<PAGE>   1
                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                              Washington, DC 20549

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

                                    FORM 10-Q



       (Mark one)
      [X]    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                  For the Quarterly Period Ended June 30, 1998

             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:   0-24509
                                            -------

                            ALLEGIANCE TELECOM, INC.
           (Exact name of registrant as specified in its certificate)


          Delaware                                       75-2721491
----------------------------                  ---------------------------------
(State or other jurisdiction                  (IRS Employer Identification No.)
of incorporation or organization)


                              1950 STEMMONS FREEWAY
                                   SUITE 3026
                               DALLAS, TEXAS 75207
                    (Address of principal executive offices)
                                   (Zip Code)

                                 (214) 853-7100
              ----------------------------------------------------
              (Registrant's telephone number, including area code)

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

                            [ ] Yes    [X]  No

      AS OF AUGUST 1, 1998, THE REGISTRANT HAS 50,341,554 SHARES OF COMMON
STOCK, PAR VALUE $0.01 PER SHARE OUTSTANDING.


<PAGE>   2
                    ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES

                                 FORM 10-Q INDEX

<TABLE>
<CAPTION>
                                                                                Page No.
                                                                                --------
<S>                                                                             <C>
PART I.   FINANCIAL INFORMATION

Item 1.   Financial Statements

          Condensed Consolidated Balance Sheets as of December 31, 1997
             and June 30, 1998 ..............................................      3

          Condensed Consolidated Statements of Operations for the Three
             and Six Months Ended June 30, 1998 .............................      4

          Condensed Consolidated Statement of Cash Flows for the Six
             Months Ended June 30, 1998 .....................................      5

          Notes to Condensed Consolidated Financial Statements ..............      6

Item 2.   Management's Discussion and Analysis of Financial Condition
             and Results of Operations ......................................     12

PART II.  OTHER INFORMATION

Item 1.   Legal Proceedings .................................................     18

Item 2.   Changes in Securities and Use of Proceeds .........................     18

Item 3.   Defaults upon Senior Securities ...................................     19

Item 4.   Submission of Matters to a Vote of Security Holders ...............     19

Item 5.   Other Information .................................................     19

Item 6.   Exhibits and Reports on Form 8-K ..................................     19
</TABLE>





                                       2
<PAGE>   3
PART I.  FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

                    ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
                      CONDENSED CONSOLIDATED BALANCE SHEETS
                  (Dollars in thousands, except share amounts)

                                     ASSETS

<TABLE>
<CAPTION>
                                                                                  December 31,       June 30,
                                                                                      1997            1998
                                                                                   ----------      -----------
                                                                                                   (Unaudited)
<S>                                                                                <C>             <C>       
CURRENT ASSETS:
      Cash and cash equivalents                                                    $  5,726.4      $177,669.1
      Short-term investments                                                             --          62,494.8
      Accounts receivable, net of allowance for doubtful accounts of $0
          and $62.5 at December 31, 1997 and June 30, 1998, respectively                  4.3         1,678.7
      Prepaid expenses and other current assets                                         245.2           460.8
                                                                                   ----------      ----------
            Total current assets                                                      5,975.9       242,303.4

PROPERTY AND EQUIPMENT:
      Property and equipment                                                         23,912.6        50,821.2
      Accumulated depreciation and amortization                                         (12.7)       (1,226.2)
                                                                                   ----------      ----------
            Property and equipment, net                                              23,899.9        49,595.0

OTHER NON-CURRENT ASSETS:
      Deferred debt issuance costs (net of accumulated amortization of $252.0)           --           9,948.1
      Other assets                                                                      171.2           425.2
                                                                                   ----------      ----------
            Total other non-current assets                                              171.2        10,373.3
                                                                                   ----------      ----------

            Total assets                                                           $ 30,047.0      $302,271.7
                                                                                   ==========      ==========

                                         LIABILITIES AND STOCKHOLDERS' DEFICIT

CURRENT LIABILITIES:
      Accounts payable                                                             $  2,261.7      $  4,569.0
      Accrued liabilities and other                                                   1,668.0         8,100.7
                                                                                   ----------      ----------
            Total current liabilities                                                 3,929.7        12,669.7

LONG-TERM DEBT                                                                           --         254,883.2

REDEEMABLE CUMULATIVE CONVERTIBLE PREFERRED STOCK:
     Redeemable cumulative convertible preferred stock - 40,498,062 and
          40,771,424 shares issued and outstanding at December 31, 1997 and
          June 30, 1998, respectively                                                33,409.4        65,810.6
     Preferred stock subscriptions receivable                                            --              --
                                                                                   ----------      ----------
            Total redeemable cumulative preferred stock                              33,409.4        65,810.6

REDEEMABLE WARRANTS                                                                      --           8,381.2

COMMITMENTS AND CONTIGENCIES

STOCKHOLDERS' DEFICIT:
     Common stock - 426 shares issued and outstanding at December 31, 1997
          and June 30, 1998                                                              --              --
     Additional paid-in capital                                                       3,008.4        19,500.2
     Deferred compensation                                                           (2,798.4)      (16,921.4)
     Accumulated deficit                                                             (7,502.1)      (42,051.8)
                                                                                   ----------      ----------
            Total stockholders' deficit                                              (7,292.1)      (39,473.0)
                                                                                   ----------      ----------

            Total liabilities and stockholders' deficit                            $ 30,047.0      $302,271.7
                                                                                   ==========      ==========
</TABLE>



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



                                       3
<PAGE>   4


                  ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
               CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                 (DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
                                 (UNAUDITED)



<TABLE>
<CAPTION>
                                                                    Three Months Ended   Six Months Ended 
                                                                      June 30, 1998        June 30, 1998
                                                                     ---------------      ---------------
<S>                                                                  <C>                  <C>            
REVENUES                                                             $       1,212.0      $       1,414.9

OPERATING EXPENSES:
   Network                                                                   1,350.9              1,585.7
   Selling                                                                   1,771.2              2,461.0
   General and administrative                                                6,303.8             10,315.1
   Non-cash deferred compensation                                            1,389.9              2,368.8
   Depreciation and amortization                                             1,005.1              1,213.5
                                                                     ---------------      ---------------
       Total operating expenses                                             11,820.9             17,944.1
                                                                     ---------------      ---------------
       Loss from operations                                                (10,608.9)           (16,529.2)

OTHER (EXPENSE) INCOME:
   Interest income                                                           3,401.9              5,596.1
   Interest expense                                                         (7,229.0)           (11,898.1)
                                                                     ---------------      ---------------
       Total other (expense) income                                         (3,827.1)            (6,302.0)

NET LOSS                                                                   (14,436.0)           (22,831.2)

ACCRETION OF REDEEMABLE PREFERRED STOCK AND WARRANT VALUES                  (6,453.8)           (11,718.5)

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

NET LOSS APPLICABLE TO COMMON STOCK                                  $     (20,889.8)     $     (34,549.7)
                                                                     ===============      ===============

NET LOSS PER SHARE, basic and diluted                                $       (49,037)     $       (81,102)
                                                                     ===============      ===============

WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING, basic and diluted                 426                  426
                                                                     ===============      ===============
</TABLE>


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


                                       4
<PAGE>   5


                    ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
                 CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
                             (DOLLARS IN THOUSANDS)
                                   (UNAUDITED)


<TABLE>
<CAPTION>
                                                                            Six Months 
                                                                          Ended June 30,
                                                                              1998
                                                                          --------------
<S>                                                                       <C>            
CASH FLOWS FROM OPERATING ACTIVITIES:
      Net loss                                                            $    (22,831.2)
      Adjustments to reconcile net loss to net cash used in operating
      activities --
        Depreciation and amortization                                            1,213.5
        Accretion of senior discount notes                                      11,646.1
        Amortization of deferred debt issuance costs                               252.0
        Deferred compensation                                                    2,368.8
        Changes in assets and liabilities --
           Accounts receivable                                                  (1,674.4)
           Prepaid expenses and other current assets                              (215.6)
           Other assets                                                           (254.0)
           Accounts payable                                                      1,085.0
           Accrued liabilities and other                                         3,106.7
                                                                          --------------
               Net cash used in operating activities                            (5,303.1)
                                                                          --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
      Purchases of property and equipment                                      (21,416.9)
      Short-term investments                                                   (62,494.8)
                                                                          --------------
               Net cash used in investing activities                           (83,911.7)
                                                                          --------------
CASH FLOWS FROM FINANCING ACTIVITIES:
      Proceeds from issuance of senior discount notes                          242,293.6
      Proceeds from issuance of warrants                                         8,183.6
      Debt issuance costs                                                      (10,200.1)
      Proceeds from issuance of redeemable preferred stock                          62.5
      Proceeds from redeemable capital contributions                            20,542.9
      Proceeds from preferred stock subscriptions receivable                       275.0
                                                                          --------------
               Net cash provided by financing activities                       261,157.5
                                                                          --------------
INCREASE IN CASH AND CASH EQUIVALENTS                                          171,942.7
CASH AND CASH EQUIVALENTS, beginning of period                                   5,726.4
                                                                          --------------
CASH AND CASH EQUIVALENTS, end of period                                  $    177,669.1
                                                                          ==============
</TABLE>

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


                                       5
<PAGE>   6

                            ALLEGIANCE TELECOM, INC.
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                    THREE AND SIX MONTHS ENDED JUNE 30, 1998
                  (DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
                                   (UNAUDITED)

1. GENERAL:

    Allegiance Telecom, Inc., a competitive local exchange carrier ("CLEC"),
seeks to become a leading provider of voice, data, and Internet services to
business, government, and other institutional users in major metropolitan areas
across the United States. Allegiance Telecom, Inc. and its subsidiaries are
referred to herein as the "Company."

    The Company plans two phases of development, the first to offer services in
12 of the largest U.S. metropolitan areas ("Phase I markets") and the second to
offer services in 12 additional large metropolitan areas ("Phase II markets") in
the U.S. As of June 30, 1998, Allegiance is operational in three Phase I
markets: New York City, Dallas and Atlanta; and is in the process of deploying
networks in six additional Phase I markets: Chicago, Los Angeles, San Francisco,
Boston, Fort Worth and Washington D.C. Initial facilities-based service for the
New York City market began in the first quarter of 1998, and for the Dallas and
Atlanta markets in the second quarter of 1998. Initial facilities-based service
for the Fort Worth and Chicago markets is scheduled to begin in the third
quarter of 1998, and for the Los Angeles, San Francisco and Boston markets in
the fourth quarter of 1998. The Company is planning to begin providing services
in an additional twelve markets in 1999 and 2000.

    Until December 16, 1997, the Company was in the development stage. Since
August 1997, at which time the Company received its initial funding, its
principal activities have included developing its business plans, procuring
governmental authorizations, raising capital, hiring management and other key
personnel, working on the design and development of its local exchange telephone
networks and operations support systems ("OSS"), acquiring equipment and
facilities and negotiating interconnection agreements. Accordingly, the Company
has incurred operating losses and operating cash flow deficits.

    The Company's success will be affected by the problems, expenses, and delays
encountered in connection with the formation of any new business, and the
competitive environment in which the Company intends to operate. The Company's
performance will further be affected by its ability to assess potential markets,
secure financing or raise additional capital, implement expanded interconnection
and collocation with incumbent local exchange carrier ("ILEC") facilities, lease
adequate trunking capacity from the ILECs or other CLECs, purchase and install
switches in additional markets, implement efficient OSS and other back office
systems, develop a sufficient customer base, and attract, retain, and motivate
qualified personnel. The Company's networks and the provisioning of
telecommunications services are subject to significant regulation at the
federal, state, and local levels. Delays in receiving required regulatory
approvals or the enactment of new adverse regulation or regulatory requirements
may have a material adverse effect upon the Company. Although management
believes that the Company will be able to successfully mitigate these risks,
there is no assurance that the Company will be able to do so or that the Company
will ever operate profitably.

    Expenses are expected to exceed revenues in each location in which the
Company offers service until a sufficient customer base is established. It is
anticipated that obtaining a sufficient customer base will take a number of
years, and positive cash flows from operations are not expected in the near
future.

2. BASIS OF PRESENTATION:

    The accompanying unaudited condensed consolidated financial statements have
been prepared by the Company in accordance with generally accepted accounting
principles for interim financial information and are in the form prescribed by
the Securities and Exchange Commission in instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, they do not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements. The interim unaudited financial statements should be read
in conjunction with the audited financial statements of the Company as of March
31, 1998 and for the year ended December 31, 1997. In the opinion of management,
all adjustments (consisting only of normal recurring accruals) 



                                       6

<PAGE>   7

considered necessary for a fair presentation have been included. Operating
results for the three months ended June 30, 1998 are not necessarily indicative
of the results that may be expected for the year ending December 31, 1998.

    Because the Company did not commence operations until August 1997, no 
comparative condensed consolidated statements of operations or cash flows are 
available.

    The accompanying consolidated financial statements include the accounts of
Allegiance Telecom, Inc. and its wholly owned subsidiaries Allegiance Telecom
Service Corporation, Allegiance Telecom of California, Inc., Allegiance Telecom
of the District of Columbia, Inc., Allegiance Telecom of Georgia, Inc.,
Allegiance Telecom of Illinois, Inc., Allegiance Telecom of Maryland, Inc.,
Allegiance Telecom of Massachusetts, Inc., Allegiance Telecom of New Jersey,
Inc., Allegiance Telecom of New York, Inc., Allegiance Telecom of Texas, Inc.,
and Allegiance Telecom International, Inc. All significant intercompany balances
and transactions have been eliminated.

    Certain amounts in the prior period's consolidated financial statements have
been reclassified to conform with the current period presentation.

3. SHORT-TERM INVESTMENTS:

    Short-term investments consist primarily of commercial paper with original
maturities at date of purchase beyond three months and less than 12 months. Such
short-term investments are carried at their accreted value, which approximates
fair value, due to the short period of time to maturity.

4. PROPERTY AND EQUIPMENT:

    Property and equipment includes network equipment, leasehold improvements,
office equipment, furniture and fixtures, and construction-in-progress of
network equipment and leasehold improvements. These assets are stated at cost,
which includes direct costs and interest expense capitalized and are depreciated
once placed in service using the straight-line method. Interest expense for the
three and six months ended June 30, 1998 was $7,704.9 and $12,841.5 before the
capitalization of $475.9 and $943.4 of interest expense related to
construction-in-progress for the three and six months ended June 30, 1998,
respectively. Repair and maintenance costs are expensed as incurred. Property
and equipment at December 31, 1997 and June 30, 1998, consisted of the
following:

<TABLE>
<CAPTION>
                                                         DECEMBER 31,       JUNE 30,      USEFUL LIVES
                                                            1997             1998          (IN YEARS)
                                                         -----------      -----------      -----------
<S>                                                      <C>              <C>              <C>
Network equipment ..................................     $      --        $  24,558.6        5-7
Leasehold improvements .............................            37.5          3,652.1        5-10
Furniture and fixtures .............................           150.2            545.3         5
Office equipment and other .........................            89.9          1,007.6         2
                                                         -----------      -----------
  Property and equipment, in service ...............           277.6         29,763.6
Less: Accumulated depreciation .....................           (12.7)        (1,226.2)
                                                         -----------      -----------
  Property and equipment in service, net ...........     $     264.9      $  28,537.4
Construction-in-progress network
     equipment .....................................        19,989.9         14,801.8
   
Construction-in-progress leasehold 
     improvements...................................         2,458.7          4,556.4
     
Construction-in-progress office
     equipment and other ...........................         1,186.4          1,699.4
                                                         -----------      -----------
       Property and equipment, net .................     $  23,899.9      $  49,595.0
                                                         ===========      ===========
</TABLE>

5. REPORTING ON THE COST OF START-UP ACTIVITIES:

    On April 3, 1998, the American Institute of Certified Public Accountants
issued Statement of Position No. 98-5, "Reporting on the Costs of Start-up
Activities" ("SOP 98-5"). SOP 98-5 requires start-up activities and organization
costs to be expensed as incurred and that start-up cost capitalized prior to the
adoption of SOP 98-5 to be reported as the cumulative effect of a change in
accounting principle. The Company adopted SOP 98-5 during the second quarter of
1998. Adoption of SOP 98-5 did not have an affect on the Company, inasmuch as
the Company had previously expensed all such costs.

6. EARNINGS PER SHARE:

    The net loss per share amounts reflected on the statements of operations and
the number of shares outstanding on the balance sheets reflect a 426.2953905
for-one stock split, which occurred in connection with the initial public
offering of Common Stock (the "IPO") (see Note 12). The preferred shares,
warrants and options were not included 




                                       7
<PAGE>   8

in the net loss per share calculation as the effect from the conversion would be
antidilutive. The net loss applicable to common stock includes the accretion of
redeemable preferred stock and warrant values of $6,453.8 and $11,718.5 for the
three months and six months ended June 30, 1998, respectively.

7. COMPREHENSIVE INCOME:

    In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS
130"). SFAS 130 establishes reporting and disclosure requirements for
comprehensive income and its components within the financial statements. The
Company's comprehensive income components were immaterial as of June 30, 1998
and the Company had no comprehensive income components as of December 31, 1997;
therefore, comprehensive income is the same as net income for both periods.

8. CAPITAL LEASE:

    On May 29, 1998, the Company signed a capital lease agreement for three,
four-fiber rings at an expected total cost of $3,485.0, all of which is expected
to be paid in 1998, for a term of ten years with a renewal term of ten years.
The fiber rings are expected to be placed in service before the end of 1998.

9. LONG-TERM DEBT:

    On February 3, 1998, the Company raised gross proceeds of approximately
$250,477.2 in an offering of 445,000 Units (the "Unit Offering"), each of which
consisted of one 11 3/4% Senior Discount Note due 2008 (the "11 3/4% Notes") and
one warrant to purchase .0034224719 shares of Common Stock (the "Redeemable
Warrants") at an exercise price of $.01 per share, subject to certain
antidilution provisions. Of the gross proceeds, $242,293.6 was allocated to the
initial accreted value of the 11 3/4% Notes and $8,183.6 was allocated to the
Redeemable Warrants. The Redeemable Warrants became exercisable in connection
with the IPO (see Note 12) in July 1998, and each warrant may now purchase
1.45898399509 shares of Common Stock.

    A Registration Statement on Form S-4 (File No. 333-49013) registering the
Company's 11 3/4% Notes, and offering to exchange (the "Exchange Offer") any and
all of the outstanding 11 3/4% Notes for Series B 11 3/4% Notes due 2008 (the
"Series B Notes"), was declared effective by the Securities and Exchange
Commission on May 22, 1998. The Exchange Offer terminated on June 23, 1998 after
substantially all of the outstanding 11 3/4% Notes were exchanged. The terms and
conditions of the Series B Notes are identical to those of the 11 3/4% Notes in
all material respects.

    The Series B Notes have a principal amount at maturity of $445,000.0 and an
effective interest rate of 12.45%. The Series B Notes mature on February 15,
2008. From and after February 15, 2003, interest on the Series B Notes will be
payable semi-annually in cash at the rate of 11 3/4% per annum.

    The Company must make an offer to purchase the Redeemable Warrants for 
cash at the Relevant Value upon the occurrence of a Repurchase Event. A
Repurchase Event is defined to occur when (i) the Company consolidates with or
merges into another person if the Common Stock thereafter issuable upon
exercise of the Redeemable Warrants is not registered under the Securities
Exchange Act of 1934, as amended (the "Exchange Act") or (ii) the Company sells
all or substantially all of its assets to another person, if the Common Stock
thereafter issuable upon the exercise of the Redeemable Warrants is not
registered under the Exchange Act, unless the consideration for such a
transaction is cash. The Relevant Value is defined to be the fair market value
of the Common Stock as determined by the trading value of the securities if
publicly traded or at an estimated fair market value without giving effect to
any discount for lack of liquidity, lack of registered securities, or the fact
that the securities represent a minority of the total shares outstanding. As
required by SEC accounting standards the Company is recognizing the potential
future redemption value of the Redeemable Warrants by recording accretion of
the Redeemable Warrants to their estimated fair market value at February 3,
2008 using the effective interest method. In the event the Redeemable Warrants
are exercised and used to purchase the Common Stock of the Company or expires,
the redemption provisions terminate and amounts accreted would be reversed as a
reduction of the losses applicable to Common Stock in measuring results of
operations of the Company. Accretion recorded in the three and six months ended
June 30, 1998 was $123.7 and $197.7, respectively.




                                       8
<PAGE>   9
    The Series B Notes are redeemable by the Company, in whole or in part,
anytime on or after February 15, 2003, at 105.875% 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 and after February 15,
2006. In addition, at any time prior to February 15, 2001, the Company may, at
its option, redeem up to 35% of the principal amount at maturity of the Series B
Notes in connection with a public IPO at 111.750% of the accreted value on the
redemption date; provided that at least $289.3 million aggregate principal
amount at maturity of the Series B Notes remains outstanding after such
redemption.

    The Series B Notes carry certain restrictive covenants that, among other
things, limit the ability of the Company to incur indebtedness, pay dividends,
issue or sell capital stock, create liens, sell assets, and enter into
transactions with any holder of 5% or more of any class of capital stock of the
Company or any of its affiliates. The Company was in compliance with all such
restrictive covenants at June 30, 1998.

10. LEGAL MATTERS:

    On August 29, 1997, WorldCom, Inc. ("WorldCom") sued the Company and two
individual employees. In its complaint, WorldCom alleges that these employees
violated certain noncompete and nonsolicitation agreements by accepting
employment with the Company and by soliciting then current WorldCom employees to
leave WorldCom's employment and join the Company. In addition, WorldCom claims
that the Company tortiously interfered with WorldCom's relationships with its
employees, and that the Company's behavior constituted unfair competition.
WorldCom seeks injunctive relief and damages, although it has filed no motion
for a temporary restraining order or preliminary injunction. The Company denies
all claims and will vigorously defend itself. The Company does not expect the
ultimate outcome to have a material adverse effect on the results of operations
or financial condition of the Company and an estimate of possible loss cannot be
made at this time.

    On October 7, 1997, the Company filed a counterclaim against WorldCom for,
among other things, attempted monopolization of the "one stop shopping"
telecommunications market, abuse of process, and unfair competition. WorldCom
did not move to dismiss the attempted monopolization claim, but has moved to
dismiss the abuse of process and unfair competition claims. On March 4, 1998,
the court dismissed the claim for unfair competition.


11. COMMITMENTS AND CONTINGENCIES:

    The Company has entered into various operating lease agreements, with
expirations through 2007, for office space and equipment. Future minimum lease
obligations related to the Company's operating leases as of June 30, 1998 are as
follows:

<TABLE>
<S>                       <C>          <C>      
                          1998........ $ 4,492.9
                          1999........   4,101.8
                          2000........   4,139.0
                          2001........   3,539.5
                          2002........   3,373.7
                          Thereafter..  17,397.2
</TABLE>

    Total rent expense for the three and six months ended June 30, 1998, was
$305.5 and $760.3, respectively.

    In October 1997, the Company entered into a five-year general agreement with
Lucent Technologies, Inc. ("Lucent") establishing terms and conditions for the
purchase of Lucent products, services, and licensed materials. This agreement
includes a three-year exclusivity commitment for the purchase of products and
services related to new switches. The agreement contains no minimum purchase
requirements.

12. SUBSEQUENT EVENTS:

CAPITALIZATION

    In connection with an initial public offering of common stock, the Company
increased the number of authorized common shares and preferred shares to 150
million and 1 million, respectively, and effected a 426.2953905 for-one stock
split which is reflected in the net loss per share amounts and the weighted
number of shares outstanding reflected on the statements of operations, and the
shares outstanding on the balance sheets.



                                       9
<PAGE>   10
INITIAL PUBLIC OFFERING

    On July 7, 1998, the Company raised $150,000.0 of gross proceeds in the IPO.
The Company sold 10,000,000 shares of its Common Stock at a price of $15 per
share.

    On July 7, 1998, certain venture capital investors (the "Fund Investors")
and certain management investors (the "Management Investors") owned 95.0% and
5.0%, respectively, of the ownership interests of Allegiance LLC, an entity that
owned substantially all of the Company's outstanding capital stock. As a result
of the successful IPO, Allegiance LLC will dissolve and its assets (which
consisted almost entirely of such capital stock) have been distributed to the
Fund Investors and the Management Investors in accordance with Allegiance LLC's
Limited Liability Company Agreement (the "LLC Agreement"). The LLC Agreement
provided that the equity allocation between the Fund Investors and the
Management Investors be 66.7% and 33.3%, respectively, based upon the valuation
implied by the IPO. Under generally accepted accounting principles, the Company
will record the increase in the assets of Allegiance LLC allocated to the
Management Investors as a $193,536.6 increase in additional paid-in capital, of
which $122,475.5 will be recorded as a non-cash, non-recurring charge to
operating expense and $71,061.1 will be recorded as a deferred management
ownership allocation charge. The deferred charge will be amortized at $38,058.9,
$6,777.5, $18,870.2, $7,175.7 and $178.8 during the third quarter of 1998, the
fourth quarter of 1998, and the years 1999, 2000, 2001, respectively, which is
the period over which the Company has the right to repurchase the securities (at
the lower of fair market value or the price paid by the employee) in the event
the management employee's employment with the Company is terminated.

In connection with the consummation of the IPO, the outstanding shares of the
Company's Redeemable Cumulative Convertible Preferred Stock (the "Preferred
Stock") have been converted to Common Stock and the obligation of Allegiance LLC
to make additional capital contributions to the Company (and the obligation of
the members of Allegiance LLC to make capital contributions to it) has
terminated. Upon such conversion of the Preferred Stock, the obligation of the
Company to redeem the Preferred Stock also terminated and, therefore, the
accretion of the Preferred Stock value recorded to the date of the IPO will be
reclassified to additional paid-in capital in the stockholders' equity section
of the balance sheet in the third quarter of 1998.

Had the IPO occurred on June 30, 1998, excluding the deferred management
ownership allocation charge to operating expense of $160,534.4 which will be
booked during the third quarter of 1998, the basic net loss per share for the
three and six months ended June 30, 1998 would have been $0.41 and $0.69,
respectively. The diluted net loss per share for the three and six months ended
June 30, 1998 would have been $0.40 and $0.67, respectively. The basic and
diluted shares outstanding would have been 50,341,554 and 51,883,466,
respectively.

NOTE OFFERING

    In July 1998, the Company raised approximately $200,918.5 of gross proceeds
from the sale of its 12 7/8% Senior Notes due 2008 (the "July 1998 Debt
Offering") of which approximately $69,033.4 was used to purchase U.S. government
securities, which were placed in a pledged account to secure and fund the first
six scheduled payments of interest on the notes.

    The 12 7/8% Senior Notes due 2008 (the "12 7/8% Notes") have a principal
amount at maturity of $205,000.0 with an initial accreted value of $200,918.5.
The 12 7/8% Notes mature on May 15, 2008. Interest on the 12 7/8% Notes will be
payable semi-annually in cash at the rate of 12 7/8% on May 15 and November 15
of each year, commencing November 15, 1998.

    The 12 7/8% Notes are redeemable by the Company, in whole or in part, at any
time on or after May 15, 2003, at 106.438% of their principal amount, plus
accrued interest, declining to 100% of their principal amount, plus accrued
interest, on or after May 15, 2006. In addition, prior to May 15, 2001, the
Company may redeem up to 35% of the aggregate principal amount of the 12 7/8%
Notes with the proceeds of one or more public offerings (as defined in the
indenture relating to the 12 7/8% Notes) at 112.875% of their principal amount,
plus accrued 




                                       10
<PAGE>   11

interest, provided, however, that after any such redemption at least 65% of the
aggregate principal amount of the 12 7/8% Notes originally issued remain
outstanding.

    The 12 7/8% Notes carry certain restrictive covenants that, among other
things, limit the ability of the Company to incur indebtedness, create liens,
engage in sale-leaseback transactions, pay dividends or make distributions in
respect of their capital stock, redeem capital stock, make investments or
certain other restricted payments, sell assets, issue or sell stock of
restricted subsidiaries (as defined in the indenture relating to the 12 7/8%
Notes), enter into transactions with stockholders or affiliates or effect a
consolidation or merger. However, these limitations are subject to a number of
important qualifications and exceptions (as defined in the indenture relating to
the 12 7/8% Notes).

RELATED PARTIES

    In connection with the IPO and the July 1998 Debt Offering, the Company
incurred approximately $5,250.0 and $3,264.9, respectively, in fees to an
affiliate of an investor in Allegiance LLC.




                                       11
<PAGE>   12

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.

OVERVIEW

    Allegiance seeks to be a premier provider of telecommunications services to
business, government and other institutional users in major metropolitan areas
across the United States. As a CLEC, Allegiance anticipates offering an
integrated set of telecommunications products and services including local
exchange, local access, domestic and international long distance, enhanced
voice, data and a full suite of Internet services.

    Since the initiation of operations in August 1997, the Company's principal
activities have included developing its business plans, procuring governmental
authorizations, raising capital, hiring management and other key personnel,
working on the design and development of its local exchange telephone networks
and operations support systems ("OSS"), acquiring equipment and facilities and
negotiating interconnection agreements. The Company does not expect to achieve
positive earnings before interest, taxes, depreciation, amortization and
non-cash deferred compensation ("EBITDA") in any market until at least two to
three years after it commences initial service in such market. As a result of
its development activities, the Company has experienced significant operating
losses and negative EBITDA to date.

    Allegiance is currently operational in three Phase I markets: New York City,
Dallas and Atlanta; and is in the process of deploying networks in six
additional Phase I markets: Chicago, Los Angeles, San Francisco, Boston, Fort
Worth and Washington D.C. The Company expects to continue to experience
increasing operating losses and negative EBITDA as it expands its operations.

    At July 7, 1998, the Fund Investors and Management Investors owned 95.0% and
5.0%, respectively, of the ownership interests of Allegiance LLC, an entity that
owned substantially all of the Company's outstanding capital stock. As a result
of the successful IPO, Allegiance LLC will dissolve and its assets (which
consisted almost entirely of such capital stock) have been distributed to the
Fund Investors and the Management Investors in accordance with the LLC
Agreement. The LLC Agreement provides that the equity allocation between the
Fund Investors and the Management Investors be 66.7%/33.3%, respectively, based
upon the valuation implied by the IPO.

    Under generally accepted accounting principles, the Company will be required
to record the $193.5 million increase in the assets of Allegiance LLC allocated
to the Management Investors as an increase in additional paid-in capital, of
which the Company will be required to record $122.4 million as a non-cash,
non-recurring charge to operating expense and $71.1 million will be recorded as
a deferred management ownership allocation charge. The deferred charge will be
amortized at $38.1 million, $6.8 million, $18.9 million, $7.1 million and $.2
million during the third quarter of 1998, the fourth quarter of 1998, and the
years 1999, 2000 and 2001, respectively, which is the period over which the
Company has the right to repurchase the securities (at the lower of fair market
value or the price paid by the employee) in the event the management employee's
employment with the Company is terminated.

Revenues

     The Company generated $1.2 million and $1.4 million in revenue during the
three months and six months ended June 30, 1998, respectively. As of June 30,
1998, the Company had sold approximately 21,100 access lines, of which
approximately 11,000 were installed. Comparable numbers as of March 31, 1998
were approximately 4,700 lines sold and approximately 3,000 lines installed.

    Revenues realized to date have been derived exclusively from sales of
telecommunications services, principally local service. There have been no sales
of customer premise equipment, no revenue from installation of customer premise
equipment, no revenue from system integration activities, no wireless revenue
and no data or internet service provider (ISP) revenue. The Company expects to
initiate data and ISP services during the fourth quarter of 1998. The Company
has no plans to sell customer premise equipment, install customer premise
equipment or sell system integration or wireless services in the foreseeable
future. Allegiance generates sales through its direct sales force, which
numbered less than five at December 31, 1997 but represents about 100 of
Allegiance's total staff at June 30, 1998. The Company does not use agents to
sell its services, and has no plans to do so in the future.





                                       12
<PAGE>   13
    Operating Expenses

    The Company's primary operating expenses will consist of network, selling,
general and administrative expenses.

    Network Costs (Cost of Services). Under its "smart build" strategy,
Allegiance plans to deploy digital switching platforms with local and long
distance capability and initially lease fiber trunking capacity from the ILECs
and other CLECs to connect the Company's switch with its transmission equipment
collocated in ILEC central offices. Allegiance will lease unbundled copper loop
lines and high capacity digital lines from the ILECs to connect the Company's
customers and other carriers' networks to the Company's network. Allegiance
plans to lease capacity or overbuild specific network segments as economically
justified by traffic volume growth. The Company is moving to the next stage of
its "smart build" strategy in New York City where the Company has entered into a
lease agreement with Metromedia Fiber Network, Inc. for three "dark fiber" rings
in Manhattan with an extension into Brooklyn. In addition, Allegiance expects to
increase the capacity of its switches, and may add additional switches, in a
market as demand warrants.

    In October 1997, the Company entered into a five-year general agreement with
Lucent establishing terms and conditions for the purchase of Lucent products,
services and licensed materials. The agreement includes a three-year exclusivity
commitment for the purchase of products and services related to new switches.
The agreement contains no minimum purchase requirements.

    The Company expects switch site lease costs will be a significant part of
the Company's ongoing cost of services. The costs to lease unbundled copper loop
lines and high capacity digital lines from the ILECs will vary by ILEC and are
regulated by state authorities pursuant to the Telecommunications Act. The
Company believes that in most of the markets it plans to enter there are
multiple carriers in addition to the ILEC from which it could lease trunking
capacity. The Company expects that the costs associated with these leases will
increase with customer volume and will be a significant part of the Company's
ongoing cost of services.

    Collocation costs are also expected to be a significant part of the
Company's network development and ongoing cost of services. Under the
Telecommunications Act, carriers like the Company must be allowed to place their
equipment within the central offices of the ILEC for the purposes of
interconnecting its network with that of the ILEC ("collocation"). For example,
Allegiance will use collocation to access the ILECs unbundled networks elements.
This collocation can be a physical space or cage within the ILEC central office
where the Company would place its equipment. In some cases, virtual collocation
would be used where the ILEC places equipment within the central office and
would maintain the equipment on behalf of the Company. In this virtual
collocation scenario, the Company would not have physical access to the ILEC's
central office. For use of their central offices for collocation, ILECs
typically charge both a start-up fee as well as a monthly recurring fee. The
Company will be required to invest a significant amount of funds to develop the
central office collocation sites and to deploy the transmission and distribution
electronics. As of June 30, 1998, the Company was physically collocated in seven
ILEC central offices, and had hubbing arrangements in seven additional central
offices. In a hubbed central office, the Company connects its switching
equipment to an ILEC central office via a leased, high capacity circuit. The
Company also purchases, from the ILEC, multiplexing services and high capacity
circuits to customer premises in order to connect the customer to the Allegiance
network. Typically, the hubbing arrangement is implemented in advance of
collocation; it may continue indefinitely depending upon the quantity and type
of services provided over that facility.

    In order to enter a market, Allegiance must enter into an interconnection
agreement with the ILEC to make ubiquitous calling available to its customers.
Typically these agreements set the cost per minute to be charged by each party
for the calls which have traversed between each carrier's network. These costs
will grow in proportion to the Company's customers outbound call volume and are
expected to be a major portion of the Company's cost of services. However, the
Company does expect to generate increased revenue from the ILECs as the
Company's customers inbound calling volume increases. To the extent the
Company's customers' outbound call volume is equivalent to their inbound call
volume, the Company expects that its interconnection costs paid to the ILECs
will be substantially offset by the interconnection revenues received from the
ILECs.



                                       13
<PAGE>   14
    The Company has entered into one resale agreement with a long distance
carrier to provide the Company with transmission services and expects to enter
into resale agreements with other carriers in the future. Such agreements
typically provide for the resale of long distance services on a per-minute basis
and may contain minimum volume commitments; however, the existing resale
agreement does not contain any minimum volume commitments. In the event the
Company fails to meet its minimum volume commitments, it may be obligated to pay
underutilization charges and in the event it underestimates its need for
transmission capacity, the Company may be required to obtain capacity through
more expensive means. These costs will increase as the Company's customers' long
distance calling volume increases, and the Company expects that these costs will
be a significant portion of its cost of long distance services. As traffic on
specific routes increases, the Company may lease long distance trunk capacity.

    Selling, General and Administrative Expenses. The Company's selling, general
and administrative expenses will include its infrastructure costs, including
selling and marketing costs, customer care, billing, corporate administration,
personnel and network maintenance.

    The Company plans to employ a large direct sales force in each market and to
build a national sales force as the Company grows. To attract and retain a
highly qualified sales force, the Company plans to offer its sales and customer
care personnel a compensation package emphasizing commissions and stock options.
The Company expects to incur significant selling and marketing costs as it
continues to expand its operations. In addition, Allegiance plans to offer sales
promotions to win customers, especially in the first few years as its
establishes its market presence.

    Allegiance has acquired and integrated back office systems to facilitate a
smooth, efficient order management, provisioning, installation, trouble
management, billing and collection, and customer service process. Allegiance has
licensed and is using MetaSolv software for order management and customer
provisioning, Lucent's ConnectVu for switch provisioning and Intertech for
billing. The Company is actively working toward "electronic bonding" between the
Allegiance operating support systems and those of the ILEC which will permit
creation of service requests on-line and real-time monitoring of the
provisioning and installation process.

       During the second quarter of 1998, Allegiance achieved permanent local
number portablilty in New York with Bell Atlantic and in Texas with Southwestern
Bell. Allegiance entered into an agreement with DSET Corporation to utilize
DSET's Service Order Administration Gateway for local number portability
implementation.

    Along with the development cost of the systems, the Company will also incur
ongoing expenses for customer care and billing. As the Company's strategy
stresses the importance of personalized customer care, the Company expects that
its customer care department will become a larger part of the Company's ongoing
administrative expenses. The Company also expects billing costs to increase as
its number of customers, and the call volume, increases. Billing is expected to
be a significant part of the Company's ongoing administrative expenses.

    Allegiance will incur other costs and expenses, including the costs
associated with the maintenance of its network, administrative overhead, office
leases and bad debt. The Company expects that these costs will grow
significantly as its expands its operations and that administrative overhead
will be a large portion of these expenses during the start-up phase of the
Company's business. However, the Company expects these expenses to become
smaller as a percentage of the Company's revenue as the Company builds its
customer base.

RESULTS OF OPERATIONS

    Because the Company did not commence operations until August 1997, no
comparative data for the periods presented herein is available.

    For the three months and six months ended June 30, 1998, the Company
generated revenues of $1.2 million and $1.4 million, respectively, from local
and long distance services. As of June 30, 1998, the Company had sold
approximately 21,100 access lines, of which approximately 11,000 were installed.
Access lines sold increased approximately 350% and lines installed increased
approximately 265% from March 31, 1998 levels. At the beginning of 1998, there
were limited numbers of lines installed.



                                       14
<PAGE>   15
    The Company expects to continue to experience increasing operating losses
and negative EBITDA as it expands its operations. The net loss (after accreting
redeemable preferred stock and warrant values) for the second quarter was $20.9
million and was $34.5 million for the six months ended June 30, 1998. EBITDA for
the same periods was a negative $8.2 million and negative $12.9 million,
respectively. EBITDA excludes the non-cash deferred compensation charge to
operations of $1.4 million and $2.4 million for the three and six months ended
June 30, 1998, respectively.

     For the three and six months ended June 30, 1998, the Company incurred
network costs of approximately $1.4 million and $1.6 million. The Company also
incurred $8.1 million and $12.8 million for selling and general and
administrative expenses during the same periods, respectively. These expenses
primarily result from an expansion of the Company's staffing from less than 50
at December 31, 1997, to approximately 250 full-time staff at June 30, 1998.
Approximately 40% of the staff at June 30, 1998 are sales personnel.

    In addition to the above expenses, the Company recognized $1.4 million and
$2.4 million amortization of deferred stock compensation expense for the three
and six months periods ended June 30, 1998, a non-cash charge. Interest expense
for the three months then ended was $7.2 million, and for the six months ending
at the same date, it was $11.9 million. These amounts reflect the issuance of
the 11 3/4% Notes during February 1998. Interest income during such periods was
$3.4 million and $5.6 million, respectively, resulting from the investment of
the net proceeds from equity contributions and the sale of the 11 3/4% Notes and
Redeemable Warrants.

    As required by accounting principles promulgated by the Securities and
Exchange Commission, the Company has recorded the potential redemption values of
the Redeemable Convertible Preferred Stock and the Redeemable Warrants in the
potential event that they are redeemed at fair market value in August 2004 and
February 2008, respectively. Amounts are accreted using the effective interest
method and management's estimates of the future fair market value of these
securities when redemption is first permitted. Amounts accreted increase the
recorded value of the Redeemable Convertible Preferred Stock and Redeemable
Warrants on the balance sheet and result in a non-cash charge to increase the
net loss applicable to Common Stock. Upon consummation of the Company's initial
public offering in July 1998, such preferred stock was converted into Common
Stock. Accordingly, the amounts accreted for the Redeemable Convertible
Preferred Stock will be reclassified as an increase to additional paid-in
capital in the stockholders' equity section of the balance sheet, and there will
be no additional accretion of Redeemable Convertible Preferred Stock values
beyond that point in time.

FINANCIAL CONDITION

     The balance sheet of Allegiance at June 30, 1998 reflects additional cash,
short-term investments, deferred debt issuance costs, long-term debt and
redeemable warrants compared to the December 31, 1997 balance sheet as a result
of the Unit Offering in February 1998 wherein 11 3/4% Notes and Redeemable
Warrants were sold. Accounts receivable increased during the same period as the
Company's networks in New York City, Dallas and Atlanta became operational.

     Property and Equipment, net of accumulated depreciation, increased between
June 30, 1998 and December 31, 1997 from capital expenditures incurred in
building out the Company's networks in New York City, Dallas, Atlanta, Chicago,
Los Angeles, San Francisco, Boston, Fort Worth and Washington, D.C., from
developing operations support and other systems required to effectively manage
the business and to provide general office space and equipment for employees.

     Accounts payable and accrued liabilities have increased consistent with
operations and the Company's policy to make use of working capital in funding
network buildouts and operations. Redeemable cumulative convertible preferred
stock increased as a result of additional contributions from Management
Investors and Fund Investors received during the period.

     Stockholders' deficit increased consistent with the net loss for the six
months ending June 30, 1998, and from the recognition of deferred compensation
(consistent with accounting rules promulagated by the SEC) from the issuance of
options and shares in Allegiance LLC purchased by Management Investors at prices
below fair market value.



                                       15
<PAGE>   16
LIQUIDITY AND CAPITAL RESOURCES

    Allegiance plans to establish networks in 24 Tier I U.S. markets. The
Company plans to deploy its networks principally in two phases of development,
each to contain 12 major U.S. metropolitan markets.

    At June 30, 1998, Allegiance was operational in three Phase I markets: New
York City, Dallas and Atlanta; and in the process of deploying networks in six
additional Phase I markets: Chicago, Los Angeles, San Francisco, Boston, Fort
Worth and Washington, D.C. As part of this effort, in October 1997, the Company
acquired two Lucent Series 5ESS(R)-2000 digital switches in New York City and
Atlanta and certain furniture and fixtures in Dallas from US ONE Communications,
Inc. for an aggregate purchase price of $19.3 million. The Company has also
purchased from Lucent, switches for the Dallas, Chicago, Los Angeles, San
Francisco, Boston and Washington, D.C. markets. The cost of these switches and
related equipment and installation will be approximately $41.6 million.

    Allegiance's financing plan is predicated on the pre-funding of each
market's expansion to Positive Free Cash Flow (operating cash flow from a market
sufficient to fund such market's operating costs and capital expenditures). This
approach is designed to allow the Company to be opportunistic and raise capital
on more favorable terms and conditions.

    To pre-fund each Phase I market's expansion, the Company raised
approximately $50.1 million from Management Investors and Fund Investors
("Equity Contributions") and received approximately $240.7 million of net
proceeds, after deducting estimated underwriting discounts and commissions and
other expenses payable by the Company, from the sale of 11 3/4% Notes due
2008 and attached Redeemable Warrants in February 1998. Following completion of
the Unit Offering, the Company increased the scope of its business plan to
accommodate (i) an expansion of the Company's network buildout in certain Phase
I markets to include additional central offices, thereby giving the Company
access to a larger number of potential customers in those markets, (ii) an
accelerated and expanded deployment of data, Internet and enhanced services in
the Company's markets and (iii) the acceleration of network deployment in Phase
II markets.

    The Company estimates that its cumulative cash requirements to fund its
modified business plan, including pre-funding each Phase I and Phase II market's
expansion to Positive Free Cash Flow, will be between $650 million and $700
million. To supplement the funds raised from Equity Contributions and the Unit
Offering, the Company registered the IPO and the sale of additional notes (the
"July 1998 Debt Offering") during the second quarter of 1998. These
registrations became effective on June 30, 1998, and the consummation of the
transactions occurred on July 7, 1998. Net proceeds of approximately $263.3
million were raised from the combined offerings. The Company has raised
approximately $550 million through the Equity Contributions, the Unit Offering,
the IPO and the July 1998 Debt Offering.

    The Company believes, based on its modified business plan, that the net
proceeds from the capital raising activities completed thus far will be
sufficient to pre-fund its Phase I market deployment, including an expansion in
four of these markets, New York, Chicago, Los Angeles and San Francisco, the
complete deployment of the Company's data and ISP plan, and six Phase II
markets, to Positive Free Cash Flow. The Company will require an estimated
additional $100 to $150 million to completely fund its modified business plan.
Sources of additional financing may include commercial bank borrowings, vendor
financing, or the private or public sale of equity or debt securities. There can
be no assurance that such financing will be available on terms acceptable to the
Company or at all, or that the Company's estimate of additional funds required
is accurate.

    The actual amount and timing of the Company's future capital requirements
may differ materially from the Company's estimates as a result of, among other
things, the demand for the Company's services and regulatory, technological and
competitive developments (including additional market developments and new
opportunities) in the Company's industry. The Company also expects that it will
require additional financing (or require financing sooner than anticipated) if:
(i) the Company's development plans or projections change or prove to be
inaccurate; (ii) the Company engages in any acquisitions; or (iii) the Company
alters the schedule or targets of its roll-out plan. Sources of additional
financing may include commercial bank borrowings, vendor financing, or the
private or public sale of equity or debt securities. There can be no assurance
that such financing will be available on terms acceptable to the Company or at
all.



                                       16
<PAGE>   17
    Because the Company's cost of rolling out its networks and operating its
business, as well as the Company's revenues, will depend on a variety of factors
(including the ability of the Company to meet its roll-out schedules, negotiate
favorable prices for purchases of equipment, and develop, acquire and integrate
the necessary OSS and other back office systems, as well as the number of
customers and the services for which they subscribe, the nature and penetration
of new services that may be offered by the Company, regulatory changes and
changes in technology), actual costs and revenues will vary from expected
amounts, possibly to a material degree, and such variations are likely to affect
the Company's future capital requirements. Accordingly, there can be no
assurance that the Company's actual capital requirements will not exceed the
anticipated amounts described above. Further, the exact amount of the Company's
future capital requirements will depend upon many factors, including the cost of
the development of its networks in each of its markets, the extent of
competition and pricing of telecommunications services in its markets, and the
acceptance of the Company's services. Also, the Company expects that the
expansion into additional markets will require additional financing, which may
include commercial bank borrowing, vendor financing, or the public or private
sale of equity or debt securities. There can be no assurance that the Company
will be successful in raising sufficient additional capital at all or on terms
acceptable to the Company.

    For the six month period ending June 30, 1998, the proceeds of the Unit
Offering, together with additional Equity Contributions received in 1998, as
well as cash in bank at the beginning of 1998, have been used, in part, to fund
the buildout of networks in New York City, Dallas and Atlanta, each of which is
operational, as well as networks under development in Chicago, Los Angeles, San
Francisco, Boston, Fort Worth and Washington, D.C., to fund the development of
operations support and other systems required to effectively manage the business
and to provide general office space and equipment for its employees. Capital
resources not required for the above purposes were used to fund the operations
of the Company; excess amounts available were used to purchase short-term
investments or money market investments.

    On February 3, 1998, the Company raised gross proceeds of approximately
$250.5 million in an offering of 445,000 Units, each of which consists of one 11
3/4% Note and one warrant to purchase .0034224719 shares of Common Stock at an 
exercise price of $.01 per share, subject to certain antidilution provisions. Of
the gross proceeds, $242.3 million was allocated to the initial accreted value
of the 11 3/4% Notes and $8.2 million was allocated to the Redeemable Warrants.
The 11 3/4% Notes were the subject of an Exchange Offer during the second
quarter of 1998 and were exchanged for Series B Notes which contain
substantially identical terms and conditions. The Redeemable Warrants became
exercisable in connection with the IPO in July 1998, and each warrant may now
purchase 1.45898399509 shares of Common Stock as a result of a
426.2953905 for-one stock split in connection with the IPO.

    The Series B Notes have a principal amount at maturity of $445.0 million and
an effective interest rate of 12.45%. The Series B Notes mature on February 15,
2008. From and after February 15, 2003, interest on the Series B will be payable
semi-annually in cash at the rate of 11 3/4% per annum. The accretion of
original issue discount will cause an increase in indebtedness from June 30,
1998 to February 15, 2008 of $190.1 million. The net proceeds from the sale of
the Series B Notes have been, and are continuing to be, used to fund the
completion of networks in the Phase I markets. See Note 9 to the financial
statements contained in Part I which includes a summary of the terms and
conditions related to the Series B Notes and the Redeemable Warrants.

    The 12 7/8% Notes due 2008 issued July 1998, mature May 15, 2008. Interest 
is payable in cash semi-annually, commencing November 15, 1998. Gross proceeds
of approximately $200.9 million were realized from the sale. The 12 7/8% Notes
were sold at less than par, resulting in an effective rate of 13 1/4%, and the
value of the notes is being accreted (using the effective interest method
prescribed by SEC) from the $200.9 million gross proceeds realized at the time
of the sale to the aggregate value at maturity, $205.0 million, over the period
ending May 15, 2008. In connection with the sale of the 12 7/8% Notes, the
Company purchased U.S. government securities for approximately $69.0 million and
placed them in a pledged account to fund interest payments for the first three
years the 12 7/8% Notes are outstanding. The remaining proceeds will be used, in
conjunction with the net proceeds of the IPO, to fund the development of
networks and operations in six Phase II markets and the complete data and ISP
plan, as well as an expansion of the New York City, Chicago, Los Angeles and San
Francisco markets. See Note 12 to the financial statements contained in Part I
which includes a summary of the terms and conditions related to the 12 7/8%
Notes.



                                       17
<PAGE>   18
YEAR 2000

     The Company has reviewed its computer systems to identify those areas that
could be affected by the "Year 2000" issue. The Company believes that its
systems are Year 2000 compliant. In addition, the Company believes that many of
its customers and suppliers, particularly the ILECs and long distance carriers,
are also impacted by the Year 2000 issue, which in turn could affect the
Company. The Company is assessing the compliance effort of its major customers
and suppliers. If the systems of certain of the Company's customers and
suppliers, particularly the ILECs, long distance carriers and others on whose
services the Company depends or with whom the Company's systems interface, are
not Year 20000 compliant, it would have a material adverse effect on the
Company.

PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

     On August 29, 1997, WorldCom, Inc. ("WorldCom") sued the Company and two
individual employees. In its complaint, WorldCom alleges that these employees
violated certain noncompete and nonsolicitation agreements by accepting
employment with the Company and by soliciting then current WorldCom employees to
leave WorldCom's employment and join the Company. In addition, WorldCom claims
that the Company tortiously interfered with WorldCom's relationships with its
employees, and that the Company's behavior constituted unfair competition.
WorldCom seeks injunctive relief and damages, although it has filed no motion
for a temporary restraining order or preliminary injunction. The Company denies
all claims and will vigorously defend itself. The Company does not expect the
ultimate outcome to have a material adverse effect on the results of operations
or financial condition of the Company and an estimate of possible loss cannot be
made at this time.

     On October 7, 1997, the Company filed a counterclaim against WorldCom for,
among other things, attempted monopolization of the "one stop shopping"
telecommunications market, abuse of process, and unfair competition. WorldCom
did not move to dismiss the attempted monopolization claim, but has moved to
dismiss the abuse of process and unfair competition claims. On March 4, 1998,
the court dismissed the claim for unfair competition.

ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS

     A Registration Statement on Form S-1 (File No. 333-53475) (the "IPO
Registration Statement") registering shares of the Company's Common Stock, par
value $0.01 per share, the Company's IPO of common shares, was declared
effective by the Securities and Exchange Commission on June 30, 1998. The IPO
commenced on the effective date and terminated after 10 million shares of Common
Stock were sold by the Company for pursuant to the IPO Registration Statement,
for an aggregate offering price of $150 million. The managing underwriters of
the IPO were Morgan Stanley Dean Witter and Salomon Smith Barney.

     In connection with the IPO, the Company incurred expenses of approximately
$11.3 million, including underwriting discounts and commissions of $10.5 million
and other expenses of $.8 million. After such expenses, the Company's net
proceeds from the IPO were $138.7 million.

     A Registration Statement on Form S-1 (File No. 333-53479) registering the
Company's 12 7/8% Notes was declared effective by the Securities and Exchange
Commission on June 30, 1998. The offering of the 12 7/8% Notes commenced on
July 1, 1998 and terminated after $205.0 million aggregate principal amount of
the 12 7/8% Notes registered under such registration statement were sold for
gross proceeds of $200.9 million. The managing underwriters of the sale were
Morgan Stanley Dean Witter and Salomon Smith Barney.

     In connection with the sale of the 12 7/8% Notes, the Company purchased
approximately $69.0 million U.S. Treasury securities and placed them in a
pledged account to be used solely to fund interest payments for the first three
years the 12 7/8% Notes are outstanding. In addition, the Company incurred
expenses of approximately $7.3 




                                       18
<PAGE>   19

million, including underwriting discounts and commissions of $6.5 million and
other expenses of $.8 million. After such purchase and expenses, the Company's
net proceeds from the sale of the 12 7/8% Notes were $124.6 million.

     The total net proceeds from the IPO and the sale of the 12 7/8% Notes were
$263.3 million, which will be used to fund the data and ISP plan, the expansion
of four Phase I markets, New York City, Chicago, Los Angels and San Francisco, 
and the first six Phase II markets.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

     None

ITEM 4.  SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS

     Pursuant to Section 228 of the General Corporation Law of the State of
Delaware, on June 18, 1998, Allegiance Telecom, L.L.C., the sole stockholder of
the Company, by written consent adopted the following resolutions:


     1.   Approving the Amended and Restated Certificate of Incorporation and
          the Amended and Restated By-Laws of the Company.

     2.   Electing as Directors the following persons: (i) John J. Callahan,
          Paul J. Finnegan, Paul D. Carbery and John B. Ehrenkranz to serve
          until the annual meeting of stockholders in 1999; (ii) C. Daniel Yost,
          Thomas M. Lord, James E. Crawford, III and Richard D. Frisbie to serve
          until the annual meeting of stockholders in 2000 and (iii) Royce J.
          Holland, Reed E. Hundt, James N. Perry, Jr. and Robert H. Niehaus to
          serve until the annual meeting of stockholders in 2001.

     3.   Approving a form of Indemnification Agreement for directors and
          officers of the Company.

     4.   Approving the adoption of the Company's 1998 Stock Incentive Plan and
          Employee Stock Discount Purchase Plan.

     5.   Approving the conversion of the Company's 12% Cumulative Convertible
          Preferred Stock into shares of Common Stock.


ITEM 5.  OTHER INFORMATION

     None

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

     (A) Exhibit Index

            Exhibit No.    Description of Exhibit
            -----------    ----------------------

            3.1            Amended and Restated Certificate of Incorporation of
                           Allegiance Telecom, Inc.

            3.2            Amended and Restated By-Laws of Allegiance Telecom,
                           Inc.

            27.1           Financial Data Schedule


     (B) No reports on Form 8-K were filed by the Registrant during the three
months ended June 30, 1998.




                                       19
<PAGE>   20

                                    SIGNATURE

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


                                    ALLEGIANCETELECOM,INC.


Dated: August 12, 1998              By: /s/ ROYCE J. HOLLAND
                                       ----------------------------------------
                                    Name:  Royce J. Holland
                                    Title: Chairman and Chief Executive Officer

                                    By: /s/ THOMAS M. LORD
                                       ----------------------------------------
                                    Name:  Thomas M. Lord
                                    Title: Executive Vice President and
                                           Chief Financial Officer


                                       20
<PAGE>   21
                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>
          EXHIBIT
           NUMBER             DESCRIPTION
           ------             -----------
<S>                       <C>
             3.1           Amended and Restated Certificate of Incorporation of
                           Allegiance Telecom, Inc.

             3.2           Amended and Restated By-Laws of Allegiance Telecom, Inc.

            27.1           Financial Data Schedule
</TABLE>