<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION

                            Washington, D.C.  20549

                                   FORM 10-K

          [X]      Annual Report Pursuant to Section 13 or 15(d)
                     of the Securities Exchange Act of 1934
                  For the fiscal year ended December 31, 1998

                                       OR

          [ ]    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:  0-20763

                             McLEODUSA INCORPORATED
             ------------------------------------------------------
             (Exact name of registrant as specified in its charter)

          Delaware                                    42-1407240
-------------------------------                    --------------------
(State or other jurisdiction of                     (I.R.S. Employer
incorporation or organization)                      Identification No.)
                                           
      McLeodUSA Technology Park                  
    6400 C Street SW, P.O. Box 3177            
          Cedar Rapids, IA                             52406-3177
----------------------------------------               ----------
(Address of principal executive offices)               (Zip Code)

      Registrant's telephone number, including area code:  (319) 364-0000

          Securities registered pursuant to Section 12(b) of the Act:

                                 Not Applicable

          Securities registered pursuant to Section 12(g) of the Act:

                 Class A common stock, par value $.01 per share
                ------------------------------------------------
                                 Title of Class

  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 and (2) has been subject to such filing
requirements for the past 90 days.  Yes  X      No 
                                        ----       ----     

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

  The aggregate market value of the voting stock held by non-affiliates of the
registrant, based upon the closing price of the registrant's common stock as of
March 22, 1999 is $1,102,713,924. */
                                  - 

  The number of shares outstanding of each of the registrant's classes of common
stock, as of the latest practicable date is:


  Class A common stock, par value $.01 per share, outstanding as of March 22,
1999: 68,630,796                            
                                  


                      DOCUMENTS INCORPORATED BY REFERENCE

  List hereunder the following documents incorporated by reference and the Part
of the Form 10-K into which the document is incorporated:

                                      None
                                        
--------------
*/  Solely for the purposes of this calculation, all directors and executive
-                                                                           
officers of the registrant and all stockholders beneficially owning more than 5%
of the registrant's common stock are considered to be affiliates.
<PAGE>
 
                               TABLE OF CONTENTS
<TABLE>
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Page
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<S>          <C>       <C>                                                  <C>
           
PART I       Item 1.   Business.............................................   1
             Item 2.   Properties...........................................  30
             Item 3.   Legal Proceedings....................................  30
             Item 4.   Submission of Matters to a Vote of Security Holders..  31
           
PART II      Item 5.   Market for Registrant's Common Equity and
                       Related Stockholder Matters..........................  32
             Item 6.   Selected Financial Data..............................  34
             Item 7.   Management's Discussion and Analysis of Financial
                       Condition and Results of Operations..................  36
             Item 7A.  Quantitative and Qualitative Disclosures
                       About Market Risk....................................  48
             Item 8.   Financial Statements and Supplementary Data..........  48
             Item 9.   Changes in and Disagreements with Accountants on
                       Accounting and Financial Disclosure..................  48
           
PART III     Item 10.  Directors and Executive Officers of the Registrant...  50
             Item 11.  Executive Compensation...............................  55
             Item 12.  Security Ownership of Certain Beneficial Owners
                       and Management.......................................  58
             Item 13.  Certain Relationships and Related Transactions.......  63
           
PART IV      Item 14.  Exhibits, Financial Statement  Schedules, and
                       Reports on Form 8-K..................................  65
 
GLOSSARY....................................................................  74
 
SIGNATURES..................................................................  77
 
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS.................................. F-1
 
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS 
ON THE FINANCIAL STATEMENT SCHEDULES........................................ S-1
 
</TABLE>

                                      (i)
<PAGE>
 
     Unless the context suggests otherwise, references in this Form 10-K to
"we," "us," "our" and "McLeodUSA" mean McLeodUSA incorporated and its
subsidiaries and predecessors.  Unless otherwise indicated, dollar amounts over
$1 million have been rounded to one decimal place and dollar amounts less than
$1 million have been rounded to the nearest thousand.  Some of the statements
contained in this Form 10-K discuss future expectations, contain projections of
results of operations or financial condition or state other forward-looking
information.  These statements are subject to known and unknown risks,
uncertainties and other factors that could cause the actual results to differ
materially from those contemplated by the statements.  The forward-looking
information is based on various factors and was derived using numerous
assumptions.  In some cases, you can identify these so-called "forward-looking
statements" by words like "may," "will," "should," "expects," "plans,"
"anticipates," "believes," "estimates," "predicts," "potential," or "continue"
or the negative of those words and other comparable words.  You should be aware
that those statements only reflect our predictions.  Actual events or results
may differ substantially.  Important factors that could cause our actual results
to be materially different from the forward-looking statements are disclosed
under the heading "Business--Risk Factors" and throughout this Form 10-K.  See
the "Glossary" appearing at page 74 for definitions of some of the terms used in
this Form 10-K.

                                     PART I

Item 1.  Business.

Overview

     We provide communications services to business and residential customers in
the Midwestern and Rocky Mountain regions of the United States.  Our
communications services include local, long distance, Internet access, data,
voice mail and paging, all from a single company on a single bill.  We believe
we are the first communications provider in most of our markets to offer one-
stop shopping for communications services tailored to customers' specific needs.

     Our approach makes it easier for both our business and our residential
customers to satisfy their communications needs.  It also allows businesses to
receive customized services, such as competitive long distance pricing and
enhanced calling features, that might not otherwise be directly available on a
cost-effective basis.  As of December 31, 1998, we served over 397,600 local
lines in 269 cities and towns.

     In addition to our core business of providing competitive local, long
distance and related communications services, we also derive revenue from:

  .  sale of advertising space in telephone directories
  .  traditional local telephone company services in east central Illinois and
     southeast South Dakota
  .  special access, private line and data services
  .  communications network maintenance services
  .  telephone equipment sales, leasing, service and installation
  .  video services
  .  telemarketing services
  .  computer networking services
  .  other communications services, including cellular, operator, payphone,
     mobile radio and paging services

     In most of our markets, we compete with the incumbent local phone company
by leasing its lines and switches.  In other markets, primarily in east central
Illinois and southeast South Dakota, we operate our own lines and switches.  We
provide long distance services by using our own communications network
facilities and leasing capacity from long distance and local communications
providers.  We are constructing fiber optic communications networks in Iowa,
Illinois, Wisconsin, Indiana, Missouri, Minnesota, South Dakota, North Dakota,
Colorado and Wyoming to carry additional communications traffic on our own
network.
<PAGE>
 
     The following chronology highlights some of the important events in the
development of our business:


           Date                                     Event
---------------------------  ---------------------------------------------------
June 1991                    McLeodUSA was incorporated in Iowa as "McLeod
                             Telecommunications, Inc."

November 1992                McLeodUSA began operations, providing fiber optic
                             maintenance services for the Iowa Communications
                             Network. The Iowa Communications Network is a
                             fiber optic communications network that links many
                             of the State of Iowa's schools, libraries and
                             other public buildings.

August 1993                  McLeodUSA was reincorporated in the State of
                             Delaware.

December 1993                One of our wholly owned subsidiaries, McLeodUSA
                             Telecommunications Services, Inc., received
                             regulatory approvals in Iowa and Illinois to offer
                             local and long distance services.

January 1994                 McLeodUSA began providing local and long distance
                             services in Iowa and Illinois.

April 1995                   McLeodUSA acquired MWR Telecom, Inc., a
                             competitive access provider in Des Moines, Iowa.

June 1996                    McLeodUSA completed its initial public offering of
                             Class A common stock.

July 1996                    McLeodUSA acquired Ruffalo, Cody & Associates,
                             Inc., a telemarketing company.

September 1996               McLeodUSA acquired TelecomUSA Publishing Group,
                             Inc. (now known as McLeodUSA Media Group, Inc.), a
                             telephone directory company.

April and June 1997          The Federal Communications Commission awarded
                             McLeodUSA a total of 26 "D" and "E" block
                             frequency personal communications services ("PCS")
                             licenses for approximately $32.8 million.

May 1997                     McLeodUSA changed its name from "McLeod, Inc." to
                             "McLeodUSA Incorporated."

July 1997                    The FCC awarded McLeodUSA four wireless
                             communications services ("WCS") licenses.

September 1997               McLeodUSA acquired Consolidated Communications
                             Inc. ("CCI"), a diversified telecommunications
                             holding company offering a variety of
                             communications products and services, including
                             local exchange and long distance services and
                             telephone directory publishing.  As part of the
                             acquisition of CCI, McLeodUSA acquired one
                             additional "E" block frequency PCS license.


     As of the date hereof, we offer communications services to business and
residential customers in Iowa, Illinois, North Dakota, South Dakota, Wisconsin
and Colorado.  We also offer communications services to business customers in a
number of markets in Minnesota, Missouri, Indiana, and Wyoming.  Over the next
several years, depending on competitive and other factors, we intend to offer
communications services in Idaho, Montana, Nebraska and Utah.  We offer long
distance service in 48 states in the continental United States.

                                       2
<PAGE>
 
     Our 27 PCS licenses cover areas of Iowa, Illinois, Minnesota, Nebraska and
South Dakota, encompassing approximately 110,000 square miles and a population
of approximately 6.9 million.  We plan to offer PCS or other wireless services
as part of our communications services by building a wireless network, entering
into strategic acquisitions or alliances, or employing a combination of these
methods.  Our four WCS licenses cover the Major Economic Areas of Milwaukee,
Wisconsin, Minneapolis/St. Paul, Minnesota, Des Moines-Quad Cities,
Iowa/Illinois and Omaha, Nebraska.  We intend to use the frequency blocks
covered by these licenses to provide fixed services, such as wireless local
loop, Internet access or meter reading.  See "--Proposed Wireless Services," "--
Regulation" and "--Risk Factors--We May Not Succeed in Developing or Making a
Profit from Wireless Services."

     The statements in the foregoing paragraphs about our expansion plans and
proposed wireless services are forward-looking statements within the meaning of
the safe harbor provisions of the Private Securities Litigation Reform Act of
1995. These plans may be revised, and our actual geographic expansion and
services may differ materially from that indicated by our current plans, in each
case as a result of a variety of factors, including:

     .  the availability of financing and regulatory approvals
     .  the number of potential customers in a target market
     .  the existence of strategic alliances or relationships
     .  technological, regulatory or other developments in our business
     .  changes in the competitive climate in which we operate
     .  the emergence of future opportunities.

     Our principal executive offices are located at McLeodUSA Technology Park,
6400 C Street SW, P.O. Box 3177, Cedar Rapids, Iowa 52406-3177, and our main
phone number is (319) 364-0000.

Recent Transactions

     Acquisition of Talking Directories and Info America.  On February 10, 1999,
we acquired Talking Directories, Inc., a Michigan corporation, for an aggregate
of 2,556,390 shares of our Class A common stock.  In a related and concurrent
transaction, on February 10, 1999, we also acquired Info America Phone Books,
Inc., a Michigan corporation, for an aggregate of 1,203,007 shares of our Class
A common stock.  We also paid approximately $27 million of the outstanding
obligations of Talking Directories and Info America at the time of these
transactions.

     Talking Directories and Info America are related companies, headquartered
in Grand Rapids, Michigan, that together publish and distribute proprietary
"white page" and "yellow page" telephone directories primarily in Michigan and
northwestern Ohio. In 1998, Talking Directories and Info America collectively
published and distributed approximately 2.6 million copies of 19 telephone
directories. As of December 31, 1998, Talking Directories had 257 employees and
Info America had no employees.

     The Ovation Merger Agreement.  On January 7, 1999, we entered into an
Agreement and Plan of Merger with Ovation Communications, Inc., a Delaware
corporation, and several stockholders of Ovation by which Ovation will be merged
with and into a newly formed wholly owned subsidiary of McLeodUSA.  As a result
of the Ovation merger, (1) each share of Ovation's preferred stock will be
converted into the right to receive cash, and (2) each share of Ovation's common
stock will be converted, at the election of the stockholder, into the right to
receive cash or shares of our Class A common stock.  The amount of cash into
which each share of Ovation's preferred stock will be converted and the amount
of cash or number of shares of Class A common stock into which each share of
Ovation's common stock will be converted will be determined immediately before
completion of the Ovation merger based on formulas specified in the Ovation
merger agreement.  We estimate that we will be required to issue approximately
5.1 million shares of our Class A common stock and to pay approximately $141
million cash to effect the Ovation merger.  We will also assume approximately
$95 million in Ovation debt.  In addition, under the terms of the Ovation merger
agreement, each option to purchase Ovation common stock issued under Ovation's
stock option plan will become or be replaced by an option to purchase a number
of shares of our Class A common stock equal to the number of shares of Ovation
common stock that could have been 

                                       3
<PAGE>
 
purchased (assuming full vesting) under the Ovation stock option multiplied by
the exchange ratio used to convert Ovation common stock into Class A common
stock.

     Consummation of the Ovation merger is subject to the satisfaction of
several conditions.  Stockholders of Ovation holding in the aggregate
approximately 94% of the voting power attributable to Ovation's common stock and
preferred stock have agreed to vote all of their shares in favor of the Ovation
merger at a meeting of the stockholders of Ovation.

     In connection with the execution of the Ovation merger agreement, we
entered into a revolving credit agreement with Ovation by which we agreed to
lend Ovation up to $20 million on a senior subordinated unsecured basis.  In
addition, several Ovation stockholders agreed through December 31, 2001 to
restrictions on their ability to transfer the shares of Class A common stock
they will receive in the Ovation merger.  See "Security Ownership of Certain
Beneficial Owners and Management--Investor Agreement and Stockholders'
Agreements."

     Ovation is a diversified communications services company serving business
customers primarily in larger metropolitan areas in Minnesota, Illinois and
Wisconsin (such as Minneapolis/St. Paul, Chicago and Milwaukee) and in small to
mid-sized cites in Michigan.  Ovation provides the following services:

     .  local and network access
      
     .  competitive local exchange
      
     .  incumbent local exchange
      
     .  long distance
      
     .  voice mail, teleconferencing and calling card

     .  Internet access

     As of December 31, 1998, Ovation served approximately 32,650 business local
lines and 12,900 residential local lines to approximately 2,900 business
customers and 11,750 residential customers in 135 cities and towns.  Ovation had
1998 revenues of $21.5 million, including revenues received between October 1,
1998 and December 31, 1998 as a result of Ovation's acquisition of BRE
Communications, L.L.C. d/b/a Phone Michigan on October 1, 1998.  As of December
31, 1998, Ovation had four switches, approximately 564 miles of fiber optic
communications network and 384 employees.

                                  ___________


     We have obtained information regarding Talking Directories, Info America
and Ovation from each of these companies, respectively.  Although we believe
this information is reliable, it has not been independently verified.  The
financial information about each of these companies is unaudited.

     Recent Financings. On February 22, 1999, we completed a private offering of
$500 million aggregate principal amount of our 8 1/8% senior notes due February
15, 2009, yielding net proceeds of approximately $487.8 million. The 8 1/8%
senior notes accrue interest at a rate of 8 1/8% per annum payable in cash semi-
annually in arrears on February 15 and August 15 of each year, starting August
15, 1999.

     As of December 31, 1998, we estimated, based on our business plan, capital
requirements and growth projections as of that date, our aggregate capital
requirements through 2001 would be $1.4 billion.  Our estimated aggregate
capital requirements include the projected cost of:

     .  building our fiber optic communications network, including intra-city
        fiber optic communications networks

     .  expanding operations in existing and new markets
      
     .  developing wireless services
      
     .  funding general corporate purposes
      
     .  completing recent and pending acquisitions
      
     .  constructing, acquiring, developing or improving telecommunications
        assets

                                       4
<PAGE>
 
     The estimated costs and incremental capital needs associated with the
acquisitions of Talking Directories, Info America and Ovation are included in
our estimated aggregate capital requirements.

     We expect to use the following to address our capital needs:

     .  approximately $487.8 million in net proceeds from our offering of 8 1/8%
        senior notes

     .  approximately $591.7 million of cash and investments on hand at December
        31, 1998
     
     .  additional issuances of debt or equity securities
     
     .  projected operating cash flow

     The actual amount and timing of our future capital requirements is subject
to risks and uncertainties and may differ materially from our estimates.
Accordingly, we may need additional capital to continue to expand our markets,
operations, facilities, network and services. See "Risk Factors Failure to Raise
Necessary Capital Could Restrict Our Ability to Develop Our Network and Services
and Engage in Strategic Acquisitions."

Business Strategy

     We want to be the leading and most admired provider of communications
services in our markets.  To achieve this goal, we are:

     .  aggressively capturing customer share and generating revenue using
        leased communications network capacity

     .  concurrently building our own communications network

     .  migrating customers to our communications network to provide enhanced
        services and reduce operating costs

     The principal elements of our business strategy are to:

     Provide integrated communications services.  We believe we can rapidly
     penetrate our target markets and build customer loyalty by providing an
     integrated product offering to business and residential customers.

     Build customer share through branding.  We believe we will create and
     strengthen brand awareness in our target markets by branding our
     communications services with the trade name McLeodUSA in combination with
     the distinctive black-and-yellow motif of our telephone directories.

     Provide outstanding customer service.  Our customer service representatives
     are available 24 hours a day, seven days a week, to answer customer calls.
     Our customer-focused software and systems allow our representatives
     immediate access to our customer and network data, enabling a rapid and
     effective response to customer requests.

     Emphasize small and medium sized businesses.  We primarily target small and
     medium sized businesses because we believe we can rapidly capture customer
     share by providing face-to-face business sales and strong service support
     to these customers.

     Expand our fiber optic communications network.  We are building a state-of-
     the-art fiber optic communications network to deliver multiple services and
     reduce operating costs.

     Expand our intra-city fiber optic communications network.  Within selected
     cities, we plan to extend our network directly to our customers' locations.
     This will allow us to provide expanded services and reduce the expense of
     leasing communications facilities from the local exchange carrier.

     Explore acquisitions and strategic alliances. We plan to pursue
     acquisitions, joint ventures 

                                       5
<PAGE>
 
     and strategic alliances to expand or complement our business.

     Leverage proven management team.  Our executive management team consists of
     veteran telecommunications managers who successfully implemented similar
     customer-focused telecommunications strategies in the past.

Market Potential

     The telecommunications industry is undergoing substantial changes due to
statutory, regulatory and technological developments.  We believe that we are
well-positioned to take advantage of these fundamental changes.

     Wireline Services.   The market for local exchange services consists of a
number of distinct service components, including:

     .    local network services, which generally include basic dial tone, local
          area charges, enhanced calling features and private line services
          (dedicated for a customer's use between locations)

     .    network access services, which consist of access provided by local
          exchange carriers to long distance communications network carriers

     .    short-haul long distance communications network services, which
          include intraLATA long distance calls and private lines

     .    other varied services, including operator services, Internet access,
          calling cards, publication of "white page" and "yellow page" telephone
          directories and the sale of business telephone equipment.

     Industry sources have estimated that the 1999 aggregate revenues of all
local exchange carriers will approximate $102 billion.  Until recently, there
was little competition in the local exchange markets, particularly for local
network and network access services.

     Before 1984, AT&T largely monopolized local and long distance telephone
services in the United States.  In 1984, as the result of a court decree, AT&T
was required to divest its local telephone systems (the "Divestiture"), which
created the present structure of the telecommunications industry in the U.S.
The Divestiture and subsequent related proceedings divided the country into 201
Local Access and Transport Areas ("LATAs").  As part of the Divestiture, AT&T's
former local telephone systems were organized into seven (now five, as a result
of industry consolidation) independent regional Bell operating companies.
Regional Bell operating companies were given the right to provide local
telephone service, local access service and intraLATA long distance service, but
were prohibited from providing interLATA service.  AT&T retained its long
distance services operations.  The separation of the regional Bell operating
companies from AT&T's long distance business created two distinct
telecommunications market segments: local exchange and long distance.  The
Divestiture decreed direct, open competition in the long distance segment, but
continued the regulated monopoly environment in local exchange services.

     Subsequently, several factors began to promote competition with respect to
local exchange services, including:

     .    growing customer demand for an alternative to the local exchange
          carrier monopoly, spurred partly by the development of competitive
          activities in the long distance market

     .    advances in the technology for transmission of voice, data and video
          requiring greater capacity and reliability levels than many local
          exchange carrier networks, which principally are copper-based, can
          accommodate

     .    the development of fiber optic and digital electronic technology,
          which reduced communications network construction costs while
          increasing transmission speeds, capacity

                                       6
<PAGE>
 
          and reliability compared to the older copper-based network typically
          employed by the existing local exchange carriers

     .    the significant access charges long distance carriers are required to
          pay to local exchange carriers to access the local exchange carriers'
          networks  

     .    statutory and regulatory initiatives in the telecommunications
          industry permitting and promoting competition in the local exchange
          market.

     Opportunities to compete in the local exchange market expanded
substantially on February 8, 1996, when the Telecommunications Act of 1996 was
enacted.  The Telecommunications Act of 1996 eliminated state legal prohibitions
against local exchange competition and requires incumbent local exchange
carriers to allow other providers of telecommunications services to purchase
elements of their local communications network offerings and to interconnect
with their communications facilities and equipment.  Most significantly, it
requires the incumbent local exchange carriers to complete local calls
originated by our customers and transferred or connected by us using our own
communications network facilities, and to deliver inbound local calls to us for
connection to our customers, assuring our customers of unimpaired local calling
ability.  In addition, local exchange carriers are obligated to provide local
number portability and dialing parity upon request and make their local services
available for resale by competitors.  Local exchange carriers also are required
to allow competitors non-discriminatory access to local exchange carrier poles,
conduit space and other rights-of-way.

     We believe that these requirements are likely, when fully implemented, to
increase competition among providers of local communications services and
simplify the process of switching from incumbent local exchange carrier services
to those offered by competitive local exchange carriers.  The Telecommunications
Act of 1996 also offers important benefits to the regional Bell operating
companies, however, such as the ability to provide interLATA long distance
services under specified conditions.  The process of implementing the
Telecommunications Act of 1996 is still incomplete, and important questions
remain unresolved.  See "--Regulation".

     A number of states have also taken regulatory and legislative action to
open local communications markets to various degrees of competition.  We expect
that continuing pro-competitive regulatory changes, together with increasing
customer demand, will create more opportunities for competitive service
providers to introduce additional services, expand their networks and address a
larger customer base.  However, we cannot assure you that government actions to
implement local telephone competition will be as complete or as timely as we
require to implement our business plans.

     Wireless Services. Demand for wireless communications has grown rapidly
over the past decade. According to the Cellular Telecommunications Industry
Association ("CTIA"), the number of wireless telephone subscribers nationwide
has grown from approximately 680,000 in 1986 to an estimated 61 million as of
June 30, 1998, with a compound annual growth rate of approximately 40% from
1990 through 1997. Wireless communication revenues for the 12-month period ended
June 30, 1998 are estimated by CTIA to have totaled over $29.6 billion, a 16%
increase over the prior 12-month period. We believe that the demand for wireless
communications will continue to grow dramatically, and that PCS will capture a
significant share of the wireless market, due to anticipated declines in costs
of service, increased function versatility, and increased awareness of the
productivity, convenience and safety benefits associated with such services. We
also believe the rapid growth of notebook computers and personal digital
assistants, combined with emerging software applications for wireless delivery
of electronic mail, fax and database searching, will further stimulate demand
for wireless service. In addition, we expect future competition between wireline
local exchange carriers and wireless service providers as "wireless local loop"
technology and reduced wireless rates facilitate migration of wireline minutes
to wireless carriers.

                                       7
<PAGE>
 
Current Products and Services

     We derive our revenue from:

     .    our core business of providing local, long distance and related
          communications services to end users, typically in a bundled package 

     .    the sale of advertising space in telephone directories

     .    traditional local telephone company services through the operation of
          Illinois Consolidated Telephone Company ("ICTC") in east central
          Illinois and Dakota Telecommunications Group, Inc. in southeast South
          Dakota

     .    special access, private line and data services 

     .    communications network maintenance services 

     .    telephone equipment sales, leasing, service and installation 

     .    video services 

     .    telemarketing services 

     .    computer networking services 

     .    other communications services, including cellular, operator, payphone
          and paging services

     For the year ended December 31, 1998, we derived 44% of our total revenues
from our core business of providing local, long distance and related
communications services, 24% from the sale of advertising space in telephone
directories, and 11% from traditional local telephone company services.  See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Overview."

     Integrated Communications Services.

     Overview.  As of December 31, 1998, we provided service, on a retail basis,
to over 397,000 local lines in our markets, primarily to small and medium sized
business customers and to residential customers.  Since beginning sales
activities in January 1994, we have increased our revenue from the sale of local
and long distance telecommunications services from $4.6 million for the year
ended December 31, 1994 to $267.4 million for the year ended December 31, 1998.

     In order to provide local communications services to most of our business
and residential customers in Iowa, Minnesota, North Dakota, South Dakota,
Colorado, Wisconsin, and Illinois, we purchase "Centrex" services through
various resale, interconnection and retail rate stability agreements with U S
WEST Communications, Inc. for our customers located in U S WEST's service
territories and Ameritech Corporation for most of our customers located in
Ameritech's service territories.  These "Centrex" agreements allow us to
partition part of the central office switching equipment serving the communities
in which we provide local services, which allows us to aggregate lines, have
control over several characteristics of those lines and provide a set of
standard features on them.  Our customers' telephone lines and numbers are
assigned to our portion of the switch.  U S WEST or Ameritech, as the case may
be, bills us for all the lines assigned to our customers and provides us with
call detail reports, which enable us to verify our customers' bills for both
local and long distance service.  These Centrex agreements protect us from
unilateral rate increases until 2002 or 2003, depending on the state.  We
believe that our Centrex-based local services are superior to a standard
business or residential telephone line, since we can offer features, such as
three-way calling, consultation hold and call transfer, at no extra charge.
Other custom calling features are available at additional cost.  Because we also
purchase the "Centrex Management System" and the "Centrex Mate Service" from U S
WEST and Ameritech, respectively, our personnel have on-line access to U S WEST
and Ameritech facilities and may make changes to the customers' services
electronically and quickly.

     In Missouri, we have an interconnection agreement with Southwestern Bell
Telephone Company that allows us to provide local service by leasing individual
lines and switches from Southwestern Bell for 

                                       8
<PAGE>
 
resale to our customers. This interconnection agreement provides for a wholesale
discount from the prevailing Southwestern Bell retail price, but does not allow
us to partition a portion of Southwestern Bell's switching equipment as with
Centrex services. As of the date hereof, we are renegotiating the terms of this
interconnection agreement with Southwestern Bell.

     In addition, in order to provide integrated communications services to many
of our business and residential customers in central Illinois and in the
Indianapolis, Indiana metropolitan area, we use our own switching equipment and
communications network facilities together with unbundled local "loop" elements
of Ameritech's telecommunications network that we purchase through
interconnection agreements.  In Cedar Rapids, Iowa and southeast South Dakota,
we also provide communications services to some of our business and residential
customers using only our own lines and communications network facilities.

     We provide most of our long distance service by purchasing communications
network capacity, in bulk, from national long distance carriers, and routing our
customers' long distance traffic over this capacity.  In some service areas, we
also carry long distance traffic on our own network facilities.

     Business Services.  End-user business customers can obtain local, long
distance and ancillary services, such as three-way calling and call transfer,
directly from us in each of the cities and towns in which we offer
communications services today.

     We generally offer business customers our integrated local communications
services at prices that are similar to the published retail rates for basic
business service provided by the incumbent local exchange carrier.  We offer our
business customers a flat rate or a negotiated rate for long distance service
consistent with their particular needs and within the guidelines of our filed
tariffs.  These rates are not subject to increase for the duration of the term
selected by the customer.  We also offer some of our business customers long
distance rates calculated by totaling their monthly calls and comparing the
total charges that would be applicable to such calls under different pricing
plans of the major long distance carriers.  The customer is then billed an
amount equal to the approximate lowest monthly charges among these plans, minus
any discount to which the customer may be entitled as a result of having made a
long-term commitment to use our services.

     Business customers previously served by CCI were on different long distance
rate plans.  We are transitioning these customers to our most appropriate rate
plan consistent with their needs.  Furthermore, in some states, including states
outside of our target markets, we offer business customers long distance service
only, in order to enhance our ability to attract business customers that have
offices outside of our target markets.

     Residential Services. We introduced our PrimeLine(R) service in 1996 and
now offer that service to residential and small business customers in various
cities and towns in Iowa, Illinois, North Dakota, South Dakota, Wisconsin,
Wyoming and Colorado. Our basic PrimeLine(R) service includes local and long
distance telephone service, as well as enhanced features such as three-way
calling, call transfer and consultation hold. Paging, voice mail, Internet
access and travel card services are also available at the customer's option as
part of our PrimeLine(R) service. We generally price our basic PrimeLine(R)
local service slightly higher than the rates for basic local service offered by
the incumbent local exchange carrier since our basic PrimeLine(R) local service
includes enhanced features that are not typically provided as part of the
incumbent local exchange carrier's basic local service. Our customers can add
paging, voice mail and Internet access services to their basic PrimeLine(R)
service at incremental rates designed to be no higher than separately purchasing
these services from other companies. We generally offer our PrimeLine(R)
customers a choice of either long distance rates that vary with the time of the
call or flat-rate long distance pricing applicable 24 hours a day, seven days a
week.

     Directory Services.  In 1998, we published 156 proprietary "white page" and
"yellow page" telephone directory titles and distributed approximately 14.2
million copies of these directories to local telephone subscribers in 21 states
in the Midwestern and Rocky Mountain regions of the United States, including
most of our target markets.  We also published 287 "white page" and "yellow
page" telephone directory titles for other companies and distributed
approximately 4 million copies of these directories to local telephone
subscribers in 38 states and the U.S. Virgin Islands.  Our telephone directory
services generated 1998 revenues of approximately $144.9 million, primarily from
the sale of advertising space in the directories.

                                       9
<PAGE>
 
     Many of our telephone directories serve as "direct mail" advertising
because they contain information on how to contact us and detailed product
descriptions and step-by-step instructions on the use of our telecommunications
products.  In addition, we believe that our directories' distinctive black-and-
yellow motif combined with the trade name McLeodUSA strengthens brand awareness
in our markets.  See "--Sales and Marketing."

     Traditional Local Telephone Services.  Through ICTC and Dakota
Telecommunications, we provide regulated incumbent local exchange telephone
service to subscribers in central Illinois and southeast South Dakota.

     ICTC operates in 37 exchanges, or service areas, the largest of which are
in Mattoon, Charleston, and Effingham, Illinois.  As of December 31, 1998, ICTC
had over 91,000 local access lines in its existing service areas.  ICTC offers a
broad range of local exchange services, including long distance carrier access
service, intraLATA toll service, local telephone service, local paging service,
national directory assistance, and equipment leasing.  Local telephone service
consists of furnishing a dial tone to local subscribers, at which time
subscribers can make a local call or a long distance call.  ICTC also offers
most of its local telephone subscribers custom calling features such as call
waiting, call forwarding, conference calling, speed dialing, caller
identification, and call blocking.  The rates for these and other local exchange
services are regulated by the Illinois Commerce Commission and the FCC.  To
provide these services, ICTC owns and operates three central office switches and
33 remote switches.

     As of December 31, 1998, Dakota Telecommunications served approximately
7,350 local service access lines in 13 telephone exchanges in southeastern South
Dakota.  Dakota Telecommunications provides a full range of communications
products and services, including local dial tone and enhanced services, local
private line and public telephone services, dedicated and switched data
transmission services, long distance telephone services, operator assisted
calling services, Internet access and related services.

     Special Access, Private Line and Data Services.  We provide, on a private
carrier basis, a wide range of special access, private line and data services to
our long distance carrier, wireless, cable television and other end-user
customers.  These services include:

     .    POP-to-POP special access

     .    end user/long distance carrier special access

     .    private line services

     POP-to-POP special access services provide telecommunications lines that
link the POPs of one long distance carrier or the POPs of different long
distance carriers in a market, allowing these POPs to exchange
telecommunications traffic for transport to final destinations.

     End user/long distance carrier special access services provide
telecommunications lines that connect an end user such as a large business to
the local POP of its selected long distance carrier.

     Long distance carrier special access services provide telecommunications
lines that link a long distance carrier POP to the local central office.  For
example, we have agreed to furnish long distance carrier special access services
to AT&T in up to 30 Midwestern cities in Illinois, Iowa, Minnesota, North Dakota
and South Dakota, providing a catalyst for the expansion of our intra-city
networks.

     Private line services provide telecommunications lines that connect various
locations of a customer's operation to transmit internal voice, video and/or
data traffic.  We provide private line services by using our own communications
network facilities, leasing communications network facilities from other
telecommunications carriers, or using some combination of owned and leased
communications network facilities

     Network Maintenance Services.  In 1990, the State of Iowa authorized
construction of the initial fiber optic links of the Iowa Communications Network
(the "Part I and II segments").  The Part I and II segments, which are owned by
the State of Iowa, provide 3,400 miles of fiber optic communications network
connections to approximately 139 sites in Iowa and are used primarily for
interactive distance 

                                       10
<PAGE>
 
learning, telemedicine and the State's own long distance telephone traffic. We
have entered into a fiber optic maintenance contract with the State of Iowa to
provide maintenance services for the Part I and II segments of the Iowa
Communications Network until 2004. Our maintenance activities under this
contract are performed on a 24-hour-per-day, 365-days-per-year basis, and
consist of alarm monitoring, repair services and cable location services.

     We believe that the expertise in fiber optic maintenance we have developed
through the maintenance of the Iowa Communications Network provides advantages
in maintaining our own communications network facilities.  Because commercial
use of the Part I and II segments is forbidden, however, neither McLeodUSA nor
any other communications carrier may use capacity on the Part I and II segments
to provide communications services to customers.

     Telephone Equipment Services.  We sell, lease, install and service
telephone systems, primarily to small and medium sized businesses in Iowa,
Illinois and Minnesota.  We believe these services provide valuable expertise
for and complement our communications services offerings, giving us additional
contact with the small and medium sized businesses we target in marketing our
communications services.

     Video Services.  We own 85% of Greene County Partners, Inc., a cable
television company that as of the date hereof provides cable television service
to approximately 16,800 subscribers in Illinois and Michigan.  Through Dakota
Telecommunications, we also own and operate 26 cable television systems located
in southeastern South Dakota, northwestern Iowa and southwestern Minnesota.  As
of December 31, 1998, these systems provided service to approximately 5,930
subscribers.

     We have also received a franchise from the city of Cedar Rapids, Iowa to
provide cable television service.  We are using this franchise to explore the
possible synergies between cable television and our advanced communications
services offerings, such as Integrated Services Digital Network ("ISDN"), low
and high speed Internet, video and other advanced services.  Depending on the
results of this preliminary initiative and on other factors, including
technological, regulatory or other developments in our business, changes in the
competitive climate in which we operate, and the emergence of future
opportunities, we may elect to offer cable service on an expanded basis in the
future.

     Telemarketing Services.  We provide direct marketing and telemarketing
services for third parties, as well as a variety of fund-raising services for
colleges, universities and other non-profit organizations throughout the United
States.  We believe that these services provide valuable marketing opportunities
and expertise for our communications services, particularly with respect to
potential residential customers.  In addition to providing telemarketing
services for third parties, we also use our telemarketing sales personnel for
sales of our PrimeLine(R) residential services.  See "--Sales and Marketing."

     Computer Networking Services.  Through Dakota Telecommunications, we
provide customized, integrated solutions for computing networks in some markets
in South Dakota.  Typical services include review of customer system
requirements; selection, design and planning of system components and networks;
and operating and network support services.

     Other Communications Services.  We provide pay telephone service, operator
services and paging services in some markets.  In addition, we own a minority
interest in a partnership that provides cellular service in central Illinois.

Expansion of Services Using Our Own Communications Network Facilities

     As of the date hereof, we are providing service to over 2,300 local lines
in Cedar Rapids, Iowa and southeast South Dakota using only our own switching
and fiber optic communications network facilities connected directly to our
customers' locations.  We are extending our intra-city fiber optic
communications network and switching capacity to enable us to provide expanded
services directly to our customers and reduce the expense of leasing
communications facilities from the existing telephone company.

     As of the date hereof, we are also offering service to over 7,000 local
lines located in central
                                       11
<PAGE>
 
Illinois and in Indianapolis, Indiana using our own switches and fiber optic
communications network facilities combined with network elements purchased from
Ameritech through interconnection agreements. We are building a state-of-the-art
fiber optic communications network to enable us to serve additional end-user
customers in this manner, using our communications network facilities in
combination with network elements of existing telephone companies. Our
communications network and switching capacity is also designed to serve other
wireline and wireless carriers on a wholesale basis.

     We have received state regulatory approval to offer local switched services
using our own communications network facilities in Colorado, Idaho, Iowa,
Illinois, Indiana, Minnesota, Missouri, Nebraska, North Dakota, South Dakota,
Utah, Wisconsin and Wyoming.  We intend to offer additional local switched
services using our own network facilities, either alone or in combination with
network elements purchased from existing telephone companies, in Des Moines,
Waterloo, Cedar Falls, Dubuque, Sioux City, Council Bluffs, and Iowa City, Iowa
and the Quad Cities of Iowa/Illinois (Davenport, Bettendorf, Rock Island and
Moline), among other places.  We then plan to expand these facilities-based
services to other cities as our communications network develops and our market
penetration increases.

     Our plans to provide local switched services using our own communications
network facilities will depend upon obtaining favorable interconnection
agreements and terms for leasing network elements from existing telephone
companies.  In August 1996, the FCC released a decision (the "Interconnection
Decision") implementing the interconnection portions of the Telecommunications
Act of 1996. The Interconnection Decision has been the subject of significant
legal dispute. In January 1999, the U.S. Supreme Court rejected challenges to
the Interconnection Decision and affirmed the authority of the FCC to establish
rules governing interconnection. We believe that additional disputes regarding
the Interconnection Decision and other related FCC actions are likely. We cannot
assure you that we will succeed in obtaining interconnection agreements on terms
that would permit us to offer local services using our own communications
network facilities at profitable and competitive rates. See "--Regulation."

     The foregoing statements are forward-looking statements within the meaning
of the Private Securities Litigation Reform Act of 1995 and where we actually
provide such services will depend on factors such as:

     .    the outcome of the judicial proceedings regarding the Interconnection
          Decision

     .    technological, regulatory or other developments in our business

     .    changes in the competitive climate in which we operate

     .    the emergence of future opportunities

     For a detailed description of the expansion of our fiber optic
communications network, see "--Network Facilities."

Proposed Wireless Services

     As of the date hereof, we do not offer wireless services, although we do
own a minority interest in a cellular telephone partnership serving parts of
east central Illinois.  In April and June 1997, the FCC awarded us a total of 26
"D" and "E" block frequency PCS licenses, each covering 10 MHz of radio
spectrum, and in September 1997 we acquired CCI and its "E" block frequency PCS
license, giving us a total of 27 PCS licenses in 25 markets covering areas of
Illinois, Iowa, Minnesota, Nebraska and South Dakota.  We paid approximately
$32.8 million for the 26 PCS licenses awarded to us by the FCC.  CCI paid the
FCC for its PCS license before we acquired CCI.  Our PCS licenses encompass
approximately 110,000 square miles and a population of approximately 6.9
million.  We plan to offer PCS or other wireless services as part of our
communications services by building a wireless network, entering into strategic
acquisitions or alliances, or employing a combination of these methods.

     PCS differs from traditional cellular telephone service principally in that
PCS systems operate at a higher frequency band and employ advanced digital
technology.  Compared to existing cellular service, these features are expected
to enable PCS system operators to offer customers lower cost service options,
lighter handsets with longer battery lives, and new and enhanced service
offerings.

                                       12
<PAGE>
 
     We will need to spend significant time and money to develop wireless
services.  To implement a wireless system, we will need to build or otherwise
acquire access to wireless infrastructure.  The infrastructure of a wireless
system generally consists of switches, base station transmitters and receivers,
and related equipment.  We may also incur costs related to site acquisition and
preparation, installation services, zoning approval or other permits, frequency
planning, construction and equipment procurement, installation and testing.
Furthermore, we believe that our ability to successfully offer wireless services
will depend on our ability to offer roaming service to our customers so they can
use their handsets outside our service area.  This will require us to establish
suitable roaming arrangements with other wireless operators in other markets
constructing systems compatible with our own.  We cannot predict when, or
whether, we will be able to enter into such roaming agreements with local
providers.

     We have entered into long-term agreements with our electric utility
stockholders (Alliant Energy Investments Inc. (collectively with its
predecessors and affiliates, "Alliant Energy"), and MHC Investment Company
(collectively with its predecessors and affiliates, "MidAmerican")) and with
Wisconsin Power and Light Company, Illinois Power Company and Illinois Central
Railroad Corporation, that will enable us to install base stations and other
equipment on such companies' towers.  See "--Network Facilities."  We expect the
use of these existing towers and other facilities occupied by other
telecommunications service providers and utility companies to facilitate our
development of wireless services.

     On July 21, 1997, the FCC also awarded us four WCS licenses covering
Milwaukee, Wisconsin, Minneapolis/St. Paul, Minnesota, Des Moines-Quad Cities,
Iowa/Illinois and Omaha, Nebraska.  We expect to use the frequency blocks
covered by such licenses to provide fixed services, such as wireless local loop,
Internet access or meter reading.

     As the wireline and wireless markets converge, we believe that we can
identify other opportunities to generate revenues from the wireless industry on
both a retail and a wholesale basis.  On a retail basis, we believe that we will
be able to enter into strategic arrangements with both cellular and PCS
companies on favorable economic terms to allow us to offer wireless services as
part of our integrated communications services offerings.  On a wholesale basis,
these opportunities may include (1) leasing tower sites to wireless providers,
(2) connecting or transferring wireless traffic through our communications
network facilities and (3) transporting wireless traffic using our fiber optic
communications network to interconnect wireless providers' cell sites or to
connect such sites to either our communications network facilities or to
communications network facilities of other providers of wireline services.  For
example, we have entered into agreements with five wireless companies to provide
access to several of the towers we control.

     The statements in the foregoing paragraphs about our plans to offer
wireless services are forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995.  These plans may be revised,
and our actual wireless services may differ materially from that indicated by
our current plans, in each case as a result of a variety of factors, including:

     .    the availability of financing and regulatory approvals

     .    the number of potential customers in a target market

     .    the existence of strategic alliances or relationships

     .    technological, regulatory or other developments in our business

     .    changes in the competitive climate in which we operate

     .    the emergence of future opportunities

See "--Risk Factors--We May Not Succeed in Developing or Making a Profit from
Wireless Service" and "--Risk Factors--Competition in the Wireless
Telecommunications Industry Could Make it Harder for Us Successfully to Offer
Wireless Services."

Network Facilities

     As the incumbent local exchange carriers are compelled, by regulatory
changes and competitive forces, to unbundle their network components and to
permit resale of their network elements and products, we expect to be able to
provide our customers with a full range of communications services 

                                       13
<PAGE>
 
using a combination of our own communications network, the networks of the
incumbent local exchange carriers and the networks of other competitive
carriers.

     As of December 31, 1998, we owned approximately 7,100 route miles of fiber
optic communications network and expect to add approximately 2,000
additional route miles of fiber optic network during 1999.  We will decide
whether to begin construction of fiber optic network in a market based on
various economic factors, including:

     .    the number of our customers in a market

     .    the anticipated operating cost savings associated with such
          construction

     .    any strategic relationships with owners of existing infrastructure
          (e.g., utilities and cable operators)

     .    strategic acquisitions of providers of wireless services or owners of
          existing infrastructure

     We are installing backbone communications network facilities that form a
series of fiber optic "self-healing rings" and intra-city communications network
facilities that provide access directly to customer locations.  These
communications network facilities are intended to enable us to provide local and
long distance service using our own facilities in selected cities and towns in
Iowa, Illinois, Indiana, Wisconsin and Minnesota, and in Sioux Falls, South
Dakota.  Our communications networks are designed to support a wide range of
communications services, provide increased network reliability and reduce costs.
Our communications network consists of fiber optic cables, which typically
contain between 24 and 144 fiber strands, each of which is capable of providing
many telecommunications circuits.  A single pair of fibers on our network can
transmit 32,256 simultaneous voice conversations, whereas a typical pair of
copper wires can carry a maximum of 24 digitized simultaneous voice
conversations.  We expect that continuing developments in compression technology
and multiplexing equipment will increase the capacity of each fiber, providing
greater capacity at relatively low incremental cost.

     In 1995, the Iowa General Assembly passed legislation to extend the Iowa
Communications Network to 543 more endpoints (which are usually located in
schools or public libraries) throughout the State of Iowa (the "Part III
segments").  The majority of these fiber optic links, unlike the Part I and II
segments of the Iowa Communications Network, will be leased to the State of
Iowa, from a private entity, such as McLeodUSA.  As of December 31, 1998, we had
contracts to build and then lease capacity to the State of Iowa on 235 of such
segments.  Under our lease agreements with the State of Iowa, we are
constructing a "fiber-rich" broadband communications network on which the State
of Iowa has agreed to lease one DS-3 circuit for a period of seven years for a
total aggregate lease cost of approximately $27.0 million.  Upon completion of
installation of each segment, the leases provide that the State of Iowa will
make a one-time up-front lease payment to us for the capacity, with nominal
monthly lease payments thereafter.  At the end of a seven-year period, the
leases may be extended, upon terms to be mutually agreed upon.  During the term
of the leases, the State of Iowa may order additional DS-3 circuits at a
mutually agreed upon price.

     In September 1997, as a result of our acquisition of CCI, we acquired
approximately 900 route miles of fiber optic network facilities, parts of which
are currently connected to Ameritech unbundled network elements through an
interconnection agreement.  We believe that CCI's experience in serving end user
local lines under the interconnection agreement will substantially assist our
technical abilities in interconnection to the unbundled network elements of
incumbent local exchange carriers.

     In March 1999, as a result of our acquisition of Dakota Telecommunications,
we acquired approximately 290 additional route miles of fiber optic
communications network facilities.

     We have reached agreements with our electric utility stockholders
(MidAmerican and Alliant Energy) and with Wisconsin Power and Light Company,
Illinois Power and Illinois Central Railroad that allow us to make use of those
companies' rights-of-way, underground conduits, distribution poles, transmission
towers and building entrances in exchange for rights by such companies to use
capacity on our network.  These agreements give us access to rights-of-way in
parts of Iowa, Illinois and Wisconsin for installation of our wireline and
wireless networks.  We expect our access to these rights-of-way to have a
significant positive impact on our capital costs for network construction and
the speed with which we can 

                                       14
<PAGE>
 
construct our networks. We believe that our strategic relationships with our
electric utility stockholders and other companies that own rights-of-way and
infrastructure give us a competitive advantage.

Sales and Marketing

     Until June 1996, we directed our communications sales efforts primarily
toward small and medium sized businesses.  In June 1996, we began marketing our
PrimeLine(R) services to residential customers.

     Marketing of our integrated communications services to business customers
is conducted by direct sales personnel, located at our headquarters in Cedar
Rapids, Iowa and in branch sales offices in Iowa, Illinois, North Dakota, South
Dakota, Minnesota, Missouri, Wisconsin, Indiana, Colorado, Nebraska and Wyoming.
Sales activities in our branch sales offices are organized and managed by
region.

     Marketing of our integrated communications services to residential
customers is conducted by telemarketers.  The telemarketers emphasize the
PrimeLine(R) integrated package of communications services and its flat-rated
per minute pricing structure for long distance service.  We also use Ruffalo
Cody's information database to identify attractive sales opportunities and
pursue those opportunities through a variety of methods, including calls from
our telemarketing personnel.

     Our sales force is trained to emphasize our customer-focused sales and
service efforts, including our 24-hours-per-day, 365-days-per-year customer
service center.  Our employees answer customer service calls directly rather
than requiring customers to use an automated queried message system.  We believe
that our emphasis on a single point of contact for meeting our customer's
communications needs is very appealing to our current and prospective customers.
We have also developed and installed customer-focused software for providing
integrated communications services.  This software permits us to present our
customers with one fully integrated monthly billing statement for local, long
distance, 800, international, voice mail, paging, Internet access and travel
card services, and will permit us to include additional services, such as
wireless services, when available.  We believe that our customer-focused
software platform is an important element in the marketing of our communications
services and gives us a competitive advantage in the marketplace.

     We believe our strategic acquisitions have enhanced our sales and marketing
efforts and increased our penetration of existing markets.  We believe these
acquisitions will also help accelerate our entry into new markets.  For example,
we began publishing and distributing telephone directories as a result of
acquisitions.  We can use our proprietary telephone directories as direct mail
advertising simply by including detailed product descriptions and information
about our communications products in them.  We believe that these telephone
directories provide us with a long-term marketing presence in the millions of
households and businesses that receive them.  We also believe that combining our
directories' distinctive black-and-yellow motif with the trade name McLeodUSA
strengthens brand awareness in all of our markets.

     In 1998, we expanded our communications sales and marketing efforts
primarily by opening new branch sales offices in North Dakota, South Dakota,
Minnesota, Colorado, Missouri, Wisconsin and Wyoming and continuing to expand
our sales and marketing efforts in Iowa and Illinois.  Over the next several
years, depending on competitive and other factors, we also intend to begin sales
and marketing efforts in Montana, Idaho and Utah.  The foregoing statements are
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995 and the results of our actual expansion efforts
may be materially different, depending on a variety of other factors, including:

     .    the availability of financing and regulatory approvals
     .    the number of potential customers in a target market
     .    the existence of strategic alliances or relationships
     .    technological, regulatory or other developments in our business
     .    changes in the competitive climate in which we operate
     .    the emergence of future opportunities 

                                       15
<PAGE>
 
Competition

     Wireline Competition.   The communications services industry is highly
competitive. We face intense competition from local exchange carriers, including
the regional Bell operating companies (primarily U S WEST, Ameritech and
Southwestern Bell) and GTE, which currently dominate their respective local
telecommunications markets.  Our long distance services also compete with the
services of hundreds of other companies in the long distance marketplace.  AT&T,
MCI WorldCom and Sprint currently dominate the long distance market.  Our local
and long distance services also compete with the services of other competitive
local exchange carriers in some markets.  Other competitors may include cable
television companies, competitive access providers, microwave and satellite
carriers, wireless telecommunications providers, and private networks owned by
large end-users.  In addition, we compete with the regional Bell operating
companies and other local exchange carriers, numerous direct marketers and
telemarketers, equipment vendors and installers, and telecommunications
management companies with respect to portions of our business.  Many of our
existing and potential competitors have financial and other resources far
greater than our own.

     We believe that the distinction between the local and long distance markets
is eroding, and other competitors will begin to offer integrated communications
services similar to our own.  For example, each of AT&T, MCI WorldCom and Sprint
has begun to offer local telecommunications services using their own network
facilities, network elements obtained from incumbent local exchange carriers, or
the facilities of other parties.  AT&T has announced its plan to enter into
exclusive arrangements with cable operators to use their local network
facilities for telecommunications services.  These and other companies currently
hold state regulatory certificates to offer local and long distance service in
Iowa, Illinois and other states within our target markets.  We cannot assure you
that these firms, and others, will not enter the markets or target the small and
medium sized businesses where we focus our sales efforts.

     A continuing trend toward business combinations and strategic alliances in
the telecommunications industry may strengthen our competitors.  For example,
WorldCom acquired MCI in September 1998 and AT&T acquired Teleport
Communications Group Inc. in July 1998 and Tele-Communications, Inc. in March
1999.  In addition, merger plans have been announced by Southwestern Bell and
Ameritech and by Bell Atlantic and GTE.  U S WEST and  Ameritech also announced
in May 1998 that each had entered into a marketing arrangement with Qwest
Communications, a long distance company.  The FCC ruled that these marketing
arrangements violate the Telecommunications Act of 1996, but both U S WEST and
Ameritech have appealed this ruling.  In addition, Southwestern Bell and
Williams Communications, Inc., a long distance company, have announced a
strategic alliance to supply services to each other.  These or other alliances
or combinations between our competitors could put us at a significant
competitive disadvantage.

     We depend on incumbent local exchange carriers to provide access service
for the origination and termination of most of our toll long distance traffic
and interexchange private lines.  Historically, charges for such access service
made up a significant percentage of the overall cost of providing long distance
service.  The FCC and various states are considering changes to access charge
rate levels and related issues involving support for universal service and other
public policy objectives.  The impact of these changes on us and our competitors
is not yet clear.  We could be adversely affected if we do not experience access
cost reductions proportionally equivalent to those of our competitors, if our
competitors receive a disproportionate share of universal service revenues, or
if regulation of incumbent local exchange carriers' access services is reduced.
As long as new Internet-based competitors continue to be exempt from these
charges, they could enjoy a significant cost advantage in this area.

     We also depend on incumbent local exchange carriers to provide our local
telephone service through access to local communications network elements,
termination service or local central office switching, or through wholesale
purchase of the local telephone services of such carriers that we then resell to
end users.  Any successful effort by the incumbent local exchange carriers to
deny or substantially limit our access to their network elements or wholesale
services would have a material adverse effect on our ability to provide local
telephone services.  Although the Telecommunications Act of 1996 imposes
interconnection obligations on incumbent local exchange carriers, we cannot
assure you that we will be able to obtain access to their communications network
elements or services at rates, and on terms and conditions, that will permit us
to offer local services at rates that are both profitable and competitive.

                                       16
<PAGE>
 
     The Telecommunications Act of 1996 also provides the incumbent local
exchange carriers with new competitive opportunities.  For example, under the
Telecommunications Act of 1996, the regional Bell operating companies will, upon
the satisfaction of various conditions, be able to offer interLATA long distance
services to local telephone service customers in their regions.  The regional
Bell operating companies are actively engaged in proceedings and other
activities by which they are seeking to satisfy those conditions.  We believe
that we have advantages over the incumbent local exchange carriers in providing
our telecommunications services, including our management's prior experience in
the competitive telecommunications industry and our emphasis on marketing
(primarily using a direct sales force for sales to business customers and
telemarketing for sales to residential customers) and on responsive customer
service.  However, the regional Bell operating companies may be allowed to offer
interLATA long distance services before their local exchange markets are
completely open to competition.  Under such circumstances in particular,
additional competition from the incumbent local exchange carriers could have a
material adverse effect on our business, results of operations and financial
condition.

     Competition for local and special access telecommunications services is
based principally on price, quality, network reliability, customer service and
service features.  We believe that our management expertise and emphasis on
customer service allows us to compete effectively with the incumbent local
exchange carriers in providing these services.  In addition, our fiber optic
communications networks provide both diverse access routing and redundant
electronics, which design features are not widely deployed by the local exchange
carriers' networks.  However, if the incumbent local exchange carriers,
particularly the regional Bell operating companies, charge alternative providers
such as McLeodUSA unreasonably high fees for interconnection to their networks,
significantly lower their rates for access and private line services, or offer
significant volume and term discount pricing options to their customers, we
could be at a significant competitive disadvantage.

     In the future, an important element of providing competitive services may
be the ability to offer customers high-speed broadband local connections.  The
FCC is considering a proposal that would allow incumbent local exchange carriers
to offer these and other services through separate affiliates, in which case
their network elements for providing these services would not need to be made
available to us or other competitors.  AT&T has announced that it is entering
into arrangements with cable companies for the exclusive use of their local
networks for broadband telecommunications and several cable companies are
offering broadband Internet access over their network facilities.  As of the
date hereof, we offer such broadband local access to our customers only in
limited areas in Cedar Rapids, Iowa and southeast South Dakota.  If we are
unable to meet future demands of our customers for broadband local access or
other services on a timely basis at competitive rates, we may be at a
significant competitive disadvantage.

     For more information about the regulatory environment in which we operate,
see "--Regulation."

     Wireless Competition.   The wireless telecommunications industry is
experiencing significant technological change, as evidenced by the increasing
pace of improvements in the capacity and quality of digital technology, shorter
cycles for new products and enhancements, and changes in consumer preferences
and expectations.  We believe the market for wireless telecommunications
services is likely to expand significantly as equipment costs and service rates
continue to decline, equipment becomes more convenient and functional, wireless
services become more diverse, technology improves and new competitors enter the
market.  We also believe providers of wireless services increasingly will offer,
in addition to products that supplement a customer's wireline communications
like cellular telephone services in use today, wireline replacement products
that may result in wireless services becoming the customer's primary mode of
communication.  Accordingly, we expect competition in the wireless
telecommunications business to be dynamic and intense as a result of the
entrance of new competitors and the development of new technologies, products
and services.  We anticipate that in the future there could potentially be eight
wireless competitors in each of our proposed PCS markets: two existing cellular
providers, five other PCS providers and Nextel Communications Inc., an ESMR
provider.  There are over ten principal cellular providers and over 20 principal
PCS licensees in our proposed PCS markets.  In addition, we could face
competition from mobile satellite services which are under development.

     Competition with these or other providers of wireless telecommunications
services may be intense.  Many of our potential wireless competitors have
substantially greater financial, technical, marketing, sales, manufacturing and
distribution resources than our own and have significantly greater experience
than us in testing new or improved wireless telecommunications products and
services.  Some 

                                       17
<PAGE>
 
competitors, particularly WCS carriers, are expected to market other services,
such as cable television access, with their wireless telecommunications service
offerings. We do not currently offer wireless cable television access. In
addition, several of our potential wireless competitors are operating or
planning to operate, through joint ventures and affiliation arrangements,
wireless telecommunications systems that encompass most of the United States. We
cannot assure you that we will be able to compete successfully in this
environment or that new technologies and products that are more commercially
effective than our technologies and products will not be developed. See
"--Wireless Services."

Regulation

     Overview.   Our services are subject to federal, state and local
regulation.  The FCC exercises jurisdiction over our facilities and services to
the extent they are used to provide, originate or terminate interstate or
international common carrier communications.  State regulatory commissions
retain jurisdiction over the same facilities and services to the extent they are
used to originate or terminate intrastate common carrier communications.  Local
governments may require us to obtain licenses, permits or franchises regulating
use of public rights-of-way necessary to install and operate our networks.  In
addition, the licensing, construction, operation, sale and interconnection
arrangements of wireless telecommunications systems are regulated to varying
degrees by the FCC.  The construction and operation of wireless systems also may
be subject to state and local regulation.

     Through our subsidiaries, we hold various federal and state regulatory
authorizations.  We often join other industry members in seeking regulatory
reform at the federal and state levels to open additional telecommunications
markets to competition.

     Through our wholly owned subsidiary McLeodUSA Network Services, we provide
competitive access services as a private carrier on a non-regulated basis.  In
general, a private carrier is one that provides service to customers on an
individually negotiated contractual basis, as opposed to a common carrier that
provides service to the public on the basis of generally available rates, terms
and conditions.  We believe that McLeodUSA Network Services' private carrier
status is consistent with applicable federal and state laws, as well as
regulatory decisions interpreting and implementing those laws as of the date
hereof.  Should such laws and/or regulatory interpretations change in the future
to reclassify McLeodUSA Network Services' regulatory status, we believe that
compliance with such reclassification would not have a material adverse effect
on us.

     Through our wholly owned subsidiaries, we are also subject to federal and
state regulatory requirements, including, in some states, bonding requirements,
due to our direct marketing, telemarketing and fund-raising activities.

     Federal Regulation.   The FCC classifies us as a non-dominant carrier.  As
a non-dominant carrier, our interstate and international services are not
subject to material federal regulation, although we are required to file tariffs
with the FCC for our common carrier services.  The FCC also imposes prior
approval requirements on transfers of control and assignments of radio licenses
and operating authorizations.  The FCC has the authority to condition, modify,
cancel, terminate or revoke such licenses and authorizations for failure to
comply with federal laws or the rules, regulations and policies of the FCC.  The
FCC may also impose fines or other penalties for such violations.  While we
believe we are in compliance with applicable laws and regulations, we cannot
assure you that the FCC or third parties will not raise issues with regard to
our compliance.

     The FCC's role with respect to local telephone competition arises
principally from the Telecommunications Act of 1996, which became effective
February 8, 1996.  The Telecommunications Act of 1996 preempts state and local
laws to the extent that they prevent competitive entry into the provision of any
telecommunications service and gives the FCC jurisdiction over important issues
related to local competition.  However, state and local governments retain
authority over significant aspects of the provision of local telecommunications.
The Telecommunications Act of 1996 imposes a variety of new duties on local
exchange carriers, including non-incumbent local exchange carriers like
McLeodUSA, in order to promote competition in local exchange and access
services.  These duties include requirements to:

                                       18
<PAGE>
 
     .    complete calls originated by competing carriers on a reciprocal basis
     .    permit resale of services
     .    permit users to retain their telephone numbers when changing carriers
     .    provide competing carriers access to poles, ducts, conduits and
          rights-of- way at regulated prices

     Incumbent local exchange carriers are also subject to additional
requirements.  These duties include obligations of the incumbent local exchange
carriers to:

     .    interconnect their networks with competitors
     .    offer collocation of competitors' equipment at their premises
     .    make available elements of their networks (including network
          facilities, features and capabilities) on non-discriminatory,
          cost-based terms
     .    offer wholesale versions of their retail services for resale at
          discounted rates

     Collectively, these requirements recognize that local exchange competition
is dependent upon cost-based and non-discriminatory interconnection with and use
of incumbent local exchange carrier networks.  Failure to achieve such
interconnection arrangements could have an adverse impact on the ability of
McLeodUSA or other entities to provide competitive local exchange services.
Under the Telecommunications Act of 1996, incumbent local exchange carriers are
required to negotiate in good faith with carriers requesting any or all of the
above arrangements.  In addition, in the Interconnection Decision and related
actions the FCC has adopted more specific rules to implement these requirements.
The Interconnection Decision has been the subject of significant legal dispute.
In January 1999, the U.S. Supreme Court rejected challenges to the
Interconnection Decision and affirmed the authority of the FCC to establish
rules governing interconnection.  We believe that additional disputes regarding
the Interconnection Decision and other related FCC actions are likely.

     The Telecommunications Act of 1996 also eliminates previous prohibitions on
the provision of interLATA long distance services by the regional Bell operating
companies and the general telephone operating companies.  The regional Bell
operating companies are permitted to provide interLATA long distance service
outside those states in which they provide local exchange service ("out-of-
region long distance service") upon receipt of any necessary state and/or
federal regulatory approvals that are otherwise applicable to the provision of
intrastate and/or interstate long distance service.  Under the
Telecommunications Act of 1996, the regional Bell operating companies will be
allowed to provide long distance service within the regions in which they also
provide local exchange service ("in-region service") on a state-by-state basis
upon specific approval of the FCC and satisfaction of other conditions,
including a checklist of interconnection requirements intended to open local
telephone markets to competition.  As of the date hereof, the FCC has not found
that any regional Bell operating company has met these interconnection
requirements.  If the FCC does permit U S WEST, Ameritech or Southwestern Bell
to provide long distance service in their local service regions before they meet
our local interconnection needs, they would be able to offer integrated local
and long distance services and could have a significant competitive advantage in
marketing those services to their existing local customers.

     The Telecommunications Act of 1996 imposes restrictions on the regional
Bell operating companies in connection with their entry into the interLATA long
distance services market.  Among other things, for the first three years (unless
extended by the FCC) the regional Bell operating companies must pursue such
activities only through separate subsidiaries with separate books and records,
financing, management and employees.  In addition, affiliate transactions with
these subsidiaries must be conducted on a non-discriminatory basis.

     In the future, an important element of providing competitive services may
be the ability to offer customers high-speed broadband local connections.  The
FCC is considering a proposal that would allow incumbent local exchange carriers
to offer these and other services through separate affiliates, in which case
their network elements for providing these services would not need to be made
available to us or other competitors.  AT&T has announced that it is entering
into arrangements with cable companies for the exclusive use of their local
networks for broadband telecommunications and several cable companies are
offering broadband Internet access over their network facilities.  As of the
date hereof, we offer such broadband local access to our customers only in
limited areas in Cedar Rapids, Iowa and southeast South 

                                       19
<PAGE>
 
Dakota. If we are unable to meet future demands of our customers for broadband
local access or other services on a timely basis at competitive rates, we may be
at a significant competitive disadvantage.

     The FCC also regulates the interstate access rates charged by incumbent
local exchange carriers for the origination and termination of interstate long
distance traffic.  Those access rates make up a significant portion of the cost
of providing long distance service.  The FCC has implemented changes to its
interstate access rules that result in restructuring of the access charge system
and changes in access charge rate levels.  These and related actions may reduce
access rates, and hence the cost of providing long distance service, especially
to business customers.  The impact of these new changes will not be known until
they are fully implemented over the next several years.  In a related
proceeding, the FCC has adopted changes to the methodology by which access has
been used in part to subsidize universal telephone service and other public
policy goals.  Telecommunications providers like McLeodUSA will pay a fee
calculated as a percentage of their revenues to support these goals.  The full
implications of these changes also remain uncertain and subject to change.

     In addition, the FCC and the states are considering related questions
regarding the applicability of access charge and universal service fees to
Internet service providers.  Currently, Internet service providers are not
subject to these expenses.  Many incumbent local exchange carriers and other
parties have argued that this exemption unfairly advantages Internet service
providers, particularly when they provide data, voice or other services in
direct competition with conventional telecommunications.

     In connection with its interconnection decisions, the FCC has granted local
exchange carriers additional flexibility in pricing their interstate special and
switched access services on a central office specific basis.  Under this pricing
scheme, local exchange carriers may establish pricing zones based on access
traffic density and charge different prices for central offices in each zone.
We anticipate that the FCC will grant local exchange carriers increasing pricing
flexibility as the number of interconnection agreements and competitors
increases.  The potential impact of such pricing flexibility on McLeodUSA and
other competitors is unclear at this time.

     As of the date hereof, we do not offer PCS services, although we do own a
minority interest in a cellular telephone partnership serving parts of east
central Illinois.  In April and June 1997, the FCC awarded us a total of 26 "D"
and "E" block frequency PCS licenses and in September 1997 we acquired CCI and
its "E" block frequency PCS license, giving us a total of 27 PCS licenses in 25
markets covering areas of Iowa, Illinois, Minnesota, Nebraska and South Dakota.
We paid approximately $32.8 million for the 26 PCS licenses awarded to us by the
FCC.  Our PCS licenses encompass approximately 110,000 square miles and a
population of approximately 6.9 million.  In July 1997, the FCC also awarded us
four WCS licenses in the Major Economic Areas of Milwaukee, Wisconsin,
Minneapolis/St. Paul, Minnesota, Des Moines-Quad Cities, Iowa/Illinois and
Omaha, Nebraska.  We are evaluating proposed wireless systems and expect to
utilize our PCS licenses as part of a network or a strategic combination to add
PCS or other wireless services to our integrated communications services.  We
intend to use the frequency blocks covered by our WCS licenses to provide fixed
services such as wireless local loop, Internet access or meter reading.

     All PCS licenses are awarded for a ten-year period, at the end of which,
absent prior revocation or a violation of the FCC's rules by the licensee, they
will be renewed.  As a PCS licensee, we are subject to "build-out" requirements
which require that specified levels of service be available by specified times.
If we fail to meet these coverage requirements, we may be subject to forfeiture
of our PCS licenses.

     PCS licenses permit use of radio spectrum that may be currently occupied by
fixed microwave systems.  The existing licensees of such systems retain the
right to continue to operate their systems until 2005.  To secure a sufficient
amount of unencumbered spectrum to operate a PCS system efficiently, we may need
to relocate many of these existing licensees.  In an effort to balance the
competing interests of existing microwave users and newly authorized PCS
licensees, the FCC has adopted a transition plan to relocate such microwave
operators to other spectrum blocks.  This transition plan allows most microwave
users to operate in the PCS spectrum for a one-year voluntary negotiation period
and an additional one-year mandatory negotiation period.  For public safety
entities dedicating a majority of their system communications for police, fire
or emergency medical services operations, the voluntary negotiation period is
three years.  Parties unable to reach agreement within these time periods may
refer the matter to the FCC for resolution, but the existing microwave user is
permitted to continue its operations until final FCC 

                                       20
<PAGE>
 
resolution of the matter. We estimate that we would be required to pay to
relocate approximately 50 microwave links operated by 19 different microwave
licensees in order to develop a PCS system in our target wireless markets. In
addition, the FCC has imposed new universal service requirements on wireless
carriers, as well as new number portability and enhanced "911" obligations on
commercial mobile radio service providers including PCS carriers, which may
require us to invest in advanced technology over the next few years.

     Wireless systems are also subject to Federal Aviation Administration
regulations respecting the location, lighting and construction of transmitter
towers and antennas and may be subject to regulation under the National
Environmental Policy Act and the environmental regulations of the FCC.  Wireless
providers also must satisfy a variety of FCC requirements relating to technical
and reporting matters.  One such requirement is the coordination of proposed
frequency usage between adjacent systems.  In addition, the height and power of
base station transmitting facilities and the type of signals they emit must fall
within specified parameters.

     The Communications Act of 1934 requires the FCC's prior approval of the
assignment or transfer of control of a PCS or other radio license.  In addition,
the FCC has established transfer disclosure requirements that require licensees
who transfer control of or assign a PCS license within the first three years to
file associated contracts for sale, option agreements, management agreements or
other documents disclosing the total consideration that the applicant would
receive in return for the transfer or assignment of its license.  Non-
controlling interests in an entity that holds a PCS license or PCS system
generally may be bought or sold by U.S. companies or individuals without prior
FCC approval, but subsequent notice must be provided to the FCC.

     The Telecommunications Act of 1996 imposes restrictions on investment in
McLeodUSA by foreign persons or corporations arising from our ownership of
common carrier radio licenses.  However, these restrictions generally do not
apply to investment by nationals of member countries of the World Trade
Organization.  As of the date hereof, we have no knowledge of any ownership by
or affiliation with foreign persons or telecommunications carriers in violation
of the Communications Act or the FCC's rules.

     Through our wholly owned subsidiaries, we are also subject to rules
governing telemarketing that have been promulgated by both the FCC and the
Federal Trade Commission.  The FCC and FTC telemarketing rules prohibit
telemarketers from engaging in deceptive telemarketing practices and require
that telemarketers make specified disclosures.  For example, these telemarketing
rules:

     .    prohibit the use of autodialers that employ prerecorded voice messages
          without the prior express consent of the dialed party

     .    proscribe the facsimile transmission of unsolicited advertisements

     .    require telemarketers to disclose clear and conspicuous information
          concerning quality, cost and refunds to a customer before a customer
          makes a purchase

     .    require telemarketers to compile lists of individuals who desire not
          to be contacted

     .    limit telemarketers to calling residences between the hours of 8:00
          a.m. and 9:00 p.m.

     .    require telemarketers to explicitly identify the seller and state the
          purpose of the call

     .    prohibit product misrepresentations

     State Regulation.  We provide intrastate common carrier services and are
subject to various state laws and regulations.  Most public utility commissions
subject providers such as McLeodUSA to some form of certification requirement,
which requires providers to obtain authority from the state public utility
commission before initiating service.  In most states, including Iowa and
Illinois, we are also required to file tariffs setting forth the terms,
conditions and prices for services that are classified as intrastate.  We are
required to update or amend these tariffs when we adjust our rates or add new
products, and are subject to various reporting and record-keeping requirements
in these states.

     Many states also require prior approval for transfers of control of
certified carriers, corporate reorganizations, acquisitions of
telecommunications operations, assignment of carrier assets, carrier stock

                                       21
<PAGE>
 
offerings and incurrence by carriers of significant debt obligations.
Certificates of authority can generally be conditioned, modified, canceled,
terminated or revoked by state regulatory authorities for failure to comply with
state law or the rules, regulations and policies of state regulatory
authorities.  Fines or other penalties also may be imposed for such violations.
State utility commissions or third parties could raise issues with regard to our
compliance with applicable laws or regulations which could have a material
adverse effect on our business, results of operations and financial condition.

     We hold certificates of authority to resell the local services of the
regional Bell operating companies and to offer local services using our own
communications network facilities in incumbent regional Bell operating company
exchanges in Iowa, Illinois, Wisconsin, Minnesota, North Dakota, South Dakota,
Wyoming, Idaho, Indiana, Missouri, Nebraska and Utah.  We also hold certificates
of authority to resell the local services of the regional Bell operating
companies in Colorado and Montana.  We intend to seek regulatory approval to
provide resale and facilities-based services in all states within our target
markets when the economic terms of interconnection with the incumbent local
exchange company make the provision of local services using our own
communications network facilities cost-effective. See "-- Expansion of Services
Using Our Own Communications Network Facilities."  We are also authorized to
offer long distance service in all 48 states in the continental United States.
We have obtained authority to offer long distance service in such states,
including states outside our target markets, because we believe this capability
will enhance our ability to attract business customers that have offices outside
of our target markets.  We may also apply for authority to provide services in
non-regional Bell operating company exchanges in our target market states and
other states in the futures.  While we expect and intend to obtain the necessary
regulatory authority in each jurisdiction where we plan to operate, we cannot
assure you that each respective agency will grant our request for authority.

     The Telecommunications Act of 1996 preserves the ability of states to
impose reasonable terms and conditions on the provision of intrastate service
and other related regulatory requirements.  In the last several years, Iowa,
Illinois, Minnesota, Wisconsin, Wyoming and North Dakota have enacted broad
changes in their telecommunications laws that authorize the entry of competitive
local exchange carriers and provide for new regulations to promote competition
in local and other intrastate telecommunications services.  As a general matter,
we believe the states will play a key role in the development of local exchange
competition.  Consequently, we could face regulatory decisions that adversely
affect our ability to compete in particular states.

     States also regulate the intrastate carrier access services of the
incumbent local exchange carriers.  We are required to pay access charges to
originate and connect our intrastate long distance traffic.  We could be
adversely affected by high access charges, particularly to the extent that the
incumbent local exchange carriers do not incur the same level of costs with
respect to their own intrastate long distance services.  In a related
development, states also will be developing intrastate universal service charges
parallel to the interstate charges created by the FCC.  For example, some
incumbent local exchange carriers are proposing that states create funds that
would be supported by potentially large payments by firms such as McLeodUSA
based on their total intrastate revenues.  Another state regulatory issue that
could adversely affect our business is the approval by some state regulatory
agencies of extended local area calling for incumbent local exchange carriers,
converting otherwise competitive intrastate toll service to local service.
States also are or will be addressing various intraLATA dialing parity issues
that may affect competition.  Our business could be adversely affected by these
or other developments.

     We believe that, as the degree of intrastate competition increases, states
will offer the local exchange carriers increasing pricing flexibility.  This
flexibility may present the local exchange carriers with an opportunity to
subsidize services that compete with our services with revenues generated from
non-competitive services, allowing incumbent local exchange carriers to offer
competitive services at prices below the cost of providing the service.  We
cannot predict the extent to which this may occur or its impact on our business.

     ICTC is subject to rate of return regulation by the Illinois Commerce
Commission.  Under such regulation, ICTC is allowed to earn up to a fixed rate
of return on its equity.  In the event that the Illinois Commerce Commission
finds that ICTC has exceeded its authorized rate of return on equity, ICTC could
be required to lower its customer rates or make refunds.  While we believe ICTC
is earning less than its authorized rate of return, we cannot assure you that
the Illinois Commerce Commission will not, at some 

                                       22
<PAGE>
 
future date, find that ICTC has earned more than its authorized rate of return
or that such a finding would not have a material adverse effect on us.

     In addition, a substantial proportion of ICTC's and Dakota
Telecommunications' revenues are derived from access charges imposed on long
distance carriers.  Access charge rate structures and rate levels have been
modified by recent regulatory changes, and further changes are possible.  If
such revisions result in a reduction of ICTC's and Dakota Telecommunications'
revenues and gross margins, it could have a material adverse effect on us.

     Several of our subsidiaries also hold state and federal certificates and
FCC licenses in connection with the operation of wireless telecommunications
services and paging services.

     Through our wholly owned subsidiaries, we engage in various direct
marketing, telemarketing and fund-raising activities.  Most states have laws
that govern these activities.  In states that regulate such activities, several
types of restriction have been imposed, either singly or in combination,
including requirements to:

     .    register with state authorities
     .    post professional bonds
     .    file operational contracts with state authorities
     .    respect statutory waiting periods
     .    register employees with state authorities
     .    prohibit control over funds collected from such activities

     Local Government Authorizations.  We are required to obtain construction
permits and licenses or franchises to install and expand our fiber optic
communications networks using municipal rights-of-way.  Some municipalities
where we have installed or anticipate constructing networks are proposing and
enacting ordinances regulating use of rights-of-way and imposing various fees in
connection with such use.  In some instances we have negotiated interim
agreements to authorize installation of facilities pending resolution of the fee
issue.  In many markets, the local exchange carriers do not pay rights-of-way
fees or pay fees that are substantially less than the fees we are required to
pay.  To the extent that competitors do not pay the same level of fees as us, we
could be at a competitive disadvantage.  We must also negotiate and enter into
franchise agreements with local governments in order to operate our video
services networks.  We have franchises for our existing services, but will need
additional franchises in order to expand into additional markets.  If we fail to
receive necessary permits or franchise agreements on commercially reasonable
terms or are unable to obtain or maintain right-of-way authorization or license
agreements, we could be materially adversely affected.  If we lose a right-of-
way, we could be required to remove our facilities from the right-of-way or
abandon our network in place.

Risk Factors

     In connection with the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995, set forth below are cautionary statements
identifying important factors that could cause our actual results to differ
materially from those projected in any forward-looking statements made by or on
behalf of us, whether oral or written.  We wish to ensure that any forward-
looking statements are accompanied by meaningful cautionary statements in order
to maximize to the fullest extent possible the protections of the safe harbor
established in the Private Securities Litigation Reform Act of 1995.
Accordingly, any such statements are qualified in their entirety by reference
to, and are accompanied by, the following important factors that could cause our
actual results to differ materially from those projected in our forward-looking
statements.


Fluctuations in the Market Price of Our Class A Common Stock May Make it More
Difficult for Us to Raise Capital.


     The market price of our Class A common stock is extremely volatile and has
fluctuated over a wide range.  These fluctuations may impair our ability to
raise capital by offering equity securities.  The market price may continue to
fluctuate significantly in response to various factors, including:

                                       23
<PAGE>
 
     .    market conditions in the industry
     .    announcements and actions by competitors
     .    low trading volume
     .    quarterly variations in operating results or growth rates
     .    changes in estimates by securities analysts
     .    regulatory and judicial actions
     .    general economic conditions

     See "Market for Registrants' Common Equity and Related Stockholder Matters
--Price Range of Class A Common Stock."

We May Not Be Able to Successfully Integrate Acquired Companies into Our
Operations, Which Could Slow Our Growth.

     The integration of acquired companies into our operations involves a number
of risks, including:

     .    difficulty integrating new operations and personnel
     .    diversion of management attention
     .    potential disruption of ongoing business
     .    inability to retain key personnel
     .    inability successfully to incorporate new assets and rights into our
          service offerings
     .    inability to maintain uniform standards, controls, procedures and
          policies
     .    impairment of relationships with employees, customers or vendors

     Failure to overcome these risks or any other problems encountered in
connection with acquisition transactions could slow our growth or lower the
quality of our services, which could reduce customer demand.

Continued Rapid Growth of Our Network, Services and Subscribers Could Be Slowed
if We Cannot Manage this Growth

     We have rapidly expanded and developed our network, services and
subscribers.  This has placed and will continue to place significant demands on
our management, operational and financial systems and procedures and controls.
We may not be able to manage our anticipated growth effectively, which would
harm our business, results of operations and financial condition.  Further
expansion and development will depend on a number of factors, including:

     .    cooperation of the existing local telephone companies
     .    regulatory and governmental developments
     .    changes in the competitive climate in which we operate
     .    development of customer billing, order processing and network
          management systems
     .    availability of financing
     .    technological developments
     .    availability of rights-of-way, building access and antenna sites
     .    existence of strategic alliances or relationships
     .    emergence of future opportunities

     We will need to continue to improve our operational and financial systems
and our procedures and controls as we grow. We must also develop, train and
manage our employees.

We Expect to Incur Significant Losses Over the Next Several Years.

     If we do not become profitable in the future, the value of our shares may
fall and we could have difficulty obtaining funds to continue our operations.
We have incurred net losses every year since we began operations.  Since January
1, 1995, our net losses have been as follows:

                                       24
<PAGE>
 
                            Net Losses
                            ----------

                    Period              Amount       
                    ------              ------
                    1995           $  11.3 million
                    1996           $  22.3 million
                    1997           $  79.9 million
                    1998           $ 124.9 million


We expect to incur significant operating losses during the next several years
while we develop our businesses, expand our fiber optic communications network
and develop wireless services.

Failure to Raise Necessary Capital Could Restrict Our Ability to Develop Our
Network and Services and Engage in Strategic Acquisitions.

     We need significant capital to continue to expand our operations,
facilities, network and services. We cannot assure you that our capital
resources will permit us to fund our planned network deployment and operations
or achieve operating profitability. Failure to generate or raise sufficient
funds may require us to delay or abandon some of our expansion plans or
expenditures, which could harm our business and competitive position.

     As of December 31, 1998, based on our business plan, capital requirements
and growth projections as of that date, we estimated that we would require
approximately $1.4 billion through 2001 to fund our planned capital expenditures
and operating expenses. Our estimated aggregate capital requirements include the
projected costs of:

     .    building our fiber optic communications network, including intra-city
          fiber optic networks
     .    expanding operations in existing and new markets
     .    developing wireless services
     .    funding general corporate expenses
     .    completing recent and pending acquisitions
     .    constructing, acquiring, developing or improving telecommunications
          assets

     Our estimate of future capital requirements is a forward-looking statement
within the meaning of the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995.  The actual amount and timing of our future
capital requirements may differ substantially from our estimate due to factors
such as:

     .    strategic acquisition costs and effects of acquisitions on our
          business plan, capital requirements and growth projections
     .    unforeseen delays
     .    cost overruns
     .    engineering design changes
     .    changes in demand for our services
     .    regulatory, technological or competitive developments
     .    new opportunities

     We also expect to evaluate potential acquisitions, joint ventures and
strategic alliances on an ongoing basis.  We may require additional financing if
we pursue any of these opportunities.  We may meet any additional capital needs
by issuing additional debt or equity securities or borrowing funds from one or
more lenders.  We cannot assure you that we will have timely access to
additional financing sources on acceptable terms.  If we do not, we may not be
able to expand our markets, operations, facilities, network and services through
acquisitions as we intend.  See "Managements' Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Capital Resources."

                                       25
<PAGE>
 
Our High Level of Debt Could Limit Our Flexibility in Responding to Business
Developments and Put Us at a Competitive Disadvantage.

     We have substantial debt, which could adversely affect us in a number of
ways, including:

     .    limiting our ability to obtain necessary financing in the future
     .    limiting our flexibility to plan for, or react to, changes in our
          business
     .    requiring us to use a substantial portion of our cash flow from
          operations to pay debt rather than for other purposes, such as working
          capital or capital expenditures
     .    making us more highly leveraged than some of our competitors, which
          may place us at a competitive disadvantage
     .    making us more vulnerable to a downturn in our business

     As of December 31, 1998, we had $1.2 billion of long-term debt and $462.8
million of stockholders' equity.  We incurred an additional $500 million of
long-term debt on February 22, 1999.  As a result, we expect our fixed charges
to exceed our earnings for the foreseeable future.  See "Managements' Discussion
and Analysis of Financial Condition and Results of Operations--Liquidity and
Capital Resources."

Covenants in Debt Instruments Restrict Our Capacity to Borrow and Invest, Which
Could Impair Our Ability to Expand or Finance Our Operations.

     The indentures governing the terms of our long-term debt impose operating
and financial restrictions that limit our discretion on some business matters,
which could make it more difficult for us to expand, finance our operations or
engage in other business activities that may be in our interest.  These
restrictions limit or prohibit our ability to:

     .    incur additional debt
     .    pay dividends or make other distributions
     .    make investments or other restricted payments
     .    enter into sale and leaseback transactions
     .    pledge or mortgage assets
     .    enter into transactions with related persons
     .    sell assets
     .    consolidate, merge or sell all or substantially all of our assets

If we fail to comply with these restrictions, all of our long-term debt could
become immediately due and payable.  See "Managements' Discussion and Analysis
of Financial Condition and Results of Operations--Liquidity and Capital
Resources."

We Are Prohibited from Paying Dividends.

  We do not anticipate paying any dividends for the foreseeable future.  The
indentures governing our debt prohibit us from paying cash dividends.  You
should therefore not expect to receive dividends on shares of our Class A common
stock.

Our Dependence on Regional Bell Operating Companies to Provide Most of Our
Communications Services Could Make it Harder for Us to Offer Our Services at a
Profit.

     We depend on the regional Bell operating companies to provide most of our
core local and some of our long distance services.  Today, without using the
communications facilities of these companies, we could not provide bundled local
and long distance services to most of our customers.  Because of this
dependence, our communications services are highly susceptible to changes in the
conditions for access to these facilities and we may therefore have difficulty
offering our services at profitable and competitive rates.

                                       26
<PAGE>
 
     U S WEST, Ameritech and Southwestern Bell are our primary suppliers of
local lines to our customers and communications services that allow us to
transfer and connect calls.  Their communications facilities allow us to provide
(1) local service, (2) long distance service and (3) private lines dedicated to
our customers' use.  If these or other companies deny or limit our access to
their communications network elements or wholesale services, we may not be able
to offer profitable communications services.

     Our plans to provide local service using our own communications network
equipment also depend on the regional Bell operating companies.  In order to
interconnect our network equipment and other communications facilities to
network elements controlled by the regional Bell operating companies, we must
first negotiate and enter into interconnection agreements with them.
Interconnection obligations imposed on the regional Bell operating companies by
the Telecommunications Act of 1996 have been and continue to be subject to a
variety of legal proceedings, which could affect our ability to obtain
interconnection agreements on acceptable terms.  We cannot assure you that we
will succeed in obtaining interconnection agreements on terms that would permit
us to offer local services using our own communications network facilities at
profitable and competitive rates.

Actions by U S WEST May Make it More Difficult for Us to Offer Our
Communications Services.

     U S WEST has introduced several measures that may make it more difficult
for us to offer our communications services.  For example, in February 1996, U S
WEST filed tariffs and other notices with the public utility commissions in its
fourteen-state service region to limit future Centrex access to its switches.
Centrex access allows us to aggregate lines, have control over several
characteristics of those lines and provide a set of standard features on them.
We use U S WEST's Centrex services to provide most of our local communications
services in U S WEST's service territories.

     In January 1997, U S WEST also proposed interconnection surcharges in
several of the states in its service region, which would increase our costs of
providing communications services in those states.

     We have challenged or are challenging these actions by U S WEST before the
FCC or applicable state public utility commissions.  We cannot assure you we
will succeed in our challenges to these or other actions by U S WEST that would
prevent or deter us from using U S WEST's Centrex service or communications
network elements.  If U S WEST successfully withdraws or limits our access to
Centrex services in any jurisdiction, we may not be able to offer communications
services in that jurisdiction, which could harm our business.

     We anticipate that U S WEST will also pursue legislation in states within
our target market area to reduce state regulatory oversight over our rates and
operations. If adopted, these initiatives could make it more difficult for us to
challenge U S WEST's actions in the future.

Competition in the Communications Services Industry Could Cause Us to Lose
Customers and Revenue and Could Make it More Difficult for Us to Enter New
Markets.

     We face intense competition in all of our markets.  This competition could
result in loss of customers and lower revenue for us.  It could also make it
more difficult for us to enter new markets.  Existing local telephone companies,
including U S WEST, Ameritech, Southwestern Bell and GTE, currently dominate
their local telecommunications markets.  Three major competitors, AT&T, MCI
WorldCom and Sprint, dominate the long distance market. Hundreds of other
companies also compete in the long distance marketplace.  AT&T, MCI WorldCom and
Sprint also offer local telecommunications services in many locations.

     Our local and long distance services also compete with the services of
other communications services companies competing with the existing local
telephone companies in some markets.

     Other competitors may include cable television companies, providers of
communications network facilities dedicated to particular customers, microwave
and satellite carriers, wireless telecommunications providers, private networks
owned by large end-users, and telecommunications management companies.

                                       27
<PAGE>
 
     These and other firms may enter the markets where we focus our sales
efforts.  Many of our existing and potential competitors have financial and
other resources far greater than our own.  In addition, the trend toward mergers
and strategic alliances in the communications industry may strengthen some of
our competitors and could put us at a significant competitive disadvantage.

     For additional information, see "--Competition."

We May Not Succeed in Developing or Making a Profit from Wireless Services.

     Our proposal to offer wireless services involves a high degree of risk and
will impose significant demands on our management and financial resources.
Developing wireless services may require us to, among other things, spend
substantial time and money to acquire, build and test a wireless infrastructure
and enter into roaming arrangements with wireless operators in other markets.
We may not succeed in developing wireless services.  Even if we spend
substantial amounts to develop wireless services, we may not make a profit from
wireless operations.

     Our ability to successfully offer wireless services will also depend on a
number of factors beyond our control, including:

     .    changes in communications service rates charged by other companies
     .    changes in the supply and demand for wireless services due to
          competition with other wireline and wireless operators in the same
          geographic area
     .    changes in the federal, state or local regulatory requirements
          affecting the operation of wireless systems
     .    changes in wireless technologies that could render obsolete the
          technology and equipment we choose for our wireless services

     See "--Proposed Wireless Services."

Competition in the Wireless Telecommunications Industry Could Make it Harder for
Us Successfully to Offer Wireless Services.

     The wireless telecommunications industry is experiencing increasing
competition and significant technological change.  This will make it harder for
us to gain a share of the wireless communications market.  We expect up to eight
wireless competitors in each of our target wireless markets.  We could face
additional competition from mobile satellite services.

     Many of our potential wireless competitors have financial and other
resources far greater than our own and have more experience testing new or
improved products and services.  In addition, several wireless competitors
operate or plan to operate wireless telecommunications systems that encompass
most of the United States, which could give them a significant competitive
advantage, particularly if we only offer regional wireless services.  See "--
Competition--Wireless Competition."

The Success of Our Communications Services Will Depend on Our Ability to Keep
Pace with Rapid Technological Changes in Our Industry.

     Communications technology is changing rapidly.  These changes influence the
demand for our services.  We need to be able to anticipate these changes and to
develop new and enhanced products and services quickly enough for the changing
market.  This will determine whether we can continue to increase our revenues
and number of subscribers and be competitive.

The Loss of Key Personnel Could Weaken Our Technical and Operational Expertise,
Delay Our Introduction of New Services or Entry into New Markets and Lower the
Quality of Our Service.

     We may not be able to attract, develop, motivate and retain experienced and
innovative personnel.  There is intense competition for qualified personnel in
our business.  The loss of the services of key personnel, or the inability to
attract additional qualified personnel, could cause us to make less 

                                       28
<PAGE>
 
successful strategic decisions, which could hinder the introduction of new
services or the entry into new markets. We could also be less prepared for
technological or marketing problems, which could reduce our ability to serve our
customers and lower the quality of our services. As a result, our financial
condition could worsen.

     Our future success depends on the continued employment of our senior
management team, particularly Clark E. McLeod, our Chairman and Chief Executive
Officer, and Stephen C. Gray, our President and Chief Operating Officer. We do
not have term employment agreements with these employees.

Failure to Obtain and Maintain Necessary Permits and Rights-of-Way Could Delay
Installation of Our Networks and Interfere with Our Operations.

     To obtain access to rights-of-way needed to install our fiber optic cable,
we must reach agreements with state highway authorities, local governments,
transit authorities, local telephone companies, other utilities, railroads, long
distance carriers and other parties.  The failure to obtain or maintain any
rights-of-way could delay our planned network expansion, interfere with our
operations and harm our business.  For example, if we lose access to a right-of-
way, we may need to spend significant sums to remove and relocate our
facilities.  See "--Regulation--Local Government Authorizations."

Government Regulation May Increase Our Cost of Providing Services, Slow Our
Expansion into New Markets and Subject Our Services to Additional Competitive
Pressures.

     Our facilities and services are subject to federal, state and local
regulation.  The time and expense of complying with these regulations could slow
down our expansion into new markets, increase our costs of providing services
and subject them to additional competitive pressures.  One of the primary
purposes of the Telecommunications Act of 1996 was to open the local telephone
services market to competition.  While this has presented us with opportunities
to enter local telephone markets, it also provides important benefits to the
existing local telephone companies, such as the ability, under specified
conditions, to provide out-of-region long distance service to customers in their
regions.  In addition, we need to obtain and maintain licenses, permits and
other regulatory approvals in connection with some of our services.  Any of the
following could harm our business:

     .    failure to maintain proper federal and state tariffs
     .    failure to maintain proper state certifications
     .    failure to comply with federal, state or local laws and regulations
     .    failure to obtain and maintain required licenses and permits
     .    burdensome license or permit requirements to operate in public
          rights-of- way
     .    burdensome or adverse regulatory requirements

For additional information, see "--Regulation."

Our Management and Principal Stockholders Can Control McLeodUSA and May Have
Different Interests Than Those of Other Stockholders.

     As of December 31, 1998, Alliant Energy, MidAmerican, Richard A. Lumpkin
and various trusts for the benefit of his family, Clark and Mary McLeod, and our
directors and executive officers beneficially owned approximately 59.4% of our
outstanding Class A common stock. These stockholders can collectively control
management policy and all corporate actions requiring a stockholder vote,
including election of the board of directors.  Conflicts of interest may arise
between the interests of these stockholders and our other stockholders.  For
example, the fact that these stockholders hold so much Class A common stock
could make it more difficult for a third party to acquire us.  You should expect
these stockholders to resolve any conflicts in their favor.

                                       29
<PAGE>
 
Computer Systems May Malfunction and Interrupt Our Services if We and Our
Suppliers Do Not Attain Year 2000 Readiness.

     We and our major suppliers of communications services and network elements
rely greatly on computer systems and other technological devices.  These may not
be capable of recognizing January 1, 2000 or subsequent dates.  This problem
could cause any or all of our systems or services to malfunction or fail.

     We are reviewing our computer systems and programs and other technological
devices to determine which are not capable of recognizing the Year 2000 and to
verify system readiness for the millennium date. The review covers all of our
operations and is centrally managed.  This review may not be sufficient,
however, to prevent interruptions to our systems and services.

     Some of our critical operations and services depend on other companies.
For example, we depend on the existing local telephone companies, primarily the
regional Bell operating companies, to provide most of our local and some of our
long distance services.  To the extent U S WEST, Ameritech or Southwestern Bell
fail to address Year 2000 issues which might interfere with their ability to
fulfill their obligations to us, it could interfere with our operations.  If we,
our major vendors, our material service providers or our customers fail to
address Year 2000 issues in a timely manner, our business, results of operations
and financial condition could be significantly harmed.  See "Managements'
Discussion and Analysis of Financial Condition and Results of Operations--Year
2000 Date Conversion."

Employees

     As of December 31, 1998, we employed a total of 5003 full-time employees
and 570 part-time employees.  We believe that our future success will depend on
our continued ability to attract and retain highly skilled and qualified
employees.  We believe that our relations with our employees are good.

Item 2.  Properties.

     We own or lease offices and space in a number of locations, primarily for
sales offices and network equipment installations.  In August 1996, we purchased
approximately 194 acres of farm land in southern Cedar Rapids, Iowa for the
development of an office complex, known as the McLeodUSA Technology Park.  We
have constructed our new headquarters buildings on this site, consisting of a
one-story, 160,000 square foot office building, a two-story, 320,000 square foot
office building which also houses some of our telephone switching and computer
equipment, and a 36,000 square foot maintenance building and warehouse.  The
total cost of the construction of our new headquarters buildings was
approximately $35.6 million.  We also purchased approximately 120 acres of
undeveloped land adjacent to the McLeodUSA Technology Park for a purchase price
of approximately $1.4 million in August 1997.  As a result of our acquisition of
CCI, we also own a 60,000 square foot office building in Mattoon, Illinois, as
well as other properties in central Illinois.  We also maintain 55,000 square
feet of office space at our former headquarters in Cedar Rapids, Iowa, under a
lease expiring in March 2001.  In addition, we own 88 acres of undeveloped farm
and forest land in southern Cedar Rapids, Iowa.

Item 3.  Legal Proceedings.

     We are not aware of any material litigation against McLeodUSA. We are
involved in numerous regulatory proceedings before various public utility
commissions and the FCC, particularly in connection with actions by the regional
Bell operating companies.  For example, on February 5, 1996, U S WEST filed
tariffs and other notices with the public utility commissions in its fourteen-
state service region to limit future Centrex access to its switches.  Under the
terms of these tariffs and other notices, U S WEST would permit us to use its
central office switches until April 2005, but would not allow us to expand to
new cities and would severely limit the number of new lines we could partition
onto U S WEST's switches in cities we serve.

     We have challenged, or are challenging, this action by U S WEST in many of
the states where we do business or plan to do business. We have succeeded in
blocking this action in Iowa, Minnesota, South Dakota, North Dakota and
Colorado, although U S WEST could take further legal action in some of these

                                       30
<PAGE>
 
states. In Montana, Nebraska and Idaho, however, similar challenges to this
action have not succeeded. In Wyoming and Utah, challenges to this action remain
pending.

     U S WEST has introduced other measures that may make it more difficult or
expensive for us to use Centrex service. In January 1997, U S WEST proposed
interconnection surcharges in several of the states in its service region. In
February 1997, we joined other parties in filing a petition with the FCC
objecting to this proposal based on our belief that it violates several
provisions of the Telecommunications Act of 1996. The matter remains pending
before the FCC and various state public utility commissions.

     We anticipate that U S WEST will also pursue legislation in states within
our target market area to reduce state regulatory oversight over its rates and
operations. If adopted, these initiatives could make it more difficult for us to
challenge U S WEST's actions in the future.

     We cannot assure you we will succeed in our challenges to these or other
actions by U S WEST that would prevent or deter us from using U S WEST's Centrex
service or network elements. If U S WEST successfully withdraws or limits our
access to Centrex services in any jurisdiction, we may not be able to offer
integrated communications services in that jurisdiction, which could have a
material adverse effect on our business, results of operations and financial
condition.  See "Business--Risk Factors--Our Dependence on Regional Bell
Operating Companies to Provide Most of Our Communications Services Could Make it
Harder for Us to Offer Our Services at a Profit" and "Business--Risk Factors--
Actions by U S WEST May Make it More Difficult for Us to Offer Our
Communications Services."

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

     None.

                                       31
<PAGE>
 
                                    PART II

Item 5.  Market for Registrant's Common Equity and Related Stockholder Matters.

Price Range of Class A Common Stock

     We completed our initial public offering of Class A common stock in June
1996, at a price per share of Class A common stock of $20.00. Our Class A common
stock has been quoted on The Nasdaq Stock Market's National Market System under
the symbol "MCLD" since June 11, 1996.  Before June 11, 1996, no established
public trading market for the Class A common stock existed. The following table
sets forth for the periods indicated the high and low sales price per share of
our Class A common stock as reported by The Nasdaq Stock Market.

<TABLE>
<CAPTION>
     1996                                                               High      Low
     ----                                                             -------   -------
<S>                                                                  <C>       <C>
Second Quarter (from June 11, 1996)................................   $26.75    $22.25
Third Quarter......................................................   $39.50    $23.50
Fourth Quarter.....................................................   $34.50    $25.00
                                                                              
     1997                                                                     
     ----                                                                     
First Quarter......................................................   $28.75    $17.375
Second Quarter.....................................................   $34.25    $16.375
Third Quarter......................................................   $40.00    $28.625
Fourth Quarter.....................................................   $41.75    $32.00
 
     1998
     ----
First Quarter......................................................   $46.375   $30.50
Second Quarter.....................................................   $48.312   $38.00
Third Quarter......................................................   $40.125   $21.375
Fourth Quarter.....................................................   $38.50    $15.25
</TABLE>

     On March 22, 1999, the last reported sale price of our Class A common stock
on The Nasdaq Stock Market was $41.0625 per share. On March 22, 1999, there were
826 holders of record of our Class A common stock and no holders of record of
our Class B common stock, $.01 par value per share.

Dividend Policy

     We have never declared or paid any cash dividends on our capital stock and
do not anticipate paying dividends in the foreseeable future. Restrictions
contained in the indentures that govern the terms of our debt prohibit us from
paying dividends. Future dividends, if any, will be at the discretion of our
board of directors and will depend upon, among other things, our operations,
capital requirements and surplus, general financial condition, contractual
restrictions in financing agreements (including the indentures that govern the
terms of our debt) and such other factors as our board of directors may deem
relevant. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Liquidity and Capital Resources."

Recent Sales of Unregistered Securities

     During 1998, we offered and sold the following equity securities that were
not registered under the Securities Act of 1933, as amended:

     (1) On April 24, 1998, we issued an aggregate of 70,508 shares of Class A
common stock and paid approximately $1 million to the stockholders of NewCom
Technologies, Inc. and NewCom OSP Services, Inc. (collectively, "NewCom") in
exchange for all of the outstanding shares of capital stock of NewCom.  The
transaction was valued at approximately $4.2 million based on the average
closing sales price of our Class A common stock on The Nasdaq Stock Market at
the time of the transaction.

     (2) On June 29, 1998, we issued 151,019 shares of Class A common stock to
Communications Cable-Laying Company, Inc. ("CCC") in exchange for the assets of
CCC.  The transaction was valued at approximately $6 million based on the
average closing sales price of our Class 

                                       32
<PAGE>
 
A common stock on The Nasdaq Stock Market at the time of the transaction and
including $78,000 of cash acquisition costs.

     (3) On August 21, 1998, we paid an aggregate of approximately $20 million
and issued an option to acquire 245,536 shares of Class A common stock at an
exercise price of $37.25 per share to the stockholders of QST Communications,
Inc. in exchange for all of the share of capital stock of QST.

     (4) On November 25, 1998, we issued an aggregate of 70,672 shares of Class
A common stock and an option to acquire 10,414 shares of Class A common stock at
an exercise price of $34.50 per share to Inlet, Inc. in exchange for
substantially all of the assets of Inlet.  The transaction was valued at
approximately $2.4 million based on the average closing sales price of our Class
A common stock on The Nasdaq Stock Market at the time of the transaction.

     Each issuance of securities described above was made in reliance upon the
exemption from registration provided by Section 4(2) of the Securities Act or
Regulation D promulgated thereunder for transactions by an issuer not involving
any public offering. The recipients of securities in each such transaction
represented their intention to acquire the securities for investment only and
not with a view to or for distribution in connection with such transactions. All
recipients had adequate access to information about us through their
relationship with us or through information about us made available to them.

     See "Executive Compensation" for information regarding the grant of options
to purchase shares of Class A common stock to some of our employees under our
1996 Employee Stock Option Plan as partial consideration for the execution of
employment, confidentiality and non-competition agreements.

                                       33
<PAGE>
 
Item 6.  Selected Financial Data.

     The following table sets forth selected consolidated financial data and
should be read in conjunction with and is qualified by reference to 
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," our consolidated financial statements, the notes thereto and the
other financial data contained elsewhere in this Form 10-K.

     The information in the following table reflects financial information for
the following companies we have acquired:

                      Acquired Company                  Date Acquired
                      ----------------                  -------------

         MWR Telecom, Inc.                              April 28, 1995
         Ruffalo, Cody & Associates, Inc.               July 15, 1996
         TelecomUSA Publishing Group, Inc.              September 20, 1996
         Consolidated Communications, Inc.              September 24, 1997

The operations statement data and other financial data in the table include the
operations of these companies beginning on the dates they were acquired.  The
balance sheet data in the table include the financial position of these
companies at the end of the periods presented, beginning with the period in
which they were acquired.  These acquisitions affect the comparability of the
financial data for the periods presented.

     The information in the table also reflects the following debt securities
that McLeodUSA has issued:

<TABLE>
<CAPTION>
    Description of Debt Securities               Principal Amount at Maturity      Date Issued
    ------------------------------               ----------------------------      -----------
<S>                                              <C>                               <C>    
10 1/2% senior discount notes due March 1, 2007          $500 million              March 4, 1997
9 1/4% senior notes due July 15, 2007                    $225 million              July 21, 1997
8 3/8% senior notes due March 15, 2008                       $300 million              March 10, 1998
9 1/2% senior notes due November 1, 2008                 $300 million              October 30, 1998
</TABLE>

The operations statement data and other financial data in the table reflect the
issuance of the 10 1/2% senior discount notes, the 9 1/4% senior notes, the 
8 3/8% senior notes and the 9 1/2% senior notes beginning on the dates the notes
were issued. The balance sheet data in the table include the effects of these
issuances at the end of the periods presented, beginning with the period in
which they occurred.

                                                 (table begins on the next page)

                                       34
<PAGE>
 
                      (In thousands except per share data)
<TABLE>
<CAPTION>
                                                                    Year Ended December 31,
                                                  -----------------------------------------------------------
                                                     1994        1995        1996         1997         1998
                                                  ----------  ----------  ----------  ------------  ----------
<S>                                               <C>         <C>         <C>         <C>           <C>
Operations Statement Data:
 Revenue.....................................      $  8,014    $ 28,998    $ 81,323     $ 267,886   $ 604,146
                                                   --------    --------    --------     ---------   ---------
 Operating expenses:
  Cost of service............................         6,212      19,667      52,624       151,190     323,208
  Selling, general and
   administrative............................        12,373      18,054      46,044       148,158     260,931
  Depreciation and
   amortization..............................           772       1,835       8,485        33,275      89,107
  Other......................................            --          --       2,380         4,632       5,575
                                                   --------    --------    --------     ---------   ---------
  Total operating
   Expenses..................................        19,357      39,556     109,533       337,255     678,821
                                                   --------    --------    --------     ---------   ---------
 Operating loss..............................       (11,343)    (10,558)    (28,210)      (69,369)    (74,675)
 Interest income (expense),
  Net........................................           (73)       (771)      5,369       (11,967)    (52,234)
  Other income...............................            --          --         495         1,426       1,997
 Income taxes................................            --          --          --            --          --
                                                   --------    --------    --------     ---------   ---------
 Net loss....................................      $(11,416)   $(11,329)   $(22,346)    $ (79,910)  $(124,912)
                                                   ========    ========    ========     =========   =========
 Loss per common share.......................      $   (.53)   $   (.40)   $   (.55)    $   (1.45)  $   (1.99)
                                                   ========    ========    ========     =========   =========
 Weighted average common
  Shares outstanding.........................        21,464      28,004      40,506        54,974      62,807
                                                   ========    ========    ========     =========   =========

                                                                            December 31,
                                                  ------------------------------------------------------------
                                                     1994        1995        1996         1997         1998
                                                  ----------  ----------  ----------  ------------  ----------
Balance Sheet Data:
 Current assets..............................       $ 4,862     $ 8,507    $224,401    $  517,869  $  793,192
 Working capital (deficit)...................       $ 1,659     $(1,208)   $185,968    $  378,617  $  613,236
 Property and equipment, net.................       $ 4,716     $16,119    $ 92,123    $  373,804  $  629,746
 Total assets................................       $10,687     $28,986    $452,994    $1,345,652  $1,925,197
 Long-term debt..............................       $ 3,500     $ 3,600    $  2,573    $  613,384  $1,245,170
 Stockholders' equity........................       $ 3,291     $14,958    $403,429    $  559,379  $  462,806

                                                                       Year Ended December 31,
                                                  ------------------------------------------------------------
                                                     1994        1995        1996         1997         1998
                                                  ----------  ----------  ----------  ------------  ----------
Other Financial Data:
 Capital expenditures, includ-
  ing business acquisitions....................    $  3,393     $14,697    $173,782     $601,137     $339,660
 EBITDA(1).....................................    $(10,571)    $(8,723)   $(17,345)    $(31,462)    $ 20,007
</TABLE>
 
--------------
(1) EBITDA consists of operating loss before depreciation, amortization and
    other nonrecurring operating expenses.  We have included EBITDA data because
    it is a measure commonly used in the industry.  EBITDA is not a measure of
    financial performance under generally accepted accounting principles and
    should not be considered an alternative to net income as a measure of
    performance or to cash flows as a measure of liquidity.

                                       35
<PAGE>
 
Item 7.  Management's Discussion and Analysis of Financial Condition and Results
         of Operations.

     The following discussion and analysis should be read together with our
consolidated financial statements and the notes thereto and the other financial
data appearing elsewhere in this Form 10-K.

Overview

     We derive our revenue from:

     .    our core business of providing local, long distance and related
          communications services to end users, typically in a bundled package

     .    the sale of advertising space in telephone directories

     .    traditional local telephone company services in east central Illinois
          and southeast South Dakota

     .    special access, private line and data services

     .    communications network maintenance services and telephone equipment
          sales, leasing, service and installation

     .    telemarketing services

     .    other communications services, including video, computer networking,
          cellular, operator, payphone, mobile radio and paging services

     We began providing traditional local telephone company services and other
communications services as a result of our acquisition of CCI in September 1997,
telephone directory advertising as a result of our acquisition of TelecomUSA
Publishing in September 1996, and telemarketing services as a result of our
acquisition of Ruffalo Cody in July 1996.  The table set forth below summarizes
our percentage of revenues from these sources:

<TABLE>
<CAPTION>
                                                                 Year Ended December 31,
                                                                --------------------------
                                                                  1996     1997     1998
                                                                --------  -------  -------
<S>                                                             <C>       <C>      <C>
Local and long distance communications services...............       51%      41%      44%
Telephone directory advertising...............................       19       30       24
Traditional local telephone company services..................       --        6       11
Special access, private line and data services................       13        6        7
Network maintenance and equipment services....................        7        8        6
Telemarketing services........................................       10        5        3
Other communications services.................................       --        4        5
                                                                   ----     ----     ----
                                                                    100%     100%     100%
                                                                   ====     ====     ====
</TABLE>

     We began offering local and long distance services to business customers in
January 1994.  At the end of 1995, we began offering, on a test basis, long
distance services to residential customers.  In June 1996, we began marketing
and providing to residential customers in Cedar Rapids, Iowa and Iowa City, Iowa
an integrated package of communications services, marketed under the name
PrimeLine(R), that includes local and long distance service, voice mail,
Internet access and travel card services.  Since June 1996, we have expanded the
states in which we offer service to business customers to include Iowa,
Illinois, Indiana, Minnesota, Wisconsin, North Dakota, South Dakota, Colorado,
Missouri and Wyoming.  We also expanded our PrimeLine(R) service to additional
cities in Iowa and Illinois and began offering the service to customers in North
Dakota, South Dakota, Wisconsin, Wyoming and Colorado.  We plan to continue our
efforts to market and provide local, long distance and other communications
services to business customers and market our PrimeLine(R) service to
residential customers.

     Our principal operating expenses consist of cost of service; selling,
general and administrative expenses ("SG&A"); and depreciation and amortization.
Cost of service primarily includes local services purchased from regional Bell
operating companies, costs to terminate the long distance calls of our customers
through long distance carriers, costs of printing and distributing telephone
directories and costs 

                                       36
<PAGE>
 
associated with maintaining the Iowa Communications Network. The Iowa
Communications Network is a fiber optic communications network that links many
of the State of Iowa's schools, libraries and other public buildings. SG&A
consists of sales and marketing, customer service and administrative expenses,
including the costs associated with operating our communications network.
Depreciation and amortization include depreciation of our telecommunications
network and equipment; amortization of goodwill and other intangibles related to
our acquisitions, amortization expense related to the excess of estimated fair
market value in aggregate of options over the aggregate exercise price of such
options granted to some of our officers, other employees and directors; and
amortization of one-time installation costs associated with transferring
customers' local line service from the regional Bell operating companies to our
local telecommunications service.

     As we expand into new markets, both cost of service and SG&A will increase.
We expect to incur cost of service and SG&A expenses before achieving
significant revenues in new markets.  Fixed costs related to leasing of central
office facilities needed to provide telephone services must be incurred prior to
generating revenue in new markets, while significant levels of marketing
activity may be necessary in the new markets in order for us to build a customer
base large enough to generate sufficient revenue to offset such fixed costs and
marketing expenses.

     In January and February 1996, we granted options to purchase an aggregate
of 965,166 and 688,502 shares of our Class A common stock, respectively, at an
exercise price of $2.67 per share, to some of our directors, officers and other
employees.  The estimated fair market value of these options, in the aggregate,
at the date of grant was later determined to exceed the aggregate exercise price
by approximately $9.2 million.  Additionally, in September 1997, we granted
options to purchase an aggregate of 1,468,945 shares of our Class A common stock
at an exercise price of $24.50 to some employees of CCI.  The fair market value
of these options, in the aggregate, at the date of grant exceeded the aggregate
exercise price by approximately $15.8 million.  These amounts are being
amortized on a monthly basis over the four-year vesting period of the options.

     We have experienced operating losses since our inception as a result of
efforts to build our customer base, develop and construct our communications
network infrastructure, build our internal staffing, develop our systems and
expand into new markets.  We expect to continue to focus on increasing our
customer base and geographic coverage and bringing our customer base onto our
communications network.  Accordingly, we expect that our cost of service, SG&A
and capital expenditures will continue to increase significantly, all of which
may have a negative impact on operating results.

     In addition, our projected increases in capital expenditures will continue
to generate negative cash flows from construction activities during the next
several years while we install and expand our fiber optic communications network
and develop wireless services.  We may also be forced to change our pricing
policies to respond to a changing competitive environment, and we cannot assure
you that we will be able to maintain our operating margin.  We cannot assure you
that growth in our revenue or customer base will continue or that we will be
able to achieve or sustain profitability or positive cash flows.

     We have generated net operating losses since our inception and,
accordingly, have incurred no income tax expense.  We have reduced the net
deferred tax assets generated by these losses by a valuation allowance which
offsets the net deferred tax asset due to the uncertainty of realizing the
benefit of the tax loss carry forwards.  We will reduce the valuation allowance
when, based on the weight of available evidence, it is more likely than not that
some portion or all of the deferred tax assets will be realized.

Year Ended 1998 Compared with Year Ended 1997

     Total revenue increased from $267.9 million for the year ended December 31,
1997 to $604.1 million for the year ended December 31, 1998, representing an
increase of $336.2 million or 125%.  Revenue from the sale of local and long
distance communications services accounted for $157.4 million of this increase,
including $58.1 million contributed by CCI. Local exchange services generated by
ICTC increased by $51.7 million over 1997.  Private line and data revenues
accounted for $26.7 million of increased revenues over 1997, which was primarily
attributable to the acquisition of CCI.  Network maintenance and equipment
revenue increased $11.9 million over 1997 due primarily to the acquisitions of
Digital Communications of Iowa, Inc., ESI Communications, Inc., CCI and NewCom.
Other 

                                       37
<PAGE>
 
communications revenue, which was due almost entirely to the acquisition
of CCI, represented $17.9 million of the increase in revenues.  Directory
revenues increased $63.8 million from 1997 to 1998 due to revenues from new
directories acquired in 1998 and the acquisition of CCI.  The $6.8 million
increase in telemarketing revenues from 1997 to 1998 was due almost entirely to
the acquisition of CCI.

     Cost of service increased from $151.2 million for 1997 to $323.2 million
for 1998, representing an increase of $172.0 million or 114%.  This increase in
cost of service was due primarily to the growth in our local and long distance
communications services and to the acquisitions of Digital Communications, ESI
Communications, CCI, CCC and NewCom, which contributed an aggregate of 
$109.7 million to the increase. Cost of service as a percentage of revenue
decreased from 56% for 1997 to 53% for 1998, as a result of these acquisitions
and as a result of reductions in the cost of providing local and long distance
services as a percentage of local and long distance communications revenue,
which decreased from 84% in 1997 to 70% in 1998. This decrease was primarily due
to the realization of benefits associated with new wholesale line cost rate
agreements with the regional Bell operating companies and reduced long distance
costs resulting from migration of over 60% of customer long distance traffic to
our fiber optic communications network.


     SG&A increased from $148.2 million for the year ended December 31, 1997 
to $260.9 million for the year ended December 31, 1998, an increase of 
$112.7 million or 76%. The acquisitions of Digital Communications, ESI
Communications, CCI, CCC, NewCom and Inlet contributed an aggregate of 
$61.9 million to the increase. Also contributing to this increase were increased
costs of $50.8 million primarily related to expansion of selling, customer
support and administration activities to support our growth.

     Depreciation and amortization expenses increased from $33.3 million for the
year ended December 31, 1997 to $89.1 million for the year ended December 31,
1998, representing an increase of $55.8 million or 168%. This increase consisted
of $38.1 million related to the acquisitions of Digital Communications, ESI
Communications, CCI, CCC, NewCom and Inlet, and $17.7 million due primarily to
the growth of our communications network.

     Other operating expenses represented the amortization of capitalized costs
associated with CCD directories in progress at the time we acquired CCI.

     Interest income increased from $22.7 million for the year ended December
31, 1997, to $26 million in 1998. This increase resulted from increased earnings
on investments made with the remaining proceeds from our debt offerings in March
and July 1997 and the proceeds from our offerings of 8 3/8% senior notes and 
9 1/2% senior notes in March and October 1998, respectively.

     Gross interest expense increased from $39.0 million for the year ended
December 31, 1997 to $88.9 million in 1998. This increase was primarily a result
of an increase in the accretion of interest on our 10 1/2% senior discount notes
of $8.4 million and an increase of interest of $36 million as the result of the
issuance of our 9 1/4% senior notes, 8 3/8% senior notes and 9 1/2% senior
notes. Interest expense of approximately $8 million and $4.4 million was
capitalized as part of our construction of fiber optic communications network
during 1998 and 1997, respectively. In addition, interest expense of
approximately $2.6 million was capitalized as part of our operating facilities
building construction and our software development in 1998, with no
corresponding amount in 1997.


     Net loss increased from $79.9 million for the year ended December 31, 
1997 to $124.9 million for the year ended December 31, 1998, an increase of
$45 million. This increase resulted primarily from the following three factors:

     .    the expansion of our local and long distance services, which requires
          significant expenditures, a substantial portion of which is incurred
          before the realization of revenues

     .    the increased depreciation expense related to the construction and
          expansion of our communications networks and amortization of
          intangibles related to acquisitions

                                       38
<PAGE>
 
     .    net interest expense on indebtedness to fund market expansion, network
          development and acquisitions 

Year Ended 1997 Compared with Year Ended 1996

     Revenue was $267.9 million for the year ended December 31, 1997, an
increase of $186.6 million or 229% from $81.3 million for 1996.  This increase
was due to the many acquisitions completed in 1997 and 1996 as well as the
increase in local and long distance customers.  Revenue from the sale of local
and long distance communications services accounted for $68.6 million of the
increase, including $23.1 million contributed by CCI from September 25, 1997 to
December 31, 1997.  Local exchange services represented $16.1 million for the
period from September 25, 1997 to December 31, 1997, for which there were no
corresponding 1996 revenues.  Private line and data revenues accounted for 
$6.9 million of increased revenues over 1996 which was primarily attributable to
the acquisition of CCI. Network maintenance and equipment revenue increased
$15.0 million over 1996 due to the acquisitions of Digital Communications, ESI
Communications and CCI. Other communications revenue, which was due entirely to
the acquisition of CCI, represented $9.9 million of 1997 revenues with no
corresponding 1996 amount. Directory revenues increased $65.9 million from 1996
to 1997 and were due to a full year of TelecomUSA Publishing revenues in 1997
and the acquisition of CCI on September 24, 1997. The increase in telemarketing
revenues from 1996 to 1997 of $4.1 million was due almost entirely to the
acquisition of CCI.

     Cost of service increased from $52.6 million for the year ended 
December 31, 1996 to $151.2 million for the year ended December 31, 1997,
representing an increase of $98.6 million or 187%. This increase in cost of
service was due primarily to the growth in our local and long distance
communications services and to the acquisitions of Ruffalo Cody, TelecomUSA
Publishing, Digital Communications, ESI Communications and CCI, which
contributed an aggregate of $62.2 million to the increase. Cost of service as a
percentage of revenue decreased from 65% for the year ended December 31, 1996 to
58% for the year ended December 31, 1997, primarily as a result of the effect of
these acquisitions. The cost of providing local and long distance services as a
percentage of local and long distance communications revenue increased from 70%
for the year ended December 31, 1996 to 73% for the year ended December 31,
1997, primarily as a result of increased line costs associated with our
accelerated expansion into new markets.

     SG&A increased from $46 million for the year ended December 31, 1996 to
$148.2 million for the year ended December 31, 1997, an increase of 
$102.2 million or 222%. The acquisitions of Ruffalo Cody, TelecomUSA Publishing,
Digital Communications, ESI Communications and CCI contributed an aggregate of
$54.3 million to the increase. Also contributing to this increase were increased
costs of $43.6 million primarily related to expansion of selling, customer
support and administration activities to support our growth.

     Depreciation and amortization expenses increased from $8.5 million for the
year ended December 31, 1996 to $33.3 million for the year ended December 31,
1997, representing an increase of $24.8 million or 292%.  The increase was
primarily due to $14.3 million related to the acquisitions of Ruffalo Cody,
TelecomUSA Publishing, Digital Communications, ESI Communications and CCI, and
$3.8 million due primarily to the growth of our network in 1997.

     Other operating expenses in 1997 represented the realization of a purchase
accounting adjustment related to the capitalization of costs associated with
TelecomUSA Publishing and CCI directories in progress at the time of the
acquisitions.

     Interest income increased from $6 million for the year ended December 31,
1996 to $22.7 million for the year ended December 31, 1997.  This increase
resulted from increased earnings on investments made with a portion of the
proceeds from our offerings of Class A common stock in June and November 1996
and from our private offerings of 10 1/2% senior discount notes and 9 1/4%
senior notes in March 1997 and July 1997, respectively.

     Gross interest expense increased from $869,000 for the year ended 
December 31, 1996 to $39.0 million for the year ended December 31, 1997. This
increase was primarily a result of accretion of

                                       39
<PAGE>
 
interest on the 10 1/2% senior discount notes of $26.8 million and accrual of
interest on the 9 1/4% senior notes of $9.5 million. Interest expense of
approximately $4.4 million and $204,000 was capitalized as part of our
construction of fiber optic network during the years ended December 31, 1997 
and 1996, respectively.

     Net loss increased from $22.3 million for the year ended December 31, 
1996 to $79.9 million for the year ended December 31, 1997, an increase of 
$57.6 million. This increase resulted primarily from the following three
factors:

     .    the construction and expansion of our communications network which
          require significant expenditures, a substantial portion of which is
          incurred before the realization of revenues

     .    the increased depreciation expense related to those networks and
          amortization of intangibles related to acquisitions 

     .    net interest expense on indebtedness to fund market expansion, network
          development and acquisitions

     Operating loss before depreciation, amortization and other non-recurring
operating expenses increased from a negative $17.3 million for the year ended
December 31, 1996 to a negative $31.5 million for the year ended December 31,
1997, an increase of $14.2 million.  The change reflected the increase in the
operating loss incurred in 1997 due primarily to the expansion of our local,
long distance and other communications services as described above.

Year Ended 1996 Compared with Year Ended 1995

     Revenue increased from $29 million for the year ended December 31, 1995 to
$81.3 million for the year ended December 31, 1996, representing an increase of
$52.3 million or 180%.  Revenue from the sale of local and long distance
communications services accounted for $19.9 million of this increase.  Included
in the year ended December 31, 1996 revenue was $8.6 million of revenue from
Ruffalo Cody, which was acquired on July 15, 1996, and $15.1 million in revenue
from TelecomUSA Publishing, which was acquired on September 20, 1996.  Excluding
these acquisitions, 1996 revenue would have been $57.6 million.

     Cost of service increased from $19.7 million for the year ended 
December 31, 1995 to $52.6 million for the year ended December 31, 1996, an
increase of $32.9 million or 168%. This increase in cost of service was due
primarily to the growth in our local and long distance communications services
and to the acquisitions of Ruffalo Cody and TelecomUSA Publishing, which
contributed $4.5 million and $6.7 million, respectively, to the increase. Cost
of service as a percentage of revenue decreased from 68% to 65%, primarily as a
result of the effect of these acquisitions. The cost of providing local and long
distance services as a percentage of local and long distance communications
revenue increased from 68% for the year ended December 31, 1995 to 70% for the
year ended December 31, 1996, primarily as a result of an increased number of
higher volume, price-sensitive customers and increased local line costs
associated with expansion into new markets.

     SG&A increased from $18.1 million for the year ended December 31, 1995 to
$46 million for the year ended December 31, 1996, an increase of $27.9 million
or 155%.  The acquisitions of Ruffalo Cody and TelecomUSA Publishing contributed
$3.3 million and $7.3 million, respectively, to the increase.  Increased costs
of $17.3 million related to expansion of selling, customer support and
administration activities to support our growth also contributed to this
increase.

     Depreciation and amortization expenses increased from $1.8 million for the
year ended December 31, 1995 to $8.5 million for the year ended December 31,
1996, an increase of $6.7 million or 362%.  This increase consisted of 
$2.1 million related to the acquisitions of Ruffalo Cody and TelecomUSA
Publishing; amortization expense of $2 million related to the excess of
estimated aggregate fair market value of options over the aggregate exercise
price of such options granted to some of our officers, other employees, and
directors; and $2.6 million due primarily to the growth of our network in 1996.

                                       40
<PAGE>
 
     Other operating expense in 1996 represented the realization of a purchase
accounting adjustment related to the capitalization of costs associated with
directories in progress at the time we acquired TelecomUSA Publishing.

     We had net interest income of $5.4 million for the year ended December 31,
1996 compared to net interest expense of $771,000 for the year ended 
December 31, 1995 as a result of earnings on investments made with a portion of
the proceeds of our public offerings of Class A common stock during 1996 and
decreased interest expense on reduced borrowings as a result of our repayment of
all amounts outstanding under a bank credit facility maintained by McLeodUSA
from May 1994 until June 1996 with a portion of the net proceeds from our
initial public offering of Class A common stock. We also had other non-operating
income of $495,000 for the year ended December 31, 1996.

     Net loss increased from $11.3 million for the year ended December 31, 
1995 to $22.3 million for the year ended December 31, 1996, an increase of 
$11 million. This increase resulted primarily from the expansion of the local
and long distance businesses, amortization and other operating expenses related
to the acquisitions of Ruffalo Cody and TelecomUSA Publishing and amortization
expense related to stock options granted to some of our officers, other
employees and directors. The development of our business and the construction
and expansion of our communications network require significant expenditures, a
substantial portion of which is incurred before the realization of revenues.

     Operating loss before depreciation, amortization and other non-recurring
operating expenses increased from a negative $8.7 million for the year ended
December 31, 1995 to a negative $17.3 million for the year ended December 31,
1996, an increase of $8.6 million.  The change reflected the increase in the
operating loss incurred in 1996 due primarily to the expansion of our local,
long distance and other communications services and the factors described above.

Liquidity and Capital Resources

     Our total assets increased from $1.3 billion at December 31, 1997 to $1.9
billion at December 31, 1998, primarily due to the net proceeds of approximately
$583.8 million from our private offerings of 8 3/8% senior notes and 9 1/2%
senior notes in March 1998 and October 1998, respectively. At December 31, 1998,
our current assets of $793.2 million exceeded our current liabilities of $180.0
million, providing working capital of $613.2 million, which represents an
increase of $234.6 million compared to December 31, 1997, primarily attributable
to the net proceeds from our private offerings of 8 3/8% senior notes and 9 1/2%
senior notes. At December 31, 1997, our current assets of $517.9 million
exceeded current liabilities of $139.3 million, providing working capital of
$378.6 million.

     Net cash used in operating activities totaled $22.5 million for the year
ended December 31, 1998 and $8.8 million for the year ended December 31, 1997.
During the year ended December 31, 1998, cash for operating activities was used
primarily to fund our net loss of $124.9 million for such period.  As a result
of the expansion of our local and long distance communications services, we also
required cash to fund:

     .    growth in trade receivables of $6.4 million

     .    growth in inventory of $8.2 million

     .    prepaid and other expenses of $34.3 million

     .    deferred line installation costs of $13.6 million

These amounts were partially offset by:

     .    increases in accounts payable and accrued expenses of $32.2 million

     .    increases in deferred revenue of $4.6 million

     .    increases in customer deposits of $4.1 million

     .    cumulative non-cash expenses of $123.2 million

     During the year ended December 31, 1997, cash for operating activities was
used primarily to fund our net loss of $79.9 million for such period.  We also
required cash to fund the growth in accounts receivable and deferred line
installation costs of $15.9 million and $9.7 million, respectively, offset by

                                       41
<PAGE>
 
increases in accounts payable and accrued expenses of $27.1 million, deferred
revenues of $7.2 million, customer deposits of $3 million and cumulative non-
cash expenses of $60 million.

     Net cash used in investing activities totaled $424.0 million during the
year ended December 31, 1998 and $242.8 million during the year ended 
December 31, 1997. The expansion of our local and long distance communications
services, development and construction of our fiber optic communications
networks and other capital expenditures resulted in purchases of equipment and
fiber optic cable and other property and equipment totaling $289.9 million and
$151.3 million during the years ended December 31, 1998 and 1997, respectively.
We also used cash of $607.4 million to acquire available-for-sale securities
during the year ended December 31, 1998, offset by proceeds from sales and
maturities of available-for-sale securities of $506.4 million during the period.
During the year ended December 31, 1997, the cash used in investing activities
was partially offset by net proceeds of $120.2 million from the sales and
maturities of available-for-sale securities.

     During the year ended December 31, 1998, we used an aggregate of 
$27.8 million cash to acquire:


     .    directories from F.D.S.D. Rapid City Directories, Inc. in March 1998

     .    directories from Bi-Rite Directories, Inc. in March 1998

     .    directories from Smart Pages, Inc. and Yellow Pages Publishers, Inc.
          in April 1998

     .    directories from ADCO Publishing Co., Inc. in September 1998

     .    directories from River Directories, Inc. in November 1998

     .    directories from Mo-Ark Directories, Inc. in December 1998

     .    the capital stock of NewCom in April 1998

     .    the assets of CCC in June 1998

     .    the capital stock of QST in August 1998

     .    the assets of Inlet in November 1998

     During the year ended December 31, 1997, we used an aggregate of $181.9
million cash to acquire:

     .    the assets of ESI Communications in June 1997

     .    directories from Fronteer Financial Holdings, Inc. in February 1997

     .    directories from Indiana Directories, Inc. in March 1997

     .    directories from Smart Pages, Inc. and Yellow Pages Publishers, Inc.
          in September 1997

     .    the capital stock of CCI in September 1997


     In 1997, the FCC awarded us 26 "D" and "E" block frequency PCS licenses and
in September 1997 we acquired CCI and its "E" block frequency PCS license,
giving us a total of 27 PCS licenses in 25 markets covering areas of Iowa,
Illinois, Minnesota, Nebraska and South Dakota.  During 1996 and 1997, we paid
an aggregate of approximately $32.8 million for the 26 PCS licenses awarded to
us by the FCC.

     Net cash received from financing activities was $569.6 million during the
year ended December 31, 1998, primarily as a result of our private offerings of
8 3/8% senior notes in March 1998 and 9 1/2% senior notes in October 1998. Net
cash received from financing activities during the year ended December 31, 1997
was $487 million and was primarily obtained from our private offerings of 10
1/2% senior discount notes in March 1997 and 9 1/4% senior notes in July 1997.

     1998 Financings. On March 16, 1998, we completed a private offering of $300
million aggregate principal amount of our 8 3/8% senior notes in which we
received net proceeds of approximately $291.9 million. Interest on the 8 3/8%
senior notes accrues at the rate of 8 3/8% per annum and is payable in cash 
semi-annually in arrears on March 15 and September 15, starting September 15, 
1998. The 8 3/8% senior notes are redeemable at our option, in whole or in 
part, at any time on or after March 15, 2003 at 104.188% of their principal 
amount at maturity, plus accrued and unpaid interest, declining to 100.000% of
their principal amount at maturity, plus accrued and unpaid interest, on or 
after March 15, 2006. In the event of specified equity investments in McLeodUSA
by specified strategic investors on or before March 15, 2001, we may, at our
option, use all or a portion of the net proceeds from such sale to redeem up to
33 1/3% of the
                                       42
<PAGE>
 
original principal amount of the 8 3/8% senior notes at a redemption price equal
to 108.375% of their principal amount plus accrued and unpaid interest, if any,
to but excluding the redemption date, provided that at least 66 2/3% of the
original principal amount of the 8 3/8% senior notes would remain outstanding
immediately after giving effect to such redemption. In addition, in the event of
a "Change of Control" (as defined in the indenture governing the 8 3/8% senior
notes) of McLeodUSA, each holder of 8 3/8% senior notes will have the right to
require us to repurchase all or any part of such holder's 8 3/8% senior notes at
a purchase price equal to 101% of the principal amount of the 8 3/8% senior
notes tendered by such holder plus accrued and unpaid interest, if any, to any
"Change of Control Payment Date" (as defined in the indenture governing the 8
3/8% senior notes). The 8 3/8% senior notes will mature on March 15, 2008.

     On October 30, 1998, we completed a private offering of $300 million
aggregate principal amount of our 9 1/2% senior notes in which we received net
proceeds of approximately $291.9 million. Interest on the 9 1/2% senior notes
accrues at the rate of 9 1/2% per annum and is payable in cash semi-annually in
arrears on November 1 and May 1, starting May 1, 1999. The 9 1/2% senior notes
are redeemable at our option, in whole or in part, at any time on or after
November 1, 2003 at 106.75% of their principal amount at maturity, plus accrued
and unpaid interest, declining to 100.000% of their principal amount at
maturity, plus accrued and unpaid interest, on or after November 1, 2008. In the
event of specified equity investments in McLeodUSA by specified strategic
investors on or before November 1, 2001, we may, at our option, use all or a
portion of the net proceeds from such sale to redeem up to 33 1/3% of the
original principal amount of the 9 1/2% senior notes at a redemption price equal
to 111.5% of their principal amount plus accrued and unpaid interest, if any, to
but excluding the redemption date, provided that at least 66 2/3% of the
original principal amount of the 9 1/2% senior notes would remain outstanding
immediately after giving effect to such redemption. In addition, in the event of
a "Change of Control" (as defined in the indenture governing the 9 1/2% senior
notes) of McLeodUSA, each holder of 9 1/2% senior notes will have the right to
require us to repurchase all or any part of such holder's 9 1/2% senior notes at
a purchase price equal to 101% of the principal amount of the 9 1/2% senior
notes tendered by such holder plus accrued and unpaid interest, if any, to any
"Change of Control Payment Date" (as defined in the indenture governing the 9
1/2% senior notes). The 9 1/2% senior notes will mature on November 1, 2008.

     1997 Financings. On March 4, 1997, we completed a private offering of $500
million aggregate principal amount at maturity of our 10 1/2% senior discount
notes. The 10 1/2% senior discount notes were issued with an original issue
discount in which we received approximately $288.9 million in net proceeds. The
10 1/2% senior discount notes accrete from March 4, 1997 at a rate of 10 1/2%
per year, compounded semi-annually to an aggregate principal amount of $500
million by March 1, 2002. As of December 31, 1998, the accreted balance of the
10 1/2% senior discount notes was $361.9 million. Interest will not accrue on
the 10 1/2% senior discount notes before March 1, 2002. Thereafter, interest
will accrue at a rate of 10 1/2% per annum and will be payable in cash semi-
annually in arrears on March 1 and September 1 of each year, starting September
1, 2002. The 10 1/2% senior discount notes are redeemable, at our option, in
whole or in part, at any time on or after March 1, 2002, at 105.25% of their
principal amount at maturity, plus accrued and unpaid interest, declining to
100% of their principal amount at maturity, plus accrued and unpaid interest, on
or after March 1, 2005. In the event of specified equity investments in
McLeodUSA by specified strategic investors on or before March 1, 2000, we may,
at our option, use all or a portion of the net proceeds therefrom to redeem up
to a maximum of 33 1/3% of the original principal amount of the 10 1/2% senior
discount notes at a redemption price of 110.5% of their accreted value, provided
that at least 66 2/3% of the original principal amount of the 10 1/2% senior
discount notes would remain outstanding after giving effect to such redemption.
In addition, in the event of a "Change of Control" (as defined in the indenture
governing the 10 1/2% senior discount notes) of McLeodUSA, each holder of 10
1/2% senior discount notes will have the right to require us to repurchase all
or any part of such holder's 10 1/2% senior discount notes at a purchase price
equal to 101% of the accreted value thereof prior to March 1, 2002, or 101% of
the principal amount thereof plus accrued and unpaid interest, if any, on or
after March 1, 2002. The 10 1/2% senior discount notes will mature on March 1,
2007.

     On July 21, 1997, we completed a private offering of $225 million aggregate
principal amount of our 9 1/4% senior notes in which we received net proceeds of
approximately $217.6 million.  Interest on the 9 1/4% senior notes accrues at
the rate of 9 1/4% per annum and is payable in cash semi-annually in arrears on
July 15 and January 15, starting January 15, 1998.  The 9 1/4% senior notes are
redeemable at our option, in whole or in part, at any time on or after July 15,
2002 at 104.625% of their principal amount at 

                                       43
<PAGE>
 
maturity, plus accrued and unpaid interest, declining to 100.000% of their
principal amount at maturity, plus accrued and unpaid interest, on or after July
15, 2005. In the event of specified equity investments in McLeodUSA by specified
strategic investors on or before July 15, 2000, we may, at our option, use all
or a portion of the net proceeds from such sale to redeem up to 33 1/3% of the
original principal amount of the 9 1/4% senior notes at a redemption price equal
to 109.25% of their principal amount plus accrued and unpaid interest, if any,
to but excluding the redemption date, provided that at least 66 2/3% of the
original principal amount of the 9 1/4% senior notes would remain outstanding
immediately after giving effect to such redemption. In addition, in the event of
a "Change of Control" (as defined in the indenture governing the 9 1/4% senior
notes) of McLeodUSA, each holder of 9 1/4% senior notes will have the right to
require us to repurchase all or any part of such holder's 9 1/4% senior notes at
a purchase price equal to 101% of the principal amount of the 9 1/4% senior
notes tendered by such holder plus accrued and unpaid interest, if any, to any
"Change of Control Payment Date" (as defined in the indenture governing the 9
1/4% senior notes). The 9 1/4% senior notes will mature on July 15, 2007.

     Recent Events.  On February 10, 1999, we acquired Talking Directories for
an aggregate of 2,556,390 shares of our Class A common stock.  In a related and
concurrent transaction, on February 10, 1999, we also acquired Info America for
an aggregate of 1,203,007 shares of our Class A common stock.  We paid
approximately $27 million of the outstanding obligations of Talking Directories
and Info America at the time of these transactions.

     On March 5, 1999, we acquired Dakota Telecommunications for an aggregate of
1,375,000 shares of our Class A common stock and the assumption of $31 million
in debt.

     On January 7, 1999, we entered into the Ovation merger agreement with
Ovation and several stockholders of Ovation to acquire Ovation, subject to
several conditions, for an amount of cash and a number of shares of Class A
common stock to be determined immediately prior to consummation of the
transaction.  We estimate that we will be required to issue approximately 
5.1 million shares of our Class A common stock and to pay approximately 
$141 million cash to effect the Ovation merger. We will also assume
approximately $95 million in Ovation debt. Consummation of the Ovation merger is
subject to the satisfaction of several conditions, including receipt of
specified regulatory approvals and other customary conditions. We cannot assure
you that the Ovation merger will be consummated.

     On February 22, 1999, we completed a private offering of $500 million 
aggregate principal amount of our 8 1/8% senior notes in which we received net
proceeds of approximately $487.8 million. Interest on the 8 1/8% senior notes 
accrues at the rate of 8 1/8% per annum and is payable in cash semi-annually 
in arrears on February 15 and August 15, starting August 15, 1999. The 8 1/8% 
senior notes are redeemable at our option, in whole or in part, at any time on
or after February 15, 2004 at 104.063% of their principal amount at maturity, 
plus accrued and unpaid interest, declining to 100.000% of their principal 
amount at maturity,plus accrued and unpaid interest, on or after February 15, 
2007. In the event of specified equity investments in McLeodUSA by specified 
strategic investors on or before February 15, 2002, we may, at our option, use
all or a portion of the net proceeds from such sale to redeem up to 33 1/3% of
the original principal amount of the 8 1/8% senior notes at a redemption price
equal to 108.125% of their principal amount plus accrued and unpaid interest,
if any, to but excluding the redemption date, provided that at least 66 2/3% 
of the original principal amount of the 8 1/8% senior notes would remain 
outstanding immediately after giving effect to such redemption. In addition, 
in the event of a "Change of Control" (as defined in the indenture governing 
the 8 1/8% senior notes) of McLeodUSA, each holder of 8 1/8% senior notes will
have the right to require us to repurchase all or any part of such holder's 
8 1/8% senior notes at a purchase price equal to 101% of the principal amount
of the 8 1/8% senior notes tendered by such holder plus accrued and unpaid 
interest, if any, to any "Change of Control Payment Date" (as defined in the 
indenture governing the 8 1/8% senior notes). The 8 1/8% senior notes will 
mature on February 15, 2009.

     Our 10 1/2% senior discount notes, 9 1/4% senior notes, 8 3/8% senior
notes, 9 1/2% senior notes and 8 1/8% senior notes are senior unsecured
obligations of McLeodUSA ranking pari passu in right of payment with all other
existing and future senior unsecured obligations of McLeodUSA and senior to all
existing and future subordinated debt of McLeodUSA. The 10 1/2% senior discount
notes, 9 1/4% senior notes, 8 3/8% senior notes, 9 1/2% senior notes and 8 1/8%
senior notes are effectively subordinated to all existing and future secured
indebtedness of McLeodUSA and our subsidiaries to the extent of the value of the
assets

                                       44
<PAGE>
 
securing such indebtedness. The 10 1/2% senior discount notes, 9 1/4% senior
notes, 8 3/8% senior notes, 9 1/2% senior notes and 8 1/8% senior notes also are
effectively subordinated to all existing and future third-party indebtedness and
other liabilities of our subsidiaries.

     The indentures governing our 10 1/2% senior discount notes, 9 1/4% senior
notes, 8 3/8% senior notes, 9 1/2% senior notes and 8 1/8% senior notes impose
operating and financial restrictions on us and our subsidiaries. These
restrictions affect, and in many cases significantly limit or prohibit, among
other things, our and our subsidiaries' ability to:

     .    incur additional indebtedness

     .    pay dividends or make distributions in respect of our or our
          subsidiaries' capital stock

     .    redeem capital stock

     .    make other restricted payments

     .    enter into sale and leaseback transactions

     .    create liens upon assets

     .    enter into transactions with affiliates or related persons

     .    sell assets

     .    consolidate, merge or sell all or substantially all of our assets

We cannot assure you that such covenants will not adversely affect our ability
to finance our future operations or capital needs or to engage in other business
activities that may be in our interests.

     We need significant capital to continue to expand our operations,
facilities, network and services.  We cannot assure you that our capital
resources will permit us to fund our planned network deployment and operations
or achieve operating profitability.  Failure to generate or raise sufficient
funds may require us to delay or abandon some of our expansion plans or
expenditures, which could have a material adverse effect on our business,
results of operations or financial condition.

     As of December 31, 1998, based on our business plan, capital requirements
and growth projections as of that date, we estimated that we would require
approximately $1.4 billion through 2001.  Our estimated aggregate capital
requirements include the projected costs of:


     .    building our fiber optic communications network, including intra-city
          fiber optic communications networks

     .    expanding operations in existing and new markets

     .    developing wireless services

     .    funding general corporate expenses

     .    completing recent and pending acquisitions

     .    constructing, acquiring, developing or improving telecommunications
          assets

     The estimated costs and incremental capital needs associated with the
acquisitions of Talking Directories, Info America, Dakota Telecommunications and
Ovation are included in our estimated aggregate capital requirements.


     We expect to use the following to address our capital needs:

     .    approximately $487.8 million in net proceeds from our offering of 8 
          1/8% senior notes

     .    approximately $591.7 million of cash and investments on hand at
          December 31, 1998

     .    additional issuances of debt or equity securities

     .    projected operating cash flow

                                       45
<PAGE>
 
     Our estimate of future capital requirements is a forward-looking statement
within the meaning of the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995.  The actual amount and timing of our future
capital requirements may differ substantially from our estimate due to factors
such as:

     .    strategic acquisition costs and effects of acquisitions on our
          business plan, capital requirements and growth projections

     .    unforeseen delays

     .    cost overruns

     .    engineering design changes

     .    changes in demand for our services

     .    regulatory, technological or competitive developments

     .    new opportunities


     We also expect to evaluate potential acquisitions, joint ventures and
strategic alliances on an ongoing basis.  We may require additional financing if
we pursue any of these opportunities.  Accordingly, we may need additional
capital to continue to expand our markets, operations, facilities, network and
services.

     We may meet any additional capital needs by issuing additional debt or
equity securities or borrowing funds from one or more lenders.  We cannot assure
you that we will have timely access to additional financing sources on
acceptable terms.

     We have received a non-binding commitment from The Chase Manhattan Bank to
lead a syndication to provide a senior secured revolving credit facility.  We
cannot assure you, however, that we will be successful in obtaining such credit
facility on acceptable terms or at all.

     Failure to generate or raise sufficient funds may require us to delay or
abandon some of our expansion plans or expenditures, which could have a material
adverse effect on our business, results of operations or financial condition.
See "Business--Risk Factors--Failure to Raise Necessary Capital Could Restrict
Our Ability to Develop Our Network and Services and Engage in Strategic
Acquisitions."

Market Risk

     At December 31, 1998, we recorded the marketable equity securities that we
hold at a fair value of $30.6 million.  These securities have exposure to price
risk.  A hypothetical ten percent adverse change in quoted market prices would
amount to a decrease in the recorded value of investments of approximately 
$3 million. We believe our exposure to market price fluctuations on all other
investments is nominal due to the short-term nature of our investment portfolio.

     We have no material future earnings or cash flow exposures from changes in
interest rates on our long-term debt obligations, as substantially all of our
long-term debt obligations are fixed rate obligations.

Year 2000 Date Conversion

     We are currently verifying system readiness for the processing of date-
sensitive information by our computerized information systems. The Year 2000
problem impacts computer programs and hardware timers using two digits (rather
than four) to define the applicable year. Some of our programs and timers that
have time-sensitive functions may recognize a date using "00" as the year 1900
rather than 2000, which could result in miscalculations or system failures.

     We are reviewing our IT and non-IT computer systems and programs to
determine which are not capable of recognizing the Year 2000 and to verify
system readiness for the millennium date. The review covers all of our
operations and is centrally managed.  The review includes:

     1.   increasing employee awareness and communication of Year 2000 issues

                                       46
<PAGE>
 
     2.   inventorying hardware, software and data interfaces and confirming
          Year 2000 readiness of key vendors

     3.   identifying mission-critical components for internal systems, vendor
          relations and other third parties

     4.   estimating costs for remediation

     5.   estimating completion dates

     6.   testing and verifying systems

     7.   remediating any identified problems by correcting or replacing systems
          or components

     8.   implementing the remediation plan

     9.   developing contingency plans

     10.  training for contingency plans

     We have completed more than 95% of the activities required for the first
three of these steps, more than 75% of the activities required for the fourth
and fifth steps, more than 30% of the activities required for the sixth and
seventh steps and more than 20% of the activities required for the eighth step.
We are in the initial stages of performing the activities required to complete
the remaining steps and have begun to develop contingency plans to handle our
most reasonably likely worst case Year 2000 scenarios.  The completion
percentages do not include information for pending or recently completed
acquisitions.  The review and related Year 2000 activities have not caused us to
defer or forego, to any material degree, any other critical IT project.

     We estimate that our Year 2000 readiness costs will not exceed 
$11.5 million. We generally expense these costs as incurred. As of February 28,
1999, we had incurred costs of $2.3 million in connection with our Year 2000
readiness activities.

     Our estimate of our Year 2000 readiness costs is a forward-looking
statement within the meaning of the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. Costs, results, performance and
effects of Year 2000 activities described in those forward-looking statements
may differ materially from actual costs, results, performance and effects in the
future due to the interrelationship and interdependence of our computer systems
and those of our vendors, material service providers, customers and other third
parties.

     We have not yet fully identified our most reasonably likely worst case Year
2000 scenarios. We continue to contact our vendors, suppliers and third parties
with which we have material relationships, regarding their state of readiness.
This activity is focused primarily on mission critical systems and key business
suppliers.  U S WEST, Ameritech and Southwestern Bell are our primary suppliers
of local central office switching and local lines.  Until we have received and
analyzed substantial responses from them we will have difficulty determining our
worst case scenarios.

     We have begun to develop contingency plans to handle worst case scenarios,
to the extent they can be identified fully. We intend to complete our
contingency planning after completing our determination of worst case scenarios.
Completion of these activities depends upon the responses to the inquiries we
have made of our major vendors, material service providers and third parties
with which we have material relationships. We have also begun work on
contingency plans for some systems identified as critical to our operations.

     If we, our major vendors, our material service providers or our customers
fail to address Year 2000 issues in a timely manner, such failure could have a
material adverse effect on our business, results of operations and financial
condition. We depend on local exchange carriers, primarily the regional Bell
operating companies, to provide most of our local and some of our long distance
services. To the extent U S WEST, Ameritech or Southwestern Bell fail to address
Year 2000 issues which might interfere with their ability to fulfill their
obligations to us, such interference could have a material adverse effect on our
future operations.  If other telecommunications carriers are unable to resolve
Year 2000 issues, it is likely that we will be affected to a similar degree as
others in the telecommunications industry.

                                       47
<PAGE>
 
Effects of New Accounting Standards

     In March 1998, the American Institute of Certified Public Accountants
issued Statement of Position 98-1, Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use.  This statement provides guidance on
accounting for the costs of computer software developed or obtained for internal
use and is required to be adopted no later than our 1999 fiscal year.  We plan
to modify our method of capitalization of such costs by adopting this statement
prospectively on January 1, 1999.  We are currently evaluating this statement
but do not expect it to have a material impact on our financial condition or
results of operations.

     In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities" 
("SFAS 133"). SFAS 133 establishes accounting and reporting standards requiring
that every derivative instrument (including derivative instruments embedded in
other contracts) be recorded in the balance sheet as either an asset or
liability measured at its fair value. SFAS 133 requires that changes in the
derivative's fair value be recognized currently in earnings unless specific
hedge accounting criteria are met. Special accounting for qualifying hedges
allows a derivative's gains and losses to offset related results on the hedged
item in the income statement, and requires that a company must formally
document, designate and assess the effectiveness of transactions that receive
hedge accounting.

     SFAS 133 is effective for fiscal years beginning after June 15, 1999.  A
company may also implement SFAS 133 as of the beginning of any fiscal quarter
after issuance (that is, fiscal quarters beginning June 16, 1998 and
thereafter).  SFAS 133 cannot be applied retroactively.  SFAS 133 must be
applied to (a) derivative instruments and (b) derivative instruments embedded in
hybrid contracts that were issued, acquired or substantively modified after
December 31, 1997 (and, at the company's election, before January 1, 1998).

     We do not expect the impact of the adoption of SFAS 133 to be material to
our results of operations as we do not currently hold any derivative instruments
or engage in hedging activities.

Inflation

     We do not believe that inflation has had a significant impact on our
consolidated operations.

Item 7A.  Quantitative and Qualitative Disclosures About Market Risk.

     At December 31, 1998, we recorded the marketable equity securities that we
hold at a fair value of $30.6 million.  These securities have exposure to price
risk.  A hypothetical ten percent adverse change in quoted market prices would
amount to a decrease in the recorded value of investments of approximately 
$3 million. We believe our exposure to market price fluctuations on all other
investments is nominal due to the short-term nature of our investment portfolio.

     We have no material future earnings or cash flow exposures from changes in
interest rates on our long-term debt obligations, as substantially all of our
long-term debt obligations are fixed rate obligations.

Item 8.  Financial Statements and Supplementary Data.

     Our consolidated financial statements, including our consolidated balance
sheets as of December 31, 1998 and 1997, consolidated statements of operations
for the years ended December 31, 1998, 1997 and 1996, consolidated statements of
stockholders' equity for the years ended December 31, 1998, 1997 and 1996,
consolidated statements of cash flows for the years ended December 31, 1998,
1997 and 1996, and notes to our consolidated financial statements, together with
a report thereon of Arthur Andersen LLP, dated January 27, 1999, are attached
hereto as pages F-2 through F-31.

Item 9.  Changes in and Disagreements with Accountants on Accounting and
         Financial Disclosure.

     On March 27, 1997, we engaged the accounting firm of Arthur Andersen LLP as
our principal independent accountants, to replace McGladrey & Pullen, LLP, our
former independent accountants, 

                                       48
<PAGE>
 
effective with such engagement. The decision to change independent accountants
was made following a review of competitive proposals submitted by Arthur
Andersen LLP and two other major public accounting firms, and was recommended by
the audit committee of our board of directors and approved by our board of
directors. McGladrey & Pullen, LLP did not resign and did not decline to stand
for re-election.

     During the fiscal years ended December 31, 1996 and 1995, and the interim
period between December 31, 1996 and March 27, 1997, there were no disagreements
with McGladrey & Pullen, LLP on any matter of accounting principles or
practices, financial statement disclosure, or auditing scope or procedure which
would have caused McGladrey & Pullen, LLP to make reference in their report to
such disagreements if not resolved to their satisfaction.

     McGladrey & Pullen, LLP's reports on the financial statements of McLeodUSA
for the fiscal years ended December 31, 1996 and 1995 contained no adverse
opinion or disclaimer of opinion and were not qualified or modified as to
uncertainty, audit scope or accounting principles.

     We provided McGladrey & Pullen, LLP with a copy of this disclosure and
requested that McGladrey & Pullen, LLP furnish us with a letter addressed to the
Securities and Exchange Commission stating whether it agrees with the above
statements. (A copy of the McGladrey & Pullen, LLP letter addressed to the SEC
is filed as Exhibit 16.1 to this Form 10-K).

                                       49
<PAGE>
 
                                    PART III

Item 10.  Directors and Executive Officers of the Registrant.

Our Directors and Executive Officers

     The following is a list of our directors and executive officers as of
December 31, 1998.  Our board of directors currently consists of nine directors,
divided into three classes serving staggered three-year terms, with one-third
elected at each annual stockholders meeting.  Our executive officers generally
are appointed for one-year terms by our board of directors at their first
meeting after our annual stockholders meeting.  Our directors and executive
officers serve until their terms expire and their successors are elected and
qualified, or until they resign or are removed or disqualified to serve.  The
ages of the persons set forth below are as of December 31, 1998.

<TABLE>
<CAPTION>
                                                                                                        Term as
             Name               Age                    Position(s) with Company                     Director Expires
------------------------------  ---  -------------------------------------------------------------  ----------------
<S>                             <C>  <C>                                                            <C>
Clark E. McLeod...............   52  Chairman, Chief Executive Officer and Director                        2000
Richard A. Lumpkin............   63  Vice Chairman and Director                                            2001
Stephen C. Gray...............   40  President, Chief Operating Officer and Director                       1999
Blake O. Fisher, Jr...........   54  Group Vice President, Regional President--Iowa and Minnesota          2000
                                     and Director                                                         
J. Lyle Patrick...............   46  Group Vice President--Finance and Accounting and Chief               
                                     Financial and Accounting Officer                                     
Arthur L. Christoffersen......   52  Group Vice President--Publishing Services                            
Kirk E. Kaalberg..............   39  Group Vice President--Network Services                               
Stephen K. Brandenburg........   46  Group Vice President--Intelligent Technologies and Systems           
                                     and Chief Information Officer                                        
David M. Boatner..............   50  Group Vice President and Regional President--Colorado,               
                                     Wyoming, North Dakota and South Dakota                               
Albert P. Ruffalo.............   52  Group Vice President--Human Resources, Training and Direct           
                                     Marketing                                                            
Dennis L. Erickson............   52  Group Vice President and Regional President--Indiana,                
                                     Illinois and Wisconsin                                               
Steven J. Shirar..............   40  Group Vice President and Regional President--Missouri                
Michael J. Brown..............   41  Group Vice President--Customer Support                               
Randall Rings.................   36  Vice President, General Counsel and Secretary                        
Thomas M. Collins(1)(2).......   71  Director                                                              2001
Robert J. Currey..............   53  Director                                                              1999
Lee Liu(2)....................   65  Director                                                              2000
Paul D. Rhines(2).............   55  Director                                                              1999
Ronald W. Stepien(1)..........   52  Director                                                              2001
</TABLE>

-------------------
(1) Member of the Audit Committee.
(2) Member of the Compensation Committee.

     Biographical summaries of the experience and principal occupations for the
past five years of each of our directors and executive officers are set out
below.

     Clark E. McLeod.   Mr. McLeod founded McLeodUSA and has served as Chairman,
Chief Executive Officer and a director since our inception in June 1991. His
previous business venture, Teleconnect Company, an Iowa-based long distance
telecommunications company, was founded in January 1980. Mr. McLeod served as
Chairman and Chief Executive Officer of Teleconnect from January 1980 to
December 1988, and from December 1988 to August 1990, he served as President of
TelecomUSA, Inc., the successor to Teleconnect following its merger with
SouthernNet, Inc. in December 1988. By 1990, TelecomUSA had become America's
fourth largest long distance telecommunications company with nearly 
6,000 employees. MCI purchased TelecomUSA in August 1990 for $1.25 billion.

     Richard A. Lumpkin.   Mr. Lumpkin has served as Vice Chairman and a
director since September 1997.  Mr. Lumpkin was elected as an officer and a
director based on requirements under the CCI merger 

                                       50
<PAGE>
 
agreement. Mr. Lumpkin served as Chairman and Chief Executive Officer of CCI
from 1990 to September 24, 1997, the date we acquired CCI. He continues to serve
as Chairman and Chief Executive Officer of ICTC, a post he has held since 1990.
From its formation in 1984 to 1990, Mr. Lumpkin served as President of CCI. From
1968 to 1990, Mr. Lumpkin held various executive positions at ICTC, including
Vice President of Operations and Treasurer. He is a director of Ameren
Corporation, an electric utility holding company, First Mid-Illinois Bancshares,
Inc., a bank holding company, and its wholly owned subsidiary First Mid-Illinois
Bank & Trust, a bank. Mr. Lumpkin served as a director of International Teledata
Corporation, an information technology company, until January 1999. Mr. Lumpkin
is Chairman of the Board of Illuminet Holdings, Inc., a telecommunications
company. See "Security Ownership of Certain Beneficial Owners and
Management--Investor Agreement and Stockholders' Agreements."

     Stephen C. Gray.   Mr. Gray has been Chief Operating Officer since
September 1992, President since October 1994 and a director since April 1993.
Mr. Gray is one of Mr. McLeod's nominees on our board of directors.  Before
joining us, Mr. Gray served from August 1990 to September 1992 as Vice President
of Business Services at MCI, where he was responsible for MCI's local access
strategy and for marketing and sales support of the Business Markets division.
From February 1988 to August 1990, he served as Senior Vice President of
National Accounts and Carrier Services for TelecomUSA, where his
responsibilities included sales, marketing, key contract negotiations and
strategic acquisitions and combinations. Before joining TelecomUSA, from
September 1986 to February 1988, Mr. Gray held a variety of management positions
with WilTel, Inc. and Clay Desta Communications, Inc., long-distance telephone
companies. See "Security Ownership of Certain Beneficial Owners and Management--
Investor Agreement and Stockholders' Agreements."

     Blake O. Fisher, Jr.   Mr. Fisher has served as a director since October
1996 and as Group Vice President and Regional President--Iowa and Minnesota
since September 1998.  Mr. Fisher is one of Mr. McLeod's nominees on our board
of directors.  Mr. Fisher served as Executive Vice President, Corporate
Administration and Chief Financial Officer from September 1996 through September
1998, as Chief Financial and Administrative Officer from October 1997 to
September 1998 and as Treasurer from February 1996 to September 1998.  
Mr. Fisher also served as one of Alliant Energy's nominees on our board of
directors from April 1993 to February 1996. He served as Executive Vice
President and Chief Financial Officer of IES Industries Inc., a diversified
electric utility holding company and predecessor to Alliant Energy, from January
1991 to February 1996. Mr. Fisher also served as President of IES Utilities
Inc., an electric utility, from February 1995 to February 1996. Before joining
IES, Mr. Fisher held a variety of management positions with Consumers Power
Company, an electric utility, including Vice President of Finance and Treasurer.
See "Security Ownership of Certain Beneficial Owners and Management--Investor
Agreement and Stockholders' Agreements."

     J. Lyle Patrick.   Mr. Patrick has served as Group Vice President Finance
and Chief Financial and Accounting Officer since September 1998. From September
1997 to September 1998, Mr. Patrick served as Executive Vice President
Accounting and Public Policy, with responsibility for financial, billing and
other administrative functions, as well as regulatory and legislative efforts.
From June 1988 until September 1997, Mr. Patrick was Vice President and Chief
Financial Officer of CCI. Mr. Patrick is a Certified Public Accountant and was a
partner with Arthur Andersen LLP prior to joining CCI.

     Arthur L. Christoffersen.   Mr. Christoffersen has served as Group Vice
President--Publishing Services since September 1998.  Mr. Christoffersen served
as Group President, Publishing Services from September 1997 to September 1998
and as Executive Vice President, Publishing Services from September 1996, the
date we acquired TelecomUSA Publishing, to September 1997. Mr. Christoffersen
served as Chairman, President and Chief Executive Officer of TelecomUSA
Publishing from November 1990, the date Mr. Christoffersen and other investors
acquired TelecomUSA Publishing from MCI, and has continued to serve in that
capacity following our acquisition of TelecomUSA Publishing in September 1996.
From December 1987 to August 1990, Mr. Christoffersen served as Executive Vice
President and Chief Financial Officer of Teleconnect and its successor,
TelecomUSA. From 1975 to 1987, Mr. Christoffersen held a variety of management
positions, including Executive Vice President, of Life Investors, Inc., a
diversified financial services company.

     Kirk E. Kaalberg.  Mr. Kaalberg has served since September 1998 as Group
Vice President--Network Services, responsible for the design and development of
our communications network and 

                                       51
<PAGE>
 
switching platforms and maintenance of the Iowa Communications Network. From
September 1996 to September 1998, Mr. Kaalberg served as Executive Vice
President, Network Services, from March 1994 to September 1996, he served as
Senior Vice President, Network Design and Development, and from January 1992 to
February 1994, he served as Vice President. From August 1990 to January 1992,
Mr. Kaalberg served as a senior manager of MCI, where he managed a 175-person
conference calling, financial and operations group. From August 1987 to August
1990, Mr. Kaalberg was an employee of Teleconnect and its successor, TelecomUSA,
where he was responsible for business planning and management information
systems project prioritization. From 1983 to 1987, he held a variety of product
management positions with Banks of Iowa, Computer Services, Inc., a computer
services company, and Source Data Systems, a software company.

     Stephen K. Brandenburg.   Mr. Brandenburg has served since September 1998
as Group Vice President--Intelligent Technologies and Systems and since
September 1996 as Chief Information Officer, where he is responsible for the
design and deployment of our internal computing systems and operations.  From
September 1996 to September 1998, Mr. Brandenburg served as Executive Vice
President and from June 1995 to September 1996, he served as Senior Vice
President, Intelligent Technologies and Systems.  Prior to joining McLeodUSA,
Mr. Brandenburg served from August 1990 to June 1995 as Vice President, Revenue
Management Systems at MCI, where he was responsible for MCI's 1,400 person
business markets traffic/call processing, order/entry, billing and calling card
operations. From 1987 to August 1990, he served as Senior Vice President of
Information Systems at Teleconnect and its successor, TelecomUSA. Prior to
joining Teleconnect, Mr. Brandenburg held a variety of information systems
positions with academic medical centers, including the Mayo Medical Clinic and
the University of Wisconsin.

     David M. Boatner.  Mr. Boatner has served since September 1998 as Group
Vice President and Regional President--Colorado, Wyoming, North Dakota and South
Dakota.  From September 1996 to September 1998, Mr. Boatner served as Executive
Vice President, Business Services and from February 1996 to September 1996, he
served as Senior Vice President, Sales and Marketing.  Prior to joining us, 
Mr. Boatner served from January 1995 to February 1996 as Regional Vice President
of Sales of WorldCom, a long distance telecommunications company, where he was
responsible for sales in the central, western and southwest regions of the
United States. From May 1989 to January 1995, Mr. Boatner served as Vice
President for Commercial Sales of WilTel, Inc., a long distance
telecommunications company which was acquired by WorldCom in January 1995.
Before joining WilTel, Inc., Mr. Boatner held a variety of positions at AT&T 
and its Bell operating subsidiaries.

     Albert P. Ruffalo.  Mr. Ruffalo has served as Group Vice President--Human
Resources, Training and Direct Marketing since January 1999.  He served as Group
Vice President--Direct Marketing from September 1998 to January 1999.  He served
as Executive Vice President, Consumer Services from September 1996 to September
1998.  From August 1991 to September 1998, Mr. Ruffalo served as President and
Chief Executive Officer of Ruffalo Cody, which we acquired on July 15, 1996.
From September 1990 to July 1991, Mr. Ruffalo served as President of a
subsidiary of MCI. From 1983 to August 1990, Mr. Ruffalo held various executive
positions at Teleconnect and TelecomUSA Data Base Marketing Company, an indirect
wholly owned subsidiary of TelecomUSA, Teleconnect's successor. From 1980 to
1983, Mr. Ruffalo was Marketing Manager of National Oats Corporation, a grain
distribution firm.

     Dennis L. Erickson.  Mr. Erickson has served as Group Vice President and
Regional President Illinois, Indiana and Wisconsin since September 1998 and as
President of ICTC since February 1998.  He served as Executive Vice President of
Integrated Business Systems from September 1997 to September 1998.  Before
September 1997, Mr. Erickson held a variety of senior management positions with
CCI, including President of Consolidated Communications Telecom Services from
February 1996 to February 1998; Vice President of Operations from November 1990
to February 1996; and Vice President of Human Resources from July 1990 to
November 1990.

     Steven J. Shirar.  Mr. Shirar has served as Group Vice President and
Regional President Missouri since September 1998. From September 1997 until
September 1998, Mr. Shirar served as Executive Vice President of
Telecommunications Marketing.  From August 1996 until September 1997, Mr. Shirar
was President of Consolidated Systems and Services, a billing services and
software development subsidiary 

                                       52
<PAGE>
 
of CCI. From September 1994 through August 1996, Mr. Shirar was Chief Operating
Officer of MedAdvantage, a managed health care company. From January 1992 until
August 1994, he was President of Ameritech Industrial Infosource, Inc., an
advertising services and publishing company. From January 1989 through December
1991, Mr. Shirar was responsible for corporate and market strategy development
for Ameritech, focused on the consumer and small business marketplace.

     Michael J. Brown.  Mr. Brown has served as Group Vice President Customer
Support since September 1998.  From February 1998 until September 1998,  
Mr. Brown served as Senior Vice President, Customer Support. He served as Senior
Vice President of Sales for Colorado, Minnesota, North Dakota and South Dakota
from August 1997 until February 1998. Before August 1997, Mr. Brown held a
variety of positions at McLeodUSA, including Director of Iowa Sales from January
1994 to September 1994; Vice President of Sales from September 1994 to July
1995; and Vice President, Telecommunications from July 1995 to March 1996. From
March 1996 to February 1998, Mr. Brown also served as Vice President of Sales
for several of our field sales regions. Before joining McLeodUSA, Mr. Brown was
Director for Iowa, Nebraska, and South Dakota in MCI's Business Services
division from 1990 to 1994.

     Randall Rings.  Mr. Rings has served as Vice President, Secretary and
General Counsel since March 9, 1998. From May 1996 to March 1998, he served as
General Counsel of McLeodUSA Publishing, where he was responsible for its legal,
legislative and regulatory affairs.  From 1992 to 1996, Mr. Rings served as an
Associate Attorney at March & McMillan, P.C., with a diverse legal practice
which included business planning, commercial litigation, employment and
environmental law, as well as representation of electric and telephone
cooperatives. From November 1988 to June 1992, he served as Corporate Counsel to
the Association of Illinois Electric Cooperatives, where he acted as its chief
legal officer and advised electric and telephone cooperatives throughout
Illinois on corporate, tax, employment and other legal matters.

     Thomas M. Collins.   Mr. Collins has served as a director since April 1993.
Mr. Collins is Of Counsel at Shuttleworth & Ingersoll, P.C., a law firm in Cedar
Rapids, Iowa, where he has practiced law since 1952. Mr. Collins was a director
of Teleconnect and its successor, TelecomUSA, from 1985 to August 1990.  He is
also a director of APAC TeleServices, Inc., a telemarketing company.

     Robert J. Currey.   Mr. Currey has served as a director since September
1997. Mr. Currey was elected as a director based on requirements under the CCI
merger agreement. Mr. Currey also served as Group President, Telecommunications
Services between October 1997 and March 6, 1998; he resigned his position as an
executive officer effective March 6, 1998.  Mr. Currey is President of 21st
Century Telecom Group, Inc., a cable and Internet services company.  Mr. Currey
is also a director of Brenton Banks Inc., a bank holding company.  Mr. Currey
served as President of CCI from March 1990 to September 24, 1997, the date we
acquired CCI. From June 1988 to March 1990, Mr. Currey served as Senior Vice
President, Operations and Engineering of Citizens Utility Co., a diversified
utility company. From 1987 to 1988, he served as Executive Vice President of 
US SPRINT, an interexchange carrier, and from 1984 to 1987, he served as Senior
Vice President, Operations for United Telecommunications, Inc., a
telecommunications company. Prior to 1984, Mr. Currey served as an Assistant
Vice President with Ameritech and also held a succession of management positions
in operations, personnel, labor relations and marketing.

     Lee Liu.   Mr. Liu has served as a director since April 1993, during
which time he has been the nominee of IES and its successor, Alliant Energy, to
our board of directors. Mr. Liu has been Chairman of IES Industries and its
successor, Interstate Energy Corporation, since July 1993. Mr. Liu previously
served as Chairman of IES Industries from May 1986 to July 1991. He also served
as Chief Executive Officer of IES Industries from May 1986 to April 1998 and as
President from May 1986 to November 1996. Mr. Liu has worked for IES and its
successor, Alliant Energy, since 1957. Mr. Liu is also a director of Eastman
Chemical Company, a chemical company, and the Principal Financial Group, a
financial services company. See "Security Ownership of Certain Beneficial Owners
and Management--Investor Agreement and Stockholders' Agreements."



                                       53
<PAGE>
 
     Paul D. Rhines.   Mr. Rhines has served as a director since April 1993.
Since 1997, Mr. Rhines has been Executive Vice President and Managing Member of
Marshall Venture Capital, L.C., which is the General Partner of Marshall Capital
Fund, L.P., a venture capital limited partnership.  He is a founder and a
general partner of R.W. Allsop & Associates, L.P. and R.W. Allsop & Associates
II L.P., two venture capital limited partnerships established in Cedar Rapids,
Iowa, in 1981 and 1983, respectively. He is also a founder and general partner
of MARK Venture Partners L.P., a limited partnership which is the general
partner of Allsop Venture Partners III, L.P., a venture capital limited
partnership established in Cedar Rapids, Iowa in 1987. He has also served since
1980 as Executive Vice President and a director of RWA, Inc., a venture capital
management firm. Mr. Rhines was a director of Teleconnect and its successor,
TelecomUSA, from 1982 to 1990.  He is also a director of American Safety Razor
Company, a consumer product manufacturing company.

     Ronald W. Stepien.   Mr. Stepien has served as a director since 
December 1997, during which time he has been the nominee of MidAmerican to our
board of directors. He previously served as one of MidAmerican's nominees to our
board of directors from July 1995 to February 1996. He has been President of
MidAmerican Energy Co., an electric utility, since November 1998 and Executive
Vice President--Marketing and Delivery for MidAmerican since November 1996.
Mr. Stepien was Senior Vice President--Strategy and Corporate Development for
MidAmerican from June 1995 through November 1996. He previously served as an
officer of Iowa-Illinois Gas and Electric Company from 1990 through 1995. See
"Security Ownership of Certain Beneficial Owners and Management--Investor
Agreement and Stockholders' Agreements."


Section 16(a) Beneficial Ownership Reporting Compliance

     Section 16(a) of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"), requires our directors, officers and beneficial owners of more
than 10% of our Class A common stock to file with the SEC initial reports of
ownership of our equity securities and to file subsequent reports when there are
changes in such ownership. Officers, directors and beneficial owners of more
than 10% of our Class A common stock are required by SEC regulations to furnish
us with copies of all Section 16(a) reports they file.

  Based on our review of these reports and on written representations from the
reporting persons that no other reports were required, we believe that during
the fiscal year ended December 31, 1998 all Section 16(a) filing requirements
applicable to our officers, directors and greater than 10% beneficial owners
were complied with, except that one Form 4 for each of Stephen C. Gray and
Paul D. Rhines was filed late.

                                       54
<PAGE>
 
Item 11.  Executive Compensation.

Summary Compensation Table

  The following table sets forth information concerning the cash and non-cash
compensation paid or accrued during the periods indicated to our Chief Executive
Officer and four other most highly compensated officers whose combined salary
and bonus exceeded $100,000 during the fiscal year ended December 31, 1998 (the
"Named Executive Officers").

<TABLE>
<CAPTION>
                                                                        Long Term
                                                                       Compensation
                                                                          Awards
                                                                       ------------
                                                  Annual Compensation   Securities
                                                  -------------------   Underlying      All Other
Name and Principal Position               Year       Salary  Bonus       Options     Compensation(1)
---------------------------------------  -------  -------------------  ------------  ---------------
<S>                                      <C>      <C>        <C>       <C>           <C>
Clark E. McLeod                          1998      $228,077  $122,732       100,000    $1,883,200(2)
 Chairman and Chief                      1997       185,262    79,216       223,000         3,000
 Executive Officer                       1996       156,269    72,422       135,500        48,200(3)
 
Stephen C. Gray                          1998       228,077   122,732       100,000         3,200
 President and Chief                     1997       184,728   199,216       253,000         3,000
 Operating Officer                       1996       156,269    72,422       105,500         3,200
 
Blake O. Fisher, Jr.                     1998       176,193    92,607        35,000         3,200
 Group Vice President and Regional       1997       143,484   131,048       168,000            --
 President--Iowa and Minnesota           1996        97,654    28,392       238,625            --
 
Arthur L. Christoffersen                 1998       176,538    68,000        63,000         3,200
 Group Vice President--Publishing        1997       154,524        --       197,000         3,000
 Services                                1996(4)     51,782   106,815            --            --
 
Richard A. Lumpkin                       1998       161,231   194,309        40,000         3,200
 Vice Chairman                           1997(5)     60,411    28,469        45,000        59,250(6)
                                         1996            --        --            --            --
</TABLE>
______________________
(1) Unless otherwise indicated, all other compensation represents matching
    contributions made by McLeodUSA to the McLeodUSA Incorporated 401(k) Plan on
    behalf of the Named Executive Officers.
(2) Includes $1,880,000 of premiums paid on split dollar life insurance policies
    for the benefit of the McLeod Family 1998 Special Trust.  For additional
    information, see "Certain Relationships and Related Transactions."
(3) Includes $45,000 paid by McLeodUSA to the FTC to cover the filing fee for a
    HSR Act notification filed by Mr. and Mrs. McLeod in connection with their
    November 1996 purchase of Class A common stock.
(4) Includes amounts received from September 20, 1996 (the date McLeodUSA
    acquired TelecomUSA Publishing Group, Inc.) to December 31, 1996.
(5) Includes amounts received from September 24, 1997 (the date McLeodUSA
    acquired CCI) to December 31, 1997.
(6) Represents the payment of accumulated vested vacation at the time McLeodUSA
    acquired CCI.

                                       55
<PAGE>
 
Option Grants

     The following table sets forth information with respect to grants of stock
options to each of the Named Executive Officers during the year ended December
31, 1998.

<TABLE>
<CAPTION>
                                                Individual Grants                                   Potential Realized      
                  -----------------------------------------------------------------------------      Value at Assumed    
                    Number of      Percent of                                                     Annual Rates of Stock  
                   Securities    Total Options                                                    Price Appreciation for 
                   Underlying      Granted to                                                          Option Term       
                     Options      Employees in   Exercise                                        ------------------------
  Name            Granted         Fiscal Year    Price        Grant Date       Expiration Date        5%          10%
----------------  ----------     -------------   --------  -----------------  -----------------  ----------   ----------
<S>               <C>            <C>             <C>       <C>                <C>                <C>          <C>
Clark E. McLeod      100,000(1)            1.6%   $ 29.75  December 31, 1998  December 31, 2008  $1,870,962   $4,741,384
 
Stephen C. Gray      100,000(1)            1.6      29.75  December 31, 1998  December 31, 2008   1,870,962    4,741,384
 
Blake O.              35,000(1)            0.6      29.75  December 31, 1998  December 31, 2008     654,837    1,659,484
 Fisher, Jr.
 
Arthur L.
 Christoffersen       23,000(2)            0.4     41.625      April 3, 1998      April 3, 2008     602,088    1,525,809
 
                      40,000(1)            0.6      29.75  December 31, 1998  December 31, 2008     748,385    1,896,554
 
Richard A.            40,000(1)            0.6      29.75  December 31, 1998  December 31, 2008     748,385    1,896,554
 Lumpkin
</TABLE>
_______________________
(1) These options vest according to the following schedule: 25% per year for
    four years.
(2) These options vest according to the following schedule: 1/3 at 56 months 
    with an additional 1/3 at each of 63 and 70 months.

Aggregate Option Exercises and Fiscal Year-End Values

     The following table sets forth information for each Named Executive Officer
concerning the exercise of options during fiscal year 1998, the number of
securities underlying unexercised options at the 1998 year-end and the year-end
value of all unexercised in-the-money options held by such individuals.

<TABLE>
<CAPTION>
                                                                                Value of Unexercised
                                                    Number of Unexercised       In-the-Money Options
                       Shares                    Options at Fiscal Year-End    at Fiscal Year-End(2)
                     Acquired on     Value       --------------------------  --------------------------
       Name           Exercise     Realized(1)   Exercisable  Unexercisable  Exercisable  Unexercisable
-------------------  -----------  -------------  -----------  -------------  -----------  -------------
<S>                  <C>          <C>            <C>          <C>            <C>          <C>
Clark E. McLeod          123,750  $4,415,709         172,813        318,937  $ 5,441,031     $3,831,220
Stephen C. Gray          217,202   6,367,453         459,697        374,250   13,354,521      4,835,810
Blake O. Fisher, Jr.      41,250   1,363,181         114,969        261,593    2,822,977      4,190,904
Arthur L.                                             15,000        245,000                   1,909,500
 Christoffersen
Richard A. Lumpkin                                    11,250         73,750                      60,000
</TABLE>
________________
(1) Represents the difference between the exercise price and the closing price
    of our Class A common stock on The Nasdaq Stock Market on the date of
    exercise.
(2) Represents the difference between the exercise price and the closing price
    of our Class A common stock on The Nasdaq Stock Market on December 31, 1998.

Compensation Committee Interlocks and Insider Participation

     During the fiscal year ended December 31, 1998, no member of our board of
directors served as a director or a member of the compensation committee of any
other company of which any executive officer served as a member of our board of
directors.

     In 1998, we paid 2060 Partnership, L.P. $1,654,000 for the rental of office
and parking spaces in Cedar Rapids, Iowa.  2001 Development Company, an Iowa
corporation, is the general partner and 80% owner of 2060 Partnership, L.P.
Alliant Energy and McLeodUSA own 54.55% and 3.03%, respectively, of the
outstanding stock of 2001 Development 

                                       56
<PAGE>
 
Company. The directors and officers of 2001 Development Company include Lee Liu
and Thomas M. Collins, directors of McLeodUSA, and Clark E. McLeod, a director
and executive officer of McLeodUSA.

     During 1998, we paid $86,000 to Shuttleworth & Ingersoll, P.C., a law firm
in Cedar Rapids, Iowa, for legal services rendered. We plan to retain the firm
in 1999.  We provide local and long distance telephone service for Shuttleworth
& Ingersoll.  Shuttleworth & Ingersoll paid us $64,000 for these services in
1998.  Thomas M. Collins is Of Counsel and a stockholder of Shuttleworth &
Ingersoll.

     For a description of other related-party transactions, see "Certain
Relationships and Related Transactions."

Employment, Confidentiality and Non-Competition Agreements

     We have entered into employment, confidentiality and non-competition
agreements with most members of our senior management, including the Named
Executive Officers.  These agreements typically provide that the applicable
senior management employee:

     .    may not compete with us during the term of his or her employment and
          for a one or two-year period following a termination for cause,
          resignation or voluntary termination of employment

     .    may not disclose any confidential information while employed by us and
          thereafter

The agreements have an indefinite term but may be terminated on 30 days' written
notice by either party, provided, however, that the confidentiality and non-
competition obligations survive any such termination. As partial consideration
for the execution of the employment, confidentiality and non-competition
agreements, we have granted to the employees signing such agreements options to
purchase shares of our Class A common stock at exercise prices which are based
on the fair market value of the Class A common stock on the date of grant. Such
options were granted under our 1996 Employee Stock Option Plan.

Change-of-Control Agreements

     We have entered into change-of-control agreements with our executive
officers, including the Named Executive Officers, which provide for payments and
benefits in connection with specified terminations of employment after a "change
of control" of McLeodUSA (as such term is defined in the change-of-control
agreements). The change-of-control agreements terminate on December 31, 2006,
unless a change of control has occurred during the six months preceding December
31, 2006, in which case the agreements terminate on December 31, 2007. If an
executive who is a party to a change-of-control agreement terminates employment
within six months after such a change of control or, if within 24 months after
such a change of control, the executive's employment is terminated by McLeodUSA
(other than for "disability," "cause," death or "retirement") or by the
executive following a "material reduction" in responsibilities or compensation
(as such terms are defined in the change-of-control agreements):

     .    the executive will be entitled to a lump sum payment equal to 12 or 
          24 times the executive's "average monthly compensation" (as defined in
          the change-of-control agreements) during the 12 months immediately
          preceding the change of control or the date of termination, whichever
          average monthly compensation is higher

     .    all of the executive's outstanding options to purchase stock of
          McLeodUSA will become immediately exercisable in full

     .    if the executive elects to continue coverage under McLeodUSA's group
          health plan, McLeodUSA will continue to pay the employer portion of
          the premiums for such coverage for the longer of 24 months or the
          period of coverage provided by the Internal Revenue Code of 1986, as
          amended (the "Code")

An executive who is entitled to payment(s) under a change-of-control agreement
is subject to a non-compete provision generally restricting the executive from
competing with McLeodUSA for a two-year period after the termination of
employment.

                                       57
<PAGE>
 


Directors' Compensation

     Directors who are also employees of McLeodUSA receive no directors fees.
Non-employee directors receive directors fees of $1,000 for each board of
directors and committee meeting attended in person and $500 for each board of
directors and committee meeting attended by telephone. In addition, directors
are reimbursed for their reasonable out-of-pocket travel expenses. Directors are
also eligible to receive grants of stock options under our Directors Stock
Option Plan (the "Directors Plan").

     The Directors Plan was adopted by our board of directors and approved by
our stockholders in 1993. On March 28, 1996, the Directors Plan was amended and
restated to be a "formula" plan providing for an automatic grant of stock
options to eligible non-employee directors. Under the Directors Plan, as
amended, the number of shares reserved for purchase upon exercise of options was
increased to an aggregate of 550,000 shares of our Class A common stock (subject
to adjustment for certain events, such as recapitalizations or stock splits,
effected without consideration) for grants to directors who are not officers or
employees of McLeodUSA (each an "Eligible Director"). Options to purchase
450,000 shares of Class A common stock had been granted under the Directors Plan
and options to purchase 142,314 shares of Class A common stock had been
exercised as of December 31, 1998. Under the Directors Plan, each Eligible
Director who commences service as a director is granted an initial option to
purchase 10,000 shares of Class A common stock. Each such Eligible Director is
also granted an additional option to purchase 5,000 shares of Class A common
stock immediately after each of the subsequent two annual stockholders' meetings
if the Eligible Director continues to be an Eligible Director. The Directors
Plan will terminate automatically on March 28, 2006, unless terminated earlier
by our board of directors.

     Other than the compensation described above, none of the directors received
any other compensation from McLeodUSA in 1998 in connection with their service
as directors.

Item 12.  Security Ownership of Certain Beneficial Owners and Management.

Stock Owned by Management

     The following beneficial ownership table sets forth information regarding
beneficial ownership of our Class A common stock as of February 28, 1999 by:

     .    each of our directors

     .    each Named Executive Officer

     .    all executive officers and directors as a group

Under the Exchange Act, a person is deemed to be a "beneficial owner" of a
security if he or she has or shares the power to vote or direct the voting of
such security or the power to dispose or direct the disposition of such
security. A person is also deemed to be a beneficial owner of any securities of
which that person has the right to acquire beneficial ownership within 60 days.
More than one person may be 

                                       58
<PAGE>
 
deemed to be a beneficial owner of the same securities. The percentage ownership
of each stockholder is calculated based on the total number of outstanding
shares of our Class A common stock as of February 28, 1999 plus those shares of
Class A common stock that such stockholder has the right to acquire within 60
days. Consequently, the denominator for calculating such percentage may be
different for each stockholder.


     The table is based upon information supplied by our directors and executive
officers.  Unless otherwise indicated in the footnotes to the table, each of the
stockholders listed has sole voting and dispositive power with respect to the
shares shown as beneficially owned. Also, except as noted below, the table
includes the following shares that the individuals named below have the right to
acquire within 60 days from February 28, 1999 upon exercise of options:

<TABLE>
<S>                                                                        <C>
          Clark E. McLeod................................................    235,623
          Richard A. Lumpkin.............................................     11,250
          Stephen C. Gray................................................    529,072
          Thomas M. Collins..............................................     77,345
          Blake O. Fisher, Jr............................................    189,562
          Paul D. Rhines.................................................     77,345
          Ronald W. Stepien..............................................     18,750
          Lee Liu........................................................     27,345
          Robert J. Currey...............................................     37,500
          Arthur L. Christoffersen.......................................     19,800
                                                                           ---------
               Total.....................................................  1,223,592
                                                                           =========
          Directors and executive officers as a group
             (19 persons)................................................  1,884,642
                                                                           =========
</TABLE>


<TABLE>
<CAPTION>
                                                                       Beneficial Ownership
                                                                    --------------------------
                     Name of Beneficial Owner                       Number of Shares  Percent
------------------------------------------------------------------  ----------------  --------
<S>                                                                 <C>               <C>
Clark E. McLeod(1)(2).............................................         9,371,329     13.8%
Richard A. Lumpkin(1)(3)..........................................         5,067,778      7.5
Stephen C. Gray(4)................................................           740,634      1.1
Thomas M. Collins.................................................           269,619        *
Blake O. Fisher, Jr...............................................           222,133        *
Paul D. Rhines....................................................           194,921        *
Ronald W. Stepien.................................................            42,188        *
Lee Liu...........................................................            39,545        *
Robert J. Currey..................................................            37,500        *
Arthur L. Christoffersen..........................................            19,800        *
Directors and executive officers as a group (19 persons)..........        16,870,171     25.0
</TABLE>
___________________
  * Less than one percent.

(1) Richard Anthony Lumpkin, Margaret L. Keon, Mary Lee Sparks and all of their
    children, along with Steven L. Grissom, David R. Hodgman and BankOne, Texas,
    N.A., individually, or as trustees or settlors for trusts for the benefit of
    members of the family of Richard Adamson Lumpkin, MidAmerican, Alliant
    Energy, Clark E. McLeod and Mary E. McLeod are parties to a stockholders'
    agreement and, accordingly, may constitute a group within the meaning of
    Section 13(d)(3) of the Exchange Act.  As of February 28, 1999, these
    stockholders beneficially owned an aggregate of 34,334,329 shares of our
    Class A common stock, including 1,300,688 shares that Alliant Energy has the
    right to acquire upon exercise of options, and 235,623 and 11,250 shares
    that Messrs. McLeod and Lumpkin, respectively, have the right to purchase
    upon exercise of options, within 60 days from February 28, 1999,
    representing an ownership interest of 49.7%.  See "--Investor Agreement and
    Stockholders' Agreements."
(2) Includes 4,296,993 shares of Class A common stock held of record by Mary E.
    McLeod, Mr. McLeod's wife, over which Mr. McLeod has shared voting power.
    Also includes 125,000 shares of Class A common stock held by the Clark E.
    McLeod Unitary Trust and 125,000 shares of Class A common stock held by the
    Mary E. McLeod Unitary Trust for which Mr. McLeod is a trustee and over
    which Mr. McLeod has shared voting and investment power. Mr. McLeod's

                                       59
<PAGE>
 
    address is c/o McLeodUSA Incorporated, McLeodUSA Technology Park, 6400 C
    Street SW, P.O. Box 3177, Cedar Rapids, IA  52406-3177.
(3) Includes 311,127 shares of Class A common stock held of record by Gail G.
    Lumpkin, Mr. Lumpkin's wife, over which Mr. Lumpkin has shared voting power.
    Includes 2,245,081 shares of Class A common stock held by various trusts for
    the benefit of the family of Richard Adamson Lumpkin over which Mr. Lumpkin
    has shared voting and investment power.  Includes 2,500,320 shares of Class
    A common stock held by various trusts for the benefit of the family of
    Richard Adamson Lumpkin over which Mr. Lumpkin has shared investment power.
    Includes 11,250 shares of Class A common stock that Mr. Lumpkin has the
    right of purchase within 60 days from March 8, 1999 pursuant to options.
    Mr. Lumpkin's address is c/o McLeodUSA Incorporated, McLeodUSA Technology
    Park, 6400 C Street SW, P.O. Box 3177, Cedar Rapids, IA  52406-3177.
(4) Includes 3,750 shares of Class A common stock held of record by the Stephen
    Samuel Gray Irrevocable Trust, and 3,750 shares of Class A common stock held
    of record by the Elizabeth Mary Fletcher Gray Education Trust, of which Mr.
    Gray is the trustee. Includes 26,250 shares of Class A common stock held of
    record by Morgan Stanley Dean Witter & Co. for the benefit of Mr. Gray.

Principal Holders of Voting Securities

     The following table sets forth information as of February 28, 1999 with
respect to the ownership of shares of our Class A common stock by each person
believed by management to be the beneficial owner of more than five percent of
our outstanding Class A common stock. The information is based on the most
recent Schedule 13D or 13G filed with the SEC on behalf of such persons or other
information made available to us. Except as otherwise indicated, the reporting
persons have stated that they possess sole voting and sole dispositive power
over the entire number of shares reported.

<TABLE>
<CAPTION>
                                                                         Beneficial Ownership
                                                                      --------------------------
Name of Beneficial Owner                                              Number of Shares  Percent
------------------------                                              ----------------  --------
<S>                                                                   <C>               <C>
     Alliant Energy Investments, Inc.(1)............................        10,278,288     14.9%
     Clark E. McLeod(2).............................................         9,371,329     13.8
     MHC Investment Company(3)......................................         6,741,116     10.0
     Richard A. Lumpkin(2)..........................................         5,067,778      7.5
     Mary E. McLeod(4)..............................................         4,546,993      6.7
</TABLE>
__________________
(1) Includes 1,300,688 shares of Class A common stock that Alliant Energy has
    the right to acquire upon exercise of options. Alliant Energy Investments,
    Inc. is a wholly owned indirect subsidiary of Interstate Energy Corporation.
    The address of Alliant Energy is c/o Interstate Energy Corporation, 222 West
    Washington Avenue, P.O. Box 192, Madison, WI  53701
(2) See "Stock Owned by Management."
(3) MHC Investment Company is a wholly owned indirect subsidiary of MidAmerican
    Energy Holdings Company. The address of MHC is c/o MidAmerican Energy 
    Holdings Company, 666 Grand Ave., Des Moines, IA 50309. Includes 42,188 
    shares of Class A common stock held of record by Ronald W. Stepien. Includes
    18,750 shares of Class A common stock that Ronald W. Stepien has the right
    to purchase within 60 days from February 28, 1999 upon exercise of options.
    MHC Investment Company has the power to direct the disp osition of such
    shares.
(4) Includes 125,000 shares of Class A common stock held by the Mary E. McLeod
    Unitary Trust and 125,000 shares of Class A common stock held by the Clark
    E. McLeod Unitary Trust for which Mrs. McLeod is a trustee and over which
    Mrs. McLeod has shared voting and investment power. Mrs. McLeod's address is
    c/o McLeodUSA Incorporated, McLeodUSA Technology Park, 6400 C Street SW,
    P.O. Box 3177, Cedar Rapids, IA 52406-3177.

Investor Agreement and Stockholders' Agreements

     We have entered into an agreement (as amended, the "Investor Agreement")
with Alliant Energy, MidAmerican, Clark E. and Mary E. McLeod and several other
stockholders. The Investor Agreement provides that each of Alliant Energy,
MidAmerican and Clark and Mary McLeod, for so long as each owns at least 10% of
our outstanding capital stock, will vote such party's shares and take all action
within its power to:

                                       60
<PAGE>
 
     .    establish the size of our board of directors at nine directors

     .    cause to be elected to our board of directors one director designated
          by Alliant Energy for so long as Alliant Energy owns at least 10% of
          our outstanding capital stock

     .    cause to be elected to our board of directors one director designated
          by MidAmerican for so long as MidAmerican owns at least 10% of our
          outstanding capital stock

     .    cause to be elected to our board of directors three directors who are
          executive officers of McLeodUSA designated by Clark E. McLeod for so
          long as Clark E. and Mary E. McLeod collectively own at least 10% of
          our outstanding capital stock

     .    cause to be elected to our board of directors four independent
          directors nominated by the board

     On June 14, 1997, we entered into a stockholders' agreement (as amended,
the "June 1997 Stockholders' Agreement") with Alliant Energy, MidAmerican, Clark
and Mary McLeod and several shareholders of CCI.  The June 1997 Stockholders'
Agreement became effective on September 24, 1997.  Under the June 1997
Stockholders' Agreement, which amends and restates the Investor Agreement among
the parties thereto, each party agreed, for so long as such party owns at least
10% of our outstanding Class A common stock, for a period of three years after
September 24, 1997, to vote such party's shares and take all action within its
power to:

     .    establish the size of our board of directors at up to 11 directors

     .    cause to be elected to our board of directors one director designated
          by Alliant Energy for so long as Alliant Energy owns at least 10% of
          our outstanding Class A common stock

     .    cause to be elected to our board of directors one director designated
          by MidAmerican for so long as MidAmerican owns at least 10% of our
          outstanding Class A common stock

     .    cause to be elected to our board of directors three directors who are
          executive officers of McLeodUSA designated by Clark E. McLeod for so
          long as Clark E. and Mary E. McLeod collectively own at least 10% of
          our Class A common stock

     .    cause Richard A. Lumpkin to be elected to our board of directors for
          so long as the former shareholders of CCI who are a party to the
          agreement collectively own at least 10% of our Class A common stock

     .    cause to be elected to our board of directors four non-employee
          directors nominated by our board


     The June 1997 Stockholders' Agreement also provides, among other things,
that:

     .    for a period ending in June 1999, and subject to exceptions, each of
          Alliant Energy and MidAmerican will refrain from acquiring, or
          agreeing or seeking to acquire, beneficial ownership of any securities
          issued by us

     .    if we grant any party to the agreement the opportunity to register any
          of our equity securities under the Securities Act, we will grant all
          other parties to the agreement the same opportunity to register their
          pro rata portion of our equity securities owned by them


The other operative provisions of the Investor Agreement remain unchanged in the
June 1997 Stockholders' Agreement.


     On November 18, 1998, we entered into a stockholders' agreement (the
"November 1998 Stockholders' Agreement") with Alliant Energy, Clark E. and Mary
E. McLeod, and Richard A. Lumpkin, Gail G. Lumpkin and several other parties
affiliated or related to the Lumpkins, but not including MidAmerican, which was
a party to prior agreements.

                                       61
<PAGE>
 
     The November 1998 Stockholders' Agreement provides, among other things,
that:

     .    until December 31, 2001, the parties to the agreement will not sell or
          otherwise dispose of any of our equity securities, or any other
          securities convertible into or exercisable for such equity securities,
          beneficially owned by them without receiving the prior written consent
          of our board of directors, except for transfers specifically permitted
          by the November 1998 Stockholders' Agreement 

     .    our board of directors will determine on a quarterly basis starting
          with the quarter ending December 31, 1998 and ending on December 31,
          2001, the aggregate number, if any, of shares of our Class A common
          stock, not to exceed in the aggregate 150,000 shares per quarter, that
          the parties to the agreement may sell or otherwise dispose of during
          designated trading periods following the release of our quarterly or
          annual financial results

     .    to the extent our board of directors grants registration rights to a
          party to the agreement in connection with a sale or other disposition
          of our securities by such party, it will grant similar registration
          rights to the other parties to the agreement

     .    our board of directors will determine on an annual basis starting with
          the year ending December 31, 1999 and ending on December 31, 2001
          (each such year, an "Annual Period"), the aggregate number, if any, of
          shares of our Class A common stock, not to exceed in the aggregate on
          an annual basis a number of shares equal to 15% of the total number of
          shares of Class A common stock beneficially owned by the parties as of
          December 31, 1998 (the "Registrable Amount"), to be registered by us
          under the Securities Act, for sale or other disposition by the parties
          to the agreement

     .    in any underwritten offering of shares of Class A common stock by us,
          other than an offering on a registration statement on Form S-4 or Form
          S-8 or other form which would not permit the inclusion of shares of
          Class A common stock owned by the parties to the agreement, we will
          give written notice of such offering to the parties and will undertake
          to register their shares of Class A common stock up to the Registrable
          Amount, if any, as determined by our board of directors

     .    we may subsequently determine not to register any shares of the
          parties under the Securities Act and may either not file a
          registration statement or otherwise withdraw or abandon a registration
          statement previously filed


     The November 1998 Stockholders' Agreement terminates on December 31, 2001.
In addition, if during any Annual Period we have not provided a party to the
agreement a reasonable opportunity to sell or otherwise dispose of an aggregate
number of shares of Class A common stock equal to not less than 15% of the total
number of shares of Class A common stock beneficially owned by such party as of
December 31, 1998, then such party may terminate the November 1998 Stockholders'
Agreement as it applies to such party within 10 business days following the end
of any such Annual Period.

     The November 1998 Stockholders' Agreement also contains provisions relating
to the designation and election of directors to our board of directors which
provisions take effect on the terms and under the circumstances specified in the
agreement.

     We have entered into a stockholders' agreement (the "Ovation Stockholders'
Agreement") with M/C Investors L.L.C. and Media/Communications Partners III
Limited Partnership (collectively, "M/C"), Alliant Energy, Clark E. and Mary E.
McLeod, Richard A. and Gail G. Lumpkin and several other parties related to the
Lumpkins with respect to the shares of our Class A common stock that M/C will
receive in the Ovation merger.

     The Ovation Stockholders' Agreement provides that:

     .    until December 31, 2001, M/C will not sell or otherwise dispose of any
          of our equity securities or any other securities convertible into or
          exercisable for such equity securities beneficially owned by M/C as a
          result of the Ovation merger without receiving the prior written
          consent of our board of directors, except for transfers specifically
          permitted by the Ovation Stockholders' Agreement

                                       62
<PAGE>
 
     .    our board of directors will determine on a quarterly basis starting
          with the quarter ending December 31, 1999 and ending on December 31,
          2001, the aggregate number, if any, of shares of Class A common stock,
          not to exceed in the aggregate 50,000 shares per quarter, that M/C may
          sell or otherwise dispose of during designated trading periods
          following the release of our quarterly or annual financial results

     .    our board of directors will determine on an annual basis for each of
          the years ending December 31, 2000 and December 31, 2001, the
          aggregate number, if any, of shares of our Class A common stock, not
          to exceed in the aggregate on an annual basis a number of shares equal
          to 15% of the total number of shares of Class A common stock
          beneficially owned by M/C as of the completion of the Ovation merger,
          to be registered by us under the Securities Act for sale or other
          disposition by M/C

     .    in any underwritten offering of shares of Class A common stock by us,
          other than an offering on a registration statement on Form S-4 or Form
          S-8 or other form which would not permit the inclusion of shares of
          Class A common stock owned by M/C, during the period starting on
          January 1, 2000 and ending on December 31, 2001, we will give written
          notice of such offering to M/C and will undertake to register a number
          of shares of Class A common stock owned by M/C, if any, determined by
          our board of directors

     .    we may subsequently determine not to register any shares owned by M/C
          under the Securities Act and may either not file a registration
          statement or otherwise withdraw or abandon a registration statement
          previously filed

     The Ovation Stockholders' Agreement also contains various provisions
intended to insure that M/C is generally treated on a similar basis to the other
parties to the agreement in connection with any sale or other disposition of our
securities permitted by us with respect to any of these other parties or any
registration rights granted by us to any of these other parties under the
November 1998 Stockholders' Agreement for the period starting on January 1, 2000
and ending on December 31, 2001.  Similar protective rights are also granted in
the Ovation Stockholders' Agreement to each of these other parties with respect
to any sale or other disposition or registration of our securities owned by M/C
permitted by us under the Ovation Stockholders' Agreement.  In addition, during
the year ending December 31, 1999, if we participate in a strategic transaction
with an outside investor who agrees to acquire our securities at a premium to
their then average trading price, after we have been paid or otherwise received
our consideration or proceeds from such transaction as determined by us, the
parties to the Ovation Stockholders' Agreement may be entitled to participate in
such transaction on a pro rata basis as determined by our board of directors.

     Under the Ovation Stockholders' Agreement, each party has agreed, for so
long as each such party owns at least 2.5 million shares of our Class A common
stock, in the case of M/C, or 4.0 million shares of our Class A common stock, in
the case of the other parties, to (1) establish the size of our board of
directors at up to 11 directors, (2) cause to be elected to our board of
directors one director designated by M/C, for so long as M/C owns at least 2.5
million shares of our Class A common stock, and (3) cause to be elected to our
board the directors designated by the other parties as set forth in the Ovation
Stockholders' Agreement.

          The Ovation Stockholders' Agreement terminates on the earlier to occur
of the termination of the Ovation merger agreement and December 31, 2001.  In
addition, if (1) during each of the years ending December 31, 2000 and December
31, 2001, we have not provided M/C a reasonable opportunity to register under
the Securities Act for sale or other disposition an aggregate number of shares
of our Class A common stock equal to not less than 15% of the total number of
shares of Class A common stock beneficially owned by M/C as of the effective
time of the Ovation merger or (2) after January 1, 2000, the November 1998
Stockholders' Agreement has been terminated by all parties to such agreement,
then M/C may terminate the Ovation Stockholders' Agreement by providing written
notice of termination to all other parties (x) in the case of clause (1) above,
no later than 30 days following the end of such year and (y) in the case of
clause (2) above, at any time after January 1, 2000.  Lastly, the Ovation
Stockholders' Agreement will be terminated with respect to all parties other
than McLeodUSA and M/C at such time as the November 1998 Stockholders' Agreement
is terminated.

                                       63
<PAGE>
 
Item 13.  Certain Relationships and Related Transactions.

     We provide paging services, customer premise equipment, labor and services
for customer premise equipment, long distance service, 800 service and private
lines to First Mid-Illinois Bancshares. First Mid-Illinois Bancshares paid us
$559,000 for these services in 1998. Richard A. Lumpkin, Margaret Lumpkin Keon
and Mary Lumpkin Sparks own approximately 11.3%, 6.8% and 6.9% of the capital
stock of First Mid-Illinois Bancshares, respectively.  Richard A. Lumpkin is
also a director of First Mid-Illinois Bancshares. Mr. Lumpkin is a director,
executive officer and significant stockholder of McLeodUSA and Mrs. Keon and
Mrs. Sparks are significant stockholders of McLeodUSA.

     Illuminet Holdings paid us $1,696,000 in 1998 for the rental of building
space and for DS-1 usage and transmission facilities in the form of private
leased lines. We paid Illuminet Holdings $1,326,000 in 1998 for database
verification services and SS7 link services. Richard A. Lumpkin is the Chairman
of the Board of Directors of Illuminet Holdings.

     Ameren Corporation and Central Illinois Public Service Company collectively
paid us $1,380,000 in 1998 for private line services and long distance services.
Richard A. Lumpkin is a director of Ameren Corporation and Central Illinois
Public Service Company.

     In April 1997, McLeodUSA, Clark E. McLeod, Stephen C. Gray and Blake O.
Fisher, Jr. jointly purchased a jet aircraft for an aggregate of approximately
$2.25 million. Subsequently, the ownership was reallocated and Arthur L.
Christoffersen and Richard A. Lumpkin each purchased an interest. In connection
with the ownership reallocation, we paid approximately $1.35 million for a 60%
ownership percentage and Messrs. McLeod, Gray, Fisher, Christoffersen and
Lumpkin each paid approximately $180,000 for an ownership percentage of 8% each.
During 1998, Messrs. Fisher and Christoffersen sold their ownership back to
McLeodUSA for $180,000 each and Mr. McLeod purchased an additional 4% ownership
from us for $90,000, increasing his ownership percentage from 8% to 12%.
McLeodUSA and Messrs. McLeod, Gray and Lumpkin are parties to a Joint Ownership
Agreement by which they have agreed to share the operational expenses of the
aircraft in proportion to their respective ownership interest in the aircraft
(72% by McLeodUSA, 12% by Mr. McLeod and 8% each by Messrs. Gray and Lumpkin).
Messrs. McLeod and Fisher are directors and executive officers of McLeodUSA and
Mr. Christoffersen is an executive officer of McLeodUSA.

     We have entered into two agreements with Alliant Energy by which Alliant
Energy has agreed to grant us access to towers, rights-of-way, conduits and
poles in exchange for capacity on our communications network.

     In February 1996, we entered into two agreements with MidAmerican by which
MidAmerican has agreed to grant us access to towers, rights-of-way, conduits and
poles in exchange for capacity on our communications network.

     On July 18, 1995 and March 29, 1996, respectively, we loaned $75,000 to
each of Kirk E. Kaalberg and Stephen K. Brandenburg in exchange for unsecured
notes executed by Mr. Kaalberg and Mr. Brandenburg, respectively. Interest
accrues on both loan amounts at the applicable rate established in Internal
Revenue Service regulations. Mr. Brandenburg made an annual interest-only
payment in 1998 and will make annual payments of $25,000 plus accrued interest
in each of the next three years. Mr. Kaalberg made an annual payment of $25,000
plus accrued interest in 1998 and will make similar payments in each of the next
two years.  Messrs. Kaalberg and Brandenburg are executive officers of
McLeodUSA.

     In December 1998, we entered into a split dollar arrangement for life
insurance policies owned by the McLeod Family 1998 Special Trust on the joint
lives of Clark and Mary McLeod.  The McLeod Family 1998 Special Trust agreed to
assign the policies to us as collateral for our payment of the premiums for
these policies.  No loans have been taken against these policies.  In 1998, the
premium payments paid by us on these policies totaled $1,880,000.  The aggregate
face amount of the policies is $113,000,000.  The McLeod Family 1998 Special
Trust is sole owner and beneficiary of each policy. We have agreed with Clark
and Mary McLeod that one of the principle reasons for entering into this
arrangement is to avoid any need for their heirs to liquidate their holdings of
our Class A common stock at or soon after the death of one or both of them.
Clark and Mary McLeod have agreed to restrictions on their ability to sell or

                                       64
<PAGE>
 
otherwise dispose of their shares of Class A common stock.  See "-- Investor
Agreement and Stockholders' Agreements."  We also paid premiums of $138,257 for
a universal life policy on Clark and Mary McLeod with a face value of
$13,500,000.  We are the beneficiary of this policy.

     In March 1996, our board of directors adopted a policy requiring that any
material transactions between McLeodUSA and persons or entities affiliated with
officers, directors or principal stockholders of McLeodUSA be on terms no less
favorable to McLeodUSA than reasonably could have been obtained in arms' length
transactions with independent third parties or be approved by a majority of
disinterested directors.

      For a description of other related-party transactions, see "Executive 
Compensation -- Compensaton Committee Interlocks and Insider Participation."



                                       65
<PAGE>
 
                                    PART IV

Item 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K.

          (a)(1) The following consolidated financial statements of McLeodUSA
and report of independent public accountants are included in Item 8 of this Form
10-K.

                 Report of independent public accountants.

                 Consolidated balance sheets as of December 31, 1998 and 1997.
       
                 Consolidated statements of operations and comprehensive income
                 for the years ended December 31, 1998, 1997 and 1996.
       
                 Consolidated statements of stockholders' equity for the years
                 ended December 31, 1998, 1997 and 1996.
       
                 Consolidated statements of cash flows for the years ended
                 December 31, 1998, 1997 and 1996.
       
                 Notes to consolidated financial statements.

          (a)(2) The following financial statement schedule is filed as part of
this report and is attached hereto as pages S-1 and S-2.

                 Report of Independent Public Accountants on the Financial
                 Statement Schedule

                 Schedule II -- Valuation and Qualifying Accounts.

          All other schedules for which provision is made in the applicable
accounting regulations of the SEC either have been included in our consolidated
financial statements or the notes thereto, are not required under the related
instructions or are inapplicable, and therefore have been omitted.

          (a)(3) The following exhibits are either provided with this Form 10-K
or are incorporated herein by reference:

<TABLE>
<CPATION>
 Exhibit
 Number                         Exhibit Description
---------                       -------------------                         
<S>                             <C>
   2.1     Agreement and Plan of Reorganization dated April 28, 1995 among
           Midwest Capital Group Inc., MWR Telecom, Inc. and McLeod, Inc.
           (Filed as Exhibit 2.1 to Registration Statement on Form S-1, File
           No. 333-3112 ("Initial Form S-1"), and incorporated herein by
           reference).
         
   2.2     Agreement and Plan of Reorganization dated as of July 12, 1996 among
           Ruffalo, Cody & Associates, Inc., certain shareholders of Ruffalo,
           Cody & Associates, Inc. and McLeod, Inc. (Filed as Exhibit 2 to
           Current Report on Form 8-K, File No. 0-20763, filed with the
           Commission on July 29, 1996 and incorporated herein by reference).
         
   2.3     Agreement and Plan of Reorganization dated as of August 15, 1996
           among TelecomUSA Publishing Group, Inc. and McLeod, Inc. (Filed as
           Exhibit 2 to Current Report on Form 8-K, File No. 0-20763, filed
           with the Commission on August 26, 1996 and incorporated herein by
           reference).
         
   2.4     Agreement and Plan of Reorganization dated as of January 27, 1997
           among McLeod, Inc., Digital Communications of Iowa, Inc., Clark E.
           McLeod and Mary E. McLeod. (Filed as Exhibit 2 to Current Report on
           Form 8-K, File No. 0-20763, filed with the Commission on February
           24, 1997 and incorporated herein by reference).
</TABLE>


                                       66
<PAGE>
 
Exhibit
 Number                             Exhibit Description
---------                           -------------------                       
   2.5     Asset Purchase Agreement dated as of May 30, 1997 by and among
           McLeodUSA Incorporated, ESI/McLeodUSA, Inc., and ESI Communications,
           Inc., ESI Communications/ SW, Inc., ESI Communications/West, Inc.,
           ESI Communications Downtown, Inc., ESI Communications North, Inc.,
           and Michael Reichert, Peter Jones, John Pupkes and Jeff Meehan.
           (Filed as Exhibit 2.1 to Current Report on Form 8-K, File No.
           0-20763 (the "June 1997 Form 8-K"), filed with the Commission on
           June 26, 1997 and incorporated herein by reference).
         
   2.6     Agreement and Plan of Reorganization dated as of June 14, 1997 among
           McLeodUSA Incorporated, Eastside Acquisition Co. and Consolidated
           Communications Inc. (Filed as Exhibit 2.2 to the June 1997 Form 8-K
           and incorporated herein by reference).
         
   2.7     Agreement and Plan of Merger dated as of October 27, 1998 among
           McLeodUSA Incorporated, West Group Acquisition Co. and Dakota
           Telecommunications Group, Inc. (Filed as Exhibit 2.7 to the
           Registration Statement on Form S-4, File No. 333-68891 (the
           "December 1998 Form S-4"), and incorporated herein by reference).
         
   2.8     Agreement and Plan of Merger, dated as of January 7, 1999 among
           McLeodUSA Incorporated, Bravo Acquisition Corporation, Ovation
           Communications, Inc. and certain stockholders of Ovation
           Communications, Inc. (Filed as Exhibit 2.1 to current Report on Form
           8-K, File No. 0-20763 (the "January 1999 Form 8-K"), filed with the
           Commission on January 14, 1999 and incorporated herein by reference).
         
   2.9     Agreement and Plan of Merger, dated as of January 7, 1999, among
           McLeodUSA Incorporated, McLeodUSA Publishing Company, Pubco Merging
           Co., Talking Directories, Inc. and the stockholders of Talking
           Directories, Inc. (Filed as Exhibit 2.2 to the January 1999 Form 8-K
           and incorporated herein by reference).
         
  2.10     Agreement and Plan of Merger, dated as of January 7, 1999 among
           McLeodUSA Incorporated, McLeodUSA Publishing Company, Publication
           Merge Co., Info America Phone Books, Inc. and certain stockholders
           of Info America Phone Books, Inc. (Filed as Exhibit 2.3 to the
           January 1999 Form 8-K and incorporated herein by reference).
         
   3.1     Amended and Restated Certificate of Incorporation of McLeod, Inc.
           (Filed as Exhibit 3.1 to Initial Form S-1 and incorporated herein by
           reference).
         
   3.2     Amended and Restated Bylaws of McLeod, Inc. (Filed as Exhibit 3.2 to
           Registration Statement on Form S-1, File No. 333-13885 (the
           "November 1996 Form S-1"), and incorporated herein by reference).
         
   3.3     Certificate of Amendment of Amended and Restated Certificate of
           Incorporation of McLeod Inc. (Filed as Exhibit 3.3 to Registration
           Statement on Form S-4, File No. 333-27647 (the "July 1997 Form S-4")
           and incorporated herein by reference).
         
   3.4     Certificate of Change of Registered Agent and Registered Office of
           McLeodUSA Incorporated. (Filed as Exhibit 3.4 to Annual Report on
           Form 10-K, File No. 0-20763, filed with the Commission on March 6,
           1998 (the "1997 Form 10-K") and incorporated herein by reference).
         
   4.1     Form of Class A Common Stock Certificate of McLeod, Inc. (Filed as
           Exhibit 4.1 to Initial Form S-1 and incorporated herein by
           reference).

                                       67
<PAGE>
 
Exhibit
 Number                             Exhibit Description
---------                           -------------------                         

   4.2     Indenture dated March 4, 1997 between McLeod, Inc. and United States
           Trust Company of New York, as Trustee, relating to the 10-1/2%
           Senior Discount Notes Due 2007 of McLeod, Inc. (Filed as Exhibit 4.2
           to Annual Report on Form 10-K, File No. 0-20763, filed with the
           Commission on March 31, 1997 (the "1996 Form 10-K") and incorporated
           herein by reference).
         
   4.3     Initial Global 10-1/2% Senior Discount Note Due March 1, 2007 of
           McLeod, Inc., dated March 4, 1997. (Filed as Exhibit 4.3 to the 1996
           Form 10-K and incorporated herein by reference).
         
   4.4     Form of Certificated 10-1/2% Senior Discount Note Due March 1, 2007
           of McLeod, Inc. (Filed as Exhibit 4.4 to the 1996 Form 10-K and
           incorporated herein by reference).
         
   4.5     Registration Agreement dated March 4, 1997 among McLeod, Inc.,
           Salomon Brothers Inc. and Morgan Stanley & Co. Incorporated. (Filed
           as Exhibit 4.5 to the 1996 Form 10-K and incorporated herein by
           reference).
         
   4.6     Investor Agreement dated as of April 1, 1996 among McLeod, Inc., IES
           Investments Inc., Midwest Capital Group Inc., MWR Investments Inc.,
           Clark and Mary McLeod, and certain other stockholders. (Filed as
           Exhibit 4.8 to Initial Form S-1 and incorporated herein by
           reference).
         
   4.7     Amendment No. 1 to Investor Agreement dated as of October 23, 1996
           by and among McLeod, Inc., IES Investments Inc., Midwest Capital
           Group Inc., MWR Investments Inc., Clark E. McLeod and Mary E.
           McLeod. (Filed as Exhibit 4.3 to the November 1996 Form S-1 and
           incorporated herein by reference).
         
   4.8     Form of 10-1/2% Senior Discount Exchange Note Due 2007 of McLeodUSA
           Incorporated. (Filed as Exhibit 4.8 to the July 1997 Form S-4 and
           incorporated herein by reference).
         
   4.9     Indenture dated as of July 21, 1997 between McLeodUSA Incorporated
           and United States Trust Company of New York, as Trustee, relating to
           the 9-1/4% Senior Notes Due 2007 of McLeodUSA Incorporated. (Filed
           as Exhibit 4.9 to the July 1997 Form S-4 and incorporated herein by
           reference).
         
  4.10     Form of Initial Global 9-1/4% Senior Note Due 2007 of McLeodUSA
           Incorporated. (Filed as Exhibit 4.10 to the July 1997 Form S-4 and
           incorporated herein by reference).
         
  4.11     Registration Agreement dated July 21, 1997 among McLeodUSA
           Incorporated, Salomon Brothers Inc., Morgan Stanley Dean Witter and
           Bear, Stearns & Co. Inc. (Filed as Exhibit 4.11 to the July 1997
           Form S-4 and incorporated herein by reference).
         
  4.12     Stockholders' Agreement dated June 14, 1997 among McLeodUSA
           Incorporated, IES Investments Inc., Midwest Capital Group, Inc., MWR
           Investments Inc., Clark E. McLeod, Mary E. McLeod and Richard A.
           Lumpkin on behalf of each of the shareholders of Consolidated
           Communications Inc. listed on Schedule 1 of the Stockholders'
           Agreement. (Filed as Exhibit 4.12 to the July 1997 Form S-4 and
           incorporated herein by reference).
         
  4.13     Amendment No. 1 to Stockholders' Agreement dated as of September 19,
           1997 by and among McLeodUSA Incorporated, IES Investments Inc.,
           Midwest Capital Group, Inc., MWR Investments Inc., Clark E. McLeod,
           Mary E. McLeod and Richard A. Lumpkin on behalf of each of the
           shareholders of Consolidated Communications Inc. listed in Schedule
           I thereto. (Filed as Exhibit 4.1 to the Quarterly Report on Form
           10-Q, File No. 0-20763, filed with the Commission on November 14,
           1997 and incorporated herein by reference).

                                       68
<PAGE>
 
Exhibit
 Number                             Exhibit Description
---------                           -------------------                         

  4.14     Form of 9-1/4% Senior Exchange Note Due 2007 of McLeodUSA
           Incorporated. (Filed as Exhibit 4.14 to the 1997 Form 10-K and
           incorporated herein by reference).
         
  4.15     Indenture dated as of March 16, 1998 between McLeodUSA Incorporated
           and United States Trust Company of New York, as Trustee, relating to
           the 8-3/8% Senior Notes Due 2008 of McLeodUSA Incorporated (Filed as
           Exhibit 4.15 to Registration Statement on Form S-4, File No.
           333-52793 (the "May 1998 Form S-4") and incorporated herein by
           reference).
         
  4.16     Form of Global 8-3/8% Senior Note Due 2008 of McLeodUSA Incorporated
           (contained in the Indenture filed as Exhibit 4.15).
         
  4.17     Registration Agreement dated March 16, 1998 among McLeodUSA
           Incorporated, Solomon Brothers Inc., Bear, Stearns & Co. Inc.,
           Morgan Stanley & Co. Incorporated and Chase Securities Inc. (Filed
           as Exhibit 4.17 to the May 1998 Form S-4 and incorporated herein by
           reference).
         
  4.18     Stockholders' Agreement dated November 18, 1998 by and among
           McLeodUSA Incorporated; IES Investments Inc.; Clark E. McLeod; Mary
           E. McLeod; and Richard A. Lumpkin and each of the former
           shareholders of Consolidated Communications Inc. ("CCI") and certain
           permitted transferees of the former CCI shareholders. (Filed as
           Exhibit 99.1 to the Current Report on Form 8-K, File No. 0-20763,
           filed with the Commission on November 19, 1998 and incorporated
           herein by reference).
         
  4.19     Indenture dated as of October 30, 1998 between McLeodUSA
           Incorporated and United States Trust Company of New York, as
           Trustee, relating to the 9 1/2% Senior Notes Due 2008 of McLeodUSA
           Incorporated (Filed as Exhibit 4.19 to Registration Statement on
           Form S-4, File No. 333-69621 (the "December 23, 1998 Form S-4") and
           incorporated herein by reference).
         
  4.20     Form of Global 9 1/2% Senior Note Due 2008 of McLeodUSA Incorporated
           (contained in the Indenture filed as Exhibit 4.19).
         
  4.21     Registration Agreement dated October 30, 1998 among McLeodUSA
           Incorporated, Salomon Smith Barney Inc., Bear, Stearns & Co.
           Incorporated and Chase Securities Inc. (Filed as Exhibit 4.20 to
           December 23, 1998 Form S-4 and incorporated herein by reference).
         
  4.22     Indenture dated as of February 22, 1999 between McLeodUSA
           Incorporated and United States Trust Company of New York, as
           Trustee, relating to the 8 1/8% Senior Notes Due 2009 of McLeodUSA
           Incorporated.
         
  4.23     Form of Global 8 1/8% Senior Note Due 2009 of McLeodUSA Incorporated
           (contained in the Indenture filed as Exhibit 4.22).
         
  4.24     Registration Agreement dated February 22, 1999 among McLeodUSA
           Incorporated, Salomon Smith Barney Inc., Bear, Stearns & Co.
           Incorporated and Chase Securities Inc.
         
  10.1     Lease Agreement dated September 5, 1995 between State of Iowa and
           MWR Telecom, Inc. (Filed as Exhibit 10.21 to Initial Form S-1 and
           incorporated herein by reference).
         
  10.2     Lease Agreement dated September 5, 1995 between State of Iowa and
           McLeod Network Services, Inc. (Filed as Exhibit 10.22 to Initial
           Form S-1 and incorporated herein by reference).

                                       69
<PAGE>
 
Exhibit
 Number                             Exhibit Description
---------                           -------------------                         

           U S WEST Centrex Plus Service Rate Stability Plan dated October 15,
   10.3    1993 between McLeod Telemanagement, Inc. and U S WEST
           Communications, Inc. (Filed as Exhibit 10.26 to Initial Form S-1 and
           incorporated herein by reference).
         
           U S WEST Centrex Plus Service Rate Stability Plan dated July 17,
   10.4    1993 between McLeod Telemanagement, Inc. and U S WEST
           Communications, Inc. (Filed as Exhibit 10.27 to Initial Form S- 1
           and incorporated herein by reference).
         
           Ameritech Centrex Service Confirmation of Service Orders dated
   10.5    various dates in 1994, 1995 and 1996 between McLeod Telemanagement,
           Inc. and Ameritech Information Industry Services. (Filed as Exhibit
           10.28 to Initial Form S-1 and incorporated herein by reference).
         
           Lease Agreement dated as of December 28, 1993 between 2060
   10.6    Partnership and McLeod Telemanagement, Inc., as amended by
           Amendments First to Ninth dated as of July 3, 1994, March 25, 1994,
           June 22, 1994, August 12, 1994, September 12, 1994, September 20,
           1994, November 16, 1994, September 20, 1995 and January 6, 1996,
           respectively. (Filed as Exhibit 10.29 to Initial Form S-1 and
           incorporated herein by reference).
         
           Lease Agreement dated as of May 24, 1995 between 2060 Partnership
   10.7    and McLeod Telemanagement, Inc. (Filed as Exhibit 10.30 to Initial
           Form S-1 and incorporated herein by reference).
         
           Lease Agreement dated October 31, 1995 between I.R.F.B. Joint
   10.8    Venture and McLeod Telemanagement, Inc. (Filed as Exhibit 10.31 to
           Initial Form S-1 and incorporated herein by reference).
         
           First Amendment to Lease Agreement dated as of November 20, 1995
   10.9    between I.R.F.B. Joint Venture and McLeod Telemanagement, Inc.
           (Filed as Exhibit 10.32 to Initial Form S-1 and incorporated herein
           by reference).
         
           Master Right-of-Way Agreement dated July 27, 1994 between McLeod
  10.10    Network Services, Inc. and IES Industries Inc. (Filed as Exhibit
           10.34 to Initial Form S-1 and incorporated herein by reference).
         
           Master Right-of-Way and Tower Use Agreement dated February 13, 1996
  10.11    between IES Industries Inc. and McLeod, Inc. (Filed as Exhibit 10.35
           to Initial Form S-1 and incorporated herein by reference).
         
           Master Pole, Duct and Tower Use Agreement dated February 20, 1996
  10.12    between MidAmerican Energy Company and McLeod, Inc. (Iowa and South
           Dakota). (Filed as Exhibit 10.36 to Initial Form S-1 and
           incorporated herein by reference).
         
           Master Pole, Duct and Tower Use Agreement dated February 20, 1996
  10.13    between MidAmerican Energy Company and McLeod, Inc. (Illinois).
           (Filed as Exhibit 10.37 to Initial Form S-1 and incorporated herein
           by reference).
         
           Settlement Agreement dated March 18, 1996 between U S WEST
  10.14    Communications, Inc. and McLeod Telemanagement, Inc. (Filed as
           Exhibit 10.38 to Initial Form S-1 and incorporated herein by
           reference).
         
           McLeod Telecommunications, Inc. 1992 Incentive Stock Option Plan.
  10.15    (Filed as Exhibit 10.40 to Initial Form S-1 and incorporated herein
           by reference).
         
           McLeod, Inc. 1993 Incentive Stock Option Plan. (Filed as Exhibit
  10.16    10.41 to Initial Form S-1 and incorporated herein by reference).

                                       70
<PAGE>
<PAGE>
 
Exhibit
 Number                             Exhibit Description
---------                           -------------------                         
  10.17    McLeod, Inc. 1995 Incentive Stock Option Plan. (Filed as Exhibit
           10.42 to Initial Form S-1 and incorporated herein by reference).
         
  10.18    McLeod Telecommunications, Inc. Director Stock Option Plan. (Filed
           as Exhibit 10.43 to Initial Form S-1 and incorporated herein by
           reference).
         
  10.19    Promissory Note dated July 18, 1995 between Kirk E. Kaalberg and
           McLeod, Inc. (Filed as Exhibit 10.44 to Initial Form S-1 and
           incorporated herein by reference).
         
  10.20    Promissory Note dated March 29, 1996 between Stephen K. Brandenburg
           and McLeod, Inc. (Filed as Exhibit 10.45 to Initial Form S-1 and
           incorporated herein by reference).
         
 +10.21    Telecommunications Services Agreement dated March 14, 1994 between
           WilTel, Inc. and McLeod Telemanagement, Inc., as amended. (Filed as
           Exhibit 10.47 to Initial Form S-1 and incorporated herein by
           reference).
         
  10.22    First Amendment to Agreement Regarding Support Agreement dated May
           14, 1996 among McLeod, Inc., IES Diversified Inc. and IES
           Investments Inc. (Filed as Exhibit 10.50 to Initial Form S-1 and
           incorporated herein by reference).
         
  10.23    First Amendment to Agreement Regarding Guarantee dated May 14, 1996
           among McLeod, Inc., IES Diversified Inc. and IES Investments Inc.
           (Filed as Exhibit 10.51 to Initial Form S-1 and incorporated herein
           by reference).
         
  10.24    Amended and Restated Directors Stock Option Plan of McLeod, Inc.
           (Filed as Exhibit 10.52 to Initial Form S-1 and incorporated herein
           by reference).
         
  10.25    Forms of Employment, Confidentiality and Non-Competition Agreement
           between McLeod, Inc. and certain employees of McLeod, Inc. (Filed as
           Exhibit 10.53 to Initial Form S-1 and incorporated herein by
           reference).
         
  10.26    Form of Change-of-Control Agreement between McLeod, Inc. and certain
           employees of McLeod, Inc. (Filed as Exhibit 10.54 to Initial Form
           S-1 and incorporated herein by reference).
         
  10.27    McLeod, Inc. 1996 Employee Stock Option Plan, as amended. (Filed as
           Exhibit 10.55 to the November 1996 Form S-1 and incorporated herein
           by reference).
         
  10.28    McLeod, Inc. Employee Stock Purchase Plan, as amended. (Filed as
           Exhibit 10.56 to the 1996 Form 10-K and incorporated herein by
           reference).
         
  10.29    Form of Indemnity Agreement between McLeod, Inc. and certain
           officers and directors of McLeod, Inc. (Filed as Exhibit 10.57 to
           Initial Form S-1 and incorporated herein by reference).
         
  10.30    McLeod, Inc. Incentive Plan. (Filed as Exhibit 10.63 to the November
           1996 Form S-1 and incorporated herein by reference).
         
  10.31    Amended and Restated Credit Agreement dated as of May 5, 1996 among
           TelecomUSA Publishing Group, Inc., TelecomUSA Publishing Company and
           TelecomUSA Neighborhood Directories, Inc. and Norwest Bank Iowa,
           National Association. (Filed as Exhibit 10.64 to the November 1996
           Form S-1 and incorporated herein by reference).

                                       71
<PAGE>
 
Exhibit
 Number                             Exhibit Description
---------                           -------------------                         

 10.32     First Amendment to Amended and Restated Credit Agreement dated as of
           January 31, 1996 by and between TelecomUSA Publishing Group, Inc.,
           TelecomUSA Publishing Company and TelecomUSA Neighborhood
           Directories, Inc. and Norwest Bank Iowa, National Association.
           (Filed as Exhibit 10.65 to the November 1996 Form S-1 and
           incorporated herein by reference).
         
 10.33     Lease Agreement dated as of July 18, 1995 between 2060 Partnership,
           L.P. and TelecomUSA Publishing Company. (Filed as Exhibit 10.68 to
           the November 1996 Form S-1 and incorporated herein by reference).
         
 10.34     Lease Agreement dated April 26, 1995 by and between A.M. Henderson
           and TelecomUSA Publishing Company. (Filed as Exhibit 10.69 to the
           November 1996 Form S-1 and incorporated herein by reference).
         
 10.35     License Agreement dated as of April 19, 1994, between Ameritech
           Information Industry Services and TelecomUSA Publishing Company.
           (Filed as Exhibit 10.70 to the November 1996 Form S-1 and
           incorporated herein by reference).
         
 10.36     License Agreement dated September 13, 1993 between U S WEST
           Communications, Inc. and TelecomUSA Publishing Company. (Filed as
           Exhibit 10.71 to the November 1996 Form S-1 and incorporated herein
           by reference).
         
 10.37     Form of McLeod, Inc. Directors Stock Option Plan Option Agreement.
           (Filed as Exhibit 10.72 to the November 1996 Form S-1 and
           incorporated herein by reference).
         
 10.38     Forms of McLeod, Inc. 1996 Employee Stock Option Plan Incentive
           Stock Option Agreement. (Filed as Exhibit 10.73 to the November 1996
           Form S-1 and incorporated herein by reference).
         
 10.39     Forms of McLeod, Inc. 1996 Employee Stock Option Plan Non-Incentive
           Stock Option Agreement. (Filed as Exhibit 10.74 to the November 1996
           Form S-1 and incorporated herein by reference).
         
 10.40     Sale and Purchase Agreement dated January 27, 1997 among McLeodUSA
           Publishing Company, Fronteer Financial Holdings, Ltd., Classified
           Directories, Inc., Larry A. Scott, James Greff, Randall L. Gowin and
           Edwin Dressler and certain directors, officers and shareholders of
           Fronteer Financial Holdings, Ltd. (Filed as Exhibit 10.90 to the
           1996 Form 10-K and incorporated herein by reference).
         
 10.41     Sale and Purchase Agreement dated February 27, 1997 among McLeodUSA
           Publishing Company, Indiana Directories, Inc., John Morgan, Hank
           Meijer, Jack Hendricks, Brad Nelson and Talking Directories, Inc.
           (Filed as Exhibit 10.91 to the 1996 Form 10-K and incorporated
           herein by reference).
         
 10.42     Amendment to Sale and Purchase Agreement dated February 28, 1997
           between McLeodUSA Publishing Company and Indiana Directories, Inc.
           (Filed as Exhibit 10.92 to the 1996 Form 10-K and incorporated
           herein by reference).
         
 10.43     Ameritech Centrex Service Confirmation of Service Orders dated
           August 21, 1996 between McLeod Telemanagement, Inc. and Ameritech
           Information Industry Services. (Filed as Exhibit 10.93 to the 1996
           Form 10-K and incorporated herein by reference).

                                       72
<PAGE>
 
Exhibit
 Number                             Exhibit Description
---------                           -------------------

+10.44     Amended and Restated Program Enrollment Terms dated November 1, 1996
           between WorldCom Network Services, Inc. d/b/a WilTel and McLeod
           Telemanagement, Inc. (Filed as Exhibit 10.94 to Annual Report on
           Form 10-K/A, File No. 0-20763, filed with the Commission on April 8,
           1997 and incorporated herein by reference).
         
 10.45     Letter Agreement dated April 15, 1997 between U S WEST
           Communications and McLeodUSA Network Services, Inc. (Filed as
           Exhibit 10.1 to Quarterly Report on Form 10-Q, File No. 0-20763,
           filed with the Commission on May 14, 1997 and incorporated herein by
           reference).
         
 10.46     Network Agreement dated April 7, 1997, between Wisconsin Power and
           Light Company and McLeodUSA Telecommunications Services, Inc. (Filed
           as Exhibit 10.96 to the July 1997 Form S-4 and incorporated herein
           by reference).
         
 10.47     Agreement dated July 7, 1997 between McLeodUSA Telecommunications
           Services, Inc. and U S WEST Communications, Inc. (Filed as Exhibit
           10.97 to the July 1997 Form S-4 and incorporated herein by
           reference).
         
 10.48     Agreement dated August 14, 1997 between McLeodUSA Incorporated and
           Taylor Ball, Inc. (Filed as Exhibit 10.98 to Registration Statement
           on Form S-4, File No. 333-34227 (the "November 1997 Form S-4") and
           incorporated herein by reference).
         
 10.49     Interconnection Agreement Under Sections 251 and 252 of the
           Telecommunications Act of 1996 dated as of October 28, 1996 between
           Ameritech Information Industry Services and Consolidated
           Communications Telecom Services Inc. (Filed as Exhibit 10.99 to the
           November 1997 Form S-4 and incorporated herein by reference).
         
 10.50     Interconnection Agreement Under Sections 251 and 252 of the
           Telecommunications Act of 1996 dated as of July 17, 1997 between
           Ameritech Information Industry Services and Consolidated
           Communications Telecom Services Inc. (Filed as Exhibit 10.100 to the
           November 1997 Form S-4 and incorporated herein by reference).
         
  10.51    Supply Agreement dated February 26, 1990 and Amendment Number 4 to
           Supply Agreement dated January 4, 1999 between Alcatel USA Marketing,
           Inc. and McLeodUSA Incorporated.
           
  11.1     Statement regarding Computation of Per Share Earnings.
         
  16.1     Letter regarding Change in Certifying Accountant (Filed as Exhibit
           16.1 to the 1997 Form 10-K and incorporated herein by reference).
         
  21.1     Subsidiaries of McLeodUSA Incorporated.
         
  23.1     Consent of Arthur Andersen LLP.
         
  27.1     Financial Data Schedule.
________________________

 
+    Confidential treatment has been granted. The copy filed as an exhibit omits
     the information subject to the confidential treatment request.

(b)  Reports on Form 8-K.


     On October 29, 1998, we filed a Current Report on Form 8-K to report (1)
our announcement of our intention to offer 9 1/2% senior notes, (2) our
agreement to acquire Dakota Telecommunications and (3) our executive
realignment.

                                       73
<PAGE>
 
     On October 29, 1998, we filed a Current Report on Form 8-K to report our
financial results for the third quarter of 1998.

     On November 19, 1998, we filed a Current Report on Form 8-K to report that
we had entered into a Stockholders' Agreement with Alliant Energy Investments
Inc., Clark E. McLeod, Mary E. McLeod, Richard A. Lumpkin, Gail G. Lumpkin and
certain other parties affiliated or related thereto.

     (c)  Exhibits.

     We hereby file as part of this Form 10-K the exhibits listed in the Index
to Exhibits.

     (d)  Financial Statement Schedule

     The following financial statement schedule is filed herewith:

          Schedule II -- Valuation and Qualifying Accounts

     Schedules not listed above have been omitted because they are inapplicable
or the information required to be set forth therein is provided in our
consolidated financial statements or notes thereto.

                                       74
<PAGE>
 
                                    GLOSSARY

     Access--Telecommunications services that permit long distance carriers to
use local exchange facilities to originate and/or terminate long distance
service.

     Access to Rights-of-Way--Access to poles, ducts, conduits and other rights-
of-way.

     CAP (competitive access provider)--A company that provides its customers
with an alternative to the local exchange company for local transport of private
line and special access telecommunications services.

     Central offices--The switching centers or central switching facilities of
the local exchange companies.

     Collocation--The ability of a CAP such as McLeodUSA to connect its network
to the LECs central offices. Physical collocation occurs when a CAP places its
network connection equipment inside the local exchange company's central
offices. Virtual collocation is an alternative to physical collocation by which
the local exchange company permits a CAP to connect its network to the local
exchange company's central offices on comparable terms, even though the CAP's
network connection equipment is not physically located inside the central
offices.

     Dedicated--Telecommunications service or capacity reserved for use by
particular customers.

     Dialing Parity--The ability of a competing local or toll service provider
to provide telecommunications services in such a manner that customers have the
ability to route automatically, without the use of any access code, their
telecommunications to the service provider of the customer's designation.

     Digital--A method of storing, processing and transmitting information
through the use of distinct electronic or optical pulses that represent the
binary digits 0 and 1. Digital transmission and switching technologies employ a
sequence of these pulses to represent information as opposed to the continuously
variable analog signal. The precise digital numbers minimize distortion (such as
graininess or snow in the case of video transmission, or static or other
background distortion in the case of audio transmission).

     FCC--Federal Communications Commission.

     Interconnection--Interconnection of facilities between or among local
exchange carriers, including potential physical collocation of one carrier's
equipment in the other carrier's premises to facilitate such interconnection.

     Initial Interconnection Decisions--Rulings by the FCC announced in
September 1992 and August 1993, which require the regional Bell operating
companies and most other large local exchange carriers to provide
interconnection in local exchange company central offices to any CAP, long
distance carrier or end user seeking such interconnection for the provision of
interstate special access and switched access transport services.

     Interconnection Decision--The August 1996 order issued by the FCC
implementing the interconnection provisions of the Telecommunications Act of
1996.

     InterLATA--Telecommunications services originating in a LATA and
terminating outside of that LATA.

     IntraLATA--Telecommunications services originating and terminating in the
same LATA.

     LATA (local access and transport area)--A geographic area composed of
contiguous local exchanges, usually but not always within a single state. The
State of Iowa contains all or part of five LATAs; the State of Illinois contains
all or part of 17 LATAs. There are approximately 200 LATAs in the United States.

                                       75
<PAGE>
 
     Local exchange--A geographic area determined by the appropriate state
regulatory authority in which calls generally are transmitted without toll
charges to the calling or called party.

     LEC (local exchange carrier)--A company providing local telephone services.

     Long distance carriers (interexchange carriers)--Long distance carriers
provide services between local exchanges on an interstate or intrastate basis. A
long distance carrier may offer services over its own or another carrier's
facilities.

     Number portability--The ability of an end user to change local exchange
carriers while retaining the same telephone number.

     POPs (points of presence)--Locations where a long distance carrier has
installed transmission equipment in a service area that serves as, or relays
calls to, a network switching center of that long distance carrier.

     Private line--A dedicated telecommunications connection between end user
locations.

     Public switched network--That portion of a local exchange company's network
available to all users generally on a shared basis (i.e., not dedicated to a
particular user). Traffic along the public switched network is generally
switched at the local exchange company's central offices.

     Public utility commission--A state regulatory body, established in most
states, which regulates utilities, including telephone companies providing
intrastate services.

     Reciprocal compensation--The same compensation of a new competitive local
exchange carrier for termination of a local call by the local exchange carrier
on its network, as the new competitor pays the local exchange carrier for
termination of local calls on the local exchange carrier network.

     Resale--Resale by a provider of telecommunications services (such as a
local exchange carrier) of such services to other providers or carriers on a
wholesale or a retail basis.

     Route mile--The number of miles of the telecommunications path in which
fiber optic cables are installed.

     Self-healing ring--A self-healing ring is a network design in which the
network backbone consists of a continuous ring connecting a central hub facility
with one or more network nodes (such as customer premises). Traffic is routed
between the hub and each of the nodes simultaneously in both a clockwise and a
counterclockwise direction. In the event of a cable cut or component failure
along one of these paths, traffic will continue to flow along the alternate path
so no traffic is lost. In the event of a catastrophic node failure, other nodes
will be unaffected because traffic will continue to flow along whichever path
(primary or alternate) does not pass through the affected node. The switch from
the primary to the alternate path will be imperceptible to most users.

     Special access services--The lease of private, dedicated telecommunications
lines or "circuits" along the network of a local exchange company or a CAP,
which lines or circuits run to or from the long distance carrier POPs. Examples
of special access services are telecommunications lines running between POPs of
a single long distance carrier, from one long distance carrier POP to the POP of
another long distance carrier or from an end user to a long distance carrier
POP.

     Switch--A device that opens or closes circuits or selects the paths or
circuits to be used for transmission of information. Switching is a process of
interconnecting circuits to form a transmission path between users.

     Switched access transport services--Transportation of switched traffic
along dedicated lines between the local exchange company central offices and
long distance carrier POPs.

                                       76
<PAGE>
 
     Switched traffic--Telecommunications traffic along the public switched
network. This traffic is generally switched at the local exchange company's
central offices.

     Unbundled Access--Access to unbundled elements of a telecommunications
services provider's network, including network facilities, equipment, features,
functions and capabilities, at any technically feasible point within such
network.

                                       77
<PAGE>
 
                                   SIGNATURES

          Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                                    McLEODUSA INCORPORATED


                                    By  /s/ Clark E. McLeod
                                       -------------------
                                       Clark E. McLeod
                                       Chairman and Chief Executive Officer

                                    March 24, 1999

          Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated and on the dates indicated.

<TABLE>
<CAPTION>
             Signature                                     Title                            Date
             ---------                                     -----                            ----      
<S>                                   <C>                                              <C>
/s/ Clark E. McLeod                   Chairman, Chief Executive Officer and Director   March 24, 1999
-------------------------------         (Principal Executive Officer)
Clark E. McLeod                     
                                    
/s/ Richard A. Lumpkin                Vice Chairman and Director                       March 24, 1999
-------------------------------     
Richard A. Lumpkin                  
                                    
/s/ Stephen C. Gray                   President, Chief Operating Officer and Director  March 24, 1999
-------------------------------     
Stephen C. Gray                     
                                    
/s/ Blake O. Fisher, Jr.              Group Vice President, Regional President--Iowa   March 24, 1999
-------------------------------         and Minnesota, and Director
Blake O. Fisher, Jr.                
                                    
     /s/ J. Lyle Patrick              Group Vice President--Finance and Accounting     March 24, 1999
-------------------------------         and Chief Financial and Accounting Officer
     J. Lyle Patrick                    (Principal Financial Officer and Principal
                                        Accounting Officer)
                                    
   /s/ Thomas M. Collins              Director                                         March 24, 1999
-------------------------------     
   Thomas M. Collins                
                                    
   /s/ Robert J. Currey               Director                                         March 24, 1999
-------------------------------     
   Robert J. Currey                 
                                    
       /s/ Lee Liu                    Director                                         March 24, 1999
-------------------------------     
       Lee Liu                      
                                    
     /s/ Paul D. Rhines               Director                                         March 24, 1999
-------------------------------     
     Paul D. Rhines                 
                                    
                                      Director                                         March __, 1999
-------------------------------     
  Ronald W. Stepien
</TABLE>

                                       78
<PAGE>
 
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
<TABLE> 
<S>                                                                                       <C> 
MCLEODUSA INCORPORATED AND SUBSIDIARIES
Report of Independent Public Accountants................................................  F-2
Consolidated Balance Sheets as of December 31, 1998 and 1997............................  F-3
Consolidated Statements of Operations and Comprehensive Income for the years ended
December 31, 1998, 1997 and 1996........................................................  F-4
Consolidated Statements of Stockholders' Equity for the years ended December 31, 1998,
1997 and 1996...........................................................................  F-5
Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997
and 1996................................................................................  F-6
Notes to Consolidated Financial Statements..............................................  F-7
</TABLE>

                                      F-1
<PAGE>
 
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To the Board of Directors and Stockholders of
McLeodUSA Incorporated:

  We have audited the accompanying consolidated balance sheets of McLeodUSA
Incorporated (a Delaware corporation) and subsidiaries as of December 31, 1998
and 1997, and the related consolidated statements of operations and
comprehensive income, stockholders' equity, and cash flows for each of the three
years in the period ended December 31, 1998. These financial statements are the
responsibility of McLeodUSA Incorporated's management. Our responsibility is to
express an opinion on these financial statements based on our audits.

  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

  In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of McLeodUSA
Incorporated and subsidiaries as of December 31, 1998 and 1997, and the results
of their operations and their cash flows for each of the three years in the
period ended December 31, 1998 in conformity with generally accepted accounting
principles.

                                  ARTHUR ANDERSEN LLP



Chicago, Illinois
January 27, 1999 (except with respect to the 
matters discussed in Note 16, as to
which the date is March 5, 1999)

                                      F-2
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

                          CONSOLIDATED BALANCE SHEETS
                         (In thousands, except shares)

<TABLE> 
<CAPTION> 
                                                                                                 December 31,
                                                                                          ------------------------
                                                                                              1998        1997
                                                                                          -----------  -----------
<S>                                                                                       <C>          <C> 
                                          ASSETS
Current Assets
    Cash and cash equivalents...........................................................  $  455,067  $  331,941  
    Investment in available-for-sale securities.........................................     136,585      34,696  
    Trade receivables, net..............................................................     116,369     108,472  
    Inventory...........................................................................      12,824       3,992  
    Deferred expenses...................................................................      26,693      27,641  
    Prepaid expenses and other..........................................................      45,654      11,127  
                                                                                          ----------  ----------
        Total current assets............................................................     793,192     517,869  
                                                                                          ----------  ----------
Property and Equipment
    Land and building...................................................................      60,325      35,420  
    Telecommunications networks.........................................................     307,310     198,046  
    Furniture, fixtures and equipment...................................................     138,349      70,579  
    Networks in progress................................................................     185,505      81,432  
    Building in progress................................................................      12,567      10,002  
                                                                                          ----------  ----------
                                                                                             704,056     395,479  
    Less accumulated depreciation.......................................................      74,310      21,675  
                                                                                          ----------  ----------
                                                                                             629,746     373,804
                                                                                          ----------  ----------

Investments, Intangibles and Other Assets
    Other investments...................................................................      35,870      30,189  
    Goodwill, net.......................................................................     289,639     273,359  
    Other intangibles, net..............................................................     112,379      97,935  
    Other...............................................................................      64,371      52,496  
                                                                                          ----------  ----------
                                                                                             502,259     453,979  
                                                                                          ----------  ----------
                                                                                          $1,925,197  $1,345,652  
                                                                                          ==========  ==========

                           LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
    Current maturities of long-term debt................................................  $    8,236  $    6,004  
    Contracts and notes payable.........................................................       4,508       6,556  
    Accounts payable....................................................................      62,000      45,354  
    Accrued payroll and payroll related expenses........................................      13,579      21,454  
    Other accrued liabilities...........................................................      63,849      36,793  
    Deferred revenue, current portion...................................................      10,995      10,381  
    Customer deposits...................................................................      16,789      12,710  
                                                                                          ----------  ----------
        Total current liabilities.......................................................     179,956     139,252  
                                                                                          ----------  ----------

Long-Term Debt, less current maturities.................................................   1,245,170     613,384  
                                                                                          ----------  ----------
Deferred Revenue, less current portion..................................................      16,798      12,664  
                                                                                          ----------  ----------
Other Long-term liabilities.............................................................      20,467      20,973  
                                                                                          ----------  ----------

Stockholders' Equity
    Capital stock:
        Common, Class A, $.01 par value; authorized 250,000,000 shares; issued and
          outstanding 1998 63,679,175 shares and 1997 61,799,412 shares.................         637         618  
        Common, Class B, convertible, $.01 par value; authorized 22,000,000 shares;
          issued and outstanding 1998 none; 1997 none ..................................          --          --   
    Additional paid-in capital..........................................................     716,475     688,964  
    Accumulated deficit.................................................................    (252,647)   (127,735) 
    Accumulated other comprehensive income .............................................      (1,659)     (2,468)
                                                                                          ----------  ----------

                                                                                             462,806     559,379  
                                                                                          ----------  ----------
                                                                                          $1,925,197  $1,345,652  
                                                                                          ==========  ==========
</TABLE> 

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

                                      F-3
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

        CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
                     (In thousands, except per share data)


<TABLE> 
<CAPTION>                                                                          Year Ended December 31,
                                                                                ----------------------------
                                                                                1998        1997         1996
                                                                            -----------  ------------  -----------
<S>                                                                          <C>          <C>           <C>                         

Revenue:
   Telecommunications:
     Local and long distance ............................................    $ 267,435    $ 110,023     $ 41,399  
     Local exchange services.............................................       67,785       16,117          --
     Private line and data...............................................       43,892       17,174       10,272  
     Network maintenance and equipment...................................       32,885       20,965        5,936  
     Other telecommunications............................................       27,794        9,907          --
                                                                            -----------  ------------  -----------
          TOTAL TELECOMMUNICATIONS REVENUE...............................      439,791      174,186       57,607  
   Directory.............................................................      144,876       81,055       15,152  
   Telemarketing.........................................................       19,479       12,645        8,564  
                                                                            -----------  ------------  -----------
          TOTAL REVENUE..................................................      604,146      267,886       81,323  

Operating expenses:
   Cost of service.......................................................      323,208      151,190       52,624  
   Selling, general and administrative...................................      260,931      148,158       46,044  
   Depreciation and amortization.........................................       89,107       33,275        8,485  
   Other.................................................................        5,575        4,632        2,380  
                                                                            -----------  ------------  -----------
          TOTAL OPERATING EXPENSES.......................................      678,821      337,255      109,533  
                                                                            -----------  ------------  -----------
          OPERATING LOSS.................................................      (74,675)     (69,369)     (28,210) 
                                                                            -----------  ------------  -----------
Nonoperating income (expense):
   Interest income.......................................................       26,000       22,660        6,034  
   Interest (expense)....................................................      (78,234)     (34,627)        (665) 
   Other income..........................................................        1,997        1,426          495
                                                                             ----------- -----------   -----------
          TOTAL NONOPERATING INCOME (EXPENSE)............................      (50,237)     (10,541)       5,864  
                                                                            -----------  ------------  -----------

          LOSS BEFORE INCOME TAXES.......................................     (124,912)     (79,910)     (22,346) 

Income taxes.............................................................           --           --           --
                                                                            ----------   ------------  -----------
          NET LOSS.......................................................   $ (124,912)   $ (79,910)   $ (22,346) 
                                                                            ===========  ============  ===========
Loss per common share....................................................     $  (1.99)     $ (1.45)     $ (0.55) 
                                                                              ========      =======     =======
Weighted average common shares outstanding...............................       62,807       54,974       40,506
                                                                            ===========  ============  ===========
Other comprehensive income (loss):
    Unrealized gains on securities:
      Unrealized holding gains (losses) arising during the
        period ..........................................................        3,020       (2,468)          --
      Less:  reclassification adjustment for gains included in
         net income......................................................       (2,211)          --           --
                                                                            -----------  ------------  -----------
           TOTAL OTHER COMPREHENSIVE INCOME (LOSS) ......................          809       (2,468)          --
                                                                            -----------  ------------  -----------
           COMPREHENSIVE LOSS .....................................         $ (124,103)   $ (82,378)   $ (22,346)  
                                                                            ===========  ============  ===========
</TABLE> 

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



                                               

                                      F-4
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                 Years Ended December 31, 1998, 1997 and 1996
                         (In thousands, except shares)

<TABLE> 
<CAPTION>
                                                                                                         Accumulated
                                                                               Additional                    Other
                                                              Common Stock      Paid-In   Accumulated   Comprehensive
                                                              ------------
                                                            Class A  Class B    Capital     Deficit        Income        Total
                                                            -------  -------   --------    ---------   --------------  ---------
<S>......................................................   <C>       <C>     <C>         <C>          <C>            <C>
Balance, December 31, 1995.............................. .   $ 164    $ 156   $ 40,117    $  (25,479)    $      --    $  14,958
  Net loss...............................................      --        --         --       (22,346)           --      (22,346)
  Issuance of 19,424,316 shares of Class A
    common stock.........................................      194       --    396,020            --            --      396,214
  Issuance of 361,420 shares of Class A common
    stock in connection with the acquisition of
    Ruffalo, Cody & Associates, Inc. ....................        4       --      8,941            --            --        8,945
  Options to purchase 158,009 shares of Class A
    common stock granted in connection with the
    acquisition of Ruffalo, Cody & Associates, Inc.,
    less cash to be received upon exercise of options....       --       --      3,301            --            --        3,301
  Amortization of fair value of stock options issued
    to nonemployees......................................       --       --        341            --            --          341
  Amortization of compensation expense related to
    stock options........................................       --       --      2,016            --            --        2,016
                                                            ------    -----   --------     ----------     ----------   ---------
Balance, December 31, 1996...............................      362      156    450,736       (47,825)           --      403,429
  Net loss...............................................       --       --         --       (79,910)           --      (79,910)
  Issuance of 1,137,883 shares of Class A
    common stock.........................................       11       --        881            --            --          892
  Release of 56,177 shares of Class A common
    stock from escrow....................................        1       --      1,346            --            --        1,347
  Issuance of 84,430 shares of Class A common
    stock in connection with the acquisition of
    Digital Communications of Iowa, Inc. ................        1       --      2,249            --            --        2,250
  Issuance of 8,488,596 shares of Class A
    common stock in connection with the
    acquisition of CCI. .................................       85       --    223,590            --            --      223,675
  Issuance of 55,500 shares of Class A common stock
    in connection with the acquisition of certain
    assets of OneTEL Corp. ..............................        1       --      1,962            --            --        1,963
  Issuance of 140,000 shares of Class A common stock
    in connection with the acquisition of ownership
    interests of Colorado Directory Company LLC .........        1       --      4,479            --            --        4,480
  Issuance of 38,080 shares of Class A common stock
    to participants in the Employee Stock
    Purchase Plan........................................       --       --        728            --            --          728
  Conversion of 15,625,929 shares of Class B
    common stock to 15,625,929 shares of Class
    A common stock.......................................      156     (156)        --            --            --           --
  Amortization of compensation expense
   related to stock options..............................       --       --      2,993            --            --        2,993
  Other comprehensive income.............................       --       --         --            --         (2,468)     (2,468)
                                                            ------    -----   --------    ----------     ----------   ---------
Balance, December 31, 1997...............................      618       --    688,964      (127,735)        (2,468)    559,379
  Net loss...............................................       --       --         --      (124,912)            --    (124,912)
  Issuance of 1,353,785 shares of Class A
    common stock.........................................       13       --      3,755            --             --       3,768
  Issuance of 70,508 shares of Class A common
    stock in connection with the acquisition
    of NewCom Technologies, Inc. and NewCom OSP
    Services, Inc. ......................................        1       --      3,216            --             --       3,217
  Issuance of 151,019 shares of Class A common stock in
    connection with the acquisition of certain assets
    of Communications Cable-Laying Company, Inc. ........        1       --      5,964            --             --       5,965
  Issuance of 70,672 shares of Class A common
    stock in connection with the acquisition of
    of Inlet, Inc. ......................................        1       --      2,387            --             --       2,388
  Issuance of 82,602 shares of Class A common
    stock to participants in the 401(k)
    profit-sharing plans.................................        1       --      2,611            --             --       2,612
  Issuance of 132,893 shares of Class A
    common stock to participants in the Employee Stock
    Purchase Plan........................................        2       --      3,707            --             --       3,709
  Amortization of compensation expense
    related to stock options.............................       --       --      5,871            --             --       5,871

  Other comprehensive income.............................       --       --         --            --            809         809
                                                            ------    -----   --------    ----------     ----------   ---------
Balance, December 31, 1998...............................   $  637    $  --   $716,475    $ (252,647)    $   (1,659)  $ 462,806
                                                            ======    =====   ========    ==========     ==========   =========
</TABLE> 

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

                                      F-5
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                (In thousands)
<TABLE> 
<CAPTION> 
                                                                                      Year Ended December 31,
                                                                                      -------------------------    
                                                                                       1998      1997       1996
                                                                                      ------   ------    -------       
<S>                                                                                <C>        <C>        <C> 
Cash Flows from Operating Activities
  Net loss........................................................................ $(124,912) $(79,910) $(22,346) 
  Adjustments to reconcile net loss to net cash (used in) operating activities:
    Depreciation..................................................................    53,343    17,622     3,944  
    Amortization..................................................................    34,693    15,653     4,882  
    Accretion of interest on senior discount notes................................    35,145    26,754       --   
    Changes in assets and liabilities, net of effects of acquisitions:
      (Increase) in trade receivables.............................................    (6,409)  (15,937)   (9,317) 
      (Increase) in inventory.....................................................    (8,242)     (773)       (2) 
      Decrease in deferred expenses...............................................       948     1,218     1,966  
      (Increase) in prepaid expenses and other....................................                       
                                                                                     (34,288)   (1,041)   (3,703) 
      (Increase) in deferred line installation costs..............................   (13,630)   (9,669)   (1,289) 
      Increase in accounts payable and accrued expenses...........................    32,178     27,117    3,192  
      Increase in deferred revenue................................................     4,597     7,186     9,505    
      Increase in customer deposits...............................................     4,077     3,024     1,366   
                                                                                      -----      -----     -----
        NET CASH (used in) operating activities...................................   (22,500)   (8,756)  (11,802) 
                                                                                    -------     ------   -------

Cash Flows from Investing Activities
  Purchase of property and equipment..............................................  (289,923) (151,280)  (70,290) 
  Available-for-sale securities:
    Purchases.....................................................................  (607,440) (115,985) (207,681) 
    Sales.........................................................................   264,383   102,368    17,577  
    Maturities....................................................................   241,977   133,817    62,389  
  Business acquisitions...........................................................   (27,812) (181,892)  (80,081) 
  Deposits on PCS licenses........................................................      --     (27,975)   (4,889) 
  Other...........................................................................                      
                                                                                      (5,175)   (1,863)     (133) 
                                                                                     ------     ------      ----
        Net cash (used in) investing activities...................................  (423,990)  (242,810) (283,108) 
                                                                                     -------   --------  --------
                                                                                     
Cash Flows from Financing Activities
  Proceeds from line of credit agreements.........................................        --        --    55,925  
  Payments on line of credit agreements...........................................        --        --   (59,825) 
  Payments on contracts and notes payable.........................................   (11,082)  (18,967)      --   
  Proceeds from long-term debt....................................................   583,923   506,626     2,060  
  Payments on long-term debt......................................................   (10,895)   (2,252)   (2,065) 
  Net proceeds from issuance of common stock......................................     7,670     1,620   396,214  
  Other...........................................................................        --        --      (919) 
                                                                                      ------   -------   -------   
        Net cash provided by financing activities.................................   569,616   487,027   391,390  
                                                                                     -------   -------   -------

        Net increase in cash and cash equivalents.................................   123,126   235,461    96,480  
Cash and cash equivalents:
  Beginning.......................................................................   331,941    96,480        --   
                                                                                    --------  --------        --
  Ending.......................................................................... $ 455,067  $331,941  $ 96,480  
                                                                                    ========  ========  ========

Supplemental Disclosure of Cash Flow Information
  Cash payment for interest, net of interest capitalized 1998 $10,616; 1997 $4,440;
    1996 $204....................................................................  $  26,992  $  1,764  $    300  
                                                                                   =========  ========   =======
Supplemental Schedule of Noncash Investing and Financing Activities
  Release of 56,177 shares of Class A common stock from escrow ...................            $  1,347  
                                                                                              ========
  Capital leases incurred for the acquisition of property and equipment ..........   $ 5,914  $  3,367  
                                                                                     =======  ========
</TABLE> 

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

                                      F-6
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES

     Nature of business: McLeodUSA Incorporated and subsidiaries (the "Company")
is a diversified telecommunications company, incorporated in Delaware, that
provides a broad range of products and services to business customers in Iowa,
Illinois, North Dakota, South Dakota, Minnesota, Indiana, Colorado and Wyoming
and residential customers in Iowa, Illinois, North Dakota, South Dakota,
Wisconsin and Colorado. The Company's services primarily include local and long-
distance telecommunications services, telecommunications network maintenance
services and telephone equipment sales, service and installation, private line
and data services, the sale of advertising space in telephone directories, the
operation of an independent local exchange company, and telemarketing services.
The Company's business is highly competitive and is subject to various federal,
state and local regulations. In 1997, the Company's stockholders approved a
change in its name to McLeodUSA Incorporated from McLeod, Inc.

     Accounting estimates: The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amount of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.

     A summary of the Company's significant accounting policies is as follows:

     Principles of consolidation: The accompanying financial statements include
those of the Company and its subsidiaries, substantially all of which are wholly
owned. All significant intercompany items and transactions have been eliminated
in consolidation.

     Regulatory accounting: Illinois Consolidated Telephone Company ("ICTC"), an
independent local exchange carrier and a wholly owned subsidiary of the Company,
prepares its financial statements in accordance with the provisions of Statement
of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain
Types of Regulation" ("SFAS No. 71"). The provisions of SFAS No. 71 require,
among other things, that regulated enterprises reflect rate actions of
regulators in their financial statements, when appropriate. These rate actions
can provide reasonable assurance of the existence of an asset, reduce or
eliminate the value of an asset, or impose a liability on a regulated
enterprise. SFAS No. 71 also specifies that the actions of a regulator can
eliminate only liabilities imposed by the regulator.

     Cash and cash equivalents: For purposes of reporting cash flows, the
Company considers all highly liquid debt instruments purchased with a maturity
of three months or less and all certificates of deposit, regardless of maturity,
to be cash equivalents.

     Investments: Management determines the appropriate classification of the
securities at the time they are acquired and evaluates the appropriateness of
such classifications at each balance sheet date. The Company has classified its
securities as available-for-sale. Available-for-sale securities are stated at
fair value, and unrealized holding gains and losses are reported as a component
of stockholders' equity. Realized gains and losses are determined on the basis
of the specific securities sold.

     Trade receivables: In accordance with the industry practice for the
publication of telephone directories, trade receivables include certain unbilled
revenue from installment contracts. It is anticipated that a substantial portion
of all such amounts at December 31, 1997 and 1998 will be collected within one
year (see Note 2).

                                      F-7
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
                                        
NOTE 1. NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED)

  Inventory: Inventory is carried principally at the lower of average cost or
market and consists primarily of new and reusable parts to maintain fiber optic
networks and parts and equipment used in the maintenance and installation of
telephone systems. All inventory is classified as raw materials.

  Property and equipment: Property and equipment is stated at cost. Construction
costs, including interest, are capitalized during the installation of fiber
optic telecommunications networks. Interest expense was also capitalized as part
of the construction of the Company's headquarters buildings and the development
of the Company's software.

  ICTC's property and equipment for its regulated operations is summarized as
follows at December 31, 1998 (In thousands):

<TABLE>
   <S>                                                                                              <C>
   Telephone plant:
     In service...............................................................................      $101,126
     Under construction.......................................................................           902
                                                                                                    --------
                                                                                                     102,028
     Less accumulated depreciation............................................................       (10,576)
                                                                                                    --------
                                                                                                    $ 91,452
                                                                                                    ========
</TABLE>
 
  When regulated property and equipment are retired, the original cost, net of
salvage, is charged against accumulated depreciation. The cost of maintenance
and repairs of property and equipment including the cost of replacing minor
items not constituting substantial betterments is charged to operating expense.

  The provision for depreciation of regulated property and equipment is based
upon remaining life rates for property placed in service through 1980 and equal
life rates for property additions placed in service after 1980. The regulated
provision is equivalent to an annual composite rate of 5.58% for 1998.

  The provision for depreciation of nonregulated property and equipment is
recorded using the straight-line method based on the following estimated useful
lives:

<TABLE>
<CAPTION> 
                                                                                                     Years
                                                                                                   ---------
<S>                                                                                                <C>
    Buildings....................................................................................      20-39
    Telecommunications networks..................................................................       5-15
    Furniture, fixtures and equipment............................................................       2-10
</TABLE>

  The Company's telecommunications networks are subject to technological risks
and rapid market changes due to new products and services and changing customer
demand. These changes may result in changes in the estimated economic lives of
these assets.

  Other investments: Other investments primarily includes $26,195,000 for a
minority interest in a limited partnership which provides cellular services to
customers in east central Illinois. The Company follows the equity method of
accounting for this investment, which recognizes the Company's proportionate
share of the income and losses accruing to it under the terms of its partnership
agreement.

  Goodwill: Goodwill resulting from the Company's acquisitions is being
amortized over a range of 15 to 30 years using the straight-line method and the
acquisitions are periodically reviewed for impairment

                                      F-8
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
                                        
NOTE 1. NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED)

based upon an assessment of future operations to ensure that it is appropriately
valued. Accumulated amortization on goodwill totaled $16,356,000 and $5,834,000
at December 31, 1998 and 1997, respectively.

  Other intangibles: Other intangibles consist of customer lists and noncompete
agreements related to the Company's acquisitions, deferred line installation
costs incurred in the establishment of local access lines for customers and
franchise rights to provide cable services to customers in three Illinois
counties and in a Michigan city. The customer lists and noncompete agreements
are being amortized using the straight-line method over periods ranging from 3
to 15 years. The deferred line installation costs are being amortized using the
straight-line method over 36 to 60 months, which approximates the average lives
of residential and business customer contracts. The franchise rights are being
amortized using the straight-line method over periods ranging from 10 to 15
years. Accumulated amortization on the other intangibles totaled $25,066,000 and
$9,158,000 at December 31, 1998 and 1997, respectively.

  Income tax matters: The Company recognizes deferred tax assets and liabilities
for the expected future tax consequences of events that have been included in
the financial statements or tax returns. Under this method, deferred tax assets
and liabilities are determined based on the difference between the financial
statement and tax bases of assets and liabilities using enacted tax rates in
effect for the year in which the differences are expected to reverse. Net
deferred tax assets are reduced by a valuation allowance when appropriate (see
Note 6). Deferred tax assets and liabilities are adjusted for the effects of
changes in tax laws and rates on the date of enactment.

  Deferred revenue: Amounts received in advance under long-term leases of fiber
optic telecommunications networks are recognized as revenue on a straight-line
basis over the life of the leases.

  Revenue recognition: Revenues for local and long-distance services are
recognized when subscribers use telecommunications services. The revenue from
long-term leases of fiber optic telecommunications networks is recognized over
the term of the lease. Base annual revenue for telecommunications network
maintenance is recognized on a straight-line basis over the term of the
contract. Additional services provided under these contracts are recognized as
the services are performed.

  ICTC's toll revenue is provided through a combination of billed carrier access
charges, traditional end-user billed toll revenues, interstate tariffed
subscriber line charges and ICTC's share of revenues and expenses from the non-
traffic sensitive pool administered by the National Exchange Carrier
Association.

  As allowed by the FCC, ICTC's presubscribed rate of return on interstate
access revenues for 1998 was 11.25%. The FCC further restricted overall
interstate revenues to a maximum 11.50% rate of return on related investments,
or to a maximum of 11.65% rate of return on related investments per any
individual rate element.

  Fees from telemarketing contracts are recognized as revenue in the period the
services are performed.

  Revenues from directories are recorded upon publication.

                                      F-9
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
                                        
NOTE 1. NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED)

  Customer deposits consist of cash received from customers at the time a sales
contract is signed. They are recorded as revenue when the related directory is
published or when the related service is performed.

  Cost of service and deferred expenses: Cost of service includes local and 
long-distance services purchased from certain Regional Bell Operating Companies
and interexchange carriers, the cost of providing local exchange services to
customers in ICTC's service area and the cost of operating the Company's fiber
optic telecommunications networks. Cost of service also includes production
costs associated with the publication of directories and direct costs associated
with telemarketing services and the sale and installation of telephone systems.

  Deferred expenses consist of production and selling costs on unpublished
directory advertising orders. They are expensed when the related directory is
published and the related revenue of the directory is recognized.

  Key business suppliers: U S WEST, Ameritech and Southwestern Bell Company are
the Company's primary suppliers of local central office switching and local
lines.

  Stock options issued to employees: In fiscal year 1996, the Company adopted
the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, which
establishes a fair value based method for the financial reporting of its stock-
based employee compensation plans. The Company measures compensation using the
intrinsic value based method as prescribed by Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees. Under this method,
compensation is measured as the difference between the market value of the stock
on the grant date, less the amount required to be paid for the stock. The
difference, if any, is charged to expense over the vesting period of the
options.

  The estimated market value used for the stock options granted was determined
on a periodic basis by the Company's Board of Directors prior to the Company's
initial public offering on June 10, 1996. Subsequent to the Company's initial
public offering, the market value used for stock options granted is based upon
the closing price of the Class A common stock on the day before the grant date.

  Stock options issued to nonemployees: The Company uses the Black-Scholes model
to determine the fair value of the stock options issued to nonemployees at the
date of grant. This amount is amortized to expense over the vesting period of
the options.

  Loss per common share: Loss per common share has been computed using the
weighted average number of shares of common stock outstanding after giving
effect to the recapitalization in 1996. All stock options granted are anti-
dilutive, and therefore excluded from the computation of earnings per share. In
the future, these stock options may become dilutive.

  Fair value of financial instruments: The carrying amount of cash and cash
equivalents approximates fair value due to the short maturity of the
instruments. For other investments for which there are no quoted market prices,
a reasonable estimate of fair value could not be made without incurring
excessive cost. The $29.9 million carrying amount of unquoted investments at
December 31, 1998, represents the original cost of the investments, which
management believes is not impaired. The fair value of the Company's long-term
debt is estimated to be $1.3 billion based on the quoted market rates for the
same or similar issues or the current rates offered to the Company for debt with
similar maturities.

                                      F-10
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 1. NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED)

  Reclassifications:  Certain items in the 1997 consolidated financial
statements have been reclassified to be consistent with the classification in
the 1998 consolidated financial statements.

NOTE 2. TRADE RECEIVABLES

  The composition of trade receivables, net is as follows:

<TABLE> 
<CAPTION> 
                                                                                            DECEMBER 31,
                                                                                       ------------------------
 
                                                                                          1998          1997
                                                                                       --------       --------
                                                                                           (In thousands)
   <S>                                                                                 <C>            <C>  
    Billed.......................................................................      $110,587       $ 86,309
    Unbilled.....................................................................        21,350         34,114
                                                                                       --------       --------
                                                                                        131,937        120,423
                                                                                        (15,568)       (11,951) 
  Less allowance for doubtful accounts and discounts.............................      --------       --------          
                                                                                       $116,369       $108,472
                                                                                       ========       ======== 
</TABLE>

NOTE 3. INVESTMENTS

  At December 31, 1998, the Company held $187,136,000, $30,298,000 and
$30,614,000 in corporate debt securities, United States Government and
governmental agency securities and marketable equity securities, respectively.
At December 31, 1997, the Company held $4,493,000, $94,341,000 and $27,491,000
in repurchase agreements, corporate debt securities and marketable equity
securities, respectively. The Company has classified these securities as
available-for-sale, and at December 31, 1998 and 1997, the debt securities'
amortized cost approximates fair value. The marketable equity securities have
been recorded at their fair market value at December 31, 1998. The available-
for-sale securities have been classified as cash and cash equivalents, and
investment in available-for-sale securities-current, with $111,463,000 and
$136,585,000, respectively, being recorded in each classification at December
31, 1998. At December 31, 1997, $91,629,000 and $34,696,000, respectively, were
recorded in each classification.

  The contractual maturities of the available-for-sale securities of
$248,048,000 and $126,325,000 in 1998 and 1997, respectively, are due within one
year.

  Expected maturities will differ from contractual maturities because the
issuers of certain debt securities have the right to call or prepay their
obligations without any penalties. The amount classified as current assets on
the accompanying balance sheets represent the expected maturities of the debt
securities during the next year.

                                      F-11
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 4. PLEDGED ASSETS AND DEBT

  Debt offerings: On March 4, 1997, the Company completed a private offering of
10 1/2% Senior Discount Notes (the "Senior Discount Notes") due March 1, 2007 at
an original issue discount in which the Company received approximately $288.9
million in net proceeds. The Company filed a registration statement with the
Securities and Exchange Commission ("SEC") for the registration of $500 million
principal amount at maturity of 10 1/2% Senior Discount Notes due March 1, 2007
(the "Senior Discount Exchange Notes") to be offered in exchange for the Senior
Discount Notes (the "Senior Discount Exchange Offer"). The registration
statement was declared effective by the SEC on July 28, 1997 and the Senior
Discount Exchange Offer was commenced. The Senior Discount Exchange Offer
expired on August 24, 1997, at which time all of the Senior Discount Notes were
exchanged for the Senior Discount Exchange Notes. The form and terms of the
Senior Discount Exchange Notes are identical in all material respects to the
form and terms of the Senior Discount Notes except that (i) the Senior Discount
Exchange Notes have been registered under the Securities Act of 1933 (the
"Securities Act") and (ii) holders of the Senior Discount Exchange Notes are not
entitled to certain rights under a registration agreement relating to the Senior
Discount Notes. The Senior Discount Exchange Notes rank pari passu in right of
payment with all existing and future senior unsecured indebtedness of the
Company and rank senior in right of payment to all existing and future
subordinated indebtedness of the Company. The Senior Discount Exchange Notes
accrete interest at a rate of 10 1/2% per year, compounded semi-annually, to an
aggregate principal amount of $500 million by March 1, 2002. Interest will not
accrue on the Senior Discount Exchange Notes for five years, after which time
the Senior Discount Exchange Notes will accrue interest at 10 1/2%, payable 
semi-annually. The indenture related to the Senior Discount Exchange Notes
contains certain covenants which, among other things, restrict the ability of
the Company to incur additional indebtedness, pay dividends or make
distributions of the Company's or its subsidiaries' stock, enter into sale and
leaseback transactions, create liens, enter into transactions with affiliates or
related persons, or consolidate, merge or sell all of its assets.

  On July 21, 1997, the Company completed a private offering of $225 million
aggregate principal amount of 9 1/4% Senior Notes due July 15, 2007 (the "Senior
Notes"). The Company received net proceeds of approximately $217.6 million from
the Senior Note offering. Interest on the Senior Notes is payable in cash semi-
annually in arrears on July 15 and January 15 of each year at a rate of 9 1/4%
per annum, commencing January 15, 1998. The Senior Notes rank pari passu in
right of payment with all existing and future senior unsecured indebtedness of
the Company and rank senior in right of payment to all existing and future
subordinated indebtedness of the Company. As of December 31, 1997, the Senior
Notes had not been registered under the Securities Act and therefore cannot be
offered for resale, resold or otherwise transferred unless so registered or
unless an applicable exemption from the registration requirements of the
Securities Act is available. The Company has filed a registration statement with
the SEC for the registration of $225 million aggregate principal amount of 9
1/4% Senior Notes due July 15, 2007 (the "Exchange Notes") to be offered in
exchange for the Senior Notes (the "Exchange Offer"). The registration statement
was declared effective by the SEC on December 1, 1997, and the Exchange Offer
was commenced on December 2, 1997. The Exchange Offer expired on January 9,
1998, at which time all of the Senior Notes were exchanged for the Exchange
Notes. The form and terms of the Exchange Notes are identical in all material
respects to the form and terms of the Senior Notes except that (i) the Exchange
Notes have been registered under the Securities Act and (ii) holders of the
Exchange Notes will not be entitled to certain rights under a registration
agreement relating to the Senior Notes. The indentures relating to the Senior
Notes and the Exchange Notes contain certain covenants which are materially the
same as the covenants relating to the Senior Discount Exchange Notes.

  On March 16, 1998, the Company completed a private offering of its 8 3/8%
Senior Notes due March 5, 2008 (the "March 1998 Privately Placed Senior Notes"),
for which the Company received net proceeds

                                      F-12
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 4.  PLEDGED ASSETS AND DEBT (CONTINUED)

of approximately $291.9 million. The Company filed a registration statement with
the SEC for the registration of $300 million principal amount of 8 3/8% Senior
Notes due March 15, 2008 (the "March Exchange Notes" together with the March
1998 Privately Placed Senior Notes, the "March 1998 Senior Notes") to be offered
in exchange for the March 1998 Privately Placed Senior Notes (the "March
Exchange Offer"). The registration statement was declared effective by the SEC
on May 15, 1998 and the March Exchange Offer was commenced. The March Exchange
Offer expired on June 25, 1998, at which time all of the March 1998 Privately
Placed Senior Notes were exchanged for the March Exchange Notes. The form and
terms of the March Exchange Notes are identical in all material respects to the
form and terms of the March 1998 Privately Placed Senior Notes except that (i)
the March Exchange Notes have been registered under the Securities Act of 1933
(the "Securities Act") and (ii) holders of the March Exchange Notes are not
entitled to certain rights under a registration agreement related to the March
1998 Privately Placed Senior Notes. Interest on the March 1998 Senior Notes will
be payable in cash semi-annually in arrears on March 15 and September 15 of each
year at a rate of 8 3/8% per annum, commencing September 15, 1998. The March
1998 Senior Notes rank pari passu in right of payment with all existing and
future senior unsecured indebtedness of the Company and rank senior in right of
payment to all existing and future subordinated indebtedness. The March 1998
Senior Notes will mature on March 15, 2008. The March 1998 Senior Notes will be
redeemable at the option of the Company, in whole or in part, at any time on or
after March 15, 2003 at 104.188% of their principal amount at maturity, plus
accrued and unpaid interest, declining to 100.000% of their principal amount at
maturity, plus accrued and unpaid interest, on or after March 15, 2006. In the
event of certain equity investments in the Company by certain strategic
investors on or before March 15, 2001, the Company may, at its option, use all
or a portion of the net proceeds from such sale to redeem up to 33 1/3% of the
originally issued principal amount of the March 1998 Senior Notes at a
redemption price equal to 108.375% of the principal amount of the March 1998
Senior Notes plus accrued and unpaid interest thereon, if any, to the redemption
date, provided that at least 66 2/3% of the originally issued principal amount
of the March 1998 Senior Notes would remain outstanding immediately after giving
effect to such redemption. In addition, in the event of a Change of Control (as
defined in the indenture dated as of March 16, 1998 between the Company and the
United States Trust Company of New York as trustee, governing the March 1998
Senior Notes (the "March 1998 Senior Note Indenture")) of the Company, each
holder of March 1998 Senior Notes shall have the right to require the Company to
repurchase all or any part of such holder's March 1998 Senior Notes at a
purchase price equal to 101% of the principal amount of the March 1998 Senior
Notes tendered by such holder plus accrued and unpaid interest, if any, to any
Change of Control Payment Date (as defined in the March 1998 Senior Note
Indenture).

  The March 1998 Senior Note Indenture imposes operating and financial
restrictions on the Company and its subsidiaries.  These restrictions affect,
and in certain cases significantly limit or prohibit, among other things, the
ability of the Company and its subsidiaries to incur additional indebtedness,
pay dividends or make distributions in respect of the Company's or such
subsidiaries' capital stock, make other restricted payments, enter into sale and
leaseback transactions, create liens upon assets, enter into transactions with
affiliates ore related persons, sell assets, or consolidate, merge or sell all
or substantially all of their assets.

  On October 30, 1998, the Company completed a private offering of its 9 1/2%
Senior Notes due November 1, 2008 (the "October 1998 Privately Placed Senior
Notes"), for which the Company received net proceeds of approximately $291.9
million. The Company filed a registration statement with the SEC for the
registration of $300 million principal amount of 9 1/2% Senior Notes due
November 1, 2008 (the "October Exchange Notes" together with the October 1998
Privately Placed Senior Notes, the

                                      F-13
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 4. PLEDGED ASSETS AND DEBT (CONTINUED)

"October 1998 Senior Notes") to be offered in exchange for the October 1998
Privately Placed Senior Notes (the "October Exchange Offer"). The registration
statement was declared effective by the SEC on January 29, 1999 and the October
Exchange Offer was commenced. The October Exchange Offer expired on March 3,
1999, at which time all of the October 1998 Privately Placed Senior Notes were
exchanged for the October Exchange Notes. The form and terms of the October
Exchange Notes are identical in all material respects to the form and terms of
the October 1998 Privately Placed Senior Notes except that (i) the October
Exchange Notes have been registered under the Securities Act and (ii) holders of
the October Exchange Notes are not entitled to certain rights under a
registration agreement related to the October 1998 Privately Placed Senior
Notes. Interest on the October 1998 Senior Notes will be payable in cash semi-
annually in arrears on May 1 and November 1 of each year at a rate of 9 1/2% per
annum, commencing May 1, 1999. The October 1998 Senior Notes rank pari passu in
right of payment with all existing and future senior unsecured indebtedness of
the Company and rank senior in right of payment to all existing and future
subordinated indebtedness. The October 1998 Senior Notes will mature on November
1, 2008. The October 1998 Senior Notes will be redeemable at the option of the
Company, in whole or in part, at any time on or after November 1, 2003 at
106.750% of their principal amount at maturity, plus accrued and unpaid
interest, declining to 100.000% of their principal amount at maturity, plus
accrued and unpaid interest, on November 1, 2008. In the event of certain equity
investments in the Company by certain strategic investors on or before November
1, 2001, the Company may, at its option, use all or a portion of the net
proceeds from such sale to redeem up to 33 1/3% of the originally issued
principal amount of the October 1998 Senior Notes at a redemption price equal to
111.500% of the principal amount of the October 1998 Senior Notes plus accrued
and unpaid interest thereon, if any, to the redemption date, provided that at
least 66 2/3% of the originally issued principal amount of the October 1998
Senior Notes would remain outstanding immediately after giving effect to such
redemption. In addition, in the event of a Change of Control (as defined in the
indenture dated as of October 30, 1998 between the Company and the United States
Trust Company of New York as trustee, governing the October 1998 Senior Notes
(the "October 1998 Senior Note Indenture")) of the Company, each holder of
October 1998 Senior Notes shall have the right to require the Company to
repurchase all or any part of such holder's October 1998 Senior Notes at a
purchase price equal to 101% of the principal amount of the October 1998 Senior
Notes tendered by such holder plus accrued and unpaid interest, if any, to any
Change of Control Payment Date (as defined in the October 1998 Senior Note
Indenture).

  The October 1998 Senior Note Indenture imposes operating and financial
restrictions on the Company and its subsidiaries. These restrictions affect, and
in certain cases significantly limit or prohibit, among other things, the
ability of the Company and its subsidiaries to incur additional indebtedness,
pay dividends or make distributions in respect of the Company's or such
subsidiaries' capital stock, make other restricted payments, enter into sale and
leaseback transactions, create liens upon assets, enter into transactions with
affiliates ore related persons, sell assets, or consolidate, merge or sell all
or substantially all of their assets.

                                      F-14
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 4. PLEDGED ASSETS AND DEBT--(CONTINUED)

  The Company's debt consisted of the following at December 31, 1998 and 1997:

<TABLE>
<CAPTION>
                                                                                                      1998       1997     
                                                                                                   ----------  --------   
                                                                                                      (IN THOUSANDS)      
<S>                                                                                                <C>         <C>        
  Contracts payable, unsecured, non-interest bearing, due in various installments                                         
    with the final payment to be made in 1999...............................................       $    4,400  $  1,056   
  Notes payable, banks, bearing interest at 6.1875% due in various installments                                           
    through October 1997 (A)................................................................               --     5,500   
  Other long-term borrowings, due in various installments                                                                 
    bearing interest at rates ranging from 0% to 8.625%.....................................              108        --   
                                                                                                   ----------  --------   
                                                                                                   $    4,508  $  6,556   
                                                                                                   ==========  ========   
                                                                                                                          
  10 1/2% Senior Discount Notes.............................................................       $  361,902  $326,754   
  9 1/4% Senior Notes.......................................................................          225,000   225,000   
  8 3/8% Senior Notes.......................................................................          300,000        --   
  9 1/2% Senior Notes.......................................................................          300,000        --   
  CCI unsecured senior notes payable, with semiannual interest payments                                                   
    at 7.75% payable April 1 and October 1. Annual principal payments                                                     
    of $1,428,571 are due beginning October 1, 1998 until maturity in                                                     
    October 2004............................................................................            8,571    10,000     
  CCI Series A Senior Unsecured Notes, with semiannual interest payments                                                    
    at 6.83% payable June 1 and December 1. Annual principal payments of                                                    
    $909,091 are due beginning December 1, 2001 until maturity in                                                           
    December 2010...........................................................................           10,000    10,000     
  CCI Series B Senior Unsecured Notes, with semiannual interest payments                                                    
    at 6.71% payable June 1 and December 1. Annual principal payments                                                       
    of $454,546 are due beginning December 1, 2001 until maturity in                                                        
    December 2010...........................................................................            5,000     5,000     
  Greene County Partners, Inc. senior notes due in quarterly payments of                                                    
    $450,000 bearing interest at 6.35% and maturing in April 2001...........................           13,500    15,300     
  ICTC Series K, 8.620% First Mortgage Bonds due September 2022 (B).........................           10,000    10,000     
  ICTC Series L, 7.050% First Mortgage Bonds due October 2013 (B)...........................           10,000    10,000     
  Contracts payable, to finance company, due in various monthly                                                             
    payments, including interest at 3.90%, through March 2000,                                                              
    collateralized by equipment with a depreciated cost of                                                                  
    $4,173,000 at December 31, 1998.........................................................            2,204     2,637     
  Note payable due in various annual installments, including                                                                
    interest at 8.25%, through 2006. Collateralized by publishing                                                           
    rights to purchased directories.........................................................              606       995     
  Other long-term borrowings, due in various installments                                                                   
    bearing interest at rates ranging from 0% to 8.625%                                                                     
    through March 2004......................................................................            5,429     2,092     
  Incentive compensation agreements, due in various                                                                         
    estimated amounts plus interest at 6.0% through                                                                         
    January 2001 (See Note 11)..............................................................            1,194     1,610     
                                                                                                   ----------  --------     
                                                                                                    1,253,406   619,388     
  Less current maturities...................................................................            8,236     6,004     
                                                                                                   ----------  --------     
                                                                                                   $1,245,170  $613,384     
                                                                                                   ==========  ========     
</TABLE>

________________________

(A) CCI and ICTC have various short-term line of credit agreements with certain
    financial institutions totaling $30,000,000 of which no borrowings were
    outstanding at December 31, 1998 and $5,500,000 in borrowings were
    outstanding at December 31, 1997.

(B) ICTC's first mortgage bonds are collateralized by substantially all real and
    personal property of the subsidiary. The bond indenture contains various
    provisions restricting, among other things, the payment of dividends and
    repurchase of its own stock. Early redemption of the Series K and Series L
    Bonds is permitted.

                                     F-15
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 4.  PLEDGED ASSETS AND DEBT--(CONTINUED)

   In 1996, the Company used a portion of the proceeds from the Company's
initial public offering (see Note 8) to pay off all existing indebtedness under
three line of credit facilities, which were then canceled. Options to purchase
Class B common stock were granted to a stockholder which had guaranteed
borrowings under two of the facilities. The Company used the Black-Scholes model
to determine the value of the options, which was approximately $3,400,000, at
the date of grant. This value was being amortized over the vesting period of the
options. Upon cancellation of the credit facilities, the options' vesting
schedule and amortization of the fair value of the options were terminated. A
total of 1,300,688 Class B common stock options were outstanding at December 31,
1998 and December 31, 1997.

   Principal payments required on the outstanding debt at December 31, 1998 are
as follows (In thousands):

<TABLE>
<S>                                                                          <C>
     1999...........................................................         $    8,236
     2000...........................................................              6,643
     2001...........................................................             13,414
     2002...........................................................              3,256
     2003...........................................................              3,203
     Later years....................................................          1,218,654
                                                                             ----------
                                                                             $1,253,406
                                                                             ==========
</TABLE>


NOTE 5.    LEASES AND COMMITMENTS

  Leases:   The Company leases certain of its office and network facilities
under noncancelable agreements which expire at various times through September
2022. These agreements require various monthly rentals plus the payment of
applicable property taxes, maintenance and insurance. The Company also leases
vehicles and equipment under agreements which expire at various times through
December 2003 and require various monthly rentals.

  The total minimum rental commitment at December 31, 1998 under the leases
mentioned above is as follows (In thousands):

<TABLE>
<S>                                                                             <C>
   1999.............................................................            $17,786
   2000.............................................................             10,908
   2001.............................................................              6,090
   2002.............................................................              3,877
   2003.............................................................              3,026
   Thereafter.......................................................              4,398
                                                                                -------
                                                                                $46,085
                                                                                =======
</TABLE>

  The total rental expense included in the consolidated statements of operations
for 1998, 1997 and 1996 is approximately $19,824,000, $8,060,000 and $3,640,000,
respectively, which also includes short-term rentals for office facilities.

                                     F-16
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 5.   LEASES AND COMMITMENTS--(CONTINUED)

  Network construction:  During 1995, the Company was awarded contracts from
the State of Iowa to build fiber optic telecommunications network segments
throughout the State of Iowa. As of December 31, 1998, the contracts call for
the construction of 235 network segments. Upon completion of each segment, the
Company will receive approximately $115,000 for a seven-year lease for certain
capacity on that segment. The Company will recognize this revenue of
approximately $27,025,000 on a straight-line basis over the term of the lease
based on the relationship of individual segment costs to total projected costs.
For the years ended December 31, 1998, 1997 and 1996, revenue of $2,763,000,
$1,794,000 and $445,000, respectively, had been recognized under these
contracts.

  The Company estimates that minimum future construction costs required to
fulfill its obligations under the 1995 contract with the State of Iowa would be
approximately $5,393,000.  The Company, however, expects that its actual
construction costs will be higher with respect to such network segments, because
the Company is adding more fiber and route miles than is contractually required
with respect to such construction, in order to optimize the design of its
network. The Company anticipates that the minimum costs to complete this project
will be incurred in 1999.

  Buildings:  In August 1996, the Company purchased approximately 194 acres of
land on which the Company constructed its headquarters and associated buildings.
Of the land purchased, approximately 75 acres was purchased from a subsidiary of
a stockholder for approximately $692,000. At December 31, 1998, the total
remaining contracted commitments on the building in progress is approximately $8
million.

  Alcatel: In January 1999 the Company entered into an agreement with Alcatel
USA Marketing, Inc. to purchase equipment, software and services for a total
commitment of $200,000,000 over a six (6) year period. If McLeodUSA does not
meet the committed purchases on a cumulative annual basis, Alcatel retains the
right to renegotiate the applicable prices. If regulatory conditions
substantially prevent the Company from continuing to implement these plans, the
Company has the option to request renegotiation of unit prices based on revised
quantities of products or to renegotiate unit prices based on the quantities of
products purchased to that time and cease any further purchases of products.

                                     F-17
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
NOTE 6.    INCOME TAX MATTERS

  Net deferred taxes consist of the following components as of December 31, 1998
and 1997:

<TABLE>
<CAPTION>
                                                                                          1998           1997
                                                                                      -------------  -------------
                                                                                             (In thousands)
Deferred tax assets:
<S>                                                                                   <C>            <C>
    Net operating loss carryforwards................................................    $106,498        $60,335   
    Accruals and reserves not currently deductible..................................      24,485         15,910   
    Deferred revenues...............................................................       8,149          7,093   
    Intangibles and other assets....................................................       7,605          3,669   
    Other...........................................................................       2,144          2,125   
                                                                                        --------        -------   
                                                                                         148,881         89,132   
    Less valuation allowance........................................................      78,556         29,532   
                                                                                        --------        -------   
                                                                                          70,325         59,600   
                                                                                        --------        -------   
  Deferred tax liabilities:                                                                                       
    Property and equipment..........................................................      39,549         24,620   
    Other investments...............................................................      11,395         15,333   
    Differences in revenue recognition..............................................      10,900         12,140   
    Deferred line installation cost.................................................       7,952          3,945   
    Other intangibles...............................................................          --          3,318   
    Other...........................................................................         529            244   
                                                                                        --------        -------   
                                                                                          70,325         59,600   
                                                                                        --------        -------   
                                                                                        $     --        $    --   
                                                                                        ========        =======    
</TABLE>

  A valuation allowance has been recognized to offset the related net deferred
tax assets due to the uncertainty of realizing the benefit of the loss
carryforwards. The Company has available net operating loss carryforwards
totaling approximately $262.5 million which expire in various amounts in the
years 2008 to 2018.

  The income tax rate differs from the U. S. Federal income tax rate for 1998,
1997 and 1996 due to the following:

<TABLE>
<CAPTION>
                                                                                 1998         1997         1996
                                                                              -----------  -----------  -----------
<S>                                                                           <C>          <C>          <C>
  "Expected" tax (benefit) rate.............................................      (35)%        (35)%        (35)%    
  Percent increase (decrease) in income taxes resulting from:                                                       
     Change in valuation allowance..........................................       34           15           35     
     Tax deductions due to exercises of incentive stock options.............       (2)          (2)          (9)    
     Goodwill amortization for stock purchases..............................        6           --           --     
     Net deferred liability balance purchased in CCI                                                                
       transaction (see Note 11)............................................       --           21           --     
     Other..................................................................       (3)           1            9     
                                                                                 ----         ----         ----     
                                                                                   --%          --%          --%    
                                                                                 ====         ====         ====      
</TABLE>

                                     F-18
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 7.   STOCK-BASED COMPENSATION PLANS

  At December 31, 1998, the Company has various stock-based compensation plans
which are described below. Grants under the Company's stock option plans are
accounted for in accordance with Accounting Principles Board (APB) Opinion No.
25 and related Interpretations. The Company granted a total of 1,653,688 stock
options in January and February 1996 at an exercise price of $2.67 per share.
The estimated aggregate fair market value of these options at the date of grant
was later determined to exceed the aggregate exercise price by approximately
$9,190,000. Additionally, in September 1997, the Company granted a total of
1,468,945 stock options at an exercise price of $24.50 per share. The aggregate
fair market value of these options at the date of grant exceeded the aggregate
exercise price by approximately $15,790,000. As a result, the Company is
amortizing these amounts over the four-year vesting period of the options.
Compensation cost of $5,820,000 and $2,993,000 has been charged to income for
the year ended December 31, 1998 and 1997, respectively, using the intrinsic
value based method as prescribed by APB No. 25. Had compensation cost for all of
the stock-based compensation plans been determined based on the grant date fair
values of awards granted during 1998, 1997 and 1996, as prescribed by SFAS No.
123, reported net loss and loss per common share would have been as follows (in
thousands, except per share data):

<TABLE>
<CAPTION>
                                                                                      DECEMBER 31,
                                                                     ---------------------------------------------
                                                                          1998            1997            1996
                                                                     --------------  --------------  -------------
<S>                                                                  <C>             <C>             <C>
  Pro forma net loss...............................................      $(151,227)       $(93,855)       $(24,776)
  Pro forma loss per common share..................................          (2.41)          (1.71)          (0.61)
</TABLE>

  1992, 1993 and 1995 Incentive Stock Option Plans:   The Company has reserved
2,903,243 shares of Class A common stock for issuance to employees under the
1992, 1993 and 1995 Incentive Stock Option Plans. Options outstanding under
these plans were granted at prices equal to the estimated fair market value on
the dates of grant as determined by the Company's Board of Directors. Under the
1992 and 1993 plans, all options granted become exercisable at a rate of 25% per
year, on a cumulative basis, and expire seven years after the date of grant.
Under the 1995 plan, all options, except for options granted to the Company's
chairman and chief executive officer, become exercisable at a rate of 25% per
year, on a cumulative basis, beginning five years from the date of grant. The
options granted to the Company's chairman and chief executive officer vest at a
rate of 20% per year on a cumulative basis. All options granted under the 1995
plan expire ten years after the date of grant. These plans have been superseded
by the 1996 Employee Stock Option Plan, and no future grants of options will be
made under these plans.

  1996 Employee Stock Option Plan:   In 1997, the Company's stockholders
approved an amendment to the 1996 Employee Stock Option Plan to increase the
number of Class A common shares available under the plan to 37,500,000 shares
from 4,525,000 shares. At December 31, 1998, after adjusting for option
exercises, the Company has reserved 37,277,305 shares of Class A common stock
for issuance to employees under the plan, which supersedes the 1992, 1993 and
1995 Incentive Stock Option Plans. The exercise price for options granted under
this plan is the fair market value of the Company's Class A common stock on the
day before the grant date (or 110% of the fair market value if the grantee
beneficially owns more than 10% of the outstanding Class A common stock). The
options granted expire ten years after the grant date (or five years after the
grant date if the grantee beneficially owns more than 10% of the outstanding
Class A common stock), and vest over periods determined by the Compensation
Committee; however, no more than $100,000 worth of stock covered by the options
may become exercisable in any calendar year by an individual employee. The 1996
Plan will terminate in March 2006, unless terminated earlier by the Board of
Directors.

                                     F-19
<PAGE>
 
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 7.   STOCK-BASED COMPENSATION PLANS--(CONTINUED)

  Directors' Stock Option Plan:   The Company has reserved 397,686 shares of
Class A common stock for issuance under the Directors' Plan to directors who are
not officers or employees of the Company. The Director's Plan was adopted and
approved by the stockholders in 1993 and amended and restated on March 28, 1996
to be a "formula" plan providing for an automatic grant of options to eligible
directors. Each eligible director who commences service on the Board of
Directors after the amendment and restatement of the plan will be granted an
initial option to purchase 10,000 shares of Class A common stock. An additional
option to purchase 5,000 shares of Class A common stock will be granted after
each of the next two annual meetings to each eligible director who remains for
the two-year period. Options granted under the Directors' Plan vest at a rate of
25% per year, on a cumulative basis, and expire seven years after the date of
grant (ten years after the date of grant for options granted under the amended
and restated plan). However, upon a change in control of the Company as defined
in the Directors' Plan, all options will become fully exercisable. The Company
has the right to repurchase any Class A common stock issued pursuant to the
exercise of an option granted under this plan that is offered for sale to an
individual who is not an employee or director of the Company. The Directors'
Plan will terminate in March 2006, unless terminated earlier by the Board of
Directors.

  The fair value of each grant under the Company's stock option plans is
estimated at the grant date using the Black-Scholes option-pricing model with
the following weighted-average assumptions for grants in 1998, 1997 and 1996,
respectively: no expected dividends, risk-free interest rates of 4.65%, 5.48%,
and 6.08%; price volatility of 59.39% in 1998, 48.63% in 1997 and 40% in 1996
and expected lives of 4 years for all three years.

  Employee Stock Purchase Plan: Under the stock purchase plan, employees may
purchase up to an aggregate of 1,000,000 shares of Class A common stock through
payroll deductions. Employees of the Company who have been employed more than
six months and who are regularly scheduled to work more than 20 hours per week
are eligible to participate in the plan, provided that they own less than five
percent of the total combined voting power of all classes of stock of the
Company. The purchase price for each share will be determined by the
Compensation Committee, but may not be less than 90% of the closing price of the
Class A common stock on the first or last trading day of the payroll deduction
period, whichever is lower. No employee may purchase in any calendar year Class
A common stock having an aggregate fair value in excess of $25,000. Upon
termination of employment, an employee other than a participating employee who
is subject to Section 16(b) under the Securities Exchange Act of 1934, as
amended, will be refunded all moneys in his or her account and the employee's
option to purchase shares will terminate. The plan will terminate in March 2006,
unless terminated earlier by the Board of Directors. The Company has implemented
this plan effective February 1, 1997. Under the plan, the Company sold 132,893
shares of Class A common stock in 1998 and 38,080 shares in 1997. The fair value
of the employees' purchase rights was calculated for disclosure purposes using
the Black-Scholes model with the following assumptions: an expected life of 12
months in 1998 and 11 months in 1997; a risk-free interest rate of 4.65% in 1998
and 5.40% in 1997; expected volatility of 59.39% in 1998 and 48.63% in 1997; and
no expected dividends. The fair value of each purchase right granted in 1998 was
$10.76 and in 1997 was $6.35.

                                     F-20
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Note 7.   STOCK-BASED COMPENSATION PLANS--(CONTINUED)

  A summary of the status of the Company's stock option plans as of and for the
years ended December 31, 1998, 1997 and 1996 is as follows (In thousands, except
price data):

<TABLE>
<CAPTION>
                                                                                                                 WEIGHTED-
                                                                                                                  AVERAGE
                                                                                                                  EXERCISE
                                                                                                  SHARES           PRICE
                                                                                              ---------------  --------------
<S>                                                                                           <C>              <C>
  Outstanding at January 1, 1996............................................................           4,869           $ 1.33
     Granted................................................................................           3,502            13.14
     Exercised..............................................................................            (491)            1.30
     Forfeited..............................................................................            (336)            7.64
                                                                                                      ------
  Outstanding at December 31, 1996..........................................................           7,544             6.54
     Granted................................................................................           6,674            26.72
     Exercised..............................................................................          (1,138)            1.15
     Forfeited..............................................................................          (2,472)           29.74
                                                                                                      ------
  Outstanding at December 31, 1997..........................................................          10,608            14.40
     Granted................................................................................           6,273            31.28
     Exercised..............................................................................          (1,373)            2.72
     Forfeited..............................................................................          (3,237)           35.85
                                                                                                      ------
  Outstanding at December 31, 1998..........................................................          12,271            18.69
                                                                                                      ======
</TABLE>

<TABLE>
<CAPTION>
                                                                                                 NUMBER OF OPTIONS
                                                                                        ------------------------------------
                                                                                          1998         1997          1996
                                                                                        ---------  -------------  ----------
<S>                                                                                     <C>        <C>            <C>
  Exercisable, end of year............................................................      2,776          2,397       2,324
                                                                                           ======         ======      ======
  Weighted-average fair value per option of options granted
    during the year...................................................................     $18.18         $12.24      $ 5.74
                                                                                           ======         ======      ====== 
</TABLE>

  Other pertinent information related to the options outstanding at December 31,
1998 is as follows:

<TABLE>
<CAPTION>
                                                OPTIONS OUTSTANDING           OPTIONS EXERCISABLE
                                        -----------------------------------  ----------------------
                                                                
                                                      WEIGHTED-                                     
                                                       AVERAGE    WEIGHTED-               WEIGHTED- 
                                                      REMAINING    AVERAGE                 AVERAGE  
                                          NUMBER     CONTRACTUAL  EXERCISE     NUMBER     EXERCISE  
       RANGE OF EXERCISE PRICES         OUTSTANDING     LIFE        PRICE    EXERCISABLE    PRICE   
--------------------------------------  -----------  -----------  ---------  -----------  --------- 
<S>                                     <C>          <C>          <C>        <C>          <C>
$0.27 to $2.27........................    1,926,362         3.14     $ 1.68    1,373,212     $ 1.49
$2.49 to $2.93........................    1,275,525         4.20       2.68      569,491       2.67
$4.29 to $9.30........................       43,073         5.81       7.63       30,917       7.08
$17.75 to $17.75......................    2,145,639         8.07      17.75      186,408      17.75
$18.63 to $23.50......................      242,566         7.70      20.14       41,333      20.01
$24.25 to $24.25......................    2,678,612         9.77      24.25           80      24.25
$24.50 to $24.50......................    1,639,730         8.66      24.50      399,926      24.50
$24.75 to $29.61......................      112,511         8.49      29.38       24,093      29.16
$29.75 to $29.75......................    1,316,560        10.00      29.75           --         --
$31.56 to $46.63......................      889,956         9.06      35.77      150,066      34.31
                                         ----------                            ---------
                                         12,270,534         7.61     $18.69    2,775,526     $ 8.49
                                         ==========                            =========
</TABLE>

  In addition, options to purchase shares of Class B common stock were granted
to a stockholder which had guaranteed borrowings under certain credit facilities
which were paid off with a portion of the proceeds from the Company's initial
public offering and subsequently canceled. These options have a weighted-average
exercise price of $1.79 and are fully vested at December 31, 1998.

                                      F-21
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Note 8.   CAPITAL STOCK INFORMATION AND INVESTOR AGREEMENT

  Public offerings:   On June 10, 1996, the Company undertook an initial public
offering of Class A common stock which yielded net proceeds of approximately
$258 million. On November 20, 1996, the Company completed an additional public
offering of Class A common stock which yielded net proceeds of approximately
$138 million in additional capital.

  Recapitalization:   In May 1997, the Company's stockholders approved an
increase in the authorized Class A common stock from 75,000,000 shares of $.01
par value stock to 250,000,000 shares of $.01 par value stock. In March 1996,
the Company's Board of Directors had authorized an increase in the authorized
Class A common stock to 75,000,000 shares of $.01 par value stock from
15,000,000 shares of $.01 par value stock and an increase in the authorized
Class B common stock to 22,000,000 shares of $.01 par value stock from
15,000,000 shares of $.01 par value stock. All Class B common stock has rights
identical to Class A common stock other than their voting rights, which are
equal to .40 vote per share. Each share of Class B common stock is convertible
into one share of Class A common stock at the option of the holder. The restated
Articles of Incorporation also authorizes the Board of Directors to issue up to
2,000,000 shares of $.01 par value preferred stock. The terms of the preferred
stock are determined at the time of issuance. No preferred shares were issued or
outstanding at December 31, 1998. Also in March 1996, the Board of Directors
declared a 3.75 to 1 stock split for both the Class A and Class B common stock
which was effected in the form of a stock dividend. All references to share and
per share amounts give retroactive effect to this stock split and
recapitalization.

  Stockholders' Agreement: Certain of the Company's principal stockholders have
entered into a Stockholders' Agreement, which amended and restated a prior
Investor Agreement, and became effective on September 24, 1997. This agreement
provides for the election of directors designated by certain principal
stockholders and prevents certain principal stockholders from disposing of any
equity securities of the Company for a period of one year unless consented to by
the Board of Directors. In addition, certain principal stockholders agreed that
for a period of two years they will not acquire any securities or options issued
by the Company, except as allowed by previous agreements or by the Board of
Directors.

     On November 18, 1998, the Company entered into a stockholders' agreement
(the "November 1998 Stockholders' Agreement") with Alliant Energy, Clark E. and
Mary E. McLeod, and Richard A. Lumpkin, Gail G. Lumpkin and several other
parties affiliated or related to Richard A. Lumpkin (collectively, the
"Lumpkins," and together with Alliant Energy and Clark E. and Mary E. McLeod,
the "Principal Stockholders").

     The November 1998 Stockholders' Agreement provides, among other things,
that:

 
     . until December 31, 2001, the Principal Stockholders will not sell or
       otherwise dispose of any of our equity securities, or any other
       securities convertible into or exercisable for such equity securities,
       beneficially owned by such Principal Stockholder without receiving the
       prior written consent of the Company's board of directors, except for
       permitted transfers as provided in the November 1998 Stockholders'
       Agreement

 
     . the Company's board of directors will determine on a quarterly basis
       commencing with the quarter ending December 31, 1998 and ending on
       December 31, 2001, the aggregate number, if any, of shares of Class A
       common stock (not to exceed in the aggregate 150,000 shares per quarter)
       that the Principal Stockholders may sell or otherwise dispose of during
       designated trading periods following the release of the Company's
       quarterly or annual financial results

                                      F-22
<PAGE>
 
     .  to the extent the Company's board of directors grants registration
        rights to a Principal Stockholder in connection with a sale or other
        disposition of the Company's securities by such Principal Stockholder,
        it will grant similar registration rights to the other parties

     . the Company's board of directors will determine on an annual basis
       commencing with the year ending December 31, 1999 and ending on December
       31, 2001 (each such year, an "Annual Period"), the aggregate number, if
       any, of shares of Class A common stock (not to exceed in the aggregate on
       an annual basis a number of shares equal to 15% of the total number of
       shares of Class A common stock beneficially owned by the Principal
       Stockholders as of December 31, 1998) (the "Registrable Amount"), to be
       registered by the Company under the Securities Act, for sale or other
       disposition by the Principal Stockholders

     . in any underwritten offering of shares of Class A common stock by the
       Company, other than an offering registering shares of our Class A common
       stock on a registration statement on Form S-4 or Form S-8 or other form
       which would not permit the inclusion of shares of Class A common stock of
       the Principal Stockholders, the Company will give written notice of such
       offering to the Principal Stockholders and will undertake to register the
       shares of Class A common stock of such parties up to the Registrable
       Amount, if any, as determined by the Company's board of directors

 
     . the Company may subsequently determine not to register any shares of the
       Principal Stockholders under the Securities Act and may either not file a
       registration statement or otherwise withdraw or abandon a registration
       statement previously filed

  The November 1998 Stockholders' Agreement terminates on December 31, 2001.

NOTE 9.   CHANGE-OF-CONTROL AGREEMENTS

  Change-of-Control Agreements: The Company has entered into change-of-control
agreements with certain executive employees, which provide for certain payments
in connection with termination of employment after a change of control (as
defined within the agreements) of the Company. The change-of-control agreements
terminate on December 31, 2006 unless a change of control occurs during the six-
month period prior to December 31, 2006, in which case the agreements terminate
on December 31, 2007. The agreements provide that if an executive terminates his
or her employment within six months after a change of control or if the
executive's employment is terminated within 24 months after a change of control
in accordance with the terms and conditions set forth in the agreements, the
executive will be entitled to certain benefits. The benefits include cash
compensation, immediate vesting of outstanding stock options and coverage under
the Company's group health plan.

NOTE 10.   RETIREMENT PLANS AND POSTRETIREMENT BENEFITS

     CCI, a wholly owned subsidiary of the Company, maintains noncontributory
defined pension and death benefit plans covering substantially all of its
salaried and hourly employees. The pension benefit formula used in the
determination of pension cost is based on the highest five consecutive calendar
years' base earnings within the last ten calendar years immediately preceding
retirement or termination. It is CCI's policy to fund pension costs as they
accrue subject to any applicable Internal Revenue Code limitations.

     In 1997, the Company offered salaried plan participants a choice between
transferring their plan assets to the hourly defined benefit plan or
participating in the 1996 Employee Stock Option Plan, as the salaried defined
benefit plan was terminated effective April 1, 1998.  This plan change
substantially reduced the expected future benefits under the defined benefits
pension plans and has been reflected in the tables below.  As a result of the
termination of the salaried plan, the Company recognized a gain of $2.2 million.
The Company continues to maintain the defined benefit pension plan for
substantially all hourly employees of CCI.

                                      F-23
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
                                        
NOTE 10.   RETIREMENT PLANS AND POSTRETIREMENT BENEFITS--(CONTINUED)

  In addition to providing pension benefits, CCI provides an optional retiree
medical program to its salaried and union retirees and spouses under age 65 and
common life insurance coverage for the salaried retirees. All retirees are
required to contribute to the cost of their medical coverage while the salaried
life insurance coverage is provided at no cost to the retiree.

     The change in benefit obligations and the change in plan assets for 1998
and 1997, and the components of net periodic benefit costs and the weighted-
average assumption for 1998, 1997 and 1996, are as follows (in thousands):

<TABLE>
<CAPTION>
                                                      PENSION BENEFITS     POSTRETIREMENT BENEFITS
                                                    --------------------  -------------------------
                                                      1998       1997         1998         1997
                                                    ---------  ---------  ------------  -----------
<S>                                                 <C>        <C>        <C>           <C> 
CHANGE IN BENEFIT OBLIGATIONS
-----------------------------
Benefit obligation at beginning of year             $ 52,120   $ 59,495   $     4,998   $    9,905
Service cost                                             788      2,440           114          606
Interest cost                                          3,904      3,517           337          581
Plan amendments                                           --         --            --       (2,389)
Curtailment gain                                          --     (4,067)           --           --
Special termination benefits and other                 6,544         --            --           --
Benefits paid                                        (20,319)    (2,580)         (367)        (297)
Actuarial gains                                        2,013     (6,685)         (493)      (3,408)
                                                    --------   --------       -------      -------
Benefit obligation at end of year                   $ 45,050   $ 52,120   $     4,589   $    4,998
                                                    ========   ========       =======      =======
 
CHANGE IN PLAN ASSETS
---------------------
Fair value of plan assets at beginning of year      $ 65,694   $ 55,257   $        --   $       -- 
Actual return on plan assets                           6,835      7,767            --           --
Employer contributions                                    --      5,250           367          297
Benefits paid                                        (20,319)    (2,580)         (367)        (297)
                                                    --------   --------   -----------   ----------
Fair value of plan assets at end of year            $ 52,210   $ 65,694   $        --   $       --       
                                                    ========   ========   ===========   ========== 
                                                                                                   
 
Funded status                                       $  7,160   $ 13,574   $    (4,589)  $   (4,998)
Unrecognized net actuarial gain                      (13,829)   (22,963)       (3,742)      (3,463)
Unrecognized prior service cost                        4,464      3,425        (2,215)      (2,389)
Unrecognized transition (asset) or obligation           (118)      (157)        4,346        4,733
                                                    --------   --------       -------      -------
Accrued benefit cost                                $ (2,323)  $ (6,121)  $    (6,200)  $   (6,117)
                                                    ========   ========       =======      =======
</TABLE>



<TABLE>
<CAPTION>
                                               Pension Benefits           POSTRETIREMENT BENEFITS
                                         -----------------------------  ---------------------------
                                           1998       1997      1996     1998      1997      1996
                                         ---------  --------  --------  -------  --------  --------
<S>                                      <C>        <C>       <C>       <C>      <C>       <C>  
COMPONENTS OF NET
PERIODIC BENEFIT COSTS
----------------------
Service cost                              $   788   $ 2,440   $ 2,195    $ 114    $  606    $  572
Interest cost                               3,904     3,517     3,327      337       581       540
Expected return on plan assets             (5,043)   (3,877)   (3,417)      --        --        --
Amortization of prior service costs           482       496       496     (174)       --        --
Amortization of transitional (asset)
 or obligation                                (39)       12        12      387       387       387
 
Recognized actuarial (gain) or loss        (1,708)     (543)     (373)    (215)      (26)      (14)
                                          -------   -------   -------   ------    ------    ------
Net periodic benefit cost                 $(1,616)  $ 2,045   $ 2,240    $ 449    $1,548    $1,485
                                          =======   =======   =======   ======    ======    ======
 
WEIGHTED-AVERAGE ASSUMPTION
AS OF DECEMBER 31
-----------------
Discount rate                                   7%        7%        7%       7%        7%        6%
Expected return on plan assets                  8%        8%        8%      --        --        --
Rate of compensation increase                   5%        5%        5%       5%        5%        5%
</TABLE>

                                      F-24
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 10.   RETIREMENT PLANS AND POSTRETIREMENT BENEFITS--(CONTINUED)

  The postretirement benefit obligation is calculated assuming that health-care
costs increased by 8% in 1998 and 7.5% in 1999, and that the rate of increase
thereafter (the health-care cost trend rate) will decline to 5% in 2004 and
subsequent years. The health-care cost trend rate has a significant effect on
the amounts reported for costs each year as well as on the accumulated
postretirement benefit obligation. For example, a one percentage point increase
each year in the health-care trend rate would have the following effects:

<TABLE>
<CAPTION>
                                                  ONE PERCENTAGE                 ONE PERCENTAGE
                                                  POINT INCREASE                 POINT DECREASE
                                                  --------------                 --------------
<S>                                               <C>                            <C>
Effect on total of service and
 interest cost components in 1998                    $ 40,565                      $ (35,853)
 
Effect on year-end 1998
 postretirement benefit obligations                  $370,825                      $(333,297)
</TABLE>

  The weighted average discount rate used in determining the benefit obligation
was 7% in 1998.

  The postretirement medical and life insurance benefit plans have been modified
effective January 1, 1998 to provide benefits only to employees meeting certain
age and years of service requirements as of January 1, 1998.

  CCI also has a nonqualified deferred compensation plan, which allows selected
employees to defer a portion of any compensation received. Those deferred
amounts are invested in various funds at December 31, 1998 to provide assets and
accumulated earnings to offset the deferred compensation amounts due to the
participating employees.

  In addition, the Company has various 401(k) profit-sharing plans available to
eligible employees. The Company contributed approximately $2,007,000, $1,252,000
and $242,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
An additional discretionary 1998 contribution of $1,500,000 was also made.

NOTE 11.   ACQUISITIONS

  Ruffalo, Cody & Associates, Inc. (Ruffalo Cody): On July 15, 1996, the
Company acquired Ruffalo Cody for a total purchase price of approximately $17.3
million, which consisted of approximately $5.1 million in cash (including
approximately $243,000 in direct acquisition costs), 361,420 shares of Class A
common stock and 158,009 options to purchase shares of Class A common stock
granted to the holders of Ruffalo Cody options. An additional $50,782 in cash
and 56,177 shares of Class A common stock were delivered to certain stockholders
of Ruffalo Cody upon fulfillment certain conditions relating to ongoing revenues
from an agreement with a major long distance carrier to provide telemarketing
services. The long distance carrier terminated this contract effective December
31, 1996.

  TelecomUSA Publishing Group, Inc. (McLeodUSA Media Group): On September 20,
1996, the Company acquired TelecomUSA Publishing Group, Inc. (now known as
McLeodUSA Media Group, Inc.) for a total purchase price of approximately $76.1
million, which consisted of approximately $74.5 million in cash (including
approximately $436,000 in direct acquisition costs) and $1.6 million resulting
from the Company entering into an incentive compensation program with all
holders of nonvested McLeodUSA Media Group options, which provides for payments
to be made to these individuals on January 1 of the year following the year in
which the corresponding options would have vested.

                                      F-25
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
                                        
NOTE 11.   ACQUISITIONS--(CONTINUED)

  Total Communications Systems, Inc. (TCSI):  On December 9, 1996, the Company
purchased the customer base and certain other assets of TCSI for a cash purchase
price of approximately $534,000.

  Digital Communications of Iowa, Inc. (DCI): In January 1997, the Company
issued 84,430 shares of Class A common stock in exchange for all the outstanding
shares of DCI, in a transaction accounted for as a purchase. The total purchase
price was approximately $2.3 million based on the average closing market price
of the Company's Class A common stock at the time of the acquisition.

  Fronteer Financial Holdings, Ltd. (Fronteer): In January 1997, McLeodUSA
Media Group exercised its option to acquire six directories from Fronteer for a
total cash purchase price of approximately $3.9 million.

  Indiana Directories, Inc. (Indiana Directories): On March 31, 1997,
McLeodUSA Media Group acquired 26 telephone directories published by Indiana
Directories for a total cash purchase price of approximately $10 million.

  ESI Communications, Inc. (ESI): On June 10, 1997, the Company acquired
substantially all of the assets of ESI and related entities for a total cash
purchase price of approximately $15.2 million.

  Smart Pages, Inc. and Yellow Pages Publishers, Inc. (Smart Pages): On
September 22, 1997, McLeodUSA Media Group acquired two telephone directories
published by Smart Pages for a total cash purchase price of approximately $2
million.

  CCI: On September 24, 1997, pursuant to the terms and conditions of an
Agreement and Plan of Reorganization dated June 14, 1997 (the "Merger
Agreement"), the Company issued 8,488,586 shares of Class A common stock and
paid approximately $155 million in cash to the shareholders of CCI in exchange
for all of the outstanding shares of CCI in a transaction accounted for using
the purchase method of accounting. The total purchase price was approximately
$382.1 million based on the average closing price of the Company's Class A
common stock five days before and after the date of the Merger Agreement. The
purchase price includes approximately $3.4 million of direct acquisition costs.

  OneTEL Corp. (OneTEL): On October 15, 1997, the Company issued 55,500 shares
of Class A common stock as consideration for certain assets of OneTEL. The total
purchase price was approximately $2 million based on the closing price of the
Company's Class A common stock on the purchase date.

  Colorado Directory Company LLC (Colorado Directory): On December 31, 1997, the
Company issued 140,000 shares of Class A common stock as consideration for all
of the outstanding membership and ownership interests of Colorado Directory. The
total purchase price was approximately $4.5 million based on the closing price
of the Company's Class A common stock on the purchase date.


  F.D.S.D. Rapid City Directories, Inc. (F.D.S.D.): On March 17, 1998, McLeodUSA
Media Group acquired a telephone directory published by F.D.S.D. for a cash
purchase price of approximately $2.2 million.

  Bi-Rite Directories, Inc. (Bi-Rite): On March 20, 1998, McLeodUSA Media Group
acquired a telephone directory published by Bi-Rite for a cash purchase price of
approximately $3.7 million.

  Smart Pages, Inc. and Yellow Page Publishers, Inc. (Smart Pages): On April 8,
1998, McLeodUSA Media Group acquired a telephone directory published by Smart
Pages for a cash purchase price of approximately $1.3 million.

                                      F-26
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
                                        
NOTE 11.   ACQUISITIONS--(CONTINUED)

  NewCom Technologies, Inc. and NewCom OSP Services, Inc. (collectively,
NewCom): On April 24, 1998, the Company issued 70,508 shares of Class A common
stock and paid approximately $1 million cash for all of the outstanding shares
of NewCom, in a transaction accounted for using the purchase method of
accounting. The total purchase price was approximately $4.2 million based on the
average closing market price of the Class A common stock at the time of the
acquisition.

  Communications Cable-Laying Company, Inc. (CCC): On June 29, 1998, the Company
issued 151,019 shares of Class A common stock to acquire certain of the assets
of CCC. The total purchase price was approximately $6 million based on the
average closing market price of the Class A common stock at the time of the
acquisition and including $78,000 of cash acquisition costs.

  QST Communications, Inc. (QST): On August 21, 1998, the Company acquired all
the outstanding shares of QST for approximately $20 million cash and an option
to purchase 245,536 shares of the Company's Class A common stock at an exercise
price of the lower of $40.00 or the closing price of the Class A common stock on
the day prior to the closing date of the acquisition ($37.25). This transaction
is accounted for using the purchase method of accounting.  The purchase price
includes approximately $151,000 of cash acquisition costs.

  ADCO Publishing Co, Inc. (ADCO): On September 15, 1998, McLeodUSA Media Group
acquired two telephone directories published by ADCO for a cash purchase price
of approximately $8.9 million.

  Rivers Directories, Inc. (Mozarks): On November 19, 1998, McLeodUSA Media
Group acquired three telephone directories published by Mozarks for a total cash
purchase price of $216,000.

  Inlet, Inc. (Inlet): On November 25, 1998, the Company acquired Inlet for a
total purchase price of approximately $2.4 million, which consisted of 70,672
shares of Class A common stock and an option to purchase 10,414 shares of Class
A common stock.  The total purchase price was based on the average closing
market price of the Class A common stock on the five days prior to and after the
closing date of the acquisition ($31.76). This transaction is accounted for
using the purchase method of accounting.

  Mo-Ark Directories, Inc. (Mo-Ark): On December 3, 1998, McLeodUSA Media Group
acquired two telephone directories published by Mo-Ark for a total cash purchase
price of $606,000.

                                      F-27
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
                                        
NOTE 11.   ACQUISITIONS--(CONTINUED)

  The following table summarizes the purchase price allocations for the
Company's business acquisitions (in thousands):
 
<TABLE>
<CAPTION>
TRANSACTION YEAR:                                                         1998             1997            1996
----------------                                                     --------------  ----------------  -------------
<S>                                                                  <C>             <C>               <C>
Cash purchase price                                                        $27,583          $178,477        $79,402
Acquisition costs                                                              229             3,415            679
Incentive agreements                                                            --                --          1,610
Contracts payable                                                            9,540             7,022             --
Option agreements                                                               --               500             --
Promissory notes                                                               815               100             --
Stock issued                                                                11,427           232,368          8,945
Options to purchase Class A common stock                                       143                --          3,911
Less cash to be received upon option exercised                                  --                --           (610)
                                                                           -------          --------        -------
                                                                           $49,737          $421,882        $93,937
 
Working capital acquired, net                                              $  (118)         $ 41,797        $ 9,138
Fair value of other assets acquired                                         13,480           174,401          5,817
Intangibles                                                                 38,742           288,038         79,966
Liabilities assumed                                                         (2,367)          (82,354)          (984)
                                                                           -------          --------        -------
                                                                           $49,737          $421,882        $93,937
</TABLE>

  These acquisitions have been accounted for as purchases and the results of
operations are included in the consolidated financial statements since the dates
of acquisition.

  The unaudited consolidated results of operations for the years ended December
31, 1998 and 1997 on a pro forma basis as though the above entities had been
acquired as of the beginning of the respective periods are as follows:


<TABLE>
<CAPTION>
                                                                         1998            1997
                                                                    -------------    ------------
                                                                         (IN THOUSANDS, EXCEPT
                                                                            PER SHARE DATA)
<S>                                                                 <C>              <C>
   Revenue.....................................................      $  612,703       $  484,376
   Net loss....................................................        (127,006)         (86,996)
   Loss per common share.......................................           (2.02)           (1.42)
</TABLE>
                                                                                
  The pro forma financial information is presented for informational purposes
only and is not necessarily indicative of the operating results that would have
occurred had the acquisitions been consummated as of the above dates, nor are
such operating results necessarily indicative of future operating results.

  On October 27, 1998, the Company entered into an Agreement and Plan of
Reorganization with Dakota Telecommunications Group, Inc., a Delaware
corporation (DTG), pursuant to which the Company agreed, subject to certain
conditions, to acquire DTG for an aggregate of 1,375,000 shares of Class A
common stock and the assumption of $31 million in debt.  The DTG transaction was
consummated on March 5, 1999 (see Note 16).

                                      F-28
<PAGE>
 
PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 12.   RELATED PARTY TRANSACTIONS

  The Company has entered into agreements with two stockholders that gives
certain rights-of-way to the Company for the construction of its
telecommunications network in exchange for capacity on the network.

  The Company provided and purchased services from various companies, the
principals of which are stockholders or directors of McLeodUSA Incorporated or
are affiliates. Revenues from services provided totaled $3,698,000, $1,018,000
and $254,000 and services purchased, primarily rent, legal services and database
verification services, totaled $3,065,000, $2,030,000 and $934,000 for the years
ended December 31, 1998, 1997 and 1996, respectively.

  In December 1998, the Company entered into a split dollar arrangement for life
insurance policies owned by the McLeod Family 1998 Special Trust on the joint
lives of Clark and Mary McLeod. The McLeod Family 1998 Special Trust agreed to
assign the policies to the Company as collateral for the premium payments. No
loans have been taken against these policies. In 1998, the premium payments paid
by the Company totaled $1,880,000. The aggregate face amount of the policies is
$113,000,000. The McLeod Family 1998 Special Trust is sole owner and beneficiary
of each policy. The Company has agreed with Clark and Mary McLeod that one of
the principle reasons for entering into this arrangement is to avoid any need
for their heirs to liquidate their holdings of Class A common stock at or soon
after the death of one or both of them. Clark and Mary McLeod have agreed to
restrictions on their ability to sell or otherwise dispose of their shares of
Class A common stock. The Company also paid premiums of $138,257 for a universal
life policy on Clark and Mary McLeod with a face value of $13,500,000. The
Company is the beneficiary of this policy.

  During 1997, the Company also acquired two condominium units from a Company
director for a total purchase price of $171,000 and purchased a 15,000 square
foot building, which is used as a support facility for its fiber optic network,
from a stockholder for a cash purchase price of $500,000.

  In addition, at December 31, 1998 the Company has two $75,000 notes receivable
from officers. The notes bear interest at the applicable federal interest rate
for mid-term loans.  One note requires interest-only payments for one year and
then annual $25,000 payments plus interest until paid in full.   The other note
requires annual $25,000 payments plus interest until paid in full.

                                      F-29
<PAGE>
 
                     MCLEODUSA INCORPORATED AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

NOTE 13.   QUARTERLY DATA--(UNAUDITED)

     The following tables include  summarized  quarterly  financial data for the
years ended December 31:

<TABLE> 
<CAPTION> 
                                                                                 QUARTERS
                                                             --------------------------------------------------
                                                                 FIRST      SECOND       THIRD     FOURTH (1)
                                                             -----------  ----------  ---------- -------------
                                                                   (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                          <C>          <C>         <C>        <C> 
     1998:
        Revenue..............................................  $134,331     $155,695    $148,616    $165,504  
        Operating loss.......................................   (20,813)     (17,300)    (21,257)    (15,305) 
        Net loss.............................................   (30,267)     (29,791)    (33,042)    (31,812) 
        Loss per common share................................     (0.49)       (0.48)      (0.52)      (0.50) 

     1997:
        Revenue..............................................  $ 35,747     $ 46,523    $ 49,325    $136,291  
        Operating loss.......................................   (15,168)     (15,668)    (20,074)    (18,459) 
        Net loss.............................................   (13,355)     (16,496)    (23,705)    (26,354) 
        Loss per common share................................     (0.26)       (0.31)      (0.45)      (0.43) 

     1996:
        Revenue..............................................  $ 12,488     $ 13,918    $ 19,091    $ 35,826  
        Operating loss.......................................    (4,076)      (4,791)     (7,689)    (11,654) 
        Net loss.............................................    (4,340)      (4,543)     (4,535)     (8,928) 
        Loss per common share................................     (0.14)       (0.13)      (0.10)      (0.18) 
</TABLE> 

----------------------

(1)  The fourth quarter 1997 results include the operations of CCI, which was
acquired on September 24, 1997.

NOTE 14:  INFORMATION BY BUSINESS SEGMENT

     The Company operates predominantly in the business of providing local, long
distance and related communications services to end users and the sale of
advertising space in telephone directories. The two business segments have
separate management teams and infrastructures that offer different products and
services. The principal elements of these segments are to provide integrated
communications services, provide outstanding customer service, expand fiber
optic network, expand intra-city fiber network build, and publish and distribute
directories to local area subscribers.

     The Company evaluates the performance of its operating segments based on
earnings before interest, taxes, depreciation and amortization, excluding
general corporate expenses ("EBITDA"). The accounting policies of the reportable
segments are the same as those described in Note 1 of Notes to Consolidated
Financial Statements. Intersegment transfers are accounted for on an arm's
length pricing basis.

     Identifiable assets (excluding intersegment receivables) are the Company's
assets that are identified in each business segment. Corporate assets primarily
include cash and cash equivalents, investments in available-for-sale securities,
administrative headquarters and goodwill recorded primarily as a result of the
CCI merger in 1997.

     In 1998, 1997 and 1996, no single customer or group under common control
represented 10% or more of the Company's sales.

<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 14:   INFORMATION BY BUSINESS SEGMENT--(CONTINUED)

Segment information for the years 1998, 1997 and 1996 was as follows (in
thousands):
 
<TABLE>
<CAPTION>
                                      TELECOMMUNICATIONS          MEDIA            CORPORATE             TOTAL
                                    -----------------------  ----------------  ------------------  -----------------
<S>                                 <C>                      <C>               <C>                 <C>
1998
Revenues                                          $459,270          $144,876      $           --         $  604,146
                                    ================================================================================
 
EBITDA                                              13,139            18,829             (11,961)            20,007
Depreciation and amortization                      (56,136)           (9,814)            (23,157)           (89,107)
Interest Revenue                                       941                41              25,018             26,000
Interest Expense                                    (5,256)               --             (72,978)           (78,234)
Taxes and Other                                     (4,014)              (42)                478             (3,578)
                                  ---------------------------------------------------------------------------------
Net Income (Loss)                                  (51,326)            9,014             (82,600)          (124,912)
                                  =================================================================================
 
Total assets                                       684,730           199,734           1,040,733          1,925,197
Capital expenditures                               251,401            26,395              61,864            339,660

-------------------------------------------------------------------------------------------------------------------
1997
Revenues                                          $218,245          $ 49,641            $     --         $  267,886
                                  =================================================================================
 
EBITDA                                             (29,954)           11,914             (13,422)           (31,462)
Depreciation and amortization                      (18,302)           (5,814)             (9,159)           (33,275)
Interest Revenue                                       290                21              22,349             22,660
Interest Expense                                    (1,415)              (27)            (33,185)           (34,627)
Taxes and Other                                      1,366            (2,547)             (2,025)            (3,206)
                                  ---------------------------------------------------------------------------------
Net Income (Loss)                                  (48,015)            3,547             (35,442)           (79,910)
                                  =================================================================================
 
Total assets                                       351,990           172,424             821,238          1,345,652
Capital expenditures                               121,618            34,204             445,315            601,137

-------------------------------------------------------------------------------------------------------------------
1996
Revenues                                          $ 66,171          $ 15,152           $      --         $   81,323
                                  =================================================================================
 
EBITDA                                             (10,490)            1,141              (7,996)           (17,345)
Depreciation and amortization                       (4,327)           (1,346)             (2,812)            (8,485)
Interest Revenue                                        --                87               5,947              6,034
Interest Expense                                        (1)             (133)               (531)              (665)
Other                                                   --            (2,162)                277             (1,885)
                                  ---------------------------------------------------------------------------------
Net Income (Loss)                                  (14,818)           (2,413)             (5,115)           (22,346)
                                  =================================================================================
 
Total assets                                       110,302            94,270             248,422            452,994
Capital expenditures                                66,507               528             106,747            173,782
</TABLE>

                                      F-31
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 15:   EFFECTS OF NEW ACCOUNTING STANDARDS

  In March 1998, the American Institute of Certified Public Accountants issued
Statement of Position 98-1, Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use.  This statement provides guidance on
accounting for the costs of computer software developed or obtained for internal
use and is required to be adopted no later than our 1999 fiscal year.  The
Company plans to modify its method of capitalization of such costs by adopting
this statement prospectively on January 1, 1999.  The Company is currently
evaluating this statement but does not expect it to have a material impact on
its financial condition or results of operations.

  In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
133").  SFAS 133 establishes accounting and reporting standards requiring that
every derivative instrument (including derivative instruments embedded in other
contracts) be recorded in the balance sheet as either an asset or liability
measured at its fair value.  SFAS 133 requires that changes in the derivative's
fair value be recognized currently in earnings unless specific hedge accounting
criteria are met.  Special accounting for qualifying hedges allows a
derivative's gains and losses to offset related results on the hedged item in
the income statement, and requires that a company must formally document,
designate and assess the effectiveness of transactions that receive hedge
accounting.

  SFAS 133 is effective for fiscal years beginning after June 15, 1999.  A
company may also implement SFAS 133 as of the beginning of any fiscal quarter
after issuance (that is, fiscal quarters beginning June 16, 1998 and
thereafter).  SFAS 133 cannot be applied retroactively.  SFAS 133 must be
applied to (a) derivative instruments and (b) derivative instruments embedded in
hybrid contracts that were issued, acquired or substantively modified after
December 31, 1997 (and, at the company's election, before January 1, 1998).

  The Company does not expect the impact of the adoption of SFAS 133 to be
material to its results of operations as it does not currently hold any
derivative instruments or engage in hedging activities.

NOTE 16:  SUBSEQUENT EVENTS

  The Ovation Merger Agreement.  On January 6, 1999, the Company entered into an
Agreement and Plan of Merger (the "Ovation Merger Agreement") with Ovation
Communications, Inc., a Delaware corporation ("Ovation"), and certain
stockholders of Ovation pursuant to which Ovation will be merged with and into a
newly formed wholly owned subsidiary of the Company (the "Ovation Merger").  As
a result of the Ovation Merger, (i) each share of Ovation's preferred stock will
be converted into the right to receive cash, and (ii) each share of Ovation's
common stock will be converted, at the election of the stockholder, into the
right to receive cash or shares of Class A common stock.  The amount of cash
into which each share of Ovation's preferred stock will be converted and the
amount of cash or number of shares of Class A common stock into which each share
of Ovation's common stock will be converted will be determined immediately prior
to consummation of the Ovation Merger in accordance with formulas specified in
the Ovation Merger Agreement.  The Company estimates that it will be required to
issue approximately 5.1 million shares of Class A common stock and to pay
approximately $141 million cash to effect the Ovation Merger.  The Company will
also assume approximately $95 million in Ovation debt.  In addition, under the
terms of the Ovation Merger Agreement, each option to purchase Ovation common
stock issued under Ovation's stock option plan will become or be replaced by an
option to purchase a number of shares of Class A common stock equal to the
number of shares of Ovation common stock that could have been purchased
(assuming full vesting) under the Ovation stock option multiplied by the
exchange ratio used to convert Ovation common stock into Class A common stock.

  Consummation of the Ovation Merger is subject to the satisfaction of certain
conditions, including (i) approval of the Ovation Merger Agreement and the
Ovation Merger by the stockholders of Ovation,

                                      F-32
<PAGE>
 
                    MCLEODUSA INCORPORATED AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
                                        
NOTE 16:   SUBSEQUENT EVENTS--(CONTINUED)

(ii) effectiveness of the registration statement registering the shares of Class
A common stock to be issued in the Ovation Merger, (iii) compliance with the
applicable provisions of the Hart-Scott-Rodino Antitrust Improvements Act of
1976 and the related waiting periods thereunder, (iv) receipt of specified
regulatory approvals, and (v) certain other customary conditions.  Both the
Company and Ovation may terminate the Ovation Merger Agreement if the Ovation
Merger has not been consummated by May 1, 1999.  Certain stockholders of Ovation
holding in the aggregate approximately 94% of the voting power attributable to
Ovation's common stock and preferred stock have agreed to vote all of their
shares in favor of the Ovation Merger at a meeting of the stockholders of
Ovation.

  In connection with the execution of the Ovation Merger Agreement, the Company
entered into a Revolving Credit Agreement with Ovation pursuant to which the
Company agreed to lend Ovation up to $20 million on a senior subordinated
unsecured basis.  In addition, pursuant to a stockholders' agreement, certain
Ovation stockholders agreed through December 31, 2001 to certain restrictions on
their ability to transfer the shares of Class A common stock that they will
receive in the Ovation Merger.

  Acquisition of Talking Directories, Inc. and Info America Phone Books, Inc.
On February 10, 1999, the Company acquired Talking Directories, Inc., a Michigan
corporation ("Talking Directories"), in exchange for 2.6 million shares of its
Class A common stock.  In a related and concurrent transaction, on February 10,
1999, the Company acquired Info America Phone Books, Inc., a Michigan
corporation ("Info America"), in exchange for 1.2 million shares of Class A
common stock.  The Company also paid outstanding obligations of Talking
Directories and Info America of approximately $27 million.

  1999 Senior Note Offering. In February 1999, the Company completed a private
offering of $500 million aggregate principal amount of our 8 1/8% Senior Notes
due February 15, 2009 (the "1999 Senior Notes"), yielding net proceeds of
approximately $487.8 million. The 1999 Senior Notes accrue interest at a rate of
8 1/8% per annum payable in cash semi-annually in arrears on February 15 and
August 15 of each year, commencing August 15, 1999.

  Acquisition of Dakota Telecommunications Group, Inc.  On March 5, 1999, the
Company acquired Dakota Telecommunications Group, Inc. in exchange for 1,375,000
shares of its Class A common stock and the assumption of approximately $31
million in Dakota Telecommunications Group, Inc. debt.

                                      F-33
<PAGE>
 
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors and Stockholders of
McLeodUSA Incorporated:

     We have audited, in accordance with generally accepted auditing standards,
the financial statements of McLeodUSA Incorporated included in this Form 10-K,
and have issued our report thereon dated January 27, 1999 (except with respect 
to matters described in Note 16 to the financial statements, as to which the
date is March 5, 1999). Our audit was made for the purpose of forming an opinion
on those statements taken as a whole. The supplemental Schedule II--Valuation
and Qualifying Accounts ("Schedule II") is presented for purposes of complying
with the Securities and Exchange Commission's rules and is not part of the basic
financial statements. The Schedule II has been subjected to the auditing
procedures applied in the audit of the basic financial statements and, in our
opinion, fairly states in all material respects the financial data required to
be set forth therein in relation to the basic financial statements taken as a
whole.

                                        ARTHUR ANDERSEN LLP



Chicago, Illinois
January 27, 1999

                                      S-1
<PAGE>
 
                            MCLEODUSA INCORPORATED

               SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS

<TABLE>
<CAPTION>
                       COLUMN A                           COLUMN B            COLUMN C             COLUMN D      COLUMN E
                                                                              ADDITIONS
                                                                      -------------------------
                                                          BALANCE         CHARGED      CHARGED                   BALANCE
                                                             AT             TO            TO                        AT
                                                         BEGINNING       COST AND       OTHER                     END OF
                     DESCRIPTION                         OF PERIOD       EXPENSES      ACCOUNTS   DEDUCTIONS      PERIOD
                  -----------------                    -------------  ---------------  --------  ------------  ------------
<S>                                                     <C>           <C>              <C>       <C>           <C>
Year Ended December 31, 1996:
 Allowance for uncollectible accounts
  and discounts.......................................   $   219,000   $ 3,680,000(1)  $     --  $         --   $ 3,899,000
 Valuation reserve on deferred tax assets.............     8,418,000     7,793,000           --            --    16,211,000
                                                         -----------   -----------     --------  ------------   -----------
                                                         $ 8,637,000   $11,473,000     $     --  $         --   $20,110,000
                                                         ===========   ===========     ========  ============   ===========

Year Ended December 31, 1997:
 Allowance for doubtful accounts
  and discounts.......................................   $ 3,899,000   $ 8,052,000(2)  $     --  $         --   $11,951,000
 Valuation reserve on deferred tax assets.............    16,211,000    13,321,000           --            --    29,532,000
                                                         -----------   -----------     --------  ------------   -----------
                                                         $20,110,000   $21,373,000     $     --  $         --   $41,483,000
                                                         ===========   ===========     ========  ============   ===========

Year Ended December 31, 1998:
 Allowance for doubtful accounts
  and discounts.......................................   $11,951,000   $19,620,000(3)  $     --   $16,364,000   $15,207,000
 Valuation reserve on deferred tax assets.............    29,532,000    49,024,000           --            --    78,556,000
                                                         -----------   -----------     --------  ------------   -----------
                                                         $41,483,000   $68,644,000     $     --   $16,364,000   $93,763,000
                                                         ===========   ===========     ========  ============   ===========
</TABLE>
 
_____________________________

(1) Includes $2,768,000 of allowance for doubtful accounts and discounts related
    to acquisitions during the year.

(2) Includes $4,809,000 of allowance for doubtful accounts and discounts related
    to acquisitions during the year.

(3) Includes $15,000 of allowance for doubtful accounts and discounts related to
    acquisitions during the year.

                                      S-2
<PAGE>
 
                               INDEX TO EXHIBITS

 Exhibit
 Number                               Exhibit Description
 ------                               -------------------

   2.1         Agreement and Plan of Reorganization dated April 28, 1995 among
               Midwest Capital Group Inc., MWR Telecom, Inc. and McLeod, Inc.
               (Filed as Exhibit 2.1 to Registration Statement on Form S-1, File
               No. 333-3112 ("Initial Form S-1"), and incorporated herein by
               reference).
                 
   2.2         Agreement and Plan of Reorganization dated as of July 12, 1996
               among Ruffalo, Cody & Associates, Inc., certain shareholders of
               Ruffalo, Cody & Associates, Inc. and McLeod, Inc. (Filed as
               Exhibit 2 to Current Report on Form 8-K, File No. 0-20763, filed
               with the Commission on July 29, 1996 and incorporated herein by
               reference).
               
   2.3         Agreement and Plan of Reorganization dated as of August 15, 1996
               among TelecomUSA Publishing Group, Inc. and McLeod, Inc. (Filed
               as Exhibit 2 to Current Report on Form 8-K, File No. 0-20763,
               filed with the Commission on August 26, 1996 and incorporated
               herein by reference).
                 
   2.4         Agreement and Plan of Reorganization dated as of January 27, 1997
               among McLeod, Inc., Digital Communications of Iowa, Inc., Clark
               E. McLeod and Mary E. McLeod. (Filed as Exhibit 2 to Current
               Report on Form 8-K, File No. 0-20763, filed with the Commission
               on February 24, 1997 and incorporated herein by reference).
                 
   2.5         Asset Purchase Agreement dated as of May 30, 1997 by and among
               McLeodUSA Incorporated, ESI/McLeodUSA, Inc., and ESI
               Communications, Inc., ESI Communications/ SW, Inc., ESI
               Communications/West, Inc., ESI Communications Downtown, Inc., ESI
               Communications North, Inc., and Michael Reichert, Peter Jones,
               John Pupkes and Jeff Meehan. (Filed as Exhibit 2.1 to Current
               Report on Form 8-K, File No. 0-20763 (the "June 1997 Form 8-K"),
               filed with the Commission on June 26, 1997 and incorporated
               herein by reference).
               
   2.6         Agreement and Plan of Reorganization dated as of June 14, 1997
               among McLeodUSA Incorporated, Eastside Acquisition Co. and
               Consolidated Communications Inc. (Filed as Exhibit 2.2 to the
               June 1997 Form 8-K and incorporated herein by reference).
                 
   2.7         Agreement and Plan of Merger dated as of October 27, 1998 among
               McLeodUSA Incorporated, West Group Acquisition Co. and Dakota
               Telecommunications Group, Inc. (Filed as Exhibit 2.7 to the
               Registration Statement on Form S-4, File No. 333-68891 (the
               "December 1998 Form S-4"), and incorporated herein by reference).
               
   2.8         Agreement and Plan of Merger, dated as of January 7, 1999 among
               McLeodUSA Incorporated, Bravo Acquisition Corporation, Ovation
               Communications, Inc. and certain stockholders of Ovation
               Communications, Inc. (Filed as Exhibit 2.1 to current Report on
               Form 8-K, File No. 0-20763 (the "January 1999 Form 8-K"), filed
               with the Commission on January 14, 1999 and incorporated herein
               by reference).
                 
   2.9         Agreement and Plan of Merger, dated as of January 7, 1999, among
               McLeodUSA Incorporated, McLeodUSA Publishing Company, Pubco
               Merging Co., Talking Directories, Inc. and the stockholders of
               Talking Directories, Inc. (Filed as Exhibit 2.2 to the January
               1999 Form 8-K and incorporated herein by reference).
               
   2.10        Agreement and Plan of Merger, dated as of January 7, 1999 among
               McLeodUSA Incorporated, McLeodUSA Publishing Company, Publication
               Merge Co., Info America Phone Books, Inc. and certain
               stockholders of Info America Phone Books, Inc. (Filed as Exhibit
               2.3 to the January 1999 Form 8-K and incorporated herein by
               reference).
                 
   3.1         Amended and Restated Certificate of Incorporation of McLeod, Inc.
               (Filed as Exhibit 3.1 to Initial Form S-1 and incorporated herein
               by reference).
 
<PAGE>
 
 Exhibit
 Number                               Exhibit Description
 ------                               -------------------

   3.2         Amended and Restated Bylaws of McLeod, Inc. (Filed as Exhibit 3.2
               to Registration Statement on Form S-1, File No. 333-13885 (the
               "November 1996 Form S-1"), and incorporated herein by reference).
                 
   3.3         Certificate of Amendment of Amended and Restated Certificate of
               Incorporation of McLeod Inc. (Filed as Exhibit 3.3 to
               Registration Statement on Form S-4, File No. 333-27647 (the "July
               1997 Form S-4") and incorporated herein by reference).
                 
   3.4         Certificate of Change of Registered Agent and Registered Office
               of McLeodUSA Incorporated. (Filed as Exhibit 3.4 to Annual Report
               on Form 10-K, File No. 0-20763, filed with the Commission on
               March 6, 1998 (the "1997 Form 10-K") and incorporated herein by
               reference).
                 
   4.1         Form of Class A Common Stock Certificate of McLeod, Inc. (Filed
               as Exhibit 4.1 to Initial Form S-1 and incorporated herein by
               reference).
                 
   4.2         Indenture dated March 4, 1997 between McLeod, Inc. and United
               States Trust Company of New York, as Trustee, relating to the 10-
               1/2% Senior Discount Notes Due 2007 of McLeod, Inc. (Filed as
               Exhibit 4.2 to Annual Report on Form 10-K, File No. 0-20763,
               filed with the Commission on March 31, 1997 (the "1996 Form 10-
               K") and incorporated herein by reference).
               
   4.3         Initial Global 10-1/2% Senior Discount Note Due March 1, 2007 of
               McLeod, Inc., dated March 4, 1997. (Filed as Exhibit 4.3 to the
               1996 Form 10-K and incorporated herein by reference).
               
   4.4         Form of Certificated 10-1/2% Senior Discount Note Due March 1,
               2007 of McLeod, Inc. (Filed as Exhibit 4.4 to the 1996 Form 10-K
               and incorporated herein by reference).
               
   4.5         Registration Agreement dated March 4, 1997 among McLeod, Inc.,
               Salomon Brothers Inc. and Morgan Stanley & Co. Incorporated.
               (Filed as Exhibit 4.5 to the 1996 Form 10-K and incorporated
               herein by reference).
                 
   4.6         Investor Agreement dated as of April 1, 1996 among McLeod, Inc.,
               IES Investments Inc., Midwest Capital Group Inc., MWR Investments
               Inc., Clark and Mary McLeod, and certain other stockholders.
               (Filed as Exhibit 4.8 to Initial Form S-1 and incorporated herein
               by reference).
                 
   4.7         Amendment No. 1 to Investor Agreement dated as of October 23,
               1996 by and among McLeod, Inc., IES Investments Inc., Midwest
               Capital Group Inc., MWR Investments Inc., Clark E. McLeod and
               Mary E. McLeod. (Filed as Exhibit 4.3 to the November 1996 
               Form S-1 and incorporated herein by reference).
               
   4.8         Form of 10-1/2% Senior Discount Exchange Note Due 2007 of
               McLeodUSA Incorporated. (Filed as Exhibit 4.8 to the July 1997
               Form S-4 and incorporated herein by reference).
                 
   4.9         Indenture dated as of July 21, 1997 between McLeodUSA
               Incorporated and United States Trust Company of New York, as
               Trustee, relating to the 9-1/4% Senior Notes Due 2007 of
               McLeodUSA Incorporated. (Filed as Exhibit 4.9 to the July 1997
               Form S-4 and incorporated herein by reference).
 
   4.10        Form of Initial Global 9-1/4% Senior Note Due 2007 of McLeodUSA
               Incorporated. (Filed as Exhibit 4.10 to the July 1997 Form S-4
               and incorporated herein by reference).
               

                                       2
<PAGE>
 
 Exhibit
 Number                               Exhibit Description
 ------                               -------------------

   4.11        Registration Agreement dated July 21, 1997 among McLeodUSA
               Incorporated, Salomon Brothers Inc., Morgan Stanley Dean Witter
               and Bear, Stearns & Co. Inc. (Filed as Exhibit 4.11 to the July
               1997 Form S-4 and incorporated herein by reference).
                 
   4.12        Stockholders' Agreement dated June 14, 1997 among McLeodUSA
               Incorporated, IES Investments Inc., Midwest Capital Group, Inc.,
               MWR Investments Inc., Clark E. McLeod, Mary E. McLeod and Richard
               A. Lumpkin on behalf of each of the shareholders of Consolidated
               Communications Inc. listed on Schedule 1 of the Stockholders'
               Agreement. (Filed as Exhibit 4.12 to the July 1997 Form S-4 and
               incorporated herein by reference).
                 
   4.13        Amendment No. 1 to Stockholders' Agreement dated as of September
               19, 1997 by and among McLeodUSA Incorporated, IES Investments
               Inc., Midwest Capital Group, Inc., MWR Investments Inc., Clark E.
               McLeod, Mary E. McLeod and Richard A. Lumpkin on behalf of each
               of the shareholders of Consolidated Communications Inc. listed in
               Schedule I thereto. (Filed as Exhibit 4.1 to the Quarterly Report
               on Form 10-Q, File No. 0-20763, filed with the Commission on
               November 14, 1997 and incorporated herein by reference).
        
   4.14        Form of 9-1/4% Senior Exchange Note Due 2007 of McLeodUSA
               Incorporated. (Filed as Exhibit 4.14 to the 1997 Form 10-K and
               incorporated herein by reference).
                 
   4.15        Indenture dated as of March 16, 1998 between McLeodUSA
               Incorporated and United States Trust Company of New York, as
               Trustee, relating to the 8-3/8% Senior Notes Due 2008 of
               McLeodUSA Incorporated (Filed as Exhibit 4.15 to Registration
               Statement on Form S-4, File No. 333-52793 (the "May 1998 Form S-
               4") and incorporated herein by reference).
               
   4.16        Form of Global 8-3/8% Senior Note Due 2008 of McLeodUSA
               Incorporated (contained in the Indenture filed as Exhibit 4.15).
                 
   4.17        Registration Agreement dated March 16, 1998 among McLeodUSA
               Incorporated, Solomon Brothers Inc., Bear, Stearns & Co. Inc.,
               Morgan Stanley & Co. Incorporated and Chase Securities Inc.
               (Filed as Exhibit 4.17 to the May 1998 Form S-4 and incorporated
               herein by reference).
                 
   4.18        Stockholders' Agreement dated November 18, 1998 by and among
               McLeodUSA Incorporated; IES Investments Inc.; Clark E. McLeod;
               Mary E. McLeod; and Richard A. Lumpkin and each of the former
               shareholders of Consolidated Communications Inc. ("CCI") and
               certain permitted transferees of the former CCI shareholders.
               (Filed as Exhibit 99.1 to the Current Report on Form 8-K, File
               No. 0-20763, filed with the Commission on November 19, 1998 and
               incorporated herein by reference).
                 
   4.19        Indenture dated as of October 30, 1998 between McLeodUSA
               Incorporated and United States Trust Company of New York, as
               Trustee, relating to the 9 1/2% Senior Notes Due 2008 of
               McLeodUSA Incorporated (Filed as Exhibit 4.19 to Registration
               Statement on Form S-4, File No. 333-69621 (the "December 23, 1998
               Form S-4") and incorporated herein by reference).
                 
   4.20        Form of Global 9 1/2% Senior Note Due 2008 of McLeodUSA
               Incorporated (contained in the Indenture filed as Exhibit 4.19).
                 
   4.21        Registration Agreement dated October 30, 1998 among McLeodUSA
               Incorporated, Salomon Smith Barney Inc., Bear, Stearns & Co.
               Incorporated and Chase Securities Inc. (Filed as Exhibit 4.20 to
               December 23, 1998 Form S-4 and incorporated herein by reference).
               

                                       3
<PAGE>
 
 Exhibit
 Number                               Exhibit Description
 ------                               -------------------

   4.22        Indenture dated as of February 22, 1999 between McLeodUSA
               Incorporated and United States Trust Company of New York, as
               Trustee, relating to the 8 1/8% Senior Notes Due 2009 of
               McLeodUSA Incorporated.
                 
   4.23        Form of Global 8 1/8% Senior Note Due 2009 of McLeodUSA
               Incorporated (contained in the Indenture filed as Exhibit 4.22).
                 
   4.24        Registration Agreement dated February 22, 1999 among McLeodUSA
               Incorporated, Salomon Smith Barney Inc., Bear, Stearns & Co.
               Incorporated and Chase Securities Inc.
               
  10.1         Lease Agreement dated September 5, 1995 between State of Iowa and
               MWR Telecom, Inc. (Filed as Exhibit 10.21 to Initial Form S-1 and
               incorporated herein by reference).

  10.2         Lease Agreement dated September 5, 1995 between State of Iowa and
               McLeod Network Services, Inc. (Filed as Exhibit 10.22 to Initial
               Form S-1 and incorporated herein by reference).

  10.3         U S WEST Centrex Plus Service Rate Stability Plan dated October
               15, 1993 between McLeod Telemanagement, Inc. and U S WEST
               Communications, Inc. (Filed as Exhibit 10.26 to Initial Form S- 1
               and incorporated herein by reference).

  10.4         U S WEST Centrex Plus Service Rate Stability Plan dated July 17,
               1993 between McLeod Telemanagement, Inc. and U S WEST
               Communications, Inc. (Filed as Exhibit 10.27 to Initial Form S- 1
               and incorporated herein by reference).

  10.5         Ameritech Centrex Service Confirmation of Service Orders dated
               various dates in 1994, 1995 and 1996 between McLeod
               Telemanagement, Inc. and Ameritech Information Industry Services.
               (Filed as Exhibit 10.28 to Initial Form S-1 and incorporated
               herein by reference).

  10.6         Lease Agreement dated as of December 28, 1993 between 2060
               Partnership and McLeod Telemanagement, Inc., as amended by
               Amendments First to Ninth dated as of July 3, 1994, March 25,
               1994, June 22, 1994, August 12, 1994, September 12, 1994,
               September 20, 1994, November 16, 1994, September 20, 1995 and
               January 6, 1996, respectively. (Filed as Exhibit 10.29 to Initial
               Form S- 1 and incorporated herein by reference).

  10.7         Lease Agreement dated as of May 24, 1995 between 2060 Partnership
               and McLeod Telemanagement, Inc. (Filed as Exhibit 10.30 to
               Initial Form S-1 and incorporated herein by reference).

  10.8         Lease Agreement dated October 31, 1995 between I.R.F.B. Joint
               Venture and McLeod Telemanagement, Inc. (Filed as Exhibit 10.31
               to Initial Form S-1 and incorporated herein by reference).

  10.9         First Amendment to Lease Agreement dated as of November 20, 1995
               between I.R.F.B. Joint Venture and McLeod Telemanagement, Inc.
               (Filed as Exhibit 10.32 to Initial Form S-1 and incorporated
               herein by reference).

  10.10        Master Right-of-Way Agreement dated July 27, 1994 between McLeod
               Network Services, Inc. and IES Industries Inc. (Filed as Exhibit
               10.34 to Initial Form S-1 and incorporated herein by reference).

  10.11        Master Right-of-Way and Tower Use Agreement dated February 13,
               1996 between IES Industries Inc. and McLeod, Inc. (Filed as
               Exhibit 10.35 to Initial Form S-1 and incorporated herein by
               reference).

                                       4
<PAGE>
 
 Exhibit
 Number                               Exhibit Description
 ------                               -------------------

  10.12        Master Pole, Duct and Tower Use Agreement dated February 20, 1996
               between MidAmerican Energy Company and McLeod, Inc. (Iowa and
               South Dakota). (Filed as Exhibit 10.36 to Initial Form S-1 and
               incorporated herein by reference).

  10.13        Master Pole, Duct and Tower Use Agreement dated February 20, 1996
               between MidAmerican Energy Company and McLeod, Inc. (Illinois).
               (Filed as Exhibit 10.37 to Initial Form S-1 and incorporated
               herein by reference).

  10.14        Settlement Agreement dated March 18, 1996 between U S WEST
               Communications, Inc. and McLeod Telemanagement, Inc. (Filed as
               Exhibit 10.38 to Initial Form S-1 and incorporated herein by
               reference).

  10.15        McLeod Telecommunications, Inc. 1992 Incentive Stock Option Plan.
               (Filed as Exhibit 10.40 to Initial Form S-1 and incorporated
               herein by reference).
 
  10.16        McLeod, Inc. 1993 Incentive Stock Option Plan. (Filed as Exhibit
               10.41 to Initial Form S-1 and incorporated herein by reference).

  10.17        McLeod, Inc. 1995 Incentive Stock Option Plan. (Filed as Exhibit
               10.42 to Initial Form S-1 and incorporated herein by reference).

  10.18        McLeod Telecommunications, Inc. Director Stock Option Plan.
               (Filed as Exhibit 10.43 to Initial Form S-1 and incorporated
               herein by reference).

  10.19        Promissory Note dated July 18, 1995 between Kirk E. Kaalberg and
               McLeod, Inc. (Filed as Exhibit 10.44 to Initial Form S-1 and
               incorporated herein by reference).

  10.20        Promissory Note dated March 29, 1996 between Stephen K.
               Brandenburg and McLeod, Inc. (Filed as Exhibit 10.45 to Initial
               Form S-1 and incorporated herein by reference).

 +10.21        Telecommunications Services Agreement dated March 14, 1994
               between WilTel, Inc. and McLeod Telemanagement, Inc., as amended.
               (Filed as Exhibit 10.47 to Initial Form S-1 and incorporated
               herein by reference).

  10.22        First Amendment to Agreement Regarding Support Agreement dated
               May 14, 1996 among McLeod, Inc., IES Diversified Inc. and IES
               Investments Inc. (Filed as Exhibit 10.50 to Initial Form S-1 and
               incorporated herein by reference).

  10.23        First Amendment to Agreement Regarding Guarantee dated May 14,
               1996 among McLeod, Inc., IES Diversified Inc. and IES Investments
               Inc. (Filed as Exhibit 10.51 to Initial Form S-1 and incorporated
               herein by reference).

  10.24        Amended and Restated Directors Stock Option Plan of McLeod, Inc.
               (Filed as Exhibit 10.52 to Initial Form S-1 and incorporated
               herein by reference).

  10.25        Forms of Employment, Confidentiality and Non-Competition
               Agreement between McLeod, Inc. and certain employees of McLeod,
               Inc. (Filed as Exhibit 10.53 to Initial Form S-1 and incorporated
               herein by reference).

  10.26        Form of Change-of-Control Agreement between McLeod, Inc. and
               certain employees of McLeod, Inc. (Filed as Exhibit 10.54 to
               Initial Form S-1 and incorporated herein by reference).

  10.27        McLeod, Inc. 1996 Employee Stock Option Plan, as amended. (Filed
               as Exhibit 10.55 to the November 1996 Form S-1 and incorporated
               herein by reference).

                                       5
<PAGE>
 
 Exhibit
 Number                               Exhibit Description
 ------                               -------------------

  10.28        McLeod, Inc. Employee Stock Purchase Plan, as amended. (Filed as
               Exhibit 10.56 to the 1996 Form 10-K and incorporated herein by
               reference).

  10.29        Form of Indemnity Agreement between McLeod, Inc. and certain
               officers and directors of McLeod, Inc. (Filed as Exhibit 10.57 to
               Initial Form S-1 and incorporated herein by reference).

  10.30        McLeod, Inc. Incentive Plan. (Filed as Exhibit 10.63 to the
               November 1996 Form S-1 and incorporated herein by reference).

  10.31        Amended and Restated Credit Agreement dated as of May 5, 1996
               among TelecomUSA Publishing Group, Inc., TelecomUSA Publishing
               Company and TelecomUSA Neighborhood Directories, Inc. and Norwest
               Bank Iowa, National Association. (Filed as Exhibit 10.64 to the
               November 1996 Form S-1 and incorporated herein by reference).

  10.32        First Amendment to Amended and Restated Credit Agreement dated as
               of January 31, 1996 by and between TelecomUSA Publishing Group,
               Inc., TelecomUSA Publishing Company and TelecomUSA Neighborhood
               Directories, Inc. and Norwest Bank Iowa, National Association.
               (Filed as Exhibit 10.65 to the November 1996 Form S-1 and
               incorporated herein by reference).

  10.33        Lease Agreement dated as of July 18, 1995 between 2060
               Partnership, L.P. and TelecomUSA Publishing Company. (Filed as
               Exhibit 10.68 to the November 1996 Form S-1 and incorporated
               herein by reference).

  10.34        Lease Agreement dated April 26, 1995 by and between A.M.
               Henderson and TelecomUSA Publishing Company. (Filed as Exhibit
               10.69 to the November 1996 Form S-1 and incorporated herein by
               reference).

  10.35        License Agreement dated as of April 19, 1994, between Ameritech
               Information Industry Services and TelecomUSA Publishing Company.
               (Filed as Exhibit 10.70 to the November 1996 Form S-1 and
               incorporated herein by reference).

  10.36        License Agreement dated September 13, 1993 between U S WEST
               Communications, Inc. and TelecomUSA Publishing Company. (Filed as
               Exhibit 10.71 to the November 1996 Form S-1 and incorporated
               herein by reference).

  10.37        Form of McLeod, Inc. Directors Stock Option Plan Option
               Agreement. (Filed as Exhibit 10.72 to the November 1996 Form S-1
               and incorporated herein by reference).

  10.38        Forms of McLeod, Inc. 1996 Employee Stock Option Plan Incentive
               Stock Option Agreement. (Filed as Exhibit 10.73 to the November
               1996 Form S-1 and incorporated herein by reference).

  10.39        Forms of McLeod, Inc. 1996 Employee Stock Option Plan Non-
               Incentive Stock Option Agreement. (Filed as Exhibit 10.74 to the
               November 1996 Form S-1 and incorporated herein by reference).

  10.40        Sale and Purchase Agreement dated January 27, 1997 among
               McLeodUSA Publishing Company, Fronteer Financial Holdings, Ltd.,
               Classified Directories, Inc., Larry A. Scott, James Greff,
               Randall L. Gowin and Edwin Dressler and certain directors,
               officers and shareholders of Fronteer Financial Holdings, Ltd.
               (Filed as Exhibit 10.90 to the 1996 Form 10-K and incorporated
               herein by reference).

                                       6
<PAGE>
 
 Exhibit
 Number                               Exhibit Description
 ------                               -------------------

  10.41        Sale and Purchase Agreement dated February 27, 1997 among
               McLeodUSA Publishing Company, Indiana Directories, Inc., John
               Morgan, Hank Meijer, Jack Hendricks, Brad Nelson and Talking
               Directories, Inc. (Filed as Exhibit 10.91 to the 1996 Form 10-K
               and incorporated herein by reference).

  10.42        Amendment to Sale and Purchase Agreement dated February 28, 1997
               between McLeodUSA Publishing Company and Indiana Directories,
               Inc. (Filed as Exhibit 10.92 to the 1996 Form 10-K and
               incorporated herein by reference).

  10.43        Ameritech Centrex Service Confirmation of Service Orders dated
               August 21, 1996 between McLeod Telemanagement, Inc. and Ameritech
               Information Industry Services. (Filed as Exhibit 10.93 to the
               1996 Form 10-K and incorporated herein by reference).

 +10.44        Amended and Restated Program Enrollment Terms dated November 1,
               1996 between WorldCom Network Services, Inc. d/b/a WilTel and
               McLeod Telemanagement, Inc. (Filed as Exhibit 10.94 to Annual
               Report on Form 10-K/A, File No. 0-20763, filed with the
               Commission on April 8, 1997 and incorporated herein by
               reference).

  10.45        Letter Agreement dated April 15, 1997 between U S WEST
               Communications and McLeodUSA Network Services, Inc. (Filed as
               Exhibit 10.1 to Quarterly Report on Form 10-Q, File No. 0-20763,
               filed with the Commission on May 14, 1997 and incorporated herein
               by reference).

  10.46        Network Agreement dated April 7, 1997, between Wisconsin Power
               and Light Company and McLeodUSA Telecommunications Services, Inc.
               (Filed as Exhibit 10.96 to the July 1997 Form S-4 and
               incorporated herein by reference).

  10.47        Agreement dated July 7, 1997 between McLeodUSA Telecommunications
               Services, Inc. and U S WEST Communications, Inc. (Filed as
               Exhibit 10.97 to the July 1997 Form S-4 and incorporated herein
               by reference).

  10.48        Agreement dated August 14, 1997 between McLeodUSA Incorporated
               and Taylor Ball, Inc. (Filed as Exhibit 10.98 to Registration
               Statement on Form S-4, File No. 333-34227 (the "November 1997
               Form S-4") and incorporated herein by reference).

  10.49        Interconnection Agreement Under Sections 251 and 252 of the
               Telecommunications Act of 1996 dated as of October 28, 1996
               between Ameritech Information Industry Services and Consolidated
               Communications Telecom Services Inc. (Filed as Exhibit 10.99 to
               the November 1997 Form S-4 and incorporated herein by reference).

  10.50        Interconnection Agreement Under Sections 251 and 252 of the
               Telecommunications Act of 1996 dated as of July 17, 1997 between
               Ameritech Information Industry Services and Consolidated
               Communications Telecom Services Inc. (Filed as Exhibit 10.100 to
               the November 1997 Form S-4 and incorporated herein by reference).

  10.51        Supply Agreement dated February 26, 1990 and Amendment Number 4
               to Supply Agreement dated January 4, 1999 between Alcatel USA 
               Marketing, Inc. and McLeodUSA Incorporated.

  11.1         Statement regarding Computation of Per Share Earnings.

  16.1         Letter regarding Change in Certifying Accountant (Filed as
               Exhibit 16.1 to the 1997 Form 10-K and incorporated herein by
               reference).

  21.1         Subsidiaries of McLeodUSA Incorporated.

                                       7
<PAGE>
 
 Exhibit
 Number                               Exhibit Description
 ------                               -------------------

  23.1         Consent of Arthur Andersen LLP.

  27.1         Financial Data Schedule.

______________________
 
+    Confidential treatment has been granted. The copy filed as an exhibit omits
     the information subject to the confidential treatment request.

                                       8