**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  March 31, 2005**                                                                                                                                                                                                                                                                                                          |
| ** **      | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                  |
| **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 ofregistrant as specified 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 telephonenumber,including area code)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.   Yes   ý     Noo

 

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

 

Indicate by check mark whether the registrant hasfiled all documents and reports required to be filed by Section 12, 13 or 15(d)of the Securities Exchange Act of 1934 subsequent to the distribution ofsecurities under a plan confirmed by a court. Yes   ý     No o

 
| The number of shares  outstanding of each class of the issuer’s common stock as of April 29, 2005: |
|---------------------------------------------------------------------------------------------------------|
| Common  Stock Class A: ($0.01 par value)                                                                |   | 198,381,768  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 ANDSUBSIDIARIES**

**INDEX**

 
| **PART I. Financial Information** |                                                                                         |
|-----------------------------------|----------------------------------------------------------------------------------------------|
|                              |                                                                                         |
| Item 1.                           | Financial Statements                                                                         |   |
|                              |                                                                                         |   |
|                              | Condensed  Consolidated Balance Sheets                                                       |   |
|                              | March 31, 2005  (unaudited) and December 31, 2004                                            |   |
|                              |                                                                                         |   |
|                              | Unaudited  Condensed Consolidated Statements of Operations – for the three months ended |   |
|                              | March  31, 2005 and 2004                                                                     |   |
|                              |                                                                                         |   |
|                              | Unaudited  Condensed Consolidated Statements of Cash Flows – for the three months ended |   |
|                              | March  31, 2005 and 2004                                                                     |   |
|                              |                                                                                         |   |
|                              | 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 3.                           | Defaults Upon  Senior Securities                                                             |   |
|                              |                                                                                         |   |
| Item 6.                           | Exhibits                                                                                     |   |
|                              |                                                                                         |   |
| Signatures                        |                                                                                         |

 

2

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**PART I – FINANCIAL INFORMATION**

**Item 1.Financial Statements**

**McLEODUSA INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCESHEETS**

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

 
| ** **                                                                                                                                                                                             | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                             | ** ** | **(unaudited)**     | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                                                                             | ** ** | ** **          | ** ** | ** **             | ** ** |
| Current assets                                                                                                                                                                                         |       |                |       |                   |       |
| Cash and cash  equivalents                                                                                                                                                                             |       | $                   | 34.9       |                   | $          | 50.0 |   |
| Trade  receivables, net                                                                                                                                                                                |       | 57.0                |       | 58.6                   |       |
| Prepaid expenses  and other                                                                                                                                                                            |       | 19.8                |       | 19.9                   |       |
| Total current  assets                                                                                                                                                                                  |       | 111.7               |       | 128.5                  |       |
|                                                                                                                                                                                                   |       |                |       |                   |       |
| Property and  equipment                                                                                                                                                                                |       |                |       |                   |       |
| Land and  buildings                                                                                                                                                                                    |       | 74.7                |       | 76.4                   |       |
| Communications  networks                                                                                                                                                                               |       | 1,121.7             |       | 1,116.4                |       |
| Furniture,  fixtures and equipment                                                                                                                                                                     |       | 208.3               |       | 204.5                  |       |
| Networks in  progress                                                                                                                                                                                  |       | 47.8                |       | 51.3                   |       |
| Total property  and equipment                                                                                                                                                                          |       | 1,452.5             |       | 1,448.6                |       |
| Less accumulated  depreciation                                                                                                                                                                         |       | 792.4               |       | 719.9                  |       |
| Net property and  equipment                                                                                                                                                                            |       | 660.1               |       | 728.7                  |       |
|                                                                                                                                                                                                   |       |                |       |                   |       |
| Intangibles and  other assets                                                                                                                                                                          |       |                |       |                   |       |
| Other  intangibles, net                                                                                                                                                                                |       | 135.4               |       | 144.9                  |       |
| Other                                                                                                                                                                                                  |       | 22.4                |       | 23.7                   |       |
| Total  intangibles and other assets                                                                                                                                                                    |       | 157.8               |       | 168.6                  |       |
|                                                                                                                                                                                                   |       |                |       |                   |       |
| **TOTAL  ASSETS**                                                                                                                                                                                      |       | $                   | 929.6      |                   | $          | 1,025.8 |   |
|                                                                                                                                                                                                   |       |                |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ DEFICIENCY**                                                                                                                                                      |       |                |       |                   |       |
| ** **                                                                                                                                                                                             |       |                |       |                   |       |
| Current  liabilities                                                                                                                                                                                   |       |                |       |                   |       |
|                                                                                                                                                                                                   |       |                |       |                   |       |
| Current  maturities of long-term debt                                                                                                                                                                  |       | $                   | 777.3      |                   | $          | 49.5 |   |
| Accounts payable                                                                                                                                                                                       |       | 37.5                |       | 39.6                   |       |
| Accrued payroll  and payroll related expenses                                                                                                                                                          |       | 17.1                |       | 19.7                   |       |
| Other accrued  liabilities                                                                                                                                                                             |       | 81.9                |       | 75.4                   |       |
| Deferred  revenue, current portion                                                                                                                                                                     |       | 6.4                 |       | 6.8                    |       |
| Total current  liabilities                                                                                                                                                                             |       | 920.2               |       | 191.0                  |       |
|                                                                                                                                                                                                   |       |                |       |                   |       |
| Long-term debt,  less current maturities                                                                                                                                                               |       | —              |       | 727.8                  |       |
| Deferred  revenue, less current portion                                                                                                                                                                |       | 16.9                |       | 17.0                   |       |
| Other long-term  liabilities                                                                                                                                                                           |       | 61.5                |       | 61.4                   |       |
| Total  liabilities                                                                                                                                                                                     |       | 998.6               |       | 997.2                  |       |
|                                                                                                                                                                                                   |       |                |       |                   |       |
| Redeemable  convertible preferred stock                                                                                                                                                                |       |                |       |                   |       |
| McLeodUSA  Preferred Series A, redeemable, convertible, $0.01 par value; 10,000,000  authorized and issued; 3,185,441 and 4,131,336 outstanding at March 31, 2005  and December 31, 2004, respectively |       | 58.6                |       | 75.4                   |       |
|                                                                                                                                                                                                   |       |                |       |                   |       |
| Stockholders’  equity                                                                                                                                                                             |       |                |       |                   |       |
| McLeodUSA  Common, Class A $0.01 par value; 1,886,249,986 authorized, 197,150,538 and  192,227,818 issued and outstanding at March 31, 2005 and December 31, 2004,  respectively                       |       | 2.0                 |       | 1.9                    |       |
| McLeodUSA  Common, Class B $0.01 par value; 78,203,135 authorized, issued and  outstanding at March 31, 2005 and December 31, 2004                                                                     |       | 0.8                 |       | 0.8                    |       |
| McLeodUSA  Common, Class C $0.01 par value; 35,546,879 authorized, issued and  outstanding at March 31, 2005 and December 31, 2004                                                                     |       | 0.3                 |       | 0.3                    |       |
| McLeodUSA  Preferred Series B, $0.01 par value; 10 authorized, issued and outstanding at  March 31, 2005 and December 31, 2004                                                                         |       | —              |       | —                 |       |
| McLeodUSA  Warrants                                                                                                                                                                                    |       | 22.6                |       | 22.6                   |       |
| Additional  paid-in capital                                                                                                                                                                            |       | 1,065.8             |       | 1,049.2                |       |
| Accumulated  deficit                                                                                                                                                                                   |       | (1,219.1            | )          | (1,121.6               | )          |
| Total  stockholders’ deficiency                                                                                                                                                                   |       | (127.6              | )          | (46.8                  | )          |
|                                                                                                                                                                                                   |       |                |       |                   |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ DEFICIENCY**                                                                                                                                               |       | $                   | 929.6      |                   | $          | 1,025.8 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financial statements

 

3

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**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inmillions, except per share data)**

 
| ** **                                                                           | ** ** | **Three months ended March 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                         | ** ** | **2004** | ** ** |
|                                                                                 |       |                             |       |   |   |
| Revenues                                                                             |       | $                                | 160.5      |   | $ | 193.6 |   |
|                                                                                 |       |                             |       |   |   |
| Operating expenses:                                                                  |       |                             |       |   |   |
| Cost of service (exclusive of depreciation and amortization shown  separately below) |       | 93.3                             |       | 107.6 |   |
| Selling, general and administrative                                                  |       | 56.7                             |       | 75.7 |   |
| Depreciation and amortization                                                        |       | 91.3                             |       | 90.2 |   |
| Restructuring charges                                                                |       | 2.0                              |       | — |   |
| **Total operating expenses**                                                         |       | 243.3                            |       | 273.5 |   |
| **Operating loss**                                                                   |       | (82.8                            | )          | (79.9 | ) |
| ** **                                                                           |       |                             |       |   |   |
| Nonoperating expense:                                                                |       |                             |       |   |   |
| Interest expense, net of amounts capitalized                                         |       | (14.4                            | )          | (11.1 | ) |
| Other expense                                                                        |       | (0.3                             | )          | (0.4 | ) |
| **Total nonoperating expense**                                                       |       | (14.7                            | )          | (11.5 | ) |
| **Net loss**                                                                         |       | (97.5                            | )          | (91.4 | ) |
| Preferred stock dividend                                                             |       | (0.5                             | )          | (0.8 | ) |
|                                                                                 |       |                             |       |   |   |
| **Net loss applicable to common shares**                                             |       | $                                | (98.0      | ) | $ | (92.2 | ) |
|                                                                                 |       |                             |       |   |   |
| **Basic and diluted loss per common share**                                          |       | $                                | (0.32      | ) | $ | (0.32 | ) |
| **Weighted average common shares outstanding**                                       |       | 308.4                            |       | 291.0 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

 

4

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** McLEODUSA INCORPORATED AND SUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Inmillions)**

 
| ** **                                                                           | ** ** | **Three months ended March 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| **Cash Flows from Operating Activities**                                             |       |                             |       |   |   |
| Net loss                                                                             |       | $                                | (97.5      | ) | $ | (91.4 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities:         |       |                             |       |   |   |
| Depreciation                                                                         |       | 77.0                             |       | 76.0 |   |
| Amortization                                                                         |       | 14.3                             |       | 14.2 |   |
| Accretion of interest                                                                |       | 0.9                              |       | 0.9 |   |
| Amortization of deferred financing fees                                              |       | 1.2                              |       | 1.0 |   |
| Loss on sale of assets                                                               |       | 0.3                              |       | 0.4 |   |
| Changes in assets and liabilities:                                                   |       |                             |       |   |   |
| Trade receivables                                                                    |       | 0.5                              |       | 7.9 |   |
| Prepaid expenses and other                                                           |       | (4.5                             | )          | 0.1 |   |
| Accounts payable and accrued expenses                                                |       | 2.5                              |       | (21.1 | ) |
| Deferred revenue                                                                     |       | (0.8                             | )          | 1.0 |   |
| **Net cash used in operating activities**                                            |       | (6.1                             | )          | (11.0 | ) |
| ** **                                                                           |       |                             |       |   |   |
| **Cash Flows from Investing Activities**                                             |       |                             |       |   |   |
| Purchases of property and equipment                                                  |       | (11.9                            | )          | (13.3 | ) |
| Other assets                                                                         |       | (6.7                             | )          | (8.4 | ) |
| Proceeds from the sale of assets                                                     |       | 9.6                              |       | 6.0 |   |
| **Net cash used in investing activities**                                            |       | (9.0                             | )          | (15.7 | ) |
| ** **                                                                           |       |                             |       |   |   |
| **Cash Flows from Financing Activities**                                             |       |                             |       |   |   |
| Net proceeds from long-term debt                                                     |       | —                           |       | 25.0 |   |
| Payments on long-term debt                                                           |       | —                           |       | (5.8 | ) |
| **Net cash provided by financing activities**                                        |       | —                           |       | 19.2 |   |
|                                                                                 |       |                             |       |   |   |
| **Net decrease in cash and cash equivalents**                                        |       | (15.1                            | )          | (7.5 | ) |
|                                                                                 |       |                             |       |   |   |
| **Cash and cash equivalents**                                                        |       |                             |       |   |   |
| Beginning                                                                            |       | 50.0                             |       | 56.5 |   |
| Ending                                                                               |       | $                                | 34.9       |   | $ | 49.0 |   |
| ** **                                                                           |       |                             |       |   |   |
| **Supplemental Disclosure of Cash Flow Information**                                 |       |                             |       |   |   |
| Cash payments for interest                                                           |       | $                                | 1.6        |   | $ | 10.3 |   |
|                                                                                 |       |                             |       |   |   |
| **Supplemental Schedule of Noncash Investing and Financing Activities**              |       |                             |       |   |   |
| Principal amount converted of Redeemable Preferred Series A to Class A  common stock |       | $                                | 17.3       |   | $ | 9.6 |   |
| Preferred stock dividends                                                            |       | $                                | 0.5        |   | $ | 0.8 |   |

 

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

 

5

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**McLEODUSA INCORPORATED AND SUBSIDIARIES**

**NOTES TOTHE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

###### **Note 1:  Basis of Presentation**

 

McLeodUSA Incorporated (“McLeodUSA” or the “Company”),a Delaware corporation, through its subsidiaries, provides integratedcommunications services in 25 Midwest, Southwest, Northwest and Rocky Mountainstates.  McLeodUSA’s business is highlycompetitive and is subject to various federal, state and local regulations.

 

*Overview*

 

In the fourth quarter of2001, the Company developed a revised strategic plan, which focused onprofitable revenue growth in our 25-state footprint.  This plan served as the basis for itsrecapitalization with its principal shareholder, Forstmann Little & Co.,lender group, and Preferred Shareholders, as well as the structuring of theExit Facility (as defined below) and continues to serve as the basis of theCompany’s yearly operating plans.

 

In order to execute itsplan the Company initiated a variety of programs across the business tosignificantly improve the customer experience, eliminate unneededinfrastructure and cost, improve the quality of the network and grow the topline revenues.  Over the past three yearsthe Company has successfully executed nearly all of these programs.  The operational and certain financial resultsof the Company, as reported in its quarterly and annual financial releases,reflect the significant progress that has been made in the operational areas.

 

However, the Company’srevenues have not increased as forecasted and have been declining since2002.  The decline in revenue was drivenby the Company’s program to eliminate non-profitable customers, turnover ofcustomers to competitors in excess of new customers acquired, reduction of longdistance minutes used by its customer base, reduction in access rates asmandated by the Federal Communications Commission (“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. To date, these actions have not resultedin profitable new revenue growth whichcontinues to be a challenge as the Company competes against large, financiallystrong competitors with well-known brands. With the recent merger announcements in the industry, the Companybelieves that the large telecommunications providers will likely become evenmore aggressive upon the closing of these transactions further challenging itsability to grow revenue.

 

Inlight of the inability of the Company to achieve new revenue growth in excessof existing customer turnover and ultimately generate enough operating cashflow to service the existing level of debt, the Company’s Board of Directorshas authorized the Company to pursue strategic alternatives. In support ofthese initiatives, the Company has hired Miller Buckfire Ying & Co., LLCand Gleacher Partners, LLC as its financial advisors. The Company is nowactively pursuing a strategic partner or a sale of the Company while alsotaking steps to maintain future liquidity, including evaluating a capitalrestructuring to reduce the current debt level enabling the Company to achievepositive cash flow going forward.

 

The Company hasundertaken numerous actions to conserve cash, including the reduction ofcapital expenditures and selling, general and administrative expenses (“SG&A”),as well as the execution of extensive cost reduction efforts initiated in late2001 and continuing through today.  Theseactions have resulted in a 25% reduction in SG&A expenses from the samequarter of last year.  The Company hasbeen selective in managing capital expenditures and does not believe that anyof the reductions in capital spending will have a material impact on its abilityto services its customers.

 

The Company ended March31, 2005 with $34.9 million of cash on hand.  In light of the level of cash held by the Company at year end and thepayments required during the first quarter of 2005 under its Credit Agreementdated May 31, 2000, as amended (the “Credit Agreement”) and its Exit CreditAgreement, dated April 16, 2002, as amended, (the “Exit Facility” orcollectively, the “Credit Facilities”), the Company began discussions with itsagent bank and a group of lenders acting as a steering committee for thelenders under its Credit Facilities.  TheCompany entered a forbearance agreement on March 16, 2005 with its lenders withrespect to scheduled principal and interest payments on its loans whereby thelenders agreed not to take any action as a result of non-payment by the Companyof approximately $7.8 million of scheduled principal amortization and $10.3million of interest payments due on or before March 31, 2005 and any relatedevents of default through May 23, 2005. In accordance with the forbearance agreement, on March 22, 2005, theCompany elected not to make $2.8 million of interest payments on such loansand, as a result, an event of default occurred and the Company is

 

6

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required to accrue anadditional two percentage points of interest on such loans as provided in theforbearance agreement. The Company believes that by not making principal andinterest payments on the Credit Facilities, cash on hand together with cashflows from operations is sufficient to maintain operations in the ordinarycourse without disruption of services.

 

In light of therevenue outlook and the Company’s on-going cash requirements, the Company hasalso begun discussions related to a capital restructuring with its agent bankand a group of lenders acting as a steering committee for the lenders under itsCredit Facilities. The Company and this committee are in negotiations relatedto terms of a capital restructuring which includes the conversion of asignificant portion of the Company’s current outstanding debt into equity.Under such a restructuring, the holders of the Company’s current debt wouldbecome equity shareholders of the Company with the current holders of thepreferred and common stock unlikely to receive any recovery.

 

The Company is currentlyin discussions with the lender committee regarding an extension to the existingforbearance agreement.  There can be noassurance that the Company will be able to reach an agreement with its lendersregarding a capital restructuring or continued forbearance and covenant reliefprior to the end of the initial forbearance period on May 23, 2005.  There also can be no assurance that theCompany will be able to identify a suitable strategic partner or buyer or reachagreement with any such strategic partner or buyer on terms and conditionsacceptable to the Company prior to the end of the initial forbearanceperiod.  In the event these alternativesare not available to the Company, it is likely that the Company will elect toforgo making future principal and interest payments to its lenders while itcontinues to seek an extended forbearance period or permanent capitalrestructuring from its lenders, or alternatively, the Company could be forcedto seek protection from its creditors.

 

Our financial statementsfor the period ending March 31, 2005 are prepared on a going concern basis,which contemplates the realization of assets and the satisfaction ofliabilities in the normal course of business, but it may not be able tocontinue as a going concern.  The reportof McLeodUSA’s independent registered public accounting firm accompanying itsfinancial statements in its Annual Report on 10-K filed with the Securities andExchange Commission (“SEC”) on March 25, 2005, contains a comment stating thatthere is substantial doubt as to its ability to continue as a goingconcern.  In the event the Company’srestructuring activities are not successful and it is required to seekprotection from its creditors, additional significant adjustments may benecessary in the carrying value of assets and liabilities, the revenues andexpenses reported and the balance sheet classifications used.

 

**Interim Financial Information(unaudited)**

 

In the opinion of management, the accompanyingunaudited condensed consolidated financial statements include adjustments,consisting of normal recurring adjustments, necessary for a fair presentationof the financial position and results of operations of McLeodUSA.  The operating results for the interim periodsare not necessarily indicative of the operating results to be expected for afull year or for other interim periods. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America (“GAAP”) have been condensedor omitted pursuant to instructions, rules and regulations prescribed by theSEC.  Although management believes thatthe disclosures 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, 2004, filedwith the SEC on March 25, 2005.

 

**Accounting for Stock-based Compensation**

 

Aspermitted by Statement of Financial Accounting Standards (“SFAS”) No. 123, *Accounting for Stock-Based Compensation*(“SFAS 123”),McLeodUSA measures compensation using the intrinsic value based method asprescribed by Accounting Principles Board Opinion No. 25, *Accountingfor Stock Issued to Employees,*but is required to make proformadisclosures in the footnotes to the financial statements as if the measurementprovisions of SFAS 123 and SFAS No. 148 *Accounting for Stock-BasedCompensation-Transition and Disclosure — an Amendment of SFAS 123*hadbeen adopted. Under the intrinsic value method, compensation is measured as thedifference between the market value of the stock on the grant date, less theamount required to be paid for the stock. The difference, if any, is charged toexpense over the vesting period of the options. No stock-based employee compensationcost is reflected in net loss, as all options granted under the plan had anexercise price greater than or equal to the market value of the underlyingcommon stock on the date of grant.  Thefollowing table illustrates the effect on net loss and net loss per share forthe three months ended March 31, 2005 and 2004 as if McLeodUSA had applied thefair value recognition provisions of SFAS 123 to stock-based employeecompensation.

 

7

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| ** **                                                                                       | ** ** | **Three months ended March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                       | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Net loss  applicable to common shares, as reported                                               |       | $                                | (98.0      | ) | $ | (92.2 | ) |
| Less: Total stock-based  employee compensation expense determined under fair value based methods |       | (2.0                             | )          | (3.2 | ) |
| Pro forma net  loss applicable to common shares                                                  |       | $                                | (100.0     | ) | $ | (95.4 | ) |
|                                                                                             |       |                             |       |   |   |
| **Loss  per share:**                                                                             |       |                             |       |   |   |
| Basic and  diluted, as reported                                                                  |       | $                                | (0.32      | ) | $ | (0.32 | ) |
| Basic and  diluted, pro forma                                                                    |       | $                                | (0.32      | ) | $ | (0.33 | ) |

 

**Basic and diluted loss per common share**

 

Lossper common share has been computed using the weighted average number of sharesof common stock outstanding.  All stockoptions granted, and the convertible preferred stock and warrants outstandingare anti-dilutive, and are therefore excluded from the computation of earningsper share. In the future, the stock options, convertible preferred stock andwarrants totaling approximately 110 million shares and 138 million shares atMarch 31, 2005 and 2004, respectively, may become dilutive.  Assuming exercise or conversion of stockoptions and convertible securities, diluted shares would have beenapproximately 420 million and 430 million at March 31, 2005 and 2004,respectively.

 

**New accounting pronouncement**

 

**In December 2004, The FinancialAccounting Standards Board revised and reissued SFAS 123 as SFAS 123(R), *Accounting for Stock Issued to Employees*(“SFAS 123(R)”).  This statement establishes standards for theaccounting for transactions in which an entity exchanges its equity instrumentsfor goods or services.  It requires anentity to measure the cost of employee services received in exchange for anaward of equity instruments based on the grant-date fair value of theaward.  The cost will then be recognizedas compensation cost over the period during which an employee is required toprovide service in exchange for the award. The provisions of this statement are effective for McLeodUSA January 1,2006.  McLeodUSA is still evaluating theimpact that SFAS 123(R) will have on its financial position and results ofoperations but expects that the disclosure above, adjusted for estimatedforfeitures, provides a reasonable measure of the expected impact.**

 

**Guarantees**

 

In November 2002, theFinancial Accounting Standards Board (“FASB”) issued FASB Interpretation No.45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*.  This interpretation clarifies disclosuresthat are required to be made by a guarantor in its interim and annual financialstatements about obligations under certain of its issued guarantees. Inaddition, the interpretation clarifies that a guarantor is required torecognize, at the inception of certain types of guarantees, a liability for thefair value of the obligation undertaken in issuing these guarantees.  At March 31, 2005, McLeodUSA, the parent company, has various guarantees related tosubsidiary commitments under operating leases. As of March 31, 2005 the guarantees total $22.8 million and expire overvarious periods through September 2016, corresponding with the termination ofthe lease agreements.

 

McLeodUSA hasindemnification obligations to its current and former Directors andOfficers.  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.

 

McLeodUSAentered into an executive employment agreement with its Chief ExecutiveOfficer, Chris A. Davis, as of October 14, 2004.  Under the agreement, McLeodUSA has agreed tomake equalization payments, as necessary, to offset any reduction in certainannual cash compensation currently received by Ms. Davis from Forstmann Little.  The amount of such equalization payments isnot to exceed $500,000 annually.

 

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**Note 2:  Trade Receivables**

 

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

 

| ** **                                     | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| Trade  Receivables:                            |       |                |       |                   |       |
| Billed                                         |       | $                   | 66.0       |                   | $          | 66.3 |   |
| Unbilled                                       |       | 4.6                 |       | 4.8                    |       |
|                                           |       | 70.6                |       | 71.1                   |       |
| Allowance for  doubtful accounts and discounts |       | (13.6               | )          | (12.5                  | )          |
|                                           |       | $                   | 57.0       |                   | $          | 58.6 |   |

 

**Note 3:  Other Accrued Liabilities**

 

Other accrued liabilitiesconsisted of the following (in millions):

 

| ** **                      | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------|------------|---------------------|------------|------------------------|------------|
| Accrued  sales/use/excise taxes |       | $                   | 17.5       |                   | $          | 17.8 |   |
| Accrued interest                |       | 12.8                |       | 1.8                    |       |
| Restructuring                   |       | 12.3                |       | 15.2                   |       |
| Accrued property  taxes         |       | 9.3                 |       | 10.9                   |       |
| Other                           |       | 30.0                |       | 29.7                   |       |
|                            |       | $                   | 81.9       |                   | $          | 75.4 |   |

 

As discussed in Note 1,the Company elected not to make $10.3 million in interest payments due on orbefore March 31, 2005.  As a result ofthe non-payment on March 22, 2005, an event of default occurred and the Companyis required to accrue two additional percentage points of interest on theCredit Facilities as provided in the forbearance agreement.

 

**Note 4:  Restructuring Charges**

 

Changes in the carryingamount of the restructuring liability for the three months ended March 31, 2005is summarized as follows (in millions):

 
| **Facility  closure costs** | ** ** | ** ** | ** ** |
|-----------------------------|------------|------------|------------|
| Balance,  December 31, 2004 |       | $          | 15.2       |   |
| Payments                    |       | (2.9       | )          |
| Balance, March  31, 2005    |       | $          | 12.3       |   |

 

**Note 5: Other Intangible Assets**

 

In accordance with SFASNo. 142, *Goodwill and Other Intangible Assets*(“SFAS142”), other indefinite lived intangible assets are not amortized but reviewedannually for impairment or more frequently if an event occurs or circumstanceschange that would more likely than not reduce the fair value below its carryingamount.  For other indefinite livedintangible assets, SFAS 142 requires that the impairment test consist of acomparison of the fair value of the intangible asset with its carryingamount.  If the carrying amount of theintangible asset exceeds its fair value, an impairment loss is recognized in anamount equal to that excess.  McLeodUSAhas established July 1 as the date for its annual impairment test for its otherindefinite lived intangible asset. McLeodUSA performed its annual indefinite lived intangible assetsevaluation using the July 1 test date in connection with the preparation of itsfinancial statements for the period ended September 30, 2004.  This evaluation (for which management engageda third party appraisal firm) indicated partial impairment in the McLeodUSAtrade name.  An $18.0 million charge wasrecorded in the third quarter of 2004, reducing the carrying value to $64.9million. During the quarter ended March 31, 2005, the Company reviewed thespecific requirements of SFAS 142 regarding the need for impairmenttesting between annual tests and concluded that there were no such events orchanges in circumstances that would indicated that the asset may be impaired.

 

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Intangible assets withfinite lives at March 31, 2005 and December 31, 2004 are summarized as follows(in millions):

 

| ** **                       | ** ** | **Gross** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|----------------------------------|------------|-----------|------------|-------------------------------|------------|---------|------------|
| **March 31, 2005:**              |       |      |       |                          |       |    |       |
| Deferred line installation costs |       | $         | 195.0      |                          | $          | 134.6   |       | $ | 60.4 |   |
| Customer base                    |       | 29.8      |       | 20.0                          |       | 9.8     |       |
| PrimeLine Trademark              |       | 0.9       |       | 0.6                           |       | 0.3     |       |
|                             |       | $         | 225.7      |                          | $          | 155.2   |       | $ | 70.5 |   |

 

 

| ** **                       | ** ** | **Gross** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|----------------------------------|------------|-----------|------------|-------------------------------|------------|---------|------------|
| **December 31, 2004:**           |       |      |       |                          |       |    |       |
| Deferred line installation costs |       | $         | 190.5      |                          | $          | 121.9   |       | $ | 68.6 |   |
| Customer base                    |       | 29.8      |       | 18.7                          |       | 11.1    |       |
| PrimeLine Trademark              |       | 0.9       |       | 0.6                           |       | 0.3     |       |
|                             |       | $         | 221.2      |                          | $          | 141.2   |       | $ | 80.0 |   |

 

Annual estimatedamortization expense for intangible assets above for 2005 is $37 million, $30million for 2006, and $3 million for 2007.

 

**Note 6:  Accounting for Asset Retirement Obligations**

 

SFAS No. 143, *Accounting for Asset Retirement Obligations* (“SFAS 143”),requires entities to record the fair value of a liability for an assetretirement obligation in the period in which the legal or contractual removalobligation is incurred.  McLeodUSA’s assetretirement obligations relate to three categories of assets: fiber, centraloffice colocation equipment and technical sites.

 

The liability wasestablished by calculating the present value of the asset retirement obligationusing a discount rate of 6.1% over a period of 15 years, which isrepresentative of the estimated life of McLeodUSA’s telecommunications network.

 

Changes in the carryingamount of the asset retirement obligation for the three months ended March 31,2005 is summarized as follows (in millions):

 
| Balance, December 31, 2004 |   | $    | 61.4   |   |
|----------------------------|--------|------|--------|--------|
| Interest accretion         |   | 0.9  |   |
| Payments                   |   | (0.2 | )      |
| Adjustments                |   | (0.6 | )      |
| Balance, March 31, 2005    |   | $    | 61.5   |   |

 

**Note 7:  Long Term Debt**

 

On March 16, 2005,McLeodUSA and certain of its subsidiaries entered into a Forbearance Agreementwith JPMorgan Chase Bank, N.A., as administrative agent related to the CreditAgreement and Exit Facility. Pursuant to the Forbearance Agreement, the lendershave agreed to forbear from exercising any remedies as a result of certain specifieddefaults under the Credit Facilities anticipated by the Company during theforbearance period, including, without limitation, the failure to makescheduled amortization payments under the Credit Facilities and interestpayments under the Credit Agreement.  Theforbearance period, the purpose of which is to enable the parties to explorepossible strategic transactions, runs through May 23, 2005.

 

In accordance with theforbearance agreement, the Company did not make approximately $18.1 million ofscheduled principal amortization and interest payments due on or before March31, 2005.  As a result of the nonpaymentof interest on March 22, 2005, an event of default occurred and the Company isrequired to accrue an additional two percentage points of

 

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interest on such loans asprovided in the forbearance agreement. The Company’s debt has been classified as current in the condensedconsolidated balance sheet because the default is not expected to be cured byMay 23, 2005, the date the Forbearance Agreement ends, and the ForbearanceAgreement does not extend beyond one year from the balance sheet date. TheCompany is currently in discussions with the lender committee regarding anextension to the existing forbearance agreement. There can be no assurance thatthe Company will be able to reach an agreement with its lenders regarding acapital restructuring or continued forbearance and covenant relief prior to theend of the initial forbearance period on May 23, 2005.

 

**Note 8: Litigation**

 

FormerChairman Clark E. McLeod, former President Stephen C. Gray (then also ChiefExecutive Officer), Chairman and Chief Executive Officer Chris A. Davis (thenChief Operating and Financial Officer) and former Chief Financial andAccounting Officer J. Lyle Patrick (the “Individual Defendants”) are defendantsin a consolidated class action entitled In re McLeodUSA Incorporated SecuritiesLitigation, Civil Action No. C02-0001 (N.D. Iowa) (the “Iowa Class Action”),alleging inter alia, violations of the Securities Act of 1933 and theSecurities Exchange Act of 1934. The Individual Defendants moved to dismiss theconsolidated amended complaint in the Iowa Class Action.  That motion was denied. Discovery isongoing.   One of the putative classplaintiffs, New Millennium Growth Fund LLC, also filed proofs of claim againstMcLeodUSA in McLeodUSA’s Chapter 11 Case, seeking at least $104,650 on its ownbehalf and no less than approximately $300 million (plus interest, costs andattorneys’ fees as allowed) on behalf of all class claimants in the Iowa ClassAction (the “Bankruptcy Claims” and, together with the Iowa ClassAction, the “Securities Claims”).  TheBankruptcy Claims were transferred from the bankruptcy court in Delaware to theIowa court, and consolidated with the Iowa Class Action on February 1,2005.  As the Securities Claims are inearly stages, it is impossible to evaluate the likelihood of unfavorableoutcomes or, with respect to McLeodUSA’s indemnification obligations in connectionwith the claims alleged again the Individual Defendants in the consolidatedamended complaint, estimate the amount or range of potential loss, if any, toMcLeodUSA.  With respect to theBankruptcy Claims, on May 2, 2002, the Bankruptcy Court issued an orderestablishing a disputed claims reserve of 18,000,000 shares of ReorganizedMcLeodUSA Class A Common Stock. Any recovery from the Bankruptcy Claims wouldbe limited to those shares of stock. McLeodUSA believes that the Securities Claims are without merit andintends to defend them vigorously.

 

McLeodUSAhas indemnification obligations running to the Individual Defendants, the termsof which provide for no limitation to the maximum potential future paymentsunder such indemnifications.  McLeodUSAis unable to develop an estimate of the maximum potential amount of futurepayments under the indemnifications due to the inherent uncertainties involvedin such litigation. McLeodUSA maintains insurance, subject to limitations setforth in the policies, which is intended to cover the costs of claims madeagainst its current and former Directors and Officers, including the IndividualDefendants.

 

McLeodUSA,as successor to Caprock Communications Corporation, is a defendant in a lawsuitbrought by Alcatel USA Marketing, Inc. (“Alcatel”), in County Court No. 5,Dallas County, Texas, entitled Alcatel USA Marketing, Inc vs. CaprockCommunications Corporation and McLeodUSA Holdings, Inc., Cause No.CC04-11573-E.  Plaintiff alleges breachof a 1994 supply agreement and certain purchase orders issued in 2000 under theagreement.  Alcatel seeks damages ofapproximately $6.3 million plus interest, costs and attorneys’ fees.  McLeodUSA has filed an answer denyingliability, including asserting that a May 17, 2002 Privileged SettlementCommunication between the parties rendered the purchase orders in dispute nulland void.  The suit is in the discoverystage therefore, an estimate of a possible loss or range of loss cannot be madeat this time. While McLeodUSA intends to vigorously defend against theseclaims, there can be no assurance that the Company will prevail in thisdispute, given the uncertainties inherent in a jury trial.

 

McLeodUSAis also involved in numerous regulatory proceedings before various publicutility commissions and the FCC, particularly in connection with actions by theRegional Bell Operating Companies (“RBOCs”). McLeodUSA anticipates the RBOCs will continue to pursue litigation,regulations and legislation in states within McLeodUSA’s 25-state footprint andwith the FCC to reduce regulatory oversight and regulation over rates, networkaccess and operations. The RBOCs are also actively pursuing major changes inthe Telecommunications Act of 1996 (“1996 Act”), by regulatory litigation andlegislation, which McLeodUSA believes would adversely affect competitivetelecommunications service providers including McLeodUSA. If adopted, thesechanges 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.

 

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TheFCC released its Triennial Review Order (“TRO”) in August 2003 modifying itsrules governing availability of RBOC unbundled network elements to competitivecarriers. The Triennial Review Order established new rules governing theavailability and pricing for the network elements the RBOCs must provide tocompetitive carriers, and delegated authority to the states to apply certain ofthe new rules in individual markets. Several appeals of the TRO wereconsolidated in the Court of Appeals for the District of Columbia (the “Courtof Appeals”).  On March 2, 2004, theCourt of Appeals issued a decision overturning many key elements of the TRO,remanding most of the order to the FCC for further action (*USTA II*).The Court of Appeals ruled that the FCC’s delegation of final impairmentdecisions to state agencies was unlawful. The Court also reversed the FCC’s nationwide finding regarding massmarket switching, dedicated transport and its delegation of decision-makingauthority to the states. The Court directed the FCC to give strongerconsideration to intermodal competition when revising its rules on remand. TheCourt upheld the FCC determination that RBOCs do not have to provide unbundledaccess at current prices to newly deployed technologies based on fiber andpacket-switching capabilities. The Court also upheld the FCC’s findings thatRBOCs are not required to provide unbundled switching to CLECs for businesscustomers served by high-capacity loops, such as DS-1 or packet switching.  State proceedings that had been started toimplement the TRO were suspended in some states and continued in otherstates.  The FCC and U. S.Department of Justice declined to appeal *USTA II*.  Competitive and interexchange carriers and anorganization representing state regulatory agencies filed appeals to the U.S.Supreme Court and requested a stay.  TheU.S. Supreme Court declined to issue a stay.  On July 22, the FCC adopted and on August 22, 2004, the FCC released anInterim UNE Order (the “Interim Order”) establishing requirements that governthe availability of UNEs until the FCC adopts new, permanent unbundlingrules.  The Interim Order maintained theRBOC obligations to provide UNEs at current prices until March 2005.  Verizon, Qwest and the United StatesTelephone Association (“USTA”) appealed the Interim Order to the Court ofAppeals.  On October 4, all parties filedwritten comments with the FCC addressing permanent unbundling rules.  The Court of Appeals on October 6, 2004,issued a decision that puts on hold until January 4, 2005, the petition filedby Verizon, Qwest and USTA to immediately overturn the FCC’s InterimOrder.  On October 12, 2004, the U.S.Supreme Court rejected the appeal asking the Court to hear an appeal of theCourt of Appeals *USTA II* decision. On December 15,2004, the FCC announced adoption of revised permanent unbundling rules that itbelieves are in compliance with prior appellate decisions.  These new unbundling rules impact access tolocal switching, high capacity loops, high capacity transport, dark fiber, andentrance facilities.  The FCC alsoadopted a transition plan for those elements that will no longer be UNEs.  The Company believes that the new rules arepredominantly supportive of its facilities-based (UNE-L) strategy.  The new unbundling rules became effectiveMarch 11, 2005.

 

Regardless of thesuccess, or lack of success, of commercial negotiations with Qwest and SBC andadoption of final unbundling rules, it is likely that unbundling rules will bethe subject of continued litigation.  There can be no assurance that our businesseswill not be materially adversely affected by continued legal challenges tounbundling rules, new legislation passed in response to unbundling rules or anycourt decisions that result from continued legal challenge to unbundling rulesor current law and regulations.

 

TheFCC has an open docket proposing to reform intercarrier compensation.  An industry group known as the IntercarrierCompensation Forum provided a recommended framework for reforming intercarriercompensation related to switched access and reciprocal compensation charges.  Other coalitions provided competing recommendationsfor reforming intercarrier compensation to the FCC in the Fall 2004.  The FCC is evaluating all proposals and hassolicited further comments on the issue. A final decision is expected no earlier than the first quarter of 2006,and the current framework of intercarrier compensation rules could bematerially affected.

 

OnSeptember 10, 2003, the FCC issued a Notice of Proposed Rulemaking (“NPRM”) onTotal Element Long Run Incremental Cost (“TELRIC”).  This is a proceeding to review the TELRIC methodologyused to determine the prices charged to competitive carriers for unbundlednetwork elements. A change in pricing methodology that materially increasesunbundled network element prices would increase our costs and could adverselyaffect our ability to compete. A decision is anticipated during 2005.

 

OnOctober 18, 2004, the FCC released an Order that extends unbundling relief tothe RBOCs for mass market fiber-to-the-curb loops with fiber that is within 500feet of the premises.  The FCC also clarifiedthat incumbent LECs are not required to add TDM capabilities into newpacketized transmission facilities.  Itis likely that this additional unbundling relief and new network modificationrule will be the subject of litigation. Such changes could limit our access to mass market customers andadversely affect our ability to compete.

 

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OnOctober 22, 2004, the FCC voted to eliminate any independent unbundlingobligation under Section 271 of the 1996 Act for any network element that hasbeen removed from Section 251 of the 1996 Act. Such relief could limit our access to customers and adversely affect ourability to compete.

 

TheFCC issued on March 10, 2004 its NPRM on “IP-enabled communications,” whichincludes VoIP. The NPRM asks broad questions regarding the regulatoryclassifications of various “IP-enabled” services, including different VoIPservices; the access charge and other intercarrier compensation implications;the universal service implications; and the other social policy implicationssuch as law enforcement, disability and emergency 911 service issues andsuggests, as a general proposition, the economic regulation of variousIP-enabled services should be kept to a minimum.

 

In April2001, the FCC released an Order in which it established a benchmark rate atwhich CLECs’ interstate access charges would be presumed reasonable and which aCLEC could impose on an interexchange carrier (“IXC”) by tariff. In May of 2004, the FCC announced a new rulegoverning CLEC interstate access charges that imposed a limit on CLEC accesscharges when the CLEC did not directly serve the end user.  The new rule provided that the charge couldbe no more than the rate charged by the ILEC for the same functionality.  The FCC order stated its new rule limitingCLEC interstate access charges was to be applied on a prospective basis.  McLeodUSA filed tariff changes to implementthe FCC’s new rule.  The FCC’s Order alsoprovided that under its prior rules, it would not have been unreasonable for aCLEC to charge an IXC for those services at the higher benchmark rate.  Some IXCs have disputed and withheldpayment of billed access charges for wireless originated toll free calls andhave also withheld payments due to the Company for other charges.  The Company, in response to these actions,has also withheld payments from them.  Asof March 3, 2005, the amounts charged by the Company but not paid by these IXCsare:  MCI, approximately $6.4 million;Sprint, approximately $4.7 million; and Qwest, approximately $4.9 million.  The Company’s withholdings, all of which areless than the amounts withheld by the IXCs are: MCI, approximately $3.4 million; Qwest, approximately $3.8 million; andSprint, approximately $0.8 million.  Intotal, approximately $23.5 million of access charges are disputed by thesethree IXCs related to certain types of tollfree traffic for prior periods based on alleged insufficiency of tariffgrounds.  McLeodUSA has written contractswith two of the IXCs that identify the rates or source of rates that McLeodUSAis entitled to charge for interstate access services.  McLeodUSA continued to bill for its servicesat the full benchmark rate until the FCC’s new rule went into effect as of June22, 2004 at which time it billed at the revised rates in accordance with by theFCC’s new rule.  As a consequence of thewithholding of payments by these carriers, McLeodUSA filed suit against SprintCommunications Corporation (“Sprint”) in the United States District Court for theNorthern District of Iowa claiming that, by Sprint’s failure to pay theinterstate access charges that the Company billed, Sprint was in breach of itscontract with the Company.  In additionto its breach of express contract claim against Sprint, the Company is pursuingrecovery of its interstate access charges for toll free traffic under impliedcontract and unjust enrichment theories. McLeodUSA filed suit against Qwest Corporation in this same court, latertransferred to Denver, CO, to recover charges unpaid by Qwest.  Qwest filed suit against McLeodUSA in Denver,CO, contesting these charges.  On March23, 2005, the federal court in Northern District of Iowa issued a  temporary restraining order preventing Qwestfrom terminating certain services to the Company in connection with thedispute.   A hearing on a PreliminaryInjunction is scheduled for May 19, 2005. On March 22, 2005, the Company and MCI filed demands for bindingarbitration in connection with these disputes. On December 15, 2004, the FCC issued an order in *USTelepacific*reaffirming that its rule limiting CLEC access rates tobe no more than the rate charged by the ILEC for the same functionality,adopted in May 2004, was to be applied on a prospective basis only, and that itwas not unreasonable for a CLEC to charge the full benchmark rate for trafficto or from end-users of other carriers, provided that the carrier serving theend-user did not also charge the IXC and provided that the CLEC’s charges wereotherwise in compliance with and supported by its tariff.  The Company believes that recovery ofwithheld amounts is probable; accordingly, no amounts have been reserved by theCompany at December 31, 2004.  However,certain of the underlying issues have never been litigated and are largelyquestions of first impression.

 

McLeodUSAis a defendant in a lawsuit brought by SBC and its affiliates in the U.S.District Court in the Eastern District of Missouri. SBC alleges that McLeodUSAconspired with one or more of Global Crossing and its affiliates, certain namedcompetitive local exchange carriers, and/or certain unnamed “least cost routers”to breach SBC’s state or federal tariffs, unjustly enrich themselves, andcommit fraud on SBC.   SBC alleges thatthe defendants knowingly disguised long distance calls that were terminated toSBC so that they appeared to SBC to be local calls thereby depriving SBC of thedifference between the access charge rate owed for termination of long distancecalls and the reciprocal compensation rate owed for termination of local calls.McLeodUSA’s answer was filed on April 1, 2005, denying all liability.   McLeodUSA intends to vigorously defendagainst these claims.

 

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OnMay 9, 2005, AT&T sent a demand to the Company for arbitration of its claimfor in excess of $8 million under an Engineering and Construction ManagementAgreement between AT&T and CapRock Telecommunications Corp. dated November1999.  The claim principally relates toconstruction and fiber optic cable costs incurred in connection withconstruction of the Ring 3 fiber optic cable project from Tulsa, OK to OklahomaCity, OK from 1999 to 2000.  The Companydenies that it owes the monies.  WhileMcLeodUSA intends to vigorously defend against this demand, there can be noassurance that the Company will prevail in this dispute.

 

Generally,state utility commissions or third parties could raise issues with regard toour compliance with applicable laws or regulations that could have a materialadverse effect on our business, results of operations and financialcondition.  On September 8, 2004, theWashington State commission settled all issues with McLeodUSA for $25,000 plusother non-financial issues.  Severalother state utility commissions have reviewed or are actively reviewing thepropriety of certain agreements we entered into with Qwest, including Arizonaand Colorado, and these proceedings may result in fines or other sanctionsagainst us or the imposition of other conditions detrimental to us, includingthe establishment of discounts available to other competitive telephonecompanies but not to us. Other states may initiate similar proceedings.

 

McLeodUSAis not aware of any other material litigation against it. McLeodUSA does,however, have various other legal proceedings pending against it or itssubsidiaries or on its behalf or that of its subsidiaries

 

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**Information Regarding Forward-Looking Statements**

 

Some of the statements inthis discussion include statements about our future expectations.  Statements that are not historical facts areforward-looking statements for the purpose of the safe harbor provided bySection 21E of the Exchange Act and Section 27A of the Securities Act.  Such statements may include projections offinancial and operational results and goals, including revenue, profitability,savings and cash. In some cases, you canidentify these so-called “forward looking statements” by our use of words suchas “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,”“predict”, “project”, “intend” or “potential” or the negative of those wordsand other comparable words.****Theseforward-looking statements are subject to known as well as unknown risks anduncertainties that may cause actual results to differ materially from ourexpectations.  Our expectations are basedon various factors and assumptions and reflect only our predictions.  Factors that could cause actual results todiffer materially from the forward-looking statement include technological,regulatory, public policy or other developments in our industry, availabilityand adequacy of capital resources, our ability to continue as a going concern,our ability to implement a strategic transaction or a capital restructuring,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 tomigrate traffic to appropriate platforms and changes in the competitive climatein which we operate.  These and otherrisks are described in more detail in our most recent Annual Report on Form10-K filed with the SEC.  Except asrequired under the federal securities laws and rules and regulations of theSEC, the Company undertakes no obligation to update publicly anyforward-looking statements, whether as a result of future events, newinformation or otherwise.

 

**Item2.             Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

The following discussionand analysis provides information concerning the results of operations and ourfinancial condition and should be read in conjunction with the accompanyingunaudited condensed consolidated financial statements and notes thereto.  Additionally, the following discussion andanalysis should be read in conjunction with our audited consolidated financialstatements included in our Annual Report on Form 10-K for the year endedDecember 31, 2004.

 

# ***ExecutiveOverview***

 

In the fourth quarter of2001, we developed a revised strategic plan, which focused on profitablerevenue growth in our 25-state footprint. This plan served as the basis for our recapitalization with ourprincipal shareholder, Forstmann Little & Co., lender group, and PreferredShareholders, as well as the structuring of the Exit Facility and continues toserve as the basis of our yearly operating plans.

 

In order to execute ourplan we initiated a variety of programs across the business to significantlyimprove the customer experience, eliminate unneeded infrastructure and cost,improve the quality of the network and grow the top line revenues.  Over the past three years we havesuccessfully executed nearly all of these programs.  The operational and certain financial resultsof the Company, as reported in its quarterly and annual financial releases,reflect the significant progress that has been made in the operational areas.

 

However, the Company’srevenues have not increased as forecasted and have been declining since2002.  The decline in revenue was drivenprimarily by our program to eliminate non-profitable customers, turnover ofcustomers to competitors in excess of new customers acquired, reduction of longdistance minutes used by our customer base, reduction in access rates asmandated by the FCC, and lower prices for some of our products.  We have taken significant actions to increaserevenue, including introduction of new competitively priced products,reorganization of the sales operation into three distinct channels, hiring ofexperienced executive sales leadership, expanding the involvement of the boardof directors and executive staff in the sales process and reducing customerchurn.  To date, these actions have notresulted in profitable new revenue growthwhich continues to be a challenge as we compete against large, financiallystrong competitors with well-known brands.  With the recent merger announcements in the industry, we believe that thelarge telecommunications providers will likely become even more aggressive uponthe closing of these transactions further challenging our ability to growrevenue.

 

Inlight of the inability of the Company to achieve new revenue growth in excessof existing customer turnover and ultimately generate enough operating cashflow to service the existing level of debt, our Board of Directors hasauthorized the Company to pursue strategic alternatives.  In support of these initiatives, we havehired Miller Buckfire Ying & Co., LLC and Gleacher Partners, LLC as theCompany’s financial advisors. We are now actively pursuing a strategic partneror a

 

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saleof the Company while also taking steps to maintain future liquidity, includingevaluating a capital restructuring to reduce the current debt level enablingthe Company to achieve positive cash flow going forward.

 

Webelieve that the Company’s operational excellence combined with a highlytrained workforce, state of the art product offerings and expansive networkcould provide strategic benefits to existing multi-state and regional telecomservices providers. In addition, through the extensive cost reduction programs,which have been implemented over the past several years, we believe the Company’swholesale product suite offers an attractive alternative to UNE-P providers forlocal access lines and competitive long distance services.

 

We have undertakennumerous actions to conserve cash, including the reduction of capitalexpenditures and SG&A, as well as the execution of extensive cost reductionefforts initiated in late 2001 and continuing through today.  In addition, we been selective in managingcapital expenditures and do not believe that any of the reductions in capitalspending will have a material impact on our ability to service our customers.

 

We ended March 31, 2005with $34.9 million of cash on hand.  Inlight of our level of cash at year end and the payments required during thefirst quarter of 2005 under the Credit Facilities, we began discussions withour agent bank and a group of lenders acting as a steering committee for thelenders under our Credit Facilities.  TheCompany entered a forbearance agreement with our lenders with respect toscheduled principal and interest payments on our loans whereby the lendersagree not to take any action as a result of non-payment by the Company ofapproximately $18.1 million of scheduled principal amortization and interestpayments due on or before March 31, 2005 and any related events of defaultthrough May 23, 2005.  In accordance withthe forbearance agreement, on March 22, 2005, we elected not to make $2.8million of interest payments on such loans and, as a result, an event ofdefault occurred and we are required to accrue an additional two percentagepoints of interest on such loans as provided in the forbearance agreement.  We believe that by not making principal andinterest payments on the Credit Facilities, cash on hand together with cashflows from operations is sufficient to maintain operations in the ordinarycourse without disruption of services.

 

In light of therevenue outlook and the Company’s on-going cash requirements, we have alsobegun discussions related to a capital restructuring with our agent bank and agroup of lenders acting as a steering committee for the lenders under ourCredit Facilities. The Company and this committee are in negotiations relatedto terms of a capital restructuring which includes the conversion of asignificant portion of the Company’s current outstanding debt into equity.  Under such a restructuring, the holders ofour current debt would become equity shareholders of the Company with thecurrent holders of the preferred and common stock unlikely to receive anyrecovery.

 

The Company iscurrently in discussions with the lender committee regarding an extension tothe existing forbearance agreement. There can be no assurance that we will be able to reach an agreementwith our lenders regarding a capital restructuring or continued forbearance andcovenant relief prior to the end of the initial forbearance period on May 23,2005.  There also can be no assurancethat we will be able to identify a suitable strategic partner or buyer or reachagreement with any such strategic partner or buyer on terms and conditionsacceptable to us prior to the end of the initial forbearance period.  In the event these alternatives are notavailable to the Company, it is likely that we will elect to forgo makingfuture principal and interest payments to our lenders while we continue to seekan extended forbearance period or permanent capital restructuring from ourlenders, or alternatively, the Company could be forced to seek protection fromits creditors.

 

While we continue toexplore a variety of options with a view toward maximizing value for all of ourstakeholders, none of the options presented to date have suggested that therewill be any meaningful recovery for the Company’s current preferred stock orcommon stockholders.  Accordingly, it isunlikely that holders of the Company’s preferred stock or common stock willreceive any recovery in a capital restructuring or other strategic transaction.

 

Our financial statementsfor the periods ending March 31, 2005 and December 31, 2004 are prepared on agoing concern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business, but we may not beable to continue as a going concern.  Thereport of our independent registered public accounting firm accompanying ourfinancial statements in our report on Form 10-K filed March 25, 2005, containsa comment stating that there is substantial doubt as to our ability to continueas a going concern.  In the event ourrestructuring activities are not successful and we are required to seekprotection from our creditors, additional significant adjustments may benecessary in the carrying value of assets and liabilities, the revenues andexpenses reported and the balance sheet classifications used.

 

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**Overviewof Our Business**

 

Wederive our revenue from our core telecommunications and related communicationsservices.  These include local and longdistance services; local data services such as dial-up and dedicated Internetaccess services, using DSL, cable modem and dedicated T1 access; integratedaccess services, which link voice and data lines together on one high-speedconnection; conference calling services; wireless services; bandwidth andnetwork facilities leasing, sales and services, including access services;facilities and services dedicated for a particular customer’s use; advancedcommunications services for larger businesses such as frame relay, privateline, and ISDN; and value-added services such as virtual private networks,hosted Exchange and shared web hosting.

 

As of March 31, 2005, weoperated a network with 699 access nodes collocated in RBOC centraloffices.  We serve our customers by usingvarious loop/access unbundled network elements (“UNEs”) provided by the RBOCsand aggregating them through our access nodes. In turn, our access nodes are interconnected through approximately 39service node locations where our switching/routing systems reside.  In a metropolitan area, access node toservice node connectivity is based either on our own fiber facilities or on UNEtransport from the RBOCs.  Our servicenodes are located in most of the major metropolitan areas across ourfootprint.  These service nodes are inturn interconnected by our high capacity, inter-city core network.  The underlying transport for our core networkis based either on our own fiber or on leased capacity from interexchangecarriers.

 

To develop thesenetworks, we have assembled a collection of metro and inter-city network assetsin our 25-state footprint, substantially all of which we own or control, makingus a facilities-based carrier.  Thesenetwork assets incorporate state-of-the-art fiber optic cable, dedicatedwavelengths of transmission capacity on fiber optic networks and transmissionequipment capable of carrying high volumes of data, voice, video and Internettraffic.  We operate in a 25-statefootprint, which consists of the following states:

 

| ArizonaArkansasColoradoIdahoIllinois |   | IndianaIowaKansasLouisianaMichigan |   | MinnesotaMissouriMontanaNebraskaNew Mexico |   | North  DakotaOhioOklahomaOregonSouth Dakota |   | TexasUtahWashingtonWisconsin  Wyoming |
|--------------------------------------|--------|------------------------------------|--------|--------------------------------------------|--------|---------------------------------------------|--------|---------------------------------------|

 

**CriticalAccounting Policies and Estimates**

 

Preparation of thefinancial statements requires management to make estimates and assumptions thataffect the reported amounts of assets, liabilities, revenues and expenses.Management believes the most complex and sensitive judgments, because of theirsignificance to the consolidated financial statements, result primarily fromthe need to make estimates about the effects of matters that are inherentlyuncertain. Management’s Discussion and Analysis and Note 1 to the ConsolidatedFinancial Statements in the McLeodUSA Annual Report on Form 10-K for the yearended December 31, 2004, describe the significant accounting estimates andpolicies used in preparation of the Condensed Consolidated FinancialStatements. Actual results in these areas could differ from management’sestimates.  There have been nosignificant changes in our critical accounting estimates during the firstquarter of 2005. Management will continue to monitor its estimates andassumptions as well as events or changes in circumstances with respect to thereported amounts of assets, liabilities, revenues and expenses while wecontinue our pursuit of strategic alternatives and financial restructuring.

 

**Liquidity and Capital Resources**

 

Prior to August 2001,McLeodUSA grew rapidly by focusing on top-line revenue growth, which requiredsignificant capital for the construction of local and long distance voice networksand a national data network and included the acquisition of numerousbusinesses.  By mid-2001, due to certainfactors, including but not limited to complications related to our rapid growthand a general downturn in the economy and the telecommunications sector inparticular, we were not meeting internal expectations in terms of profitabilityand cash flow.

 

Beginning in August of2001, we initiated a new strategic plan that included a broad financial andoperational restructuring.  Our newstrategy was to refocus our business to be a facilities-based communicationservices provider within our 25-state footprint, improve business disciplineand processes and reduce our cost structure, all with the goal of profitablygrowing revenues and generating positive cash flow from operations.  Key elements of the restructuring includedabandonment of the national network plan, disposing of non-core businesses,reducing the employee base, consolidating facilities, reducing capitalexpenditures, and eliminating unprofitable services and unprofitable customers.

 

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We 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 three years we have successfully executed nearly all of theseprograms.  The operational and certain financialresults of the Company, as reported in our quarterly and annual financialreleases, reflect the significant progress that has been made in theoperational areas.

 

Asan independent communications services provider, realizing the revenue growthbenefits of operational excellence continues to be a challenge for the Companyas we compete against large, financially strong competitors with well-knownbrands. Most recently, the FCC has finalized its unbundling rules and thecommunications industry consolidation has accelerated. With the recent mergerannouncements in the industry, we believe that the large telecommunicationsproviders will likely become even more aggressive upon the closing of thesetransactions further challenging our ability to grow revenue.

 

Asdiscussed in the “Executive Overview,” we are pursuing strategic alternativesand are now actively pursuing a strategic partner or a sale of the Companywhile also taking steps to maintain future liquidity, including evaluating acapital restructuring to reduce the current debt level enabling the Company toachieve positive cash flow going forward.

 

As previously discussed,we have begun discussions with our agent bank and a group of lenders acting asa steering committee for the lenders under our Credit Facilities.  The Company has entered a forbearance agreementwith its lenders with respect to scheduled principal and interest payments onits loans whereby the lenders agree not to take any action as a result ofnon-payment by the Company of approximately $18.1 million of scheduledprincipal amortization and interest payments due on or before March 31, 2005and any related events of default through May 23, 2005.  We believe that by not making principal andinterest payments on the Credit Facilities, cash on hand together with cashflows from operations is sufficient to maintain operations in the ordinarycourse without disruption of services.

 

**2005 Cash Flow**

 

Weended March 31, 2005 with $34.9 million of cash and cash equivalents versus$50.0 million at December 31, 2004.  Thisdecrease of $15.1 million resulted primarily from the following:

 

| Operating Activities:                                                          |   |   |   |
|--------------------------------------------------------------------------------|--------|--------|--------|
| Decrease in cash  from operations, excluding changes in assets and liabilities |   | $      | (2.5   | ) |
| Payments for  restructuring charges and liabilities                            |   | (5.3   | )      |
| Cash provided by  changes in assets and liabilities                            |   | 1.7    |   |
| Net cash used in  operating activities                                         |   | (6.1   | )      |
|                                                                           |   |   |   |
| Investing  Activities:                                                         |   |   |   |
| Capital  expenditures                                                          |   | (11.9  | )      |
| Deferred line  installation costs                                              |   | (6.7   | )      |
| Sale of assets                                                                 |   | 9.6    |   |
| Net cash used in  investing activities                                         |   | (9.0   | )      |
|                                                                           |   |   |   |
| Net decrease in  cash and cash equivalents                                     |   | $      | (15.1  | ) |

 

Thepayments for restructuring charges and liabilities relate to leasepayments and lease buyouts associated with facility exits and costs inconnection with our pursuit of strategic alternatives and financialrestructuring.  We expect our cash requirements to payremaining lease payments and lease buyouts associated with facility exits to beless than $8 million during the remainder of 2005.

 

Asdiscussed above, we have reduced our growth-related capital expenditure planand expect to spend less than $45 million during 2005.  The capital expenditure plan for the rest of2005 remains focused on new product introduction and strategic growthinitiatives.  Deferred line installationcosts are the result of costs required to add customers onto our network.  Our deferred line installation expendituresthroughout the rest of 2005 will be dependent on the rate at which we add newcustomers.

 

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During2005, mandatory debt repayments under the Credit Agreement are scheduled tototal $49.5 million.  Currently,we have used a total of $108 million, including outstanding letters of credit,against the Exit Facility.  As discussedabove, the Company has entered a forbearance agreement with its lenders withrespect to scheduled principal and interest payments on its loans whereby thelenders agree not to take any action as a result of non-payment by the Companyof approximately $18.1 million of scheduled principal amortization and interestpayments due on or before March 31, 2005 and any related events of defaultthrough May 23, 2005.  In accordance withthe forbearance agreement, on March 22, 2005, we elected not to make $2.8million of interest payments on such loans and, as a result, an event of defaultoccurred and we are required to accrue an additional two percentage points ofinterest on such loans as provided in the forbearance agreement.  We believe that by not making principal andinterest payments on the Credit Facilities, cash on hand together with cashflows from operations is sufficient to maintain operations in the ordinarycourse without disruption of services.

 

The Company iscurrently in discussions with the lender committee regarding an extension tothe existing forbearance agreement.  Therecan be no assurance that we will be able to reach an agreement with our lendersregarding a capital restructuring or continued forbearance and covenant reliefprior to the end of the initial forbearance period on May 23, 2005.  There also can be no assurance that we willbe able to identify a suitable strategic partner or buyer or reach agreementwith any such strategic partner or buyer on terms and conditions acceptable tous prior to the end of the initial forbearance period.  In the event these alternatives are notavailable to the Company, it is likely that we will elect to forgo makingfuture principal and interest payments to our lenders while we continue to seekan extended forbearance period or permanent capital restructuring from ourlenders, or alternatively, the Company could be forced to seek protection fromits creditors.

 

**Outlook for 2005 andFuture Funding Needs**

 

We ended March 31, 2005with $34.9 million of cash on hand.  In2005, our cash requirements will consist of new products, important capitalexpenditure projects, remaining lease payments and lease buyouts associatedwith facility exits made in 2001 and 2002 as well as changes in workingcapital. A combination of cash on hand, cash generated from operatingactivities and the proceeds from the sale of certain assets will be used tomeet these ongoing cash requirements while we continue to pursue strategicalternatives and continue discussion with our lenders regarding a capitalrestructuring.

 

Wehave continued to take additional steps to conserve cash and improveliquidity.  Actions that have been takento generate further operational efficiencies and focused expense managementresulted in a 25% reduction in SG&A expenses compared to the first quarterof 2004.  We have reduced our growthrelated capital expenditure plan and now expect to spend approximately $45million in 2005. The capital expenditure plan for 2005 remains focused on newproduct introduction and strategic growth initiatives.  As a result of the actions describedabove we have significantly reduced our cash usage and expect to realizecontinuing benefits from these programs in 2005.  We will continue to execute our cashmanagement program while pursuing the strategic initiatives and capitalrestructuring discussions mentioned above.

 

There can be noassurance that we will be able to reach an agreement with our lenders regardinga capital restructuring or continued forbearance and covenant relief prior tothe end of the initial forbearance period on May 23, 2005.  There also can be no assurance that we willbe able to identify a suitable strategic partner or buyer or reach agreementwith any such strategic partner or buyer on terms and conditions acceptable tous prior to the end of the initial forbearance period.  In the event these alternatives are notavailable to us, it is likely that we will elect to forgo making futureprincipal and interest payments to our lenders while we continue to seek anextended forbearance period or permanent capital restructuring from our lenders,or alternatively, the Company could be forced to seek protection from itscreditors.

 

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**Three Months Ended March 31, 2005 Compared with Three Months EndedMarch 31, 2004**

 

***Revenue.***  Total revenue for the quarter ended March 31,2005 declined $33.1 million, or 17%, to $160.5 million from $193.6 million forthe quarter ended March 31, 2004.  Thefollowing table compares our revenue for the three months ended March 31:

 

| ** **                                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **Variance** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Local                                                                                         |       | $        | 83.4       |     | $          | 95.5         |       | $ | (12.1 | ) |
| Long distance                                                                                 |       | 33.5     |       | 35.9     |       | (2.4         | )          |
| Data services and other                                                                       |       | 29.0     |       | 35.5     |       | (6.5         | )          |
| Carrier access                                                                                |       | 12.5     |       | 24.8     |       | (12.3        | )          |
| Indefeasible rights of use agreements including those  that qualify as sales type leases |       | 2.1      |       | 1.9      |       | 0.2          |       |
|                                                                                          |       | $        | 160.5      |     | $          | 193.6        |       | $ | (33.1 | ) |

 

Total revenues declinedby $33.1 million versus the first quarter of 2004 due to a continued decline intotal customers, FCC mandated reduction in access rates, and lower longdistance rates.  Approximately $10.5 millionof the decrease in local revenue is attributed to a reduction in the number ofaccess lines in service due to customer turnover in excess of new linessold.  Retail long distance declined byapproximately $8.5 million primarily as a result of a reduction in the volumeof minutes.  This decline was partiallyoffset by a $6.1 million increase in wholesale long distance due to substantialvolume increases related to several wholesale contracts.  Access revenues have decreased $12.3 millionfrom the first quarter of 2004 primarily due to the final phase of the FCCmandated rate reduction.  Included inrevenues from indefeasible rights of use in the above table is $1.3 million and$1.5 million for the quarters ended March 31, 2005 and 2004, respectively,related to on-going revenues from operating leases.

 

***Costof Service***.  Costof service includes expenses directly associated with providing communicationservices to our customers.  Costsclassified as cost of service include, among other items, the cost of connectingcustomers to our network via leased facilities, the costs paid to third partyproviders for interconnect access and transport services, the costs of leasingcomponents of our network facilities and the cost of fiber related to sales andleases of network facilities.  Cost ofservice was $93.3 million for the quarter ended March 31, 2005, a decrease of$14.4 million or 13% from the quarter ended March 31, 2004.  Approximately half of the decrease reflectsthe results of our ongoing network cost reduction efforts that began in 2002,including least cost routing, network optimization including grooms, migrationof customers to the McLeodUSA network and elimination of non-profitablecustomers.  The balance of the decreaseis attributed to the reduction in revenues. The cost of fiber related to sales and leases of network facilities wasnot significant for the quarters ended March 31, 2005 and 2004.

 

***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 $56.7 million for thefirst quarter of 2005, a decrease of $19 million or 25% from 2004.  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 andadditional actions to reduce expenses and manage cash which were implementedduring 2004 and will continue throughout 2005. These combined actions have reduced non-essential expenses and reducedheadcount from approximately 3,000 at March 31, 2004 to 2,300 employees atMarch 31, 2005.

 

***Depreciationand amortization.*** Depreciation and amortization includes the depreciation of ourcommunications network and equipment, amortization of other intangiblesdetermined to have finite lives, and amortization over the life of the customercontract of one-time direct installation costs associated with transferring customers’local line service from the RBOCs to our local telecommunicationsservices.  Depreciation and amortizationexpenses were $91.3 million for the quarter ended March 31, 2005, consistentwith $90.2 million recorded in the first quarter of 2004.

 

***Restructuringcharges.  ***In thefirst quarter of 2005, we incurred $2.0 million in restructuring chargesrelated to financial and legal advisors supporting our pursuit of strategicalternatives and financial restructuring.

 

***Interestexpense.***  Grossinterest expense was $14.6 million for the quarter ended March 31, 2005, anincrease of $2.8 million over the first quarter of 2004 primarily due to analmost 2% increase in the average interest rates during the period.

 

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Net interest expenseincreased by $3.3 million in the quarter ended March 31, 2005 primarily due tolower capitalized interest as a result of lower construction in progressbalances during the quarter.  Interestexpense of approximately $0.2 million and $0.7 million was capitalized as partof our construction of our network during the quarter ended March 31, 2005 and2004, respectively.

 

**Inflation**

 

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

 

**Item3.  Quantitative and QualitativeDisclosures About Market Risk**

 

We have variable ratedebt of approximately $777 million under the Credit Agreement outstanding atMarch 31, 2005.  If market interest ratesaverage 1% more in subsequent quarters than the rates during the quarter endedMarch 31, 2005, quarterly interest expense would increase by $1.9 million.  This amount was determined by calculating theeffect of the hypothetical interest rate increase on our variable rate debt forthe quarter and does not assume changes in our financial structure.

 

**Item 4.  Controls and Procedures**

 

*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 were effective.

 

*Internal Controls over FinancialReporting*.  There havenot been any changes in the Company’s internal control over financial reportingidentified in connection with the evaluation required by paragraph (d) ofExchange Act Rules 13a-15 or 15d-15 that occurred during our last fiscalquarter that have materially affected, or are reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

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**PART IIOTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

FormerChairman Clark E. McLeod, former President Stephen C. Gray (then also ChiefExecutive Officer), Chairman and Chief Executive Officer Chris A. Davis (thenChief Operating and Financial Officer) and former Chief Financial andAccounting Officer J. Lyle Patrick (the “Individual Defendants”) are defendantsin a consolidated class action entitled In re McLeodUSA Incorporated SecuritiesLitigation, Civil Action No. C02-0001 (N.D. Iowa) (the “Iowa Class Action”),alleging inter alia, violations of the Securities Act of 1933 and theSecurities Exchange Act of 1934. The Individual Defendants moved to dismiss theconsolidated amended complaint in the Iowa Class Action.  That motion was denied. Discovery isongoing.   One of the putative classplaintiffs, New Millennium Growth Fund LLC, also filed proofs of claim againstMcLeodUSA in McLeodUSA’s Chapter 11 Case, seeking at least $104,650 on its ownbehalf and no less than approximately $300 million (plus interest, costs andattorneys’ fees as allowed) on behalf of all class claimants in the Iowa ClassAction (the “Bankruptcy Claims” and, together with the Iowa ClassAction, the “Securities Claims”).  TheBankruptcy Claims were transferred from the bankruptcy court in Delaware to theIowa court, and consolidated with the Iowa Class Action on February 1,2005.  As the Securities Claims are inearly stages, it is impossible to evaluate the likelihood of unfavorableoutcomes or, with respect to McLeodUSA’s indemnification obligations inconnection with the claims alleged again the Individual Defendants in theconsolidated amended complaint, estimate the amount or range of potential loss,if any, to McLeodUSA.  With respect tothe Bankruptcy Claims, on May 2, 2002, the Bankruptcy Court issued an orderestablishing a disputed claims reserve of 18,000,000 shares of ReorganizedMcLeodUSA Class A Common Stock. Any recovery from the Bankruptcy Claims wouldbe limited to those shares of stock. McLeodUSA believes that the Securities Claims are without merit andintends to defend them vigorously.

 

McLeodUSAhas indemnification obligations running to the Individual Defendants, the termsof which provide for no limitation to the maximum potential future paymentsunder such indemnifications.  McLeodUSAis unable to develop an estimate of the maximum potential amount of futurepayments under the indemnifications due to the inherent uncertainties involvedin such litigation. McLeodUSA maintains insurance, subject to limitations setforth in the policies, which is intended to cover the costs of claims madeagainst its current and former Directors and Officers, including the IndividualDefendants.

 

McLeodUSA,as successor to Caprock Communications Corporation, is a defendant in a lawsuitbrought by Alcatel USA Marketing, Inc. (“Alcatel”), in County Court No. 5,Dallas County, Texas, entitled Alcatel USA Marketing, Inc vs. CaprockCommunications Corporation and McLeodUSA Holdings, Inc., Cause No.CC04-11573-E.  Plaintiff alleges breachof a 1994 supply agreement and certain purchase orders issued in 2000 under theagreement.  Alcatel seeks damages ofapproximately $6.3 million plus interest, costs and attorneys’ fees.  McLeodUSA has filed an answer denyingliability, including asserting that a May 17, 2002 Privileged SettlementCommunication between the parties rendered the purchase orders in dispute nulland void.  The suit is in the discoverystage therefore, an estimate of a possible loss or range of loss cannot be madeat this time. While McLeodUSA intends to vigorously defend against theseclaims, there can be no assurance that the Company will prevail in thisdispute, given the uncertainties inherent in a jury trial.

 

McLeodUSAis also involved in numerous regulatory proceedings before various publicutility commissions and the FCC, particularly in connection with actions by theRBOCs. McLeodUSA anticipates the RBOCs will continue to pursue litigation,regulations and legislation in states within McLeodUSA’s 25-state footprint andwith the FCC to reduce regulatory oversight and regulation over rates, networkaccess and operations. The RBOCs are also actively pursuing major changes inthe Telecommunications Act of 1996, by regulatory litigation and legislation,which McLeodUSA believes would adversely affect competitive telecommunicationsservice providers including McLeodUSA. If adopted, these changes could make itmore difficult for McLeodUSA to challenge the RBOCs’ actions, or to competewith the RBOCs, in the future. There are no assurances that McLeodUSA willprevail in its disputes with the RBOCs.

 

TheFCC released its TRO in August 2003 modifying its rules governing availabilityof RBOC unbundled network elements to competitive carriers. The TriennialReview Order established new rules governing the availability and pricing forthe network elements the RBOCs must provide to competitive carriers, anddelegated authority to the states to apply certain of the new rules inindividual markets. Several appeals of the TRO were consolidated in the Courtof Appeals for the District of Columbia (the “Court of Appeals”). On March 2,2004, the Court of Appeals issued a decision overturning many key elements ofthe TRO, remanding most of the order to the FCC for further action (*USTA II*). The Court of Appeals ruled that

 

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theFCC’s delegation of final impairment decisions to state agencies wasunlawful.  The Court also reversed theFCC’s nationwide finding regarding mass market switching, dedicated transportand its delegation of decision-making authority to the states. The Courtdirected the FCC to give stronger consideration to intermodal competition whenrevising its rules on remand. The Court upheld the FCC determination that RBOCsdo not have to provide unbundled access at current prices to newly deployedtechnologies based on fiber and packet-switching capabilities. The Court alsoupheld the FCC’s findings that RBOCs are not required to provide unbundledswitching to CLECs for business customers served by high-capacity loops, suchas DS-1 or packet switching. State proceedings that had been started toimplement the TRO were suspended in some states and continued in otherstates.  The FCC and U. S.Department of Justice declined to appeal *USTA II*.  Competitive and interexchange carriers and anorganization representing state regulatory agencies filed appeals to the U.S.Supreme Court and requested a stay.  TheU.S. Supreme Court declined to issue a stay.  On July 22, the FCC adopted and on August 22, 2004, the FCC released anInterim UNE Order (the “Interim Order”) establishing requirements that governthe availability of UNEs until the FCC adopts new, permanent unbundlingrules.  The Interim Order maintained theRBOC obligations to provide UNEs at current prices until March 2005.  Verizon, Qwest and the United StatesTelephone Association (“USTA”) appealed the Interim Order to the Court ofAppeals.  On October 4, all parties filedwritten comments with the FCC addressing permanent unbundling rules.  The Court of Appeals on October 6, 2004,issued a decision that puts on hold until January 4, 2005, the petition filedby Verizon, Qwest and USTA to immediately overturn the FCC’s InterimOrder.  On October 12, 2004, the U.S.Supreme Court rejected the appeal asking the Court to hear an appeal of theCourt of Appeals *USTA II* decision. On December 15,2004, the FCC announced adoption of revised permanent unbundling rules that itbelieves are in compliance with prior appellate decisions.  These new unbundling rules impact access tolocal switching, high capacity loops, high capacity transport, dark fiber, andentrance facilities.  The FCC alsoadopted a transition plan for those elements that will no longer be UNEs.  The Company believes that the new rules arepredominantly supportive of its facilities-based (UNE-L) strategy.  The new unbundling rules became effectiveMarch 11, 2005.

 

Regardless of thesuccess, or lack of success, of commercial negotiations with Qwest and SBC andadoption of final unbundling rules, it is likely that unbundling rules will bethe subject of continued litigation.  There can be no assurance that our businesseswill not be materially adversely affected by continued legal challenges tounbundling rules, new legislation passed in response to unbundling rules or anycourt decisions that result from continued legal challenge to unbundling rulesor current law and regulations.

 

TheFCC has an open docket proposing to reform intercarrier compensation.  An industry group known as the IntercarrierCompensation Forum provided a recommended framework for reforming intercarriercompensation related to switched access and reciprocal compensationcharges.  Other coalitions providedcompeting recommendations for reforming intercarrier compensation to the FCC inthe Fall 2004.  The FCC is evaluating allproposals and has solicited further comments on the issue.  A final decision is expected no earlier thanthe first quarter of 2006, and the current framework of intercarriercompensation rules could be materially affected.

 

OnSeptember 10, 2003, the FCC issued an NPRM on TELRIC. This is a proceeding toreview 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.

 

OnOctober 18, 2004, the FCC released an Order that extends unbundling relief tothe RBOCs for mass market fiber-to-the-curb loops with fiber that is within 500feet of the premises.  The FCC alsoclarified that incumbent LECs are not required to add TDM capabilities into newpacketized transmission facilities.  Itis likely that this additional unbundling relief and new network modificationrule will be the subject of litigation. Such changes could limit our access to mass market customers andadversely affect our ability to compete.

 

OnOctober 22, 2004, the FCC voted to eliminate any independent unbundlingobligation under Section 271 of the 1996 Act for any network element that hasbeen removed from Section 251 of the 1996 Act. Such relief could limit our access to customers and adversely affect ourability to compete.

 

TheFCC issued on March 10, 2004 its NPRM on “IP-enabled communications,” whichincludes VoIP. The NPRM asks broad questions regarding the regulatoryclassifications of various “IP-enabled” services, including different VoIPservices; the access charge and other intercarrier compensation implications;the universal service implications; and the other social policy implicationssuch as law enforcement, disability and emergency 911 service issues andsuggests, as a general proposition, the economic regulation of variousIP-enabled services should be kept to a minimum.

 

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In April2001, the FCC released an Order in which it established a benchmark rate atwhich CLECs’ interstate access charges would be presumed reasonable and which aCLEC could impose on an interexchange carrier (“IXC”) by tariff. In May of 2004, the FCC announced a new rulegoverning CLEC interstate access charges that imposed a limit on CLEC accesscharges when the CLEC did not directly serve the end user.  The new rule provided that the charge could beno more than the rate charged by the ILEC for the same functionality.  The FCC order stated its new rule limitingCLEC interstate access charges was to be applied on a prospective basis.  McLeodUSA filed tariff changes to implementthe FCC’s new rule.  The FCC’s Order alsoprovided that under its prior rules, it would not have been unreasonable for aCLEC to charge an IXC for those services at the higher benchmark rate.  Some IXCs have disputed and withheldpayment of billed access charges for wireless originated toll free calls andhave also withheld payments due to the Company for other charges.  The Company, in response to these actions,has also withheld payments from them.  Asof March 3, 2005, the amounts charged by the Company but not paid by these IXCsare:  MCI, approximately $6.4 million;Sprint, approximately $4.7 million; and Qwest, approximately $4.9 million.  The Company’s withholdings, all of which areless than the amounts withheld by the IXCs are: MCI, approximately $3.4 million; Qwest, approximately $3.8 million; andSprint, approximately $0.8 million.  Intotal, approximately $23.5 million of access charges are disputed by thesethree IXCs related to certain types of tollfree traffic for prior periods based on alleged insufficiency of tariffgrounds.  McLeodUSA has written contractswith two of the IXCs that identify the rates or source of rates that McLeodUSAis entitled to charge for interstate access services.  McLeodUSA continued to bill for its servicesat the full benchmark rate until the FCC’s new rule went into effect as of June22, 2004 at which time it billed at the revised rates in accordance with by theFCC’s new rule.  As a consequence of thewithholding of payments by these carriers, McLeodUSA filed suit against SprintCommunications Corporation (“Sprint”) in the United States District Court forthe Northern District of Iowa claiming that, by Sprint’s failure to pay theinterstate access charges that the Company billed, Sprint was in breach of itscontract with the Company.  In additionto its breach of express contract claim against Sprint, the Company is pursuingrecovery of its interstate access charges for toll free traffic under impliedcontract and unjust enrichment theories. McLeodUSA filed suit against Qwest Corporation in this same court, latertransferred to Denver, CO, to recover charges unpaid by Qwest.  Qwest filed suit against McLeodUSA in Denver,CO, contesting these charges.  On March23, 2005, the federal court in Northern District of Iowa issued a  temporary restraining order preventing Qwestfrom terminating certain services to the Company in connection with thedispute.   A hearing on a PreliminaryInjunction is scheduled for May 19, 2005. On March 22, 2005, the Company and MCI filed demands for bindingarbitration in connection with these disputes. On December 15, 2004, the FCC issued an order in *USTelepacific*reaffirming that its rule limiting CLEC access rates tobe no more than the rate charged by the ILEC for the same functionality,adopted in May 2004, was to be applied on a prospective basis only, and that itwas not unreasonable for a CLEC to charge the full benchmark rate for trafficto or from end-users of other carriers, provided that the carrier serving theend-user did not also charge the IXC and provided that the CLEC’s charges were otherwisein compliance with and supported by its tariff. The Company believes that recovery of withheld amounts is probable;accordingly, no amounts have been reserved by the Company at December 31, 2004.  However, certain of the underlying issueshave never been litigated and are largely questions of first impression.

 

McLeodUSAis a defendant in a lawsuit brought by SBC and its affiliates in the U.S.District Court in the Eastern District of Missouri. SBC alleges that McLeodUSAconspired with one or more of Global Crossing and its affiliates, certain namedcompetitive local exchange carriers, and/or certain unnamed “least cost routers”to breach SBC’s state or federal tariffs, unjustly enrich themselves, andcommit fraud on SBC.   SBC alleges thatthe defendants knowingly disguised long distance calls that were terminated toSBC so that they appeared to SBC to be local calls thereby depriving SBC of thedifference between the access charge rate owed for termination of long distancecalls and the reciprocal compensation rate owed for termination of local calls.McLeodUSA’s answer  was filed on April 1,2005, denying all liability.   McLeodUSAintends to vigorously defend against these claims.

 

OnMay 9, 2005, AT&T sent a demand to the Company for arbitration of its claimfor in excess of $8 million under an Engineering and Construction ManagementAgreement between AT&T and CapRock Telecommunications Corp. dated November1999.  The claim principally relates toconstruction and fiber optic cable costs incurred in connection withconstruction of the Ring 3 fiber optic cable project from Tulsa, OK to OklahomaCity, OK from 1999 to 2000.  The Companydenies that it owes the monies.  WhileMcLeodUSA intends to vigorously defend against this demand, there can be no assurancethat the Company will prevail in this dispute.

 

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Generally,state utility commissions or third parties could raise issues with regard toour compliance with applicable laws or regulations that could have a materialadverse effect on our business, results of operations and financialcondition.  On September 8, 2004, theWashington State commission settled all issues with McLeodUSA for $25,000 plusother non-financial issues.  Severalother state utility commissions have reviewed or are actively reviewing thepropriety of certain agreements we entered into with Qwest, including Arizonaand Colorado, and these proceedings may result in fines or other sanctionsagainst us or the imposition of other conditions detrimental to us, includingthe establishment of discounts available to other competitive telephonecompanies but not to us. Other states may initiate similar proceedings.

 

McLeodUSAis not aware of any other material litigation against it. McLeodUSA does,however, have various other legal proceedings pending against it or itssubsidiaries or on its behalf or that of its subsidiaries

 

###### **Item3.    Defaults Upon Senior Securities**

The nonpayment of $2.8million of interest on March 22, 2005 constituted an event of default under theCredit Facilities.  At March 31, 2005,there was $777.3 million outstanding under the Credit Facilities indefault.  McLeodUSA has not made $7.8million of principal payments and $16.2 million of interest payments due on orbefore May 10, 2005.  Pursuant to theForbearance Agreement the Company entered into with JP Morgan Chase Bank, N.A.,as administrative agent related to the Credit Facilities on March 16, 2005, thelenders have agreed to forbear from exercising any remedies as a result ofcertain specified defaults under the Credit Facilities anticipated by theCompany during the forbearance period, including, without limitation, thefailure to make scheduled amortization payments under the Credit Facilities andinterest payments under the Credit Agreement. The forbearance period, the purpose of which is to enable the parties toexplore possible strategic transactions, runs through May 23, 2005.

 

**Item 6. 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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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|               |   | **McLEODUSA INCORPORATED** |
|--------------------|--------|----------------------------|
|               |   | (registrant)               |
|               |   |                       |
|               |   |                       |
| Date: May 10, 2005 |   | By:                        | /s/ Chris A.  Davis |   |
|               |   |                       | Chris A. Davis |   |
|               |   |                       | *Chairman  and Chief Executive Officer* |   |
|               |   |                       |   |
|               |   |                       |   |
| Date: May 10, 2005 |   | By:                        | /s/ G. Kenneth  Burckhardt |   |
|               |   |                       | G. Kenneth  Burckhardt |   |
|               |   |                       | *Chief  Financial Officer* |   |

 

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**INDEX TO 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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