will be utilized first to reduce any associated intangibles and goodwill.
On September 22, 2000, the Company acquired BlueStar, in a transaction accounted for as a purchase (Note 3). The Company deconsolidated BlueStar effective June 25, 2001, which resulted in the recognition of a deferred gain in the Company’s consolidated balance sheet as of December 31, 2001. Such 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 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, the Company recognized the deferred gain of $53,963 and the related deferred tax asset was recognized in 2005.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In August 2000, the Company made an equity investment in 10 shares of ACCA (Note 6). In March 2005, ACCA completed a public offering of its shares in Japan and the Company subsequently sold its investment, resulting in a capital gain. Proceeds in excess of the Company’s tax basis on such investment resulted in a tax gain of $18,069 which was offset against the Company’s capital loss carryforward.
The tax benefits associated with employee stock options provided cumulative deferred tax benefits of approximately $9,823, $8,858 and $6,938 for 2005, 2004 and 2003, respectively. Such deferred tax benefits have been offset by a valuation allowance and will be credited to additional paid-in capital if and when realized.
The utilization of the Company’s net operating loss may be subject to substantial annual limitation due to the “change in ownership” provisions of the Internal Revenue Code of 1986, as amended, and similar state provisions. The annual limitation may result in the expiration of net operating losses and tax credits before utilization.
13.
Employee Benefit Plans
Defined Contribution Plan
The Company has a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code that covers substantially all employees. Eligible employees may contribute amounts to the plan, via payroll withholding, subject to certain limitations. The Company does not match contributions by plan participants.
In connection with the Company’s acquisition of Laser Link.net, Inc. (“Laser Link”) on March 20, 2000 and BlueStar on September 22, 2000, the Company merged Laser Link’s and BlueStar’s defined contribution retirement plan under Section 401(k) of the Internal Revenue Code into the Company’s defined contribution retirement plan.
Employee Stock Purchase Plan
In January 1999, the Company adopted the 1998 Employee Stock Purchase Plan. Under this plan, eligible employees could purchase common stock at 85% of the lesser of the fair market value of the Company’s common stock on the first day of the applicable twenty-four month offering period or the last day of the applicable six-month purchase period. The 1998 Employee Stock Purchase Plan was terminated on April 28, 2003.
Employee Stock Purchase Plan
In June 2003, the Company adopted the 2003 Employee Stock Purchase Plan (“2003 ESPP”). Under this plan, eligible employees may purchase common stock at 85% of: (i) the fair market value of the Company’s common stock on the first day of the applicable twenty-four month offering period, or (ii) the fair market value on the last day of the applicable six-month purchase period. The offering period that commenced in July 2003 and ended in June 2005 was subject to variable accounting and accordingly the Company recorded net cumulative deferred stock-based compensation of $13,886 and $15,637 as of December 31, 2005 and 2004, respectively. In 2005, 2004 and 2003, the Company recognized stock-based compensation expense (reversal) of $(1,011), $2,526 and $12,371, respectively. The remaining net deferred stock-based compensation balance of $0 and $740 at December 31, 2005 and 2004, respectively, which fluctuated with changes in the Company’s stock price, was amortized to operations over the remainder of the offering period.
The number of shares that may be issued under the 2003 ESPP is subject to an annual increase to be added on January 1 of each year equal to the lesser of either (a) 2% of the outstanding shares of the Company’s stock on such date, (b) 7,000 shares or (c) an amount determined by a committee of the board.
On December 8, 2005, the compensation committee of the board of directors of the Company approved an amendment to the 2003 ESPP. The amendment (a) reduces each offering period to six-months (with a co-terminus exercise period) for all offering periods that commence on or after January 1, 2006, and (b) terminates all offering periods that commenced prior to January 1, 2006 on December 31, 2005.
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Stock Option Plans
The 1997 Stock Plan (the “Plan”) provides for the grant of stock purchase rights and options to purchase shares of common stock to employees and consultants from time to time as determined by the Company’s board of directors. The options expire from two to eight years after the date of grant. As of December 31, 2005, the Company has reserved 16,818 shares of the Company’s common stock under the Plan for sale and issuance at prices to be determined by the Company’s board of directors. The number of shares that may be issued under the Plan is subject to an annual increase to be added on the first day of the Company’s fiscal year equal to the lesser of (a) 3% of the outstanding shares of the Company’s stock on such date or (b) an amount determined by the board.
On December 19, 2005, the compensation committee of the board of directors of the Company approved the acceleration of vesting of unvested and “out-of-the-money” stock options with exercise prices equal to or greater than $1.34 per share previously awarded to its employees, including its executive officers, and directors, under the Company’s 1997 Stock Plan. The acceleration of vesting was effective for stock options outstanding as of December 20, 2005. The closing stock price on the American Stock Exchange at the effective date of the acceleration was $0.67. Options to purchase approximately 6,374 shares of common stock, or approximately 74% of the Company’s outstanding unvested options, of which options to purchase approximately 1,896 shares are held by the Company’s executive officers and directors, were subject to the acceleration. The weighted average exercise price of the options subject to the acceleration was approximately $2.73.
In connection with the Company’s acquisition of Laser Link, the Company assumed Laser Link’s stock option plan. Laser Link’s stock option plan provides for the grant of options to purchase shares of common stock to employees and consultants from time to time. The options expire up to ten years after the date of grant. The Company assumed the Laser Link stock option plan at the time it acquired Laser Link and it is no longer issuing options under the Laser Link stock option plan. A maximum of 1,435 shares of the Company’s common stock will be available for issuance under the Laser Link Plan. The options granted under the Laser Link plan are included in the data set forth below.
In connection with the Company’s acquisition of BlueStar, the Company assumed BlueStar’s stock option plan. BlueStar’s stock option plan provides for the grant of options to purchase shares of common stock to employees and consultants from time to time. The options expire up to ten years after the date of grant. The Company assumed the BlueStar stock option plan at the time it acquired BlueStar and it is no longer issuing options under the BlueStar stock option plan. A maximum of 1,251 shares of the Company’s common stock will be available for issuance under the BlueStar stock option plan. The options granted under the BlueStar stock option plan are included in the data set forth below.
In connection with the Company’s acquisition of GoBeam, the Company assumed GoBeam’s stock option plan. GoBeam’s stock option plan provides for the grant of options to purchase shares of common stock to employees and consultants from time to time. The options expire up to ten years after the date of grant. The Company assumed the GoBeam stock option plan at the time it acquired GoBeam and it is no longer issuing options under the GoBeam stock option plan. A maximum of 266 shares of the Company’s common stock will be available for issuance under the GoBeam stock option plan. The options granted under the GoBeam stock option plan are included in the data set forth below.
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes stock option activity for 2005, 2004 and 2003:
The following is a summary of the status of stock options outstanding at December 31, 2005:
As of December 31, 2004 and 2003, the Company had 14,444 and 12,289, respectively, stock options outstanding that were exercisable with an weighted-average exercise price of $8.39 and $11.02, respectively.
In 2005, 2004 and 2003, the Company recorded (reversed) deferred stock-based compensation of $(1,751), $(11,143) and $26,778, respectively, as a result of stock options subject to variable accounting that were granted under the 2003 ESPP. In 2004, the Company recorded deferred stock-based compensation of approximately $660 as a result of restricted stock issuances with exercise or purchase prices that were less than the fair value of the Company’s common stock at the date of grant or issuance (none in 2005 and 2003). These amounts are being amortized to operations over the respective vesting periods of the underlying options using a graded vesting method. Amortization (reversal) of deferred stock-based compensation for 2005, 2004 and 2003 was approximately $(808), $2,724, and $12,479, respectively.
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company grants options to consultants from time to time in exchange for services. In general, these options vest over the contractual period of the consulting arrangement. No options were granted to consultants in 2005, 2004 or 2003.
Pro forma Stock-Based Compensation Information
Pro forma information regarding the results of operations and net loss per share is determined as if the Company had accounted for its employee stock options using the fair value method. Under this method, the fair value of each option granted is estimated on the date of grant using the Black-Scholes option valuation model.
The Company uses the intrinsic value method in accounting for its employee stock options because, as discussed below, the alternative fair value accounting requires the use of option valuation models that were not developed for use in valuing employee stock options. Under the intrinsic value method, when the exercise price of the Company’s employee stock options equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense is recognized.
Option valuation models were developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected life of the option. Because the Company’s employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimates, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
For 2005, 2004 and 2003, the fair value of the Company’s stock-based awards to employees was calculated using the following weighted-average assumptions:
14.
Business Segments
The Company sells to businesses and consumers indirectly through ISPs, telecommunications carriers and other resellers. The Company also sells its services directly to business and consumer end-users through its field sales force, telephone sales, referral agents and its website. The Company was managed in 2003 as two strategic business units, Covad Strategic Partnerships, or CSP, and Covad Broadband Solutions, or CBS. Beginning in January 2004, the Company realigned its business and no longer maintains CSP and CBS as separate business units. The Company presently operates two business segments, wholesale and direct, which are described below in more detail.
The Company’s business segments are strategic business units that are managed 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. The Company’s wholesale segment, or Wholesale, is a provider of high-speed connectivity services to ISPs and enterprise and telecommunications carrier customers. The Company’s direct segment, or Direct, is a provider of VoIP, high-speed connectivity, Internet access and other services to individuals, small and medium-sized businesses, corporations and other organizations. All other business operations and activities of the Company are reported as Corporate Operations. These operations and activities are primarily comprised of general corporate functions to support the Company’s revenue producing segments as well as costs and expenses for headquarters facilities and equipment, depreciation and amortization, network capacity and other
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
non-recurring or unusual items not directly attributable or allocated to the segments, gains and losses on the Company’s investments, and income and expenses from the Company’s treasury and financing activities.
The Company’s 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 its customers. The Company’s business segments’ network costs consist of end-user circuits, aggregation circuits, central office space, Internet transit charges, customer premise equipment (“CPE”) and equipment maintenance. Operating expenses also consist of labor and related non-labor expenses for customer care, dispatch, and repair and installation activities. The Company allocates network costs to its business segments based on their consumption of circuit or equipment capacity. The Company allocates 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 installations performed by such segment and the cost of each specific CPE. The Company allocates labor costs from operations to its business segments based on resource consumption formulas, which are primarily based on installations, percentage of total lines in service and trouble tickets by segment. The Company allocates employee compensation for its sales forces directly to the business segments based on the customers it sells to and serves. The Company allocates advertising and promotions to the business segments primarily based on expenditures incurred to stimulate demand for target customer within those segments.
The Company evaluates performance and allocates resources to the segments based on income or loss from operations, excluding certain operating expenses, such as depreciation and amortization, and other income and expense items. The Company does not segregate certain of its assets, primarily cash, property and equipment, collocation fees and other intangibles and goodwill, or its cash flows between its two segments because these resources are not managed separately by segment. The Company similarly manages its capital expenditures and cash needs as one entity. Therefore, the Company does not allocate such operating expenses and other income and expense items to its business segments because it believes that these expenses and other income items are not directly managed or controlled by its business segments.
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Segment information, including a reconciliation to the respective balances in the Company’s consolidated financial statements, as of and for the years ended December 31, 2005, 2004 and 2003, are as follows:
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
During 2005 the Company changed certain allocations to its business segments. Certain 2004 balances have been adjusted to conform with the current year presentation.
15.
Subsequent events
On February 16, 2006, the Company completed its acquisition of all of the outstanding shares of privately-held NextWeb, a California corporation based in Fremont, California. NextWeb utilizes licensed and unlicensed wireless technology to deliver cost-effective, business-class wireless broadband services to small and medium-sized business. NextWeb currently provides service to approximately 3,000 business customers in the San Francisco Bay Area, Los Angeles, Orange County (California), Santa Barbara and Las Vegas. NextWeb’s service is available to more than 200,000 business locations in more than 175 cities throughout California and Nevada.
The Company acquired NextWeb to accelerate its entry into the emerging wireless broadband market. The purchase price is in excess of the fair value of NextWeb’s net tangible and intangible assets acquired and, as a result, the Company will record goodwill in connection with this transaction in the first quarter of 2006. The acquisition was effected by merging a wholly-owned subsidiary of the Company with and into NextWeb, with NextWeb surviving the merger as a wholly-owned subsidiary of the Company. The merger is intended to qualify as a tax-free reorganization. The Company will account for the acquisition of NextWeb using the purchase method of accounting. The consideration for the acquisition was comprised of a combination of approximately 16,204 shares of our common stock and a cash payment of approximately $4,000.
COVAD COMMUNICATIONS GROUP, INC.
SUPPLEMENTARY DATA
Selected Quarterly Financial Information (Unaudited)
Covad’s 2005 and 2004 unaudited consolidated selected quarterly financial information is as follows:
During the fourth quarter of 2005 we reduced our network costs by approximately $4,200 as a result of higher claim recoveries and settlements, primarily from a settlement agreement executed with Verizon. This amount was partially offset by approximately $3,600 of post-employment benefits as a result of reductions in our workforce.
ITEM 9.
ITEM 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
On April 12, 2004, the Company filed a current report on Form 8-K, pursuant to Item 4 thereof, reporting that the Company had dismissed Ernst & Young LLP as its independent registered public accounting firm and had determined to engage PricewaterhouseCoopers LLP as its independent registered public accounting firm for the fiscal year 2004.
The Company does not have any disagreements with its accountants on accounting and financial disclosure matters.
ITEM 9A.
ITEM 9A.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures:
The Securities and Exchange Commission defines the term “disclosure controls and procedures” to mean a company’s controls and other procedures that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. Our chief executive officer and chief financial officer have concluded, based on the evaluation of the effectiveness of the disclosure controls and procedures by our management, with the participation of our chief executive officer and chief financial officer, as of the end of the period covered by this report, that our disclosure controls and procedures were effective for this purpose.
In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures.
Management’s Report on Internal Control over Financial Reporting:
Our management is responsible for establishing and maintaining an adequate system of internal control over financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934 (the Exchange Act). Our internal control over financial reporting was 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.
Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2005. In making their assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. 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.
Based on our assessment we concluded that, as of December 31, 2005, our internal control over financial reporting was effective based on the criteria set forth by COSO in Internal Control - Integrated Framework.
Our management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report that appears under Item 8 - Financial Statements and Supplementary Data.
Changes in Internal Control over Financial Reporting:
During the fourth quarter of 2005, we did not make any change in our internal control over financial reporting that materially affected or is reasonably likely to materially affect our internal control over financial reporting.
ITEM 9B.
ITEM 9B.
Other Information
In our current report on Form 8-K as originally filed March 1, 2005, we incorrectly reported that David McMorrow, our Executive Vice President, Sales, received a raise of $50,000 when the correct amount of his raise was $20,000. Mr. McMorrow’s new annual base salary of $250,000 was listed correctly.
PART III
ITEM 10.
ITEM 10.
Directors and Executive Officers of the Registrant
Information regarding the names, ages and background of each of our executive officers and directors, Section 16(a) compliance, the Audit Committee, and the Company’s code of ethics in the Company’s 2006 Proxy Statement is hereby incorporated by reference.
ITEM 11.
ITEM 11.
Executive Compensation
Information regarding director and executive compensation in the 2006 Proxy Statement is hereby incorporated by reference.
ITEM 12.
ITEM 12.
Security Ownership of Certain Beneficial Owners and Management
Information setting forth the security ownership of certain beneficial owners and management and the Company’s equity compensation plans in the 2006 Proxy Statement is hereby incorporated by reference.
ITEM 13.
ITEM 13.
Certain Relationships and Related Transactions
Information regarding certain related transactions in the 2006 Proxy Statement is hereby incorporated by reference.
ITEM 14.
ITEM 14.
Principal Accounting Fees and Services
Information regarding principal accounting fees and services in the 2006 Proxy Statement is hereby incorporated by reference.
PART IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedules
(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 PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm
Report of Ernst & Young LLP, Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders’ Equity (Deficit)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules. Financial statement schedules not filed herein are omitted because of the absence of conditions under which they are required or because the information called for is shown in the consolidated financial statements and notes thereto.
(3) Exhibits. The Exhibits listed below and on the accompanying Index to Exhibits immediately following the signature page hereto are filed as part of, or incorporated by reference into, this Report on Form 10-K.
EXHIBIT INDEX
*
These certifications accompany the Registrant’s Annual Report on Form 10-K and are not deemed filed with the SEC.
(1)
Incorporated by reference to the exhibit of corresponding number filed with our current report on Form 8-K as originally filed on December 28, 2001.
(2)
Incorporated by reference to Exhibit 99.12 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(3)
Incorporated by reference to Exhibit 2.1 filed with our quarterly report on Form 10-Q as originally filed on May 17, 2004.
(4)
Incorporated by reference to Exhibit 2.1 filed with our current report on Form 8-K as originally filed on October 7, 2005.
(5)
Incorporated by reference to Exhibit 3.2 filed with our registration statement on Form S-1/A (No. 333-38688) as originally filed on July 17, 2000 and as subsequently amended.
(6)
Incorporated by reference to Exhibit 3.5 filed with our registration statement on Form S-1/A (No. 333-38688) as originally filed on July 17, 2000 and as subsequently amended.
(7)
Incorporated by reference to Exhibit 3.3 filed with our Annual Report on Form 10-K as filed on March 29, 2002.
(8)
Incorporated by reference to Exhibit 3.1 of our current report on Form 8-K as originally filed on November 2, 2005.
(9)
Incorporated by reference to the exhibit of corresponding number filed with our quarterly report on Form 10-Q as originally filed on May 17, 2004.
(10)
Incorporated by reference to Exhibit 4.1 filed with our current report on Form 8-A as originally filed on February 22, 2000 and as subsequently amended.
(11)
Incorporated by reference to Exhibit 4.1 filed with our current report on Form 8-K as originally filed on December 14, 2001.
(12)
Incorporated by reference to Exhibit 10.1 filed with our registration statement on Form S-1 (No. 333-63899) as originally filed on September 21, 1998 and as subsequently amended.
(13)
Incorporated by reference to Exhibit 10.2 filed with our Annual Report on Form 10-K as filed on March 29, 2002.
(14)
Incorporated by reference to Exhibit 10.3 filed with our Annual Report on Form 10-K as filed on March 29, 2002.
(15)
Incorporated by reference to Exhibit 4.1 filed with our current report on Form 8-K as originally filed on September 12, 2000 and as subsequently amended.
(16)
Incorporated by reference to Exhibit 4.2 filed with our current report on Form 8-K as originally filed on September 12, 2000 and as subsequently amended.
(17)
Incorporated by reference to Exhibit 10.2 filed with our quarterly report on Form 10-Q as originally filed on November 14, 2001.
(18)
Incorporated by reference to Exhibit 10.1 filed with our quarterly report on Form 10-Q as originally filed on November 14, 2001.
(19)
Incorporated by reference to Exhibit 99.4 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(20)
Incorporated by reference to Exhibit 99.5 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(21)
Incorporated by reference to Exhibit 99.6 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(22)
Incorporated by reference to Exhibit 99.7 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(23)
Incorporated by reference to Exhibit 99.8 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(24)
Incorporated by reference to Exhibit 99.9 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(25)
Incorporated by reference to Exhibit 99.10 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(26)
Incorporated by reference to Exhibit 99.11 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(27)
Incorporated by reference to Exhibit 99.1 filed with our current report on Form 8-K as originally filed September 5, 2002.
(28)
Incorporated by reference to Exhibit 99.1 filed with our current report on Form 8-K as originally filed January 7, 2003.
(29)
Incorporated by reference to Exhibit 99.1 filed with our current report on Form 8-K as originally filed on December 8, 2005.
(30)
Incorporated by reference to Exhibit 10.1 filed with our current report on Form 8-K as originally filed October 6, 2004.
(31)
Incorporated by reference to Exhibit 10.40 filed with our quarterly report on Form 10-Q as filed on October 24, 2003.
(32)
Incorporated by reference to Exhibit 10.41 to our annual report on Form 10-K as originally filed on February 27, 2004.
(33)
Incorporated by reference to Exhibit 10.42 to our annual report on Form 10-K as originally filed on February 27, 2004.
(34)
Incorporated by reference to Exhibit 10.2 to our current report on Form 8-K as originally filed on October 6, 2004.
(35)
Incorporated by reference to Exhibit 10.5 to our current report on Form 8-K as originally filed on October 6, 2004.
(36)
Incorporated by reference to Exhibit 10.7 to our current report on Form 8-K as originally filed on October 6, 2004.
(37)
Incorporated by reference to Exhibit 10.1 to our current report on Form 8-K as originally filed on November 2, 2005.
(38)
Incorporated by reference to Exhibit 10.2 to our current report on Form 8-K as originally filed on November 2, 2005.
(39)
Incorporated by reference to Exhibit 10.1 to our current report on Form 8-K as originally filed on November 24, 2004.
(40)
Incorporated by reference to Exhibit 10.1 to our current report on Form 8-K as originally filed on August 1, 2005.
(41)
Incorporated by reference to Exhibit 10.3 to our current report on Form 8-K as originally filed on November 2, 2005.
(42)
Incorporated by reference to Exhibit 10.1 to our current report on Form 8-K as originally filed on December 15, 2005.
(43)
Incorporated by reference to Exhibit 10.2 to our current report on Form 8-K as originally filed on December 15, 2005.
(44)
Incorporated by reference to Exhibit 10.1 to our current report on Form 8-K as originally filed on January 23, 2006.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 1, 2006.
COVAD COMMUNICATIONS GROUP, INC.
By:
/s/ Christopher Dunn
Christopher Dunn
Senior Vice President and
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 1, 2006.
EXHIBIT INDEX
*
These certifications accompany the Registrant’s Annual Report on Form 10-K and are not deemed filed with the SEC.
(1)
Incorporated by reference to the exhibit of corresponding number filed with our current report on Form 8-K as originally filed on December 28, 2001.
(2)
Incorporated by reference to Exhibit 99.12 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(3)
Incorporated by reference to Exhibit 2.1 filed with our quarterly report on Form 10-Q as originally filed on May 17, 2004.
(4)
Incorporated by reference to Exhibit 2.1 filed with our current report on Form 8-K as originally filed on October 7, 2005.
(5)
Incorporated by reference to Exhibit 3.2 filed with our registration statement on Form S-1/A (No. 333-38688) as originally filed on July 17, 2000 and as subsequently amended.
(6)
Incorporated by reference to Exhibit 3.5 filed with our registration statement on Form S-1/A (No. 333-38688) as originally filed on July 17, 2000 and as subsequently amended.
(7)
Incorporated by reference to Exhibit 3.3 filed with our Annual Report on Form 10-K as filed on March 29, 2002.
(8)
Incorporated by reference to Exhibit 3.1 of our current report on Form 8-K as originally filed on November 2, 2005.
(9)
Incorporated by reference to the exhibit of corresponding number filed with our quarterly report on Form 10-Q as originally filed on May 17, 2004.
(10)
Incorporated by reference to Exhibit 4.1 filed with our current report on Form 8-A as originally filed on February 22, 2000 and as subsequently amended.
(11)
Incorporated by reference to Exhibit 4.1 filed with our current report on Form 8-K as originally filed on December 14, 2001.
(12)
Incorporated by reference to Exhibit 10.1 filed with our registration statement on Form S-1 (No. 333-63899) as originally filed on September 21, 1998 and as subsequently amended.
(13)
Incorporated by reference to Exhibit 10.2 filed with our Annual Report on Form 10-K as filed on March 29, 2002.
(14)
Incorporated by reference to Exhibit 10.3 filed with our Annual Report on Form 10-K as filed on March 29, 2002.
(15)
Incorporated by reference to Exhibit 4.1 filed with our current report on Form 8-K as originally filed on September 12, 2000 and as subsequently amended.
(16)
Incorporated by reference to Exhibit 4.2 filed with our current report on Form 8-K as originally filed on September 12, 2000 and as subsequently amended.
(17)
Incorporated by reference to Exhibit 10.2 filed with our quarterly report on Form 10-Q as originally filed on November 14, 2001.
(18)
Incorporated by reference to Exhibit 10.1 filed with our quarterly report on Form 10-Q as originally filed on November 14, 2001.
(19)
Incorporated by reference to Exhibit 99.4 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(20)
Incorporated by reference to Exhibit 99.5 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(21)
Incorporated by reference to Exhibit 99.6 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(22)
Incorporated by reference to Exhibit 99.7 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(23)
Incorporated by reference to Exhibit 99.8 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(24)
Incorporated by reference to Exhibit 99.9 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(25)
Incorporated by reference to Exhibit 99.10 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(26)
Incorporated by reference to Exhibit 99.11 filed with our current report on Form 8-K as originally filed on December 28, 2001.
(27)
Incorporated by reference to Exhibit 99.1 filed with our current report on Form 8-K as originally filed September 5, 2002.
(28)
Incorporated by reference to Exhibit 99.1 filed with our current report on Form 8-K as originally filed January 7, 2003.
(29)
Incorporated by reference to Exhibit 99.1 filed with our current report on Form 8-K as originally filed on December 8, 2005.
(30)
Incorporated by reference to Exhibit 10.1 filed with our current report on Form 8-K as originally filed October 6, 2004.
(31)
Incorporated by reference to Exhibit 10.40 filed with our quarterly report on Form 10-Q as filed on October 24, 2003.
(32)
Incorporated by reference to Exhibit 10.41 to our annual report on Form 10-K as originally filed on February 27, 2004.
(33)
Incorporated by reference to Exhibit 10.42 to our annual report on Form 10-K as originally filed on February 27, 2004.
(34)
Incorporated by reference to Exhibit 10.2 to our current report on Form 8-K as originally filed on October 6, 2004.
(35)
Incorporated by reference to Exhibit 10.5 to our current report on Form 8-K as originally filed on October 6, 2004.
(36)
Incorporated by reference to Exhibit 10.7 to our current report on Form 8-K as originally filed on October 6, 2004.
(37)
Incorporated by reference to Exhibit 10.1 to our current report on Form 8-K as originally filed on November 2, 2005.
(38)
Incorporated by reference to Exhibit 10.2 to our current report on Form 8-K as originally filed on November 2, 2005.
(39)
Incorporated by reference to Exhibit 10.1 to our current report on Form 8-K as originally filed on November 24, 2004.
(40)
Incorporated by reference to Exhibit 10.1 to our current report on Form 8-K as originally filed on August 1, 2005.
(41)
Incorporated by reference to Exhibit 10.3 to our current report on Form 8-K as originally filed on November 2, 2005.
(42)
Incorporated by reference to Exhibit 10.1 to our current report on Form 8-K as originally filed on December 15, 2005.
(43)
Incorporated by reference to Exhibit 10.2 to our current report on Form 8-K as originally filed on December 15, 2005.
(44)
Incorporated by reference to Exhibit 10.1 to our current report on Form 8-K as originally filed on January 23, 2006.