<PAGE>   1



================================================================================

                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                              Washington, DC 20549

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

                                    FORM 10-Q

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

               FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2000.

[ ]            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 charter)

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

                         9201 NORTH CENTRAL EXPRESSWAY
                              DALLAS, TEXAS 75231
               (Address of principal executive offices) (Zip Code)

                                 (214) 261-7100
              (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 November 10, 2000, the registrant had 109,940,441 shares of common
stock 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 September 30,
            2000 and December 31, 1999 ..............................................          3
          Condensed Consolidated Statements of Operations for the
            three and nine months ended September 30, 2000 and 1999 .................          4
          Condensed Consolidated Statements of Cash Flows for the
            nine months ended September 30, 2000 and 1999 ...........................          5
          Notes to Condensed Consolidated Financial Statements ......................          6
     Item 2. Management's Discussion and Analysis of Financial
             Condition and Results of Operations ....................................         11
     Item 3. Quantitative and Qualitative Disclosures about
             Market Risk ............................................................         26
PART II. OTHER INFORMATION

     Item 1. Legal Proceedings ......................................................         27

     Item 2. Changes in Securities and Use of Proceeds ..............................         27

     Item 3. Defaults Upon Senior Securities ........................................         27

     Item 4. Submission of Matters to a Vote of Security
      Holders .......................................................................         27

     Item 5. Other Information ......................................................         27

     Item 6. Exhibits and Reports on Form 8-K .......................................         27

     Signatures .....................................................................         28
</TABLE>




                                       2
<PAGE>   3




                          PART I. FINANCIAL INFORMATION

                    ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES

                      CONDENSED CONSOLIDATED BALANCE SHEETS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)



<TABLE>
<CAPTION>
                                                                            SEPTEMBER 30,        DECEMBER 31,
                                                                                2000                 1999
                                                                           ---------------      ---------------
                                                                                      (UNAUDITED)
<S>                                                                        <C>                  <C>
                                     ASSETS
CURRENT ASSETS:
  Cash and cash equivalents ..........................................     $       764,025      $       502,234
  Short-term investments .............................................              66,127               23,783
  Short-term investments, restricted .................................              25,945               25,518
  Accounts receivable, net ...........................................              82,123               29,857
  Prepaid expenses and other current assets ..........................               5,334                2,257
                                                                           ---------------      ---------------
          Total current assets .......................................             943,554              583,649
PROPERTY AND EQUIPMENT, net ..........................................             667,725              377,413
DEFERRED DEBT ISSUANCE COSTS, net ....................................              24,888               21,668
LONG-TERM INVESTMENTS, RESTRICTED ....................................                 829               13,232
GOODWILL AND OTHER ASSETS, net .......................................              96,459               37,913
                                                                           ---------------      ---------------
          Total assets ...............................................     $     1,733,455      $     1,033,875
                                                                           ===============      ===============

                      LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
  Accounts payable ...................................................     $        92,715      $        44,805
  Accrued liabilities and other current liabilities ..................              67,227               28,868
                                                                           ---------------      ---------------
          Total current liabilities ..................................             159,942               73,673
LONG-TERM DEBT .......................................................             549,917              514,432
LONG-TERM LIABILITIES ................................................               4,738                2,154
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
  Preferred stock -- $.01 par value, 1,000,000 shares
     authorized, no shares issued or outstanding at September 30,
     2000 and December 31, 1999 ......................................                  --                   --
  Common stock-- 109,434,072 and 97,459,677 shares issued
     and 109,106,577 and 97,421,709 outstanding at September 30,
     2000 and December 31, 1999, respectively ........................               1,094                  975
  Common stock in treasury, at cost, 327,495 and 37,968
     shares at September 30, 2000 and December 31, 1999,
     respectively ....................................................                 (45)                  (5)
  Common stock warrants ..............................................               2,100                3,719
  Additional paid-in capital .........................................           1,697,107              940,120
  Deferred compensation ..............................................              (8,474)             (13,573)
  Deferred management ownership allocation charge ....................                (762)              (6,790)
  Accumulated deficit ................................................            (672,162)            (480,830)
                                                                           ---------------      ---------------
          Total stockholders' equity .................................           1,018,858              443,616
                                                                           ---------------      ---------------
          Total liabilities and stockholders' equity .................     $     1,733,455      $     1,033,875
                                                                           ===============      ===============
</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 PER SHARE AMOUNTS)
                                   (UNAUDITED)

<TABLE>
<CAPTION>
                                                    THREE MONTHS ENDED SEPTEMBER 30,            NINE MONTHS ENDED SEPTEMBER 30,
                                                  ------------------------------------      ------------------------------------
                                                       2000                  1999                2000                 1999
                                                  ---------------      ---------------      ---------------      ---------------
<S>                                               <C>                  <C>                  <C>                  <C>
REVENUES ....................................     $        80,031      $        32,051      $       190,198      $        59,773
OPERATING EXPENSES:
  Network ...................................              41,875               18,284              103,545               38,626
  Selling, general and
     administrative .........................              69,854               40,303              174,588               98,539
  Depreciation and amortization .............              37,152               17,948               83,857               35,085
  Management ownership allocation
     charge .................................               1,301                4,329                5,893               15,584
  Non-cash deferred compensation ............               2,010                2,010                6,030                5,841
                                                  ---------------      ---------------      ---------------      ---------------
          Total operating expenses ..........             152,192               82,874              373,913              193,675
                                                  ---------------      ---------------      ---------------      ---------------
          Loss from operations ..............             (72,161)             (50,823)            (183,715)            (133,902)
OTHER INCOME (EXPENSE):
  Interest income ...........................              15,131                8,876               45,026               23,159
  Interest expense ..........................             (16,302)             (14,446)             (52,643)             (43,902)
                                                  ---------------      ---------------      ---------------      ---------------
          Total other income (expense) ......              (1,171)              (5,570)              (7,617)             (20,743)
NET LOSS ....................................             (73,332)             (56,393)            (191,332)            (154,645)
ACCRETION OF REDEEMABLE PREFERRED STOCK
  AND WARRANT VALUES ........................                  --                   --                   --                 (130)
                                                  ---------------      ---------------      ---------------      ---------------
NET LOSS APPLICABLE TO COMMON STOCK .........     $       (73,332)     $       (56,393)     $      (191,332)     $      (154,775)
                                                  ===============      ===============      ===============      ===============
NET LOSS PER SHARE, basic and
  diluted ...................................     $         (0.67)     $         (0.58)     $         (1.79)     $         (1.75)
                                                  ===============      ===============      ===============      ===============
WEIGHTED AVERAGE NUMBER OF SHARES
  OUTSTANDING, basic and diluted ............         108,949,104           97,201,160          107,147,319           88,483,301
                                                  ===============      ===============      ===============      ===============
</TABLE>



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




                                       4
<PAGE>   5




                   ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES

                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                             (DOLLARS IN THOUSANDS)
                                  (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                       NINE MONTHS ENDED
                                                                                         SEPTEMBER 30,
                                                                                --------------------------------
                                                                                    2000               1999
                                                                                -------------      -------------
<S>                                                                             <C>                <C>
Cash Flows from Operating Activities:
  Net loss ................................................................     $    (191,332)     $    (154,645)
  Adjustments to reconcile net loss to cash used in
    operating activities--
    Depreciation and amortization .........................................            83,857             35,085
    Provision for bad debt ................................................            16,212              2,193
    Accretion of investments ..............................................            (2,379)            (3,320)
    Accretion of Senior Discount Notes ....................................            28,569             25,121
    Amortization of deferred debt issuance costs ..........................             9,114              1,305
    Amortization of management ownership allocation charge
     and deferred compensation ............................................            11,923             21,425
  Changes in assets and liabilities, net of affects of
    acquisitions--
    Increase in accounts receivable .......................................           (67,794)           (19,339)
    Increase in prepaid expenses and other current assets .................            (2,172)            (5,006)
    Decrease (increase) in other assets ...................................               469               (574)
    Increase in accounts payable ..........................................            45,242             12,163
    Increase in accrued liabilities and other current
     liabilities ..........................................................            30,426             26,290
                                                                                -------------      -------------
         Net cash used in operating activities ............................           (37,865)           (59,302)
                                                                                -------------      -------------
Cash Flows from Investing Activities:
  Purchases of property and equipment .....................................          (343,340)          (220,899)
  Purchases of short-term investments .....................................           (96,559)           (61,467)
  Proceeds from sale of investments .......................................            68,570            191,983
  Business acquisitions, net of cash acquired .............................           (41,745)           (34,878)
                                                                                -------------      -------------
         Net cash used in investing activities ............................          (413,074)          (125,261)
                                                                                -------------      -------------
Cash Flows from Financing Activities:
  Deferred debt issuance costs ............................................           (12,334)            (6,679)
  Proceeds from issuance of common stock ..................................           719,675            510,618
  Proceeds from stock options exercised ...................................             4,390                263
  Proceeds from issuance of common stock under the Employee
    Stock Discount Purchase Plan ..........................................             3,223                886
  Other financing activities ..............................................            (2,224)              (581)
                                                                                -------------      -------------
         Net cash provided by financing activities ........................           712,730            504,507
                                                                                -------------      -------------
         Net increase in cash and cash equivalents ........................           261,791            319,944
         Cash and cash equivalents, beginning of period ...................           502,234            262,502
                                                                                -------------      -------------
         Cash and cash equivalents, end of period .........................     $     764,025      $     582,446
                                                                                =============      =============
Supplemental disclosures of cash flow information:
  Cash paid for interest ..................................................            17,066             15,026
Supplemental disclosure of noncash investing and financing
  activities:
  Assets acquired under capital lease obligations .........................             8,081              7,413
  Fair value of assets acquired in business acquisitions ..................            24,163             10,166
  Liabilities assumed in business acquisitions ............................            11,837              8,898
  Common stock issued for business acquisitions (393,482 shares) ..........            25,033                 --
  Options issued for business acquisitions (114,375 shares) ...............             2,421                 --
</TABLE>



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




                                       5
<PAGE>   6




                    ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES

              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)

1. GENERAL

     Allegiance Telecom, Inc., a competitive local exchange carrier (CLEC), was
incorporated on April 22, 1997, as a Delaware corporation, for the purpose of
providing voice, data and Internet services to small and medium-sized 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's business plan is focused on offering services in 36 of the
largest metropolitan areas in the United States. As of September 30, 2000, the
Company is operational in 25 markets: Atlanta, Baltimore, Boston, Chicago,
Cleveland, Dallas, Denver, Detroit, Fort Worth, Houston, Long Island, Los
Angeles, Miami, Minneapolis/St. Paul, New York City, Northern New Jersey,
Oakland, Orange County, Philadelphia, San Diego, San Francisco, San Jose,
Seattle, St. Louis and Washington, D.C. Phoenix became operational on October
16, 2000 and an additional market, Tampa Bay/St. Petersburg is expected to be
added in the fourth quarter of 2000.

     The Company's success will be affected by the challenges, expenses and
delays encountered in connection with the formation and expansion of any new
business, and the competitive environment in which the Company operates. The
Company's performance will further be affected by its ability to assess and
access potential markets, implement interconnection and collocation with the
facilities of incumbent local exchange carriers (ILECs), lease adequate trunking
capacity from and otherwise develop efficient and effective working
relationships with ILECs and other carriers, obtain peering agreements with
Internet service providers, collect interexchange access and reciprocal
compensation charges, purchase and install switches in additional markets,
implement efficient operations support systems (OSS) and other back office
systems, develop and retain 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 market in which the
Company offers service until a sufficient customer base is established. It is
anticipated that obtaining a sufficient customer base will take several 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 accounting principles generally
accepted in the United States 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 accounting principles generally
accepted in the United States for complete financial statements. The interim
unaudited financial statements should be read in conjunction with the audited
financial statements of the Company as of and for the year ended December 31,
1999. In the opinion of management, all adjustments (consisting only of normal
recurring adjustments) considered necessary for a fair presentation have been
included. Operating results for the three and nine months ended September 30,
2000 are not necessarily indicative of the results that may be expected for the
year ending December 31, 2000.

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

3. ACQUISITIONS

     During the nine months ending September 30, 2000, the Company acquired all
of the outstanding stock of three regional Internet service providers (ISPs):
CONNECTnet Internet Network Services, Inc., InterAccess Co., and Virtualis
Systems, Inc. The Company acquired these ISPs for an aggregate purchase price of
$72,904, consisting of $41,847 in cash, 393,482 shares of the Company's





                                        6
<PAGE>   7

common stock, and 114,375 options granted to employees to purchase shares of the
Company's common stock. Included in the aggregate purchase price is $3,604
consisting of cash and approximately 27,893 shares of the Company's common stock
which has been held as security for indemnification claims against the former
owners of the acquired entities. The excess of the purchase price over the fair
value of the net assets acquired has been recorded as goodwill of $60,476.

     The merger agreement with CONNECTnet Internet Network Services, Inc.
provides for additional contingent consideration payable in cash and shares of
the Company's common stock effective six months following the closing date. The
contingent consideration is based on the satisfaction of certain conditions,
including the maintenance of certain minimum recurring revenues. Based on
information available at September 30, 2000, the contingent consideration is
expected to be approximately $2,500 (consisting of $450 cash and approximately
33,694 shares of the Company's common stock). If such contingent consideration
becomes due and payable, such additional purchase price will result in the
recording of a corresponding amount of goodwill.

     The merger agreement with InterAccess Co. provides for additional
contingent consideration payable in cash and shares of the Company's common
stock effective seven months following the closing date. The contingent purchase
payments are based on the satisfaction of certain conditions, including the
maintenance of certain minimum recurring revenues. Based on information
available at September 30, 2000, the contingent consideration is expected to be
approximately $1,800 (consisting of $899 cash and approximately 13,947 shares of
the Company's common stock). If such contingent consideration becomes due and
payable, such additional purchase price will result in the recording of a
corresponding amount of goodwill.

     The merger agreement with Virtualis Systems, Inc. provides for additional
contingent consideration payable in cash no later than twelve months following
the closing date. The contingent consideration is based on the satisfaction of
certain conditions, including the maintenance of certain minimum recurring
revenues. Based on information available at September 30, 2000, the contingent
consideration is expected to be approximately $6,276 of cash. Additionally, the
agreement provides for potential earnout payments totaling up to $12 million
payable solely in shares of the Company's common stock, based on Virtualis
meeting certain quarterly revenue targets through August 31, 2001. If such
contingent consideration and earnout payments becomes due and payable, such
additional purchase price will result in the recording of a corresponding amount
of goodwill.

     During 1999, the Company acquired 100% of the outstanding stock of
ConnectNet, Inc. and Kivex, Inc. and certain assets of ConnecTen, L.L.C. for
cash.

     Each of the acquisitions discussed above were accounted for using the
purchase method of accounting; accordingly, the net assets and results of
operations of the acquired companies have been included in the Company's
consolidated financial statements since the acquisition dates. The purchase
price of the acquisitions was allocated to assets acquired, including identified
intangible assets, and liabilities assumed, based on their respective estimated
fair values at acquisition. The Company's purchase price allocation of the
acquisitions made in 2000 is preliminary, subject to post-acquisition due
diligence of the acquired entities, and may be adjusted as additional
information is obtained. As of September 30, 2000, adjustments totaling $2,975
have been made to the purchase price allocation of these entities. These
adjustments increase acquired liabilities and allowances and are included in
goodwill at September 30, 2000.

     The following presents the unaudited pro forma results of operations of the
Company for the three and nine months ended September 30, 1999 as if the
acquisition of Kivex, Inc. had been consummated at the beginning of each of the
periods presented. The pro forma results of operations are prepared for
comparative purposes only and do not necessarily reflect the results that would
have occurred had the acquisition occurred at the beginning of the periods
presented or the results which may occur in the future. The pro forma results of
operations for Virtualis Systems, Inc., CONNECTnet Internet Network Services,
Inc., InterAccess Co., ConnecTen, L.L.C. and ConnectNet, Inc. are not included
in this table as the results would not have been material to the Company's
results of operations.

<TABLE>
<CAPTION>
                                                   THREE MONTHS ENDED      NINE MONTHS ENDED
                                                   SEPTEMBER 30, 1999      SEPTEMBER 30, 1999
                                                   ------------------      ------------------
<S>                                                <C>                     <C>
Revenues .....................................     $           32,051      $           63,711
Net loss before extraordinary items ..........                (56,393)               (165,501)
Net loss applicable to common stock ..........                (56,393)               (165,501)
Net loss per share, basic and diluted ........                  (0.58)                  (1.87)
</TABLE>

4. PROPERTY AND EQUIPMENT

     Property and equipment includes network equipment, leasehold improvements,
software, office equipment, furniture and fixtures,




                                       7
<PAGE>   8

and construction-in-progress. These assets are stated at cost, which includes
direct costs and capitalized interest and are depreciated over their respective
useful lives using the straight-line method. During the three months ended
September 30, 2000 and 1999, $3,605 and $1,699, respectively, of interest
expense related to network construction-in-progress was capitalized. During the
nine months ended September 30, 2000 and 1999, $10,637 and $4,149, respectively,
of interest expense related to network construction-in-progress was capitalized.
Repair and maintenance costs are expensed as incurred.

     Property and equipment at September 30, 2000 and December 31, 1999,
consisted of the following:


<TABLE>
<CAPTION>
                                                                                                               USEFUL
                                                                        SEPTEMBER 30,       DECEMBER 31,        LIVES
                                                                             2000               1999          (IN YEARS)
                                                                        -------------      -------------      ----------
<S>                                                                     <C>                <C>                <C>
Network equipment .................................................     $     458,867      $     266,727           5-7
Leasehold improvements ............................................            77,897             52,980          5-10
Software ..........................................................            51,820             26,169             3
Office equipment and other ........................................            20,127             11,073             2
Furniture and fixtures ............................................             9,363              6,061             5
                                                                        -------------      -------------
Property and equipment, in service ................................           618,074            363,010
Less: Accumulated depreciation ....................................          (127,015)           (58,113)
                                                                        -------------      -------------
     Property and equipment, in service, net ......................           491,059            304,897

Construction-in-progress ..........................................           176,666             72,516
                                                                        -------------      -------------
     Property and equipment, net ..................................     $     667,725      $     377,413
                                                                        =============      =============
</TABLE>

5. GOODWILL AND OTHER ASSETS

     Goodwill and other assets consisted of the following:


<TABLE>
<CAPTION>
                                              SEPTEMBER 30,         DECEMBER 31,
                                                   2000                 1999
                                             ---------------      ---------------
<S>                                          <C>                  <C>
Goodwill ...............................     $        94,134      $        34,211
Other acquired intangibles .............              19,061                5,705
Long-term deposits .....................               2,987                2,143
Other ..................................               1,982                2,616
                                             ---------------      ---------------
Total goodwill and other assets ........             118,164               44,675
Less: Accumulated amortization .........             (21,705)              (6,762)
                                             ---------------      ---------------
      Goodwill and other assets, net ...     $        96,459      $        37,913
                                             ===============      ===============
</TABLE>

     Other acquired intangibles include acquired subscriber lists and acquired
workforces, which were obtained in connection with certain acquisitions made in
2000 and 1999. Goodwill and other acquired intangibles are being amortized over
their estimated useful lives of three years using the straight-line method.

6. ACCRUED LIABILITIES AND OTHER CURRENT LIABILITIES

     Accrued liabilities and other current liabilities consisted of the
following:


<TABLE>
<CAPTION>
                                                      SEPTEMBER 30,     DECEMBER 31,
                                                           2000              1999
                                                      -------------     -------------
<S>                                                   <C>               <C>
Accrued employee compensation and benefits ......     $      13,962     $       4,709
Accrued network expenses ........................             9,953             7,896
Accrued taxes ...................................             5,660             3,823
Accrued interest expense ........................            11,836             3,449
Other ...........................................            25,816             8,991
                                                      -------------     -------------
    Accrued liabilities and other current
     liabilities ................................     $      67,227     $      28,868
                                                      =============     =============
</TABLE>



                                       8
<PAGE>   9




7. LONG-TERM DEBT

     Long-term debt consisted of the following:

<TABLE>
<CAPTION>
                                                                                      SEPTEMBER 30,       DECEMBER 31,
                                                                                           2000               1999
                                                                                     ---------------     ---------------
<S>                                                                                  <C>                 <C>
Series B 11 3/4% Notes, face amount $445,000 due
February 15, 2008; effective interest rate of 12.21%; at accreted
  value ........................................................................     $       332,754     $       304,393
12 7/8% Senior Notes, face amount $205,000 due
May 15, 2008; effective interest rate of 13.24%; at accreted
  value ........................................................................             201,467             201,259
Capital lease obligations ......................................................              15,696               8,780
                                                                                     ---------------     ---------------
        Long-term debt .........................................................     $       549,917     $       514,432
                                                                                     ===============     ===============
</TABLE>

Credit Facilities

     In February 2000, the Company closed on $500 million of new senior secured
credit facilities (Credit Facilities), which replaced the existing $225 million
revolving credit facility. The Credit Facilities consist of a $350 million
seven-year revolving credit facility and a $150 million two-year delayed draw
term loan facility. The Credit Facilities will be available, subject to
satisfaction of certain terms and conditions, to provide financing for network
build-out, including the cost to develop, acquire and integrate the necessary
operations support and back office systems, as well as for additional dark fiber
purchases and central office collocations. Interest on amounts drawn is variable
based on the Company's leverage ratio and is initially expected to be the London
Interbank Offered Rate (LIBOR) plus 3.25%. The initial commitment fee on the
unused portion of the Credit Facilities will be 1.5% per annum, paid quarterly
and will be reduced based upon usage.

     The Credit Facilities 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 certain
subsidiaries, engage in transactions with stockholders or affiliates, effect a
consolidation or merger and require the Company to maintain certain operating
and financial performance measures. The Company was in compliance with all such
restrictive covenants at September 30, 2000. No advances have been made to the
Company through the Credit Facilities as of September 30, 2000.

     Unamortized deferred debt issuance costs of $5,854 related to the $225
million revolving credit facility were expensed as additional interest expense
during first quarter 2000, upon termination of the $225 million revolving credit
facility and establishment of the Credit Facilities.

8. CAPITALIZATION

Common Stock

     During the three and nine months ended September 30, 2000, 23,322 and
72,268 shares of common stock were issued under the Company's Employee Stock
Discount Purchase Plan for proceeds of $1,269 and $3,223, respectively.

     On February 2, 2000, the Company raised $693,000 of gross proceeds from the
sale of the Company's common stock. The Company sold 9,900,000 shares at a price
of $70 per share. Net proceeds from this offering were $665,562. On February 29,
2000, the underwriters of the offering exercised an option to purchase an
additional 803,109 shares of Common Stock, providing an additional $56,218 gross
proceeds and $54,113 net proceeds to the Company.

     On February 28, 2000, a three-for-two stock split of the Company's common
stock was effected in the form of a 50% stock dividend to shareholders of record
on February 18, 2000. Par value remained unchanged at $.01 per share. All
references to the number of common shares and per share amounts have been
restated to reflect the stock split for all periods presented.

Warrants

     During the three and nine months ended September 30, 2000, 52,570 and
82,545 Warrants were exercised to purchase 115,044 and 180,636 shares of common
stock, respectively. Fractional shares are not issued; cash payments are made in
lieu thereof, according to the terms of the Warrant Agreement. At September 30,
2000 and December 31, 1999, 106,316 and 188,861 Warrants, respectively, were
outstanding.





                                       9
<PAGE>   10

9. COMMITMENTS AND CONTINGENCIES

     In April 2000, the Company executed a procurement agreement with Lucent
Technologies, Inc. for a broad range of advanced telecommunications equipment,
software and services. This agreement contains a three-year $350 million
purchase commitment. The Company must complete purchases totaling $80 million by
December 31, 2000, an aggregate of $180 million of purchases by December 31,
2001, and the full $350 million of aggregate purchases on or before December 31,
2002. As of September 30, 2000, the Company has completed purchases totaling
approximately $63 million, and expects to meet the required purchase milestones
for the remainder of the procurement agreement. If the Company does not meet the
required intermediate purchase milestones, the Company will be required to
provide cash settlement in an amount equal to the shortfall. Such cash
settlements may be applied to future purchases during the commitment period. If
the Company does not purchase $350 million of products and services from Lucent
and its affiliates by December 31, 2002, the Company will be required to provide
cash settlement in an amount equal to the shortfall.

     The Company has entered into various operating lease agreements, with
expirations through 2009, for office space, equipment and network facilities.
Future minimum lease obligations related to the Company's operating leases as of
September 30, 2000 are as follows:

<TABLE>
<S>                               <C>
2000 ........................     $    3,353
2001 ........................         12,974
2002 ........................         12,739
2003 ........................         11,721
2004 ........................         10,401
2005 ........................         10,637
Thereafter ..................         24,356
</TABLE>

     Total rent expense for the three months ended September 30, 2000 and 1999,
and the nine months ended September 30, 2000 and 1999, was $4,619, $2,694,
$11,834, and $6,190, respectively.

     During July 2000, the Company entered into an operating lease for office
facilities for its corporate headquarters in Dallas, Texas. The lease for the
new facility has an initial term of approximately twelve years.

10. LOSS PER SHARE

     The net loss per share amounts included on the condensed consolidated
statements of operations and the number of shares outstanding on the condensed
consolidated balance sheets reflect a 426.2953905 for-one stock split, which
occurred in connection with the initial public offering of common stock on July
7, 1998 and a three-for-two stock split which occurred on February 28, 2000 (see
Note 8). The shares to be issued under the Employee Stock Discount Purchase Plan
and the warrants and options are not included in the diluted 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 warrant values of $130
for the nine months ended September 30, 1999.

11. REVENUE RECOGNITION

     In December 1999, the SEC issued Staff Accounting Bulletin No. 101,
"Revenue Recognition in Financial Statements," (SAB No. 101) which currently
must be adopted for the fourth quarter of 2000. SAB No. 101 provides additional
guidance on revenue recognition as well as criteria for when revenue is
generally realized and earned and also requires the deferral of incremental
costs. The Company believes that SAB No. 101 will not have a material impact on
the Company's financial position.

12. RELATED PARTIES

     In connection with the Credit Facilities and the February 2, 2000 equity
offering, the Company incurred approximately $1,091 and $2,944, respectively in
fees to an affiliate of an investor in the Company.




                                       10
<PAGE>   11




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

OVERVIEW

     Allegiance Telecom, Inc. (Allegiance) is a leading competitive provider of
telecommunications services to small and medium-sized business, government and
other institutional users in major metropolitan areas across the United States.
Allegiance offers an integrated set of telecommunications services including
local, long distance, data and a full suite of Internet services. Our principal
competitors are incumbent local exchange carriers (ILECs), such as the regional
Bell operating companies.

     Allegiance was formed in 1997 by a management team of industry veterans to
take advantage of the opportunity for facilities-based competition created by
the Telecommunications Act of 1996. Since our inception, we have focused on
building a reliable nationwide network based on proven technologies, strong
nationwide direct sales force and efficient operational support systems. We
believe that by doing so we have positioned ourselves to compete effectively
with the incumbent carriers, most of whom do not address our customers with
direct sales efforts and are burdened by legacy operational support systems.

     Our business plan covers 36 of the largest metropolitan areas in the United
States. Our network rollout has proceeded on schedule, with 25 markets
operational as of September 30, 2000, including Atlanta, Baltimore, Boston,
Chicago, Cleveland, Dallas, Denver, Detroit, Fort Worth, Houston, Long Island,
Los Angeles, Miami, Minneapolis/St. Paul, New York, Northern New Jersey,
Oakland, Orange County, Philadelphia, St. Louis, San Diego, San Francisco, San
Jose, Seattle and Washington, D.C. Phoenix became operational on October 16,
2000 and an additional market, Tampa Bay/St. Petersburg, is expected to be added
in the fourth quarter of 2000. We believe we have successfully raised the
projected capital required to build our networks and operate in each of these
markets to the point at which projected operating cash flow from the market is
sufficient to fund such market's projected operating costs and capital
expenditures.

     Allegiance seeks to achieve competitive advantages by deploying multiple
technologies and a mixture of leased and owned facilities at the edge of the
communications network so that we can most effectively serve our customer base
where it is physically located. We install state-of-the art voice and data
aggregation and switching infrastructure in each local market and connect the
switches to our customers by installing transmission and aggregation equipment
in the central offices or "hubs" of the existing local incumbent carrier's
networks. This approach allows us to connect into the "local loop" which
consists of the existing copper wire and fiber plant throughout each local
market owned by the ILECs. Our local loop presence provides us with a flexible
platform for delivering traditional voice and broadband access services to our
end user customers. We connect our switches to our central office locations by
either leasing network elements from ILECs and other providers on a short-term
basis or leasing dedicated fiber on a long-term basis. We have increasingly
focused our local network capital investment on dedicated fiber because of the
growth of our customer base and traffic volume and the increased availability of
this fiber throughout the major metropolitan areas in the United States.

     As we have developed our local networks to service end user customers, we
have also attempted to capitalize on our expertise and investment in the edge of
the network by optimizing utilization of our network assets. Through the
deployment of our end user focused infrastructure, we have a predominantly fixed
cost network that has periods of under utilization. We have addressed this under
utilization by providing network solutions to other service providers, primarily
the leading national providers, who also have end user customers but who do not
have the facilities and expertise to directly access these customers through the
local loop. Many of these network service providers focus on the residential
Internet access market. The traffic patterns in this market generally complement
those of our end user business customers, making this type of wholesale business
an incremental revenue opportunity for Allegiance.

     The other way we intend to serve our customers and leverage our focus on
the small and medium-sized business end users is by developing electronic
commerce products designed to help these customers market their products and
services on-line, improve communication and collaboration and increase
productivity. While these types of products and solutions are readily available
to larger business customers that can afford to devote the resources necessary
to develop and customize them internally, we believe that smaller business
customers are demanding easy to use electronic commerce solutions that allow
them with minimal design and development costs to market products on-line as
well as increase their own productivity by using corporate intranets.




                                       11
<PAGE>   12




     The table below provides selected key operational data for the quarters
ended:

<TABLE>
<CAPTION>
                                                              SEPTEMBER  30, 2000        SEPTEMBER 30, 1999
                                                              -------------------        ------------------
<S>                                                           <C>                        <C>
Markets served.........................................       25                         17
Number of switches deployed............................       24                         13
Central office collocations............................       552                        260
Addressable market-- business lines (cumulative).......       14,730,000                 8,400,000
Lines sold.............................................       135,500                    69,800
Lines installed (cumulative)...........................       499,700                    181,400
Sales force employees..................................       1,231                      608
Total employees........................................       2,936                      1,525
</TABLE>

RESULTS OF OPERATIONS -- THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2000 COMPARED
WITH THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1999

     During the third quarter of 2000 and 1999, we generated revenues of $80.0
million and $32.1 million, respectively. For the nine months ended September 30,
2000 and 1999, we generated revenues of approximately $190.2 million and $59.8
million, respectively. The increase in revenue is attributable to an increase in
number of customers and lines installed. For the three months ended September
30, 2000 and 1999, we sold 135,500 lines and 69,800 lines, and installed 91,900
lines and 59,100 lines, respectively. Facilities-based lines represented
approximately 89% of all lines installed as of September 30, 2000 as compared to
approximately 87% as of September 30, 1999.

     Local voice service revenues for the three months ended September 30, 2000
and 1999 were approximately $59.7 million and $27.2 million and for the nine
months ended September 30, 2000 and 1999 were $143.0 million and $53.1 million,
respectively. Local voice service revenues consisted of:

     o    the monthly recurring charge for basic local voice service;

     o    usage-based charges for local and toll calls in certain markets;

     o    charges for services such as call waiting and call forwarding;

     o    certain non-recurring charges, such as charges for additional lines
          for an existing customer; and

     o    interconnection revenues from switched access charges to long distance
          carriers and reciprocal compensation charges to other local carriers.

     Components of our local voice service revenue are subject to various
federal and state regulations and to disputes and uncertainties. Moreover, we
expect and have modified our business plans to anticipate a decrease in switched
access charges and reciprocal compensation charges. For a discussion of the
risks and uncertainties associated with our local voice revenues, see "Risk
Factors" below.

     Long distance service revenue for the three months ended September 30, 2000
and 1999 were approximately $3.3 million and $0.9 million and for the nine
months ended September 30, 2000 and 1999 were $7.1 million and $1.7 million,
respectively.

     Data revenue, including revenue generated from Internet access, web hosting
and high-speed data services, for the three months ended September 30, 2000 and
1999 were approximately $17.0 million and $4.0 million and for the nine months
ended September 30, 2000 and 1999 were $40.1 million and $5.0 million,
respectively.

     We have had discussions, and will continue to have discussions in the
foreseeable future, concerning potential acquisitions of Internet service
providers and other providers of telecommunications and Internet services. On
September 28, 2000 we completed the acquisition of Virtualis Systems, Inc., a
web hosting company and applications service provider based in Los Angles. We
have utilized the purchase method of accounting for the acquisitions of the
common stock of, Virtualis Systems, Inc., InterAccess Co., CONNECTNet Internet
Network Services, Inc., Kivex, Inc. and ConnectNet, Inc. and the acquisition of
certain assets of ConnecTen, L.L.C. We have recognized the revenues earned since
the closing of each of these acquisitions in our condensed consolidated




                                       12
<PAGE>   13


statement of operations for the period ended September 30, 2000.

     For the quarters ended September 30, 2000 and 1999, network expenses were
$41.9 million and $18.3 million, respectively. For the nine months ended
September 30, 2000 and 1999, network expenses were $103.5 million and $38.6
million, respectively. The increase in network expenses is consistent with the
deployment of our networks and initiation and growth of our services during 2000
and 1999. Network expenses included:

     o    the cost of leasing high-capacity digital lines that interconnect our
          network with ILEC networks;

     o    the cost of leasing high-capacity digital lines that connect our
          switching equipment to our transmission equipment located in ILEC
          central offices;

     o    the cost of leasing local loop lines which connect our customers to
          our network;

     o    the cost of completing local and long distance calls originated by our
          customers;

     o    the cost of leasing space in ILEC central offices for collocating our
          transmission equipment; and

     o    the cost of leasing our nationwide Internet network.

     The costs to lease local loop lines and high-capacity digital lines from
the ILECs vary by ILEC and are regulated by state authorities under the
Telecommunications Act of 1996. We believe that in many instances there are
multiple carriers in addition to the ILEC from whom we can lease high-capacity
lines, and that we can generally lease those lines at lower prices than are
charged by the ILEC. We expect that the costs associated with these leases will
increase with customer volume and will be a significant part of our ongoing cost
of services. The cost of leasing switch sites is also a significant part of our
ongoing cost of services. For a discussion of the risks and uncertainties
associated with our leasing of network elements from the ILECs, see "Risk
Factors" below.

     In constructing switching and transmission equipment for a new market, we
capitalize as a component of property and equipment only the non-recurring
charges associated with our initial network facilities and the monthly recurring
costs of those network facilities until the switching equipment begins to carry
revenue producing traffic. Typically, the charges for just one to two months are
capitalized. We generally expense the monthly recurring costs resulting from the
growth of existing collocation sites, and the costs related to expansion of the
network to additional collocation sites in operational markets as we incur these
charges.

     We incur "reciprocal compensation" costs in providing both voice and data
services and expect reciprocal compensation costs to be a major portion of our
cost of services. We must enter into an interconnection agreement with the ILEC
in each market to make widespread calling available to our customers. These
agreements typically set the cost per minute to be charged by each party for the
calls that are exchanged between the two carriers' networks. Generally, a
carrier must compensate another carrier when a local call by the first carrier's
customer terminates on the other carrier's network. These reciprocal
compensation costs will grow as our customers' outbound calling volume grows.

     The cost of securing long distance service capacity is a variable cost that
increases in direct relationship to increases in our customer base and their
long distance calling volumes. We believe that these costs, measured as a
percentage of long distance revenues, will be relatively consistent from period
to period. However, we do expect period over period growth in the absolute cost
of such capacity, and that the cost of long distance capacity will be a
significant portion of our cost of long distance services.

     We have developed a national Internet data network by connecting our
markets with leased high-capacity digital lines. The costs of these lines will
increase as we increase capacity to address customer demand, open new markets
and connect additional markets to our Internet network.

     Selling, general and administrative expenses increased to $69.9 million in
the third quarter of 2000 from $40.3 million in the third quarter of 1999
primarily due to the growth of our business. On a year-to-date basis, selling,
general, and administrative expenses increased to $174.6 million for the nine
months ended September 30, 2000 from $98.5 million for the nine months ended
September 30, 1999. Selling, general and administrative expenses include
salaries and related personnel costs, facilities costs and legal and
professional fees. The number of employees increased to 2,936 as of September
30, 2000, from 1,525 as of September 30, 1999. As of




                                       13
<PAGE>   14


September 30, 2000, the sales force, including sales managers and sales
administrators, had grown to 1,231 from 608 as of September 30, 1999. As we
continue to grow in terms of number of customers and call volume, we expect that
ongoing expenses for customer care and billing will increase.

     We amortized $1.3 million and $5.9 million of the deferred management
ownership allocation charge, a non-cash charge to income, for the three and nine
months ended September 2000, respectively. The same charge for the three and
nine months ended September 30, 1999 was $4.3 million and $15.6 million,
respectively. Our original private equity fund investors and original management
team investors owned 95.0% and 5.0%, respectively, of the ownership interests of
Allegiance Telecom, LLC, an entity that owned substantially all of our
outstanding capital stock prior to our initial public offering of common stock.
As a result of that offering, the assets of Allegiance Telecom, LLC, which
consisted almost entirely of such capital stock, were distributed to the
original fund investors and management investors in accordance with the
Allegiance Telecom, LLC limited liability company agreement. This agreement
provided that the equity allocation between the fund investors and management
investors would be 66.7% and 33.3%, respectively, based upon the valuation
implied by the initial public offering. We recorded the increase in the assets
of Allegiance Telecom, LLC allocated to the management investors as a $193.5
million increase in additional paid-in capital. This transaction was recorded
during the third quarter of 1998. Of this charge, we recorded $122.5 million as
a non-cash, non-recurring charge to operating expense and $71.0 million as a
deferred management ownership allocation charge. We will further amortize this
deferred charge at $0.7 million and $0.1 million during the remainder of 2000
and 2001, respectively. This period is the time frame over which we have the
right to repurchase a portion of 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 Allegiance is terminated. During the first quarter of 2000, we
repurchased 289,527 shares from terminated management employees, and reversed
the remaining deferred charge of $0.1 million related to these shares to
additional paid-in capital. During 1999, we repurchased 37,968 shares from
terminated management employees, and reversed the remaining deferred charge of
$0.6 million related to these shares to additional paid-in capital. For the
three months ended September 30, 2000 and 1999, we recognized $2.0 million and
$2.0 million, respectively, of amortization of deferred compensation expense,
and for the nine months ended September 30, 2000 and 1999, we recognized $6.0
million and $5.8 million, respectively, of amortization of deferred compensation
expense, respectively. Such deferred compensation was recorded in connection
with membership units of Allegiance Telecom, LLC sold to certain management
employees and options granted to employees under our 1997 Stock Option Plan and
1998 Stock Incentive Plan.

     During the third quarter 2000 and 1999, we recorded depreciation and
amortization of property and equipment of $29.6 million and $14.7 million,
respectively. For the nine months ended September 30, 2000 and 1999,
depreciation and amortization expense was $68.9 million and $31.7 million,
respectively. Such increase was consistent with the deployment of our networks
and initiation of services in 25 markets by September 30, 2000.

     In connection with the acquisitions completed during 2000 and 1999, we
assigned an aggregate of $19.1 million of the purchase price to customer lists
and workforces. We also recorded an aggregate of $94.1 million of goodwill. Each
of these intangible assets is being amortized over their estimated useful lives
of three years, beginning at their respective date of the acquisition. For the
third quarter 2000 and 1999, we recorded $6.3 million and $2.7 million of
amortization for goodwill and $1.3 million and $0.5 million of amortization of
customer list and workforces, respectively. For the nine months ending September
30, 2000 and 1999, we recorded $12.6 million and $2.9 million of amortization
for goodwill and $2.4 million and $0.5 million of amortization of customer list
and workforces, respectively. Our purchase price allocation of the acquisitions
made in 2000 is preliminary, subject to post acquisition due diligence of the
acquired entities, and may be adjusted as additional information is obtained. As
of September 30, 2000, we have made adjustments to the purchase price allocation
of acquired entities totaling approximately $3.0 million. These adjustments
increase acquired liabilities and allowances and are included in goodwill at
September 30, 2000.

     For the three months ended September 30, 2000 and 1999, and for the nine
months ended September 30, 2000 and 1999, interest expense was $16.3 million,
$14.4 million, $52.6 million and $43.9 million, respectively. Interest expense
reflects the accretion of the 11 3/4% notes and related amortization of the
original issue discount, and the amortization of the original issue discount on
the 12 7/8% notes. Interest expense in 2000 also includes amortization of
deferred debt issuance costs related to the new $500 million Senior Secured
Credit Facilities (Credit Facilities). Unamortized deferred debt issuance costs
of $5.9 million related to the $225 million revolving credit facility were
charged to interest expense during first quarter 2000, upon termination of the
$225 million revolving credit facility and completion of the $500 million Credit
Facilities. The amount of interest capitalized for the three and nine months
ended September 30, 2000 was $3.6 million and $10.6 million, respectively. For
the same periods in 1999, the amounts were $1.7 million and $4.1 million,
respectively. Interest income for the three and nine months ended September 30,
2000 was $15.1 million and $45.0 million, respectively. Interest income for the
three and nine months ended September 30, 1999 was $8.9 million and $23.2
million, respectively. Interest income results from the investment of cash and
from U.S. government securities, which we purchased and placed in a pledge
account to secure the semiannual payments of interest through May 2001 on the
12 7/8% notes. Interest income




                                       14
<PAGE>   15

during 2000 is greater than for the comparable periods in 1999 because we had
additional cash invested in interest-bearing instruments as a result of our
February 2000 equity offering.

     From February 1998 through March 1999, we recorded accretion of our
redeemable warrants to reflect the possibility that they would be redeemed at
fair market value in February 2008. Amounts were accreted using the effective
interest method and management's estimate of the future fair market value of
such warrants at the time redemption is permitted. Amounts accreted increased
the recorded value of such warrants on the balance sheet and resulted in
non-cash charges to increase the net loss applicable to common stock. As the
terms and conditions of the Warrant Agreement do not specify a date certain for
redemption of the warrants and the exchange of warrants for cash is no longer
beyond the control of management, we have ceased accretion of the warrants and
reclassified the accreted value of the redeemable warrants at April 1, 1999 to
the stockholders' equity section. If a repurchase event occurs in the future or
becomes probable, we will adjust the warrants to the estimated redemption value
at that time.

     Our net loss for the third quarter of 2000, after amortization of the
non-cash management ownership allocation charge and amortization of deferred
compensation, was $73.3 million, and it was $191.3 million for the nine months
ended September 30, 2000. Our net loss for the third quarter of 1999, after
amortization of the non-cash management ownership allocation charge and
amortization of deferred compensation but before the accretion of warrant
values, was $56.4 million and it was $154.6 million for the nine months ended
September 30, 1999. After deducting accretion of redeemable warrant values, the
net loss applicable to common stock was $154.8 million for the nine months ended
September 30, 1999.

     Many securities analysts use the measure of earnings before deducting
interest, taxes, depreciation and amortization, also commonly referred to as
"EBITDA" as a way of measuring the performance of a company. EBITDA is not
derived pursuant to generally accepted accounting principles (GAAP), and
therefore should not be construed as an alternative to operating income, as an
alternative to cash flows from operating activities, or as a measure of
liquidity. We had EBITDA losses of $31.7 million and $87.9 million for the three
months and nine months ended September 30, 2000, respectively. For the three and
nine months ended September 30, 1999, we had EBITDA losses of $26.5 million and
$77.4 million. In calculating EBITDA, we also exclude the non-cash charges to
operations for the management ownership allocation charge and deferred
compensation expense totaling $3.3 million and $11.9 million for the three and
nine months ended September 30, 2000 and $6.3 million and $21.4 million for the
three and nine months ended September 30, 1999.

     We expect to continue to experience operating losses and negative EBITDA as
a result of our development and market expansion activities. We typically do not
expect to achieve positive EBITDA in any market until at least its third year of
operation.

LIQUIDITY AND CAPITAL RESOURCES

     Our financing plan is predicated on the pre-funding of each market's
expansion to positive free cash flow. By using this approach, we avoid being in
the position of seeking additional capital to fund a market after we have
already made a significant capital investment in that market. We believe that by
raising all required capital prior to making any commitments in a market, we can
raise capital on more favorable terms and conditions.

     On January 3, 2000, we announced a significant expansion of our business
plan to include a total of 36 target markets and which:

     o    includes an increase in our collocation footprint by approximately 100
          central offices in our initial 24 target markets; and

     o    provides for the acquisition of dark fiber capacity in an additional
          16 of our target markets as well as connecting the Boston -- New York
          -- Washington, D.C. corridor.

     We do not begin to develop a new market until we have raised the capital
that we project to be necessary to build and operate our network in the market
to the point at which operating cash flow from the market is sufficient to fund
such market's ongoing operating costs and capital expenditures. We believe that
all of our 36 target markets are now fully funded in this manner.

     We may decide to seek additional capital in the future to expand our
business. Sources of additional financing may include vendor financing and/or
the private or public sale of our equity or debt securities. We cannot assure
you, however, that such financing will be available at all or on terms
acceptable to us, or that our estimate of additional funds required is accurate.
The actual amount and timing of future capital requirements may differ
materially from our estimates as a result of, among other things:

     o    the cost of the development of our networks in each of our markets;




                                       15
<PAGE>   16


     o    a change in or inaccuracy of our development plans or projections that
          leads to an alteration in the schedule or targets of our roll-out
          plan;

     o    the extent of price and service competition for telecommunications
          services in our markets;

     o    the demand for our services;

     o    regulatory and technological developments, including additional market
          developments and new opportunities in our industry;

     o    an inability to borrow under our new credit facilities; and

     o    the consummation of acquisitions.

     Our cost of rolling out our networks and operating our business, as well as
our revenues, will depend on a variety of factors, including:

     o    our ability to meet our roll-out schedules;

     o    our ability to negotiate favorable prices for purchases of equipment;

     o    our ability to develop, acquire and integrate the necessary operations
          support systems and other back office systems;

     o    the number of customers and the services for which they subscribe;

     o    the nature and penetration of new services that we may offer; and

     o    the impact of changes in technology and telecommunication regulations.

     As such, actual costs and revenues may vary from expected amounts, possibly
to a material degree, and such variations are likely to affect our future
capital requirements.

     For the quarter ended September 30, 2000 and 1999, we made capital
expenditures of $141.2 million and $68.6 million, respectively. For the nine
months ended September 30, 2000 and 1999, we made capital expenditures of $343.3
million and $220.9 million, respectively. We also used capital during these
periods to fund our operations. Excess cash was used to purchase short-term
investments and money market investments. As of September 30, 2000, we had
transmission equipment collocated in 552 ILEC central offices.

     In April 2000, we executed a procurement agreement with Lucent
Technologies, Inc. for a broad range of advanced telecommunications equipment,
software and services. This agreement contains a three-year $350 million
purchase commitment. We must complete purchases totaling $80 million by December
31, 2000, an aggregate of $180 million of purchases by December 31, 2001, and
the full $350 million of aggregate purchases on or before December 31, 2002. If
we do not meet the required intermediate purchase milestones, we will be
required to provide cash settlement in an amount equal to the shortfall. Such
payments may be applied to future purchases during the commitment period. If we
do not purchase $350 million of products and services from Lucent and its
affiliates by December 31, 2002, we will be required to provide cash settlement
in an amount equal to the shortfall. As of September 30, 2000, we have completed
purchases totaling approximately $63 million, and we expect to be able to meet
the required purchase milestones for the remainder of the purchase agreement.
Pursuant to our expanded business plan, we expect to incur approximately $425
million to $450 million of capital expenditures in 2000 (which amount includes
the Lucent capital expenditures of $80 million in 2000).

     As of September 30, 2000, we had approximately $830.2 million of
unrestricted cash and short-term investments. In addition, $25.9 million of
restricted U.S. government securities have been placed in a pledge account to
fund interest payments on our 12 7/8% notes through May 2001.




                                       16
<PAGE>   17


     On February 28, 2000, a three-for-two stock split of our common stock was
effected in the form of a 50% dividend to shareholders of record on February 18,
2000. All references to the number of common shares and per share amounts have
been restated to reflect the stock split for the periods presented.

     On February 3, 1998, we raised gross proceeds of approximately $250.5
million in an offering of 445,000 units, each unit consisting of one 11 3/4%
note and one redeemable warrant. Net proceeds of approximately $240.7 million
were received from that offering. The 11 3/4% notes have a principal amount at
maturity of $445.0 million and an effective interest rate of 12.21%. The 11 3/4%
notes mature on February 15, 2008. From and after February 15, 2003, interest on
such notes 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 September 30, 2000 to February 15, 2003 of $112.2 million.

     We completed the initial public offering of our common stock and the
offering of the 12 7/8% notes early in the third quarter of 1998. We raised net
proceeds of approximately $137.8 million from our initial public offering of
common stock and approximately $124.8 million from the offering of these notes.
The 12 7/8% notes mature on May 15, 2008. Interest on these notes is payable in
cash semi-annually, commencing November 15, 1998. The 12 7/8% notes were sold at
less than par, resulting in an effective rate of 13.24%, and the value of the
12 7/8% notes is being accreted, using the effective interest method, 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. The
accretion of original issue discount will cause an increase in indebtedness from
September 30, 2000 to May 15, 2008 of $3.5 million. In connection with the sale
of the 12 7/8% notes, we purchased U.S. government securities for approximately
$69.0 million and placed them in a pledge account to fund interest payments for
the first three years the 12 7/8% notes are outstanding. The first interest
payment was made in November 1998. Such U.S. government securities are reflected
in the balance sheet as of September 30, 2000, at an accreted value of
approximately $25.9 million, which is classified as a current asset.

     On April 20, 1999, we completed the public offering of 17,739,000 shares of
our common stock at a price of $25.33 per share, raising gross proceeds of
$449.4 million. After underwriters' fees and other expenses, we realized net
proceeds of approximately $430.3 million. On April 28, 1999, the underwriters of
this offering exercised an option to purchase an additional 3,302,100 shares of
common stock at the same price per share. As a result, we raised an additional
$83.6 million of gross proceeds and $80.3 million of net proceeds, at that time.

     On February 2, 2000, we completed the public offering of 9,900,000 shares
of our common stock at a price of $70.00 per share, raising gross proceeds of
$693.0 million. After underwriters' fees and other expenses, we realized net
proceeds of approximately $665.6 million. On February 29, 2000, the underwriters
of this offering exercised an option to purchase an additional 803,109 shares of
common stock at the same price per share. As a result, we raised an additional
$56.2 million of gross proceeds and $54.1 million of net proceeds.

     In February 2000, we closed on $500.0 million of new Credit Facilities,
which replaced the $225 million revolving credit facility. The Credit Facilities
consist of a $350.0 million revolving credit facility and a $150.0 million
delayed draw term loan facility. The Credit Facilities are available, subject to
satisfaction of certain terms and conditions, to provide purchase money
financing for network build-out, including the cost to develop, acquire and
integrate the necessary operations support and back office systems, as well as
for additional dark fiber purchases and central office collocations. Interest on
amounts drawn is variable, based on leverage ratios, and is expected to be the
London Interbank Offered Rate + 3.25%. The initial commitment fee on the unused
portion of the Credit Facilities will be 1.5% per annum, paid quarterly and will
be reduced based upon usage. The Credit Facilities contain certain
representations, warranties, covenants and events of default customary for
credit of this nature and otherwise agreed upon by the parties.

     In July 2000, we entered into an operating lease for office facilities for
our corporate headquarters in Dallas, Texas. The lease for the new office
facility has an initial term of approximately twelve years.

     We believe that the our current capital resources are sufficient to fund
operating expenses, capital expenditures, and debt service requirements.

FORWARD-LOOKING STATEMENTS

     Certain statements in this Management's Discussion and Analysis of
Financial Condition and Results of Operations constitute "forward-looking
statements" within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and
Allegiance intends that such forward-looking statements be subject to the safe
harbors created thereby. You generally can identify these statements by our use
of forward-looking words such as "plans," "estimates,"





                                       17
<PAGE>   18
 "believes," "expects," "may," "will," "shall," "should," "projected," or
"anticipates" or the negative or other variations of such terms or comparable
terminology, or by discussion of strategy that involve risks and uncertainties.
We often use these types of statements when discussing our plans and strategies,
our anticipation of revenues and statements regarding the development of our
businesses, the markets for our services and products, acquisitions, our
anticipated capital expenditures, operations support systems or changes in
regulatory requirements and other statements contained in this report regarding
matters that are not historical facts. We caution you that these forward-looking
statements are only predictions and estimates regarding future events and
circumstances. We cannot assure you that we will achieve the future results
reflected in these statements. The risks we face that could cause us not to
achieve these results include, but are not limited to, our ability to do the
following in a timely manner, at reasonable costs and on satisfactory terms and
conditions: (1) successfully market our services to current and new customers;
(2) interconnect with and develop cooperative working relationships with ILECs
and withstand interruptions in their operations; (3) develop efficient
operations support systems and other back office systems; (4) successfully and
efficiently transfer new customers to our networks and access new geographic
markets; (5) identify, finance and complete suitable acquisitions; (6) borrow
under our credit facilities or borrow under alternative financing sources; (7)
install new switching facilities and other network equipment; (8) electronically
bond with ILECs; (9) obtain leased fiber optic line capacity, rights-of-way,
building access rights and any required governmental authorizations, franchises
and permits; and (10) collect interexchange access and reciprocal compensation
charges at the rates charged by us. Regulatory, legislative and judicial
developments could also cause actual results to differ materially from the
future results reflected in such forward-looking statements. You should consider
all of our subsequent written and oral forward-looking statements only in light
of such cautionary statements. You should not place undue reliance on these
forward-looking statements and you should understand that they represent
management's view only as of the dates we make them.

RISK FACTORS

We Could Lose Revenue if Calls to Internet Service Providers Are Treated As Long
Distance Interstate Calls

     We earn "reciprocal compensation" revenue by terminating on our network,
local calls that originate on another carrier's network. We believe that other
local exchange carriers should have to compensate us when their customers place
calls to Internet service providers who are our customers. Most incumbent local
exchange carriers disagree. A majority of our reciprocal compensation revenues
are from calls to our customers that are Internet service providers. Regulatory
decisions providing that other carriers do not have to compensate us for these
calls could limit our ability to service this group of customers profitably and
could have a material adverse effect on Allegiance. Given the uncertainty as to
whether reciprocal compensation should be payable in connection with calls to
Internet service providers, we recognize such revenue only when realization of
it is certain, which in most cases is upon receipt of cash. In addition, we
anticipate that the per minute reciprocal compensation rate we receive from
ILECs under our new interconnection agreements will be lower than it was under
our previous agreements. These reductions in reciprocal compensation will have a
material adverse effect on us if we are unable to offset them with other
revenues.

     The obligation to pay reciprocal compensation does not extend to long
distance interstate calls. The FCC in its Declaratory Ruling of February 26,
1999, determined that Internet service provider traffic is interstate for
jurisdictional purposes, but also determined that its current rules neither
require nor prohibit the payment of reciprocal compensation for such calls. In
the absence of a federal rule, the FCC determined that state commissions have
authority to interpret and enforce the reciprocal compensation provisions of
existing interconnection agreements and to determine the appropriate treatment
of Internet service provider traffic in arbitrating new agreements. The Court of
Appeals for the District of Columbia Circuit issued a decision on March 24,
2000, vacating the Declaratory Ruling. The court held that the FCC had not
adequately explained its conclusion that calls to Internet service providers
should not be treated as "local" traffic. Allegiance views this decision as
favorable, but the court's direction to the FCC to re-examine the issue will
likely result in further delay in the resolution of pending compensation
disputes, and there can be no assurance as to the ultimate outcome of these
proceedings or as to the timing of such outcome. Currently, over 30 state
commissions and several federal and state courts have ruled that reciprocal
compensation arrangements do apply to calls to Internet service providers, while
six jurisdictions have ruled to the contrary. A number of these rulings are
subject to appeal. Additional disputes over the appropriate treatment of
Internet service provider traffic are pending in other states and federal
legislation seeking to resolve this issue has been and continues to be proposed
and considered.

The Regulation of Access Charges Involves Uncertainties, and the Resolution of
These Uncertainties Could Adversely Affect Our Business

     We earn "access charge" revenue by connecting our voice service customers
to their selected long distance carriers for outbound calls or by delivering
inbound long distance traffic to our voice service customers. Our interstate
access charges were filed largely mirroring those used by the National Exchange
Carrier Association (NECA), an association of independent local exchange
carriers



                                       18
<PAGE>   19


and our state access charges were generally set the same as those of state
associations similar to NECA or of individual ILECs operating in other areas
within the same state. These charges are generally higher than those charged by
the larger ILECs operating in the same areas because these large ILECs have many
more customers and therefore have lower per unit costs. Access charges are
intended to compensate the local exchange carrier for the costs incurred in
originating and terminating long distance calls on its network and we believe
our access charges are appropriately set at levels approximately the same as
those of the smaller ILECs. Access charge levels in general, and those charged
by CLECs in particular, are subject to various disputes and are under review by
the FCC.

     AT&T has challenged the switched access rates of Allegiance and other CLECs
and has withheld some or all payments for the switched access services that they
continue to receive. AT&T has asserted that they have not ordered switched
access service from us and/or that our charges for switched access services are
higher than those of the ILEC serving the same territory and are therefore
unjust and unreasonable. AT&T has refused to pay us any originating access
charges at our tariffed rates. Given the uncertainty as to whether such amounts
will ultimately be paid to Allegiance by AT&T, we recognize such access revenues
from these carriers only when realization of it is certain, which in most cases
is upon receipt of cash. On March 30, 2000, we filed a lawsuit against each of
AT&T and Sprint in the Federal District Court of the District of Columbia
requesting that such parties pay us for outstanding interstate and intrastate
access charges. AT&T and Sprint filed counterclaims against us alleging that our
access charges fail to comply with the Telecom Act because they are unjust and
unreasonable. We have settled this dispute with Sprint and in doing so have
reached an agreement with respect to access charges payable by them for
originating and terminating calls on our local networks. Although we believe we
will ultimately receive payment for AT&T for the amounts owed to us by them, we
cannot provide any assurance as to the amount of payments that we will
ultimately receive, the actual outcome of the FCC proceedings or our lawsuits or
the positions various states will take on the similar issue of intrastate
switched access rates. If we do not receive payment from AT&T for interstate and
intrastate access charges that we believe are owed to us, this will have a
material adverse effect on us unless we are able to offset this access revenue
with other revenues. In addition, our switched access rates will have to be
adjusted to comply with future decisions of the FCC or state commissions and
these adjustments could have a material adverse effect on Allegiance.

     On July 5, 1999, the FCC issued a ruling to address the issue of CLEC
access charges in the context of a complaint filed by MGC Communications, Inc.
(now known as Mpower Communications), a CLEC that had not been receiving
payments from AT&T. In that ruling, the FCC stated that "AT&T is liable to MGC,
at MGC's tariffed rate, for the originating access service that it received . .
 ." The FCC indicated that AT&T had no obligation to purchase access from MGC
based on the arguments that MGC had made, but the FCC also made clear that there
may be other requirements that could limit AT&T's ability to not purchase such
access from a CLEC. In response to that FCC decision, AT&T filed a Petition for
Review with the FCC, which was denied on December 28, 1999. The FCC is also
reviewing the switched access rate level issue and related matters in its Access
Charge Reform docket. In this docket, the FCC has requested comment as to
whether interexchange carriers may refuse to purchase switched access services
from particular carriers. Allegiance is an active participant in that
proceeding.

     On May 31, 2000, the FCC approved a proposal made by a coalition of the
largest ILECs, AT&T and Sprint to restructure interstate access charges.
Pursuant to the proposal, price cap ILECs are required to reduce their
interstate access rates to targeted levels approved by the FCC or submit cost
studies to justify different rates. We anticipate that implementation of the
FCC's decision will lead to an industry wide reduction in interstate access
rates, even by those carriers that are not bound by the decision, including
smaller ILECs and CLECs. Reduction in interstate access rates will have a
material adverse effect on Allegiance unless we are able to offset the access
revenue with other revenues.

     Several states, including Colorado, Maryland, Massachusetts, Missouri, New
Jersey, New York, Texas, Virginia and Washington, have proposed or required that
CLEC access charges be limited to those charged by ILECs operating in the same
area as the CLEC with respect to calls originating or terminating in such area,
except where the CLEC in question can establish that its costs justify a higher
access rate through a formal cost proceeding. We believe that it is possible
that other states will enact similar requirements. We also believe, however,
that it is more likely that many states will use the same approach for
intrastate long distance as the FCC ultimately decides to use for interstate
long distance.

Our Limited History of Operations May Not Be a Reliable Basis for Evaluating Our
Prospects

     Because of our short operating history, you have limited operating and
financial data that you can use to evaluate our performance and determine
whether you should invest in our common stock.




                                       19
<PAGE>   20




If We Do Not Effectively Manage Rapid Expansion of Our Business, Our Financial
Condition Will Suffer

     We are rapidly expanding our operations and providing bundled
telecommunications services on a widespread basis. This continued rapid
expansion may place a significant strain on our management, financial and other
resources. If we fail to manage our growth effectively, we may not be able to
expand our customer base and service offerings as we have planned.

Our Success Depends on Our Key Personnel and We May Not Be Able to Replace Key
Executives Who Leave

     We are managed by a small number of key executive officers, most notably
Royce J. Holland, our Chairman and Chief Executive Officer. The loss of services
of one or more of these key individuals, particularly Mr. Holland, could
materially and adversely affect our business and our prospects. Most of our
executive officers do not have employment agreements, and we do not maintain key
person life insurance for any of our executive officers. The competition for
qualified personnel in the telecommunications industry is intense. For this
reason, we cannot assure you that we will be able to hire or retain necessary
personnel in the future.

We Are Dependent on Effective Billing, Customer Service and Information Systems
and We May Have Difficulties in Developing These Systems

     Sophisticated back office information and processing systems are vital to
our growth and our ability to monitor costs, bill customers, initiate, implement
and track customer orders and achieve operating efficiencies. We cannot assure
you that these systems will be successfully implemented on a timely basis or at
all or will perform as expected because:

     o    we have and will likely continue to have difficulties in getting
          products and services from our vendors delivered in a timely and
          effective manner, at acceptable costs and at the service and
          performance level required;

     o    we may fail to adequately identify all of our information and
          processing needs;

     o    our processing or information systems may fail or be inadequate;

     o    we may not be able to effectively integrate such products or services;

     o    we may fail to upgrade systems as necessary; and

     o    third party vendors may cancel or fail to renew license agreements
          that relate to these systems.

Under Certain Circumstances We May Need Additional Capital to Expand Our
Business and Increase Revenue

     We may need additional capital to fund capital expenditures, working
capital, debt service and cash flow deficits during the period in which we are
expanding and developing our business and deploying our networks, services and
systems. We believe that the borrowings expected to be available under our
credit facilities, together with our cash on hand, will be sufficient to
pre-fund our expanded business plan. However, we will only be able to borrow
under these credit facilities if we are in compliance with the financial
covenants and other conditions. In the event we cannot borrow under these credit
facilities, we may need to access alternative sources of capital. If we are
unable to do so we may not be able to expand as we expect, which may have an
adverse effect on us.

     The actual amount and timing of our future capital requirements may differ
materially from our estimates as a result of financial, business and other
factors, many of which are beyond our control, as well as prevailing economic
conditions.

Our Substantial Indebtedness Could Make Us Unable to Service Indebtedness and
Meet Our Other Requirements and Could Adversely Affect Our Financial Health

     We have a significant amount of debt outstanding and plan to access
additional debt financing to fund our expanded business plan, including under
our credit facilities that closed in February 2000. On September 30, 2000, we
had $549.9 million of outstanding indebtedness and $1,018.9 million of
stockholders' equity.

     This level of debt could:

     o    impair our ability to obtain additional financing for working capital,
          capital expenditures, acquisitions or general corporate purposes;





                                       20
<PAGE>   21

     o    require us to dedicate a substantial portion of our cash flow from
          operations to the payment of principal and interest on our
          indebtedness, thereby reducing the funds available for the growth of
          our networks;

     o    place us at a competitive disadvantage with those of our competitors
          who do not have as much debt as we do;

     o    impair our ability to adjust rapidly to changing market conditions;
          and

     o    make us more vulnerable if there is a downturn in general economic
          conditions or in our business.

     We cannot assure you that we will be able to meet our working capital,
capital expenditure and debt service requirements.

Limitations Imposed by Restrictive Covenants Could Limit How We Conduct Business
and a Default Under Our Indentures and Financing Agreements Could Significantly
Impact Our Ability to Repay Our Indebtedness

     Our indentures and our credit facilities contain covenants that restrict
our ability to:

     o    incur additional indebtedness;

     o    pay dividends and make other distributions;

     o    prepay subordinated indebtedness;

     o    make investments and other restricted payments;

     o    enter into sale and leaseback transactions;

     o    create liens;

     o    sell assets; and

     o    engage in certain transactions with affiliates.

     Our current and future financing arrangements contain and will continue to
contain similar or more restrictive covenants, as well as other covenants that
will require us to maintain specified financial ratios and satisfy financial
tests. As a result of these restrictions, we are limited in how we conduct
business and we may be unable to raise additional debt or equity financing to
operate during general economic or business downturns, to compete effectively or
to take advantage of new business opportunities. This may affect our ability to
generate revenues and make profits. Without sufficient revenues and cash, we may
not be able to pay interest and principal on our indebtedness.

     Our failure to comply with the covenants and restrictions contained in our
indentures and other financing agreements could lead to a default under the
terms of these agreements. If such a default occurs, the other parties to such
agreements could declare all amounts borrowed and all amounts due under other
instruments that contain provisions for cross-acceleration or cross-default due
and payable. In addition, lenders under our current and future financing
arrangements could terminate their commitments to lend to us. If that occurs, we
cannot assure you that we would be able to make payments on our indebtedness,
meet our working capital or meet our capital expenditure requirements, or that
we would be able to find additional alternative financing. Even if we could
obtain additional alternative financing, we cannot assure you that it would be
on terms that are favorable or acceptable to us.

We May Not Have the Funds Necessary to Finance the Change of Control Offer Which
May Be Required By Our Financing Agreements

     Our indentures provide that upon a change of control, each note holder will
have the right to require us to purchase all or a portion of such holder's
notes. We would be required to purchase the notes at a purchase price of 101% of
the accreted value of the 11 3/4% notes and 101% of the principal amount of the
12 7/8% notes, plus any accrued and unpaid interest to the date of repurchase.
Our credit facilities provides that upon a change of control, we may be required
to repay all of our obligations under these credit facilities. It is possible
that we will not have sufficient funds at that time to repurchase our notes or
repay any debt outstanding under our credit facilities.




                                       21
<PAGE>   22


If We Do Not Interconnect with and Maintain Efficient Working Relationships with
Our Primary Competitors, the Incumbent Local Exchange Carriers, Our Business
Will Be Adversely Affected

     Many new carriers, including Allegiance, have experienced difficulties in
working with the incumbent local exchange carriers with respect to initiating,
interconnecting, and implementing the systems used by these new carriers to
order and receive unbundled network elements and wholesale services and locating
the new carriers' equipment in the offices of the incumbent local exchange
carriers. As a new carrier, we must coordinate with incumbent local exchange
carriers so that we can provide local service to customers on a timely and
competitive basis. The Telecommunications Act created incentives for regional
Bell operating companies to cooperate with new carriers and permit access to
their facilities by denying such companies the ability to provide in-region long
distance services until they have satisfied statutory conditions designed to
open their local markets to competition. The FCC recently granted approval to
Verizon (f/k/a Bell Atlantic) to provide in-region long distance service in New
York and to SBC Communications to provide in-region long distance service in
Texas. Other regional Bell operating companies in our markets may petition and
receive approval from the FCC to offer long distance services. These companies
may not be accommodating to us once they are permitted to offer long distance
service. If we cannot obtain the cooperation of a regional Bell operating
company in a region, whether or not it has been authorized to offer long
distance service or a regional Bell operating company otherwise fails to meet
our requirements, for example, because of labor shortages, work stoppages or
disruption caused by mergers or other organizational changes, our ability to
offer local services in such region on a timely and cost-effective basis will be
adversely affected.

If We Do Not Obtain Peering Arrangements with Internet Service Providers, the
Profitability of Our Internet Access Services Will Suffer

     The profitability of our Internet access services, and related services
such as Web site hosting, may be adversely affected if we are unable to obtain
"peering" arrangements with Internet service providers. In the past, major
Internet service providers routinely exchanged traffic with other Internet
service providers that met technical criteria on a "peering" basis, meaning that
each Internet service provider accepted traffic routed to Internet addresses on
their system from their "peers" on a reciprocal basis, without payment of
compensation. However, since 1997 UUNET Technologies, Inc., the largest Internet
service provider, has been greatly restricting the use of peering arrangements
with other providers and has been imposing charges for accepting traffic from
providers other than its "peers". Other major Internet service providers have
adopted similar policies. Although we currently have peering arrangements, we
cannot assure you that we will be able to negotiate "peer" status in the future,
or that we will be able to terminate traffic on Internet service providers'
networks at favorable prices.

Our Offering of Long Distance Services Is Affected By Our Ability to Establish
Effective Resale Agreements

     We offer long distance services as part of our "one-stop shopping" offering
of bundled telecommunications services to our customers. We have relied and will
continue to rely on other carriers to provide transmission and termination
services for all of our long distance traffic. We will continue to enter into
resale agreements with long distance carriers to provide us with transmission
services. Such agreements typically provide for the resale of long distance
services on a per-minute basis and may contain minimum volume commitments.
Negotiation of these agreements involves estimates of future supply and demand
for transmission capacity as well as estimates of the calling pattern and
traffic levels of our future customers. If we fail to meet our minimum volume
commitments, we may be obligated to pay underutilization charges and if we
underestimate our need for transmission capacity, we may be required to obtain
capacity through more expensive means.

The Need to Move from Tariffs to Individual Contracts for Domestic Interstate
Long Distance Services May Increase Our Costs.

     In a decision issued April 28, 2000, the United States Court of Appeals for
the District of Columbia affirmed the FCC's 1996 order that prohibits the filing
of tariffs for domestic interstate long distance service. The FCC's order, which
had been stayed by the Court pending its decision, goes into effect on April 30,
2001, as of which date carriers must cancel all interstate domestic long
distance tariffs on file with the FCC and file no new tariffs for such service.
Although the FCC will not accept interstate long distance tariffs for filing
after April 30, 2001, carriers will still be required to maintain and make
available to the public upon request the rates, terms and conditions applicable
to their domestic long distance services. In the absence of retail tariffs,
Allegiance will be required to memorialize its legal relationship with its long
distance customers by some other means, such as individual contracts setting
forth the rates, terms and conditions of service. Negotiating individual
contracts in this manner is likely to increase our cost of providing domestic
interstate long distance services.




                                       22
<PAGE>   23

Our Principal Competitors for Local Services, the Incumbent Local Exchange
Carriers, and Potential Additional Competitors, Have Advantages that May
Adversely Affect Our Ability to Compete with Them

     The telecommunications industry is highly competitive. Many of our current
and potential competitors in the local market have financial, technical,
marketing, personnel and other resources, including brand name recognition,
substantially greater than ours, as well as other competitive advantages over
us. In each of the markets targeted by us, we will compete principally with the
ILEC serving that area. These ILECs enjoy advantages that may adversely affect
our ability to compete with them. Incumbent local exchange carriers are
established providers of local telephone services to all or virtually all
telephone subscribers within their respective service areas. Incumbent local
exchange carriers also have long-standing relationships with federal and state
regulatory authorities. FCC and state administrative decisions and initiatives
provide the incumbent local exchange carriers with pricing flexibility for
their:

     o    private lines, which are private, dedicated telecommunications
          connections between customers;


     o    special access services, which are dedicated lines from a customer to
          a long distance company provided by the local phone company; and

     o    switched access services, which refers to the call connection provided
          by the local phone company's switch between a customer's phone and the
          long distance company's switch.

     In addition, with respect to competitive access services, such as special
access services as opposed to switched access services, the FCC recently
approved incumbent local exchange carriers increased pricing flexibility and
deregulation for such access services after certain competitive levels are
reached. If the incumbent local exchange carriers are allowed by regulators to
offer discounts to large customers through contract tariffs, engage in
aggressive volume and term discount pricing practices for their customers,
and/or seek to charge competitors excessive fees for interconnection to their
networks, competitors such as us could be materially adversely affected. If
future regulatory decisions afford the incumbent local exchange carriers
increased pricing flexibility or other regulatory relief, such decisions could
also have a material adverse effect on competitors such as us.

     We also face, and expect to continue to face, competition in the local
market from other current and potential market entrants, including long distance
carriers seeking to enter, reenter or expand entry into the local exchange
marketplace such as AT&T, WorldCom and Sprint, and from other CLECs, resellers,
competitive access providers, cable television companies, electric utilities,
microwave carriers, wireless telephone system operators and private networks
built by large end users. In addition, the development of new technologies could
give rise to significant new competitors in the local market.

Significant Competition in Providing Long Distance and Internet Services Could
Reduce the Demand for and Profitability of Our Services

     We also face significant competition in providing long distance and
Internet services. Many of these competitors have greater financial,
technological, marketing, personnel and other resources than those available to
us.

     The long distance telecommunications market has numerous entities competing
for the same customers and a high average turnover rate, as customers frequently
change long distance providers in response to the offering of lower rates or
promotional incentives. Prices in the long distance market have declined
significantly in recent years and are expected to continue to decline. We face
competition from large carriers such as AT&T, WorldCom and Sprint and many
smaller long distance carriers. Other competitors are likely to include regional
Bell operating companies providing long distance services outside of their local
service area and, with the removal of regulatory barriers, long distance
services within such local service areas, other competitive local exchange
carriers, microwave and satellite carriers and private networks owned by large
end users. The FCC has recently granted approval to provide in-region long
distance service to Verizon (f/k/a Bell Atlantic) in New York and to SBC
Communications in Texas, and other regional Bell operating companies may
petition and be granted such approval in the future. We may also increasingly
face competition from companies offering local and long distance data and voice
services over the Internet. Such companies could enjoy a significant cost
advantage because they do not currently pay many of the charges or fees that we
have to pay.

     The Internet services market is highly competitive and there are limited
barriers to entry. We expect that competition will continue to intensify. Our
competitors in this market include Internet service providers, other
telecommunications companies, online service providers and Internet software
providers. Most of the regional Bell operating companies and GTE Corporation
operating units have





                                       23
<PAGE>   24

announced plans to rapidly roll out DSL services. Some of these entities,
including SBC Communications, Qwest (f/k/a US West) and Bell Atlantic, have
already commenced deployment of DSL services in selected markets and may in the
future deploy DSL services on a widespread basis.

Our Need to Comply with Extensive Government Regulation Can Increase Our Costs
and Slow Our Growth

     Our networks and the provision 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 slow our growth and have a material
adverse effect upon us.

     The FCC exercises jurisdiction over us with respect to interstate and
international services. We must obtain, and have obtained through our
subsidiary, Allegiance Telecom International, Inc., prior FCC authorization for
installation and operation of international facilities and the provision,
including by resale, of international long distance services. Additionally, we
file publicly available tariffs detailing our services and pricing with the FCC
for both international and domestic long-distance services. As noted above, as
of April 30, 2001, we will be prohibited from filing tariffs with the FCC for
domestic interstate long distance service and will be required to cancel any
such tariffs on file as of that date. There is no change in our obligation to
file tariffs with the FCC for international services. The FCC, however, has
introduced a Notice of Proposed Rulemaking requesting comment on whether it
should similarly prohibit the filing of tariffs for international long distance
services.

     State regulatory commissions exercise jurisdiction over us because we
provide intrastate services. We are required to obtain regulatory authorization
and/or file tariffs at state agencies in most of the states in which we operate.
If and when we seek to build our own network segments, local authorities
regulate our access to municipal rights-of-way. Constructing a network is also
subject to numerous local regulations such as building codes and licensing. Such
regulations vary on a city by city and county by county basis.

     Regulators at both the federal and state level require us to pay various
fees and assessments, file periodic reports, and comply with various rules
regarding the contents of our bills, protection of subscriber privacy, and
similar matters on an ongoing basis.

     We cannot assure you that the FCC or state commissions will grant required
authority or refrain from taking action against us if we are found to have
provided services without obtaining the necessary authorizations, or to have
violated other requirements of their rules and orders. Regulators or others
could challenge our compliance with applicable rules and orders. Such challenges
could cause us to incur substantial legal and administrative expenses.

Deregulation of the Telecommunications Industry Involves Uncertainties, and the
Resolution of These Uncertainties Could Adversely Affect Our Business

     The Telecommunications Act provides for a significant deregulation of the
domestic telecommunications industry, including the local exchange, long
distance and cable television industries. The Telecommunications Act remains
subject to judicial review and additional FCC rulemaking, and thus it is
difficult to predict what effect the legislation will have on us and our
operations. There are currently many regulatory actions underway and being
contemplated by federal and state authorities regarding interconnection pricing
and other issues that could result in significant changes to the business
conditions in the telecommunications industry. We cannot assure you that these
changes will not have a material adverse effect upon us.

The Regulation of Interconnection with Incumbent Local Exchange Carriers
Involves Uncertainties, and the Resolution of These Uncertainties Could
Adversely Affect Our Business

     Although the incumbent local exchange carriers are required under the
Telecommunications Act to unbundle and make available elements of their network
and permit us to purchase only the origination and termination services that we
need, thereby decreasing our operating expenses, such unbundling may not be done
as quickly as we require and may be priced higher than we expect. This is
important because we rely on the facilities of these other carriers to connect
to our high capacity digital switches so that we can provide services to our
customers. Our ability to obtain these interconnection agreements on favorable
terms, and the time and expense involved in negotiating them, can be adversely
affected by legal developments.

     A recent Supreme Court decision vacated a FCC rule determining which
network elements the incumbent local exchange carriers must provide to
competitors on an unbundled basis. On November 5, 1999, the FCC released an
order revising its unbundled network element rules to conform to the Supreme
Court's interpretation of the law, and reaffirmed the availability of the basic
network elements, such as loops and dedicated transport, used by Allegiance. It
is likely that this order may be subject to further agency





                                       24
<PAGE>   25

reconsideration and/or court review. While these court and FCC proceedings were
pending, Allegiance entered into interconnection agreements with a number of
ILECs through negotiations or, in some cases, adoption of another CLEC's
approved agreement. These agreements remain in effect, although in some cases
one or both parties may be entitled to demand renegotiation of particular
provisions based on intervening changes in the law. However, it is uncertain
whether any of these agreements will be so renegotiated or whether Allegiance
will be able to obtain renewal of these agreements on favorable terms when they
expire.

     On July 19, 2000, in a decision on remand from the Supreme Court, the
United States Court of Appeals for the Eighth Circuit vacated certain of the
FCC's total element long run incremental (TELRIC) pricing rules. While
sustaining the FCC's use of a forward-looking incremental cost methodology to
set rates for interconnection and unbundled network elements, the Court rejected
the FCC's conclusion that the costs should be based on the use of the most
efficient technology currently available and the lowest cost network
configuration. Instead, the Court stated that the statute required that costs be
based on the use of the incumbent local exchange carrier's existing facilities
and actual network equipment but that these costs should not be based on the
historic costs actually paid by such carrier for network elements. The Court
also found that the FCC erred in using avoidable, rather than actually avoided,
costs to calculate the wholesale discount for resale products. Interconnection
and unbundled network element rates set using the Court's methodology may be
higher than and the wholesale discounts set using the Court's methodology may be
lower than the comparable rates established using the FCC's methodology. The FCC
and other parties have filed Petitions for Cetiorari requesting that the Supreme
Court review the Eighth Circuit's Decision. The Eighth Circuit in turn has
stayed issuance of the mandate vacating the TELRIC rules pending disposition of
the Petitions for Certiorari. It is difficult to evaluate the potential impact
of this ruling on the prices Allegiance pays ILECs for unbundled network
elements until the Supreme Court rules. Allegiance believes that the pricing of
unbundled network elements approved by many state commissions and reflected in
many of Allegiance's interconnection agreements is already materially in
compliance with the standard set forth in the Eighth Circuit's ruling. This
ruling could have a material adverse effect on Allegiance, however, if it is
interpreted to authorize materially higher charges for unbundled network
elements than those prevailing in Allegiance's current interconnection
agreements.

If We Do Not Continually Adapt to Technological Change, We Could Lose Customers
and Market Share

     The telecommunications industry is subject to rapid and significant changes
in technology, and we rely on outside vendors for the development of and access
to new technology. The effect of technological changes on our business cannot be
predicted. We believe our future success will depend, in part, on our ability to
anticipate or adapt to such changes and to offer, on a timely basis, services
that meet customer demands. We cannot assure you that we will obtain access to
new technology on a timely basis or on satisfactory terms. Any failure by us to
obtain new technology could cause us to lose customers and market share.

We Face Potential Conflicts of Interest Caused by Fund Investor Control Which
Could Be Detrimental to Holders of Our Securities

     You should be aware that the investment funds that provided our initial
equity hold a majority of our board seats and a significant amount of our common
stock and that as a result, our direction and future operations may be
controlled by these funds. In addition, Vulcan Ventures purchased six million
shares (as adjusted for our 3-for-2 stock split effected on February 28, 2000)
of our common stock from existing stockholders and in connection with that
transaction, Allegiance agreed to nominate two Vulcan Ventures designated
directors to Allegiance's board. As a result of these relationships, decisions
concerning our operations or financial structure may present conflicts of
interest between these investors and our management and other holders of our
securities, including our notes. In addition to their investments in us, these
investors or their affiliates currently have significant investments in other
telecommunications companies and may in the future invest in other entities
engaged in the telecommunications business or in related businesses, including
entities that compete with us. Conflicts may also arise in the negotiation or
enforcement of arrangements entered into by us and entities in which these
investors have an interest.

Future Sales of Our Stock by Existing Stockholders May Adversely Affect Our
Stock Price

     As of November 10, 2000, we had 109,940,441 million shares of common stock
outstanding. Many of these shares are "restricted securities" under the federal
securities laws, and such shares are or will be eligible for sale subject to
restrictions as to timing, manner, volume, notice and the availability of
current public information regarding Allegiance. Sales of substantial amounts of
stock in the public market, or the perception that sales could occur, could
depress the prevailing market price for our stock. Sales may also make it more
difficult for us to sell equity securities or equity-related securities in the
future at a time and price that we deem appropriate.





                                       25
<PAGE>   26

Anti-Takeover Provisions in Allegiance's Charter and Bylaws Could Limit Our
Share Price and Delay a Change of Management

     Our certificate of incorporation and by-laws contain provisions that could
make it more difficult or even prevent a third party from acquiring Allegiance
without the approval of our incumbent board of directors.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Our investment policy is limited by our existing bond indentures. We are
restricted to investing in financial instruments with a maturity of one year or
less. The indentures require investments in high quality instruments, such as
obligations of the U.S. Government or any agency thereof guaranteed by the
United States of America, money market deposits and commercial paper with a
rating of A1/P1.

     We are thus exposed to market risk related to changes in short-term U.S.
interest rates. We manage these risks by closely monitoring market rates and the
duration of our investments. We do not enter into financial or commodity
investments for speculation or trading purposes and are not a party to any
financial or commodity derivatives.

     Interest income earned on our investment portfolio is affected by changes
in short-term interest rates. We believe that we are not exposed to significant
changes in fair value because of our conservative investment strategy. However,
the estimated interest income for 2000, based on the estimated average 1999
earned rate on investments is $44.9 million. Assuming a 100 basis point drop in
the estimated average rate, we would be exposed to a $8.8 million reduction in
interest income for the year. The following table illustrates this impact on a
quarterly basis:

<TABLE>
<CAPTION>
                                                                     QUARTER ENDING
                                                   -----------------------------------------------
                                                    MARCH         JUNE      SEPTEMBER     DECEMBER
                                                     2000         2000         2000         2000        TOTAL
                                                   --------     --------    ---------     --------     --------
                                                                        (DOLLARS IN MILLIONS)
<S>                                                <C>          <C>          <C>          <C>          <C>
Estimated average investments ................     $  821.3     $1,039.6     $  896.3     $  762.9          N/A
Estimated average interest earned at the
  estimated average rate of 5.1% for the
  year ended December 31, 1999 ...............     $   10.5     $   13.3     $   11.4     $    9.7     $   44.9
Estimated impact of interest rate drop .......     $    2.1     $    2.6     $    2.2     $    1.9     $    8.8
</TABLE>

     Our outstanding long-term debt consists principally of long-term, fixed
rate notes, not subject to interest rate fluctuations.






                                       26
<PAGE>   27





                           PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     Not applicable.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

     Not applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

     Not applicable.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     Not applicable.

ITEM 5. OTHER INFORMATION

     Not applicable.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

     (a) The following exhibits are filed with this report and made a part
hereof.

<TABLE>
<CAPTION>
EXHIBIT
NUMBER         DESCRIPTION
-------        -----------
<S>            <C>
  11.1         -- Statement regarding computation of per share loss for the
                    three months ended September 30, 2000

  11.2         -- Statement regarding computation of per share loss for the nine
                    months ended September 30, 2000

  11.3         -- Statement regarding computation of per share loss for the
                    three months ended September 30, 1999

  11.4         -- Statement regarding computation of per share loss for the nine
                    months ended September 30, 1999

  27.1         -- Financial Data Schedule
</TABLE>



                                       27
<PAGE>   28





                                   SIGNATURES

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

ALLEGIANCE TELECOM, INC.

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

Dated: November 14, 2000





                                       28
<PAGE>   29


                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
NUMBER         DESCRIPTION
-------        -----------
<S>            <C>
  11.1         -- Statement regarding computation of per share loss for the
                    three months ended September 30, 2000

  11.2         -- Statement regarding computation of per share loss for the nine
                    months ended September 30, 2000


  11.3         -- Statement regarding computation of per share loss for the
                    three months ended September 30, 1999

  11.4         -- Statement regarding computation of per share loss for the nine
                    months ended September 30, 1999

  27.1         -- Financial Data Schedule
</TABLE>