Covad Communications 10Q 2007 Q2 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2007


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to .

Commission file number: 001-32588

COVAD COMMUNICATIONS GROUP, INC.

(Exact name of registrant as specified in its charter)


Delaware		77-0461529
(State or other jurisdiction		(I.R.S. Employer
of incorporation or organization)		Identification Number)

110 Rio Robles
San Jose, California
(Address of principal executive		95134
offices)		(Zip Code)

(408) 952-6400
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesþ Noo

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filed and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filero Accelerated Filerþ Non-accelerated Filero

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ

As of July 30, 2007 there were 298,016,252 shares outstanding of the Registrant’s Common Stock and no shares outstanding of the Registrant’s Class B Common Stock.

COVAD COMMUNICATIONS GROUP, INC.

For the Quarterly Period Ended June 30, 2007

TABLE OF CONTENTS


		Page
	PART I. FINANCIAL INFORMATION

ITEM 1.	Financial Statements		2
	Condensed Consolidated Balance Sheets		2
	Condensed Consolidated Statements of Operations		3
	Condensed Consolidated Statements of Cash Flows		4
	Notes to Condensed Consolidated Financial Statements		5
ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		24
ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk		44
ITEM 4.	Controls and Procedures		44

	PART II. OTHER INFORMATION

ITEM 1.	Legal Proceedings		45
ITEM 1A.	Risk Factors		46
ITEM 2.	Unregistered Sales of Equity Securities and Use of Proceeds		59
ITEM 3.	Defaults Upon Senior Securities		59
ITEM 4.	Submission of Matters to a Vote of Security Holders		59
ITEM 5.	Other Information		59
ITEM 6.	Exhibits		60
SIGNATURES			61
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

COVAD COMMUNICATIONS GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

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

(Unaudited)


	June 30,			December 31,
	2007			2006
				(Note 1)
ASSETS
Current assets:
Cash and cash equivalents	$	34,643		$	46,279
Short-term investments in debt securities		18,708			15,793
Restricted cash and cash equivalents		12,202			19,578
Accounts receivable, net		35,750			31,151
Unbilled revenues		3,869			2,567
Inventories		3,378			3,602
Prepaid expenses and other current assets		4,839			4,979

Total current assets		113,389			123,949
Property and equipment, net		77,509			87,586
Collocation fees and other intangible assets, net		18,690			22,768
Goodwill		50,002			50,002
Deferred costs of service activation		25,923			24,268
Deferred debt issuance costs, net		3,043			3,823
Other long-term assets		1,961			912

Total assets	$	290,517		$	313,308

LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Accounts payable	$	35,173		$	34,189
Accrued compensation		10,504			14,539
Accrued collocation and network service fees		15,075			15,594
Accrued transaction-based taxes		8,086			7,754
Collateralized and other customer deposits		4,825			5,585
Unearned revenues		6,300			6,528
Loan payable to bank		6,100			6,100
Other accrued liabilities		12,670			11,381

Total current liabilities		98,733			101,670
Long-term debt		169,774			167,240
Unearned revenues		39,628			39,506
Other long-term liabilities		4,329			2,538

Total liabilities		312,464			310,954

Commitments and contingencies (Notes 5 and 6)
Stockholders’ equity (deficit):
Preferred stock, $0.001 par value; 5,000 shares authorized; no shares issued and outstanding at June 30, 2007 and December 31, 2006		—			—
Common stock, $0.001 par value; 590,000 shares authorized; 297,978 shares issued and outstanding at June 30, 2007 (296,877 shares issued and outstanding at December 31, 2006)		298			297
Common stock — Class B, $0.001 par value; 10,000 shares authorized; no shares issued and outstanding at June 30, 2007 and December 31, 2006		—			—
Additional paid-in capital		1,735,946			1,734,124
Accumulated other comprehensive income (loss)		(2	)		3
Accumulated deficit		(1,758,189	)		(1,732,070	)

Total stockholders’ equity (deficit)		(21,947	)		2,354

Total liabilities and stockholders’ equity (deficit)	$	290,517		$	313,308

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

COVAD COMMUNICATIONS GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

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

(Unaudited)


	Three months ended June 30,						Six months ended June 30,
	2007			2006			2007			2006
Revenues, net	$	120,585		$	118,535		$	240,735		$	236,286
Operating expenses:
Cost of sales (exclusive of depreciation and amortization)		87,136			80,802			175,131			160,739
Benefit from federal excise tax adjustment		—			(19,455	)		—			(19,455	)
Selling, general and administrative		28,455			31,889			59,789			66,854
Depreciation and amortization of property and equipment		10,796			8,080			21,806			16,728
Amortization of collocation fees and other intangible assets		2,345			2,636			4,694			5,036
Provision for post-employment benefits		1,357			511			1,357			1,274

Total operating expenses		130,089			104,463			262,777			231,176

Income (loss) from operations		(9,504	)		14,072			(22,042	)		5,110

Other income (expense), net:
Interest income		695			1,127			1,511			2,104
Interest expense		(2,837	)		(2,732	)		(5,666	)		(4,054	)
Miscellaneous income, net		43			6			78			33

Other income (expense), net		(2,099	)		(1,599	)		(4,077	)		(1,917	)

Net income (loss)	$	(11,603	)	$	12,473		$	(26,119	)	$	3,193

Earnings (loss) per common share:
Basic	$	(0.04	)	$	0.04		$	(0.09	)	$	0.01

Diluted	$	(0.04	)	$	0.04		$	(0.09	)	$	0.01

Weighted-average number of common shares outstanding used in computing earnings (loss) per common share:
Basic		296,955			292,993			296,941			284,791

Diluted		296,955			340,064			296,941			290,220

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

COVAD COMMUNICATIONS GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(All dollar amounts are presented in thousands)

(Unaudited)


	Six months ended June 30,
	2007			2006
Operating Activities:
Net income (loss)	$	(26,119	)	$	3,193
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Provision for bad debts, net		273			110
Benefit from federal excise tax adjustment		—			(19,455	)
Depreciation and amortization		26,500			21,764
Loss on disposition of property and equipment		21			19
Stock-based compensation expense		1,098			1,543
Amortization of deferred customer incentives		379			379
Amortization of deferred debt issuance costs		780			734
Accretion of interest on investments, net		(153	)		(108	)
Other non-cash items		(300	)		—
Net changes in operating assets and liabilities, net of assets acquired and liabilities assumed in acquisition:
Accounts receivable		(4,872	)		(5,614	)
Unbilled revenues		(1,302	)		(55	)
Inventories		224			144
Prepaid expenses and other current assets		140			217
Deferred costs of service activation		(1,655	)		693
Other long-term assets		(1,443	)		—
Accounts payable		5,262			3,858
Collateralized and other customer deposits		(760	)		(10,257	)
Redemption of collateralized customer deposit		—			(33,538	)
Other liabilities		2,095			900
Unearned revenues		(106	)		(2,594	)

Net cash provided by (used in) operating activities		62			(38,067	)

Investing Activities:
Restricted cash and cash equivalents, net		7,376			(33,925	)
Purchase of short-term investments in debt securities		(20,267	)		(6,176	)
Maturities of short-term investments in debt securities		17,500			18,250
Purchase of property and equipment		(16,033	)		(20,000	)
Proceeds from sale of property and equipment		5			26
Payment of collocation fees and purchase of other intangible assets		(616	)		(2,004	)
Payment in connection with business and asset acquisitions, net of cash acquired		(177	)		(3,187	)
Other long-term assets		15			(732	)

Net cash used in investing activities		(12,197	)		(47,748	)

Financing Activities:
Proceeds from the issuance of senior secured note, net of issuance costs		—			38,457
Proceeds from utilization of credit facility		12,200			6,100
Principal payments on credit facility		(12,200	)		—
Principal payment of long-term debt		—			(1,031	)
Principal payments under capital lease obligations		(526	)		(277	)
Payment of issuance costs related to credit facility		—			(651	)
Proceeds from the issuance of common stock, net of issuance costs		1,025			14,555

Net cash provided by financing activities		499			57,153

Net decrease in cash and cash equivalents		(11,636	)		(28,662	)
Cash and cash equivalents at beginning of period		46,279			84,291

Cash and cash equivalents at end of period	$	34,643		$	55,629

Supplemental Disclosures of Cash Flow Information:
Cash paid during the period for interest	$	2,079		$	2,011

Supplemental Schedule of Non-Cash Investing and Financing Activities:
Interest obligation settled with the issuance of additional convertible long-term notes	$	2,534		$	—

Equipment purchased through capital leases	$	1,201		$	—

Common stock issued for acquisition of business	$	—		$	16,314

Accrued equipment purchases	$	3,096		$	4,777

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

COVAD COMMUNICATIONS GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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

(Unaudited)

1. Basis of Presentation and Summary of Significant Accounting Policies

The condensed consolidated financial statements include the accounts of Covad Communications Group, Inc. and its wholly-owned subsidiaries (the “Company” or “Covad”). All significant intercompany accounts and transactions have been eliminated in consolidation.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary to state fairly the condensed consolidated financial statements of the Company have been included. Operating results for the three and six months ended June 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007.

The Company has incurred losses and negative cash flows from operations for the last several years and has an accumulated deficit of $1,758,189 as of June 30, 2007. For the six months ended June 30, 2007, the Company recorded a net loss of $26,119 and cash flow from operations of $62. As of June 30, 2007, the Company had $34,643 in cash and cash equivalents, $18,708 in short-term investments, and $12,202 in restricted cash and cash equivalents. The sum of these balances amounted to $65,553. Over the last two years, the Company reduced its total workforce by 26% and incurred expenditures to automate several of its business processes to improve its cost structure. In addition, as described in Note 5 —“Long-Term Debt,”the Company obtained a $50,000 revolving credit facility from a bank in April 2006, which was renewed in April 2007. As a result of these actions the Company expects it will have sufficient liquidity to fund its operations at least through June 30, 2008. However, adverse business, legal, regulatory or legislative developments may require the Company to raise additional capital, obtain additional 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, then the Company’s financial condition will be adversely affected.

The condensed consolidated balance sheet as of December 31, 2006 has been derived from the audited consolidated financial statements at that date but does not include all of the footnotes required by GAAP for complete financial statements.

All information included in this report should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

Use of Estimates

The preparation of financial statements in accordance with GAAP requires management 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 for the reporting period. Actual results may differ materially from these estimates. The Company’s critical accounting estimates include (i) revenue recognition and the establishment of accounts receivable allowances, (ii) inventory valuation, (iii) post-employment benefit liabilities, (iv) useful life assignments and impairment evaluations associated with property and equipment and intangible assets, (v) anticipated outcomes of legal proceedings and other disputes, (vi) transaction-based tax and employment-related tax liabilities, (vii) valuation allowances associated with deferred tax assets, (viii) assumptions used for estimating stock-based compensation, and (ix) expenditures for market development funds (“MDF”).

Benefit from federal excise tax adjustment —In 2004, the Company ceased the accrual of the Federal Excise Tax (“FET”) on the purchases of certain telecommunications services because it determined it should not be subject to this tax. The determination was based on the Company’s revised interpretation of the applicability of the tax. That determination prospectively removed the “probable” condition required by Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standard (“SFAS”) No. 5 to accrue a contingent liability. The Company did not reverse the liability of $19,455 that was previously accrued, because the liability was properly recorded based upon its interpretation of the tax law at that time coupled with the guidance provided by SFAS No. 5. The criteria for reversing the liability for the tax is met when: (i) a ruling, either judicial or from the Internal Revenue Service (“IRS”), that the Company is not subject to the tax, (ii) a ruling, either judicial or from the IRS that a company with similar facts and circumstances to the Company is not subject to the tax, (iii) a settlement with the IRS on this matter or, (iv) the expiration of the applicable statute of limitations. On May 25, 2006, the IRS issued Notice 2006-50 announcing that it will stop collecting FET on “long-distance” telephone service and that it will no longer litigate this issue with taxpayers. The FET is now only applicable to “local” telephone service. The services the Company purchased for which it accrued FET do not fall under the definition of local telephone service. Therefore, the Company had determined that (i) IRS Notice 2006-50 resolved the uncertainty around the applicability of the tax to those telecommunications services, and (ii) meets one of the criteria stated above for reversing the accrued liability of $19,455. Consequently, the Company reversed such liability during the three and six months ended June 30, 2006, which increased the Company’s net income by $19,455, or $0.06 and $0.07 per share, respectively.

For the three months ended June 30, 2007, the Company reduced its estimated liabilities for transaction-based and employment-related taxes as a result of the expiration of the statute of limitations for such taxes. These changes in accounting estimates decreased the Company’s cost of sales, selling, general and administrative expenses, and its net loss by $527, $215, and $742 ($0.00 per share), respectively, for the three months ended June 30, 2007. For the six months ended June 30, 2007, the Company reduced its estimated liabilities for transaction-based and employment-related taxes as a result of the expiration of the statute of limitations for such taxes. These changes in accounting estimates decreased the Company’s cost of sales, selling, general and administrative expenses, and its net loss by $761, $215, and $976 ($0.00 per share), respectively, for the six months ended June 30, 2007. In addition, for the three and six months ended June 30, 2007, the Company reduced its estimated liabilities for network costs as a result of a settlement with one of its vendors reached in July 2007. This change in accounting estimate decreased the Company’s cost of sales and its net loss by $2,748, or $0.01 per share, for the three and six months ended June 30, 2007.

For the three months ended June 30, 2006, the Company reduced its estimated liabilities for transaction-based and employment-related taxes as a result of the expiration of the statute of limitations for such taxes. These changes in accounting estimates decreased the Company’s cost of sales, selling, general and administrative expenses and increased its net income by $1,679, $1,346 and $3,025 ($0.01 per share), respectively, for the three months ended June 30, 2006. For the six months ended June 30, 2006, the Company reduced its estimated liabilities for transaction-based and employment-related taxes as a result of the expiration of the statute of limitations for such taxes. These changes in accounting estimates decreased the Company’s cost of sales, selling, general and administrative expenses and increased its net income by $2,537, $1,346, and $3,883 ($0.01 per share), respectively, for the six months ended June 30, 2006.

Restricted Cash and Cash Equivalents

As of June 30, 2007 and December 31, 2006, the Company held $12,202 and $19,578, respectively, in money market securities and mutual funds, which are classified as restricted cash. These funds primarily consist of the remaining portion of the $50,000 that the Company received in March 2006 as a result of a strategic agreement with EarthLink, Inc. (“EarthLink”), as described in Note 5 -“Long-Term Debt.”Under the terms and conditions of the agreement with EarthLink, the proceeds received were to be used for various expenditures to enable the Company to deploy and offer line-powered voice access (“LPVA”) services, accordingly, such proceeds are classified as restricted cash. As the Company pays for expenditures related to this agreement, the Company will continue to reduce the balance of the restricted cash accordingly.

Inventories

Inventories, consisting primarily of customer premises equipment (“CPE”), 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.

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 value of the reporting unit’s net assets, other than goodwill, and the fair value of the reporting unit. If the difference is less than the net book value of goodwill, 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’s management regularly reviews such financial information, and (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 February 16, 2006, the Company completed its acquisition of all of the outstanding shares of privately-held NextWeb, Inc. (“NextWeb”), as described in Note 9 —“Business Acquisition.”The Company integrated and manages the NextWeb business within its Direct segment. Accordingly, the recorded goodwill from the acquisition of NextWeb was allocated to the Company’s Direct segment for purposes of testing for impairment.

As of June 30, 2007 and December 31, 2006 the $50,002 balance of goodwill in the Company’s condensed consolidated balance sheets was allocated to the Direct segment.

Collateralized and Other Customer Deposits

In December 2001, the Company entered into a 10-year resale agreement with AT&T, Inc. (“AT&T”), formerly SBC Communications, Inc. (“SBC”), under which AT&T, its affiliates or special agents may resell the Company’s digital subscriber line (“DSL”) services. As part of the resale agreement, AT&T made a $75,000 non-interest-bearing prepayment, which was collateralized by substantially all of the Company’s domestic assets. On April 12, 2006, the Company redeemed the above described collateralized customer deposit liability with AT&T. The Company paid AT&T $33,538, which was $1,765 less than the carrying amount of such liability. As a result of the redemption, the collateralized customer deposit liability has been terminated, and AT&T has relinquished its related liens on the Company’s assets. In addition, several agreements, not including the resale agreement, between the Company and AT&T, have also been terminated, subject to certain obligations and provisions which survive termination of the agreements. The above described discount was recorded as unearned revenue and was fully amortized as of April 2007, which corresponds with the end of the contractual utilization period of the prepayment.

On May 27, 2005, the Company entered into a strategic agreement with EarthLink to develop and deploy the Company’s LPVA services. As part of the agreement, EarthLink made a non-interest-bearing prepayment, which the Company agreed to use exclusively for expenditures related to the development and deployment of its LPVA services. Consequently, the Company classified the unused cash balance of the prepayment as restricted cash and cash equivalents. As of December 31, 2006 and June 30, 2007, proceeds associated with this prepayment were fully utilized towards expenditures related to the provision of the LPVA services. As of June 30, 2007, the remaining amount of the prepayment is classified as a current liability in collateralized and other

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

Post-Employment Benefits

Post-employment benefits primarily consist 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 benefit, other than for individuals who have been notified of termination, because the Company cannot reasonably determine the probability or the amount of such payments.

Earnings (Loss) Per Share

Basic earnings (loss) per share amounts are computed by using the weighted-average number of shares of the Company’s common stock outstanding for the period, less the weighted-average number of common shares subject to repurchase.

Diluted earnings (loss) per share amounts are computed in the same manner as basic earnings (loss) per share amounts, except that the weighted-average number of common shares outstanding computed for basic earnings (loss) per share is increased by the weighted-average number of common shares resulting from the (i) purchase of shares under the Company’s employee stock purchase program, and exercise of stock options and warrants using the treasury stock method, and (ii) conversion of convertible debt instruments. Equity instruments are excluded from the calculation of diluted weighted-average number of common shares outstanding if the effect of including such instruments would not be dilutive to earnings (loss) per share. In applying the treasury stock method for dilutive stock-based compensation arrangements, the assumed proceeds are computed as the sum of (i) the amount, if any, the employee must pay upon exercise, (ii) the amounts of compensation cost attributed to future services and not yet recognized, and (iii) the amount of tax benefits (both deferred and current), if any, that would be credited to additional paid-in capital assuming exercise of the options. In addition, in computing the dilutive effect of convertible securities, net income (loss) is adjusted to add back the after-tax amount of interest expensed in the period associated with any convertible debt.

The following table presents the calculation of net income (loss) used in the computations of basic and diluted earnings (loss) per share presented in the accompanying condensed consolidated statements of operations:


	Three months ended June 30,					Six months ended June 30,
	2007			2006		2007			2006
Basic:
Net income (loss) as reported	$	(11,603	)	$	12,473	$	(26,119	)	$	3,193
Diluted:
Add back interest on 3% convertible debentures		—			1,190		—			—

Net income (loss) adjusted for assumed conversions	$	(11,603	)	$	13,663	$	(26,119	)	$	3,193

The following table presents the calculation of weighted-average common shares used in the computations of basic and diluted earnings (loss) per share amounts presented in the accompanying condensed consolidated statements of operations:


	Three months ended June 30,				Six months ended June 30,
	2007		2006		2007		2006
Basic:
Weighted-average number of common shares outstanding used in the computations of basic earnings (loss) per share		296,955		292,993		296,941		284,791
Diluted:
Dilutive stock options and warrants		—		7,691		—		5,429
Assumed conversion of 3% convertible debentures		—		39,380		—		—

Weighted-average number of common shares outstanding used in the computations of diluted earnings (loss) per share		296,955		340,064		296,941		290,220

For the three and six months ended June 30, 2007, the weighted-average number of common shares outstanding used in the computations of diluted earnings (loss) per share is the same as basic because the impact of (i) the assumed exercise of outstanding stock options and warrants, and (ii) the assumed conversion of convertible debentures and notes is not dilutive.

As stated above, the Company excludes equity instruments from the calculation of diluted weighted-average number of common shares outstanding if the effect of including such instruments would not be dilutive to earnings (loss) per share. Accordingly, certain equity instruments have been excluded from the calculation of diluted weighted-average shares. The type and number of these equity instruments that were excluded from the computation of diluted earnings (loss) per share were as follows:


	Three months ended June 30,				Six months ended June 30,
	2007		2006		2007		2006
Stock options		24,417		18,139		24,417		19,677
Warrants		6,514		5,192		6,514		5,525
Common shares issuable under the assumed conversion of convertible debentures and notes		63,452		21,505		63,452		60,885

Comprehensive Income (Loss)

Components of the Company’s comprehensive income (loss) for the three and six months ended June 30, 2007 and 2006 are as follows:


	Three months ended June 30,						Six months ended June 30,
	2007			2006			2007			2006
Net income (loss)	$	(11,603	)	$	12,473		$	(26,119	)	$	3,193
Unrealized gains (loss) on available-for-sale securities		(6	)		(3	)		(5	)		4

Comprehensive income (loss)	$	(11,609	)	$	12,470		$	(26,124	)	$	3,197

Recent Accounting Pronouncements

In February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115.”SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. This statement permits an entity to choose to measure many financial instruments and certain other items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. The Company is evaluating the effect that SFAS No. 159 will have on its financial statements upon adoption of the Statement.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements.”This Statement defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. Prior to SFAS No.157, there were different definitions of fair value and limited guidance for applying those definitions in GAAP. In developing this Statement, the FASB considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is evaluating the effect that SFAS No. 157 will have on its financial statements upon adoption of the Statement.

In June 2006, the FASB ratified the consensus on Emerging Issues Task Force (“EITF”) No. 06-3,“How Taxes Collected from Customers and Remitted to Governmental Authorities should be presented in the Income Statement.”The scope of EITF No. 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer and may include, but is not limited to, sales, use, value added, Federal Universal Service Fund (“FUSF”) contributions and excise taxes. The Task Force affirmed its conclusion that entities should present these taxes in the income statement on either a gross or a net basis, based on their accounting policy, which should be disclosed pursuant to Accounting Principles Board Opinion (“APB”) No. 22,“Disclosure of Accounting Policies.”If such taxes are significant, and are presented on a gross basis, the amounts of those taxes should be disclosed. The consensus on EITF No. 06-3 will be effective for interim and annual reporting periods beginning after December 15, 2006. The Company currently records transaction-based taxes on a net basis, except for the FUSF charges billed to customers, in its consolidated statements of operations. The Company adopted EITF No. 06-3 on January 1, 2007 and such adoption did not have a significant impact to its financial statements.

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

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 including, but not limited to, changes that affect the continued availability of the unbundled network elements of the local exchange carriers’ networks and the costs associated therewith;

	•		the Company’s dependence on the availability and functionality of the networks of the incumbent local exchange carriers;

	•		ability to generate cash flows or obtain adequate financing;

	•		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’s financial results could differ materially from those anticipated due to other risks and uncertainties.

2. Revenue Recognition

Revenues from recurring services 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 price is reasonably assured. If a customer is experiencing financial difficulties and, (a) is not current in making payments for the Company’s services or, (b) 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. The Company recognizes revenues from financially distressed customers when it collects cash for the services, assuming all other criteria for revenue recognition have been met, but only after the collection of all previous outstanding accounts receivable balances. Payments received from financially distressed customers for a defined period prior to their filing of petitions for bankruptcy protection are recorded in the condensed consolidated balance sheets caption “Unearned revenues” if the Company’s ability to retain these payments is not reasonably assured.

Revenues earned for which the Company has not billed the customer are recorded as “Unbilled revenues” in the Company’s condensed consolidated balance sheets. Amounts billed in advance of providing service are deferred and recorded as an element of the condensed consolidated balance sheets caption “Unearned revenues.” Included in revenues are FUSF charges billed to customers aggregating $2,258 and $4,077 for the three and six months ended June 30, 2007, respectively, and $1,781 and $3,471 for the three and six months ended June 30, 2006, respectively. Shipping and handling charges billed to customers are included in the Company’s net revenues with corresponding amounts included in cost of sales.

The Company recognizes up-front fees associated with service activation, which includes set-up fees and revenue from sales of CPE, using the straight-line method, over the expected term of the customer relationships, which ranges from 24 to 48 months. The Company includes revenue from sales of CPE and the set-up fees for service activation as up-front fees because neither is considered a separate unit of accounting. The Company treats the incremental direct costs of service activation, which consist principally of CPE, service activation fees paid to other telecommunications companies and sales commissions, as deferred charges in amounts that are no greater than the aggregate up-front fees that are deferred. These deferred incremental direct costs are amortized to operations using the straight-line method over a range of 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 allowances for service credits and bad debt are 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 (included in selling, general and administrative expenses in the condensed consolidated statements of operations), based on such customer’s outstanding balance.

Accounts receivable consisted of the following:


	June 30, 2007			December 31, 2006
Gross accounts receivable	$	38,693		$	34,123
Allowance for service credits		(2,652	)		(2,729	)
Allowance for bad debts		(291	)		(243	)

Accounts receivable, net	$	35,750		$	31,151

Significant Customers

For the three and six months ended June 30, 2007, the Company’s 30 largest wholesale customers, in each such period, collectively accounted for 90.7% and 90.6%, respectively, of the Company’s total wholesale net revenues, and 57.7% and 57.7%, respectively, of the Company’s total net revenues. For the three and six months ended June 30, 2006, the Company’s 30 largest wholesale customers, in each such period, collectively accounted for 91.5% and 90.6%, respectively, of the Company’s total wholesale net revenues, and 60.9% and 61.4%, respectively, of the Company’s total net revenues. As of June 30, 2007 and December 31, 2006, receivables from these customers collectively accounted for 58.4% and 53.1%, respectively, of the Company’s gross accounts receivable balance.

For the three and six months ended June 30, 2007 and 2006, two of the Company’s wholesale customers, AT&T and EarthLink, individually accounted for more than 10% of the Company’s total net revenues. AT&T accounted for 12.5% and 12.8% for the three and six months ended June 30, 2007, respectively, and for 14.4% and 14.5% for the three and six months ended June 30, 2006, respectively. EarthLink accounted for 11.3% and 11.1% for the three and six months ended June 30, 2007, respectively and for 11.5% and 11.8% for the three and six months ended June 30, 2006, respectively. As of June 30, 2007 and December 31, 2006, accounts receivable from AT&T individually accounted for 11.1% and 10.5%, respectively, of the Company’s gross accounts receivables. As of June 30, 2007 and December 31, 2006, accounts receivable from EarthLink individually accounted for 14.4% and 12.8%, respectively, of the Company’s gross accounts receivables. No other individual customer accounted for more than 10% of the Company’s total net revenues for the three and six months ended June 30, 2007 and 2006.

Wholesaler Financial Difficulties

For the three and six months ended June 30, 2007, the Company issued billings to its financially distressed customers aggregating $650 and $1,182, respectively, which were not recognized as revenues or accounts receivable in the accompanying condensed consolidated financial statements at the time of such billings, as compared to the corresponding amounts of $560 and $1,189 for the three and six months ended June 30, 2006, respectively. However, in accordance with the revenue recognition policy described above, the Company recognized revenues from certain of these customers when cash was collected aggregating $476 and $968 for the three and six months ended June 30, 2007, respectively, and $510 and $1,211 for the three and six months ended June 30, 2006, respectively. Revenues from customers that filed for bankruptcy accounted for 0.2% and 0.1%, respectively, of the Company’s total net revenues for the three and six months ended June 30, 2007, respectively, and 0.2% of the Company’s total net revenues for both, the three and six months ended June 30, 2006. As of June 30, 2007 and December 31, 2006, the Company had contractual receivables from its financially distressed customers totaling $669 and $470, respectively, which are not reflected in the accompanying condensed consolidated balance sheets as of such dates.

The Company has identified certain of its customers who were essentially current in their payments for the Company’s services prior to June 30, 2007, or have subsequently paid all or significant portions of the respective amounts that the Company recorded as accounts receivable as of June 30, 2007, that the Company believes may be at risk of becoming financially distressed. For both, the three and six months ended June 30, 2007, revenues from these customers collectively accounted for 1.8% of the Company’s total net revenues. For the three and six months ended June 30, 2006, revenues from these customers collectively accounted for 12.4% and 12.3%, respectively, of the Company’s total net revenues. As of June 30, 2007 and December 31, 2006, receivables from these customers collectively accounted for 1.7% and 1.4%, respectively, 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 timely manner in periods ending subsequent to June 30, 2007, revenues from such customers will only be recognized when cash is collected, as described above.

3. Warrants

On January 1, 2003, in conjunction with an amendment to an agreement with AT&T, the Company granted AT&T three warrants to purchase shares of the Company’s common stock as follows: 1,000 shares at $0.94 per share; 1,000 shares at $3.00 per share; and 1,000 shares at $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 was recognized as a reduction of revenues on a straight-line basis over the three-year term of the agreement because the Company believed that future revenues from AT&T would 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 152%; and a risk-free interest rate of 3.36%. None of these warrants had been exercised or had expired as of June 30, 2007. Such warrants were fully amortized as of December 31, 2006.

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 shares of the Company’s common stock as follows: 1,500 shares at $1.06 per share; 1,000 shares at $3.00 per share; and 1,000 shares at $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 156%; and a risk-free interest rate of 3.63%, was recorded as a deferred customer incentive in 2002 and was 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 had been exercised or had expired as of June 30, 2007. As of June 30, 2007 and December 31, 2006 the unamortized amount of the warrants was $127 and $506, respectively.

Other warrants for the purchase of 14 shares of the Company’s common stock were outstanding as of June 30, 2007. Such warrants are exercisable at purchase prices ranging from $0.01 to $2.13 per share and are fully vested as of June 30, 2007. Unless exercised, all such warrants will expire between October 2007 and March 2008.

The Company recorded amortization on the above described warrants in the amount of $189 and $379 for the three and six month periods ended June 30, 2007, respectively, and $189 and $379 for the three and six months ended June 30, 2006, respectively.

4. Post-Employment Benefits

During the three and six months ended June 30, 2007, the Company reduced its workforce by 70 employees, which represented 7.5% and 7.2%, respectively, of the Company’s workforce. During the three and six months ended June 30, 2006, the Company reduced its workforce by 30 and 48 employees, respectively, which represented 2.9% and 4.6%, respectively, of the Company’s workforce. For the three and six months ended 2007 and 2006, the reductions covered employees in the areas of sales and marketing, operations and corporate functions.

In connection with the reductions in its workforce, the Company recorded charges to operations for the three and six months ended June 30, 2007 of $1,357 relating to employee severance benefits. For the three and six months ended of 2007, the Company paid severance benefits of $772. The Company expects to pay the remainder of severance benefits accrued as of June 30, 2007 during the three months ending September 30, 2007. Expenses associated with the reductions in the Company’s workforce, for the three and six months ended June 30, 2007, were $435 related to the Wholesale business segment, and $475 related to the Direct business segment. The remaining $447 was related to the Company’s Corporate Operations.

For the three and six months ended June 30, 2006, the Company recorded employee severance benefits of $511 and $1,274, respectively. For the three and six months ended June 30, 2006, the Company paid severance benefits of $565 and $946, respectively. The remaining amount of severance benefits was fully paid as of June

30, 2007. Expenses associated with the reductions in the Company’s workforce, for the three and six months ended June 30, 2006, were $156 and $156, respectively, related to the Wholesale segment, and $226 and $226, respectively, related to the Direct segment. The remaining $129 and $892 were related to the Company’s Corporate Operations.

5. Long-Term Debt

12% Senior Secured Convertible Notes

On March 15, 2006, the Company entered into a strategic agreement with EarthLink to further build and deploy the Company’s LPVA services. The transaction contemplated by such agreement was consummated on March 29, 2006. In conjunction with the agreement, the Company received from EarthLink (i) $10,000 in exchange for 6,135 shares of the Company’s common stock, and (ii) $40,000 in exchange for a 12% senior secured convertible note (“Note”). Principal on the Note is payable on March 15, 2011. EarthLink may require the Company to accelerate its repayment of the remaining principal amount of the Note in certain circumstances, such as if the Company undergoes a change in control or fails to meet specific service obligations to EarthLink. As of June 30, 2007, the Company was in compliance with such agreement. Interest on the Note is payable on March 15 and September 15 of each year and may be paid in cash or in additional notes of the Company, identical to and of the same series as the Note. The Note (i) is a general secured obligation of the Company, (ii) is collateralized by certain property, plant and equipment purchased with the proceeds of the Note pursuant to the terms of a security agreement entered into between the Company and EarthLink, (iii) will rank without partiality in right of payment with all existing and future secured, unsubordinated indebtedness of the Company, and (iv) will be senior in right of payment to all unsecured indebtedness and subordinated indebtedness of the Company.

The Note will be initially convertible into 21,505 shares of the Company’s common stock, reflecting an initial conversion price of $1.86 per share. In the event that the Company makes all interest payments through the issuance of additional notes, these will be convertible into an additional 17,007 shares of the Company’s common stock, reflecting a conversion price of $1.86 per share. The conversion rate will be subject to weighted-average antidilution protection as set forth in the Note agreement. In no event will the Note and any additional notes be converted into an aggregate number of shares of the Company’s common stock which in the aggregate exceeds 19.9% of the then outstanding shares of its common stock. The Note will be initially convertible beginning on March 15, 2008, or upon a change of control of the Company, if occurring earlier. If not converted, the Company will be required to offer to redeem the Note at 100% of the principal amount thereof upon a change of control.

The 6,135 shares of the Company’s common stock and the underlying shares of the Note discussed above are subject to the terms of a registration rights agreement between the Company and EarthLink. The Note and the 6,135 shares were issued to EarthLink in reliance on the exemption from registration contained in Section 4(2) of the Securities Act of 1933 (“Securities Act”), as amended. The Company filed a registration statement on Form S-3 with the SEC to register the resale of the 6,135 shares and the common stock issuable upon conversion of the Note and this registration statement was declared effective on June 20, 2006.

Gross proceeds from the issuance of the Note and the shares of the Company’s common stock amounted to $40,000 and $10,000, respectively. The Company incurred $1,929 in transaction costs in conjunction with the issuance of the Note and the shares. Of the transaction costs, $1,543 are debt issuance costs and are being amortized to operations as an element of interest expense over the five-year life of the debt. $386 of the transaction costs were recorded as a reduction of additional paid-in capital in conjunction with the issuance of the Company’s common stock.

On September 15, 2006, the Company settled the semi-annual interest payment obligation on the above described convertible note with EarthLink. The interest obligation amounted to $2,240. As permitted by the Note, the Company settled the interest due by issuing an additional note with the same terms as the original note. Similarly, on March 15, 2007, the Company settled the semi-annual interest payment obligation of $2,534 on the convertible notes by issuing an additional note with the same terms as the original note.

3% Convertible Senior Debentures

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 $3.17 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 $119,961 after commission and other transaction costs. The Company incurred $5,039 in transaction costs in conjunction with the placement of the Debentures. The transaction costs are debt issuance costs and are being amortized to operations as an element of interest expense over sixty months, the period before the first date that Debenture holders have the option to require the Company to purchase the Debentures.

Line of Credit

On April 13, 2006, the Company entered into a Loan and Security Agreement (“Loan Agreement”) with Silicon Valley Bank (“SVB”). The Loan Agreement provides for a revolving credit facility for up to $50,000, subject to specified borrowing base limitations. At the Company’s option, the revolving line bears an interest rate equal to SVB’s prime rate or LIBOR plus specified margins. On April 20, 2007 the Company extended the maturity date of the Loan Agreement to April 19, 2009. As collateral for the loan under the Loan Agreement, the Company has granted security interests in substantially all of its real and personal property, other than intellectual property and equipment purchased with the proceeds received from the agreement with EarthLink. The Company has also provided a negative pledge on its intellectual property. As of June 30, 2007 and December 31, 2006, the Company issued irrevocable letters of credit aggregating $3,796 under this loan in favor of lessors of equipment and facilities and certain vendors. As of June 30, 2007 and December 31, 2006, the Company had an outstanding principal balance of $6,100, which carried an interest rate of 8.25% plus a margin of 0.25%. Borrowings under the facility are limited by an amount of the Company’s eligible accounts receivable and cash. As of June 30, 2007, the Company had $36,494 of funds available under the credit facility as a result of borrowings, letters of credit, and the borrowing base limitations. As the available borrowing under the facility is limited, the amount available at any time may be substantially less than $50,000 and the facility could be unavailable in certain circumstances.

The Loan Agreement imposes various limitations on the Company, including without limitation, on its ability to: (i) transfer all or any part of its businesses or properties, merge or consolidate, or acquire all or substantially all of the capital stock or property of another company; (ii) engage in a new business; (iii) incur additional indebtedness or liens with respect to any of its properties; (iv) pay dividends or make any other distribution on or purchase of, any of its capital stock; (v) make investments in other companies; (vi) make payments in respect of any subordinated debt; or (vii) make capital expenditures, measured on a consolidated basis, in excess of $35,000 per year for 2007 and 2008, subject to certain exceptions, such as capital expenditures that are related to the agreement with a strategic investor like EarthLink. The Loan Agreement also contains certain customary representations and warranties, covenants, notice and indemnification provisions, and events of default, including changes of control, cross-defaults to other debt, judgment defaults and material adverse changes to the Company’s business. In addition, the Loan Agreement requires the Company to maintain specified liquidity ratios and tangible net worth levels. As of June 30, 2007, the Company was in compliance with the above described limitations, covenants and conditions of the line of credit.

6. Commitments and Contingencies

Litigation

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 Company believes these officers and directors have strong defenses to these lawsuits and intend 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 L. Dale Crandall and Hellene Runtagh, to investigate the allegations made by Mr. Khanna. Richard Jalkut was appointed to this committee shortly after he joined 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 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. On May 9, 2006, the court dismissed several of the claims for breach of fiduciary duty as well as the claims relating to the Company’s proxy statements. The court also determined that Mr. Khanna could no longer serve as a plaintiff in this matter. The litigation with respect to the remaining claims is still pending, and 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 or 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 or cash flows if it is denied or charged higher rates for transmission lines or central office spaces.

Other Contingencies

As of June 30, 2007, 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, results of operations and cash flows. However, it is reasonably possible that the Company’s estimates of its collocation fee and network service obligations, 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, results of operations or cash flows.

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 the Company’s 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, results of operations or cash flows. 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, results of operations or cash flows.

The Company recorded an estimated liability for employment-related taxes for certain stock-based compensation provided to employees through a charge to operations in the amount of $5,931 in 2003. In each of 2006, 2005 and 2004, the Company determined that it did not owe portions of this tax, in the amounts of $2,103, $419 and $3,079, respectively, as a result of the expiration of the statute of limitations, and consequently, the Company released these amounts as a benefit to operations. For the three and six months ended June 30, 2007, the Company determined that it does not owe the remaining liability of $330 as a result of the expiration of the statute of limitations, and consequently, the Company released this amount as a benefit to 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.

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. The Company has accrued $726 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 may incur additional expenses in future periods, but the probability and amount of these obligations cannot be reasonably estimated.

7. Stock-Based Compensation

Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123R. As a result of the adoption, the Company’s loss for the three and six months ended June 30, 2007 includes $667 ($0.00 per share), and $1,092 ($0.00 per share), respectively, of stock-based compensation, of which $456 and $857, respectively, relates to the Company’s employee stock option plans, and $211 and $235, respectively, relates to the Company’s employee stock purchase plan. For the three and six months ended June 30, 2007, $273 and $445, respectively, of the total stock-based compensation was recorded in cost of sales and $394 and $647, respectively, in selling, general and administrative expenses. For the three and six months ended June 30, 2006, the Company’s net income includes $837 ($0.00 per share), and $1,501 ($0.01 per share), respectively, of stock-based compensation, of which $456 and $781, respectively, relates to the Company’s employee stock option plans, and $381 and $720, respectively, relates to the Company’s employee stock purchase plan. For the three and six months ended June 30, 2006, $342 and $612, respectively, of the total stock-based compensation was recorded in cost of sales and $495 and $889, respectively, in selling, general and administrative expenses. The Company did not recognize and does not expect to recognize in the near future, any tax benefit related to employee stock-based compensation cost as a result of the full valuation allowance on its net deferred tax assets and because of its net operating loss carryforwards. The Company did not capitalize any portion of its stock-based compensation cost for the three and six months ended June 30, 2007. For the three and six months ended June 30, 2006, the Company capitalized a portion of its stock-based compensation cost, or $8.

For the three and six months ended June 30, 2007, the Company granted 594 and 3,935, respectively, stock options with an estimated total grant-date fair value of $281 and $2,489, respectively. Of this amount, the Company estimated that the stock-based compensation for the awards not expected to vest was $83 and $780, respectively. The weighted-average grant-date fair value of options granted for the three and six months ended June 30, 2007 was $0.47 and $0.63, respectively. For the three and six months ended June 30, 2006, the Company granted 1,160 and 4,392, respectively, stock options with an estimated total grant-date fair value of $1,624 and $4,282, respectively. Of this amount, the Company estimated that the stock-based compensation for the awards not expected to vest was $338 and $891, respectively. The weighted-average grant-date fair value of options granted for the three and six months ended June 30, 2006 was $1.40 and $0.97, respectively. As of June 30, 2007 and 2006, the unrecorded deferred stock-based compensation balance related to stock options, adjusted for forfeitures, was $4,150 and $3,400, respectively, and will be recognized over an estimated weighted-average amortization period of 3.07 and 1.70 years, respectively.

For the six months ended June 30, 2007 and 2006, the Company granted 1,190 and 1,871, respectively, stock options under the Company’s 2003 Employee Stock Purchase Plan (“2003 ESPP”) with an estimated total grant-date fair value of $422 and $720, respectively. The weighted-average grant-date fair value of options under the Company’s 2003 ESPP granted for the six months ended June 30, 2007 and 2006 was $0.35 and $0.32 per share, respectively. As of June 30, 2007 and 2006, the unrecorded deferred stock-based compensation balance related to the 2003 ESPP was fully amortized to operations.

The Company estimates the fair value of stock options using a Black-Scholes valuation model. SFAS No. 123R allows the use of option pricing models that were not necessarily developed for use in valuing employee stock options. Option valuation models, such as the Black-Scholes option-pricing model, were developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. The expected life of the options was determined using historical data for options exercised, cancelled after vesting and outstanding. The expected stock price volatility assumption was determined using historical volatility of the Company’s common stock over a period equal to the expected life of the option. The forfeiture rate was determined using historical pre-vesting cancellation data for all options issued after 2001.

The fair value of each option grant was estimated on the date of grant using the following weighted-average assumptions:


	Stock Options						Employee Stock Purchase Plan
	Three months ended June 30,						Three and six months ended June 30,
	2007			2006			2007			2006
Expected life of options in years		3.5			3.3			0.5			0.5
Volatility		63.40	%		84.00	%		52.30	%		77.30	%
Risk-free interest rate		4.93	%		5.09	%		5.08	%		4.80	%
Expected dividend yield		0.00	%		0.00	%		0.00	%		0.00	%


	Stock Options
	Six months ended June 30,
	2007			2006
Expected life of options in years		3.5			3.4
Volatility		66.21	%		85.40	%
Risk-free interest rate		4.73	%		4.90	%
Expected dividend yield		0.00	%		0.00	%

The following table summarizes stock option activity as of and for the six months ended June 30, 2007:


	Number of Shares of			Option Price per		Weighted-Average
	Common Stock			Share		Exercise Price
Balance as of December 31, 2006		23,082			$0.350 - $149.79		$4.31
Granted		3,935			$0.900 - $ 1.360		$1.16
Exercised		(169	)		$0.560 - $ 1.280		$0.67
Cancelled, expired and forfeited		(2,431	)		$0.360 - $63.333		$7.96

Balance as of June 30, 2007		24,417			$0.350 - $149.79		$3.47

8. Business Segments

The Company sells to businesses and consumers indirectly through Internet service providers, or 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 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, fixed wireless broadband 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 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, CPE, and equipment maintenance. Operating expenses also include labor and related non-labor expenses for customer care, dispatch, and repair and installation activities and post-employment benefit charges. 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 the number of installations performed by such segment. 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 promotion expenses to the business segments primarily based on the target customers for such advertising and promotions.

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. 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. The Company does not allocate 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.

Segment information, including a reconciliation to the respective balances in the Company’s condensed consolidated financial statements, as of and for the three and six months ended June 30, 2007 and 2006 are as follows:


					Total		Corporate			Consolidated
As of and for the three months ended June 30, 2007:	Wholesale		Direct		Segments		Operations			Total
Revenues, net	$	76,629	$	43,956	$	120,585	$	—		$	120,585
Cost of sales (exclusive of depreciation and amortization)		48,339		26,932		75,271		11,865			87,136
Selling, general and administrative		1,847		6,886		8,733		19,722			28,455
Depreciation and amortization		—		—		—		13,141			13,141
Provision for post-employment benefits		435		475		910		447			1,357

Income (loss) from operations		26,008		9,663		35,671		(45,175	)		(9,504	)
Other income (expense), net		—		—		—		(2,099	)		(2,099	)

Net income (loss)	$	26,008	$	9,663	$	35,671	$	(47,274	)	$	(11,603	)

Total assets	$	43,347	$	22,195	$	65,542	$	224,975		$	290,517


					Total		Corporate			Consolidated
As of and for the three months ended June 30, 2006:	Wholesale		Direct		Segments		Operations			Total
Revenues, net	$	78,898	$	39,637	$	118,535	$	—		$	118,535
Cost of sales (exclusive of depreciation and amortization)		45,712		23,762		69,474		11,328			80,802
Benefit from federal excise tax adjustment		—		—		—		(19,455	)		(19,455	)
Selling, general and administrative		2,052		10,153		12,205		19,684			31,889
Depreciation and amortization		—		—		—		10,716			10,716
Provision for post-employment benefits		156		226		382		129			511

Income (loss) from operations		30,978		5,496		36,474		(22,402	)		14,072
Other income (expense), net		—		—		—		(1,599	)		(1,599	)

Net income (loss)	$	30,978	$	5,496	$	36,474	$	(24,001	)	$	12,473

Total assets	$	40,880	$	21,274	$	62,154	$	263,869		$	326,023


					Total		Corporate			Consolidated
As of and for the six months ended June 30, 2007:	Wholesale		Direct		Segments		Operations			Total
Revenues, net	$	153,380	$	87,355	$	240,735	$	—		$	240,735
Cost of sales (exclusive of depreciation and amortization)		95,939		52,832		148,771		26,360			175,131
Selling, general and administrative		3,909		15,666		19,575		40,214			59,789
Depreciation and amortization		—		—		—		26,500			26,500
Provision for post-employment benefits		435		475		910		447			1,357

Income (loss) from operations		53,097		18,382		71,479		(93,521	)		(22,042	)
Other income (expense), net		—		—		—		(4,077	)		(4,077	)

Net income (loss)	$	53,097	$	18,382	$	71,479	$	(97,598	)	$	(26,119	)


					Total		Corporate			Consolidated
As of and for the six months ended June 30, 2006:	Wholesale		Direct		Segments		Operations			Total
Revenues, net	$	159,982	$	76,304	$	236,286	$	—		$	236,286
Cost of sales (exclusive of depreciation and amortization)		91,946		46,053		137,999		22,740			160,739
Benefit from federal excise tax adjustment		—		—		—		(19,455	)		(19,455	)
Selling, general and administrative		4,281		20,556		24,837		42,017			66,854
Depreciation and amortization		—		—		—		21,764			21,764
Provision for post-employment benefits		156		226		382		892			1,274

Income (loss) from operations		63,599		9,469		73,068		(67,958	)		5,110
Other income (expense), net		—		—		—		(1,917	)		(1,917	)

Net income (loss)	$	63,599	$	9,469	$	73,068	$	(69,875	)	$	3,193


					Total		Corporate			Consolidated
As of December 31, 2006:	Wholesale		Direct		Segments		Operations			Total
Total assets	$	35,795	$	22,191	$	57,986	$	255,322		$	313,308

9. Business Acquisition

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 fixed wireless technology to deliver business-class fixed wireless broadband services to small and medium-sized businesses. Through NextWeb, the Company currently provides service to approximately 3,500 business customers in the San Francisco Bay Area, Los Angeles, Orange County (California), Santa Barbara and Las Vegas.

The Company acquired NextWeb to accelerate its entry into the emerging wireless broadband market. As a result of the acquisition the Company has added various fixed wireless broadband services to its current portfolio of products and services. These factors contributed to a purchase price that was in excess of the fair value of NextWeb’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 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.

As a result of the merger, the Company issued 15,361 shares of its common stock and $3,683 in cash in exchange for all of the outstanding shares of capital stock held by the NextWeb stockholders. Of the shares issued in conjunction with the merger, 1,395 shares were placed in escrow until February 2007 to cover NextWeb’s indemnification obligations under the merger agreement. In February 2007, 778 of these shares were released to the former NextWeb shareholders. In June 2007, the Company released an additional 358 shares from escrow and the remaining 259 shares were canceled as a result of the settlement with the former NextWeb shareholders.

The Company accounted for the acquisition of NextWeb using the purchase method of accounting. Accordingly, the Company’s condensed consolidated financial statements as of June 30, 2007 and 2006, and for the three and six months then ended, include the results of operations of NextWeb after the date of acquisition. The Company valued the common shares issued, for accounting purposes, at $1.06 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, October 4, 2005. All of the NextWeb stock options and warrants were vested and exercised before the acquisition. Consequently, there were no outstanding NextWeb stock options and warrants assumed in connection with the merger. Direct acquisition costs were included as elements of the total purchase cost.

The total purchase cost of the NextWeb acquisition has been allocated to the assets and liabilities of NextWeb based upon estimates of their fair values. The following tables set forth the total purchase cost and the allocation thereof:


Total purchase cost:
Cash	$	3,683
Value of common shares issued		16,314

		19,997
Acquisition costs		327

Total purchase cost	$	20,324


Purchase price allocation:
Tangible assets acquired	$	4,918
Liabilities assumed		(5,662	)
Intangible assets acquired:
Customer relationships		7,630
Non-compete covenant		40
Goodwill		13,398

Total purchase consideration	$	20,324

The Company acquired $4,918 in tangible assets of NextWeb, consisting principally of cash, accounts receivable and property and equipment. The Company assumed $5,662 in liabilities of NextWeb, consisting principally of accounts payable, accrued expenses, capital leases and long-term debt.

The customer relationships were valued using an income approach, which projects the associated revenues, expenses and cash flows attributable to the customer base. These cash flows are then discounted to their present value. This intangible asset is being amortized on a straight-line basis over a period of forty-eight months which represents the expected life of the customer relationships. Goodwill was determined based on the residual difference between the purchase cost and the value 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.

Pro-forma financial information, as if the acquisition of NextWeb had occurred at the beginning of the period presented, is not included as the Company determined that such information is not material to the Company’s consolidated revenues and net loss.

As part of the acquisition of NextWeb, the Company issued an aggregate of 706 shares to several employees and former employees of NextWeb pursuant to NextWeb’s bonus plan. The Company valued these shares at $750, based on the fair value of the shares issued as described above.

10. Related Party Transactions

The Company is a minority shareholder of Certive Corporation (“Certive”). The Company’s chairman of the board of directors, Charles McMinn, is also a significant stockholder of Certive.

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 $41 and $85, respectively, for the three and six months ended June 30, 2007, and $56 and $117, respectively, for the three and six months ended June 30, 2006. Accounts receivables from TelePacific were $14 and $15 as of June 30, 2007 and December 31, 2006, respectively. In August 2006, TelePacific acquired mPower Communications (“mPower”), which is also one of the Company’s vendors. The Company paid $93 and $286, respectively, to mPower for the three and six months ended June 30, 2007. No payments were made

to mPower for the three and six months ended June 30, 2006. Accounts payable to mPower were $43 and $51 as of June 30, 2007 and December 31, 2006, respectively.

L. Dale Crandall, another of the Company’s directors, is a director of BEA Systems (“BEA”), one of the Company’s vendors. The Company paid $556 to BEA for the three and six months ended June 30, 2007. The Company paid $0 and $772 to BEA for the three and six months ended June 30, 2006, respectively. There were no accounts payable to BEA as of June 30, 2007 or December 31, 2006.

Charles Hoffman, the Company’s CEO, is a director of Chordiant Software (“Chordiant”), one of the Company’s vendors. The Company paid $255 to Chordiant for the three and six months ended June 30, 2007. The Company paid $254 to Chordiant for the three and six months ended June 30, 2006. There were no accounts payable to Chordiant as of June 30, 2007 or December 31, 2006. Charles Hoffman is also a director of Synchronoss Technologies, Inc. (“Synchronoss”), one of the Company’s vendors. The Company paid $18 and $32 to Synchronoss for the three and six months ended June 30, 2007, respectively. No payments were made to Synchronoss for the three and six months ended June 30, 2006. Accounts payable to Synchronoss were $7 and $11 as of June 30, 2007 and December 31, 2006, respectively.

11. 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. The Company made no provision for income taxes in any periods presented in the accompanying condensed consolidated financial statements because it incurred net losses for the periods presented, or expect to incur net losses for the current year.

Effective January 1, 2007 the Company adopted the provisions of FIN No. 48 which clarifies the accounting for uncertainty in income taxes recognized in financial statements in accordance with SFAS No. 109,“Accounting for Income Taxes.”The Interpretation prescribes a recognition threshold and measurement attribute of tax positions taken or expected to be taken on a tax return. The interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

Due to the Company’s significant taxable loss position and full valuation allowance against its net deferred tax assets, the adoption of FIN No. 48 did not have an impact to its condensed consolidated financial statements. As of January 1, 2007 the Company had unrecognized net operating losses, which tax effected, would provide further tax benefits of approximately $273,000 which related to cancellation of debt and an alternative method of reducing tax attribute by the debt forgiveness gain as a result of the Company’s 2001 Chapter 11 bankruptcy proceedings. To the extent the unrecognized tax benefits are ultimately recognized they may have an impact on the effective tax rate in future periods; however, such impact to the effective tax rate would only occur if the recognition of such unrecognized tax benefits occurs in a future period when the Company has already determined it is more likely than not that its deferred tax assets are realizable. Additionally, the Company has not recognized any penalties and interest for unrecognized tax benefits as any resolution upon audit of the aforementioned tax position would not require payment of interest and penalties. However, if applicable, the Company’s policy is to recognize interest and penalties related to uncertain tax positions in its provision for income taxes.

The Company is subject to taxation at the federal and various state levels. All of the Company’s tax years through 2006 are subject to examination by the tax authorities.

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Report onForm 10-Q and the audited consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2006 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on February 28, 2007. This discussion contains forward-looking statements, the accuracy of which is subject to risks and uncertainties. Our actual results could differ materially from those expressed in forward-looking statements for many reasons including, but not limited to, those discussed herein and in the “Risk Factors” section of our Annual Report onForm 10-K, which is contained in “Part I, Item 1, Business - - Risk Factors,” of that report. We disclaim any obligation to update information contained in any forward-looking statement. See “Forward Looking Statements.”

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

Overview

Our Business

We provide voice and data communications products and services to consumers and businesses. We provide these services throughout the United States in 235 major metropolitan areas in 44 states. Our products and services include high-speed, or broadband, data communications, Internet access connectivity, Voice over Internet Protocol telephony, or VoIP, fixed wireless broadband, and a variety of related services. We primarily use digital subscriber line, or DSL, and T-1 technologies to deliver our services. In order to provide our services we purchase network elements, such as telecommunication lines and central office facilities, from the local telephone companies, which are often referred to as the incumbent local exchange carriers, or ILECs, and other carriers, and then combine these network elements with our own nationwide network facilities. We purchase the majority of these network elements from Verizon Communications, Inc., or Verizon, AT&T, Inc. (formerly SBC Communications, Inc., or SBC), or AT&T, and Qwest Corporation, or Qwest, which are also known as the regional Bell operating companies, or RBOCs. As of June 30, 2007, we had approximately 514,600 broadband access end-users, approximately 2,200 VoIP business customers with a combined total of approximately 3,800 VoIP sites, and 3,600 fixed wireless broadband subscribers.

We operate two business segments, Wholesale and Direct. Wholesale is a provider of high-speed data connectivity services to Internet service providers, or ISPs, and telecommunications carrier customers. As of June 30, 2007, Wholesale had approximately 441,200 DSL and T-1 lines in service, as compared to approximately 469,900 lines as of June 30, 2006. The majority of our services are sold through our Wholesale segment.

Our Direct segment sells business-grade VoIP, high-speed data connectivity, fixed wireless broadband, and related value-added services. We sell our Direct services through multiple channels including telesales, field sales, affinity partner programs, and our website. Direct focuses on the small business market and also sells to enterprise customers that purchase our services for distribution across their enterprise. As of June 30, 2007, Direct had approximately 73,400 DSL and T-1 lines in service, as compared to approximately 78,100 lines as of June 30, 2006. In addition, Direct provided service to approximately 2,200 VoIP business customers and 3,600 fixed wireless broadband subscribers at the end of June 30, 2007.

Our total lines in service as of June 30, 2007 decreased by 33,382 lines, or 6.1%, when compared to June 30, 2006 primarily as a result of a decrease in our consumer lines. However, our T-1 lines, which are typically higher revenue-producing lines, increased by 7,560 lines, or 30.9%.

Since our inception, we have and continue to generate significant net and operating losses and negative operating cash flow. Our cash reserves are limited and our business plan is based on assumptions that we believe are reasonable, but some of which are out of our control. If actual events differ from our assumptions,

we may need to raise additional capital on terms that are less favorable than we desire, or we may not be able to raise or obtain additional liquidity.

Our Opportunities and Challenges

Our business is subject to on-going changes in technologies, the competitive environment, particularly with regard to continued pricing pressure on our consumer-grade services and industry consolidation, federal and state regulations, and our resellers’ changing market strategies. We continue to experience churn among our existing end-users due to pricing pressures and other factors. As a result of these market conditions, we continue to prioritize and invest our resources towards selling (in no particular order):

	•		T-1 access;

	•		business asymmetric DSL, or ADSL;

	•		line-powered voice access service, or LPVA;

	•		VoIP; and

	•		Fixed wireless broadband access.

We refer to these services as our Growth services. Our remaining services are our Legacy services, which are consumer ADSL, business symmetric DSL, or SDSL, frame relay and high-capacity transport circuits. While we believe we are favorably positioned to take advantage of market opportunities for our Growth services, it is difficult to predict with a high degree of certainty our ability to continue to grow our sales and the profit margins we will derive from these services, and whether our sales of these services will offset slowing sales of Legacy services. In addition, some of our Growth services, such as VoIP and LPVA, require significant upfront expenditures to acquire and provision new customers. In most cases, there is a lag between the cash outlay for these expenditures and the timing of future sales. This lag negatively impacts our cash flow which in light of our limited cash resources could cause us to stop selling or develop alternative strategies for some of these services.

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

Efficient use of cash- We concluded the three months ended June 30, 2007 with cash and cash equivalents, short-term investments in debt securities, and restricted cash and cash equivalents of $65,553. This balance was comprised of $34,643 of cash and cash equivalents, $18,708 in short-term investments in debt securities, and $12,202 in restricted cash and cash equivalents. For the six months ended June 30, 2007, we recorded a net loss of $26,119 and cash flow from operations of $62. We continue to manage expenditures closely. Our ability to attain and sustain cash flow sufficiency will largely depend on the rate at which we can grow our revenues while controlling the expenditures necessary to generate and support increases in revenue.

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

In January of 2006, EarthLink, Inc., or EarthLink, began a trial offer in three markets of a consumer-grade voice service deployed over our LPVA service. LPVA service is intended to compete with the consumer voice and data bundles offered by the RBOCs and the cable companies. In addition, on March 15, 2006, we entered into a strategic agreement with EarthLink to build and deploy our LPVA services in eight additional cities which is described in Note 5 –“Long-Term Debt”to our condensed consolidated financial statements. We completed our deployment of LPVA in these additional cities in the fourth quarter of 2006.

Respond to Changes in Telecommunications Regulations —Federal, state and local government regulations affect our services. In particular, we rely upon provisions of the 1996 Telecommunications Act to procure

certain facilities and services from the RBOCs that are necessary to provide our services. As a result, our business can be materially affected by changes in applicable rules and policies as a result of Federal Communications Commission, or FCC, decisions, legislative actions at both the state and federal levels, rulings from state public utility commissions, or PUCs, and court decisions. Such changes may reduce our access to network elements at regulated prices and increase our costs. We have changed our business in the past to respond to new regulatory developments and it is likely that we will need to make similar changes in the future.

Enter and maintain acceptable line-sharing terms with the RBOCs- We currently support our consumer and small office/home office focused resellers through line-sharing. We currently generate 15.4% of our revenues from the sale of our line-shared services. Although the revenues we generate from line-sharing with the RBOCs may decline in future periods, we think this market will continue to be important to us. Since the RBOCs are the incumbent local telephone companies in almost all of the metropolitan areas where we offer our services, our ability to generate significant revenue from the sale of our line-shared DSL services will depend on whether we are able to maintain long-term agreements with the RBOCs, like our agreements with AT&T, Verizon and Qwest, or obtain favorable regulatory rulings that will allow us to share telephone lines for new customers on reasonable terms.

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

New market opportunities- We have recently developed several services, targeting both our wholesale and direct channels, which we believe will generate new revenues. For our direct channels, we continue to seek opportunities to enhance our existing services and offer additional services that are complementary to our broadband services, such as e-mail, security and web hosting. For wholesale channels, we have introduced Voice Optimized Access, or VOA, and LPVA. We believe that VOA is an ideal solution for companies that want to offer their VoIP solutions in connection with our services. LPVA is an alternative voice solution targeted at residential customers who want to purchase voice services from a provider other than their local telephone company, but want the convenience of maintaining existing inside wiring and telephones.

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

Critical Accounting Policies and Estimates

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

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We recognize revenues when persuasive evidence of our arrangement with the customer exists, service has been provided to the customer, the price to the customer is fixed or determinable and collectibility of the sales price is reasonably assured. We recognize up-front fees associated with service activation, which includes set-up fees and revenue from customer premises equipment, or CPE, using the straight-line method, over the expected term of the customer relationship, which ranges from twenty-four to forty-eight months. We include revenue from sales of CPE and the set-up fees for service activation as up-front fees because neither is considered a separate unit of accounting. We treat the incremental direct costs of service activation, which consist principally of CPE, service activation fees paid to other telecommunications

companies and sales commissions, as deferred charges in amounts no greater than the aggregate up-front fees that are deferred. These deferred incremental direct costs are amortized to operations using the straight-line method over a range of twenty-four to forty-eight months.

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We perform ongoing credit evaluations of our customers’ financial condition and maintain an allowance for estimated credit losses. In addition, we have billing disputes with some of our customers. These disputes arise in the ordinary course of business in the telecommunications industry and we believe that their impact on our accounts receivable and revenues can be reasonably estimated based on historical experience. In addition, certain customer revenues are subject to refund if the end-user terminates service within thirty days of service activation. Accordingly, we maintain allowances, through charges to revenues, based on our estimate of the ultimate resolution of these disputes and future service cancellations, and our reported revenue in any period could be different than what is reported if we employed different assumptions in estimating the outcomes of these items.

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We state our inventories at the lower of cost or market, determined using the “first-in, first-out” method. In assessing the ultimate recoverability of inventories, we are required to make estimates regarding future customer demand.

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We record property and equipment and intangible assets at cost, subject to adjustments for impairment. We depreciate or amortize property and equipment and intangible assets using the straight-line method over their estimated useful lives. In assessing the recoverability of our property and equipment and intangible assets, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates and assumptions change in the future, we may be required to record additional impairment charges relating to our property and equipment and intangible assets.

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We record goodwill when the consideration paid for an acquisition exceeds the fair value of net tangible and intangible assets acquired. We measure and test goodwill for impairment on an annual basis or more frequently if we believe indicators of impairment exists. 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, impairment exists and is recorded.

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We are a party to a variety of legal proceedings, as either plaintiff or defendant, and are engaged in other disputes that arise in the ordinary course of business. We are required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses for certain of these matters. The determination of the liabilities to be recognized, if any, for loss contingencies is made after analysis of each individual situation based on the facts and circumstances. We also have billing disputes with our telecommunication vendors that arise in the ordinary course of business. These disputes are primarily driven by the timing of implementation and interpretation of complex rate structures and the related agreements with these vendors in various states in which we operate. Upon receiving an actual credit or a firm commitment to issue the credit by the vendor, we record the recovery through an adjustment to cost of sales and the related liability. Estimated recoveries are recorded if there is a legal basis, otherwise such amounts are recorded when the actual credit or a firm commitment to issue a credit is received from the vendor. However, it is reasonably possible that the liabilities reflected in our consolidated balance sheets for loss contingencies and business disputes could change in the near term due to new facts and circumstances, the effects of which could be material to our consolidated financial position, results of operations or cash flows.

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We perform on-going research and analysis of the applicability of transaction-based taxes to sales of our products and services and purchases of telecommunications circuits from various carriers. This research

and analysis may include discussions with authorities of jurisdictions in which we do business and transaction-based tax experts to determine the extent of our transaction-based tax liabilities. In addition, we continue to analyze the probable applicability of employment-related taxes for certain stock-based compensation provided to employees in prior periods. It is reasonably possible that our estimates of our transaction-based and employment-related tax liabilities could change in the near term, the effects of which could be material to our consolidated financial position and results of operations.

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We make market development funds, or MDF, available to certain customers for the reimbursement of co-branded advertising expenses and other purposes. To the extent that MDF is used by our customers for co-branded advertising, and the customers provide us with third-party evidence of such co-branded advertising and we can reasonably estimate the fair value of our portion of the advertising, such amounts are charged to advertising expense as incurred. Other MDF activities are recorded as reductions of revenues as incurred. Amounts payable to customers relating to rebates and customer incentives are recorded as reductions of revenues based on our estimate of sales incentives that will ultimately be claimed by customers.

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We record post-employment benefits which primarily consist of our severance plans. These plans are primarily designed to provide severance benefits to our eligible employees whose employment is terminated in connection with reductions in our workforce. We do not accrue for this employee benefit, other than for individuals that have been notified of termination, because we cannot reasonably determine the probability or the amount of such payments.

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We account for income taxes using the liability method, under which deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of our assets and liabilities. We record a valuation allowance on our deferred tax assets to arrive at an amount that is more likely than not to be realized. In the future, should we determine that we are able to realize all or part of our deferred tax assets, which presently are fully reserved, an adjustment to our deferred tax assets would increase income in the period in which the determination was made.

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Effective January 1, 2006, we adopted the provisions of Financial Accounting Standards Board, or FASB, Statement of Financial Accounting Standards, or SFAS, No. 123R (revised 2004),“Share-Based Payment.”Accordingly, we account for stock-based awards exchanged for employee services based on the fair value of the award. We measure the stock-based compensation cost at the grant-date and recognize such cost over the employee requisite service period. We estimate the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of SFAS No. 123R, SEC’s Staff Accounting Bulletin, or SAB, No. 107, including stock-based compensation (determined under a fair value method as prescribed by SFAS No. 123R). We determine the expected life of the options using historical data for options exercised, cancelled after vesting and outstanding. We determine the expected stock price volatility assumption using historical volatility of our common stock over a period equal to the expected life of the option. These assumptions are consistent with our estimates prior the adoption of SFAS No. 123R. We determine the forfeiture rate using historical pre-vesting cancellation data for all options issued after 2001. Determining assumptions, such as expected term, expected volatility and expected forfeiture rates, requires significant judgment. Changes in those assumptions could materially impact reported results in future periods.

Recent Accounting Pronouncements

In February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115.”SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. This statement permits an entity to choose to measure many financial instruments and certain other items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. We are evaluating the effect that SFAS No. 159 will have on our financial statements upon adoption of the Statement.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements.”This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”), and expands disclosures about fair value measurements. Prior to SFAS No. 157, there were different definitions of fair value and limited guidance for applying those definitions in GAAP. In developing this Statement, the FASB considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are evaluating the effect that SFAS No. 157 will have on our consolidated financial statements upon adoption of the Statement.

In June 2006, the FASB ratified the consensus on Emerging Issues Task Force, or EITF, No. 06-3,“How Taxes Collected from Customers and Remitted to Governmental Authorities should be Presented in the Income Statement.”The scope of EITF No. 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer and may include, but is not limited to, sales, use, value added, Federal Universal Service Fund, or FUSF, contributions and excise taxes. The Task Force affirmed its conclusion that entities should present these taxes in the income statement on either a gross or a net basis, based on their accounting policy, which should be disclosed pursuant to Accounting Principles Board, or APB, No. 22,“Disclosure of Accounting Policies.”If such taxes are significant, and are presented on a gross basis, the amounts of those taxes should be disclosed. The consensus on EITF No. 06-3 will be effective for interim and annual reporting periods beginning after December 15, 2006. We currently record transaction-based taxes on a net basis, except for the FUSF charges billed to customers, in our consolidated statements of operations. We adopted EITF No. 06-3 on January 1, 2007 and such adoption did not have a significant impact to our financial statements.

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

Business Segment Information

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

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

We allocate network costs to our business segments based on their consumption of circuit or equipment capacity. The remaining network costs for unused capacity on our network are allocated to Corporate Operations. We allocate end-user circuit costs to a segment based on the products and services sold by such segment. Aggregation circuits are allocated based on actual capacity usage determined by the total number of customers in a segment utilizing those circuits. CPE cost is directly assigned to a business segment based on the number of installations performed by such segment. We allocate labor costs from our operations to our business segments based on resource consumption formulas, which are primarily based on installations, percentage of total lines in service and trouble tickets by segment. We allocate employee compensation for our sales forces directly to the business segments based on the customers they sell to and serve. We allocate advertising and promotions to the business segments based on the targeted customers of the advertising and promotions.

Results of Operations For The Three and Six months Ended June 30, 2007 and 2006

Revenues, net

The primary component of our net revenues is earned monthly broadband subscription billings for DSL services. We also earn revenues from monthly subscription and usage billings related to our VoIP and fixed wireless broadband services, and monthly subscription billings for high-capacity T-1 circuits sold to our wholesale customers. Because we do not recognize revenues from billings to financially distressed customers until we receive payment and until our ability to keep the payment is reasonably assured, our reported revenues for the three and six months ended June 30, 2007 and 2006 have been impacted by whether we receive, and the timing of receipt of, payments from these customers. Our net revenues also include a ratable portion of service activation fees and revenue from equipment sales for which the up-front billings are deferred and recognized as revenue over the expected life of the relationship with the end-user, and FUSF charges billed to our customers. We record customer incentives and rebates that we offer to attract and retain customers as reductions to gross revenues. We regularly have billing and service disputes with our customers. These disputes arise in the ordinary course of business in the telecommunications industry, and we believe their impact on our accounts receivable and revenues can be reasonably estimated based on historical experience. In addition, certain revenues are subject to refund if an end-user terminates service within thirty days of the service activation. Accordingly, we maintain allowances, through charges to revenues, based on our estimate of the ultimate resolution of these disputes and future service cancellations.

Our net revenues of $120,585 for the three months ended June 30, 2007 increased by $2,050, or 1.7%, over our net revenues of $118,535 for the three months ended June 30, 2006. This increase was attributable to a $9,149 increase in broadband revenues primarily as a result of higher sales of our T-1, ADSL and LPVA services, a $3,808 increase in VoIP revenues primarily as a result of adding customers and stations, and a $581 increase in wireless broadband revenues as a result of adding customers. These increases were offset by decreases in our Legacy broadband revenues primarily as a result of an $8,988 decrease in sales and $2,500 due to lower selling prices.

Our net revenues of $240,735 for the six months ended June 30, 2007 increased by $4,449, or 1.9%, over our net revenues of $236,286 for the six months ended June 30, 2006. This increase was primarily attributable to a $18,480 increase in broadband revenues primarily as a result of higher sales of our T-1, ADSL and LPVA services, a $7,610 increase in VoIP revenues primarily as a result of adding customers and stations, and a $2,588 increase in wireless broadband revenues as a result of the acquisitions of NextWeb in February 2006 and DataFlo in November 2006. These increases were offset by decreases in our Legacy broadband revenues primarily as a result of a $17,859 decrease in sales and $4,192 due to lower selling prices. In addition, our other revenues decreased by $2,174 primarily as a result of the sale of a software license related to our operational and support system software during the three months ended March 31, 2006. At this time we do not anticipate additional revenue from sales of our software.

We expect to continue to experience increases in net revenues from the sales of our Growth services. We also expect to continue to experience competitive pricing pressure on our current Legacy services. As a result, we expect to continue to experience high levels of customer service terminations, particularly in our stand-alone DSL services, which may be greater than the number of new activations. We also expect customer rebates and

incentives to continue to be an element of our sales and marketing programs and we also may reduce our prices in order to respond to competitive market conditions. It is possible that these conditions will cause our total revenues to decline in future periods if we do not generate enough new sales from our Growth services.

Segment Revenues and Significant Customers

Our segment net revenues were as follows:


	Three months ended June 30,						Six months ended June 30,
	2007			2006			2007			2006
Wholesale	$	76,629		$	78,898		$	153,380		$	159,982
Percent of net revenues		63.5	%		66.6	%		63.7	%		67.7	%
Direct	$	43,956		$	39,637		$	87,355		$	76,304
Percent of net revenues		36.5	%		33.4	%		36.3	%		32.3	%

Our Wholesale net revenues for the three months ended June 30, 2007 decreased by $2,269, or 2.9%, when compared to the three months ended June 30, 2006. This decrease was attributable to our Legacy services as a result of a $7,286 decrease in sales and $1,629 due to lower selling prices. These decreases were offset by a $6,646 increase in broadband revenues primarily as a result of higher sales from our Growth services. Our Direct net revenues for the three months ended June 30, 2007 increased by $4,319, or 10.9%, when compared to the three months ended June 30, 2006. This increase was attributable to a $3,808 increase in VoIP revenues as a result of adding customers and stations, a $2,502 increase in broadband revenues as a result of higher sales of our T-1, ADSL and LPVA services, and a $581 increase in wireless broadband revenues due to adding customers. These increases were offset by decreases in our Legacy broadband revenues primarily as a result of a $1,701 decrease in sales and $871 due to lower selling prices.

Our Wholesale net revenues for the six months ended June 30, 2007 decreased by $6,602, or 4.1%, when compared to the six months ended June 30, 2006. This decrease was attributable to our Legacy services as a result of a $14,541 decrease in sales and $2,308 due to lower selling prices. In addition, our other revenues decreased by $2,174 primarily as a result of the sale of a software license related to our operational and support system software during the three months ended March 31, 2006. These decreases were offset by a $12,421 increase in broadband revenues primarily as a result of higher sales from our Growth services. Our Direct net revenues for the six months ended June 30, 2007 increased by $11,051 or 14.5%, when compared to the six months ended June 30, 2006. This increase was attributable to a $7,610 increase in VoIP revenues as a result of adding customers and stations, a $6,059 increase in broadband revenues as a result of higher sales of our T-1, ADSL and LPVA services, and a $2,589 increase in wireless broadband revenues as a result of the acquisitions of NextWeb in February 2006 and DataFlo in November 2006. These increases were offset by decreases in our Legacy broadband revenues primarily as a result of a $3,321 decrease in sales and $1,886 due to lower selling prices.

As of June 30, 2007, we had 414 wholesale customers compared to 410 as of June 30, 2006. For the three and six months ended June 30, 2007, our 30 largest wholesale customers, in each such period, collectively accounted for 90.7% and 90.6%, respectively, of our total wholesale net revenues, and 57.7% and 57.7%, respectively, of our total net revenues. For the three and six months ended June 30, 2006, our 30 largest wholesale customers, in each such period, collectively accounted for 91.5% and 90.6%, respectively, of our total wholesale net revenues, and 60.9% and 61.4%, respectively, of our total net revenues. As of June 30, 2007 and December 31, 2006, receivables from these customers collectively accounted for 58.4% and 53.1%, respectively, of our gross accounts receivable balance.

For the three and six months ended June 30, 2007 and 2006, two of our wholesale customers, AT&T and EarthLink, individually accounted for more than 10% of our total net revenues. AT&T accounted for 12.5% and 12.8% for the three and six months ended June 30, 2007, respectively, and for 14.4% and 14.5% for the three and six months ended June 30, 2006, respectively. EarthLink accounted for 11.3% and 11.1% for the three and six months ended June 30, 2007, respectively and for 11.5% and 11.8% for the three and six months ended June 30, 2006, respectively. As of June 30, 2007 and December 31, 2006, accounts receivable from AT&T individually accounted for 11.1% and 10.5%, respectively, of our gross accounts receivables. As of June 30, 2007 and December 31, 2006, accounts receivable from EarthLink individually accounted for 14.4% and 12.8%, respectively, of our gross accounts receivables. No other individual customer accounted for more than 10% of our total net revenues for the three and six months ended June 30, 2007 and 2006.

On May 27, 2005, we entered into a strategic agreement with EarthLink to develop and deploy our LPVA services. As part of the agreement, EarthLink made a non-interest-bearing prepayment, which we agreed to use exclusively for expenditures related to the development and deployment of our LPVA services. Consequently, we classified the unused cash balance of the prepayment as restricted cash and cash equivalents. As of December 31, 2006 and June 30, 2007, proceeds associated with this prepayment were fully utilized towards expenditures related to the provision of the LPVA services. As of June 30, 2007, the remaining amount of the prepayment is classified as a current liability in collateralized and other customer deposits based on the amount of expected billings over the next twelve months. As we provide the products and services described in the agreement to EarthLink, the resultant billings are recognized as revenue in accordance with our revenue recognition policy (which is described in Note 2, “Revenue Recognition,” to our condensed consolidated financial statements) and are offset by the prepayment liability to the extent of EarthLink’s right to do so under the agreement. The amount of billings expected over the next twelve months is an estimate based on current projections of products and services EarthLink will purchase. The actual amount sold for this period may be greater or less than this estimated amount.

As of June 30, 2007, we had approximately 73,400 Direct end-users compared to approximately 78,100 as of June 30, 2006. As of June 30, 2007, we had approximately 2,200 VoIP business customers with a combined total of approximately 3,800 sites utilizing our VoIP services as compared to 1,300 VoIP business customers with a combined total of approximately 2,300 sites as of June 30, 2006. As of June 30, 2007, we had 3,600 fixed wireless broadband subscribers compared to approximately 3,000 as of June 30, 2006.

Wholesaler Financial Difficulties

We have identified certain of our customers who were essentially current in their payments for our services prior to June 30, 2007, or have subsequently paid all or significant portions of the respective amounts that we recorded as accounts receivable as of June 30, 2007, that we believe may be at risk of becoming financially distressed. Revenues from these customers accounted for 1.8% of our total net revenues for the three and six months ended June 30, 2007, respectively, and 12.4% and 12.3% of our total net revenues for the three and six months ended June 30, 2006, respectively. As of June 30, 2007 and December 31, 2006, receivables from these customers collectively accounted for 1.7% and 1.4% of our gross accounts receivable balance, respectively. If these customers are unable to demonstrate their ability to pay for our services in a timely manner in periods ending subsequent to June 30, 2007, revenue from such customers will only be recognized when cash is collected, as described above.

Operating Expenses

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

Our total operating expenses were as follows:


	Three months ended June 30,						Six months ended June 30,
	2007			2006			2007			2006
Amount	$	130,089		$	104,463		$	262,777		$	231,176
Percent of net revenues		107.9	%		88.1	%		109.2	%		97.8	%

Cost of Sales (exclusive of depreciation and amortization)

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

Our cost of sales was as follows:


	Three months ended June 30,						Six months ended June 30,
	2007			2006			2007			2006
Amount	$	87,136		$	80,802		$	175,131		$	160,739
Percent of net revenues		72.3	%		68.2	%		72.7	%		68.0	%

Our cost of sales for the three months ended June 30, 2007 increased by $6,334, or 7.8%, when compared to the three months ended June 30, 2006. This increase was attributable to increases in network costs of $4,893, of which $3,191 relates to costs associated with our LPVA and VoIP services, cost of equipment of $1,365, and labor and other related operating expenses of $2,603 as a result of the addition of broadband, VoIP and fixed wireless subscribers to our network. These increases were partially offset by a $147 decrease in employee compensation and related operating expenses as a result of a decrease in headcount and cost containment initiatives, a $479 decrease in network costs as a result of reduced rates for some of our network elements, and a $339 decrease in recoveries from billing disputes with our telecommunication vendors. For the three months ended June 30, 2007, we reduced our estimated liabilities for transaction-based, property, and employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our cost of sales and our net loss by $527, or $0.00 per share, for the three months ended June 30, 2007. In addition, for the three months ended June 30, 2007, we reduced our estimated liabilities of network costs as a result of a settlement with one of our vendors. This change in accounting estimate decreased our cost of sales and net loss by $2,748 or $0.01 per share, for the three months ended June 30, 2007. For the three months ended June 30, 2006, we reduced our estimated liabilities for transaction-based, property, and employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our cost of sales and increased our net income by $1,679, or $0.00 per share, for the three months ended June 30, 2006.

Our cost of sales for the six months ended June 30, 2007 increased by $14,392, or 9.0%, when compared to the six months ended June 30, 2006. This increase was attributable to increases in network costs of $8,511, of which $6,265 relates to costs associated with the deployment of our LPVA and VoIP services, cost of equipment of $1,688, and labor and other related operating expenses of $5,654 as a result of the addition of broadband, VoIP and fixed wireless subscribers to our network. In addition, our network costs for the six months ended June 30, 2007 increased by $594 as a result of increased rates for some of our network elements. These increases were partially offset by a $946 decrease in employee compensation and related operating expenses as a result of a decrease in headcount and cost containment initiatives and a $180 decrease in recoveries from billing disputes with our telecommunication vendors. For the six months ended June 30, 2007, we reduced our estimated liabilities for transaction-based, property, and employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our cost of sales and our net loss by $761, or $0.00 per share, for the six months ended June 30, 2007. In addition, for the six months ended June 30, 2007, we reduced our estimated liabilities of network costs as a result of a settlement with one of our vendors. This change in accounting estimate decreased our cost of sales and net loss by $2,748 or $0.01 per share, for the six months ended June 30, 2007. For the six months ended June 30, 2006, we reduced our estimated liabilities for transaction-based, property, and employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our cost of sales and increased our net income by $2,537, or $0.01 per share, for the six months ended June 30, 2006.

Some of our Growth services, such as VoIP and LPVA, require significant upfront costs to acquire and provision new customers, which creates a lag between the costs we incur in connection with these services and the amount of revenue we receive from these services. This has caused our cost of sales to increase at a rate that is higher than the rate that revenue has increased. We expect our cost of sales to increase in future periods as we anticipate we will add subscribers and services to our network. We also expect our network costs to increase as

a result of rule changes released by the FCC on February 4, 2005, which were upheld on June 16, 2006 by the United States Court of Appeals for the D.C. Circuit, regarding the obligations of ILECs to share their networks with competitive telecommunications companies like us. To offset some of the increased costs, we plan to continue to execute cost-saving programs and improve our efficiency in delivering our services.

Our cost of sales was allocated as follows:


	Three months ended June 30,				Six months ended June 30,
	2007		2006		2007		2006
Wholesale Segment	$	48,339	$	45,712	$	95,939	$	91,946
Direct Segment		26,932		23,762		52,832		46,053
Corporate Operations		11,865		11,328		26,360		22,740

Total	$	87,136	$	80,802	$	175,131	$	160,739

Our cost of sales for the Wholesale segment for the three months ended June 30, 2007 increased by $2,627, or 5.8%, when compared to the three months ended June 30, 2006. This increase was attributable to a $1,549 increase in labor and other operating expenses due to higher LPVA installations and a $2,120 increase in network costs as a result of an increase in sales of other Growth services. These increases were partially offset by a $271 decrease in network costs primarily due to reduced rates. In addition, we reduced our estimated liabilities of network cost as a result of a settlement with one of our vendors. This change in accounting estimate decreased our cost of sales by $725 for the three months ended June 30, 2007. Our cost of sales for the Direct segment for the three months ended June 30, 2007 increased by $3,170, or 13.3%, when compared to the three months June 30, 2006. This increase was attributable to an increase in network costs of $1,905 and cost of equipment of $1,365 as a result of the addition of broadband, VoIP and fixed wireless subscribers to our network and $503 increase in labor and other operating expenses due to higher growth products installations. These increases were partially offset by a $195 decrease in network costs primarily due to reduced rates. In addition, we reduced our estimated liabilities of network cost as a result of a settlement with one of our vendors. This change in accounting estimate decreased our cost of sales by $415 for the three months ended June 30, 2007. Our cost of sales for Corporate Operations for the three months ended June 30, 2007 increased by $537, or 4.7%, when compared to three months ended June 30, 2006. This increase was primarily attributable to an $868 increase in network costs and a $551 increase in labor and other operating expenses as a result of adding capacity to our network. These increases were partially offset by a $460 decrease in employee compensation and related operating expenses as a result of a decrease in headcount and cost initiatives. For the three months ended June 30, 2007, we reduced our estimated liabilities for transaction-based, property, and employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our Corporate Operations cost of sales by $527 for the three months ended June 30, 2007. In addition, we reduced our estimated liabilities of network cost as a result of a settlement with one of our vendors. This change in accounting estimates decreased our cost of sales by $1,608 for the three months ended June 30, 2007. For the three months ended June 30, 2006, we reduced our estimated liabilities for transaction-based, property, and employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our cost of sales by $1,679 for the three months ended June 30, 2006.

Our cost of sales for the Wholesale segment for the six months ended June 30, 2007 increased by $3,993, or 4.3%, when compared to the six months ended June 30, 2006. This increase was attributable to a $1,549 increase in labor and other operating expenses due to higher LPVA installations, a $609 increase in network costs due to increased rates and lower recoveries from billing disputes with our telecommunication vendors, and a $2,606 increase in network costs as a result of an increase in sales from other Growth services. In addition, we reduced our estimated liabilities of network cost as a result of a settlement with one of our vendors. This change in accounting estimate decreased our cost of sales by $725 for the six months ended June 30, 2007. Our cost of sales for the Direct segment for the six months ended June 30, 2007 increased by $6,779, or 14.7%, when compared to the six months June 30, 2006. This increase was primarily attributable to an increase in network costs of $4,689 and cost of equipment of $1,688 as a result of the addition of broadband, VoIP and fixed wireless subscribers to our network, $307 due to increased rates and lower recoveries from billing disputes

with our telecommunication vendors, and a $503 increase in labor and other operating expenses due to higher growth products installations. In addition, we reduced our estimated liabilities of network cost as a result of a settlement with one of our vendors. This change in accounting estimate decreased our cost of sales by $415 for the six months ended June 30, 2007. Our cost of sales for Corporate Operations for the six months ended June 30, 2007 increased by $3,620, or 15.9%, when compared to six months ended June 30, 2006. This increase was primarily attributable to a $1,216 increase in network costs and a $3,602 increase in labor and other operating expenses as a result of adding capacity to our network. These increases were partially offset by a $1,409 decrease in employee compensation and related operating expenses as a result of a decrease in headcount and cost initiatives. For the six months ended June 30, 2007, we reduced our estimated liabilities for transaction-based, property, employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our Corporate Operations cost of sales by $761 for the six months ended June 30, 2007. In addition, we reduced our estimated liabilities of network cost as a result of a settlement with one of our vendors. This change in accounting estimate decreased our cost of sales by $1,608 for the six months ended June 30, 2007. For the six months ended June 30, 2006, we reduced our estimated liabilities for transaction-based and property taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes and due to lower property tax valuations and actual tax assessments on our network assets. These changes in accounting estimates decreased our cost of sales by $2,537 for the six months ended June 30, 2006.

Benefit from Transaction Tax Adjustment

In 2004, we stopped accruing Federal Excise Tax (“FET”) on the purchases of certain telecommunications services because we determined we should not be subject to this tax. The determination was based on our revised interpretation of the applicability of the tax. That determination prospectively removed the “probable” condition required by the SFAS No. 5 –Accounting for Contingencies”to accrue a contingent liability. We did not reverse the liability of $19,455 that was previously accrued, because the liability was properly recorded based upon our interpretation of the tax law at that time coupled with the guidance provided by SFAS No. 5. The criteria for reversing the liability for the tax is met when: (i) a ruling, either judicial or from the Internal Revenue Service (“IRS”), that we are not subject to the tax, (ii) a ruling, either judicial or from the IRS that a company with similar facts and circumstances to us is not subject to the tax, (iii) a settlement with the IRS on this matter or, (iv) the expiration of the applicable statute of limitations.

On May 25, 2006, the IRS issued Notice 2006-50 announcing that it will stop collecting FET on “long-distance” telephone service and that it will no longer litigate this issue with taxpayers. The FET is now only applicable to “local” telephone service. The services we purchased for which we accrued FET do not fall under the definition of local telephone service. Therefore, we have determined that (i) IRS Notice 2006-50 resolved the uncertainty around the applicability of the tax to those telecommunications services, and (ii) meets one of the criteria stated above for reversing the accrued liability of $19,455. Consequently, we reversed such liability for the three and six months ended June 30, 2006. For the three and six months ended June 30, 2006, the benefit increased our net income by $19,455, or $0.06 and $0.07 per share, respectively.

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:


	Three months ended June 30,						Six months ended June 30,
	2007			2006			2007			2006
Amount	$	28,455		$	31,889		$	59,789		$	66,854
Percent of net revenues		23.6	%		26.9	%		24.8	%		28.3	%

Our selling, general and administrative expenses for the three months ended June 30, 2007 decreased by $3,434, or 10.8%, when compared to our selling, general and administrative expenses for the three months

ended June 30, 2006. This decrease was primarily attributable to a $2,168 decrease in marketing and related expenses, a $2,106 decrease in labor and other related operating expenses primarily as a result of a decrease in headcount and cost containment initiatives, and a $302 decrease in professional services primarily as a result of lower legal, consulting, contract labor and other services. For the three months ended June 30, 2007, we reduced our estimated liabilities for employment-related taxes, as a result of the expiration of the relevant statute of limitations for such taxes. This change in accounting estimate decreased our selling, general and administrative expenses, and our net loss by $215, or $0.00 per share, for the three months ended June 30, 2007. For the three months ended June 30, 2006, we reduced our estimated liabilities for employment-related taxes because we determined we do not owe some of these taxes as result of the expiration of the statute of limitations. These changes in accounting estimates decreased our selling, general and administrative expenses and increased our net income by $1,346, or $0.00 per share, for the three months ended June 30, 2006.

Our selling, general and administrative expenses for the six months ended June 30, 2007 decreased by $7,065, or 10.7%, when compared to our selling, general and administrative expenses for the six months ended June 30, 2006. This decrease was primarily attributable to a $3,324 decrease in marketing and related expenses, a $2,628 decrease in labor and other related operating expenses primarily as a result of a decrease in headcount and cost containment initiatives, and a $2,236 decrease in professional services primarily as a result of lower legal, consulting, contract labor and other services. For the six months ended June 30, 2007, we reduced our estimated liabilities for employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes. This change in accounting estimate decreased our selling, general and administrative, and our net loss by $215, or $0.00 per share, for the six months ended June 30, 2007. For the six months ended June 30, 2006, we reduced our estimated liabilities for employment-related taxes because we determined we do not owe some of these taxes as a result of the expiration of the statue of limitations. This change in accounting estimate decreased our selling, general and administrative expenses and increased our net income by $1,346, or $0.00 per share, for the six months ended June 30, 2006.

We expect our total selling, general and administrative expenses to decrease in future periods primarily as a result of continuing cost reduction initiatives. We expect these benefits to reduce our selling, general and administrative expenses in 2007 when compared to 2006.

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


	Three months ended June 30,				Six months ended June 30,
	2007		2006		2007		2006
Wholesale Segment	$	1,847	$	2,052	$	3,909	$	4,281
Direct Segment		6,886		10,153		15,666		20,556
Corporate Operations		19,722		19,684		40,214		42,017

Total	$	28,455	$	31,889	$	59,789	$	66,854

Our selling, general and administrative expenses for the Wholesale segment for the three months ended June 30, 2007 decreased by $205, or 10.0%, when compared to the three months ended June 30, 2006. This decrease was primarily attributable to lower marketing expenses as a result of cost containment initiatives. Our selling, general and administrative expenses for the Direct segment for the three months ended June 30, 2007 decreased by $3,267 or 32.2%, when compared to the three months ended June 30, 2006. This decrease was attributable to a $2,038 decrease in marketing expenses, and a $1,229 decrease in labor and other operating expenses due to a decrease in headcount and cost containment initiatives. Our selling, general and administrative expenses for Corporate Operations for the three months ended June 30, 2007 increased by $38, or 0.2%, when compared to the three months ended June 30, 2006. For the three months ended June 30, 2006, we reduced our estimated liabilities for employment-related taxes because we determined we do not owe some of these taxes. This change in accounting estimate decreased our selling, general and administrative expenses and increased our net income by $1,346, or $0.00 per share, for the three months ended June 30, 2006. The effect of this increase for the three months ended June 30, 2007 was partially offset by an $802 decrease in labor and other related operating expenses primarily as a result of a decrease in headcount and cost containment initiatives and a $302 decrease in professional services primarily as a result of lower legal, consulting, contract labor and other services. In addition, for the three months ended June 30, 2007, we reduced our estimated liabilities for employment-related taxes, as a result of the expiration of the relevant statute of limitations for such taxes. This change in accounting estimate decreased our selling, general and administrative expenses, and our net loss by $215, or $0.00 per share, for the three months ended June 30, 2007.

Our selling, general and administrative expenses for the Wholesale segment for the six months ended June 30, 2007 decreased by $372, or 8.7%, when compared to the six months ended June 30, 2006. This decrease was primarily attributable to lower marketing expenses as a result of cost containment initiatives. Our selling, general and administrative expenses for the Direct segment for the six months ended June 30, 2007 decreased by $4,890, or 23.8%, when compared to the six months ended June 30, 2006. This decrease was attributable to a $3,135 decrease in marketing expenses, and a $1,755 decrease in labor and other operating expenses due to a decrease in headcount and cost containment initiatives. Our selling, general and administrative expenses for Corporate Operations for the six months ended June 30, 2007 decreased by $1,803, or 4.3%, when compared to the six months ended June 30, 2006. This decrease was primarily attributable to a $2,236 decrease in professional services and a $691 decrease in labor and other operating expenses as a result of cost containment initiatives. For the six months ended June 30, 2007, we reduced our estimated liabilities for employment-related taxes, primarily as a result of the expiration of the relevant statute of limitations for such taxes. This change in accounting estimate decreased our selling, general and administrative expenses, and our net loss by $215, or $0.00 per share, for the six months ended June 30, 2007. In addition, for the six months ended June 30, 2006, we reduced our estimated liabilities for employment-related taxes because we determined we do not owe some of these taxes. This change in accounting estimate decreased our selling, general and administrative expenses and increased net income by $1,346, or $0.00 per share, for the six months ended June 30, 2006.

Stock-Based Compensation

As a result of adopting SFAS No. 123R, our net loss for the three and six months ended June 30, 2007 includes $667 ($0.00 per share), and $1,092 ($0.00 per share), respectively, of stock-based compensation, of which $456 and $857, respectively, relates to our employee stock option plans, and $211 and $235, respectively, relates to our employee stock purchase plan. For the three and six months ended June 30, 2007, $273 and $445, respectively, of the total stock-based compensation was recorded in cost of sales and $394 and $647, respectively, in selling, general and administrative expenses. For the three and six months ended June 30, 2006, our net income includes $837 ($0.00 per share), and $1,501 ($0.01 per share), respectively, of stock-based compensation, of which $456 and $781, respectively, relates to our employee stock option plans, and $381 and $720, respectively, relates to our employee stock purchase plan. For the three and six months ended June 30, 2006, $342 and $612, respectively, of the total stock-based compensation was recorded in cost of sales and $495 and $889, respectively, in selling, general and administrative expenses.We did not recognize and do not expect to recognize in the near future, any tax benefit related to employee stock-based compensation cost as a result of the full valuation allowance on our net deferred tax assets and because of our net operating loss carryforwards. We did not capitalize any portion of our stock-based compensation cost for the three and six months ended June 30, 2007. For the three and six months ended June 30, 2006, we capitalized a portion of its stock-based compensation cost, or $8.

Depreciation and Amortization

Our depreciation and amortization of property and equipment, or depreciation, was $10,796 for the three months ended June 30, 2007, an increase of $2,716 over our depreciation of $8,080 for the three months ended June 30, 2006. Our depreciation was $21,806 for the six months ended June 30, 2007, an increase of $5,078 over our depreciation of $16,728 for the six months ended June 30, 2006. The increase in depreciation resulted primarily from the deployment of new equipment in connection with our LPVA build out in 2006, offset by certain historical assets becoming fully depreciated.

Our amortization of intangible assets, or amortization, was $2,345 for the three months ended June 30, 2007, a decrease of $291 over our amortization of $2,636 for the three months ended June 30, 2006. Our amortization was $4,694 for the six months ended June 30, 2007, a decrease of $342 over the amortization of $5,036 for the six months ended June 30, 2006. The decrease was primarily due to historical assets becoming fully amortized.

We expect our depreciation and amortization to increase in 2007 when compared to 2006 primarily as a result of the deployment of new equipment in connection with our LPVA build out in 2006. We do not allocate depreciation and amortization expense to our business segments.

Provision for Post-Employment Benefits

For the three and six months ended June 30, 2007, we reduced our workforce by 70 employees, which represented 7.5% and 7.2%, respectively, of our workforce. We expect these cost reduction actions to result in approximately $5,500 in savings in the second half of 2007. For the three and six months ended June 30, 2006, we reduced our workforce by 30 and 48 employees, respectively, which represented 2.9% and 4.6%, respectively, of our workforce. For the three and six months ended 2007 and 2006, the reductions covered employees in the areas of sales and marketing, operations and corporate functions.

In connection with the reductions in our workforce, we recorded charges to operations for the three and six months ended June 30, 2007 of $1,357 relating to employee severance benefits that met the requirements for accrual. For the three and six months ended of 2007, we paid severance benefits of $772. We expect to pay the remainder of severance benefits accrued as of June 30, 2007 during the three months ending September 30, 2007. Expenses associated with the reductions in our workforce, for the three and six months ended June 30, 2007, were $435 related to the Wholesale business segment, and $475 related to the Direct business segment. The remaining $447 was related to our Corporate Operations.

For the three and six months ended June 30, 2006, we recorded employee severance benefits of $511 and $1,274, respectively. For the three and six months ended June 30, 2006, we paid severance benefits of $565 and $946, respectively. The remainder amount of severance benefits has been fully paid as of June 30, 2007. Expenses associated with the reductions in our workforce, for the three and six months ended June 30, 2006, were $156 and $156, respectively, related to the Wholesale segment, and $226 and $226, respectively, related to the Direct segment. The remaining $129 and $892 were related to our Corporate Operations. We continue to evaluate whether additional worforce reductions or other cost reduction initiatives are necessary, and we may incur additional charges to operations for further cost reduction initiatives in future periods.

Other Expense

Net Interest Expense

Our net interest expense was $2,142 and $4,155 for the three and six months ended June 30, 2007, respectively. Net interest expense for the three and six months ended June 30, 2007 and 2006 consisted primarily of interest expense on our 3% convertible senior debentures due 2024 and our 12% senior secured convertible note issued in March 2006, less interest income earned on our cash, cash equivalents and short-term investments balances. We expect future net interest expense to be limited to interest on our 3% convertible senior debentures, our 12% senior secured convertible notes, and our credit facility, partially offset by interest earned on our cash balances. We may, however, seek additional debt financing in the future if it is available on terms that we believe are favorable. If we seek additional debt financing, our interest expense would increase.

Income Taxes

Because we incurred operating losses for all periods presented, we made no provision for income taxes in any periods presented in the accompanying consolidated financial statements.

Effective January 1, 2007 we adopted the provisions of FIN No. 48 which clarifies the accounting for uncertainty in income taxes recognized in financial statements in accordance with SFAS No. 109,“Accounting for Income Taxes.”The Interpretation prescribes a recognition threshold and measurement attribute of tax positions taken or expected to be taken on a tax return. The interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

Due to our significant taxable loss position and full valuation allowance against our net deferred tax assets the adoption of FIN No. 48 did not have an impact to our condensed consolidated financial statements. As of January 1, 2007 we had unrecognized net operating losses which when tax effected provide further tax benefits of approximately $273,000 which related to cancellation of debt and an alternative method of reducing tax attribute by the debt forgiveness gain as a result of our 2001 Chapter 11 bankruptcy proceedings. To the extent the unrecognized tax benefits are ultimately recognized they may have an impact on the effective tax rate in future periods; however, such impact to the effective tax rate would only occur if the recognition of such unrecognized tax benefits occurs in a future period when we have already determined it is more likely than not that our deferred tax assets are realizable. Additionally, we have not recognized any penalties and interest for unrecognized tax benefits as any resolution upon audit of the aforementioned tax position would not require payment of interest and penalties. However, if applicable, our policy is to recognize interest and penalties related to uncertain tax positions in our provision for income taxes.

We are subject to taxation at the federal and various state levels. All of our tax years through 2006 are subject to examination by the tax authorities.

Related Party Transactions

We are a minority shareholder of Certive Corporation (“Certive”). Our chairman of the board of directors, Charles McMinn, is also a significant stockholder of Certive.

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 $41 and $85, respectively, for the three and six months ended June 30, 2007, and $56 and $117, respectively, for the three and six months ended June 30, 2006. Accounts receivables from TelePacific were $14 and $15 as of June 30, 2007 and December 31, 2006, respectively. In August 2006, TelePacific acquired mPower Communications (“mPower”), which is also one of our vendors. We paid $93 and $286, respectively, to mPower for the three and six months ended June 30, 2007. No payments were made to mPower for the three and six months ended June 30, 2006. Accounts payable to mPower were $43 and $51 as of June 30, 2007 and December 31, 2006, respectively.

L. Dale Crandall, another of our directors, is a director of BEA Systems (“BEA”), one of our vendors. We paid $556 to BEA for the three and six months ended June 30, 2007. We paid $772 to BEA for the three and six months ended June 30, 2006. There were no accounts payable to BEA as of June 30, 2007 or December 31, 2006.

Charles Hoffman, our CEO, is a director of Chordiant Software (“Chordiant”), one of our vendors. We paid $255 to Chordiant for the three and six months ended June 30, 2007. We paid $254 to Chordiant for the three and six months ended June 30, 2006. There were no accounts payable to Chordiant as of June 30, 2007 or December 31, 2006. Charles Hoffman is also a director of Synchronoss Technologies, Inc. (“Synchronoss”), one of our vendors. We paid $18 and $32 to Synchronoss for the three and six months ended June 30, 2007, respectively. No payments were made to Synchronoss for the three and six months ended June 30, 2006. Accounts payable to Synchronoss were $7 and $11 as of June 30, 2007 and December 31, 2006, respectively.

We believe these transactions were negotiated on an arms-length basis with 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 lower than in 2006. We expect that incremental, or “success-based,” expenditures related to the addition of subscribers in existing regions, and expenditures related to the offering of new services, will be driven by the number of new subscribers and types of new services that we add to our network.

Our cash and cash equivalents balance for the six months ended June 30, 2007 decreased by $11,636. The change in cash and cash equivalents was as follows:


	Six months ended June 30,
	2007			2006
Net cash provided by (used in):
Operating activities	$	62		$	(38,067	)
Investing activities		(12,197	)		(47,748	)
Financing activities		499			57,153

Total	$	(11,636	)	$	(28,662	)

Operating Activities

Net cash used in our operating activities for the six months ended June 30, 2007 improved by $38,129 when compared to the six months ended June 30, 2006. This improvement was attributable to the $33,538 redemption of our collateralized deposit liability with AT&T executed during the six months ended June 30, 2006, and the net change in our other operating assets and liabilities of $10,291, offset by the net change in our net loss, adjusted for non-cash and other-operating items of $5,700. The net change in our operating assets and liabilities was primarily as a result of a $9,497 increase in collateralized and other customer deposits, a $742 decrease in accounts receivable due to the timing of receipts from our customers, a $2,599 increase in our accounts payable and other liabilities primarily due to the timing of payments to our vendors, and a $2,488 increase in our unearned revenues primarily due to the sale of a software license related to our operation and support systems, partially offset by a $1,443 increase in other long-term assets, a $1,247 increase in unbilled revenues, and an increase in deferred costs of $2,348.

We expect our cash from operating activities to improve in 2007, primarily as a result of our anticipated growth in our net revenues and the effect of continuing cost reduction initiatives. In addition, as discussed above, in 2006 we redeemed $33,538 of our collateralized deposit liability with AT&T. We do not expect a similar redemption in 2007 as the collaterized deposit was repaid in full in 2006. These improvements will be partially offset by product, sales and marketing expenses which will primarily be used to promote our Growth services.

Investing Activities

Our investing activities consist primarily of purchases, maturities and sales of short-term investments in debt securities, capital expenditures for property and equipment and expenditures to acquire collocation facilities. Net cash used in our investing activities for the six months ended June 30, 2007 decreased by $35,551 when compared to the six months ended June 30, 2006. This decrease was attributable to a $41,301 decrease in restricted cash and cash equivalents, a $5,334 decrease in equipment purchases primarily as a result of the completion of the build out of our LPVA services, a $747 decrease in other long-term assets, and $3,010 from the net cash effect of our acquisitions of NextWeb and DataFlo, partially offset by $14,841 from the net cash effect of purchase, sale and maturity activities on our short-term investments in debt securities,

We expect that in 2007 our expenditures related to the purchase of infrastructure equipment necessary for the development and expansion of our networks will be lower than in recent periods while incremental, or “success-based”, expenditures related to the addition of subscribers in existing regions will be driven by the number of new subscribers that we add to our network.

Financing Activities

Our financing activities consist primarily of proceeds from long-term debt, borrowings from our credit facility with SVB, the issuance of our common stock, including issuances under our employee stock-based compensation plans, and the repayment of long-term debt. Net cash provided by our financing activities for the six months ended June 30, 2007 decreased by $56,654 when compared to the six months ended June 30, 2006. This decrease was primarily attributable to our having received the following proceeds during the six months ended June 30, 2006:

	•		$38,457 in proceeds, net of transaction and issuance costs, from the sale of a 12% senior secured convertible note to EarthLink in connection with the agreement for the expansion of our LPVA services (refer to Note 5,“Long-Term Debt,”to our consolidated Financial Statements for a description of the EarthLink transaction);

	•		$13,530 in proceeds from the issuance of our common stock to EarthLink in connection with the above mentioned agreement and from the exercise of employee stock options; and

	•		$6,100 in proceeds from draws on our credit facility.

These proceeds were partially offset by a $1,031 repayment of NextWeb’s long-term debt and $651 in issuance costs related to our credit facility with SVB. On March 15, 2007, we settled the semi-annual interest payment obligation on the above described convertible note with EarthLink. The interest obligation amounted to $2,534. As permitted by the Note, we settled the interest due by issuing an additional note with the same terms as the original note.

We expect that for 2007 our net cash from financing activities will be primarily related to borrowings under and repayments of the revolving line of credit that we entered into with SVB in April 2006, and the 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 $1,758,189 as of June 30, 2007. For the six months ended June 30, 2007, we recorded a net loss of $26,119 and cash flow from operations of $62. As of June 30, 2007, we had $34,643 in cash and cash equivalents, $18,708 in short-term investments, and $12,202 in restricted cash and cash equivalents. The sum of these balances amounted to $65,553. Over the last two years, we reduced our total workforce by 26% and incurred expenditures to automate several of our business processes to improve our cost structure. In addition, as described above, in April 2006 we obtained a $50,000 revolving credit facility with SVB, which was renewed in April of 2007. As a result of these actions we expect that we will have sufficient liquidity to fund our operations at least through June 30, 2008. 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.

On April 13, 2006, we entered into a Loan and Security Agreement (“Loan Agreement”) with SVB. We extended the Loan Agreement in April 2007. The Loan Agreement provides for a revolving credit facility for up to $50,000, subject to specified borrowing base limitations. At our option, the revolving line bears an interest rate equal to SVB’s prime rate or LIBOR plus specified margins, and matures on April 19, 2009. As collateral for the loan under the Loan Agreement, we have granted security interests in substantially all of our real and personal property, other than intellectual property and equipment purchased with the proceeds received from the agreement with EarthLink. We have also provided a negative pledge on our intellectual property. As of June 30, 2007, we had an outstanding principal balance under the Loan Agreement of $6,100, which carried an interest rate of 8.25% plus a margin of 0.25%. Borrowings under the facility are limited by an amount of our eligible accounts receivable and cash. As of June 30, 2007, we had $36,494 of funds available under the credit facility as a result of borrowings, letters of credit, and the borrowing base limitations. As the available borrowing under the facility is limited, the amount available at any time may be substantially less than $50,000 and the facility could be unavailable in certain circumstances.

The Loan Agreement imposes various limitations on us, including without limitation, on our ability to: (i) transfer all or any part of our businesses or properties, merge or consolidate, or acquire all or substantially all of the capital stock or property of another company; (ii) engage in new business; (iii) incur additional indebtedness or liens with respect to any of our properties; (iv) pay dividends or make any other distribution on or purchase of, any of our capital stock; (v) make investments in other companies; (vi) make payments in respect of any subordinated debt; or (vii) make capital expenditures, measured on a consolidated basis, in excess of specified thresholds, subject to certain exceptions. The Loan Agreement also contains certain customary

representations and warranties, covenants, notice and indemnification provisions, and events of default, including changes of control, cross-defaults to other debt, judgment defaults and material adverse changes to our business. In addition, the Loan Agreement requires us to maintain specified liquidity ratios and tangible net worth levels. As of June 30, 2007, we were in compliance with the above described limitations, covenants and conditions of the line of credit.

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

Our cash requirements for 2007 and beyond for developing, deploying and enhancing our network and operating our business will depend on a number of factors including:

	•		our continuing ability to obtain access to ILEC facilities, including telephone lines, remote terminals, interoffice transport and high-capacity circuits, all at reasonable prices;

	•		rates at which resellers and end-users purchase and pay for our services and the pricing of such services;

	•		financial condition of our customers;

	•		levels of marketing required to acquire and retain customers and to attain a competitive position in the marketplace;

	•		rates at which we invest in engineering, equipment, development and intellectual property with respect to existing and future technology;

	•		operational costs that we incur to install, maintain and repair end-user lines and our network as a whole;

	•		pending and any future litigation;

	•		existing and future technology, including any expansion of fixed wireless services;

	•		ability to generate cash flows or obtain adequate financing;

	•		unanticipated opportunities; and

	•		network development schedules and associated costs.

Contractual Cash Obligations

Our contractual debt, lease and purchase obligations as of June 30, 2007 for the next five years, and thereafter, were as follows:


	2007		2008		2009		2010		2011		Thereafter		Total
3% convertible senior debentures	$	—	$	—	$	125,000	$	—	$	—	$	—	$	125,000
12% senior secured convertible note		—		—		—		42,240		2,534		—		44,774
Bank loan		6,100		—		—		—		—		—		6,100
Interest on notes payable		7,222		9,123		6,154		5,373		1,119		—		28,991
Capital leases		437		828		785		182		4		—		2,236
Office leases		2,645		5,014		3,593		2,268		572		15		14,107
Other operating leases		856		1,318		745		442		196		57		3,614
Purchase obligations (network costs)		2,155		—		—		—		—		—		2,155

	$	19,415	$	16,283	$	136,277	$	50,505	$	4,425	$	72	$	226,977

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

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

As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities of financial partnerships, such as entities often referred to as structured finance or special purpose entities, or SPEs, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purpose. As of June 30, 2007, we were not involved in any SPE transactions.

Forward-Looking Statements

We include certain estimates, projections, and other forward-looking statements in our reports, in presentations to analysts and others, and in other publicly available material. Future performance cannot be ensured. Actual results may differ materially from those in forward-looking statements. The statements contained in this Report on Form 10-Q 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:

	•		impact of federal, state and local telecommunications regulations, decisions and related litigation, and our ability to obtain ILEC network elements and facilities at reasonable rates;

	•		continuing deployment of LPVA and our ability to bundle our data services with the voice services of EarthLink and other alternative voice providers;

	•		timing of our cash flows;

	•		extent to which customers purchase our services;

	•		relationships with our strategic partners and other potential third parties;

	•		pricing for our services in the future;

	•		plans regarding new financing arrangements;

	•		our ability to increase our revenues and the margins we generate on our service offerings;

	•		plans to make strategic investments and acquisitions and the effect of such investments and acquisitions;

	•		estimates and expectations of future operating results, including improvements in cash flow from operating activities, our selling, general and administrative expenses, adequacy of our cash reserves, and the number of anticipated installed lines;

	•		plans to increase sales of value-added services, like e-mail, security, web hosting and fixed wireless;

	•		anticipated capital expenditures;

	•		plans to enter into business arrangements with broadband-related service providers;

	•		feasibility of alternative access solutions, like fixed wireless;

	•		effects of litigation currently pending; and

	•		other statements contained in this Report on Form 10-Q regarding matters that are not historical facts

These statements are only estimates or predictions and cannot be relied upon. We can give you no assurance that future results will be achieved. Actual events or results may differ materially as a result of risks facing us or actual results differing from the assumptions underlying such statements.

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

ITEM 3.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 June 30, 2007 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 June 30, 2007:


	Carrying Value		Interest Rate
Cash and cash equivalents	$	34,643		2.50	%
Short-term investments in debt securities		18,708		1.50	%
Restricted cash and cash equivalents		12,202		0.96	%

	$	65,553

ITEM 4. 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 (“Exchange Act”) is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required or necessary disclosures. 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.

Changes in Internal Controls.

For the fiscal quarter covered by this report, 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.

PART II. OTHER INFORMATION

ITEM 1. Legal Proceedings

Several stockholders 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 us and several former and current officers and directors in addition to some of the underwriters in our 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 us as a defendant. Certain directors and officers are still named in the complaint. The plaintiffs claim that we and others failed to disclose the arrangements that some of these underwriters purportedly made with certain investors. We believe these officers and directors have strong defenses to these lawsuits and intend to contest them vigorously. However, litigation is inherently unpredictable and there is no guarantee these officers and directors will prevail.

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

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

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

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

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

We are subject to state PUC, FCC and other regulatory and court decisions as they relate to the interpretation and implementation of the 1996 Telecommunications Act. In addition, we are engaged in a variety of legal negotiations, arbitrations and regulatory and court proceedings with multiple ILECs. These negotiations, arbitrations and proceedings concern the telephone companies’ denial of central office space, the cost and delivery of transmission facilities and telephone lines and central office spaces, billing issues and other operational issues. Other than the payment of legal fees and expenses, which are not quantifiable but are expected to be material, we do not believe that these matters will result in material liability to us and the potential gains are not quantifiable at this time. An unfavorable result in any of these negotiations, arbitrations and proceedings, however, could have a material adverse effect on our consolidated financial position, results of operations or cash flows if we are denied or charged higher rates for transmission lines or central office spaces.

ITEM 1A. Risk Factors

(All dollar amounts are presented in thousands, except monthly service subscription fees)

Investing in and holding our common stock involve a degree of risk. Many factors, including those described below and set forth elsewhere in this report and in other documents we file with the Securities and Exchange Commission, or SEC, could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this report. If any of these risks materialize, our business, financial condition and results of operations could suffer. These risks are not the only ones we face. Additional risks that we currently do not know about or that we currently believe to be immaterial may also impair our business.

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

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

Over the last several years the FCC has made substantial changes to the regulatory environment in which we operate. The FCC’s August 21, 2003 Triennial Review Order and its release of further changes to its network unbundling rules on February 4, 2005, limited, and in some cases eliminated our access to some of the network elements that we use to operate our business. These orders were challenged by several parties, but in June 2006 the U.S. Court of Appeals for the District of Columbia Circuit affirmed the FCC’s rules. Where we no longer have regulated access to network elements, our costs have increased and are likely to continue to increase as a result of these orders and we may be unable to profitably offer some of our services. We may be unable to adapt to the changed regulatory environment, in its current form, or to future changes, whether resulting from these orders or from subsequent action by Congress, state legislatures, the courts, the FCC, or other regulatory authorities.

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

Most recently, on September 6, 2006, Verizon filed petitions at the FCC requesting forbearance from the regulatory requirement to provide competitors access to lines and transport at cost-based rates in Boston, New York, Philadelphia, Pittsburgh, Providence, and Virginia Beach. Qwest filed similar petitions on April 27, 2007, with respect to Denver, Seattle, Minneapolis and Phoenix. Ongoing access to these network elements at cost-based rates is material to our ability to profitably offer our services. The FCC is required to act on the Verizon petitions by December 2007 and the Qwest petitions by April 2008. If the FCC grants the Verizon and Qwest petitions, in whole or in part, it could significantly increase the costs of providing our services and have a material adverse effect on our financial results.

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

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

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

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

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

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

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

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

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

The majority of our revenue comes from Internet service providers, telecommunications carriers and other customers who resell our Internet access and other services to their business and consumer end-users. Our agreements with our resellers are generally non-exclusive, and many of our customers also resell services offered by our competitors. Our agreements with our resellers generally do not contain purchase commitments. A limited number of resellers account for a significant portion of our revenues. Our top 30 resellers accounted for 57.7% of our net revenues for the three and six months ended June 30, 2007. We expect that our reseller customers will continue to account for a significant portion of our revenue and new end user additions.

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

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

We face significant competition in the markets for business and consumer Internet access, network access and voice services and we expect this competition to intensify. We face competition from the RBOCs, cable modem service providers, competitive telecommunications companies, traditional and new national long distance carriers, Internet service providers, on-line service providers and wireless and satellite service providers. Many of these competitors have longer operating histories, greater name recognition, better strategic relationships and significantly greater financial, technical or marketing resources than we do. As a result, these competitors may be able to:

	•		develop and adopt new or emerging technologies;

	•		respond to changes in customer requirements more quickly;

	•		devote greater resources to the development, promotion and sale of their products and services;

	•		form new alliances and rapidly acquire significant market share;

	•		undertake more extensive marketing campaigns;

	•		adopt more aggressive pricing policies; and

	•		devote substantially more resources to developing new services.

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

The RBOCs represent the dominant competition in all of our target service areas, and we expect this competition to intensify. The RBOCs have established brand names and reputations for quality service, possess sufficient capital to deploy new DSL equipment and other competing products and services rapidly, have their own telephone lines and can bundle digital data services with their existing voice, wireless and other services to achieve economies of scale in serving customers. They can also offer service to end-users using fiber and fiber-fed lines that they are not required to make available to us. Certain RBOCs are aggressively pricing their

consumer DSL service subscription fees below $15 per month when ordered as part of a bundle, which has slowed sales of consumer DSL services by our reseller partners and increased the rate of churn among our existing users. We believe that we pose a competitive risk to the RBOCs and, as both our competitors and our suppliers, they have the ability and the motivation to disadvantage our business. If we are unable to enter into and maintain our agreements with the RBOCs that provide us with access to line-sharing at reasonable rates, we will be unable to price our consumer services at a price that is competitive with the RBOCs.

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

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

Our business plan is based partly on our ability to provide local and long distance voice services at a lower rate than our competitors. We expect price competition to increase in the VoIP market due to increasing emphasis on VoIP by the local telephone companies and new entrants to the VoIP market. Because networks using VoIP technology can be deployed with less capital investment than traditional networks, there are lower barriers to entry in this market and it may be easier for new competitors to emerge. Increasing competition may cause us to no longer offer our current VoIP services or lower our prices, or it may make it more difficult to attract and retain customers.

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

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

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

We may need to raise additional capital under difficult financial market conditions.

We believe our current cash, cash equivalents, and short-term investments in debt securities should be sufficient to meet our anticipated cash needs for working capital and capital expenditures, at least through June 30, 2008. Our business plan is based upon several assumptions, including growth of our subscriber base with a reasonable per subscriber profit margin and improvements in productivity. If actual events differ from these assumptions, we may be required to alter our business plan to reflect these changes. We will continue to monitor events to determine if such adjustments to our business plan are appropriate.

We are currently facing a variety of challenges that may affect the assumptions contained in our business plan, including, among others:

	•		customer disconnection rates that reduce our revenues;

	•		significant price reductions by our competitors;

	•		higher levels of marketing expense required to acquire and retain end-users that purchase our services from us and from our resellers;

	•		the need to upgrade our systems by investing in our existing and future technology and infrastructure;

	•		investment opportunities in complementary businesses, acquisitions or other opportunities;

	•		changes in government regulations and legal actions challenging government regulations; and

	•		additional risk factors mentioned throughout this section.

In March 2006 we issued a $40,000 senior secured convertible note to EarthLink, Inc., or EarthLink, and in March 2007 and September 2006 we issued $2,534 and $2,240, respectively, of additional senior secured convertible notes to EarthLink in satisfaction of accrued interest then due (collectively the “EarthLink Convertible Notes”). These notes are due in 2011 and, under specified circumstances, we may be required to repay the principal amount prior to 2011. In addition, the terms of the EarthLink Convertible Notes and our $50,000 senior secured credit facility with Silicon Valley Bank, or SVB, include restrictive covenants that limit our flexibility in planning for, or reacting to changes in, our business. If we do not comply with such covenants, or if any other event of default occurs under these agreements, our lenders could accelerate repayment of our debt or restrict our access to further borrowings. These restrictive covenants and the collateralization of the EarthLink Convertible Notes and the Silicon Valley Bank senior secured credit facility, in addition to the existence of $125,000 in 3% convertible debentures, may also limit our ability to raise additional capital through sales of debt or equity securities. The holders of our 3% debentures also have the option to require us to purchase the debentures in cash, in whole or in part, on March 15, 2009.

Adverse business, regulatory or legislative developments may require us to raise additional financing, raise our prices or substantially decrease our cost structure. We also recognize that we may not be able to raise additional capital under the current capital market conditions. If we are unable to acquire additional capital or are required to raise it on terms that are less satisfactory than we desire, our financial condition will be adversely affected.

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

We must increase the volume of Internet, data and voice transmission on our network in order to realize the anticipated cash flow, operating efficiencies and cost benefits of our network. If we do not add new customers and maintain our relationships with current customers, we may not be able to substantially increase traffic on our network, which would adversely affect our ability to become profitable. To accomplish this strategy, we must, among other things:

	•		acquire new end-users at a reasonable cost of acquisition;

	•		efficiently deploy LPVA services under our agreement with EarthLink;

	•		enter into and maintain agreements with the RBOCs or obtain favorable regulatory rulings that provide us with access to unbundled network elements on terms and conditions that allow us to profitably sell our consumer services;

	•		upgrade our network to improve reliability and remain competitive;

	•		efficiently expand fixed wireless broadband services;

	•		expand our direct sales capability and infrastructure in a cost-effective manner; and

	•		continue to implement and improve our management information systems, including our client ordering, provisioning, dispatch, trouble ticketing, customer billing, accounts receivable, payable tracking, collection, fixed assets, transaction-based taxes and other management information systems.

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

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

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

	•		move to a new location;

	•		are moved off our network when one of our customers acquires, or is acquired by, a competitor with network facilities;

	•		disconnect because of better offers in the market; or

	•		disconnect because they do not like our service or the service provided by our resellers.

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

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

Prices for our services have steadily decreased since we first began operations. We expect we will continue to experience an overall price decrease for our services due to competition, volume-based pricing and other factors. We currently charge higher prices for some of our services than some of our competitors do for similar services. As a result, we cannot assure you that our customers will select our services over those of our competitors. In addition, prices for digital communications services in general have fallen historically, and we expect this trend to continue. As a result of these factors, we cannot predict whether demand for our services will exist at prices that enable us to achieve profitability or positive cash flow.

If our internal control over financial reporting does not comply with the requirements of the Sarbanes-Oxley Act, our business, reputation and stock price could be adversely affected.

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

Although our management has determined, and our independent registered public accounting firm has attested, that our internal control over financial reporting was effective as of December 31, 2006, we cannot assure you that we or our independent registered public accounting firm will not identify a material weakness in our internal controls in the future. If our internal control over financial reporting is not considered adequate, we may experience a loss of public confidence, which could have an adverse effect on our business and our stock price.

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

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

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

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

	•		recruit, hire and train additional direct sales teams;

	•		reduce our cost of acquiring new customers;

	•		improve our provisioning, network management and monitoring and billing systems;

	•		manage expanding and increasingly diverse distribution channels;

	•		effectively manage additional vendors; and

	•		continue to enhance our network and improve our services.

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

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

The communications industry is subject to rapid and significant technological changes, including continuing developments in DSL and VoIP technology and alternative technologies for providing broadband and telephony communications, such as cable modem, satellite and wireless technology. In addition, much of the equipment in our network has been in service for several years and may become inferior to new technologies. As a consequence, our success may depend on:

	•		third parties, including some of our competitors and potential competitors, developing and providing us with access to new communications and networking technology;

	•		our ability to anticipate or adapt to new technology on a timely basis; and

	•		our ability to adapt to new products and technologies that may be superior to, or may not be compatible with, our products and technologies.

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

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

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

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

Our use of fixed broadband wireless technology presents several challenges.

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

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

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

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

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

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

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

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

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

	•		DSLAMs;

	•		CPE, including modems, routers, bridges and other devices;

	•		network routing and switching hardware;

	•		customer support;

	•		installation services;

	•		customized software design and maintenance;

	•		network management software;

	•		systems management software;

	•		database management software;

	•		collocation space;

	•		software used in our products;

	•		hosting, email and IP provisioning services;

	•		softswitches, used to provide VoIP services; and

	•		Internet connectivity and Internet protocol services.

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

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

	•		the possibility that some of our vendors will leave the DSL equipment business or will stop supporting equipment that we already have installed;

	•		the absence of guaranteed capacity;

	•		the possibility that vendors may become insolvent;

	•		the possibility that vendors will stop supporting software or equipment that we use or will no longer offer supplemental or replacement parts; and

	•		reduced control over delivery schedules, quality assurance, production yields and costs.

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

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

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

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

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

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

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

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

Under generally accepted accounting principles, we are required to review our intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of these assets may not be recoverable. In addition, we are required to review our goodwill on at least an annual basis. If presently unforeseen events or changes in circumstances arise which indicate that the carrying value of our goodwill or other intangible assets may not be recoverable, we will be required to perform impairment reviews of these assets, which have carrying values of $50,002 as of June 30, 2007. An impairment review could result in a write-down of all or a portion of these assets to their fair values. We perform an annual impairment review of our goodwill during the fourth quarter of each fiscal year or more frequently if we believe indicators of impairment exist. In light of the large carrying value associated with our goodwill and intangible assets, any write-down of these assets may result in a significant charge to our statement of operations in the period any impairment is determined and could cause our stock price to decline.

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

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

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

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

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

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

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

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

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

Third parties may claim we infringe their intellectual property rights.

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

	•		be time-consuming, costly and result in litigation;

	•		divert management’s time and attention from developing our business;

	•		require us to pay monetary damages or enter into royalty and licensing agreements that we would not normally find acceptable;

	•		require us to stop selling or to redesign certain of our products; or

	•		require us to satisfy indemnification obligations to our customers.

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

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

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

	•		state and federal regulatory and legislative actions;

	•		general economic conditions and the condition of the telecommunications industry;

	•		our ability to maintain existing customers and add new customers and recognize revenue from distressed customers;

	•		our ability to execute our operational plan and reach profitability and cash flow positive from operations;

	•		our ability to maintain sufficient liquidity to fund our operations;

	•		adverse litigation results;

	•		announcements of new products, services or pricing by our competitors or the emergence of new competing technologies;

	•		our failure to meet the expectations of investors or of analysts;

	•		the adoption of new, or changes in existing, accounting rules, guidelines and practices, which may materially impact our financial statements and may materially alter the expectations of securities analysts or investors;

	•		the level of demand for broadband Internet access services and VoIP telephony services;

	•		departures of key personnel; and

	•		effective internal controls over financial reporting.

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

Substantial leverage and debt service obligations may adversely affect our cash flow. (Refer to Part I, Item 2 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” for additional information)

We may be unable to generate cash sufficient to pay the principal of, interest on and other amounts due in respect of our indebtedness when due. In particular, under certain circumstances we may be required to repay our existing $44,774 in convertible notes payable to EarthLink, our $125,000 in 3% convertible notes and any amounts outstanding pursuant to our $50,000 senior secured credit facility with SVB prior to the scheduled maturity dates for those loans. We may also add equipment loans and lease lines to finance capital expenditures and may obtain additional long-term debt, working capital lines of credit and leases, some of which may be on less than optimal terms.

Our substantial leverage could have significant negative consequences, including:

	•		increasing our vulnerability to general adverse economic and industry conditions;

	•		limiting our ability to obtain additional financing;

	•		requiring the dedication of a portion of our expected cash flow from operations to service our indebtedness, thereby reducing the amount of our expected cash flow available for other purposes, including capital expenditures;

	•		limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we compete; and

	•		placing us at a possible competitive disadvantage relative to less leveraged competitors and competitors that have better access to capital resources.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

ITEM 3. Defaults Upon Senior Securities

None

ITEM 4. Submission of Matters to a Vote of Security Holders

On June 7, 2007 we held our Annual Meeting of Stockholders. Set forth below is a summary of each matter voted upon at the meeting and the number of votes cast for, against or withheld, as well as the number of abstentions and broker non-votes.

Proposal 1 — The election of three Class II directors to serve on our Board of Directors for a term to expire at the third succeeding annual meeting (expected to be the 2010 annual meeting) and until their successors are elected and qualified.


Name	For		Withheld
L. Dale Crandall		245,610,563		22,886,891
Diana Leonard		245,424,190		23,073,264
Robert Neumeister		245,587,956		22,909,498

Proposal 2 — Approval of Covad’s 2007 Equity Incentive Plan: 83,025,492 votes in favor, 21,315,989 votes against and 1,851,136 votes abstained.

Proposal 3 — Ratification of independent registered public accounting firm, PricewaterhouseCoopers LLP, for the 2007 fiscal year: 260,399,826 votes in favor, 5,310,312 votes against and 2,787,316 votes abstained.

ITEM 5. Other Information

None

ITEM 6. Exhibits

Incorporated by Reference

Exhibit

Number

Exhibit Description

Form

File No.

Date of First Filing

Number

Filed Herewith

10.1

Covad Communications Group, Inc 2007 Equity Incentive Plan

8-K

001-32588

6/12/07

10.1

10.2

Covad Communications Group, Inc 2007 Equity Incentive Plan-Form of Notice of Stock Option Grant and Stock Option Award Agreement

8-K

001-32588

6/12/07

10.2

10.3

Covad Communications Group, Inc 2007 Equity Incentive Plan-Form of Notice of Restricted Stock Award and Restricted Share Agreement

8-K

001-32588

6/12/07

10.3

10.4

Covad Communications Group, Inc 2007 Equity Incentive Plan-Form of Notice of Stock Bonus Award

8-K

001-32588

6/12/07

10.4

10.5

Covad Communications Group, Inc 2007 Equity Incentive Plan-Form of Notice of Restricted Stock Unit Award and Award Agreement

8-K

001-32588

6/12/07

10.5

10.6

Covad Communications Group, Inc 2007 Equity Incentive Plan-Form of Notice of Stock Appreciation Right Award and Award Agreement

8-K

001-32588

6/12/07

10.6

10.7

Indemnification Agreement between Covad Communications Group, Inc. and Justin Spencer

8-K

001-32588

4/17/07

10.1

10.8

Amendment No. 2 to Loan and Security Agreement

8-K

001-32588

4/26/07

10.1

31.1

Certification Pursuant to Rule 13a-14(a)

31.2

Certification Pursuant to Rule 13a-14(a)

32.1*

Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2*

Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


*		These certifications accompany the Registrant’s Quarterly Report on Form 10-Q and are not deemed filed with the SEC.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	COVAD COMMUNICATIONS GROUP, INC.

		By:	/s/ CHARLES E. HOFFMAN Charles E. Hoffman
			President, Chief Executive
			Officer and Director

Date: August 2, 2007

		By:	/s/ JUSTIN SPENCER Justin Spencer
			Senior Vice President and
Date: August 2, 2007			Chief Financial Officer

Incorporated by Reference

Exhibit

Number

Exhibit Description

Form

File No.

Date of First Filing

Number

Filed Herewith

10.1

Covad Communications Group, Inc 2007 Equity Incentive Plan

8-K

001-32588

6/12/07

10.1

10.2

Covad Communications Group, Inc 2007 Equity Incentive Plan-Form of Notice of Stock Option Grant and Stock Option Award Agreement

8-K

001-32588

6/12/07

10.2

10.3

Covad Communications Group, Inc 2007 Equity Incentive Plan-Form of Notice of Restricted Stock Award and Restricted Share Agreement

8-K

001-32588

6/12/07

10.3

10.4

Covad Communications Group, Inc 2007 Equity Incentive Plan-Form of Notice of Stock Bonus Award

8-K

001-32588

6/12/07

10.4

10.5

Covad Communications Group, Inc 2007 Equity Incentive Plan-Form of Notice of Restricted Stock Unit Award and Award Agreement

8-K

001-32588

6/12/07

10.5

10.6

Covad Communications Group, Inc 2007 Equity Incentive Plan-Form of Notice of Stock Appreciation Right Award and Award Agreement

8-K

001-32588

6/12/07

10.6

10.7

Indemnification Agreement between Covad Communications Group, Inc. and Justin Spencer

8-K

001-32588

4/17/07

10.1

10.8

Amendment No. 2 to Loan and Security Agreement

8-K

001-32588

4/26/07

10.1

31.1

Certification Pursuant to Rule 13a-14(a)

31.2

Certification Pursuant to Rule 13a-14(a)

32.1*

Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2*

Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


*		These certifications accompany the Registrant’s Quarterly Report on Form 10-Q and are not deemed filed with the SEC.

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. freshman Good

Covad Communications (COVD) Inactive 10-Q2007 Q2 Quarterly report

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