Covad Joins the DSL Walking Wounded

Covad Communications Group Inc. has joined the growing list of troubled digital-subscriber-line carriers, reporting a fourth-quarter loss of $854 million and revealing that its auditors doubt its ability to continue as a going concern.

Covad, which provides DSL lines to Internet-service providers, blamed the losses on ISPs that could not pay the bills and its prior accounting practice of charging costs for customer promotions and marketing-development funds as expenses, rather than as a reduction to revenue.

But financially troubled customers, a history of operating losses and negative cash flows apparently have taken their toll on Covad's auditors. In the company's annual report, filed May 24, the auditors wrote that there was "substantial doubt about the company's ability to continue as a going concern."

Covad reported revenue of $55.2 million for the quarter, a 40 percent increase over third-quarter sales of $39.5 million.

For the full year 2000, revenue was $158.7 million, compared with $66.5 million for the same period in 1999. Losses ballooned to $1.4 billion, or $9.47 per share, compared with a loss of $195.4 million, or $1.83 per share in 1999.

Covad chairman Chuck McMinn told analysts on a conference call that those accounting problems have been rectified, as has the company's policy of reflecting as revenue orders from ISPs that it believes cannot pay their bills.

"The root cause was a weakness of internal controls, and, because of that, our inability to control rapid growth," McMinn said.

The company is talking with the National Association of Securities Dealers Automated Quotation system about a possible delisting of its stock, due to the lateness of its financial filings, McMinn added.

Covad also is late with its first-quarter results, but said it should have them available in the next few weeks.

"We were not provided any outcome to the NASDAQ hearing," McMinn said. "We filed our 10-K [annual report], we're working hard to file our 10-Q [quarterly report].

"We believe the business is fundamentally sound and hope to convince NASDAQ that we have taken and are continuing to take the necessary steps to ensure future compliance with its listing requirements," he added.

During the call, McMinn said Covad would need another $400 million to $700 million to achieve free cash-flow positive results by the second quarter of 2002. He added that the company has sufficient cash to operate through that period.

"We believe we can raise those funds in a timely manner," McMinn said. "We are exploring several sources for those funds."

Punk Ziegel & Co. analyst Don Sinsabaugh said that Covad shouldn't have a problem raising the necessary funds, mainly because it is the largest independent player in the industry and has strong relationships with larger companies.

"It's manageable," Sinsabaugh said. "The company at this point is the leading independent provider by a wide margin and they have the best product in the industry."

Sinsabaugh added that strategic relationships with Sony Corp., Compaq Computer Corp., NTT Inc., and SBC Communications Corp. will also help Covad along in its quest for additional capital.

"Off of these [relationships] and those with other vendors they can put together the first round of financing and then get it done in the next two or three months."

Sinsabaugh said that although others in the sector have had similar problems with ISPs, Covad appears to have weeded out the ones that can't pay and is making moves to help some of the other more stable ISPs to continue to operate.

Covad CEO Frank Marshall said during the conference call that the company has been working hard with ISPs that are having trouble, helping them to develop a "mutually acceptable recovery plan."

Marshall said most customers have been able to find ways to continue to move forward.

In the case where customers have filed for bankruptcy, Marshall said, Covad as a creditor has worked to find solutions, such as either migrating the end user to a healthy ISP or Covad's own service.

"They've identified the problem ISPs and have taken steps to help them," Sinsabaugh said.

Like many of its counterparts in the DSL industry, such as NorthPoint Communications Group Inc. and RhythmsNet Connections, Covad has seen its fortunes sink rapidly as many of its ISP customers became unable to pay their bills. Along the way, fierce competition and increased pricing pressure from regional telephone companies and cable operators hurt the bottom line.

But McMinn said that in light of the restructuring and aggressive cost-cutting measures initiated in December, Covad is on track.