**SECURITIESAND EXCHANGE COMMISSIONWashington, D.C.  20549**

 

**FORM 10-Q**

 

**(Mark One)**

**ý****                                ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For theQuarterly Period Ended June 30, 2005**

 

**or**

 

**TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period                             to                                 **

 

**Commissionfile number 0-20763**

 

**McLEODUSAINCORPORATED**(Exact name of registrant 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 telephone number,including area code)

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes   ý      Noo

 

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes ý      Noo

 

Indicate by check markwhether the registrant has filed all documents and reports required to be filedby Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent tothe distribution of securities under a plan confirmed by a court.  Yes  ý      Noo

 

The number of sharesoutstanding of each class of the issuer’s common stock as of July 31, 2005:

 
| Common Stock Class A:  ($0.01 par value) |   | 201,685,063  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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**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**INDEX**

** **
| **PART I. Financial Information** |                                                                                         |
|-----------------------------------|----------------------------------------------------------------------------------------------|
|                              |                                                                                         |   |
| Item 1.                           | Financial Statements                                                                         |   |
|                              |                                                                                         |   |
|                              | Unaudited  Condensed Consolidated Balance Sheets                                             |   |
|                              | June  30, 2005 and December 31, 2004                                                         |   |
|                              | Unaudited  Condensed Consolidated Statements of Operations – for the three months ended |   |
|                              | June  30, 2005 and 2004                                                                      |   |
|                              | Unaudited  Condensed Consolidated Statements of Operations – for the six months ended   |   |
|                              | June 30, 2005  and 2004                                                                      |   |
|                              | Unaudited  Condensed Consolidated Statements of Cash Flows – for the six months ended   |   |
|                              | June  30, 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 6.                           | Exhibits                                                                                     |   |
|                              |                                                                                         |   |
| Signatures                        |                                                                                         |

 

2

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**PART I –FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS**

**(Inmillions, except share data)**

 
| ** **                                                                                                                                                                                            | ** ** | **June 30,   2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| **ASSETS**                                                                                                                                                                                            | ** ** | ** **          | ** ** | ** **             | ** ** |
| ** **                                                                                                                                                                                            | ** ** | ** **          | ** ** | ** **             | ** ** |
| Current assets                                                                                                                                                                                        |       |                |       |                   |       |
| Cash and cash  equivalents                                                                                                                                                                            |       | $                   | 33.4       |                   | $          | 50.0 |   |
| Trade  receivables, net                                                                                                                                                                               |       | 54.9                |       | 58.6                   |       |
| Prepaid expenses  and other                                                                                                                                                                           |       | 14.7                |       | 19.9                   |       |
| Total current  assets                                                                                                                                                                                 |       | 103.0               |       | 128.5                  |       |
| Property and  equipment                                                                                                                                                                               |       |                |       |                   |       |
| Land and  buildings                                                                                                                                                                                   |       | 57.0                |       | 76.4                   |       |
| Communications  networks                                                                                                                                                                              |       | 1,007.3             |       | 1,116.4                |       |
| Furniture,  fixtures and equipment                                                                                                                                                                    |       | 191.7               |       | 204.5                  |       |
| Networks in  progress                                                                                                                                                                                 |       | 26.3                |       | 51.3                   |       |
| Total property  and equipment                                                                                                                                                                         |       | 1,282.3             |       | 1,448.6                |       |
| Less accumulated  depreciation                                                                                                                                                                        |       | 827.9               |       | 719.9                  |       |
| Net property and  equipment                                                                                                                                                                           |       | 454.4               |       | 728.7                  |       |
| Intangibles and  other assets                                                                                                                                                                         |       |                |       |                   |       |
| Other  intangibles, net                                                                                                                                                                               |       | 98.2                |       | 144.9                  |       |
| Other                                                                                                                                                                                                 |       | 18.4                |       | 23.7                   |       |
| Total  intangibles and other assets                                                                                                                                                                   |       | 116.6               |       | 168.6                  |       |
| **TOTAL  ASSETS**                                                                                                                                                                                     |       | $                   | 674.0      |                   | $          | 1,025.8 |   |
| ** **                                                                                                                                                                                            |       |                |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ DEFICIENCY**                                                                                                                                                     |       |                |       |                   |       |
| ** **                                                                                                                                                                                            |       |                |       |                   |       |
| Current  liabilities                                                                                                                                                                                  |       |                |       |                   |       |
| Current  maturities of long-term debt                                                                                                                                                                 |       | $                   | 777.3      |                   | $          | 49.5 |   |
| Accounts payable                                                                                                                                                                                      |       | 36.7                |       | 39.6                   |       |
| Accrued payroll  and payroll related expenses                                                                                                                                                         |       | 14.7                |       | 19.7                   |       |
| Other accrued  liabilities                                                                                                                                                                            |       | 95.3                |       | 75.4                   |       |
| Deferred  revenue, current portion                                                                                                                                                                    |       | 6.8                 |       | 6.8                    |       |
| Total current  liabilities                                                                                                                                                                            |       | 930.8               |       | 191.0                  |       |
|                                                                                                                                                                                                  |       |                |       |                   |       |
| Long-term debt,  less current maturities                                                                                                                                                              |       | —              |       | 727.8                  |       |
| Deferred  revenue, less current portion                                                                                                                                                               |       | 17.9                |       | 17.0                   |       |
| Other long-term  liabilities                                                                                                                                                                          |       | 62.3                |       | 61.4                   |       |
| Total  liabilities                                                                                                                                                                                    |       | 1,011.0             |       | 997.2                  |       |
|                                                                                                                                                                                                  |       |                |       |                   |       |
| Redeemable  convertible preferred stock                                                                                                                                                               |       |                |       |                   |       |
| McLeodUSA  Preferred Series A, redeemable, convertible, $0.01 par value; 10,000,000  authorized and issued; 2,320,480 and 4,131,336 outstanding at June 30, 2005  and December 31, 2004, respectively |       | 43.0                |       | 75.4                   |       |
| Stockholders’  equity                                                                                                                                                                            |       |                |       |                   |       |
| McLeodUSA  Common, Class A $0.01 par value; 1,886,249,986 authorized, 201,685,063 and  192,227,818 issued and outstanding at June 30, 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 June 30, 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 June 30, 2005 and December 31, 2004                                                                     |       | 0.3                 |       | 0.3                    |       |
| McLeodUSA  Preferred Series B, $0.01 par value; 10 authorized, issued and outstanding at  June 30, 2005 and December 31, 2004                                                                         |       | —              |       | —                 |       |
| McLeodUSA  Warrants                                                                                                                                                                                   |       | 22.6                |       | 22.6                   |       |
| Additional  paid-in capital                                                                                                                                                                           |       | 1,081.4             |       | 1,049.2                |       |
| Accumulated  deficit                                                                                                                                                                                  |       | (1,487.1            | )          | (1,121.6               | )          |
| Total  stockholders’ deficiency                                                                                                                                                                  |       | (380.0              | )          | (46.8                  | )          |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ DEFICIENCY**                                                                                                                                              |       | $                   | 674.0      |                   | $          | 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 June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                        | ** ** | **2004** | ** ** |
|                                                                                 |       |                            |       |   |   |
| Revenue                                                                              |       | $                               | 159.7      |   | $ | 191.9 |   |
|                                                                                 |       |                            |       |   |   |
| Operating expenses:                                                                  |       |                            |       |   |   |
| Cost of service (exclusive of depreciation and amortization shown  separately below) |       | 92.2                            |       | 105.3 |   |
| Selling, general and administrative                                                  |       | 53.7                            |       | 68.5 |   |
| Depreciation and amortization                                                        |       | 54.5                            |       | 88.4 |   |
| Impairment charge                                                                    |       | 202.5                           |       | — |   |
| Restructuring charges (adjustment)                                                   |       | 4.8                             |       | (0.2 | ) |
| **Total operating expenses**                                                         |       | 407.7                           |       | 262.0 |   |
| **Operating loss**                                                                   |       | (248.0                          | )          | (70.1 | ) |
| ** **                                                                           |       |                            |       |   |   |
| Nonoperating expense:                                                                |       |                            |       |   |   |
| Interest expense, net of amounts capitalized                                         |       | (19.5                           | )          | (11.6 | ) |
| Other expense                                                                        |       | (0.5                            | )          | (0.5 | ) |
| **Total nonoperating expense**                                                       |       | (20.0                           | )          | (12.1 | ) |
| **Net loss**                                                                         |       | (268.0                          | )          | (82.2 | ) |
| Preferred stock dividend                                                             |       | (0.4                            | )          | (0.8 | ) |
|                                                                                 |       |                            |       |   |   |
| **Net loss applicable to common shares**                                             |       | $                               | (268.4     | ) | $ | (83.0 | ) |
|                                                                                 |       |                            |       |   |   |
| **Basic and diluted loss per common share**                                          |       | $                               | (0.86      | ) | $ | (0.28 | ) |
| **Weighted average common shares outstanding**                                       |       | 313.2                           |       | 292.2 |   |

 

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

 

4

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| ** **                                                                           | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                      | ** ** | **2004** | ** ** |
|                                                                                 |       |                          |       |   |   |
| Revenue                                                                              |       | $                             | 320.2      |   | $ | 385.5 |   |
|                                                                                 |       |                          |       |   |   |
| Operating expenses:                                                                  |       |                          |       |   |   |
| Cost of service (exclusive of depreciation and amortization shown  separately below) |       | 185.5                         |       | 212.9 |   |
| Selling, general and administrative                                                  |       | 110.4                         |       | 144.2 |   |
| Depreciation and amortization                                                        |       | 145.8                         |       | 178.6 |   |
| Impairment charge                                                                    |       | 202.5                         |       | — |   |
| Restructuring charges (adjustment)                                                   |       | 6.9                           |       | (0.2 | ) |
| **Total operating expenses**                                                         |       | 651.1                         |       | 535.5 |   |
| **Operating loss**                                                                   |       | (330.9                        | )          | (150.0 | ) |
| ** **                                                                           |       |                          |       |   |   |
| Nonoperating expense:                                                                |       |                          |       |   |   |
| Interest expense, net of amounts capitalized                                         |       | (33.9                         | )          | (22.8 | ) |
| Other expense                                                                        |       | (0.8                          | )          | (0.9 | ) |
| **Total nonoperating expense**                                                       |       | (34.7                         | )          | (23.7 | ) |
| **Net loss**                                                                         |       | (365.6                        | )          | (173.7 | ) |
| Preferred stock dividend                                                             |       | (0.8                          | )          | (1.6 | ) |
|                                                                                 |       |                          |       |   |   |
| **Net loss applicable to common shares**                                             |       | $                             | (366.4     | ) | $ | (175.3 | ) |
|                                                                                 |       |                          |       |   |   |
| **Basic and diluted loss per common share**                                          |       | $                             | (1.18      | ) | $ | (0.60 | ) |
| **Weighted average common shares outstanding**                                       |       | 310.8                         |       | 291.6 |   |

 

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

 

5

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**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Inmillions)**

 
| ** **                                                                                 | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                 | ** ** | **2005**                      | ** ** | **2004** | ** ** |
| **Cash Flows from Operating Activities**                                                   |       |                          |       |   |   |
| Net loss                                                                                   |       | $                             | (365.6     | ) | $ | (173.7 | ) |
| Adjustments to reconcile net loss to net cash provided by (used in)  operating activities: |       |                          |       |   |   |
| Depreciation                                                                               |       | 117.1                         |       | 150.0 |   |
| Amortization                                                                               |       | 28.7                          |       | 28.6 |   |
| Accretion of interest                                                                      |       | 1.9                           |       | 1.8 |   |
| Amortization of deferred financing fees                                                    |       | 2.3                           |       | 2.0 |   |
| Loss on sale of assets                                                                     |       | 1.0                           |       | 1.0 |   |
| Impairment charge                                                                          |       | 202.5                         |       | — |   |
| Changes in assets and liabilities:                                                         |       |                          |       |   |   |
| Trade receivables                                                                          |       | 2.7                           |       | (1.9 | ) |
| Prepaid expenses and other                                                                 |       | 1.8                           |       | 1.4 |   |
| Accounts payable and accrued expenses                                                      |       | 11.4                          |       | (12.7 | ) |
| Deferred revenue                                                                           |       | 0.9                           |       | 1.1 |   |
| **Net cash provided by (used in) operating activities**                                    |       | 4.7                           |       | (2.4 | ) |
| ** **                                                                                 |       |                          |       |   |   |
| **Cash Flows from Investing Activities**                                                   |       |                          |       |   |   |
| Purchases of property and equipment                                                        |       | (21.0                         | )          | (26.9 | ) |
| Other assets                                                                               |       | (13.7                         | )          | (14.8 | ) |
| Proceeds from the sale of assets                                                           |       | 13.4                          |       | 7.1 |   |
| **Net cash used in investing activities**                                                  |       | (21.3                         | )          | (34.6 | ) |
| ** **                                                                                 |       |                          |       |   |   |
| **Cash Flows from Financing Activities**                                                   |       |                          |       |   |   |
| Net proceeds from long-term debt                                                           |       | —                        |       | 25.0 |   |
| Payments on long-term debt                                                                 |       | —                        |       | (11.4 | ) |
| Deferred financing fees                                                                    |       | —                        |       | (1.9 | ) |
| **Net cash provided by financing activities**                                              |       | —                        |       | 11.7 |   |
| ** **                                                                                 |       |                          |       |   |   |
| **Net decrease in cash and cash equivalents**                                              |       | (16.6                         | )          | (25.3 | ) |
| ** **                                                                                 |       |                          |       |   |   |
| **Cash and cash equivalents**                                                              |       |                          |       |   |   |
| Beginning                                                                                  |       | 50.0                          |       | 56.5 |   |
| Ending                                                                                     |       | $                             | 33.4       |   | $ | 31.2 |   |
|                                                                                       |       |                          |       |   |   |
| **Supplemental Disclosure of Cash Flow Information**                                       |       |                          |       |   |   |
| Cash payments for interest                                                                 |       | $                             | 3.7        |   | $ | 20.2 |   |
|                                                                                       |       |                          |       |   |   |
| **Supplemental Schedule of Noncash Investing and Financing Activities**                    |       |                          |       |   |   |
| Principal amount converted of Redeemable Preferred Series A to Class A  common stock       |       | $                             | 33.2       |   | $ | 11.0 |   |
| Accrued capital expenditures                                                               |       | $                             | 0.9        |   | $ | 0.8 |   |
| Preferred stock dividends                                                                  |       | $                             | 0.8        |   | $ | 1.6 |   |

 

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

 

6

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**McLEODUSAINCORPORATED 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 on profitablerevenue growth in our 25-state footprint. In order to execute its plan the Company initiated a variety of programsacross the business to significantly improve the customer experience, eliminateunneeded infrastructure and cost, improve the quality of the network and growthe top line revenues.  Over the past severalyears the 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 inaccess rates as mandated by the Federal Communications Commission (“FCC”), andlower prices for some of its products. The Company has taken significant actions to increase revenue, includingintroduction of new competitively priced products, reorganization of the salesoperation, expanding the involvement of the board of directors and executivestaff in the sales process and reducing customer churn. To date, these actionshave not resulted in profitable new revenue growth which continues to be a challenge as the Company competes against large,financially strong competitors with well-known brands. With the pending mergers in the industry, theCompany believes that the large telecommunications providers will likely becomeeven more aggressive upon the closing of these transactions further challengingthe Company’s ability 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 Directorsauthorized the Company to pursue strategic alternatives.   Over the past several months the Company hasbeen actively 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 22% 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 itsability to services its customers.

 

In light of the level ofcash held by the Company at December 31, 2004 and the payments required duringthe first quarter of 2005 under its Credit Agreement dated May 31, 2000, asamended (the “Credit Agreement”) and its Exit Credit Agreement, dated April 16,2002, as amended, (the “Exit Facility” or collectively, the “Credit Facilities”),the Company began discussions with its agent bank and a group of lenders actingas a steering committee for the lenders under its Credit Facilities.  The Company entered a forbearance agreementon March 16, 2005 with its lenders whereby the lenders agreed not to take anyaction as a result of non-payment by the Company of scheduled principalamortization payments under the Credit Facilities and interest payments underthe Credit Agreement and any related events of default.  The initial forbearance agreement expired onMay 23, 2005 but has since been extended until September 9, 2005.  The forbearance agreement, among otherthings, limits the Company’s ability to sell certain assets without priorapproval of the lender group and requires McLeodUSA to accrue two additionalpercentage points of interest on the outstanding loan balances.  In accordance with the forbearance agreement,as of June 30, 2005, the Company has elected not to make $15.6 million ofscheduled principal payments and $23.1 million of scheduled interestpayments.  The Company believes that bynot making principal and interest payments on the Credit Facilities, cash onhand together with cash flows from operations is sufficient to maintainoperations in the ordinary course without disruption of services.

 

7

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At this time, the Companyhas concluded that there is not an acceptable strategic partner or buyer and isproceeding to work with its lenders to complete a capital restructuring wherethe lenders would convert a substantial portion of their debt to equity andbecome the stockholders of the Company. There can be no assurance that the Company will be able to reach anagreement with its lenders regarding a capital restructuring or continuedforbearance and covenant relief prior to the end of the current forbearanceperiod on September 9, 2005.  In theevent that the Company cannot reach an agreement with its lender group, it islikely that the Company will elect to forgo making future principal and interestpayments to its lenders while it continues to seek an extended forbearanceperiod or permanent capital restructuring from its lenders, or alternatively,the Company could be forced to seek protection from its creditors.

 

While the Companycontinues to explore with its lenders a capital restructuring, none of thealternatives presented to date have suggested that there will be any recoveryfor the Company’s current preferred stock or common stockholders.  Accordingly, the Company does not expect theholders of its preferred or common stock to receive any recovery in a capitalrestructuring.

 

The Company’s financialstatements for the period ending June 30, 2005 and December 31, 2004 areprepared on a going concern basis, which contemplates the realization of assetsand the satisfaction of liabilities in the normal course of business, but theCompany may not be able to continue as a going concern.  The report of McLeodUSA’s independentregistered public accounting firm accompanying its financial statements in itsAnnual Report on 10-K filed with the Securities and Exchange Commission (“SEC”)on March 25, 2005, contains a comment stating that there is substantial doubtas to its ability to continue as a going concern.  In the event the Company’s capitalrestructuring activities are not successful and it is required to seekprotection from its creditors, additional significant adjustments to theCompany’s consolidated financial statements may be necessary.

 

**Interim Financial Information(unaudited)**

 

In the opinion of management, the accompanying unauditedcondensed consolidated financial statements include adjustments, consisting ofnormal recurring adjustments, necessary for a fair presentation of thefinancial 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, filed with theSEC on March 25, 2005.

 

Certain prior periodamounts in the consolidated statements of cash flows have been reclassified toconform to current year presentation.

 

**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 employeecompensation cost is reflected in net loss, as all options granted under theplan had an exercise price greater than or equal to the market value of theunderlying common stock on the date of grant.

 

8

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Thefollowing table illustrates the effect on net loss and net loss per share forthe three and six months ended June 30, 2005 and 2004 as if McLeodUSA hadapplied the fair value recognition provisions of SFAS 123 to stock-basedemployee compensation.

 
| ** **                                                                                       | ** ** | **Three months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                       | ** ** | **2005**                        | ** ** | **2004** | ** ** |
| Net loss  applicable to common shares, as reported                                               |       | $                               | (268.4     | ) | $ | (83.0 | ) |
| Less: Total stock-based  employee compensation expense determined under fair value based methods |       | (1.0                            | )          | (3.2 | ) |
| Pro forma net  loss applicable to common shares                                                  |       | $                               | (269.4     | ) | $ | (86.2 | ) |
| **Loss  per share:**                                                                             |       |                            |       |   |   |
| Basic and  diluted, as reported                                                                  |       | $                               | (0.86      | ) | $ | (0.28 | ) |
| Basic and diluted,  pro forma                                                                    |       | $                               | (0.86      | ) | $ | (0.29 | ) |

 

 
| ** **                                                                                       | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                       | ** ** | **2005**                      | ** ** | **2004** | ** ** |
| Net loss  applicable to common shares, as reported                                               |       | $                             | (366.4     | ) | $ | (175.3 | ) |
| Less: Total stock-based  employee compensation expense determined under fair value based methods |       | (2.9                          | )          | (6.5 | ) |
| Pro forma net  loss applicable to common shares                                                  |       | $                             | (369.3     | ) | $ | (181.8 | ) |
| **Loss  per share:**                                                                             |       |                          |       |   |   |
| Basic and  diluted, as reported                                                                  |       | $                             | (1.18      | ) | $ | (0.60 | ) |
| Basic and  diluted, pro forma                                                                    |       | $                             | (1.19      | ) | $ | (0.62 | ) |

 

**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 102 million shares and 136 million shares atJune 30, 2005 and 2004, respectively, may become dilutive.  Assuming exercise or conversion of stockoptions and convertible securities, diluted shares would have beenapproximately 417 million and 429 million at June 30, 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 June 30, 2005, McLeodUSA, the parent company, has various guarantees related tosubsidiary commitments under operating leases. As of June 30, 2005 the guarantees total $22.2 million and expire overvarious periods through September 2016, corresponding with the termination ofthe lease agreements.

 

9

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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 its Directorsand 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 ForstmannLittle.  The amount of such equalizationpayments is not to exceed $500,000 annually. McLeodUSA will begin making the equalization payments in quarterlyinstallments during the third quarter of 2005.

 

**Note 2:  Trade Receivables**

 

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

 

| ** **                                     | ** ** | **June 30,   2005** | ** ** | **December 31,   2004** | ** ** |
|------------------------------------------------|------------|---------------------|------------|-------------------------|------------|
| Trade  Receivables:                            |       |                |       |                    |       |
| Billed                                         |       | $                   | 60.7       |                    | $          | 66.3 |   |
| Unbilled                                       |       | 4.7                 |       | 4.8                     |       |
|                                           |       | 65.4                |       | 71.1                    |       |
| Allowance for  doubtful accounts and discounts |       | (10.5               | )          | (12.5                   | )          |
|                                           |       | $                   | 54.9       |                    | $          | 58.6 |   |

 

**Note 3:  Other Accrued Liabilities**

 

Other accrued liabilitiesconsisted of the following (in millions):

 

| ** **                      | ** ** | **June 30,   2005** | ** ** | **December 31,   2004** | ** ** |
|---------------------------------|------------|---------------------|------------|-------------------------|------------|
| Accrued interest                |       | $                   | 28.2       |                    | $          | 1.8 |   |
| Accrued  sales/use/excise taxes |       | 16.8                |       | 17.8                    |       |
| Restructuring                   |       | 10.0                |       | 15.2                    |       |
| Accrued property  taxes         |       | 8.3                 |       | 10.9                    |       |
| Other                           |       | 32.0                |       | 29.7                    |       |
|                            |       | $                   | 95.3       |                    | $          | 75.4 |   |

 

As discussed in Note 1,the Company elected not to make certain interest payments in accordance withthe forbearance agreement.  As a resultof the non-payment, an event of default occurred and the Company is required toaccrue two additional percentage points of interest on the Credit Facilities asprovided in the forbearance agreement.

 

**Note 4:  Restructuring Charges**

** **

The Company incurred charges of $4.8 million and $6.9 millionfor the three and six months ending June 30, 2005, respectively, relatedto financial and legal advisors supporting the Company’s pursuit of strategic alternativesand financial restructuring.

 

Changes in the carryingamount of the restructuring liability for the six months ended June 30, 2005 issummarized as follows (in millions):

 
| **Facility  closure costs** |   |   |   |   |
|-----------------------------|--------|--------|--------|--------|
| Balance,  December 31, 2004 |   | $      | 15.2   |   |
| Payments                    |   | (5.2   | )      |
| Balance, June  30, 2005     |   | $      | 10.0   |   |

 

10

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**Note 5:  Impairment charges**

 

In accordance with SFASNo. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets (“SFAS 144”),* a long-lived asset group shall betested for recoverability whenever events or changes in circumstances indicatethat its carrying amount may not be recoverable.  As discussed in Note 1, the Company hasconcluded that there is not an acceptable strategic partner or buyer at thistime and the Company is proceeding to work with its lender group to complete acapital restructuring.  As a result, theCompany performed an evaluation of the recoverability of its property andequipment which indicated that certain of its long-lived assets wereimpaired.  The Company used aprobability-weighted discounted cash flow analysis to estimate the fair valueof the Company’s property and equipment and recorded a non-cash impairmentcharge of $174.8 million to reduce the carrying amount to estimated fair value.

 

In accordance with SFASNo. 142, *Goodwill and Other Intangible Assets (“SFAS 142”)*,indefinite-lived intangible assets are not to be amortized but reviewedannually for impairment or more frequently if an event occurs or circumstances changethat would more likely than not reduce the fair value below its carryingamount.  As a result of the potentialcapital restructuring discussed above, the Company performed an evaluation onthe McLeodUSA trade name utilizing a “relief from royalty” method ofvaluation.  The evaluation indicated animpairment of $27.7 million on the McLeodUSA trade name to reduce its carryingvalue to estimated fair value of $37.2 million. Consequently, the Company hasrecorded a non-cash impairment charge totaling $202.5 million, to include theimpairment on both the property and equipment and the McLeodUSA trade name, inits statement of operations for the three and six months ended June 30, 2005.

 

**Note 6: OtherIntangible Assets**

** **

The McLeodUSA trade namewas evaluated for impairment in conjunction with the preparation of the June30, 2005 financial statements.   Thisevaluation indicated partial impairment in the McLeodUSA trade name and theCompany has reduced the carrying value of the McLeodUSA trade name to $37.2 million.

 

Intangible assets withfinite lives at June 30, 2005 and December 31, 2004 are summarized as follows(in millions):

 
| ** **                       | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | ** ** | ** ** |
|----------------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **                       | ** ** | **Gross**  | ** ** | **Amortization** | ** ** | **Net**    | ** ** |
| **June 30, 2005:**               |       |       |       |             |       |       |       |
| Deferred line installation costs |       | $          | 199.6      |             | $          | 147.4      |       | $ | 52.2 |   |
| Customer base                    |       | 24.0       |       | 15.4             |       | 8.6        |       |
| PrimeLine Trademark              |       | 0.9        |       | 0.7              |       | 0.2        |       |
|                             |       | $          | 224.5      |             | $          | 163.5      |       | $ | 61.0 |   |

 

 
| ** **                       | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | ** ** | ** ** |
|----------------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **                       | ** ** | **Gross**  | ** ** | **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 $24 million, $30million for 2006, and $7 million for 2007.

 

11

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**Note 7:  Accounting for Asset Retirement Obligations**

 

 SFAS No. 143, *Accountingfor Asset Retirement Obligations* (“SFAS 143”), requires entities torecord the fair value of a liability for an asset retirement obligation in theperiod in which the legal or contractual removal obligation is incurred.  McLeodUSA’s asset retirement obligationsrelate to three categories of assets: fiber, central office colocationequipment and technical sites.

 

The liability was establishedby calculating the present value of the asset retirement obligation using adiscount rate of 6.1% over a period of 15 years, which is representative of theestimated life of McLeodUSA’s telecommunications network.

 

Changes in the carryingamount of the asset retirement obligation for the six months ended June 30,2005 is summarized as follows (in millions):

 
| Balance, December 31, 2004 |   | $    | 61.4   |   |
|----------------------------|--------|------|--------|--------|
| Interest accretion         |   | 1.9  |   |
| Payments                   |   | (0.2 | )      |
| Adjustments                |   | (0.8 | )      |
| Balance, June 30, 2005     |   | $    | 62.3   |   |

 

**Note 8:  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 certainspecified defaults under the Credit Facilities anticipated by the Companyduring the forbearance period, including, without limitation, the failure tomake scheduled amortization payments under the Credit Facilities and interestpayments under the Credit Agreement.  Theinitial forbearance agreement expired on May 23, 2005 but has since beenextended to September 9, 2005. At thistime, the Company has concluded that there is not an acceptable strategicpartner or buyer and is proceeding to work with its lenders to complete acapital restructuring where the lenders would convert a substantial portion oftheir debt to equity and become the stockholders of the Company.  There can be no assurance that the Companywill be able to reach an agreement with its lenders regarding a capitalrestructuring or continued forbearance and covenant relief prior to the end ofthe forbearance period on September 9, 2005.

 

In accordance with theforbearance agreement, as of June 30, 2005, the Company has elected not tomake $15.6 million of scheduled principal amortization and $23.1 millionof scheduled interest payments.  Theforbearance agreement, among other things, limits the Company’s ability to sellcertain assets without prior approval of the lender group and requires theCompany to accrue two additional percentage points of interest on theoutstanding loan balance.  The Company’sdebt has been classified as current in the condensed consolidated balance sheetbecause the default is not expected to be cured by September 9, 2005, the datethe forbearance agreement ends, and the forbearance agreement does not extendbeyond one year from the balance sheet date.

 

**Note 9:  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’’) aredefendants in a consolidated class action entitled In re McLeodUSA IncorporatedSecurities Litigation, Civil Action No. C02-0001 (N.D. Iowa) (the ‘‘Iowa ClassAction’’), alleging inter alia, violations of the Securities Act of 1933 andthe Securities Exchange Act of 1934. The Individual Defendants moved to dismissthe consolidated amended complaint in the Iowa Class Action.  That motion was denied. Discovery is ongoing.   One of the putative class plaintiffs, NewMillennium Growth Fund LLC, also filed proofs of claim against McLeodUSA inMcLeodUSA’s Chapter 11 Case, seeking at least $104,650 on its own behalf and noless than approximately $300 million (plus interest, costs and attorneys’ feesas allowed) on behalf of all class claimants in the Iowa Class Action (the ‘‘BankruptcyClaims’’ and, together with the Iowa Class Action, the ‘‘SecuritiesClaims’’).  The Bankruptcy Claims weretransferred from the bankruptcy court in Delaware to the Iowa court, and consolidatedwith the Iowa Class Action on February 1, 2005. As the Securities Claims are in early stages, it is impossible toevaluate the likelihood of unfavorable outcomes or, with respect to McLeodUSA’sindemnification obligations in connection with the 

 

12

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claims alleged again theIndividual Defendants in the consolidated amended complaint, estimate theamount or range of potential loss, if any, to McLeodUSA.  With respect to the Bankruptcy Claims, on May2, 2002, the Bankruptcy Court issued an order establishing a disputed claimsreserve of 18,000,000 shares of Reorganized McLeodUSA Class A Common Stock. Anyrecovery from the Bankruptcy Claims would be limited to those shares of stock.  McLeodUSA believes that the Securities Claimsare without merit and intends 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.

 

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.

 

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 other states.  The FCC and U. S. Department ofJustice 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.  On December 15, 2004, the FCCannounced adoption of revised permanent unbundling rules that it believes arein compliance with prior appellate decisions. These new unbundling rules impact access to local switching, highcapacity loops, high capacity transport, dark fiber, and entrancefacilities.  The FCC also adopted atransition 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 businesses willnot 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 theFCC.  The FCC is evaluating all proposalsand has solicited further comments on the issue.  

 

13

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Afinal decision is expected no earlier than the first quarter of 2006, and thecurrent framework of intercarrier compensation rules could be materiallyaffected.

 

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 TELRICmethodology used to determine the prices charged to competitive carriers forunbundled network elements. A change in pricing methodology that materiallyincreases unbundled network element prices would increase our costs and couldadversely affect our ability to compete. A decision is anticipated during 2006.

 

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.

 

OnJune 27, 2005, the United States Supreme Court recently affirmed in *National Cable and Telecom Association v. Brand X Internet Services*the FCC’s 2002 ruling that cable modem service, unlike DSL service, is anon-regulated Title I information service. Consequently, cable companies do nothave to unbundle their cable network or incur any resale obligations of theirbroadband service.  The RBOCs arerequesting that the FCC extend similar regulatory treatment to retail DSLservice in order to maintain a level playing field with cable modemservice.  If the FCC broadly rules thatRBOC broadband services provided over RBOC wireline facilities are informationservices rather than telecommunications services, then RBOCs could argue thatthey do not have an obligation to provide CLECs access to unbundled loops toprovide broadband services.  If the FCCwere to accept such RBOC arguments, the resulting changes could limit ouraccess to UNE loops to offer broadband services and affect our ability 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.; andQwest, approximately $4.9 million.  TheCompany’s withholdings, all of which are less than the amounts withheld by theIXCs are: MCI, approximately $3.4 million; Qwest, approximately $3.8 million; and Sprint, approximately $0.8million.  In total, approximately $23.5million of access charges were disputed by these three IXCs related to certain types of toll free traffic forprior periods based on alleged insufficiency of tariff grounds.  McLeodUSA has written contracts with two ofthe IXCs that identify the rates or source of rates that McLeodUSA is entitledto charge for interstate access services. McLeodUSA continued to bill for its services at the full benchmark rateuntil the FCC’s new rule went into effect as of June 22, 2004 at which time itbilled at the revised rates in accordance with by the FCC’s new rule.  As a consequence of the withholding ofpayments by these carriers, McLeodUSA filed suit against Sprint CommunicationsCorporation (“Sprint”) in the United States District Court for the NorthernDistrict of Iowa claiming that, by Sprint’s failure to pay the interstateaccess charges that the Company billed, Sprint was in breach of its contractwith the Company.  In addition to itsbreach of express contract claim against Sprint, the Company is pursuingrecovery of its interstate access charges for toll free traffic 

 

14

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underimplied contract and unjust enrichment theories.  McLeodUSA filed suit against QwestCorporation in this same court; however, the dispute with Qwest has beenresolved and the lawsuits filed in this matter have been dismissed.  The results of the resolution of this disputeare reflected in these consolidated financial statements.  On December 15, 2004, the FCC issued an orderin *US Telepacific*reaffirming that its rulelimiting CLEC access rates to be no more than the rate charged by the ILEC forthe same functionality, adopted in May 2004, was to be applied on a prospectivebasis only, and that it was not unreasonable for a CLEC to charge the fullbenchmark rate for traffic to or from end-users of other carriers, providedthat the carrier serving the end-user did not also charge the IXC and providedthat the CLEC’s charges were otherwise in compliance with and supported by itstariff.  The Company expects to resolvethe dispute with MCI by the end of the year. The Company believes that recovery of withheld amounts by Sprint and MCIis probable; accordingly, no amounts have been reserved by the Company at June30, 2005.  However, certain of theunderlying issues have never been litigated and are largely questions of firstimpression.

 

McLeodUSAis one of several defendants in a lawsuit brought by SBC and its affiliates in theU.S. District Court in the Eastern District of Missouri. SBC alleges thatMcLeodUSA conspired with one or more of Global Crossing and its affiliates,certain named competitive local exchange carriers, and/or certain unnamed “leastcost routers” to breach SBC’s state or federal tariffs, unjustly enrichthemselves, and commit fraud on SBC.  SBC alleges that the defendants knowingly disguised long distance callsthat were terminated to SBC so that they appeared to SBC to be local callsthereby depriving SBC of the difference between the access charge rate owed fortermination of long distance calls and the reciprocal compensation rate owedfor termination of local calls. McLeodUSA’s answer was filed on April 1, 2005,denying all liability.   McLeodUSA intendsto vigorously defend against these claims.

 

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 July 18, 2005, theArizona Corporation Commission approved a settlement agreement betweenMcLeodUSA and the Arizona Staff that resolved all issues related to certainagreements that we entered into with Qwest several years ago that have sinceexpired.  The Colorado Public UtilitiesCommission continues to review these agreements, and that proceeding may resultin fines or other sanctions against us or the imposition of other conditionsdetrimental to us, including the establishment of discounts available to othercompetitive telephone companies but not to us. Other states may initiatesimilar proceedings.

 

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.  The parties have agreed in principle tosettle this dispute, the results of which are reflected in these consolidatedfinancial statements.

 

OnMay 9, 2005, AT&T sent a demand to the Company for arbitration of its claimin 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 partieshave reached an agreement in principle to settle this dispute and the partiesanticipate entering into a formal settlement agreement shortly.  The results of the settlement agreement arereflected in these consolidated financial statements.

 

Asa result of the various settlements discussed above, the Company has recordedan additional charge to its operating expenses of $3.3 million during thesecond quarter of 2005.  McLeodUSA is notaware of any other material litigation against it.  McLeodUSA does, however, have various otherlegal proceedings pending against it or its subsidiaries or on its behalf orthat 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 capital restructuring, current and future economicconditions, the existence of strategic alliances, our ability to generate cash,our ability to implement process and network improvements, our ability toattract and retain customers, our ability to migrate traffic to appropriate platformsand changes in the competitive climate in which we operate.  These and other risks are described in moredetail in our most recent Annual Report on Form 10-K filed with the SEC.  Except as required under the federalsecurities laws and rules and regulations of the SEC, the Company undertakes noobligation to update publicly any forward-looking statements, whether as aresult of future events, new information or otherwise.

 

**Item 2.**             Management’sDiscussion and Analysis 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. In order to execute our plan we initiated a variety of programs acrossthe business to significantly improve the customer experience, eliminateunneeded infrastructure and cost, improve the quality of the network and growthe top line revenues.  Over the past severalyears we have 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 since 2002.  The decline in revenue was driven primarilyby our program to eliminate non-profitable customers, turnover of customers tocompetitors in excess of new customers acquired, reduction in access rates asmandated by the FCC, and lower prices for some of our products.   We have taken significant actions toincrease revenue, including introduction of new competitively priced products,reorganization of the sales operation, 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 pending mergers in the industry, we believe that the largetelecommunications providers will likely become even more aggressive upon theclosing of these transactions further challenging our ability 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, our Board of Directors authorizedthe Company to pursue strategic alternatives. Over the past several months we have been actively pursuing a strategicpartner or a sale of the Company while also taking steps to maintain futureliquidity, including evaluating a capital restructuring to reduce the currentdebt level enabling the Company to achieve positive cash flow going forward.

 

In light of our level ofcash at December 31, 2004 and the payments required during the first quarter of2005 under the Credit Facilities, we began discussions with our agent bank anda group of lenders acting as a steering committee for the lenders under ourCredit Facilities.  The Company entered aforbearance agreement on March 16, 2005 with our lenders whereby the lendersagree not to take any action as a result of non-payment by the Company of scheduledprincipal amortization under the Credit Facilities and interest payments underthe Credit Agreement and any related events of default.  

 

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The initial forbearanceagreement expired on May 23, 2005 but has since been extended until September9, 2005.  The forbearance agreement,among other things, limits our ability to sell certain assets without priorapproval of the lender group and requires McLeodUSA to accrue two additionalpercentage points of interest on the outstanding loan balances.  In accordance with the forbearance agreement,as of June 30, 2005, the Company has elected not to make $15.6 million ofscheduled principal payments and $23.1 million of scheduled interest payments.  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.

 

At this time, we haveconcluded that there is not an acceptable strategic partner or buyer and we areproceeding to work with our lenders to complete a capital restructuring wherethe lenders would convert a substantial portion of their debt to equity andbecome the stockholders of the Company. 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 forbearance period on September 9,2005.  In the event that we cannot reachan agreement with our lender group, it is likely that we will elect to forgomaking future principal and interest payments to our lenders while we continueto seek an extended forbearance period or permanent capital restructuring fromour lenders, or alternatively, we could be forced to seek protection from ourcreditors.

 

While the Companycontinues to explore with its lenders a capital restructuring,  none of the alternatives presented to datehave suggested that there will be any recovery for the Company’s currentpreferred stock or common stockholders. Accordingly, the Company does not expect its holders of preferred orcommon stock to receive any recovery in a capital restructuring.

 

Our financial statementsfor the periods ending June 30, 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 ourcapital restructuring activities are not successful and we are required to seekprotection from our creditors, additional significant adjustments to theCompany’s consolidated financial statements may be necessary.

 

**Overviewof Our Business**

 

We derive our revenuefrom our core telecommunications and related communications services.  These include local and long distanceservices; local data services such as dial-up and dedicated Internet accessservices, using DSL, cable modem and dedicated T1 access; integrated accessservices, 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 June 30, 2005, weoperated a network with 698 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 38service 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:

 

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

 

**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 and policiesused in preparation of the Condensed Consolidated Financial Statements. Actualresults in these areas could differ from management’s estimates.  There have been no significant changes in ourcritical accounting estimates during the six months ended June 30, 2005.  Management will continue to monitor itsestimates and assumptions as well as events or changes in circumstances withrespect to the reported amounts of assets, liabilities, revenues and expenseswhile we continue our pursuit of strategic alternatives and financialrestructuring.

 

**Liquidityand 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 voicenetworks and 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.

 

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 certainfinancial results of the Company, as reported in our quarterly and annualfinancial releases, 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 hasfinalized its unbundling rules and the communications industry consolidationhas accelerated. With the recent merger announcements in the industry, webelieve that the large telecommunications providers will likely become evenmore aggressive upon the closing of these transactions further challenging ourability to grow revenue.

 

Asdiscussed in the “Executive Overview,” we began exploring a capitalrestructuring with our lenders while also attempting to identify a potentialstrategic partner or buyer.  At thistime, we have concluded that there is not an acceptable strategic partner orbuyer and we are proceeding to work with our lenders to complete a capitalrestructuring where our lenders would convert a substantial portion of theirdebt to equity and become the stockholders of the Company.

 

The Company and itslenders have agreed to extend the forbearance agreement with respect toscheduled principal and interest payments on its loans whereby the lenders agreenot to take any action as a result of non-payment by the Company of scheduledprincipal amortization and interest payments under the Credit Agreement and anyrelated events of default 

 

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through September 9,2005.  We believe that by not makingprincipal and interest payments on the Credit Facilities, cash on hand togetherwith cash flows from operations is sufficient to maintain operations in theordinary course without disruption of services.

 

**2005 Cash Flow**

** **

We ended June 30, 2005with $33.4 million of cash and cash equivalents versus $50.0 million atDecember 31, 2004.  This decrease of$16.6 million resulted primarily from the following:

 
| Operating  Activities:                                                         |   |   |   |
|--------------------------------------------------------------------------------|--------|--------|--------|
| Decrease in cash  from operations, excluding changes in assets and liabilities |   | $      | (5.2   | ) |
| Payments for  restructuring charges and liabilities                            |   | (12.0  | )      |
| Cash provided by  changes in assets and liabilities                            |   | 21.9   |   |
| Net cash  provided by operating activities                                     |   | 4.7    |   |
|                                                                           |   |   |   |
| Investing  Activities:                                                         |   |   |   |
| Capital  expenditures                                                          |   | (21.0  | )      |
| Deferred line  installation costs                                              |   | (13.7  | )      |
| Sale of assets                                                                 |   | 13.4   |   |
| Net cash used in  investing activities                                         |   | (21.3  | )      |
|                                                                           |   |   |   |
| Net decrease in  cash and cash equivalents                                     |   | $      | (16.6  | ) |

 

The payments forrestructuring charges and liabilities relate to lease payments and leasebuyouts associated with facility exits and costs in connection with our pursuitof strategic alternatives and financial restructuring.  We expect our cash requirements to payremaining lease payments and lease buyouts associated with facility exits to beless than $5 million during the remainder of 2005.

 

We have reduced ourgrowth-related capital expenditure plan and expect to spend less than $45million during 2005.  The capitalexpenditure plan for the rest of 2005 remains focused on supporting new productintroductions and maintaining the existing business base.   Deferred line installation costs are theresult of costs required to add customers onto our network.  Our deferred line installation expenditures throughoutthe rest of 2005 will be dependent on the rate at which we add new customers.

 

As discussed above, theCompany has entered a forbearance agreement with its lenders with respect toscheduled principal and interest payments on its loans which extends throughSeptember 9, 2005.  In accordance withthe forbearance agreement, as of June 30, 2005, the Company has elected not tomake $15.6 million of scheduled principal payments and $23.1 million ofscheduled interest payments.  

 

**Outlook for 2005 and FutureFunding Needs**

** **

We ended June 30, 2005with $33.4 million of cash on hand.  Froman ongoing operating standpoint, our cash requirements for the remainder of2005 will consist of supporting new products, important capital expenditureprojects, remaining lease payments and lease buyouts associated with facilityexits and changes in working capital.  Acombination of cash on hand, cash generated from operating activities and theproceeds from the sale of certain assets will be used to meet these ongoing cashrequirements.  The Company is currentlyworking with its lenders to complete a capital restructuring. While thespecific terms of the restructuring have not yet been determined, it isanticipated that the expenses associated with the capital restructuring and anyrelated business restructuring would be funded by either the existing lendersor other external sources in combination with existing cash on hand and theproceeds from any additional asset sales.

 

In the interim, we havecontinued to take additional steps to conserve cash and improve liquidity.  Actions that have been taken to generatefurther operational efficiencies and focused expense management resulted in a22% reduction in SG&A expenses compared to the second quarter of 2004.  We have reduced our growth related capitalexpenditure plan and now expect to spend approximately $45 million in2005.  As a result of the actionsdescribed above we have significantly reduced our cash usage 

 

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and expect to realizecontinuing benefits from these programs in 2005.  We will continue to execute our cashmanagement program while pursuing the capital restructuring discussionsmentioned 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 forbearance period.  Inthe event that we cannot reach an agreement with our lender group, it is likelythat we will elect to forgo making future principal and interest payments toour lenders while we continue to seek an extended forbearance period orpermanent capital restructuring from our lenders, or alternatively, the Companycould be forced to seek protection from its creditors.

 

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

 

***Revenue.***  Total revenue for the quarter ended June 30,2005 declined $32.2 million, or 17%, to $159.7 million from $191.9 million forthe quarter ended June 30, 2004.  Thefollowing table compares our revenue for the three months ended June 30:

 
| ** **                                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **Variance** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Local                                                                                    |       | $        | 80.5       |     | $          | 93.0         |       | $ | (12.5 | ) |
| Long distance                                                                            |       | 33.2     |       | 33.1     |       | 0.1          |       |
| Data services and other                                                                  |       | 29.3     |       | 33.8     |       | (4.5         | )          |
| Carrier access                                                                           |       | 14.0     |       | 30.2     |       | (16.2        | )          |
| Indefeasible rights of use agreements including those that qualify as  sales type leases |       | 2.7      |       | 1.8      |       | 0.9          |       |
|                                                                                     |       | $        | 159.7      |     | $          | 191.9        |       | $ | (32.2 | ) |
|                                                                                          |            |          |            |          |            |              |            |  |  |  |  |

 

Total revenues declinedby $32.2 million versus the second quarter of 2004 primarily due to a continueddecline in total customers, the FCC mandated reduction in access rates andlower long distance rates.  Approximately$10.9 million of the decrease in local revenue is attributed to a reduction inthe number of access lines in service due to customer turnover in excess of newlines sold. Retail long distance declined by $6.0 million as a result of both areduction in volume of minutes and rates of approximately $3.1 million and $2.9million, respectively. This decline was offset by a $6.1 million increase inwholesale long distance due to substantial volume increases related to severalwholesale contracts.  Access revenueshave decreased $16.2 million from the second quarter of 2004 due to the finalphase of the FCC mandated rate reduction as well as approximately $6 million offavorable rate settlements recorded in the second quarter of 2004 related toprior period billings.  Included inrevenues from indefeasible rights of use in the above table is $1.3 million and$1.5 million for the quarters ended June 30, 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 ofconnecting customers to our network via leased facilities, the costs paid tothird party providers for interconnect access and transport services, the costsof leasing components of our network facilities and the cost of fiber relatedto sales and leases of network facilities. Cost of service was $92.2 million for the quarter ended June 30, 2005, adecrease of $13.1 million or 12% from the quarter ended June 30, 2004.  Approximately $5.9 million of the decreasereflects network cost reductions, including least cost routing, networkoptimization including grooms and migration of customers to the McLeodUSAnetwork.  The balance of the decrease isattributed to the reduction in revenues. The cost of fiber related to sales and leases of network facilities was$0.3 million and less than $0.1 million for the quarters ended June 30, 2005and 2004, respectively.

 

***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 $53.7 million for thesecond quarter of 2005, a decrease of $14.8 million or 22% from 2004.  The decrease in SG&A year over year isprimarily attributable to actions to reduce expenses and manage cash includinga planned reduction in headcount. Headcount decreased from approximately 2,500 at June 30, 2004 to 2,100employees at June 30, 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 transferringcustomers’ local line service from the RBOCs to our local telecommunicationsservices.  Depreciation and amortizationexpenses were $54.5 million for the 

 

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quarter ended June 30,2005, a decrease of $33.9 million, from the quarter ended June 30, 2004.  This decline is driven by lower depreciationexpense as certain assets reached fully depreciated status in April 2005.

 

***Impairmentcharges. ***Inaccordance with SFAS 144 and SFAS 142, we performed impairment tests on ourlong-lived assets and indefinite-lived intangible asset.  The tests resulted in a $202.5 millionnon-cash impairment charge to reduce the carrying value of our property andequipment and the McLeodUSA trade name by $174.8 million and $27.7 million,respectively.

 

***Restructuringcharges****.  *In the second quarter of 2005, weincurred $4.8 million in restructuring charges related to financial and legaladvisors supporting our pursuit of strategic alternatives and financialrestructuring.

 

***Interestexpense.***  Grossinterest expense was $19.7 million for the quarter ended June 30, 2005, anincrease of $7.7 million over the second quarter of 2004 primarily due to anincrease in the average interest rates during the period.  Market rates have increased, and, as a resultof the event of default that occurred in March, we are required to accrue twoadditional percentage points of interest on our outstanding debt balance.  Net interest expense increased by $7.9million in the quarter ended June 30, 2005 due to higher interest rates on ouroutstanding debt and lower capitalized interest.  Interest expense of approximately $0.2million and $0.4 million was capitalized as part of our construction of ournetwork during the quarter ended June 30, 2005 and 2004, respectively.

 

The Company’s operatingresults during the quarter ended June 30, 2005, include an unfavorableimpact of approximately $4.0 million related to the resolution of variouslegal & commercial disputes.

 

**SixMonths Ended June 30, 2005 Compared with Six Months Ended June 30, 2004**

 

***Revenue.***  Total revenue for the six months ended June30, 2005 declined $65.3 million, or 17%, to $320.2 million from $385.5 millionfor the six months ended June 30, 2004. The following table compares our revenue for the six months ended June30:

 
| ** **                                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **Variance** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Local                                                                                    |       | $        | 163.9      |     | $          | 188.5        |       | $ | (24.6 | ) |
| Long distance                                                                            |       | 66.7     |       | 69.0     |       | (2.3         | )          |
| Data services and other                                                                  |       | 58.3     |       | 69.3     |       | (11.0        | )          |
| Carrier access                                                                           |       | 26.5     |       | 55.0     |       | (28.5        | )          |
| Indefeasible rights of use agreements including those that qualify as  sales type leases |       | 4.8      |       | 3.7      |       | 1.1          |       |
|                                                                                     |       | $        | 320.2      |     | $          | 385.5        |       | $ | (65.3 | ) |

 

Total revenues declinedby $65.3 million versus the first six months of 2005 due to a continued declinein total customers, the FCC mandated reduction in access rates, and lower longdistance rates.  Approximately $23.8million of the decrease in local revenue is attributed to a reduction in thenumber of access lines in service due to customer turnover in excess of newlines sold.  Retail long distancedeclined by $14.5 million as a result of both a reduction in volume and ratesof approximately $8.8 million and $5.7 million, respectively.  This decline was partially offset by a $12.3million increase in wholesale long distance due to substantial volume increasesrelated to several wholesale contracts. Access revenues have decreased $28.5 million from the second quarter of2004 due to the final phase of the FCC mandated rate reduction as well asapproximately $6 million of favorable rate settlements recorded in 2004 relatedto prior period billings.  Included inrevenues from indefeasible rights of use in the above table is $2.7 million and$2.9 million for the six month periods ended June 30, 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 ofconnecting customers to our network via leased facilities, the costs paid tothird party providers for interconnect access and transport services, the costsof leasing components of our network facilities and the cost of fiber relatedto sales and leases of network facilities. Cost of service was $185.5 million for the six month period ended June30, 2005, a decrease of $27.4 million or 13% from the six month period endedJune 30, 2004.  Approximately $13.0million of the decrease reflects network cost reductions, including least costrouting, network optimization including grooms and migration of customers tothe McLeodUSA network. The balance of the decrease is attributed to thereduction in revenues.  The cost of fiberrelated to sales and leases of network facilities was $0.4 million for the sixmonths ended June 30, 2005 and $0.1 million for the six months ended June 30,2004.

 

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***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 $110.4 million for thesix months of 2005, a decrease of $33.8 million or 23% from 2004.  The decrease in SG&A year over year isprimarily attributable to actions to reduce expenses and manage cash as well asreduced headcount.  Headcount decreasedfrom approximately 2,500 at June 30, 2004 to 2,100 employees at June 30, 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 transferringcustomers’ local line service from the RBOCs to our local telecommunicationsservices.  Depreciation and amortizationexpenses were $145.8 million for the six months ended June 30, 2005, decreaseof $32.8 million over the second quarter of 2004. This decline is driven bylower depreciation expense as certain assets reached fully depreciated statusin April 2005.

 

***Impairmentcharges.***In accordance with SFAS 144 and SFAS 142, weperformed impairment tests on our long-lived assets and indefinite-livedintangible asset.  The tests resulted ina $202.5 million non-cash impairment charge to reduce the carrying value of ourproperty and equipment and the McLeodUSA trade name by $174.8 million and $27.7million, respectively.

 

***Restructuringcharges****.  *In the six months ended June 30,2005, we incurred $6.9 million in restructuring charges related to financialand legal advisors supporting our pursuit of strategic alternatives andfinancial restructuring.

 

***Interestexpense.***  Grossinterest expense was $34.3 million for the six months ended June 30, 2005, anincrease of $10.4 million over the six months ended June 30, 2004 primarily dueto an increase in the average interest rates during the period.  Market rates have increased, and, as a resultof the event of default that occurred in March, we are required to accrue twoadditional percentage points of interest on our outstanding debt balance.  Net interest expense increased by $11.1million in the six months ended June 30, 2005 due to higher interest rates onour outstanding debt.  Interest expenseof approximately $0.4 million and $1.1 million was capitalized as part of ourconstruction of our network during the six months ended June 30, 2005 and 2004,respectively.

 

The Company’s operatingresults for the six months ended June 30, 2005, include an unfavorableimpact of approximately $4.0 million related to the resolution of variouslegal and commercial disputes.

 

 

**Inflation**

** **

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

 

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**Item 3. Quantitative and Qualitative Disclosures About Market Risk**

** **

We have variable ratedebt of approximately $777 million under the Credit Agreement outstanding atJune 30, 2005.  If market interest ratesaverage 1% more in subsequent quarters than the rates during the quarter endedJune 30, 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.

 

**Item4.  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’’) aredefendants in a consolidated class action entitled In re McLeodUSA IncorporatedSecurities Litigation, Civil Action No. C02-0001 (N.D. Iowa) (the ‘‘Iowa ClassAction’’), alleging inter alia, violations of the Securities Act of 1933 andthe Securities Exchange Act of 1934. The Individual Defendants moved to dismissthe consolidated amended complaint in the Iowa Class Action.  That motion was denied. Discovery is ongoing.   One of the putative class plaintiffs, NewMillennium Growth Fund LLC, also filed proofs of claim against McLeodUSA inMcLeodUSA’s Chapter 11 Case, seeking at least $104,650 on its own behalf and noless than approximately $300 million (plus interest, costs and attorneys’ feesas allowed) on behalf of all class claimants in the Iowa Class Action (the ‘‘BankruptcyClaims’’ and, together with the Iowa Class Action, the ‘‘SecuritiesClaims’’).  The Bankruptcy Claims weretransferred from the bankruptcy court in Delaware to the Iowa court, andconsolidated with the Iowa Class Action on February 1, 2005.  As the Securities Claims are in early stages,it is impossible to evaluate the likelihood of unfavorable outcomes or, withrespect to McLeodUSA’s indemnification obligations in connection with theclaims alleged again the Individual Defendants in the consolidated amendedcomplaint, 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 set forthin the policies, which is intended to cover the costs of claims made againstits current and former Directors and Officers, including the IndividualDefendants.

 

McLeodUSAis also involved in numerous regulatory proceedings before various public utilitycommissions 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.

 

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 other states.  The FCC and U. S. Department ofJustice declined to appeal *USTA II*.  Competitive and interexchange carriers and anorganization representing state regulatory 

 

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agencies filed appeals tothe U.S. Supreme Court and requested a stay. The U.S. Supreme Court declined to issue a stay.   On July 22, the FCC adopted and on August22, 2004, the FCC released an Interim UNE Order (the “Interim Order”)establishing requirements that govern the availability of UNEs until the FCCadopts new, permanent unbundling rules. On December 15, 2004, the FCC announced adoption of revised permanentunbundling rules that it believes are in compliance with prior appellatedecisions.  These new unbundling rulesimpact access to local switching, high capacity loops, high capacity transport,dark fiber, and entrance facilities.  TheFCC also adopted a transition plan for those elements that will no longer beUNEs.  The Company believes that the newrules are predominantly supportive of its facilities-based (UNE-L)strategy.  The new unbundling rulesbecame effective March 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 theFCC.  The FCC is evaluating all proposalsand 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 a Notice of Proposed Rulemaking (“NPRM”) onTotal Element Long Run Incremental Cost (“TELRIC”).  This is a proceeding to review the TELRICmethodology used to determine the prices charged to competitive carriers forunbundled network elements. A change in pricing methodology that materiallyincreases unbundled network element prices would increase our costs and couldadversely affect our ability to compete. A decision is anticipated during 2006.

 

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 unbundling obligationunder Section 271 of the 1996 Act for any network element that has been removedfrom Section 251 of the 1996 Act.  Suchrelief could limit our access to customers and adversely affect our ability tocompete.

 

OnJune 27, 2005, the United States Supreme Court recently affirmed in *National Cable and Telecom Association v. Brand X Internet Services*the FCC’s 2002 ruling that cable modem service, unlike DSL service, is anon-regulated Title I information service. Consequently, cable companies do nothave to unbundle their cable network or incur any resale obligations of theirbroadband service.  The RBOCs arerequesting that the FCC extend similar regulatory treatment to retail DSLservice in order to maintain a level playing field with cable modem service.  If the FCC broadly rules that RBOC broadbandservices provided over RBOC wireline facilities are information services ratherthan telecommunications services, then RBOCs could argue that they do not havean obligation to provide CLECs access to unbundled loops to provide broadbandservices.  If the FCC were to accept suchRBOC arguments, the resulting changes could limit our access to UNE loops tooffer broadband services and affect our ability 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 

 

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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 $6.4million;  Sprint, approximately $4.7million.; 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; and Sprint, approximately $0.8million.  In total, approximately $23.5million of access charges were disputed by these three IXCs related to certain types of toll free traffic forprior periods based on alleged insufficiency of tariff grounds.  McLeodUSA has written contracts with two ofthe IXCs that identify the rates or source of rates that McLeodUSA is entitledto charge for interstate access services. McLeodUSA continued to bill for its services at the full benchmark rateuntil the FCC’s new rule went into effect as of June 22, 2004 at which time itbilled at the revised rates in accordance with by the FCC’s new rule.  As a consequence of the withholding ofpayments by these carriers, McLeodUSA filed suit against Sprint CommunicationsCorporation (“Sprint”) in the United States District Court for the NorthernDistrict of Iowa claiming that, by Sprint’s failure to pay the interstateaccess charges that the Company billed, Sprint was in breach of its contractwith the Company.  In addition to itsbreach 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;however, the dispute with Qwest has been resolved and the lawsuits filed inthis matter have been dismissed.  Theresults of the resolution of this dispute are reflected in these consolidatedfinancial statements.  On December 15,2004, the FCC issued an order in *US Telepacific*reaffirmingthat its rule limiting CLEC access rates to be no more than the rate charged bythe ILEC for the same functionality, adopted in May 2004, was to be applied ona prospective basis only, and that it was not unreasonable for a CLEC to chargethe full benchmark rate for traffic to or from end-users of other carriers,provided that the carrier serving the end-user did not also charge the IXC andprovided that the CLEC’s charges were otherwise in compliance with andsupported by its tariff.  The Companyexpects to resolve the dispute with MCI by the end of the year.  The Company believes that recovery ofwithheld amounts by Sprint and MCI is probable; accordingly, no amounts havebeen reserved by the Company at June 30, 2005. However, certain of the underlying issues have never been litigated andare largely questions of first impression.

 

McLeodUSAis one of several defendants in a lawsuit brought by SBC and its affiliates inthe U.S. District Court in the Eastern District of Missouri. SBC alleges thatMcLeodUSA conspired with one or more of Global Crossing and its affiliates,certain named competitive local exchange carriers, and/or certain unnamed “leastcost routers” to breach SBC’s state or federal tariffs, unjustly enrichthemselves, and commit fraud on SBC.  SBC alleges that the defendants knowingly disguised long distance callsthat were terminated to SBC so that they appeared to SBC to be local callsthereby depriving SBC of the difference between the access charge rate owed fortermination of long distance calls and the reciprocal compensation rate owedfor termination of local calls. McLeodUSA’s answer was filed on April 1, 2005,denying all liability.   McLeodUSAintends to vigorously defend against these claims.

 

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 July 18, 2005, theArizona Corporation Commission approved a settlement agreement betweenMcLeodUSA and the Arizona Staff that resolved all issues related to certainagreements that we entered into with Qwest several years ago that have sinceexpired.  The Colorado Public UtilitiesCommission continues to review these agreements, and that proceeding may resultin fines or other sanctions against us or the imposition of other conditionsdetrimental to us, including the establishment of discounts available to othercompetitive telephone companies but not to us. Other states may initiatesimilar proceedings.

 

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.  The parties have agreed in principle tosettle this dispute, the results of which are reflected in these consolidatedfinancial statements.

 

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OnMay 9, 2005, AT&T sent a demand to the Company for arbitration of its claimin 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 partieshave reached an agreement in principle to settle this dispute and the partiesanticipate entering into a formal settlement agreement shortly.  The results of the settlement agreement arereflected in these consolidated financial statements.

 

Asa result of the various settlements discussed above, the Company has recordedan additional charge to its operating expenses of $3.3 million during thesecond quarter of 2005.  McLeodUSA is notaware of any other material litigation against it. McLeodUSA does, however,have various other legal proceedings pending against it or its subsidiaries oron its behalf or that of its subsidiaries

 

**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 therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                 | **McLEODUSA INCORPORATED** |
|----------------------|----------------------------|
|                 | (registrant)               |
|                 |                       |   |
|                 |                       |   |
| Date: August 9, 2005 | By:                        | /s/ Chris A.  Davis |   |
|                 |                       | Chris A. Davis |   |
| * *             | * *                   | *Chairman  and Chief Executive Officer* |   |
|                 |                       |   |
|                 |                       |   |
| Date: August 9, 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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