**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

| **(Mark One)** |
|----------------|
| **ý**     | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|           |   |
|           | **For the Quarterly Period Ended June 30, 2004** |
|           |
| **or**         |
|           |   |
| **o**          | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|           |   |
|           | **For the transition period                     to                   ** |
|           |   |
|           | **Commission file number 0-20763** |

 

**McLEODUSA INCORPORATED**

(Exact name of registrant asspecified in its charter)

 
| **Delaware**                                                                       | ** ** | **42-1407240**                     |
|------------------------------------------------------------------------------------|------------|------------------------------------|
| (State of Incorporation)                                                           |       | (IRS Employer Identification  No.) |
| ** **                                                                         | ** ** | ** **                         |
| **McLeodUSA Technology Park  6400 C Street SW  P.O. Box 3177  Cedar Rapids, Iowa** | ** ** | **52406-3177**                     |
| (Address of principal executive  office)                                           |       | (Zip Code)                         |
|                                                                               |       |                               |
| **319-364-0000**                                                                   |
| (Registrant’s telephone number,  including area code)                         |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90days.    Yes  ý   No   ̈

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act). Yes  ý   No   ̈

 

Indicate by checkmark whether the registrant has filed all documents and reports required to befiled by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934subsequent to the distribution of securities under a plan confirmed by acourt.   Yes  ý   No   ̈

 

The number of shares outstanding of each class of the issuer’s commonstock as of July 30, 2004:

 

| Common Stock Class A:  ($0.01 par value) |   | 179,333,323 shares |
|-----------------------------------------------|--------|--------------------|
| Common Stock Class B:  ($0.01 par value) |   | 78,203,135 shares  |
| Common Stock Class C:  ($0.01 par value) |   | 35,546,879 shares  |

 

 

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**McLEODUSA INCORPORATED AND SUBSIDIARIES**

**INDEX**

 
| **PART I.  Financial Information** |                                                                                                                      |
|-----------------------------------------|---------------------------------------------------------------------------------------------------------------------------|
|                                    |                                                                                                                      |
| Item 1.                                 | Financial Statements                                                                                                      |   |
|                                    |                                                                                                                      |   |
|                                    | Condensed Consolidated  Balance Sheets, June 30, 2004 (unaudited) and December 31, 2003                         |   |
|                                    |                                                                                                                      |   |
|                                    | Unaudited  Condensed Consolidated Statements of Operations – for the three months ended  June 30, 2004 and 2003 |   |
|                                    |                                                                                                                      |   |
|                                    | Unaudited  Condensed Consolidated Statements of Operations – for the six months ended  June 30, 2004 and 2003   |   |
|                                    |                                                                                                                      |   |
|                                    | Unaudited  Condensed Consolidated Statements of Cash Flows – for the six months ended  June 30, 2004 and 2003   |   |
|                                    |                                                                                                                      |   |
|                                    | Notes to the Condensed Consolidated  Financial Statements                                                                 |   |
|                                    |                                                                                                                      |   |
| Item 2.                                 | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                               |   |
|                                    |                                                                                                                      |   |
| Item 3.                                 | Quantitative and Qualitative Disclosures  About Market Risk                                                               |   |
|                                    |                                                                                                                      |   |
| Item 4.                                 | Controls and Procedures                                                                                                   |   |
|                                    |                                                                                                                      |   |
| **PART  II.  Other Information**   |                                                                                                                      |
|                                    |                                                                                                                      |   |
| Item 1.                                 | Legal Proceedings                                                                                                         |   |
|                                    |                                                                                                                      |   |
| Item 4.                                 | Submission of Matters to a Vote of Security  Holders                                                                      |   |
|                                    |                                                                                                                      |   |
| Item 5.                                 | Other Information                                                                                                         |   |
|                                    |                                                                                                                      |   |
| Item 6.                                 | Exhibits and Reports on Form 8-K                                                                                          |   |
|                                    |                                                                                                                      |   |
| Signatures                              |                                                                                                                      |

 

2

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**PART I****– FINANCIAL INFORMATION**

**Item 1. Financial Statements**

 

**McLEODUSA INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE****SHEETS**

**(In millions, except share data)**

 
| ** **                                                                                                                                                                                                      | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                      | ** ** | **(unaudited)**         | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                      | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current assets                                                                                                                                                                                                  |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                       |       | $                       | 31.2       |                        | $          | 56.5 |   |
| Trade receivables, net                                                                                                                                                                                          |       | 68.0                    |       | 65.6                        |       |
| Prepaid expenses and other                                                                                                                                                                                      |       | 22.5                    |       | 22.4                        |       |
| Assets held for sale                                                                                                                                                                                            |       | 2.0                     |       | 2.0                         |       |
| Total current assets                                                                                                                                                                                            |       | 123.7                   |       | 146.5                       |       |
| Property and equipment                                                                                                                                                                                          |       |                    |       |                        |       |
| Land and buildings                                                                                                                                                                                              |       | 78.2                    |       | 78.6                        |       |
| Communications networks                                                                                                                                                                                         |       | 1,091.0                 |       | 996.3                       |       |
| Furniture, fixtures and equipment                                                                                                                                                                               |       | 203.9                   |       | 196.8                       |       |
| Networks in progress                                                                                                                                                                                            |       | 91.0                    |       | 171.6                       |       |
| Total property and equipment                                                                                                                                                                                    |       | 1,464.1                 |       | 1,443.3                     |       |
| Less accumulated depreciation                                                                                                                                                                                   |       | 580.0                   |       | 435.6                       |       |
| Net property and equipment                                                                                                                                                                                      |       | 884.1                   |       | 1,007.7                     |       |
| Intangibles and other assets                                                                                                                                                                                    |       |                    |       |                        |       |
| Goodwill                                                                                                                                                                                                        |       | 245.1                   |       | 245.1                       |       |
| Other intangibles, net                                                                                                                                                                                          |       | 183.1                   |       | 201.8                       |       |
| Other                                                                                                                                                                                                           |       | 25.3                    |       | 29.5                        |       |
| Total intangibles and other assets                                                                                                                                                                              |       | 453.5                   |       | 476.4                       |       |
| **TOTAL ASSETS**                                                                                                                                                                                                |       | $                       | 1,461.3    |                        | $          | 1,630.6 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                   |       |                    |       |                        |       |
| Current liabilities                                                                                                                                                                                             |       |                    |       |                        |       |
| Current maturities of long-term debt                                                                                                                                                                            |       | $                       | 31.3       |                        | $          | 27.1 |   |
| Accounts payable                                                                                                                                                                                                |       | 39.0                    |       | 30.5                        |       |
| Accrued payroll and payroll related  expenses                                                                                                                                                                   |       | 15.7                    |       | 20.6                        |       |
| Other accrued liabilities                                                                                                                                                                                       |       | 85.9                    |       | 100.9                       |       |
| Deferred revenue, current portion                                                                                                                                                                               |       | 6.2                     |       | 6.9                         |       |
| Liabilities related to discontinued  operations                                                                                                                                                                 |       | 0.3                     |       | 1.1                         |       |
| Total current liabilities                                                                                                                                                                                       |       | 178.4                   |       | 187.1                       |       |
| Long-term debt, less current maturities                                                                                                                                                                         |       | 726.7                   |       | 717.3                       |       |
| Deferred revenue, less current portion                                                                                                                                                                          |       | 17.0                    |       | 15.1                        |       |
| Other long-term liabilities                                                                                                                                                                                     |       | 60.0                    |       | 58.3                        |       |
| Total liabilities                                                                                                                                                                                               |       | 982.1                   |       | 977.8                       |       |
| Redeemable convertible preferred stock                                                                                                                                                                          |       |                    |       |                        |       |
| McLeodUSA Preferred Series A, redeemable,  convertible, $0.01 par value; 10,000,000 authorized and issued; 6,760,846 and  7,377,149 outstanding at June 30, 2004 and December 31, 2003,  respectively |       | 121.7                   |       | 131.1                       |       |
| Stockholders’ equity                                                                                                                                                                                       |       |                    |       |                        |       |
| McLeodUSA Common, Class A $0.01 par value;  1,886,249,986 authorized, 178,658,259 and 175,527,257 issued and outstanding  at June 30, 2004 and December 31, 2003, respectively                        |       | 1.8                     |       | 1.8                         |       |
| McLeodUSA Common, Class B $0.01 par value;  78,203,135 authorized, issued and outstanding at June 30, 2004 and  December 31, 2003                                                                     |       | 0.8                     |       | 0.8                         |       |
| McLeodUSA Common, Class C $0.01 par value;  35,546,879 authorized, issued and outstanding at June 30, 2004 and  December 31, 2003                                                                     |       | 0.3                     |       | 0.3                         |       |
| McLeodUSA Preferred Series B, $0.01 par  value; 10 authorized, issued and outstanding at June 30, 2004 and  December 31, 2003                                                                         |       | —                  |       | —                      |       |
| McLeodUSA Warrants                                                                                                                                                                                              |       | 22.6                    |       | 22.6                        |       |
| Additional paid-in capital                                                                                                                                                                                      |       | 1,002.8                 |       | 993.3                       |       |
| Accumulated deficit                                                                                                                                                                                             |       | (670.8                  | )          | (497.1                      | )          |
| Total stockholders’ equity                                                                                                                                                                                 |       | 357.5                   |       | 521.7                       |       |
| **TOTAL LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                            |       | $                       | 1,461.3    |                        | $          | 1,630.6 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements

 

3

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**McLEODUSA INCORPORATED AND SUBSIDIARIESUNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(In millions, except per share data)**

 
| ** **                                                                           | ** ** | **Three months ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                           | ** ** | **2004**                              | ** ** | **2003** | ** ** |
|                                                                                 |       |                                  |       |   |   |
| Revenues                                                                             |       | $                                     | 191.9      |   | $ | 222.6 |   |
|                                                                                 |       |                                  |       |   |   |
| Operating  expenses:                                                                 |       |                                  |       |   |   |
| Cost of  service (exclusive of depreciation and amortization shown separately below) |       | 105.3                                 |       | 128.1 |   |
| Selling,  general and administrative                                                 |       | 68.5                                  |       | 73.5 |   |
| Depreciation  and amortization                                                       |       | 88.4                                  |       | 85.1 |   |
| Restructuring  adjustment                                                            |       | (0.2                                  | )          | — |   |
| **Total  operating expenses**                                                        |       | 262.0                                 |       | 286.7 |   |
| **Operating  loss**                                                                  |       | (70.1                                 | )          | (64.1 | ) |
|                                                                                 |       |                                  |       |   |   |
| Nonoperating  expense:                                                               |       |                                  |       |   |   |
| Interest  expense, net of amounts capitalized                                        |       | (11.6                                 | )          | (8.3 | ) |
| Other expense                                                                        |       | (0.5                                  | )          | (0.4 | ) |
| **Total  nonoperating expense**                                                      |       | (12.1                                 | )          | (8.7 | ) |
| **Net  loss**                                                                        |       | (82.2                                 | )          | (72.8 | ) |
| Preferred  stock dividend                                                            |       | (0.8                                  | )          | (1.2 | ) |
|                                                                                 |       |                                  |       |   |   |
| **Net  loss applicable to common shares**                                            |       | $                                     | (83.0      | ) | $ | (74.0 | ) |
|                                                                                 |       |                                  |       |   |   |
|                                                                                 |       |                                  |       |   |   |
| **Basic  and diluted loss per common share**                                         |       | $                                     | (0.28      | ) | $ | (0.27 | ) |
| **Weighted  average common shares outstanding**                                      |       | 292.2                                 |       | 276.9 |   |

 

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

 

4

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**McLEODUSA INCORPORATED AND SUBSIDIARIESUNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(In millions, except per share data)**

 
| ** **                                                                           | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                           | ** ** | **2004**                           | ** ** | **2003** | ** ** |
|                                                                                 |       |                               |       |   |   |
| Revenues                                                                             |       | $                                  | 385.5      |   | $ | 448.5 |   |
|                                                                                 |       |                               |       |   |   |
| Operating  expenses:                                                                 |       |                               |       |   |   |
| Cost of  service (exclusive of depreciation and amortization shown separately below) |       | 212.9                              |       | 265.5 |   |
| Selling,  general and administrative                                                 |       | 144.2                              |       | 155.2 |   |
| Depreciation  and amortization                                                       |       | 178.6                              |       | 167.3 |   |
| Restructuring  adjustment                                                            |       | (0.2                               | )          | — |   |
| **Total  operating expenses**                                                        |       | 535.5                              |       | 588.0 |   |
| **Operating  loss**                                                                  |       | (150.0                             | )          | (139.5 | ) |
| ** **                                                                           |       |                               |       |   |   |
| Nonoperating  expense:                                                               |       |                               |       |   |   |
| Interest  expense, net of amounts capitalized                                        |       | (22.8                              | )          | (17.0 | ) |
| Other expense                                                                        |       | (0.9                               | )          | (0.4 | ) |
| **Total  nonoperating expense**                                                      |       | (23.7                              | )          | (17.4 | ) |
| **Net  loss**                                                                        |       | (173.7                             | )          | (156.9 | ) |
| Preferred  stock dividend                                                            |       | (1.6                               | )          | (2.4 | ) |
|                                                                                 |       |                               |       |   |   |
| **Net  loss applicable to common shares**                                            |       | $                                  | (175.3     | ) | $ | (159.3 | ) |
|                                                                                 |       |                               |       |   |   |
| **Basic  and diluted loss per common share**                                         |       | $                                  | (0.60      | ) | $ | (0.58 | ) |
| **Weighted  average common shares outstanding**                                      |       | 291.6                              |       | 276.6 |   |

 

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

 

5

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**McLEODUSA INCORPORATED AND SUBSIDIARIESUNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In millions)**

 
| ** **                                                                           | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                           | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| **Cash  Flows from Operating Activities**                                            |       |                               |       |   |   |
| Net loss                                                                             |       | $                                  | (173.7     | ) | $ | (156.9 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:         |       |                               |       |   |   |
| Depreciation                                                                         |       | 150.0                              |       | 134.2 |   |
| Amortization                                                                         |       | 28.6                               |       | 33.1 |   |
| Accretion of  interest                                                               |       | 1.8                                |       | 1.8 |   |
| Loss on sale  of assets                                                              |       | 1.0                                |       | — |   |
| Changes in  assets and liabilities, net of dispositions:                             |       |                               |       |   |   |
| Trade  receivables                                                                   |       | (1.9                               | )          | 1.6 |   |
| Prepaid  expenses and other                                                          |       | 3.4                                |       | 7.7 |   |
| Accounts  payable and accrued expenses                                               |       | (11.9                              | )          | (48.8 | ) |
| Deferred  revenue                                                                    |       | 1.1                                |       | (1.6 | ) |
| **Net  cash used in operating activities**                                           |       | (1.6                               | )          | (28.9 | ) |
| ** **                                                                           |       |                               |       |   |   |
| **Cash  Flows from Investing Activities**                                            |       |                               |       |   |   |
| Purchases of  property and equipment                                                 |       | (27.7                              | )          | (36.9 | ) |
| Other assets                                                                         |       | (14.8                              | )          | (21.3 | ) |
| Proceeds from  the sale of assets                                                    |       | 7.1                                |       | 1.6 |   |
| **Net  cash used in investing activities**                                           |       | (35.4                              | )          | (56.6 | ) |
| ** **                                                                           |       |                               |       |   |   |
| **Cash  Flows from Financing Activities**                                            |       |                               |       |   |   |
| Net proceeds  from long-term debt                                                    |       | 25.0                               |       | — |   |
| Payments on  long-term debt                                                          |       | (11.4                              | )          | (2.1 | ) |
| Deferred  financing fees                                                             |       | (1.9                               | )          | — |   |
| **Net  cash provided by (used in) financing activities**                             |       | 11.7                               |       | (2.1 | ) |
| ** **                                                                           |       |                               |       |   |   |
| **Net  decrease in cash and cash equivalents**                                       |       | (25.3                              | )          | (87.6 | ) |
| **Cash  and cash equivalents**                                                       |       |                               |       |   |   |
| Beginning                                                                            |       | 56.5                               |       | 170.6 |   |
| Ending                                                                               |       | $                                  | 31.2       |   | $ | 83.0 |   |
|                                                                                 |       |                               |       |   |   |
| **Supplemental  Disclosure of Cash Flow Information**                                |       |                               |       |   |   |
| Cash payments  for interest                                                          |       | $                                  | 20.2       |   | $ | 20.3 |   |
|                                                                                 |       |                               |       |   |   |
| **Supplemental  Schedule of Noncash Investing and Financing Activities**        |       |                               |       |   |   |
| Principal  amount converted of Redeemable Preferred Series A to Class A common stock |       | $                                  | 11.0       |   | $ | 8.5 |   |
| Preferred  stock dividends                                                           |       | $                                  | 1.6        |   | $ | 2.4 |   |

 

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

 

6

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**McLEODUSA INCORPORATED AND SUBSIDIARIES**

**NOTES TO THE CONDENSED CONSOLIDATED FINA****NCIAL STATEMENTS**

 

###### **Note1:  Basis of Presentation**

 

McLeodUSAIncorporated (“McLeodUSA” or the “Company”), a Delaware corporation, throughits subsidiaries, provides integrated communications services in 25 Midwest,Southwest, Northwest and Rocky Mountain states. McLeodUSA’s business is highly competitive and is subject to variousfederal, state and local regulations.

 

*Overview*

 

In the fourth quarter of 2001, the Company developed a revisedstrategic plan, which focused on profitable revenue growth in our 25-statefootprint.  This plan served as the basisfor its recapitalization with its principal shareholder, Forstmann Little &Co., lender group, and Preferred Shareholders, as well as the structuring ofthe Exit Facility (as defined below) and continues to serve as the basis of theCompany’s yearly operating plans.

 

In order to execute its plan the Company initiated a variety ofprograms across the business to significantly improve the customer experience,eliminate unneeded infrastructure and cost, improve the quality of the networkand grow the top line revenues.  Over thepast two years the Company has successfully executed nearly all of theseprograms.  The operational and financialresults of the Company, as reported in its quarterly and annual financialreleases, reflect the significant progress that has been made in theoperational areas.

 

However, the Company’s revenues have not increased as forecasted andhave been declining since 2002.  Thedecline in revenue was driven by the Company’s program to eliminatenon-profitable customers, turnover of customers to competitors in excess of newcustomers acquired, reduction of long distance minutes used by its customerbase, reduction in access rates as mandated by the FCC, and lower prices forsome of its products.  The Company hastaken significant actions to increase revenue, including introduction of newcompetitively priced products, reorganization of the sales operation into threedistinct channels, hiring of experienced executive sales leadership, expandingthe involvement of the board of directors and executive staff in the salesprocess and reducing customer churn. While the Company believes that these actions will over time result inprofitable new revenue growth, the timing and amount of that growth is yet tobe determined.

 

The strategic plan and recapitalization anticipated that the Companywould require additional funding to ultimately reach positive earnings and cashflow and established an exit financing facility (“Exit Facility”) of $160million and obtained funding for $110 million of that facility as arevolver.  In order to access the ExitFacility, the Company must be in compliance with certain restrictivecovenants.  In the first quarter of 2004the Company recognized that as a result of the continued decline in revenues,it would be necessary to obtain an amendment to those covenants from its lendergroup.  The Company sought and obtainedapproval of amendments from its lender group on April 30, 2004.  Had the Company not obtained these amendmentsit would have been in default of the prior minimum trailing four-quarterrevenue covenant but would have been in compliance with all other covenants.  The Company was in full compliance with theamended covenents as of June 30, 2004.  Goingforward the Company will need to increase its revenue and profitability inorder to continue to meet the restrictive covenants.  If revenues and profitability do not increaseas anticipated, the Company may be required to obtain waivers or furthermodifications of certain covenants in order to access any unused portion of theExit Facility.  While the Companybelieves it has strong relationships with its lender group, there can be noassurance that the Company could obtain such waivers or the necessary covenantamendments.

 

The Company has undertaken numerous actions to conserve cash over thepast 18 to 24 months, including the reduction of capital expenditures and selling,general and administrative expenses (“SG&A”), as well as the execution ofextensive cost reduction efforts initiated in late 2001 and continuing through2004.  In the second quarter of 2004 theCompany implemented a revised business plan which incorporated additionalactions focused on reducing SG&A expenses and conserving cash.  Going forward the Company will continue toexecute on these initiatives and implement additional similar actions toconserve cash until its revenue growth initiatives take hold.  The Company has been selective in managingcapital expenditures and does not believe that any of the reductions in capitalspending will have a material impact on its ability to grow short-termrevenues.

 

The Company ended June 30, 2004 with $31.2 million of cash on handexcluding approximately $7.0 million of rate settlement payments received inearly July.  Per the most recentamendments to the credit agreement, the Company made a $15 million withdrawalfrom the Exit Facility in the beginning of the third quarter. Going

 

7

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forward the combination of these funds, the remaining $20 million ofunused availability under the Exit Facility and the proceeds from the sale offiber assets will be used to meet the ongoing cash requirements while theCompany continues to execute the revenue growth plan. In addition, the ExitFacility allows for an additional $50 million of outstanding debt, which couldbe funded from our existing lender group or other parties.

 

Ultimately, the Company believes that it will be successful inexecuting its strategy to profitably grow revenue.  However, if the timing of such growth limitsor restricts its access to the unused portion of the Exit Facility, then itwould be required to initiate more aggressive expense reductions andpotentially seek alternative sources of funding.  In the event the Company seeks alternativesources of funding, there can be no assurances such funding sources would beavailable.

 

**Interim Financial Information (unaudited)**

 

In the opinion ofmanagement, the accompanying unaudited condensed consolidated financialstatements include adjustments, consisting of normal recurring adjustments,necessary for a fair presentation of the financial position and results ofoperations of McLeodUSA.  The operatingresults for the interim periods are not necessarily indicative of the operatingresults to be expected for a full year or for other interim periods.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America(“GAAP”) have been condensed or omitted pursuant to instructions, rules andregulations prescribed by the Securities and Exchange Commission (“SEC”).  Although management believes that thedisclosures provided are adequate to make the information presented notmisleading, management recommends that you read these unaudited condensedconsolidated financial statements in conjunction with the audited consolidatedfinancial statements and the related footnotes included in the McLeodUSA AnnualReport on Form 10-K for the fiscal year ended December 31, 2003, filedwith the SEC on March 15, 2004.

 

**Accounting for Stock-basedCompensation**

** **

As permitted by Statement of FinancialAccounting Standards (“SFAS”) No. 123, *Accounting for Stock-BasedCompensation*(‘‘SFAS 123’’), McLeodUSA measures compensation usingthe intrinsic value based method as prescribed by Accounting Principles BoardOpinion No. 25, *Accounting for Stock Issued to Employees,*butis required to make proforma disclosures in the footnotes to the financialstatements as if the measurement provisions of SFAS 123 and SFAS No. 148 *Accounting for Stock-Based Compensation-Transition and Disclosure — anAmendment of SFAS 123*had been adopted. Under the intrinsic valuemethod, compensation is measured as the difference between the market value ofthe stock on the grant date, less the amount required to be paid for the stock.The difference, if any, is charged to expense over the vesting period of theoptions. No stock-based employee compensation cost is reflected in net loss, asall options granted under the plan had an exercise price greater than or equalto the market value of the underlying common stock on the date of grant.  The following table illustrates the effect onnet loss and net loss per share for the three and six months endedJune 30, 2004 and 2003 as if McLeodUSA had applied the fair valuerecognition provisions of SFAS 123 to stock-based employee compensation.

 
| ** **                                                                                                                     | ** ** | **Three months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                     | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Net loss applicable to common shares, as  reported                                                                             |       | $                                    | (83.0      | ) | $ | (74.0 | ) |
| Less:      Total stock-based employee  compensation expense determined under fair value based methods |       | (3.2                                 | )          | (2.1 | ) |
| Pro forma net loss applicable to common  shares                                                                                |       | $                                    | (86.2      | ) | $ | (76.1 | ) |
|                                                                                                                           |       |                                 |       |   |   |
| **Loss per share:**                                                                                                            |       |                                 |       |   |   |
| Basic and diluted, as reported                                                                                                 |       | $                                    | (0.28      | ) | $ | (0.27 | ) |
| Basic and diluted, pro forma                                                                                                   |       | $                                    | (0.29      | ) | $ | (0.27 | ) |

 

8

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| ** **                                                                                              | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                              | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| Net loss applicable to common shares, as  reported                                                      |       | $                                  | (175.3     | ) | $ | (159.3 | ) |
| Less:   Total stock-based employee compensation expense determined under fair  value based methods |       | (6.5                               | )          | (4.4 | ) |
| Pro forma net loss applicable to common  shares                                                         |       | $                                  | (181.8     | ) | $ | (163.7 | ) |
|                                                                                                    |       |                               |       |   |   |
| **Loss per share:**                                                                                     |       |                               |       |   |   |
| Basic and diluted, as reported                                                                          |       | $                                  | (0.60      | ) | $ | (0.58 | ) |
| Basic and diluted, pro forma                                                                            |       | $                                  | (0.62      | ) | $ | (0.59 | ) |

 

**Basic and diluted loss per common share**

 

Loss per common share has been computed usingthe weighted average number of shares of common stock outstanding.  All stock options granted, and theconvertible preferred stock and warrants outstanding are anti-dilutive, and aretherefore excluded from the computation of earnings per share. In the future,the stock options, convertible preferred stock and warrants totalingapproximately 136 million shares and 143 million shares at June 30, 2004and 2003, respectively, may become dilutive. Assuming exercise or conversion of stock options and convertiblesecurities, diluted shares would have been approximately 429 million and 422million at June 30, 2004 and 2003, respectively.

 

**Guarantees**

 

In November 2002, the Financial Accounting Standards Board(“FASB”) issued FASB Interpretation No. 45, *Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others*.  Thisinterpretation clarifies disclosures that are required to be made by aguarantor in its interim and annual financial statements about obligationsunder certain of its issued guarantees. In addition, the interpretationclarifies that a guarantor is required to recognize, at the inception ofcertain types of guarantees, a liability for the fair value of the obligation undertakenin issuing these guarantees.  AtJune 30, 2004 and 2003, McLeodUSA, theparent company, has various guarantees related to subsidiary commitments underoperating leases.  As of June 30,2004 and 2003 the guarantees total $26.1 million and $29.2 million,respectively, and expire over various periods through September 2016,corresponding with the termination of the lease agreements.

 

McLeodUSA has indemnification obligations to its current and formerDirectors and Officers.  The terms of theindemnification obligations provide for no limitation to the maximum potentialfuture payments under such indemnifications. McLeodUSA maintains insurance, subject to limitations set forth in thepolicies, which is intended to cover the costs of claims made against itsDirectors and Officers.

 

**Note 2:  Trade Receivables**

 

The composition of trade receivables, net, is as follows (in millions):

 

| ** **                                     | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Trade Receivables:                             |       |                    |       |                        |       |
| Billed                                         |       | $                       | 75.3       |                        | $          | 73.7 |   |
| Unbilled                                       |       | 5.4                     |       | 5.6                         |       |
|                                           |       | 80.7                    |       | 79.3                        |       |
| Allowance for doubtful accounts and  discounts |       | (12.7                   | )          | (13.7                       | )          |
|                                           |       | $                       | 68.0       |                        | $          | 65.6 |   |

 

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**Note 3:  OtherAccrued Liabilities**

 

Other accrued liabilities consisted of the following (in millions):

 

| ** **                     | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Restructuring                  |       | $                       | 21.3       |                        | $          | 32.5 |   |
| Accrued sales/use/excise taxes |       | 16.4                    |       | 18.6                        |       |
| Accrued property taxes         |       | 13.0                    |       | 10.9                        |       |
| Other                          |       | 35.2                    |       | 38.9                        |       |
|                           |       | $                       | 85.9       |                        | $          | 100.9 |   |

 

**Note 4: Restructuring Charges**

 

Changes in the carrying amount of the restructuring liability for thesix months ended June 30, 2004 is summarized as follows (in millions):

 
| ** **                     | ** ** | **Liability at  December 31,  2003** | ** ** | **Cash Payments  Through  June 30,  2004** | ** ** | **Adjustments  Through  June 30,  2004** | ** ** | **Remaining  Liability  June 30,  2004** | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| Facility  closure costs        |       | $                                         | 32.2       |                                            | $          | (11.0                                         | )          | $                                             | —     |   | $ | 21.2 |   |
| Other  contractual commitments |       | 0.3                                       |       | —                                          |       | (0.2                                          | )          | 0.1                                           |       |
|                           |       | $                                         | 32.5       |                                            | $          | (11.0                                         | )          | $                                             | (0.2       | ) | $ | 21.3 |   |

 

**Note 5:  Goodwill and OtherIntangible Assets**

 

In accordance with SFAS 142, *Accounting for Goodwilland Other Intangibles (“SFAS 142”),* goodwill is not amortized butreviewed annually for impairment or more frequently if an event occurs orcircumstances change that would more likely than not reduce the fair valuebelow its carrying amount.  SFAS 142requires the identification of reporting units and the application of atwo-step approach to assess goodwill impairment.  In order to identify potential impairment,impairment tests of goodwill are performed by comparing the fair value of itsreporting unit with its carrying amount, including goodwill.  If the carrying amount of its reporting unitexceeds its fair value, the impairment loss is measured in the second step bycomparing the implied fair value of goodwill, determined in the same manner asin a business combination, with its carrying amount.  McLeodUSA defined reporting units during itstransitional and annual goodwill impairment tests as an operating segmentcomprised of McLeodUSA’s consolidated operations.  McLeodUSA has established July 1 as thedate for its annual impairment test.  TheCompany’s last impairment test did not yield any impairment.  During the quarter ended June 30, 2004,the Company reviewed the specific requirements of SFAS 142 regarding the needfor impairment testing between annual tests and concluded that there were no suchevents or changes in circumstances that would more likely than not reduce thefair value of its reporting unit below its carrying amount.  However, there can be no assurance that theCompany’s annual impairment test to be performed as of July 1, 2004 willnot yield any impairment.

 

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Intangible assets with finite lives at June 30, 2004 andDecember 31, 2003 are summarized as follows (in millions):

 
| ** **                        | ** ** | **Gross** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|-----------------------------------|------------|-----------|------------|-------------------------------|------------|---------|------------|
| **June 30,  2004:**          |       |      |       |                          |       |    |       |
| Deferred line  installation costs |       | $         | 136.8      |                          | $          | 51.7    |       | $ | 85.1 |   |
| Customer base                     |       | 29.8      |       | 15.2                          |       | 14.6    |       |
| PrimeLine  Trademark              |       | 0.9       |       | 0.4                           |       | 0.5     |       |
|                              |       | $         | 167.5      |                          | $          | 67.3    |       | $ | 100.2 |   |

 
| ** **                        | ** ** | **Gross** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|-----------------------------------|------------|-----------|------------|-------------------------------|------------|---------|------------|
| **December 31,  2003:**      |       |      |       |                          |       |    |       |
| Deferred line  installation costs |       | $         | 127.7      |                          | $          | 27.3    |       | $ | 100.4 |   |
| Customer base                     |       | 29.8      |       | 11.8                          |       | 18.0    |       |
| PrimeLine  Trademark              |       | 0.9       |       | 0.3                           |       | 0.6     |       |
|                              |       | $         | 158.4      |                          | $          | 39.4    |       | $ | 119.0 |   |

 

Upon its reorganization, the trademark McLeodUSA was assigned a valueof $82.9 million by independent appraisers during the adoption of fresh-startaccounting by McLeodUSA.  The trademarkwas determined to have an indefinite life and is not being amortized.  Annual estimated amortization expense forintangible assets above for 2005 is $48 million, $22 million for 2006, and $2million for 2007.

 

**Note 6:  Accounting for AssetRetirement Obligations**

 

In July 2001, the FASB issued SFAS 143, *Accountingfor Asset Retirement Obligations* (“SFAS 143”).  SFAS 143 requires entities to record the fairvalue of a liability for an asset retirement obligation in the period in whichthe legal or contractual removal obligation is incurred.  McLeodUSA’s asset retirement obligationsrelate to three categories of assets: fiber, central office colocationequipment and technical sites.

 

The liability was established by calculating the present value of theasset retirement obligation using a discount rate of 6.1% over a period of 15years, which is representative of the estimated life of McLeodUSA’stelecommunications network.

 

Changes in the carrying amount of the asset retirement obligation forthe six months ended June 30, 2004 is summarized as follows (in millions):

 
| Balance,  December 31, 2003 |   | $    | 58.3   |   |
|----------------------------------|--------|------|--------|--------|
| Interest  accretion              |   | 1.8  |   |
| Payments                         |   | (0.1 | )      |
| Balance,  June 30, 2004     |   | $    | 60.0   |   |

 

**Note 7:  LongTerm Debt**

 

On April 30, 2004 McLeodUSA entered into the Fifth Amendment tothe Credit Agreement and the Second Amendment to the Exit Facility.  The approved amendments include changes tothe minimum revenue, leverage ratio and interest coverage ratio covenants.  The trailing four quarter minimum revenuecovenant was amended to $825 million, $780 million, $760 million, and $770million in the first quarter through fourth quarter of 2004, respectively.  There is no minimum revenue covenant in2005.  The leverage ratio was replacedwith a minimum cumulative EBITDA covenant (as defined in the Credit Agreement andExit Facility, as amended) of $8 million, $16 million, $24 million and $34million for the first through fourth quarters of 2004, respectively, and atrailing four quarter minimum EBITDA of $49 million, $69 million, $89 million and $114 million for the firstthrough fourth quarters of 2005, respectively.** **The interest coverage****ratio was amended to 1.0x for each of the four quarters of2004 and 1.0x, 1.5x, 2.0x and 2.0x for the first through fourth quarters of2005, respectively.  The Company

 

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offered and included in the amendment a downward revision to thecapital expenditure limits for 2004 and 2005 to $75 million and $100 million,respectively.  There were no changes tothe capital expenditure limit of $200 million for the years 2006 andbeyond.  In addition, the second amendmentlimits the outstanding amounts under the Exit Facility to $75.0 million for theperiod from April 1, 2004 through June 30, 2004 and to $90.0 millionduring the period July 1, 2004 through September 30, 2004.  The second amendment provides the Company fullaccess to remaining amounts available under the Exit Facility after September30, 2004.

 

McLeodUSA paid approximately $1.9 million in fees in April 2004 tothe lender group in connection with the approval of these amendments.  The Company is currently in compliance withthe amended financial covenants under the Credit Agreement and ExitFacility.  As of June 30, 2004,McLeodUSA has drawn $65 million on the Exit Facility and has standby letters ofcredit outstanding of $9.0 million that further reduce its borrowingavailability under the Exit Facility.

 

Interest expense of $1.1 million and $5.9 million was capitalized aspart of the construction of the Company’s fiber optic network during the sixmonth periods ended June 30, 2004 and 2003, respectively.

 

**Note 8: Litigation**

 

Former Chairman Clark E. McLeod, PresidentStephen C. Gray (then also Chief Executive Officer), Chairman and ChiefExecutive Officer Chris A. Davis (then Chief Operating and Financial Officer)and former Chief Financial and Accounting Officer J. Lyle Patrick (the‘‘Individual Defendants’’) are defendants in a number of putative class actioncomplaints that have been consolidated into a single complaint entitled In ReMcLeodUSA Incorporated Securities Litigation, Civil Action No. C02-0001 (N.D.Iowa) (the ‘‘Iowa Class Action’’). The Individual Defendants have filed amotion to dismiss the amended consolidated complaint in the Iowa Class Action,which was denied by the district judge. One of the putative class plaintiffs,New Millennium Growth Fund LLC, also filed proofs of claim against McLeodUSA inMcLeodUSA’s Chapter 11 Case for at least $104,650 on its own behalf and for noless than approximately $300 million (plus interest, costs and attorneys’ feesas allowed) on behalf of all class claimants in the Iowa Class Action (the‘‘Bankruptcy Claims’’ and, together with the Iowa Class Action,the ‘‘Securities Claims’’). As the Securities Claims are in early stages, it isimpossible to evaluate the likelihood of unfavorable outcomes or, with respectto the Iowa Class Action, to estimate the amount or range of potential loss, ifany, to McLeodUSA. With respect to the Bankruptcy Claims, on May 2, 2002 theBankruptcy Court issued an order establishing a disputed claims reserve of18,000,000 shares of Reorganized McLeodUSA Class A Common Stock. Any recoveryfrom the Bankruptcy Claims would be limited to those shares of stock. McLeodUSAbelieves that the Securities Claims are without merit and intends to defendthem vigorously.

 

McLeodUSA has indemnification obligationsrunning to the Individual Defendants, the terms of which provide for nolimitation to the maximum potential future payments under suchindemnifications.  McLeodUSA is unable todevelop an estimate of the maximum potential amount of future payments underthe indemnifications due to the inherent uncertainties involved in suchlitigation. McLeodUSA maintains insurance, subject to limitations set forth inthe policies, which is intended to cover the costs of claims made against itscurrent and former Directors and Officers.

 

McLeodUSA is also involved in numerousregulatory proceedings before various public utility commissions and the FCC,particularly in connection with actions by the Regional Bell OperatingCompanies (“RBOCs”). McLeodUSA anticipates the RBOCs will continue to pursuelitigation, regulations and legislation in states within McLeodUSA’s 25-statefootprint and with the FCC to reduce regulatory oversight and regulation overrates, network access and operations. The RBOCs are also actively pursuingmajor changes in the Telecommunications Act of 1996, by regulatory litigationand legislation, which McLeodUSA believes would adversely affect competitivetelecommunications service providers including McLeodUSA. If adopted, these initiativescould make it more difficult for McLeodUSA to challenge the RBOCs’ actions, orto compete with the RBOCs, in the future. There are no assurances thatMcLeodUSA will prevail in its disputes with the RBOCs.

 

The FCC released its Triennial Review Order(“TRO”) in August 2003 modifying its rules governing availability of RBOCunbundled network elements to competitive carriers. The Triennial Review Orderestablished new rules governing the availability and pricing for the networkelements the RBOCs must provide to competitive carriers, and delegatedauthority to the states to apply certain of the new rules in individualmarkets. Several appeals of the TRO were consolidated in the Court of Appealsfor the District of Columbia (the “Court of Appeals”). On March 2, 2004,the Court of Appeals issued a decision overturning many key elements of theTRO, remanding most of the order to the FCC for further action (*USTA II*). The Court of Appeals ruled that the FCC’sdelegation of final impairment decisions to state agencies was unlawful.  The Court also reversed the FCC’s nationwidefinding regarding mass market switching, dedicated transport and loops, and itsdelegation of decision-making authority to the states. The Court directed theFCC to give stronger consideration to intermodal competition when revising itsrules on remand. The Court upheld the FCC determination that RBOCs do not

 

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have to provide unbundled access at currentprices to newly deployed technologies based on fiber and packet-switchingcapabilities. The Court also upheld the FCC’s findings that RBOCs are notrequired to provide unbundled switching to CLECs for business customers servedby high-capacity loops, such as DS-1 or packet switching. State proceedingsthat had been started to implement the TRO were suspended in some states andcontinued in other states. The Court originally stayed theeffective date of its order for 60 days in order to provide the FCC with anopportunity to implement new unbundling rules. Subsequently, on March 31, 2004, the FCC issued a press release andletters to a number of industry participants and trade associations encouragingindustry members to engage in commercial negotiations to address issues raisedin the TRO.  To facilitate thesecommercial negotiations, the FCC sought and obtained an additional 45-day stayfrom the Court of Appeals.   McLeodUSAhas executed Confidentiality Agreements with Qwest and SBC, our primarysuppliers of network facilities, and opened discussions with each of them. Onor about June 11, 2004, the Chief Executive Officers of each RBOC sent aletter to the FCC in which each promised to maintain the status quo forunbundled switching until the end of the year. On June 15, 2004, the stay of the Court of Appeals’ decisionexpired. The FCC and U. S. Department of Justice declined to appeal *USTA II*.  Competitiveand interexchange carriers and an organization representing state regulatoryagencies filed appeals to the U.S. Supreme Court and requested a stay.  The U.S. Supreme Court declined to issue astay.  Various representatives of the FCCstated during July 2004 that the FCC desires to adopt interim unbundling rulesin August 2004 and will concurrently issue a Notice of Proposed Rulemaking(‘NPRM”) intended to lead to final rules that the FCC will attempt to adoptbefore year-end.  Regardless of thesuccess, or lack of success, of these commercial negotiations and adoption ofinterim and final unbundling rules on remand, it is likely that unbundlingrules will be the subject of continued litigation.  There canbe no assurance that our businesses will not be materially adversely affectedby continued legal challenges to unbundling rules, new legislation passed inresponse to unbundling rules or any court decisions that result from continuedlegal challenge to unbundling rules or current law and regulations.

 

The FCC has an open docket proposing toreform intercarrier compensation.  Anindustry group known as the “Intercarrier Compensation Forum” (ICF) is expectedto provide a recommended framework for reforming intercarrier compensationrelated to switched access and reciprocal compensation charges.  If the ICF does not provide a recommendationto the FCC, the FCC will make its own proposal and solicit comments on theissue.  A final decision is expected noearlier than the first quarter of 2005, and the current framework ofintercarrier compensation rules could be materially affected.  On May 13, 2004, the FCC issued a finaldecision on CLEC access charges that apply to the routing of certain 800traffic.  There can be no assurance thatour businesses will not be materially adversely affected by the decision.

 

 OnSeptember 10, 2003, the FCC issued an NPRM on TELRIC. This is a proceedingto review the TELRIC methodology used to determine the prices charged tocompetitive carriers for unbundled network elements. A change in pricingmethodology that materially increases unbundled network element prices wouldincrease our costs and could adversely affect our ability to compete. Adecision is anticipated during 2005.

 

The FCC issued on March 10, 2004 itsNPRM on ‘‘IP-enabled communications,’’ which includes VoIP. The NPRM asks broadquestions regarding the regulatory classifications of various ‘‘IP-enabled’’services, including different VoIP services; the access charge and otherintercarrier compensation implications; the universal service implications; andthe other social policy implications such as law enforcement, disability andemergency 911 service issues and suggests, as a general proposition, theeconomic regulation of various IP-enabled services should be kept to a minimum.

 

Generally, state utility commissions or thirdparties could raise issues with regard to our compliance with applicable laws orregulations which could have a material adverse effect on our business, resultsof operations and financial condition. Several state utility commissions havereviewed or are actively reviewing the propriety of certain agreements weentered into with Qwest, including Washington, Arizona, and Colorado, and theseproceedings may result in fines or other sanctions against us or the impositionof other conditions detrimental to us, including the establishment of discountsavailable to other competitive telephone companies but not to us. Other statesmay initiate similar proceedings.

 

McLeodUSA is not aware of any other materiallitigation against it. McLeodUSA does, however, have various other legalproceedings pending against it or its subsidiaries or on its behalf or that ofits subsidiaries.

 

**Note 9:  SFAS144, Unaudited 2001 Financial Statements and Re-Audit Requirements**

 

In connection with its reorganization, McLeodUSA completed the sale ofcertain businesses, including McLeodUSA Media Group and its subsidiaries andIllinois Consolidated Telephone Company and associated businesses.  In its most recent Annual Report on Form10-K, based on the requirements of SFAS 144, McLeodUSA reflected thesebusinesses and other businesses that were sold as discontinued operations forthe periods January 1, 2002 to April 16, 2002 and April 17, 2002to

 

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December 31, 2002.  Inaccordance with GAAP, McLeodUSA is required to present its financial statementsfor the year ended December 31, 2001, reflecting these businesses asdiscontinued operations.  McLeodUSA’sformer auditors, Arthur Andersen LLP (“Arthur Andersen”), audited McLeodUSA’sfinancial statements and issued an audit opinion for the year endedDecember 31, 2001.  OnApril 24, 2002, McLeodUSA engaged Deloitte & Touche LLP (“Deloitte& Touche”) to serve as its independent accountants for fiscal year2002.  In order for McLeodUSA to complywith GAAP requirements related to the financial presentation for discontinuedoperations in accordance with Regulation S-X, McLeodUSA would be required toobtain a new audit opinion with respect to the year ended December 31,2001.  Since Arthur Andersen is no longerable to perform audits of publicly trade companies, Deloitte & Touche hasinformed McLeodUSA, consistent with Interpretations of SAS No. 58 (AUSection 508), they would be required to re-audit McLeodUSA’s financialstatements for the year ended December 31, 2001 to provide McLeodUSA withan audit opinion on such financial statements.

 

In light of McLeodUSA’s reorganization, sale of businesses, andimplementation of fresh-start accounting on April 16, 2002, McLeodUSA hasdetermined that the expense and effort associated with a re-audit is not in thebest interest of McLeodUSA or its stockholders. As an alternative to a re-audit McLeodUSA has included in its mostrecent Annual Report on Form 10-K unaudited consolidated financial statements,prepared in accordance with GAAP, reflecting the impact of the discontinuedoperations for the year ended December 31, 2001.  In order for McLeodUSA to sell securitieswith a registration statement declared effective by the SEC, the registrationstatement must contain three years of audited financials.

 

Should McLeodUSA elect to conduct a re-audit of 2001 in order toutilize such effective registration statements, McLeodUSA does not know ifDeloitte & Touche would have any differences in opinion with the prioraudit conducted by Arthur Andersen.  Atthis time, McLeodUSA is aware of no material differences of opinion.  In regard to the 2001 unaudited financialstatements, the Company is in discussions with the SEC regarding the SEC’sinquiry into certain accounting matters, including disclosures related toseveral IRU contracts.

 

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**Information RegardingForward-Looking Statements**

 

Some of the statements in this discussion include statements about ourfuture expectations.  Statements that arenot historical facts are forward-looking statements for the purpose of the safeharbor provided by Section 21E of the Exchange Act and Section 27A ofthe Securities Act.  Such statements mayinclude projections of financial and operational results and goals, includingrevenue, profitability, savings and cash. Insome cases, you can identify these so-called “forward looking statements” byour use of words such as “may,” “will,” “should,” “expect,” “plan,”“anticipate,” “believe,” “estimate,” “predict”, “project”, “intend” or“potential” or the negative of those words and other comparable words.****These forward-looking statements are subject toknown as well as unknown risks and uncertainties that may cause actual resultsto differ materially from our expectations. Our expectations are based on various factors and assumptions andreflect only our predictions.  Factorsthat could cause actual results to differ materially from the forward-lookingstatement include technological, regulatory, public policy or otherdevelopments in our industry, availability and adequacy of capital resources,current and future economic conditions, the existence of strategic alliances,our ability to generate cash, our ability to implement process and networkimprovements, our ability to attract and retain customers, our ability to migratetraffic to appropriate platforms and changes in the competitive climate inwhich we operate.  These and other risksare described in more detail in our most recent Annual Report on Form 10-Kfiled with the SEC.  Except as requiredunder the federal securities laws and rules and regulations of the SEC, theCompany undertakes no obligation to update publicly any forward-lookingstatements, whether as a result of future events, new information or otherwise.

 

**Item 2.**                                   Management’s Discussion and Analysisof Financial Condition and Results of Operations

 

The following discussion and analysis provides information concerningthe results of operations and our financial condition and should be read inconjunction with the accompanying unaudited condensed consolidated financialstatements and notes thereto. Additionally, the following discussion and analysis should be read inconjunction with our audited consolidated financial statements included in ourAnnual Report on Form 10-K for the year ended December 31, 2003.

 

In the fourth quarter of 2001, the Company developed a revisedstrategic plan, which focused on profitable revenue growth in our 25-statefootprint.  This plan served as the basisfor our re-capitalization with our principal shareholder, Forstmann Little& Co., our lender group, and our Preferred Shareholders, as well as thestructuring of the Exit Facility (as defined below) and continues to serve asthe basis of our yearly operating plans.

 

In order to execute our plan we initiated a variety of programs acrossthe business to significantly improve the customer experience, eliminateunneeded infrastructure and cost, improve the quality of the network and growthe top line revenues.  Over the past twoyears we have successfully executed nearly all of these programs.  The operational and financial results of theCompany, as reported in our quarterly and annual financial releases, reflectthe significant progress that has been made in the operational areas.

 

However, the Company’s revenues have not increased as forecasted andhave been declining since 2002.  Thedecline in revenue was driven by our program to eliminate non-profitablecustomers, turnover of customers to competitors in excess of new customersacquired, reduction of long distance minutes used by our customer base,reduction in access rates as mandated by the FCC, and lower prices for some ofour products.  We have taken significantactions to increase revenue, including introduction of new competitively pricedproducts, reorganization of the sales operation into three distinct channels,hiring of experienced executive sales leadership, expanding the involvement ofthe board of directors and executive staff in the sales process and reducingcustomer churn.  While we believe thatthese actions will over time result in profitable new revenue growth, thetiming and amount of that growth is yet to be determined.

 

The strategic plan and recapitalization anticipated that we wouldrequire additional funding to ultimately reach positive earnings and cash flowand established an exit financing facility (“Exit Facility”) of $160 millionand obtained funding for $110 million of that facility as a revolver.  In order to access the Exit Facility, theCompany must be in compliance with certain restrictive covenants.  In the first quarter of 2004 we recognizedthat as a result of the continued decline in revenues, it would be necessary toobtain an amendment to those covenants from its lender group.  We sought and obtained approval of amendmentsfrom its lender group on April 30, 2004 and was in full compliance withthe amended covenants as of June 30, 2004. Had the Company not obtained these amendments it would have been indefault of the prior minimum trailing four-quarter revenue covenant but wouldhave been in compliance with all other covenants.  Going forward we will need to increaserevenue and profitability in order to continue to meet the restrictivecovenants.  If revenues and profitabilitydo not

 

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increase as anticipated, we may be required to obtain waivers orfurther modifications of certain covenants in order to access any unusedportion of the Exit Facility.  While webelieve we have strong relationships with our lender group, there can be noassurance that we could obtain such waivers or the necessary covenantamendments.

 

We have undertaken numerous actions to conserve cash over the past 18to 24 months, including the reduction of capital expenditures and selling,general and administrative expenses (“SG&A”), as well as the execution ofour extensive cost reduction efforts initiated in late 2001.  In the second quarter of 2004 the Companyimplemented a revised business plan which incorporated additional actionsfocused on reducing SG&A expenses and conserving cash (see *Management’s Discussion and Analysis – Liquidity and Capital Resources*foradditional details).  Going forward wewill continue to execute on these initiatives and implement additional similaractions to conserve cash until our revenue growth initiatives take hold.  We have been selective in managing capitalexpenditures and do not believe that any of the reductions in capital spendingwill have a material impact on our ability to grow short-term revenues.  Ultimately, we believe the Company will besuccessful in executing its strategy to profitably grow revenue.  However, if the timing of such growth limitsor restricts our access to the unused portion of the Exit Facility, then wewould be required to initiate more aggressive expense reductions andpotentially seek alternative sources of funding.  In the event the Company seeks alternativesources of funding, there can be no assurances such funding sources would beavailable.

 

**Overview of Our Business**

 

McLeodUSA derives most of its revenue from its core competitivetelecommunications and related communications services.  These services include local and longdistance services; dial-up and dedicated Internet access services; wireless voiceservices; high-speed/broadband Internet access services using DSL, cablemodems, and dedicated T1 access; bandwidth and network facilities leasing,sales and services, including access services; facilities and servicesdedicated for a particular customer’s use; and value-added services such asvirtual private networks and web hosting. During the third quarter of 2003 we entered into a multi-year wholesaleagreement with a nationwide wireless carrier in order to offer wireless voiceservices to our customers.  We beganmarketing and selling wireless services in the fourth quarter of 2003.

 

As of June 30, 2004, we operated a network with 696 access nodescollocated in RBOC central offices.  Weserve our customers by using various loop/access unbundled network elements(“UNEs”) provided by the RBOCs and aggregating them through our accessnodes.  In turn, our access nodes areinterconnected through approximately 39 service node locations where ourswitching/routing systems reside.  In ametropolitan area, access node to service node connectivity is based either onour own fiber facilities or on UNE transport from the RBOCs.  Our service nodes are located in most of themajor metropolitan areas across our footprint. These service nodes are in turn interconnected by our high capacity,inter-city core network.  The underlyingtransport for our core network is based either on our own fiber or on leasedcapacity from interexchange carriers

 

To develop these networks, we have assembled a collection of metro andinter-city network assets in our 25-state footprint, substantially all of whichwe own or control, making us a facilities-based carrier.  These network assets incorporatestate-of-the-art fiber optic cable, dedicated wavelengths of transmissioncapacity on fiber optic networks and transmission equipment capable of carryinghigh volumes of data, voice, video and Internet traffic.  We operate in a 25-state footprint, whichconsists of the following states:

 

| Arizona  |   | Indiana   |   | Minnesota  |   | North Dakota |   | Texas      |
|----------|--------|-----------|--------|------------|--------|--------------|--------|------------|
| Arkansas |   | Iowa      |   | Missouri   |   | Ohio         |   | Utah       |
| Colorado |   | Kansas    |   | Montana    |   | Oklahoma     |   | Washington |
| Idaho    |   | Louisiana |   | Nebraska   |   | Oregon       |   | Wisconsin  |
| Illinois |   | Michigan  |   | New Mexico |   | South Dakota |   | Wyoming    |

 

**SFAS 144, Unaudited 2001 Financial Statements and Re-Audit Requirements**

 

In connection with our reorganization, McLeodUSA completed the sale ofcertain businesses.  In our most recentAnnual Report on Form 10-K, based on the requirements of SFAS 144, McLeodUSAreflected these businesses and other businesses that were sold as discontinued operationsfor the periods January 1, 2002 to April 16, 2002 and April 17,2002 to December 31, 2002.  Inaccordance with accounting principles generally accepted in the United Statesof America (“GAAP”), McLeodUSA is required to present its financial statementsfor the year ended December 31, 2001, reflecting these businesses asdiscontinued operations.  McLeodUSA’sformer auditors, Arthur Andersen LLP (“Arthur Andersen”), audited McLeodUSA’sfinancial

 

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statements and issued an audit opinion for the year endedDecember 31, 2001.  OnApril 24, 2002, McLeodUSA engaged Deloitte & Touche LLP (“Deloitte& Touche”) to serve as its independent accountants for fiscal year 2002.  In order for McLeodUSA to comply with GAAPrequirements related to the financial presentation for discontinued operationsin accordance with Regulation S-X, McLeodUSA would be required to obtain a newaudit opinion with respect to the year ended December 31, 2001.  Since Arthur Andersen is no longer able toperform audits of publicly traded companies, Deloitte & Touche has informedMcLeodUSA, consistent with *Interpretations of SAS No.58 (AU Section 508),* that they would be required to re-auditMcLeodUSA’s financial statements for the year ended December 31, 2001 toprovide McLeodUSA with an audit opinion on such financial statements.

 

In light of McLeodUSA’s reorganization, sale of businesses, andimplementation of fresh-start accounting on April 16, 2002, we havedetermined that the expense and effort associated with a re-audit is not in thebest interest of McLeodUSA or its stockholders. As an alternative to a re-audit, McLeodUSA has included in its mostrecent Annual Report on Form 10-K unaudited consolidated financial statements,prepared in accordance with GAAP, reflecting the impact of the discontinuedoperations for the year ended December 31, 2001.  In order for McLeodUSA to sell securitieswith a registration statement declared effective by the SEC, such registrationstatement must contain three years of audited financials.

 

Should McLeodUSA elect to conduct a re-audit of 2001 in order toutilize such effective registration statements, McLeodUSA does not know ifDeloitte & Touche would have any differences in opinion with the prioraudit conducted by Arthur Andersen.  At thistime, McLeodUSA is aware of no material differences of opinion.  In regard to the 2001 unaudited financialstatements, the Company is in discussions with the SEC regarding the SEC’sinquiry into certain accounting matters, including disclosures related toseveral IRU contracts.

 

**Critical Accounting Policies and Estimates**

 

Preparation of the financial statements requires management to makeestimates and assumptions that affect the reported amounts of assets,liabilities, revenues and expenses. Management believes the most complex andsensitive judgments, because of their significance to the consolidatedfinancial statements, result primarily from the need to make estimates aboutthe effects of matters that are inherently uncertain. Management’s Discussionand Analysis and Note 1 to the Consolidated Financial Statements in theMcLeodUSA Annual Report on Form 10-K for the year ended December 31, 2003,describe the significant accounting estimates and policies used in preparationof the Condensed Consolidated Financial Statements. Actual results in theseareas could differ from management’s estimates. There have been no significantchanges in our critical accounting estimates during the second quarter of 2004.

 

**Liquidity and Capital Resources**

 

Prior to August 2001, McLeodUSA grew rapidly by focusing ontop-line revenue growth, which required significant capital for theconstruction of local and long distance voice networks and a national datanetwork and included the acquisition of numerous businesses.  By mid-2001, due to certain factors,including but not limited to complications related to the Company’s rapidgrowth and a general downturn in the economy and the telecommunications sectorin particular, the Company was not meeting internal expectations in terms ofprofitability and cash flow.

 

Beginning in August of 2001, we initiated a new strategic planwhich included a broad financial and operational restructuring.  Our new strategy was to refocus our businessto be a facilities-based communication services provider within our 25-statefootprint, improve business discipline and processes and reduce our coststructure, all with the goal of profitably growing revenues and generatingpositive cash flow from operations.  Keyelements of the restructuring included abandonment of the national networkplan, disposing of non-core businesses, reducing the employee base,consolidating facilities, reducing capital expenditures, and eliminatingunprofitable services and unprofitable customers.

 

We have generally completed the construction and integration of ournetwork assets and our future capital expenditures are focused on reducing costof service, adding capacity to our network to serve new customers, anddeveloping new products to compete in the marketplace.  Our capital expenditure plan is closelymanaged.  The Company does not believethat it has significant capital requirements to complete its currentconstruction work in progress for its intended use.

 

In the near term, we expect to incur net negative cash flows as theresult of remaining lease payments and lease buyouts associated with facilityexits made in 2001 and 2002 as part of our restructuring, and to fundcontinuing working capital

 

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needs and service our debt.  Webelieve that the actions we have taken and the successful execution of ourstrategic plan will position us to be successful over the long-term.

 

*Background of Capital Structure and Credit Facilities*

 

During 2001, in connection with our revised business strategy, we beganto explore restructuring our capital structure. Any restructuring involving a payment to bondholders, other thanregularly scheduled payments of principal and interest, required a majority consentunder our Credit Agreement.  In order toeffect a restructuring, we entered into the Third Amendment to the CreditAgreement.  Under the Third Amendment,the lenders under the Credit Agreement waived: (1) any bankruptcy and paymentcross-defaults with respect to the Notes arising from the restructuring; (2)covenants restricting the sales of assets in order to allow the sale of Pubcopursuant to the restructuring, and the use of the $600 million of proceedstherefrom to make a payment to the bondholders; and (3) certain other covenantsand other provisions of the Credit Agreement that would have restricted ourability to enter into various transactions necessary to consummate therestructuring.  The Third Amendmentcontained certain modifications that became effective upon our consummation ofthe Plan, including, among other things, the modification of various financialcovenants and the addition of a capital expenditure limitation, a 1% increasein the applicable rates of interest on the borrowings under the CreditAgreement and the establishment of certain prepayment premiums applicable tothe Credit Agreement term loan repayments made in the first three yearsfollowing the restructuring.

 

As provided for in the Third Amendment to the Credit Agreement, weentered into the Exit Facility with a consortium of banks upon consummation ofthe Plan on April 16, 2002.  TheExit Facility consists initially of a revolving credit facility of $110million.  In addition, we have the rightto obtain additional commitments to increase the size of the Exit Facility upto $160 million.  The Exit Facilitymatures on May 31, 2007, with any outstanding amounts due on that date; noprincipal payments are due until this maturity date.  The Exit Facility is secured by firstpriority liens on the assets of McLeodUSA and its domestic subsidiaries andranks superior to the Credit Agreement.

 

We are required to pay a commitment fee on the average daily unusedbalance of the Exit Facility at an annual rate ranging from 1/2% to 1%.  Funds borrowed under the Exit Facility bearinterest at a rate per annum equal to either (a) the greater of (1) the primerate and (2) the federal funds effective rate plus 1/2%, in each case plus amargin ranging from 1.00% to 2.50%; or (b) LIBOR plus a margin ranging from2.00% to 3.50%.

 

The Exit Facility and the Credit Agreement include restrictions as to,among other things, additional indebtedness, liens, sale and lease-backtransactions, investments, asset sales, certain payments by restrictedsubsidiaries, capital expenditures and designation of unrestrictedsubsidiaries.  The Exit Facility and theCredit Agreement also contain restrictive covenants that limit our leverageratio and require minimum levels of interest coverage and consolidated revenue.  On April 30, 2004 we entered into theFifth Amendment to the Credit Agreement and the Second Amendment to the ExitFacility.  The approved amendmentsinclude changes to the minimum revenue, leverage ratio and interest coverageratio covenants.  The minimum revenuecovenant was amended to $825 million, $780 million, $760 million, and $770million in the first quarter through fourth quarter of 2004, respectively.  There is no minimum revenue covenant in2005.  The leverage ratio was replacedwith a minimum cumulative EBITDA covenant (as defined in the Credit Agreementand Exit Facility, as amended) of $8 million, $16 million, $24 million and $34million for the first through fourth quarters of 2004, respectively, and atrailing four quarter minimum EBITDA of $49 million, $69 million, $89 million and $114 million for the firstthrough fourth quarters of 2005, respectively.** **The interest coverage****ratio was amended to 1.0x for each of the four quarters of2004 and 1.0x, 1.5x, 2.0x and 2.0x for the first through fourth quarters of2005, respectively.  The Company offeredand included in the amendment a downward revision to the capital expenditurelimits for 2004 and 2005 to $75 million and $100 million, respectively.  There were no changes to the capitalexpenditure limit of $200 million for the years 2006 and beyond.  In addition, the second amendment limits theoutstanding amounts under the Exit Facility to $75.0 million for the periodfrom April 1, 2004 through June 30, 2004 and to $90.0 million duringthe period July 1, 2004 through September 30, 2004.  The second amendment provides the Companyfull access to remaining amounts available under the Exit Facility afterSeptember 30, 2004.  At June 30,2004 the Company was in compliance with all restrictive covenants.

 

We paid approximately $1.9 million in fees in April 2004 to thelender group in connection with the approval of the Fifth Amendment to theCredit Agreement and the Second Amendment to the Exit Facility.  We are currently in compliance with the amendedfinancial covenants under the Credit Agreement and Exit Facility and continueto have full access to the $110 million Exit Facility.  As of June 30, 2004, we have drawn $65million on the Exit Facility and we have standby letters of credit outstandingof $9.0 million that further reduce our borrowing availability under the ExitFacility.

 

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**2004 Cash Flow**

 

We ended June 30, 2004 with $31.2 million of cash and cashequivalents, excluding approximately $7.0 million of rate settlement paymentsreceived in early July, versus $56.5 million at December 31, 2003.  This decrease of $25.3 million resultedprimarily from the following:

 
| Operating Activities:                                                          |   |   |   |
|--------------------------------------------------------------------------------|--------|--------|--------|
| Increase in cash from operations, excluding  changes in assets and liabilities |   | $      | 7.7    |   |
| Payments for restructuring liabilities                                         |   | (11.0  | )      |
| Source of cash from changes in assets and  liabilities                         |   | 1.7    |   |
| Net cash used by operating activities                                          |   | (1.6   | )      |
|                                                                           |   |   |   |
| Investing Activities:                                                          |   |   |   |
| Capital expenditures                                                           |   | (27.7  | )      |
| Deferred line installation costs                                               |   | (14.8  | )      |
| Sale of assets                                                                 |   | 7.1    |   |
| Net cash used by investing activities                                          |   | (35.4  | )      |
|                                                                           |   |   |   |
| Financing Activities:                                                          |   |   |   |
| Payments on long-term debt                                                     |   | (11.4  | )      |
| Deferred financing fees                                                        |   | (1.9   | )      |
| Proceeds from long-term debt                                                   |   | 25.0   |   |
| Net cash provided by financing activities                                      |   | 11.7   |   |
|                                                                           |   |   |   |
| Net decrease in cash and cash equivalents                                      |   | $      | (25.3  | ) |

 

The payments for restructuring liabilities primarily related toremaining lease payments and lease buyouts associated with facility exits madein 2001 and 2002 as part of our restructuring. The source of cash related to changes in assets and liabilitiesprimarily related to an increase in deferred revenue, changes in other assetspartially offset by an increase in our trade accounts receivable balances.  We expect our cash requirements to payrestructuring liabilities to be less during the remainder of 2004.

 

As discussed above, we have reduced our growth-related capitalexpenditure plan and expect to spend approximately $50 million to $55 millionduring 2004.  The capital expenditure planfor 2004 remains dedicated to new product introduction, cost savings programsand strategic growth initiatives. Deferred line installation costs are the result of costs required to addcustomers onto our network in 2004.  Ourdeferred line installation expenditures throughout the rest of 2004 will bedependent on the rate at which we add new customers.

 

During 2003, our borrowings under the Credit Agreement began amortizingand principal payments of $11.1 million were made in the first six months of 2004.  In March 2004, we borrowed $25.0 millionunder our $110 million Exit Facility.  Wedid not make any withdrawals from the Exit Facility in the second quarter of2004 and made our planned $15 million withdrawal in July 2004.  During the remainder of 2004, mandatory debtrepayments under the Credit Agreement will total $15.6 million.

 

**Outlook for 2004 and Future Funding Needs**

 

In 2004, our cash requirements for new products, important capitalexpenditure projects, remaining lease payments and lease buyouts associatedwith facility exits made in 2001 and 2002 (as part of our restructuring) aswell as working capital will all be funded by cash generated from operatingactivities, sale of fiber assets and borrowings under the Exit Facility.

 

In light of the delay in revenue growth, the Company has takenadditional steps to conserve cash and improve liquidity.  Actions that have been taken to generatefurther operational efficiencies and focused expense management are expected toresult in approximately $8 million of quarterly SG&A run-rate savings bythe fourth quarter of 2004.  We havereduced our growth related capital expenditure plan and now expect to spendapproximately $50 million to $55 million in 2004 versus our initial plan of $65million.  The capital expenditure planfor 2004 remains dedicated to new product introduction, cost savings programsand strategic growth initiatives.  Inaddition, we have re-initiated our plan to sell fiber assets.  This plan was originally developed as part ofour 2002 recapitalization.  We did notimplement the plan at that time due to our success in selling other

 

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non-core assets.  We havecompleted approximately $5 million of fiber sales during the first six monthsof 2004 and continue to make progress in the execution of our target to sell$50 million in fiber in 2004. As a result of the actions described above theCompany significantly reduced its cash usage in the second quarter of 2004 andexpects to realize continuing benefits from these programs.

 

We ended June 30, 2004 with $31.2 million of cash on handexcluding approximately $7.0 million of rate settlement payments received inearly July.  Per the most recentamendments to the credit agreement we made the planned $15 million withdrawalfrom the Exit Facility in the beginning of the third quarter. Going forward thecombination of these funds, the remaining $20 million of unused availabilityunder the Exit Facility and the proceeds from the sale of fiber assets will beused to meet the ongoing cash requirements while the Company continues toexecute the revenue growth plan. In addition, the Exit Facility allows for anadditional $50 million of outstanding debt, which could be funded from ourexisting lender group or other parties.

 

Our ability to access the remaining unused portion of the Exit Facilityrequires compliance with certain restrictive covenants.  Those covenants require increases in theCompany’s revenue and profitability over time. While the Company believes it will be successful in executing itsstrategy to profitably increase revenues, it may be required to obtain waiversor amendments to those covenants from its lender group if revenues orprofitability do not increase as anticipated. The Company believes it has strong relationships with its lender group,but there can be no assurances that the Company could obtain any necessarywaivers or amendments.  Under certaincircumstances the Company would be required to initiate more aggressive expensereductions or potentially seek alternative sources of funding, the availabilityof which cannot be assured.

 

**Three Months Ended June 30, 2004 Compared with Three Months EndedJune 30, 2003**

 

***Revenue.***  Total revenue for the quarter endedJune 30, 2004 declined $30.7 million, or 13.8%, to $191.9 million from$222.6 million for the quarter ended June 30, 2003.  The following table compares our revenue forthe three months ended June 30:

 
| ** **                                                                                     | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Local                                                                                          |       | $        | 93.0       |     | $          | 106.0        |       | $ | (13.0 | ) |
| Long distance                                                                                  |       | 33.1     |       | 45.6     |       | (12.5        | )          |
| Data services  and other                                                                       |       | 33.8     |       | 34.6     |       | (0.8         | )          |
| Carrier access                                                                                 |       | 30.2     |       | 34.7     |       | (4.5         | )          |
| Indefeasible  rights of use agreements including those  that qualify as sales type leases |       | 1.8      |       | 1.7      |       | 0.1          |       |
|                                                                                           |       | $        | 191.9      |     | $          | 222.6        |       | $ | (30.7 | ) |

 

Total revenues declined by $30.7 million versus the second quarter of2003 due to a continued decline in total customers, FCC mandated reduction inaccess rates, and lower long distance volume and rates.  The decrease in long distance revenue isattributed to both a 15% drop in the volume of minutes, primarily driven bylower usage patterns across our customer base, as well as a 15% decline inaverage rates from the three months ended June 30, 2003.  Local and long distance average revenues percustomer have decreased year over year as the Company has reduced the cost ofservice and offered substantially more competitive pricing for theseproducts.  Access revenues have decreased$4.5 million from the second quarter of 2003 primarily due to the FCC mandatedrate reduction partially offset by a $6 million favorable net benefit fromongoing rate settlements related to prior period billings.  The final phase of the FCC mandated reductionin access rates is expected to negatively impact revenues in the third quarterof 2004 by approximately $8 million.  Includedin revenues from indefeasible rights of use in the above table is $1.5 millionand $1.6 million for the quarters ended June 30, 2004 and 2003,respectively, related to on-going revenues from operating leases.

 

The Company has taken significant actions to increase revenue includingintroduction of new competitively priced products, reorganization of the salesoperation into three distinct channels, hiring of experienced executiveleadership and expanding the involvement of the board of directors andexecutive staff in the sales process. While the Company believes that these actions will over time result inprofitable new revenue growth, the timing and amount of that growth is yet tobe determined.

 

***Cost of Service***.  Cost of service includes expenses directlyassociated with providing communication services to our customers.  Costs classified as cost of service include,among other items, the cost of connecting customers to our network via leasedfacilities, the costs paid to third party providers for interconnect access andtransport services, the costs of leasing components of our network facilitiesand the cost of fiber related to sales and leases of network facilities.  Cost of service

 

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was $105.3 million for the quarter ended June 30, 2004, a decreaseof $22.8 million or 17.8% from the quarter ended June 30, 2003.  Approximately $8.7 million of the decreasereflects the results of our ongoing network cost reduction efforts that beganin 2002, including least cost routing, network optimization including grooms,migration of customers to the McLeodUSA network and elimination ofnon-profitable customers.  The balance ofthe decrease is attributed to the reduction in revenues.  The cost of fiber related to sales and leasesof network facilities was not significant for the quarters ended June 30,2004 and 2003.

 

***Selling, general and administrative expenses.***  SG&A includes expenses related to salesand marketing, customer service, internal network operations and engineering,information systems and other administrative functions.  SG&A expenses were $68.5 million for thesecond quarter of 2004, a decrease of $5.0 million or 7% from 2003.  Included in SG&A in the second quarter2004 is a benefit of approximately $3.6 million related to a reduction in baddebt expense resulting from improved performance on accounts receivablecollections.  In addition, SG&A inthe second quarter 2003 included a $7.9 million recovery related topre-petition MCI accounts receivable. Excluding these items, the decrease in SG&A year over year isprimarily attributable to efficiencies realized as a result of our continuousprocess improvement program, which has been ongoing since early 2002 and additionalactions which were implemented in the second quarter of 2004.  These combined actions have reducednon-essential expenses and reduced headcount from approximately 3,700 atJune 30, 2003 to 2,500 employees at June 30, 2004.

 

***Depreciation and amortization.***  Depreciation and amortization includes thedepreciation of our communications network and equipment, amortization of otherintangibles determined to have finite lives, and amortization over the life ofthe customer contract of one-time direct installation costs associated withtransferring customers’ local line service from the RBOCs to our localtelecommunications services. Depreciation and amortization expenses were $88.4 million for thequarter ended June 30, 2004, an increase of $3.3 million over the secondquarter of 2003.  This increase was dueto a higher depreciable asset base as a result of additional assets beingplaced in service during 2003 and 2004.

 

***Interest expense.***  Gross interest expense was $12.0 million forthe quarter ended June 30, 2004, an increase of $0.9 million over thesecond quarter of 2003 primarily related to higher outstanding borrowingsduring the period.  Net interest expenseincreased by $3.3 million in the quarter ended June 30, 2004 due to lowercapitalized interest as a result of lower construction in progress balancesduring the quarter.  Interest expense ofapproximately $0.4 million and $2.8 million was capitalized as part of ourconstruction of our fiber optic network during the quarter ended June 30,2004 and 2003, respectively.

 

**Six Months Ended June 30, 2004 Compared with Six Months EndedJune 30, 2003**

 

***Revenue.***  Total revenue for the six months endedJune 30, 2004 declined $63.0 million, or 14%, to $385.5 million from$448.5 million for the six months ended June 30, 2003.  The following table compares our revenue forthe six-months ended June 30:

 
| ** **                                                                                     | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Local                                                                                          |       | $        | 188.5      |     | $          | 212.8        |       | $ | (24.3 | ) |
| Long distance                                                                                  |       | 69.0     |       | 93.9     |       | (24.9        | )          |
| Data services  and other                                                                       |       | 69.3     |       | 69.3     |       | —       |       |
| Carrier access                                                                                 |       | 55.0     |       | 68.9     |       | (13.9        | )          |
| Indefeasible  rights of use agreements including those  that qualify as sales type leases |       | 3.7      |       | 3.6      |       | 0.1          |       |
|                                                                                           |       | $        | 385.5      |     | $          | 448.5        |       | $ | (63.0 | ) |

 

Total revenues declined by $63.0 million versus the first six months of2003 due to a continued decline in total customers, FCC mandated reduction inaccess rates, and lower long distance volume and rates.  The decrease in long distance revenue isattributed to both a 14% drop in the volume of minutes, primarily driven bylower usage patterns across our customer base, as well as a 15% decline inaverage rates from the six month period ended June 30, 2003.  Local and long distance average revenues percustomer have decreased year over year as the Company has reduced the cost ofservice and offered substantially more competitive pricing for theseproducts.  Access revenues have decreased$13.9 million from 2003 primarily due to the FCC mandated rate reductionpartially offset by a $6 million favorable net benefit from ongoing ratesettlements related to prior period billings. Included in revenues from indefeasible rights of use in the above tableis $2.9 million

 

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and $3.3 million for the six month periods ended June 30, 2004 and2003, respectively, related to on-going revenues from operating leases.

 

The Company has taken significant actions to increase revenue includingintroduction of new competitively priced products, reorganization of the salesoperation into three distinct channels, hiring of experienced executiveleadership and expanding the involvement of the board of directors andexecutive staff in the sales process. While the Company believes that these actions will over time result inprofitable new revenue growth, the timing and amount of that growth is yet tobe determined.

 

***Cost of Service***.  Cost of service includes expenses directlyassociated with providing communication services to our customers.  Costs classified as cost of service include,among other items, the cost of connecting customers to our network via leasedfacilities, the costs paid to third party providers for interconnect access andtransport services, the costs of leasing components of our network facilitiesand the cost of fiber related to sales and leases of network facilities.  Cost of service was $212.9 million for thesix month period ended June 30, 2004, a decrease of $52.6 million or 19.8%from the six month period ended June 30, 2003.  Approximately $26.8 million of the decreasereflects the results of our ongoing network cost reduction efforts that beganin 2002, including least cost routing, network optimization including grooms,migration of customers to the McLeodUSA network and elimination ofnon-profitable customers. The balance of the decrease is attributed to thereduction in revenues.  The cost of fiberrelated to sales and leases of network facilities was not significant for thesix months ended June 30, 2004 and totaled $0.3 million for the six monthsended June 30, 2003.

 

***Selling, general and administrative expenses.***  SG&A includes expenses related to salesand marketing, customer service, internal network operations and engineering,information systems and other administrative functions.  SG&A expenses were $144.2 million for thesix months of 2004, a decrease of $11.0 million or 7.1% from 2003.  Our continuous process improvement program,which has been ongoing since early 2002, and specific additional actions takenin the second quarter of 2004 have yielded significant reductions in SG&Aexpense.  As a result, headcount has beenreduced from approximately 3,700 at June 30, 2003 to 2,500 employees atJune 30, 2004.

 

***Depreciation and amortization.***  Depreciation and amortization includes thedepreciation of our communications network and equipment, amortization of otherintangibles determined to have finite lives, and amortization over the life ofthe customer contract of one-time direct installation costs associated withtransferring customers’ local line service from the RBOCs to our localtelecommunications services. Depreciation and amortization expenses were $178.6 million for the sixmonths ended June 30, 2004, an increase of $11.3 million over the secondquarter of 2003.  This increase was dueto a higher depreciable asset base as a result of additional assets beingplaced in service during 2003 and 2004.

 

***Interest expense.***  Gross interest expense was $23.9 million forthe six months ended June 30, 2004, an increase of $0.8 million over thesecond quarter of 2003 primarily related to higher outstanding borrowingsduring the period.  Net interest expenseincreased by $5.8 million in the six months ended June 30, 2004 due tolower capitalized interest as a result of lower construction in progressbalances during the quarter.  Interestexpense of approximately $1.1 million and $5.9 million was capitalized as partof our construction of our fiber optic network during the six months endedJune 30, 2004 and 2003, respectively.

 

**Inflation**

 

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

 

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**Item 3.  Quantitative and QualitativeDisclosures About Market Risk**

 

Upon the consummation of our restructuring on April 16, 2002,substantially all of our fixed rate debt was eliminated. We have variable ratedebt of approximately $758 million under the Credit Agreement outstanding atJune 30, 2004.  If market interestrates average 1% more in subsequent quarters than the rates during the quarterended June 30, 2004, quarterly interest expense would increase by $1.9million.  This amount was determined bycalculating the effect of the hypothetical interest rate increase on ourvariable rate debt for the quarter and does not assume changes in our financialstructure.

 

**Item 4.  Controls and Procedures**

** **

(a) *Disclosure Controls and Procedures*.  The Company’s management, with theparticipation of the Company’s Chief Executive Officer and Chief FinancialOfficer, has evaluated the effectiveness of the Company’s disclosure controlsand procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of theend of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer andChief Financial Officer have concluded that, as of the end of such period, theCompany’s disclosure controls and procedures are effective in recording,processing, summarizing and reporting, on a timely basis, information requiredto be disclosed by the Company in the reports that it files or submits underthe Exchange Act.

 

(b) *Internal Controls over Financial Reporting*.  There have not been any changes in theCompany’s internal control over financial reporting (as such term is defined inRules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarterto which this report relates that have materially affected, or are reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

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**PART II****OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

Former Chairman Clark E. McLeod, PresidentStephen C. Gray (then also Chief Executive Officer), Chairman and ChiefExecutive Officer Chris A. Davis (then Chief Operating and Financial Officer)and former Chief Financial and Accounting Officer J. Lyle Patrick (the‘‘Individual Defendants’’) are defendants in a number of putative class actioncomplaints that have been consolidated into a single complaint entitled In ReMcLeodUSA Incorporated Securities Litigation, Civil Action No. C02-0001 (N.D.Iowa) (the ‘‘Iowa Class Action’’). The Individual Defendants have filed amotion to dismiss the amended consolidated complaint in the Iowa Class Action,which was denied by the district judge. One of the putative class plaintiffs,New Millennium Growth Fund LLC, also filed proofs of claim against McLeodUSA inMcLeodUSA’s Chapter 11 Case for at least $104,650 on its own behalf and for noless than approximately $300 million (plus interest, costs and attorneys’ feesas allowed) on behalf of all class claimants in the Iowa Class Action (the‘‘Bankruptcy Claims’’ and, together with the Iowa Class Action,the ‘‘Securities Claims’’). As the Securities Claims are in early stages, it isimpossible to evaluate the likelihood of unfavorable outcomes or, with respectto the Iowa Class Action, to estimate the amount or range of potential loss, ifany, to McLeodUSA. With respect to the Bankruptcy Claims, on May 2, 2002 theBankruptcy Court issued an order establishing a disputed claims reserve of18,000,000 shares of Reorganized McLeodUSA Class A Common Stock. Any recoveryfrom the Bankruptcy Claims would be limited to those shares of stock. McLeodUSAbelieves that the Securities Claims are without merit and intends to defendthem vigorously.

 

McLeodUSA has indemnification obligationsrunning to the Individual Defendants, the terms of which provide for nolimitation to the maximum potential future payments under suchindemnifications.  McLeodUSA is unable todevelop an estimate of the maximum potential amount of future payments underthe indemnifications due to the inherent uncertainties involved in suchlitigation. McLeodUSA maintains insurance, subject to limitations set forth inthe policies, which is intended to cover the costs of claims made against itscurrent and former Directors and Officers.

 

McLeodUSA is also involved in numerousregulatory proceedings before various public utility commissions and the FCC,particularly in connection with actions by the Regional Bell OperatingCompanies (“RBOCs”). McLeodUSA anticipates the RBOCs will continue to pursuelitigation, regulations and legislation in states within McLeodUSA’s 25-statefootprint and with the FCC to reduce regulatory oversight and regulation overrates, network access and operations. The RBOCs are also actively pursuingmajor changes in the Telecommunications Act of 1996, by regulatory litigationand legislation, which McLeodUSA believes would adversely affect competitivetelecommunications service providers including McLeodUSA. If adopted, theseinitiatives could make it more difficult for McLeodUSA to challenge the RBOCs’actions, or to compete with the RBOCs, in the future. There are no assurancesthat McLeodUSA will prevail in its disputes with the RBOCs.

 

The FCC released its Triennial Review Order(“TRO”) in August 2003 modifying its rules governing availability of RBOCunbundled network elements to competitive carriers. The Triennial Review Orderestablished new rules governing the availability and pricing for the networkelements the RBOCs must provide to competitive carriers, and delegatedauthority to the states to apply certain of the new rules in individualmarkets. Several appeals of the TRO were consolidated in the Court of Appealsfor the District of Columbia (the “Court of Appeals”). On March 2, 2004,the Court of Appeals issued a decision overturning many key elements of theTRO, remanding most of the order to the FCC for further action (*USTA II*). The Court of Appeals ruled that the FCC’sdelegation of final impairment decisions to state agencies was unlawful.  The Court also reversed the FCC’s nationwidefinding regarding mass market switching, dedicated transport and loops, and itsdelegation of decision-making authority to the states. The Court directed theFCC to give stronger consideration to intermodal competition when revising itsrules on remand. The Court upheld the FCC determination that RBOCs do not haveto provide unbundled access at current prices to newly deployed technologiesbased on fiber and packet-switching capabilities. The Court also upheld theFCC’s findings that RBOCs are not required to provide unbundled switching toCLECs for business customers served by high-capacity loops, such as DS-1 orpacket switching. State proceedings that had been started to implement the TROwere suspended in some states and continued in other states. TheCourt originally stayed the effective date of its order for 60 days in order toprovide the FCC with an opportunity to implement new unbundling rules.  Subsequently, on March 31, 2004, the FCCissued a press release and letters to a number of industry participants andtrade associations encouraging industry members to engage in commercialnegotiations to address issues raised in the TRO.  To facilitate these commercial negotiations,the FCC sought and obtained an additional 45-day stay from the Court ofAppeals.   McLeodUSA has executedConfidentiality Agreements with Qwest and SBC, our primary suppliers of networkfacilities, and opened discussions with each of them. On or about June 11,2004, the Chief Executive Officers of each RBOC sent a

 

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letter to the FCC in which each promised to maintain the status quo forunbundled switching until the end of the year. On June 15, 2004, the stay of the Court of Appeals’ decisionexpired. The FCC and U. S. Department of Justice declined to appeal *USTA II*.  Competitiveand interexchange carriers and an organization representing state regulatoryagencies filed appeals to the U.S. Supreme Court and requested a stay.  The U.S. Supreme Court declined to issue astay.  Various representatives of the FCCstated during July 2004 that the FCC desires to adopt interim unbundlingrules in August 2004 and will concurrently issue a Notice of ProposedRulemaking (‘NPRM”) intended to lead to final rules that the FCC will attemptto adopt before year-end.  Regardless ofthe success, or lack of success, of these commercial negotiations and adoptionof interim and final unbundling rules on remand, it is likely that unbundlingrules will be the subject of continued litigation.  There canbe no assurance that our businesses will not be materially adversely affectedby continued legal challenges to unbundling rules, new legislation passed inresponse to unbundling rules or any court decisions that result from continuedlegal challenge to unbundling rules or current law and regulations.

 

The FCC has an open docket proposing toreform intercarrier compensation.  An industrygroup known as the “Intercarrier Compensation Forum” (ICF) is expected toprovide a recommended framework for reforming intercarrier compensation relatedto switched access and reciprocal compensation charges.  If the ICF does not provide a recommendationto the FCC, the FCC will make its own proposal and solicit comments on theissue.  A final decision is expected noearlier than the first quarter of 2005, and the current framework ofintercarrier compensation rules could be materially affected.  On May 13, 2004, the FCC issued a finaldecision on CLEC access charges that apply to the routing of certain 800traffic.  There can be no assurance thatour businesses will not be materially adversely affected by the decision.

 

 OnSeptember 10, 2003, the FCC issued an NPRM on TELRIC. This is a proceedingto review the TELRIC methodology used to determine the prices charged tocompetitive carriers for unbundled network elements. A change in pricingmethodology that materially increases unbundled network element prices wouldincrease our costs and could adversely affect our ability to compete. Adecision is anticipated during 2005.

 

The FCC issued on March 10, 2004 itsNPRM on ‘‘IP-enabled communications,’’ which includes VoIP. The NPRM asks broadquestions regarding the regulatory classifications of various ‘‘IP-enabled’’services, including different VoIP services; the access charge and otherintercarrier compensation implications; the universal service implications; andthe other social policy implications such as law enforcement, disability andemergency 911 service issues and suggests, as a general proposition, theeconomic regulation of various IP-enabled services should be kept to a minimum.

 

Generally, state utility commissions or thirdparties could raise issues with regard to our compliance with applicable lawsor regulations which could have a material adverse effect on our business,results of operations and financial condition. Several state utilitycommissions have reviewed or are actively reviewing the propriety of certainagreements we entered into with Qwest, including Washington, Arizona, andColorado, and these proceedings may result in fines or other sanctions againstus or the imposition of other conditions detrimental to us, including the establishmentof discounts available to other competitive telephone companies but not to us.Other states may initiate similar proceedings.

 

McLeodUSA is not aware of any other materiallitigation against it. McLeodUSA does, however, have various other legal proceedingspending against it or its subsidiaries or on its behalf or that of itssubsidiaries.

 

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**Item 4. Submissions of Matters to a Voteof Security Holders**

 

The Annual Meeting of Stockholders of the Companywas held on May 21, 2004.  All of theproposals presented for stockholder consideration at the Annual Meeting wereapproved.  The following is a tabulationof the voting on each proposal presented at the Annual Meeting.

 

Proposal 1-Election of Directors

 
| ** **                            | ** ** | **Term  Expires** | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|---------------------------------------|------------|-------------------|------------|---------------|------------|--------------------|------------|
| *Board of Directors Nominees:*        | ** ** | ** **        | ** ** | ** **    | ** ** | ** **         | ** ** |
| Thomas M.  Collins                    |       | 2007              |       | 279,611,317   |       | 11,896,747         |       |
| Chris A. Davis                        |       | 2007              |       | 289,613,076   |       | 1,894,988          |       |
| *Series B Preferred Stock Designees:* |       |              |       |          |       |               |       |
| Theodore J.  Forstmann                |       | 2007              |       | 10            |       | —             |       |
| Thomas H.  Lister                     |       | 2007              |       | 10            |       | —             |       |
| *Series A Preferred Stock Designee:*  |       |              |       |          |       |               |       |
| Jeffrey D.  Benjamin                  |       | 2007              |       | 25,314,760    |       | 539,515            |       |

 

Proposal 2-Ratification of the appointment of Deloitte & Touche LLPas McLeodUSA’s independent public accountants for the fiscal year endedDecember 31, 2004.

 
| Votes For        |   | 290,192,207 |   |
|------------------|--------|-------------|--------|
| Votes Against    |   | 718,224     |   |
| Abstentions      |   | 597,633     |   |
| Broker Non-Votes |   | —      |   |

 

**Item 5.  Other Information**

 

Peter Ueberroth resigned as a member of theMcLeodUSA Board of Directors effective as of August 1, 2004.  Mr. Ueberroth confirmed that he had nodisagreements with the McLeodUSA Board of Directors or its management.  Thomas M. Collins, a current independentmember of the Board of Directors, was elected to the Company’s CompensationCommittee to replace Mr. Ueberroth.

 

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

 

(a)                                  Exhibits

 
| **Exhibit  Number** | ** ** | **Exhibit Description**                                                                                                                    | ** ** |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                |       |                                                                                                                                       |       |
| 31.1                |       | Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                      |       |
| 31.2                |       | Certification of CFO pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                      |       |
| 32.1                |       | Certification of CEO pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  |       |
| 32.2                |       | Certification of CFO  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |       |

 

(b)                                 Reportson Form 8-K

 

On May 5, 2004 we filed a Current Report on Form 8-K announcing ourfinancial results for the first quarter of 2004, and certain other information,in a press release.

 

On June 28, 2004 we filed a Current Report on Form 8-K announcingthat the Company had received notice on June 21, 2004 from the NasdaqStock Market that it is not in compliance with Nasdaq Marketplace Rule4310(c)(4), which requires companies listed on the Nasdaq SmallCap Market tomaintain a bid price of at least $1.00 per share.

 

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**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 theundersigned thereunto duly authorized.

 
|                            | **McLEODUSA INCORPORATED** |
|---------------------------------|----------------------------|
|                            | (registrant)               |
|                            |                       |
|                            |                       |
| Date:  August 9, 2004 | By:                        | /s/ Chris A. Davis |
|                            |                       | Chris A. Davis |
| * *                        | * *                   | *Chairman and Chief Executive Officer* |
|                            |                       |   |
|                            |                       |   |
| Date:  August 9, 2004 | By:                        | /s/ G. Kenneth Burckhardt |
|                            |                       | G. Kenneth Burckhardt |
|                            |                       | *Chief Financial Officer* |

 

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**INDEXTO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Exhibit Description**                                                                                                                   | ** ** |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|
| 31.1                |       | Certification of CEO pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                     |       |
| 31.2                |       | Certification of CFO pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                     |       |
| 32.1                |       | Certification of CEO pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |       |
| 32.2                |       | Certification of CFO pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |       |

 

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