**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q/A**

** **

**(Mark One)**

| **ý** |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                               |
|------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                                                                                                                                                                                       |
|       |   | **For the Quarterly Period Ended September 30, 2003**                                                                                                                                                                                                                                                                                                                                      |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                       |
|       |   | **or**                                                                                                                                                                                                                                                                                                                                                                                     |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                       |
| **o**      |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                              |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                       |
|       |   | **For the transition period                                 to                             ** |

** **

**Commissionfile number 0-20763**

 

**McLEODUSA INCORPORATED**

(Exactname 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’stelephone number,including area code)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90days.           Yes  ý  No  o

 

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

 

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

 

The number ofshares outstanding of each class of the issuer’s common stock as of November 3,2003:
| Common Stock Class A:  ($0.01 par value)  |   | 173,557,189 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 |   |

 

 

----

 

**EXPLANATORY NOTE**

 

Based on discussions with SEC staff, the Company is reissuing asExhibits 31.1 and 31.2 hereto the certifications made pursuant to Section 302of the Sarbanes-Oxley Act of 2002 (the “Certifications”) included in theCompany’s Quarterly Report on Form 10-Q for the fiscal quarter ended September30, 2003 as filed with the Securities and Exchange Commission on November 14,2003 (the “Quarterly Report”) to remove explanatory information provided innumbered paragraph 6.  This explanatoryinformation was also provided in the text of the Quarterly Report and remainstherein.  The Company’s Chief ExecutiveOfficer and Chief Financial Officer have also reconfirmed their certificationsrequired by Section 906 of the Sarbanes-Oxley Act of 2002 in connection withthis amendment.  Except as providedherein, all other information contained in the Quarterly Report remains unchanged.

 

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**McLEODUSA INCORPORATED AND SUBSIDIARIES**

**INDEX**

 
| **PART I.**  | **Financial Information**                                                                   |                                                                                         |   |
|--------------|---------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------|--------|
|         |                                                                                        |                                                                                         |   |
| Item 1.      | Condensed Consolidated  Financial Statements                                                |                                                                                         |
|         |                                                                                        |                                                                                         |
|         |                                                                                        | Condensed Consolidated Balance Sheets, September  30, 2003 (unaudited) and December 31, 2002 |   |
|         |                                                                                        |                                                                                         |   |
|         | Unaudited  Condensed Consolidated Statements of Operations                                  |                                                                                         |
|         |                                                                                        |                                                                                         |
|         |                                                                                        | Reorganized McLeodUSA –  for the three months ended September 30, 2003 and 2002         |   |
|         |                                                                                        |                                                                                         |   |
|         | Unaudited  Condensed Consolidated Statements of Operations and Comprehensive (Loss)  Income |                                                                                         |
|         |                                                                                        |                                                                                         |
|         |                                                                                        | Reorganized McLeodUSA –  for the nine months ended September 30, 2003                   |   |
|         |                                                                                        |                                                                                         |   |
|         |                                                                                        | Reorganized McLeodUSA –  for the period April 17, 2002 to September 30, 2002            |   |
|         |                                                                                        |                                                                                         |   |
|         |                                                                                        | Predecessor McLeodUSA –  for the period January 1, 2002 to April 16, 2002               |   |
|         |                                                                                        |                                                                                         |   |
|         | Unaudited  Condensed Consolidated Statements of Cash Flows                                  |                                                                                         |
|         |                                                                                        |                                                                                         |
|         |                                                                                        | Reorganized McLeodUSA –  for the nine months ended September 30, 2003                   |   |
|         |                                                                                        |                                                                                         |   |
|         |                                                                                        | Reorganized McLeodUSA –  for the period April 17, 2002 to September 30, 2002            |   |
|         |                                                                                        |                                                                                         |   |
|         |                                                                                        | Predecessor McLeodUSA –  for the period January 1, 2002 to April 16, 2002               |   |
|         |                                                                                        |                                                                                         |   |
|         | 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 and  Reports on Form 8-K                                                           |                                                                                         |   |
|         |                                                                                        |                                                                                         |   |
| Signatures   |                                                                                        |                                                                                         |
|              |                                                                                             |                                                                                              |        |  |

 

2

----

 

**PARTI**–**FINANCIAL INFORMATION**

** **

**ITEM I.Financial Statements**

** **

**McLEODUSA INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(Inmillions, except share data)**

** **
|                                                                                                                                                                                                          |   | **September  30, 2003** |    | **December  31,  2002** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------|-------------------------|--------|
|                                                                                                                                                                                                          |   | **(unaudited)**         |    |                    |   |
| **ASSETS**                                                                                                                                                                                                    |   |                    |    |                    |   |
| Current  assets                                                                                                                                                                                               |   |                    |    |                    |   |
| Cash  and cash equivalents                                                                                                                                                                                    |   | $                       | 48.3    |                    | $      | 170.6 |   |
| Restricted cash                                                                                                                                                                                               |   | 9.0                     |    | —                  |   |
| Trade receivables, net                                                                                                                                                                                        |   | 75.5                    |    | 93.1                    |   |
| Prepaid expenses and other                                                                                                                                                                                    |   | 22.4                    |    | 26.2                    |   |
| Assets held for sale                                                                                                                                                                                          |   | 9.3                     |    | 11.1                    |   |
| Total current assets                                                                                                                                                                                          |   | 164.5                   |    | 301.0                   |   |
|                                                                                                                                                                                                          |   |                    |    |                    |   |
| Property  and equipment                                                                                                                                                                                       |   |                    |    |                    |   |
| Land and buildings                                                                                                                                                                                            |   | 73.8                    |    | 72.9                    |   |
| Communications networks                                                                                                                                                                                       |   | 904.1                   |    | 816.0                   |   |
| Furniture, fixtures and equipment                                                                                                                                                                             |   | 193.4                   |    | 181.3                   |   |
| Networks in progress                                                                                                                                                                                          |   | 257.6                   |    | 303.5                   |   |
|                                                                                                                                                                                                          |   | 1,428.9                 |    | 1,373.7                 |   |
| Less accumulated depreciation                                                                                                                                                                                 |   | 369.6                   |    | 170.6                   |   |
|                                                                                                                                                                                                          |   | 1,059.3                 |    | 1,203.1                 |   |
|                                                                                                                                                                                                          |   |                    |    |                    |   |
| Intangibles and other assets                                                                                                                                                                                  |   |                    |    |                    |   |
| Goodwill                                                                                                                                                                                                      |   | 245.1                   |    | 237.8                   |   |
| Other intangibles, net                                                                                                                                                                                        |   | 209.0                   |    | 234.5                   |   |
| Other                                                                                                                                                                                                         |   | 19.8                    |    | 23.9                    |   |
|                                                                                                                                                                                                          |   | 473.9                   |    | 496.2                   |   |
| **TOTAL ASSETS**                                                                                                                                                                                              |   | $                       | 1,697.7 |                    | $      | 2,000.3 |   |
|                                                                                                                                                                                                          |   |                    |    |                    |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                |   |                    |    |                    |   |
| Current  liabilities                                                                                                                                                                                          |   |                    |    |                    |   |
| Current  maturities of long-term debt                                                                                                                                                                         |   | $                       | 25.8    |                    | $      | 15.0 |   |
| Accounts payable                                                                                                                                                                                              |   | 42.9                    |    | 71.1                    |   |
| Accrued payroll and payroll related expenses                                                                                                                                                                  |   | 22.6                    |    | 23.6                    |   |
| Other accrued liabilities                                                                                                                                                                                     |   | 131.2                   |    | 152.8                   |   |
| Deferred revenue, current portion                                                                                                                                                                             |   | 9.6                     |    | 9.8                     |   |
| Liabilities related to discontinued operations                                                                                                                                                                |   | 0.6                     |    | 6.3                     |   |
| Total current liabilities                                                                                                                                                                                     |   | 232.7                   |    | 278.6                   |   |
|                                                                                                                                                                                                          |   |                    |    |                    |   |
| Long-term debt, less current maturities                                                                                                                                                                       |   | 685.2                   |    | 704.9                   |   |
| Deferred revenue, less current portion                                                                                                                                                                        |   | 12.9                    |    | 13.5                    |   |
| Other long-term liabilities                                                                                                                                                                                   |   | 57.5                    |    | 54.9                    |   |
|                                                                                                                                                                                                          |   | 988.3                   |    | 1,051.9                 |   |
| Redeemable  convertible preferred stock                                                                                                                                                                       |   |                    |    |                    |   |
| McLeodUSA  Preferred Series A, redeemable, convertible, $0.01 par value; 10,000,000  authorized and issued; 7,981,602****and 9,999,900 outstanding at September  30, 2003 and December 31, 2002, respectively |   | 140.8                   |    | 172.6                   |   |
|                                                                                                                                                                                                          |   |                    |    |                    |   |
| Stockholders’  equity                                                                                                                                                                                    |   |                    |    |                    |   |
| McLeodUSA Common, Class A $0.01 par value;  1,886,249,986 authorized, 172,470,490 and 162,500,481 issued and outstanding  at September 30, 2003 and December 31, 2002, respectively                           |   | 1.8                     |    | 1.6                     |   |
| McLeodUSA Common, Class B $0.01 par value;  78,203,135 authorized, issued and outstanding at September 30, 2003 and  December 31, 2002                                                                        |   | 0.8                     |    | 0.8                     |   |
| McLeodUSA Common, Class C $0.01 par value;  35,546,879 authorized, issued and outstanding at September 30, 2003 and  December 31, 2002                                                                        |   | 0.3                     |    | 0.3                     |   |
| McLeodUSA Preferred Series B, $0.01 par value; 10  authorized, issued and outstanding at September 30, 2003 and December 31,  2002                                                                            |   | —                  |    | —                  |   |
| McLeodUSA Warrants                                                                                                                                                                                            |   | 22.6                    |    | 22.6                    |   |
| Additional paid-in capital                                                                                                                                                                                    |   | 983.6                   |    | 951.9                   |   |
| Accumulated deficit                                                                                                                                                                                           |   | (440.5                  | )       | (201.4                  | )      |
|                                                                                                                                                                                                          |   | 568.6                   |    | 775.8                   |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                          |   | $                       | 1,697.7 |                    | $      | 2,000.3 |   |

 

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

 

3

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**McLEODUSA INCORPORATED ANDSUBSIDIARIES**

**UNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS**

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

 
|                                                                                   |   | **Three months ended September 30,** |   |
|----------------------------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                                                   |   | **2003**                             |   | **2002** |   |
|                                                                                   |   |                                 |   |   |   |
| Revenues                                                                               |   | $                                    | 211.0  |   | $ | 243.5 |   |
|                                                                                   |   |                                 |   |   |   |
| Operating expenses:                                                                    |   |                                 |   |   |   |
| Cost of service (exclusive of depreciation shown  separately  below)                   |   | 117.4                                |   | 154.1 |   |
| Selling, general and administrative                                                    |   | 80.0                                 |   | 79.1 |   |
| Depreciation and amortization                                                          |   | 86.6                                 |   | 75.7 |   |
| **Total operating expenses**                                                           |   | 284.0                                |   | 308.9 |   |
| **Operating loss**                                                                     |   | (73.0                                | )      | (65.4 | ) |
|                                                                                   |   |                                 |   |   |   |
| Nonoperating expense:                                                                  |   |                                 |   |   |   |
| Interest expense, net of amounts capitalized                                           |   | (8.9                                 | )      | (10.7 | ) |
| Other expense                                                                          |   | (0.3                                 | )      | (1.5 | ) |
| **Total nonoperating expense**                                                         |   | (9.2                                 | )      | (12.2 | ) |
| **Loss from continuing operations**                                                    |   | (82.2                                | )      | (77.6 | ) |
|                                                                                   |   |                                 |   |   |   |
| Discontinued operations:                                                               |   |                                 |   |   |   |
| Income from discontinued operations (including loss on  disposals of $2.9 during 2002) |   | —                               |   | 10.2 |   |
| **Net loss**                                                                           |   | (82.2                                | )      | (67.4 | ) |
| Preferred stock dividend                                                               |   | (1.2                                 | )      | (1.2 | ) |
| **Net loss applicable to common shares**                                               |   | $                                    | (83.4  | ) | $ | (68.6 | ) |
|                                                                                   |   |                                 |   |   |   |
| Basic and diluted loss per common share:                                               |   |                                 |   |   |   |
| Loss from continuing operations                                                        |   | $                                    | (0.30  | ) | $ | (0.29 | ) |
| Discontinued operations                                                                |   | —                               |   | 0.04 |   |
| Loss per common share                                                                  |   | $                                    | (0.30  | ) | $ | (0.25 | ) |
| Weighted average common shares outstanding                                             |   | 278.9                                |   | 276.3 |   |

 

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

 

4

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**McLEODUSA INCORPORATED ANDSUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTSOF OPERATIONSAND COMPREHENSIVE (LOSS) INCOME**

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

** **
|                                                                                                                                                                                 |   | **Reorganized McLeodUSA**                 |   | **Predecessor  McLeodUSA**                |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                                                                                                                 |   | **Nine months ended  September 30, 2003** |   | **April 17, 2002 to  September 30, 2002** |   | **January 1, 2002 to  April 16, 2002** |   |
|                                                                                                                                                                                 |   |                                      |   |                                      |   |   |   |
| Revenues                                                                                                                                                                             |   | $                                         | 659.5  |                                      | $      | 450.7 |   | $ | 311.4 |   |
| Operating expenses:                                                                                                                                                                  |   |                                      |   |                                      |   |   |   |
| Cost of service (exclusive of depreciation shown  separately below)                                                                                                                  |   | 382.9                                     |   | 273.5                                     |   | 211.2 |   |
| Selling, general and administrative                                                                                                                                                  |   | 235.2                                     |   | 158.6                                     |   | 108.9 |   |
| Depreciation and amortization                                                                                                                                                        |   | 253.9                                     |   | 135.2                                     |   | 126.3 |   |
| Reorganization charges, net                                                                                                                                                          |   | —                                    |   | —                                    |   | 1,596.8 |   |
| Restructuring adjustment                                                                                                                                                             |   | —                                    |   | —                                    |   | (6.8 | ) |
| **Total operating expenses**                                                                                                                                                         |   | 872.0                                     |   | 567.3                                     |   | 2,036.4 |   |
| **Operating loss**                                                                                                                                                                   |   | (212.5                                    | )      | (116.6                                    | )      | (1,725.0 | ) |
|                                                                                                                                                                                 |   |                                      |   |                                      |   |   |   |
| Nonoperating (expense) income:                                                                                                                                                       |   |                                      |   |                                      |   |   |   |
| Interest expense, net of amounts capitalized  (contractual interest was $93.6 million for the period January 1 to April 16,  2002)                                                   |   | (25.9                                     | )      | (18.9                                     | )      | (33.2 | ) |
| Other (expense) income                                                                                                                                                               |   | (0.7                                      | )      | (0.4                                      | )      | 2.0 |   |
| Gain on cancellation of debt                                                                                                                                                         |   | —                                    |   | —                                    |   | 2,372.8 |   |
| **Total nonoperating (expense) income**                                                                                                                                              |   | (26.6                                     | )      | (19.3                                     | )      | 2,341.6 |   |
| **(Loss) income from continuing operations**                                                                                                                                         |   | (239.1                                    | )      | (135.9                                    | )      | 616.6 |   |
| Discontinued operations:                                                                                                                                                             |   |                                      |   |                                      |   |   |   |
| Income from discontinued operations (including net  gains (losses) on disposals of $148.3 for the period January 1 to April 16,  2002 and ($2.9) for April 17 to September 30, 2002) |   | —                                    |   | 23.2                                      |   | 167.1 |   |
| **Net (loss) income**                                                                                                                                                                |   | (239.1                                    | )      | (112.7                                    | )      | 783.7 |   |
| Preferred stock dividend (contractual dividends were  $8.9 million for the period January 1 to April 16, 2002)                                                                       |   | (3.6                                      | )      | (2.3                                      | )      | (4.8 | ) |
| **Net (loss) income applicable to common shares**                                                                                                                                    |   | $                                         | (242.7 | )                                         | $      | (115.0 | ) | $ | 778.9 |   |
|                                                                                                                                                                                 |   |                                      |   |                                      |   |   |   |
| Basic and diluted (loss) income per common share:                                                                                                                                    |   |                                      |   |                                      |   |   |   |
| (Loss) income from continuing operations                                                                                                                                             |   | $                                         | (0.87  | )                                         | $      | (0.50 | ) | $ | 0.97 |   |
| Discontinued operations                                                                                                                                                              |   | —                                    |   | 0.08                                      |   | 0.27 |   |
| (Loss) income per common share                                                                                                                                                       |   | $                                         | (0.87  | )                                         | $      | (0.42 | ) | $ | 1.24 |   |
| Weighted average common shares outstanding                                                                                                                                           |   | 277.9                                     |   | 276.3                                     |   | 627.7 |   |
|                                                                                                                                                                                 |   |                                      |   |                                      |   |   |   |
| Other comprehensive income (loss), net of tax:                                                                                                                                       |   |                                      |   |                                      |   |   |   |
| Unrealized holding gains arising during the period                                                                                                                                   |   | $                                         | — |                                      | $      | — |   | $ | (2.1 | ) |
| Less:   reclassification adjustment for gains included in net income                                                                                                            |   | —                                    |   | —                                    |   | 3.2 |   |
| **Total other comprehensive income**                                                                                                                                                 |   | —                                    |   | —                                    |   | 1.1 |   |
| **Comprehensive (loss) income**                                                                                                                                                      |   | $                                         | (239.1 | )                                         | $      | (112.7 | ) | $ | 784.8 |   |

 

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

 

5

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**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In millions)**

 
|                                                                                  |   | **Reorganized McLeodUSA**                 |       | **Predecessor  McLeodUSA**                |       |
|---------------------------------------------------------------------------------------|--------|-------------------------------------------|------------|-------------------------------------------|------------|
|                                                                                  |   | **Nine months ended  September 30, 2003** |       | **April 17, 2002 to  September 30, 2002** |       | **January 1, 2002  to April 16, 2002** |   |
|                                                                                  |   |                                      | ** ** |                                      | ** ** |   | ** ** |
| **Cash Flows from Operating Activities**                                              |   |                                      |       |                                      |       |   |   |
| Net (loss) income from continuing operations                                          |   | $                                         | (239.1     | )                                         | $          | (135.9 | ) | $ | 616.6 |   |
| Adjustments to reconcile net (loss) income to net cash  used in operating activities: |   |                                      |       |                                      |       |   |   |
| Depreciation                                                                          |   | 203.7                                     |       | 106.7                                     |       | 108.6 |   |
| Amortization                                                                          |   | 50.2                                      |       | 28.5                                      |       | 17.7 |   |
| Accretion of interest                                                                 |   | 2.6                                       |       | —                                    |       | 4.1 |   |
| (Gain) loss on sale of assets                                                         |   | (0.1                                      | )          | 2.5                                       |       | (6.4 | ) |
| Non cash reorganization items                                                         |   | —                                    |       | —                                    |       | 1,538.4 |   |
| Gain on cancellation of debt                                                          |   | —                                    |       | —                                    |       | (2,372.8 | ) |
| Restructuring adjustment                                                              |   | —                                    |       | —                                    |       | (6.8 | ) |
| Changes in assets and liabilities, net of  dispositions:                              |   |                                      |       |                                      |       |   |   |
| Trade receivables                                                                     |   | 8.2                                       |       | 38.7                                      |       | 14.3 |   |
| Prepaid expenses and other                                                            |   | 11.4                                      |       | (10.3                                     | )          | 10.2 |   |
| Accounts payable and accrued expenses                                                 |   | (52.9                                     | )          | (25.5                                     | )          | (43.3 | ) |
| Deferred revenue                                                                      |   | (0.8                                      | )          | (6.1                                      | )          | 1.1 |   |
| Increase in restricted cash                                                           |   | (9.0                                      | )          | —                                    |       | — |   |
| **Net cash used in operating activities**                                             |   | (25.8                                     | )          | (1.4                                      | )          | (118.3 | ) |
|                                                                                  |   |                                      |       |                                      |       |   |   |
| **Cash Flows from Investing Activities**                                              |   |                                      |       |                                      |       |   |   |
| Purchases of property and equipment                                                   |   | (58.8                                     | )          | (38.6                                     | )          | (37.2 | ) |
| Other assets                                                                          |   | (32.2                                     | )          | (27.2                                     | )          | (16.5 | ) |
| Sale of available for sale securities                                                 |   | —                                    |       | —                                    |       | 2.0 |   |
| Proceeds from the sale of assets                                                      |   | 3.1                                       |       | 8.1                                       |       | 19.1 |   |
| Proceeds from the sale of businesses                                                  |   | —                                    |       | 100.0                                     |       | 679.7 |   |
| Other                                                                                 |   | —                                    |       | (0.4                                      | )          | — |   |
| **Net cash (used in) provided by investing activities**                               |   | (87.9                                     | )          | 41.9                                      |       | 647.1 |   |
|                                                                                  |   |                                      |       |                                      |       |   |   |
| **Cash Flows from Financing Activities**                                              |   |                                      |       |                                      |       |   |   |
| Payments on long-term debt                                                            |   | (8.6                                      | )          | (4.1                                      | )          | (734.3 | ) |
| Investment by Forstmann Little                                                        |   | —                                    |       | —                                    |       | 175.0 |   |
| **Net cash used in financing activities**                                             |   | (8.6                                      | )          | (4.1                                      | )          | (559.3 | ) |
|                                                                                  |   |                                      |       |                                      |       |   |   |
| **Net (decrease) increase in cash and cash equivalents from  continuing operations**  |   | (122.3                                    | )          | 36.4                                      |       | (30.5 | ) |
|                                                                                  |   |                                      |       |                                      |       |   |   |
| **Net cash provided by discontinued operations**                                      |   | —                                    |       | 10.4                                      |       | 31.6 |   |
|                                                                                  |   |                                      |       |                                      |       |   |   |
| **Cash and cash equivalents**                                                         |   |                                      |       |                                      |       |   |   |
| Beginning                                                                             |   | 170.6                                     |       | 138.2                                     |       | 137.1 |   |
| Ending                                                                                |   | $                                         | 48.3       |                                      | $          | 185.0 |   | $ | 138.2 |   |
| **Supplemental Disclosure of Cash Flow Information**                                  |   |                                      |       |                                      |       |   |   |
| Cash payments for interest                                                            |   | $                                         | 30.0       |                                      | $          | 27.4 |   | $ | 16.2 |   |
| **Supplemental Schedule of Noncash Investing and Financing  Activities**              |   |                                      |       |                                      |       |   |   |
| Preferred stock dividends                                                             |   | $                                         | 3.6        |                                      | $          | 2.3 |   | $ | 4.8 |   |

 

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

 

6

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###### **Note 1:  Basisof Presentation**

 

McLeodUSA Incorporated (“McLeodUSA”), a Delawarecorporation, through its subsidiaries, provides integrated communicationsservices, including local services, primarily in 25 Midwest, Southwest,Northwest and Rocky Mountain states. McLeodUSA’s business is highly competitive and is subject to variousfederal, state and local regulations.

 

On January 31, 2002, McLeodUSA Incorporated, theparent company, filed a voluntary petition for relief under Chapter 11 of theUnited States Bankruptcy Code in the United States Bankruptcy Court for theDistrict of Delaware (the “Bankruptcy Court”). On April 16, 2002, McLeodUSA Incorporated emerged from the BankruptcyCourt proceedings pursuant to the terms of its amended plan of reorganization(the “Plan”).  The Plan was filed withthe Bankruptcy Court on February 28, 2002 and was confirmed on April 5, 2002.

 

During the period fromJanuary 31, 2002 to April 16, 2002, McLeodUSA operated as adebtor-in-possession.  The unauditedcondensed consolidated financial statements during the period from January 31,2002 to April 16, 2002, have been prepared in accordance with the provisions ofStatement of Position 90-7, *Financial Reporting by Entities in ReorganizationUnder the Bankruptcy Code* (“SOP 90-7”).  McLeodUSA adopted theprovisions of SOP 90-7 upon commencement of the Bankruptcy Court proceedings.The unaudited condensed consolidated statement of operations for the periodJanuary 1, 2002 to April 16, 2002 separately discloses expenses related to theChapter 11 proceedings as reorganization charges. Interest expense on all ofthe outstanding senior notes and the preferred stock dividends on the Series APreferred Stock ceased to accrue after filing by McLeodUSA on January 31, 2002.Interest and dividends ceased by operation of law.  See Note 3 for further discussion of the emergence frombankruptcy.

 

Upon emergence frombankruptcy, McLeodUSA implemented fresh-start reporting under the provisions ofSOP 90-7.  Under SOP 90-7, thereorganization fair value of McLeodUSA was allocated to its assets andliabilities, its accumulated deficit was eliminated, and its new equity wasissued according to the Plan as if it were a new reporting entity.  As a result of the reorganization occurringas of April 16, 2002, the financial statements have been separately presentedunder the label “Predecessor McLeodUSA” for the periods prior to April 16, 2002and “Reorganized McLeodUSA” for the periods subsequent to April 17, 2002.

 

For the periods January1, 2002 to April 16, 2002 and April 17, 2002 to September 30, 2002, theoperating results of businesses held for sale have been reported asdiscontinued operations in the McLeodUSA Unaudited Condensed ConsolidatedStatements of Operations in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 144 *Accounting for the Impairment or Disposal ofLong-Lived Assets* (“SFAS 144”). Assets held for sale and liabilities related to discontinued operationshave been presented separately in the asset and liabilities sections of thecondensed consolidated balance sheets. See Note 2 for further discussion of discontinued operations.

 

**Interim Financial Information (unaudited)**

In the opinion of management, the accompanyingunaudited condensed consolidated financial statements include all adjustments,consisting of normal recurring adjustments, necessary for a fair presentationof the financial position and results of operations of McLeodUSA.  The operating results for the interimperiods are not necessarily indicative of the operating results to be expectedfor a full 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 theSecurities and Exchange Commission (“SEC”). Although management believes that the disclosures provided are adequateto make the information presented not misleading, management recommends thatyou read these unaudited condensed consolidated financial statements inconjunction with the audited consolidated financial statements and the relatedfootnotes included in the McLeodUSA Annual Report on Form 10-K/A for thefiscal year ended December 31, 2002, filed with the SEC on April 10, 2003.

 

**Accounting for Stock-based Compensation**

Aspermitted by SFAS No. 123, *Accounting for Stock-Based Compensation*(‘‘SFAS123’’), McLeodUSA measures compensation using the intrinsic value based methodas prescribed 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-Based Compensation-Transitionand Disclosure — an Amendment of SFAS 123*had been adopted. Underthe intrinsic value method, compensation is measured as the difference betweenthe market value of the stock on the grant date, less the amount

 

7

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requiredto be paid for the stock. The difference, if any, is charged to expense overthe vesting period of the options. No stock-based employee compensation cost isreflected in net loss, as all options granted under the plan had an exerciseprice greater than or equal to the market value of the underlying common stockon the date of grant. The following table illustrates the effect on net lossand net loss per share for the three and nine months ended September 30, 2003,the three months ended September 30, 2002 and the period April 17, 2002 toSeptember 30, 2002 as if McLeodUSA had applied the fair value recognitionprovisions of SFAS 123 to stock-based employee compensation.  During the period January 1, 2002 to April16, 2002, there were options outstanding under Predecessor McLeodUSA optionplans.  No pro forma information hasbeen presented below for 2002 under Predecessor McLeodUSA option plans becausethose option plans were terminated upon the confirmation of the Plan on April5, 2002.

 
|                                                                                                    |   | **Three  months ended September 30,** |   |
|---------------------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                                                    |   | **2003**                              |   | **2002** |   |
| Net  loss applicable to common shares, as reported                                                      |   | $                                     | (83.4  | ) | $ | (68.6 | ) |
| Less:  total  stock-based employee compensation expense  determined under fair value based methods |   | (2.6                                  | )      | (2.1 | ) |
| Pro forma net loss applicable to common shares                                                          |   | $                                     | (86.0  | ) | $ | (70.7 | ) |
|                                                                                                    |   |                                  |   |   |   |
| **Loss  per share:**                                                                                    |   |                                  |   |   |   |
| Basic  and diluted, as reported                                                                         |   | $                                     | (0.30  | ) | $ | (0.25 | ) |
| Basic  and diluted, pro forma                                                                           |   | $                                     | (0.31  | ) | $ | (0.26 | ) |

** **
|                                                                                                    |   | **Nine  months  ended  September 30, 2003** |   | **April 17,  2002 to  September 30,  2002** |   |
|---------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|--------|---------------------------------------------|--------|
| Net loss applicable to  common shares, as reported                                                      |   | $                                           | (242.7 | )                                           | $      | (115.0 | ) |
| Less:   total stock-based employee compensation expense  determined under fair value based methods |   | (7.0                                        | )      | (10.8                                       | )      |
| Pro forma net loss applicable to common shares                                                          |   | $                                           | (249.7 | )                                           | $      | (125.8 | ) |
|                                                                                                    |   |                                        |   |                                        |   |
| **Loss  per share:**                                                                                    |   |                                        |   |                                        |   |
| Basic  and diluted, as reported                                                                         |   | $                                           | (0.87  | )                                           | $      | (0.42 | ) |
| Basic  and diluted, pro forma                                                                           |   | $                                           | (0.90  | )                                           | $      | (0.46 | ) |

 

 

**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 may become dilutive.  Assumingexercise or conversion of stock options and convertible securities, dilutedshares would have been approximately 423****million at September 30, 2003.

** **

**Guarantees**

In November 2002, theFinancial Accounting Standards Board (“FASB”) issued FASB Interpretation No.45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*.  This interpretation clarifies disclosures that are required to bemade by a guarantor in its interim and annual financial statements aboutobligations under certain of its issued guarantees. In addition, the interpretationclarifies that a guarantor is required to recognize, at the inception ofcertain types of guarantees, a liability for the fair value of the obligationundertaken in issuing these guarantees. The recognition and measurementprovisions of this interpretation are applicable to guarantees issued ormodified after December 31, 2002, and the disclosure requirements becameeffective as of December 31, 2002.  AtSeptember 30, 2003, McLeodUSA, the parentcompany, has various guarantees related to subsidiary commitments under

 

8

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operatingleases.  As of September 30, 2003 theguarantees total $28.4 million and expire over various periods throughSeptember 2016, corresponding with the termination of the lease agreements.

 

**Restricted cash**

McLeodUSA has recorded$9.0 million of cash as restricted at September 30, 2003.  The restricted cash was received fromMcLeodUSA’s insurance carrier pursuant to a Stipulation of Settlement datedSeptember 22, 2003 to settle the CapRock securities litigation.  The settlement agreement, which receivedpreliminary court approval on October 14, 2003, provides for the payment of$11.0 million to plaintiffs, which would be covered by a combination of the $9million of restricted cash and a portion of a rebate of insurance premiumspreviously paid to another carrier.  Asrequired by the settlement agreement, McLeodUSA placed the $9.0 million ofrestricted cash in escrow on October 27, 2003. See Note 10 for further discussion.

 

**Note 2:  Assets Held For Sale**

 

In August 2001, McLeodUSAinitiated a broad strategic and operational restructuring to re-focus itsbusiness on its core areas of expertise within its 25-state footprint, improvebusiness discipline and processes and reduce its cost structure, all with thegoal of eventually developing positive cash flow from operations.  A key element of this operationalrestructuring included selling certain non-core assets, including McLeodUSATelecom Development, Inc. and McLeodUSA Community Telephone, Inc. (collectively“DTG”), Greene County Partners, Inc., Caprock Services Corp., and McLeodUSAIntegrated Business Systems, Inc. (“IBS”).

 

Also in 2001, McLeodUSAinitiated a financial restructuring to substantially reduce its outstandingdebt.  As part of the financialrestructuring, McLeodUSA and its senior secured lenders agreed to amendMcLeodUSA’s Credit Agreement dated May 31, 2002 (the “Credit Agreement”) topermit the financial restructuring.  Thekey elements of the financial restructuring included, among other things (1)the sale of McLeodUSA Media Group Inc. and its subsidiaries (“Pubco”) and theuse of the proceeds therefrom to make a payment to holders of all of its outstanding notes (including its 10 1/2% Senior Discount Notes, 9 1/ 4% Senior Notes, 8 3/ 8% Senior Notes, 9 1/ 2%Senior Notes, 8 1/ 8% Senior Notes, 12% Senior Notes, 11 1 / 2% Senior Notesand 11 3 / 8% Senior Notes (collectively, the “Notes”)), and (2) thesale of McLeodUSA’s Illinois independent local exchange carrier (“ICTC”) uponcompletion of the restructuring and use of the first $225 million of netproceeds to prepay the term loans under the Credit Agreement.

 

For the three monthsended September 30, 2002 and the periods April 17, 2002 to September 30, 2002and January 1, 2002 to April 16, 2002, the operating results of the businesseslisted below have been reported as discontinued operations in the McLeodUSAUnaudited Condensed Consolidated Financial Statements in accordance with SFAS144.  At December 31, 2002, all of thebusinesses had been sold.  The remainingassets held for sale totaling $9.3 million are comprised of real estate and anequity interest in a partnership.  Theliabilities related to discontinued operations represent unpaid selling costs.

 

9

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For the three monthsended September 30, 2002, and the periods April 17, 2002 to September 30, 2002and January 1, 2002 to April 16, 2002, the amount of revenue and net income(including gains or losses on the sales) attributable to discontinuedoperations and the assets held for sale were as follows (in millions):

 
|             |   | **Reorganized  McLeodUSA**                   |   | **Predecessor  McLeodUSA**                 |   |
|------------------|--------|----------------------------------------------|--------|--------------------------------------------|--------|
|             |   | **Three Months  Ended  September 30,  2002** |   | **April 17, 2002  to  September 30, 2002** |   | **January 1, 2002  to  April 16, 2002** |   |
| **Revenues:**    |   |                                         |   |                                       |   |   |   |
| IBS              |   | $                                            | — |                                       | $      | — |   | $ | 1.2 |   |
| CapRock Services |   | —                                       |   | —                                     |   | 8.8 |   |
| Pubco            |   | —                                       |   | —                                     |   | 94.3 |   |
| DTG              |   | 9.1                                          |   | 17.8                                       |   | 12.0 |   |
| Greene County    |   | 1.1                                          |   | 2.6                                        |   | 2.3 |   |
| ICTC             |   | 27.7                                         |   | 50.5                                       |   | 31.7 |   |
|             |   | $                                            | 37.9   |                                       | $      | 70.9 |   | $ | 150.3 |   |

 

 
|                   |   | **Reorganized****McLeodUSA**                 |   | **Predecessor****McLeodUSA**               |   |
|------------------------|--------|----------------------------------------------|--------|--------------------------------------------|--------|
|                   |   | **Three Months  Ended  September 30,  2002** |   | **April 17, 2002  to  September 30, 2002** |   | **January 1, 2002  to  April 16, 2002** |   |
| **Net income (loss):** |   |                                         |   |                                       |   |   |   |
| IBS                    |   | $                                            | — |                                       | $      | (0.5 | ) | $ | 1.0 |   |
| CapRock Services       |   | —                                       |   | (0.1                                       | )      | 8.3 |   |
| Pubco                  |   | (0.2                                         | )      | (0.2                                       | )      | 150.0 |   |
| DTG                    |   | (0.1                                         | )      | 3.9                                        |   | (0.4 | ) |
| Greene County          |   | (0.2                                         | )      | 0.1                                        |   | 0.2 |   |
| ICTC                   |   | 10.7                                         |   | 20.0                                       |   | 8.0 |   |
|                   |   | $                                            | 10.2   |                                       | $      | 23.2 |   | $ | 167.1 |   |

###### ** **

###### **Note 3:   Emergence from Chapter 11 Proceedings**

###### ** **

###### ***Confirmation of the Plan: ***On April 5, 2002,the Bankruptcy Court confirmed the Plan. The general unsecured creditors of McLeodUSA, except for the holders ofthe Notes, were unaffected by the Chapter 11 proceedings and the Plan.  The Plan became effective on April 16, 2002and resulted in the following:

 

**•**                  Theelimination of approximately $3 billion of indebtedness, including accruedinterest, represented by the Notes;

 

•                  In exchange forthe cancellation of the Notes and the unpaid interest thereon, the bondholdersreceived their pro rata share of (1) $670 million in cash, (2) 10,000,000shares of Series A Preferred Stock, which is convertible into 15% of Class ACommon Stock on a fully diluted basis as of the Effective Date of the Planafter giving effect to the Plan and conversion of the Class B Common Stock andClass C Common Stock (but prior to the exercise of the warrants) and (3) 5-yearwarrants to purchase 22,159,091 shares of Reorganized McLeodUSA Class A CommonStock for $30 million;

 

•                  The sale of Pubco to Yell Group Ltd.for $600 million;

 

10

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•                  The investment by two fundsaffiliated with Forstmann Little & Co. of $175 million in exchange for (1)74,027,764 shares of Reorganized McLeodUSA Class A Common Stock, (2) 5-yearwarrants to purchase 22,159,091 shares of Reorganized McLeodUSA Class A CommonStock for $30 million and (3) 10 shares of Reorganized McLeodUSA Series BPreferred Stock;

 

•                  The conversion of PredecessorMcLeodUSA Series D Preferred Stock and Predecessor McLeodUSA Series E PreferredStock, held by Forstmann Little & Co., into 78,203,135 shares ofReorganized McLeodUSA Class B Common Stock and 35,546,879 shares of ReorganizedMcLeodUSA Class C Common Stock, respectively; and

 

•                  The conversion of the PredecessorMcLeodUSA Series A Preferred Stock into 33,696,559 shares of ReorganizedMcLeodUSA Class A Common Stock.

 

The Planalso provided for the distribution of a portion of Reorganized McLeodUSA commonstock to holders of Predecessor McLeodUSA common stock.  These holders were entitled to share,together with holders of certain securities claims, in the distribution of54,775,663 shares of Reorganized McLeodUSA Class A Common Stock.  On May 2, 2002, the Bankruptcy Court enteredan order establishing a disputed claims reserve of 18,000,000 shares ofReorganized McLeodUSA Class A Common Stock pending resolution of the securitiesclaims against McLeodUSA associated with the putative securities class actionlawsuits.  McLeodUSA then commenced thedistribution of 36,775,663 shares of Reorganized McLeodUSA Class A Common Stockto record holders of Predecessor McLeodUSA common stock as of April 5, 2002,the distribution record date under the Plan. Upon the final determination of the amount, if any, of allowedsecurities claims under the Plan, such holders of Predecessor McLeodUSA commonstock may be entitled to additional distributions of Reorganized McLeodUSAClass A Common Stock from the 18,000,000 shares held in the disputed claimsreserve.

 

Thecondensed financial information for the predecessor parent company, McLeodUSAIncorporated, for the period January 1, 2002 to April 16, 2002 is as follows(in millions):

 
|                                         |   | **Predecessor  McLeodUSA**              |   |
|----------------------------------------------|--------|-----------------------------------------|--------|
|                                         |   | **January 1, 2002   to April 16, 2002** |   |
| Operating expenses:                          |   |                                    |   |
| Selling, general and administrative          |   | $                                       | 8.7    |   |
| Depreciation and amortization                |   | 5.1                                     |   |
| Reorganization charges, net                  |   | 1,596.8                                 |   |
| Restructuring adjustment                     |   | (6.8                                    | )      |
| Total operating expenses                     |   | 1,603.8                                 |   |
|                                         |   |                                    |   |
| Nonoperating income:                         |   |                                    |   |
| Interest expense, net of amounts capitalized |   | (33.0                                   | )      |
| Gain on cancellation of debt                 |   | 2,372.8                                 |   |
| Other income                                 |   | 0.4                                     |   |
| Equity in net losses of subsidiaries         |   | (119.8                                  | )      |
| Total nonoperating income                    |   | 2,220.4                                 |   |
| Income from continuing operations            |   | 616.6                                   |   |
| Income from discontinued operations          |   | 167.1                                   |   |
| Net income                                   |   | 783.7                                   |   |
| Preferred stock dividend                     |   | (4.8                                    | )      |
| Net income applicable to common shares       |   | $                                       | 778.9  |   |

 

Contractual interest was$93.6 million for the period January 1, 2002 to April 16, 2002.  Contractual dividends were $8.9 million forthe period January 1, 2002 to April 16, 2002.

 

11

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|                                                                           |   | **Predecessor  McLeodUSA**             |       |
|--------------------------------------------------------------------------------|--------|----------------------------------------|------------|
|                                                                           |   | **January 1, 2002  to April 16, 2002** |       |
|                                                                           |   |                                   | ** ** |
| **Cash Flows from Operating Activities**                                       |   |                                   |       |
| Net income from continuing operations                                          |   | $                                      | 616.6      |   |
| Adjustments to reconcile net income to net cash used  in operating activities: |   |                                   |       |
| Depreciation and amortization                                                  |   | 5.1                                    |       |
| Accretion of interest                                                          |   | 4.1                                    |       |
| Noncash reorganization items                                                   |   | 1,538.4                                |       |
| Gain on cancellation of debt                                                   |   | (2,372.8                               | )          |
| Restructuring adjustment                                                       |   | (6.8                                   | )          |
| Gain on sale of assets                                                         |   | (0.4                                   | )          |
| Equity in losses of subsidiaries                                               |   | 119.8                                  |       |
| Changes in assets and liabilities, net of  dispositions:                       |   |                                   |       |
| Prepaid and other assets                                                       |   | 6.5                                    |       |
| Accounts payable and accrued expenses                                          |   | 8.3                                    |       |
| Intercompany receivables                                                       |   | (73.5                                  | )          |
| **Net cash used in operating activities**                                      |   | (154.7                                 | )          |
|                                                                           |   |                                   |       |
| **Cash Flows from Investing Activities**                                       |   |                                   |       |
| Purchases of property and equipment                                            |   | (0.6                                   | )          |
| Proceeds from the sale of businesses and assets                                |   | 679.7                                  |       |
| **Net cash provided by investing activities**                                  |   | 679.1                                  |       |
|                                                                           |   |                                   |       |
| **Cash Flows from Financing Activities**                                       |   |                                   |       |
| Proceeds from Forstmann Little investment                                      |   | 175.0                                  |       |
| Payments on long-term debt                                                     |   | (730.0                                 | )          |
| **Net cash used in financing activities**                                      |   | (555.0                                 | )          |
|                                                                           |   |                                   |       |
| **Net increase in cash and cash equivalents from  continuing operations**      |   | (30.6                                  | )          |
|                                                                           |   |                                   |       |
| **Net cash provided by discontinued operations**                               |   | 31.6                                   |       |
| **Cash and cash equivalents**                                                  |   |                                   |       |
| Beginning                                                                      |   | 120.2                                  |       |
| Ending                                                                         |   | $                                      | 121.2      |   |

 

*Reorganizationcharges, net:* Reorganization charges, net, are comprised of items incurred byMcLeodUSA as a result of reorganization under Chapter 11 of the BankruptcyCode.  Charges for the period January 1,2002 to April 16, 2002 consisted of the following (in millions):

 
|                                            |   | **Predecessor  McLeodUSA**              |       |
|-------------------------------------------------|--------|-----------------------------------------|------------|
|                                            |   | **January 1,  2002  to April 16, 2002** |       |
|                                            |   |                                    | ** ** |
| Professional fees                               |   | $                                       | 57.5       |   |
| Severance                                       |   | 0.9                                     |       |
| Write-off deferred financing fees and discounts |   | 53.3                                    |       |
| Fresh-start adjustments to fair value           |   | 1,485.1                                 |       |
|                                            |   | $                                       | 1,596.8    |   |

 

12

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**Note 4:  TradeReceivables**

 

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

 
|                                          |   | **September  30,  2003** |   | **December  31,  2002** |   |
|-----------------------------------------------|--------|--------------------------|--------|-------------------------|--------|
| Trade  Receivables:                           |   |                     |   |                    |   |
| Billed                                        |   | $                        | 94.0   |                    | $      | 137.6 |   |
| Unbilled                                      |   | 8.3                      |   | 11.2                    |   |
|                                          |   | 102.3                    |   | 148.8                   |   |
|                                          |   |                     |   |                    |   |
| Allowance for doubtful accounts and discounts |   | (26.8                    | )      | (55.7                   | )      |
|                                          |   | $                        | 75.5   |                    | $      | 93.1 |   |

** **

**Note 5:  Other Accrued Liabilities**

 

Other accrued liabilitiesconsisted of the following (in millions):

 
|                            |   | **September  30,  2003** |   | **December  31,  2002** |   |
|---------------------------------|--------|--------------------------|--------|-------------------------|--------|
| Restructuring                   |   | $                        | 37.2   |                    | $      | 61.2 |   |
| Caprock  Securities Litigation  |   | 19.0                     |   | 10.0                    |   |
| Accrued  Sales/Use/Excise Taxes |   | 13.1                     |   | 18.3                    |   |
| Accrued  Property Taxes         |   | 17.6                     |   | 15.8                    |   |
| Other                           |   | 44.3                     |   | 47.5                    |   |
|                            |   | $                        | 131.2  |                    | $      | 152.8 |   |

 

Included in other accruedexpenses at September 30, 2003 and December 31, 2002, is $19.0 million and$10.0 million, respectively, related to the CapRock securities litigationsettlement.  As discussed in Note 1 andNote 10, McLeodUSA has entered into a settlement agreement which provides for acash payment of $11.0 million to the plaintiffs.  The $19.0 million at September 30, 2003 is comprised of $9.0million received from McLeodUSA’s insurance carrier and a $10.0 millionliability recorded by McLeodUSA in 2001. The liability in excess of the settlement amount will remain until thesettlement has received final approval from the court, which is expected tooccur during December 2003.

** **

**Note 6:  Restructuring Charges**

 

Changes in the carryingamount of the restructuring liability for the nine months ended September 30,2003 is summarized as follows (in millions):

 
|                          |   | **Liability at  December 31,  2002** |   | **Cash Payments  Through  September 30,  2003** |   | **Adjustments  Through  September 30,  2003** |   | **Remaining  Liability  September 30,  2003** |   |
|-------------------------------|--------|--------------------------------------|--------|-------------------------------------------------|--------|-----------------------------------------------|--------|-----------------------------------------------|--------|
| Employee separations          |   | $                                    | 0.6    |                                            | $      | 0.8                                           |   | $                                             | 0.3    |   | $ | 0.1 |   |
| Facility closure costs        |   | 58.8                                 |   | 22.1                                            |   | (0.1                                          | )      | 36.6                                          |   |
| Other contractual commitments |   | 1.8                                  |   | 1.1                                             |   | (0.2                                          | )      | 0.5                                           |   |
|                          |   | $                                    | 61.2   |                                            | $      | 24.0                                          |   | $                                             | — |   | $ | 37.2 |   |

 

13

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**Note7:  Goodwill and Other Intangible Assets**

 

On January 1, 2002,McLeodUSA adopted SFAS 142, *Accounting for Goodwill and Other Intangible Assets*(“SFAS 142”).  SFAS 142 requires the useof a non-amortization approach to account for purchased goodwill and forseparately recognized (non-goodwill) intangible assets that have an indefiniteuseful life.  Under this approach,goodwill and intangibles with indefinite lives are not amortized but are reviewedat least annually for impairment. Intangible assets that do have finite lives will continue to beamortized over their estimated useful lives. McLeodUSA performed impairment tests on goodwill and other intangibleassets that have an indefinite useful life by comparing the fair values of itsreportable units containing goodwill and indefinite-lived intangible assetbalances to their carrying values in the third quarter of 2003.  As a result of the tests performed,McLeodUSA determined that there was no impairment of the carrying values of itsgoodwill and indefinite-lived intangible assets.

 

Changes in the carryingamount of goodwill for the nine months ended September 30, 2003 are summarizedas follows (in millions):

 
| Balance,  December 31, 2002       |   | $   | 237.8  |   |
|-----------------------------------|--------|-----|--------|--------|
| Fresh-start valuation adjustments |   | 7.3 |   |
| Balance, September 30, 2003       |   | $   | 245.1  |   |

 

Intangible assets withfinite lives at September 30, 2003 are summarized as follows (in millions):

 
|                             |   | **Gross** |   | **Accumulated  Amortization** |   | **Net** |   |
|----------------------------------|--------|-----------|--------|-------------------------------|--------|---------|--------|
|                             |   |      |   |                          |   |    |   |
| Deferred line installation costs |   | $         | 186.9  |                          | $      | 81.4    |   | $ | 105.5 |   |
| Customer base                    |   | 29.8      |   | 10.1                          |   | 19.7    |   |
|                             |   | $         | 216.7  |                          | $      | 91.5    |   | $ | 125.2 |   |

 

In connection with ouradoption of fresh-start reporting, independent appraisers valued the intangibleassets.  McLeodUSA’s customer base wasvalued at $24.0 million with a remaining life of five years.  Also included in the customer base is acustomer contract, valued at $5.8 million, and assigned a remaining life of 33months.  The trademarks McLeodUSA andPrimeLine were assigned a value collectively of $83.8 million.  The trademarks were determined to haveindefinite lives and are not being amortized. Annual estimated amortization expense for intangible assets for 2004 is$55 million, $51 million per year for 2005 through 2007 and $47 million for2008.

 

**Note 8:  Accountingfor Asset Retirement Obligations**

 

In July 2001, the FASBissued SFAS 143, *Accounting for Asset Retirement Obligations* (“SFAS143”).  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 colocation equipmentand technical sites.

 

**•**                  Fiber: McLeodUSAutilizes nearly 18,000 route miles of fiber throughout its network, over 80% ofwhich is buried in the ground.  Theremaining balance of fiber is located on poles.  In most cases, McLeodUSA may be obligated to remove its fiber ifeither the underlying right-of-way is terminated or McLeodUSA chooses todecommission those assets.

 

•                  Central Office ColocationEquipment:  McLeodUSA utilizes spacewithin regional bell operating companies’ (“RBOCs”) central offices in which ithas deployed a substantial number of assets. Termination of business in those markets would require removal of theequipment and restoration of the central office to its original state.

 

•                  Technical Sites:  McLeodUSA leases space in numerous technicalsites throughout its market area in which it deploys significant assets.Termination of the lease or business in those markets would require the removalof those assets and restoration of the leased space to its original state.

 

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The present value of theasset retirement obligation was calculated using a discount rate of 6.1% over aperiod of 15 years, which is representative of the estimated life ofMcLeodUSA’s telecommunications network.

 

Changes in the carryingamount of the asset retirement obligation for the nine months ended September30, 2003 is summarized as follows (in millions):

 
| Balance, December 31, 2002  |   | $   | 54.9   |   |
|-----------------------------|--------|-----|--------|--------|
| Interest accretion          |   | 2.6 |   |
| Balance, September 30, 2003 |   | $   | 57.5   |   |

 

**Note 9:  Long Term Debt**

 

As a result of slower thanforecasted growth in telecommunications revenue, McLeodUSA sought and obtainedamendments to the financial covenants of the Credit Agreement as well as the$110 million financing facility enteredinto on April 16, 2002 (the “Exit Facility”). The approved amendmentincludes adjustments to the leverage ratio and the minimum revenue covenants.The leverage ratio was amended to 13.0, 15.0, 13.5, 13.5, 11.0 and 8.5 startingin the third quarter of 2003 through the fourth quarter of 2004, respectively,and the minimum revenue covenant was amended to $850 million, $850 million,$875 million, $900 million and $950 million starting in the fourth quarter of2003 through the fourth quarter of 2004, respectively. ** **Inaddition, the amendment included a downward revision to the capital expenditurelimits for 2003, 2004 and 2005 to $100 million, $100 million and $200 millionrespectively, excluding any carryover provisions, which were not amended.  McLeodUSApaid approximately $5.3 million in fees in October to the lender group inconnection with the approval of this amendment.  McLeodUSA is currently in compliance with the financial covenantsand drew $40 million under the Exit Facility in October 2003.

 

**Note 10:  Litigation**

 

OnDecember 7, 2000, McLeodUSA acquired CapRock Communications Corp. (“CapRock”)pursuant to an Agreement and Plan of Merger, dated October 2, 2000, in exchangefor approximately 15.0 million shares of Class A Common Stock.  Several class action complaints have beenfiled in the United States District Court for the Northern District of Texas onbehalf of all purchasers of CapRock common stock during the period April 28,2000 through July 6, 2000.  The lawsuitsprincipally allege that, prior to its merger with McLeodUSA, CapRock madematerial misstatements or omissions of fact in violation of Section 10(b) ofthe Securities Exchange Act. Consolidated with these claims are allegations that CapRock’s June 2000registration statement for a public offering of common stock containedmaterially false and misleading statements and omitted certain materialinformation about CapRock in violation of Section 11 of the SecuritiesAct.  The named defendants in theselawsuits include CapRock and certain of its officers and directors. OnSeptember 22, 2003, the parties executed a Stipulation of Settlement(“Settlement”) by which the parties agreed to settle the action for a cashpayment of $11 million which would be covered by a combination of insurance anda rebate of previously paid insurance premiums.  The court granted preliminary approval of the Settlement onOctober 14, 2003.   The Settlement isconditioned upon final court approval. No member of the plaintiff class objected to the Settlement by thedeadline, which was November 11, 2003. Final court approval is expected by the end of the year.

 

FormerChairman Clark E. McLeod, President Stephen C. Gray (then also Chief ExecutiveOfficer), Chairman and Chief Executive Officer Chris A. Davis (then ChiefOperating and Financial Officer) and former Chief Financial and AccountingOfficer J. Lyle Patrick (the “Individual Defendants”) are defendants in anumber of putative class action complaints that have been consolidated into asingle complaint entitled In Re McLeodUSA Incorporated Securities Litigation,Civil Action No. C02-0001 (E.D. Iowa) (the “Iowa Class Action”).  The Individual Defendants have filed amotion to dismiss the amended consolidated complaint in the Iowa ClassAction.  A magistrate judge has issued arecommended ruling denying the motion to dismiss, which now awaits finaldisposition by the district judge. McLeodUSA has indemnification obligationsrunning to the Individual Defendants. One of the putative class plaintiffs, New Millenium Growth Fund LLC,also filed proofs of claim against McLeodUSA in McLeodUSA’s Chapter 11 Case forat least $104,650 on its own behalf and for no less than approximately $300million (plus interest, costs and attorney’s fees as allowed) on behalf of allclass claimants in the Iowa Class Action (the ‘‘Bankruptcy Claims’’ and,together with the Iowa Class Action, the “Securities Claims”).  As the Securities Claims are in earlystages, it is impossible to evaluate the likelihood of unfavorable outcomes or,with respect to the Iowa Class Action, to estimate the amount or range ofpotential loss, if any, to McLeodUSA. With respect to the Bankruptcy Claims, onMay 2, 2002 the Bankruptcy Court issued an order establishing a disputed claimsreserve of 18,000,000 shares of Reorganized McLeodUSA Class A Common Stock.  Any recovery from the Bankruptcy Claimswould

 

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belimited to those shares of stock. McLeodUSA believes that the Securities Claimsare without merit and intends to defend them vigorously.

 

McLeodUSAis also involved in numerous regulatory proceedings before various publicutility commissions and the FCC, particularly in connection with actions by theRBOCs.  McLeodUSA anticipates the RBOCswill continue to pursue litigation, regulations and legislation in stateswithin McLeodUSA’s 25-state footprint and before the FCC to reduce regulatoryoversight and regulation over their rates and operations.  The RBOCs are also actively pursuing majorchanges in the Telecommunications Act of 1996, by regulatory litigation andlegislation, which McLeodUSA believes would adversely affect competitivetelecommunications service providers including McLeodUSA.  If adopted, these initiatives could make itmore difficult for McLeodUSA to challenge the RBOCs’ actions, or to competewith the RBOCs, in the future.  Thereare no assurances that McLeodUSA will prevail in its disputes with theRBOCs.  On May 9, 2003, legislation wasenacted in Illinois that changes the methodology to be applied by the IllinoisCommerce Commission in setting rates to be charged by incumbent local exchangecarriers for unbundled local loops.  OnJuly 2, 2003, the United States District Court for the Northern District ofIllinois entered a permanent injunction against enforcement of thislegislation.  The 7th Circuit Court of Appeals affirmed the DistrictCourt ruling on November 10, 2003. McLeodUSA can make no assurances as to the final outcome of thislitigation or ultimate status of the legislation.

 

The FCC released itsTriennial Review Order in August 2003 modifying its rules governingavailability of RBOC unbundled network elements to competitive carriers. TheTriennial Review Order established new rules governing the availability andpricing for the network elements the RBOCs must provide to competitivecarriers, and delegated authority to the states to apply certain of the newrules in individual markets. The outcome of these individual state proceedings,or their ultimate impact on McLeodUSA and its access to particular networkelements, cannot be predicted.

 

On September 10,2003 the FCC issued a Notice of Proposed Rulemaking on TELRIC.  This is a proceeding to review the TotalElement Long Run Incremental Cost (“TELRIC”) methodology used to determine theprices charged to competitive carriers for unbundled network elements. A changein pricing methodology that materially increased unbundled network elementprices would increase our costs and could adversely affect our ability tocompete. A decision is anticipated during 2004.

 

McLeodUSAis not aware 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.

** **

**Note 11:  Effects of New Accounting Standards**

 

In May 2003, the FASBissued SFAS No. 150, *Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity (“SFAS 150”)*.  SFAS 150 establishes standards for howcompanies classify and measure certain financial instruments withcharacteristics of both liabilities and equity. The statement requirescompanies to classify a financial instrument that is within its scope as aliability (or an asset in some circumstances). SFAS 150 was effective forMcLeodUSA beginning with the third quarter of 2003.  The adoption of SFAS 150 did not have an impact on theconsolidated financial statements of McLeodUSA.

 

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**Item 2.    Management’s Discussion and Analysis of Financial Condition andResults 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/A for the year endedDecember 31, 2002.

 

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, EBITDA,profitability, savings and cash.  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 arebased on 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, availability and adequacyof capital resources, current and future economic conditions, the existence ofstrategic alliances, our ability to generate cash, our ability to implementprocess and network improvements, our ability to attract and retain customers,our ability to migrate traffic to appropriate platforms and changes in thecompetitive climate in which we operate. These and other risks are described in more detail in our most recent AnnualReport on Form 10-K and Form 10-K/A both filed with the SEC.  Except as required under federal securitieslaws and rules and regulations of the SEC, the Company undertakes no obligationto update publicly any forward-looking statements, whether as a result offuture events, new information or otherwise.

 

**Overview**

 

McLeodUSA providesintegrated communications services, including local services, in 25 Midwest,Southwest, Northwest and Rocky Mountain states.  The Company is a facilities-based telecommunications providerwith, as of September 30, 2003, 38 ATM switches, 44 voice switches, 604collocations, 435 DSLAMs and 3,480 employees. As of April 16, 2002, Forstmann Little & Co. became a 58%shareholder in the Company.

 

We derive our revenue from our core competitivetelecommunications and related communications services.  These services include local andlong-distance services; dial-up Internet access services; high-speed/broadbandInternet access services such as services using DSL, cable modems and dedicatedT1 access; bandwidth and network facilities leasing, sales and services,including access services; facilities and services dedicated for a particularcustomer’s use; advanced communication services for larger businesses such asframe relay, private line, and ISDN; and value-added services such as virtualprivate networks and web hosting.  Duringthe third quarter we entered into a multi-year wholesale agreement with anationwide wireless carrier in order to offer wireless voice services to ourcustomers.  We began marketing andselling wireless services in the fourth quarter.

 

Our principal operatingexpenses consist of cost of service; selling, general and administrativeexpenses (“SG&A”); and depreciation and amortization.  Cost of service primarily includes local andlong distance services purchased from certain Regional Bell Operating Companies(“RBOCs”) and interexchange carriers and the cost of fiber related to sales andleases of network facilities.  SG&Aexpenses consist of sales and marketing, customer service and administrativeexpenses, including the costs associated with operating our communicationsnetwork.  Depreciation and amortizationincludes depreciation of our communications network and equipment; amortizationof other intangibles determined to have finite lives; and amortization over thelife of the customer contract of one-time direct installation costs associatedwith transferring customers’ local line service from the RBOCs to our localtelecommunications service.

 

Thecommunications services industry is highly competitive. Our local exchangebusiness competes with incumbent local telephone companies that currentlydominate their respective local telecommunications markets. Our largest localservice competitors, the RBOCs, have gained approval to offer long distanceservices in a majority of the states in our 25-state footprint and we expectthat eventually they will no longer be prohibited from providing long distanceservices in any state. Our long-distance services also compete with theservices of many other companies in the long-distance marketplace in moststates.  AT&T, MCI (formerlyWorldCom) and Sprint currently dominate the long-distance market. The RBOCshave become important long-distance competitors in many states and we expectthem to become major competitors in each state as they gain approval to enterthe long-distance markets in remaining states in which they presently lack suchauthority. Our local and long-distance services also compete with the servicesof other competitive local telephone companies in many markets.

 

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Weare involved in numerous regulatory proceedings before various public utilitycommissions and the Federal Communications Commission (“FCC”), particularly inconnection with actions by the RBOCs. We anticipate the RBOCs will continue to pursue litigation, regulationsand legislation in states within our 25-state footprint and before the FCC toreduce regulatory oversight and regulation over their rates andoperations.  The RBOCs are also activelypursuing major changes in the Telecommunications Act of 1996, by regulatorylitigation and legislation, which we believe would adversely affect competitivetelecommunications service providers. If adopted, these initiatives could make it more difficult for us tochallenge the RBOCs’ actions, or to compete with the RBOCs, in the future.  There are no assurances that we will prevailin our disputes with the RBOCs.  On May9, 2003, legislation was enacted in Illinois that changes the methodology to beapplied by the Illinois Commerce Commission in setting rates to be charged byincumbent local exchange carriers for unbundled local loops.  On July 2, 2003, the United StatesDistrict Court for the Northern District of Illinois entered a permanentinjunction against enforcement of this legislation.  The 7th Circuit Courtof Appeals affirmed the District Court ruling on November 10, 2003.  We can make no assurances as to the finaloutcome of this litigation or ultimate status of the legislation.

 

The FCC released itsTriennial Review Order in August 2003 modifying its rules governingavailability of RBOC unbundled network elements to competitive carriers. TheTriennial Review Order established new rules governing the availability andpricing for the network elements the RBOCs must provide to competitivecarriers, and delegated authority to the states to apply certain of the newrules in individual markets. The outcome of these individual state proceedings,or their ultimate impact on McLeodUSA and its access to particular networkelements, cannot be predicted.

 

On September 10,2003 the FCC issued a Notice of Proposed Rulemaking on TELRIC.  This is a proceeding to review the TotalElement Long Run Incremental Cost (“TELRIC”) methodology used to determine theprices charged to competitive carriers for unbundled network elements. A changein pricing methodology that materially increased unbundled network elementprices would increase our costs and could adversely affect our ability tocompete. A decision is anticipated during 2004.

 

We have experiencedoperating losses since our inception as a result of efforts to build ourcustomer base, develop and construct our communications network infrastructure,develop our systems and expand into new markets.  We will continue to focus on increasing our customer base andmigrating our customer base onto our network, along with improving ouroperating margins by grooming our network to deliver service in the mosteffective and efficient manner, as well as scaling back certain general andadministrative functions.  We believethese actions will better leverage our existing assets to produce moreprofitable revenues.  While we haveundertaken certain strategic initiatives to improve our business that aredesigned to result in eventually generating positive cash flow, we may continueto generate negative cash from operations as a result of capital expendituresand projected interest on our remaining outstanding debt.  We may be forced to change our strategy torespond to a changing competitive regulatory environment and we cannot assureyou that we will be able to maintain our operating margin.  We cannot assure you that through ourrevised strategy we will be able to achieve or sustain profitability orpositive cash flows.

 

As of April 17, 2002, weimplemented fresh-start reporting under the provisions of SOP 90-7.  Under SOP 90-7, the reorganization equityvalue of McLeodUSA was allocated to our assets and liabilities, our accumulateddeficit was eliminated, and our new equity was issued according to the Plan asif we were a new reporting entity.  As aconsequence of the reorganization occurring as of April 16, 2002, the financialresults for the periods prior to April 16, 2002 have been separately presentedunder the label “Predecessor McLeodUSA” and “Reorganized McLeodUSA” for theperiod subsequent to April 17, 2002.

 

**SFAS 144 Re-AuditRequirement**

 

Inconnection with our reorganization, McLeodUSA completed the sale of certainbusinesses, including Pubco and ICTC. In our most recent Annual Report on Form10-K/A, based on the requirements of SFAS 144, McLeodUSA reflected thesebusinesses and other businesses that were sold as discontinued operations forthe periods January 1, 2002 to April 16, 2002 and April 17, 2002 to December31, 2002.  In accordance with accountingprinciples generally accepted in the United States of America (“GAAP”),McLeodUSA is required to present its financial statements for the years endedDecember 31, 2000 and 2001, reflecting these businesses as discontinuedoperations.  McLeodUSA’s formerauditors, Arthur Andersen LLP (“Arthur Andersen”), audited McLeodUSA’sfinancial statements and issued an audit opinion for the years ended December31, 2000 and 2001.  On April 24, 2002,McLeodUSA engaged Deloitte & Touche LLP (“Deloitte & Touche”) to serveas its independent accountants for fiscal year 2002.  In order for McLeodUSA to comply with GAAP requirements relatedto the financial presentation for discontinued operations in accordance withRegulation S-X, McLeodUSA would be required to obtain a new audit opinion withrespect to the years ending December 31, 2000 and 2001.  Since Arthur Andersen is no longer able toperform audits of publicly traded companies, Deloitte & Touche has informedMcLeodUSA, consistent with *Interpretations of SAS No. 58 (AU Section 508),*thatthey would be required to re-audit McLeodUSA’s financial statements for theyears ending December 31, 2000 and 2001 to provide McLeodUSA with an auditopinion on such financial statements.

 

Inlight of McLeodUSA’s reorganization, sale of businesses, and implementation offresh-start accounting on April 16, 2002, McLeodUSA has determined that theexpense and effort associated with a re-audit is not in the best interest ofMcLeodUSA or its stockholders.  As analternative to a re-audit McLeodUSA included in its most recent Annual Reporton Form 10-K/A unaudited consolidated financial statements, prepared inaccordance with GAAP, reflecting the impact of the discontinued operations forthe years ended December 31, 2001 and 2000.

 

Inorder for McLeodUSA to sell securities with a registration statement declaredeffective by the SEC, such registration

 

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statementmust contain three years of audited financials.  Should McLeodUSA elect to conduct a re-audit of 2001, or 2000 and2001, in order to utilize such effective registration statements, McLeodUSAdoes not know if Deloitte & Touche would have any differences in opinionwith the prior audit(s) conducted by Arthur Andersen.  At this time McLeodUSA is aware of no material differences ofopinion.

 

**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/A for the yearended December 31, 2002, describe the significant accounting estimates andpolicies used in preparation of the Condensed Consolidated FinancialStatements. Actual results in these areas could differ from management’sestimates. There have been no significant changes in our critical accountingestimates during the third quarter of 2003.

 

**Three Months EndedSeptember 30, 2003 Compared with Three Months Ended September 30, 2002**

 

Revenue was $211.0million for the quarter ended September 30, 2003, a decrease of $32.5 millionor 13% from the quarter ended September 30, 2002.  The decrease in revenue was primarily due to a decline incustomers, of which approximately 50,000 resulted from our drive to eliminatenon-profitable business.  Long distancevolume was down approximately 9% compared to the same period last yearreflecting the general economic slowdown and increased competition.  The quarter ended September 30, 2003 alsoreflects the impact of the most recent FCC mandated reduction in access rateswhich had the effect of reducing revenues by approximately $10 million.

 

Cost of service was$117.4 million for the quarter ended September 30, 2003, a decrease of $36.7million or 24% from the quarter ended September 30, 2002.  Approximately $21 million of this decreaseis attributable to the reduction in revenues. The balance of the decrease reflects the margin improvement initiativesthat we began in 2002, including network cost reductions, migration ofcustomers to the McLeodUSA network and the elimination of non-profitablecustomers.  As a result of these costsavings initiatives, gross margin as a percent of revenue improved to 44% forthe third quarter of 2003 from 37% for the same period a year ago.  As of September 30, 2003, 62% of our customerlines were serviced over our own network compared to 46% as of September 30,2002.  Utilization of our own networkinfrastructure allows us to better manageour customer base and provides for improved profitability.

 

SG&A expenses were$80.0 million for the quarter ended September 30, 2003, an increase of $0.9million or 1% from the quarter ended September 30, 2002.  As the full benefit of the reduced workforceand improved business processes was realized in the third quarter of 2002,SG&A expenses have remained essentially flat through 2003, excluding theimpact of the recovery of the $7.9 million MCI receivable in the second quarterof 2003.

 

Depreciation andamortization expenses were $86.6 million for the quarter ended September 30,2003, an increase of $10.9 million from the quarter ended September 30,2002.  This increase was primarily dueto a higher depreciable asset base as a result of additional assets beingplaced in service.

 

Gross interest expensewas $11.3 million for the quarter ended September 30, 2003, a decrease of $4.3million from the quarter ended September 30, 2002.  The reduction was principally caused by lower debt amountsoutstanding during the third quarter of 2003 resulting from the $225 millionpay down of the Credit Facility after the sale of ICTC on December 31, 2002.  The remaining portion of the decrease isattributed to lower interest rates on the amounts outstanding during 2003.  Interest expense of approximately $2.4million and $4.3 million was capitalized as part of our construction of ourfiber optic network during the third quarter of 2003 and 2002, respectively.

 

In accordance with SFAS144, the operating results of businesses held for sale, and the gain or lossresulting from the sale thereof, have been reported as discontinued operationsin the unaudited condensed consolidated statements of operations ofMcLeodUSA.  All businesses held for salewere sold during 2002, and, as such, there is no income or loss fromdiscontinued operations included in the 2003 results.

 

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**NineMonths Ended September 30, 2003 Compared with Nine Months Ended September 30,2002**

 

Revenue was $659.5million for the nine months ended September 30, 2003, a decrease of $102.6million or 14% from the nine months ended September 30, 2002.  The decrease in revenue was primarily due toa reduction in customers, including our efforts to eliminate non-profitablecustomers, as well as lower average long distance per customer.  Long distance volume was down approximately16% compared to the same period last year reflecting the general economicslowdown and increased competition.  Inaddition, we sold the assets of Splitrock Services, Inc. in 2002, whichgenerated approximately $4.7 million of revenues during the first quarter of2002.  The nine months ended September30, 2003 also reflect the impact of the most recent reduction in access ratesthat are being phased in under a June 2001 FCC order.  The rate reduction resulted in decreased revenues of approximately$11 million.

 

Cost of service was $382.9million for the nine months ended September 30, 2003, a decrease of $101.8million or 21% from the nine months ended September 30, 2002.  Approximately $65 million of the decrease isattributable to the reduction in revenues. The balance of the decrease reflects the margin improvement initiativesthat we began in 2002, including network cost reductions, migration ofcustomers to the McLeodUSA network and the elimination of non-profitablecustomers.  As a result of these costsavings initiatives, gross margin as a percent of revenue improved to 42% forthe nine months ended September 30, 2003 from 36% for the same period a yearago.

 

SG&A expenses were$235.2 million for the nine months ended September 30, 2003, a decrease of$32.3 million or 12% from the nine months ended September 30, 2002. The firstnine months of 2003 include a $7.9 million recovery related to MCI pre-petitionaccounts receivable.  During the secondquarter of 2003, an agreement was reached with MCI to offset pre-petitionaccounts receivable against amounts McLeodUSA owed MCI for pre-petitionservices.  We had recorded an $8.3million charge during the second quarter of 2002 to fully reserve for the MCIpre-petition accounts receivable after their filing for Chapter 11protection.  Excluding the effects ofthe MCI accounts receivable in both periods, SG&A expenses decreased from$259.2 million in the first nine months of 2002 to $243.1 million in the ninemonths ended September 30, 2003, resulting primarily from a reduced workforce,facilities consolidation and improved business processes.

 

Depreciation andamortization expenses were $253.9 million for the nine months ended September30, 2003, a decrease of $7.6 million from the nine months ended September 30,2002.  The decrease was primarily due tothe reduction of our depreciable asset base as a result of fresh-start fairmarket value adjustments of approximately $1.2 billion upon our emergence frombankruptcy in April 2002.

 

In accordance with SOP90-7, expenses resulting from the reorganization of the business in abankruptcy proceeding are reported separately as reorganization charges.Reorganization charges, net, of $1,596.8 million during the nine months endedSeptember 30, 2002 were comprised of professional fees of $57.5 million,severance of $0.9 million, the write-off of deferred financing fees anddiscounts on the Notes of $53.3 million and fresh-start fair value adjustmentsof $1,485.1 million.

 

In the third quarter of2001, we recorded a charge in connection with our strategic and operationalrestructuring to provide for involuntary employee separations, facilitiesconsolidations and other contractual commitments.  During the second quarter of 2002, we recorded a reduction ofthose reserves of $18.8 million due to lower than anticipated costs related toemployee separations and facility closure costs as well as the negotiation oflower payments on contractual commitments. This reduction was partially offset by additional charges of $12.0million, primarily for leased facilities identified for termination and changesin assumptions based on current market information.

 

Gross interest expensewas $34.2 million for the nine months ended September 30, 2003, a decrease of$34.7 million from the nine months ended September 30, 2002.  The significant reduction was principallycaused by the cancellation of our Notes on the effective date of our Plan ofReorganization and lower debt amounts outstanding during 2003 resulting fromthe $225 million pay down of the Credit Facility after the sale of ICTC onDecember 31, 2002.  Interest expense ofapproximately $8.3 million and $16.8 million was capitalized as part of ourconstruction of our fiber optic network during the nine months ended September30, 2003 and 2002, respectively.

 

As a result of ourrecapitalization, we recorded a gain on the cancellation of debt of $2.4billion during 2002.

 

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In accordance with SFAS 144, the operating results of businesses heldfor sale, and the gain or loss resulting from the sale thereof, have beenreported as discontinued operations in the unaudited condensed consolidatedstatements of operations of McLeodUSA. All businesses held for sale were sold during 2002, and, as such, thereis no income or loss from discontinued operations included in the 2003 results.

 

**Liquidity and Capital Resources**

 

We had $48.3 million ofcash and cash equivalents and $9 million of restricted cash at September 30,2003. The restricted cash was received from our insurance carrier pursuant to aStipulation of Settlement dated September 22, 2003 to settle the CapRocksecurities litigation.  The settlementagreement, which received preliminary court approval on October 14, 2003,provides for the payment of $11 million to plaintiffs, which would be coveredby a combination of the $9 million received and a portion of a rebate ofinsurance premiums previously paid to another carrier.  The $9 million has been included on thebalance sheet as restricted cash since we were required to place these funds inescrow by October 27, 2003.

 

During the first ninemonths of 2003 cash used in operating activities was $25.8 million and wasprimarily related to decreases in current liability accounts, resulting frompayments for payroll related expenses, restructuring liabilities and sellingcosts associated with discontinued operations.

 

Our capital expenditureswere $58.8 million during the nine months ended September 30, 2003, a decreaseof $17.0 million from the same period in 2002. Within our core footprint, our network infrastructure is largely inplace. We have managed our capital expenditures to coincide with the timing ofrevenue growth and continue to focus our expenditures on the migration ofcustomers from resale platforms to the McLeodUSA network in order to reducecosts and improve quality.  We intend tocontinue to manage our capital expenditures consistent with business conditionsto support our on-switch, facilities-based strategy and augment for profitablerevenue growth as necessary.  We expectcapital expenditures of approximately $85 million in 2003 and expect 2004capital expenditures to be below that level depending on the timing of plannedrevenue growth during the year.

 

Asof September 30, 2003, $709.5 million remained outstanding under the CreditAgreement dated May 31, 2000 (the “Credit Agreement”) with principal repaymentsof $24.4 million due within the next twelve months.  The next scheduled principal payment of $5.5 million is due December31, 2003.  As provided for in the ThirdAmendment to the Credit Agreement dated November 29, 2001, we entered into anExit Financing Facility with a consortium of banks upon consummation of thePlan on April 16, 2002 (the “Exit Facility”). The Exit Facility consistsinitially of a revolving credit facility of $110 million. In addition, we havethe right to obtain additional commitments to increase the size of the ExitFacility up to $160 million. The Exit Facility matures on May 31, 2007, withany outstanding amounts due on that date; no principal payments are due untilthis maturity date. The Exit Facility is secured by first priority liens on theassets of McLeodUSA and its domestic subsidiaries and ranks superior to theCredit Agreement.  In October 2003, wedrew $40 million under the Exit Facility. We also have standby letters of credit outstanding of $8.9 million thatreduce our borrowing availability under the Exit Facility.

 

Weare required to pay a commitment fee on the average daily unused balance of theExit Facility at a rate ranging from 1 /2% to 1%.  Funds borrowed under the Exit Facility bear interest at a rateper annum equal to either (a) the greater of (1) the prime rate and (2) thefederal funds effective rate plus 1 /2%, in each case plus a margin rangingfrom 1.00% to 2.50%; or (b) LIBOR plus a margin ranging from 2.00% to 3.50%.

 

TheExit Facility and the Credit Agreement include restrictions as to, among otherthings, additional indebtedness, liens, sale and lease-back transactions,investments, asset sales, certain payments by restricted subsidiaries, anddesignation of unrestricted subsidiaries. Both restrict our ability to make capital expenditures.  The Exit Facility and the Credit Agreementalso limit our leverage ratio and require minimum levels of access lines in service,interest coverage and consolidated revenue**. **Ourability to borrow under the Exit Facility is subject to compliance with all ofthe covenants contained in the agreement. As a result of slower than forecasted growth in revenue, we sought andobtained amendments to the Credit Agreement and Exit Facility financialcovenants.  The approvedamendment includes adjustments to the leverage ratio and the minimum revenuecovenants. The leverage ratio was amended to 13.0, 15.0, 13.5, 13.5, 11.0 and8.5 starting in the third quarter of 2003 through the fourth quarter of 2004,respectively, and the minimum revenue covenant was amended to $850 million,$850 million, $875 million, $900 million and $950 million starting in thefourth quarter of 2003 through the fourth quarter of 2004, respectively. ** **In addition, the amendmentincluded a downward revision to the capital expenditure limits for 2003, 2004and 2005 to $100 million, $100 million and $200 million respectively, excludingany carryover provisions, which were not amended.  We paid approximately $5.3million in fees in October to the lender group in connection with the

 

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approvalof this amendment.  We are currently incompliance with the financial covenants under the Credit Agreement and ExitFacility.

 

We expect to have fundsavailable to meet our operating and capital requirements from various sources,including existing cash balances, the Exit Facility, and cash flow from futureoperations.  We may meet any additionalfinancial needs by borrowing funds under the Exit Facility or by issuingadditional debt or equity securities. Althoughwe presently meet all of the conditions to make draws under the Exit Facility,an inability to achieve sufficient revenue growth and cost savings couldnegatively impact our future financial performance and cause us to fail to meetthese conditions in the future. Additionally, factors beyond our control, including a continued pooreconomic climate or a significant reduction in demand for our services, couldcause us to fail to be in compliance with certain covenants under the ExitFacility and Credit Agreement.  Wecannot assure you that additional financing will be available or available onterms that are acceptable to us.  Ourability to issue debt securities, borrow funds from additional lenders andparticipate in vendor financing programs is restricted by the terms of theCredit Facility and Exit Facility, as amended.

 

Failure to generate orraise sufficient funds may require us to delay or abandon some of our plans orexpenditures, which could have a material adverse effect on our business,results of operations or financial condition. Our estimate of future capitalrequirements is a forward-looking statement within the meaning of the safeharbor provisions of the Private Securities Litigation Reform Act of 1995.  The actual amount and timing of our futurecapital requirements may differ substantially from our estimate due to factorssuch as:

 

•                  changes in demand for our services;

•                  regulatory, technological orcompetitive developments;

•                  general economic conditions;

•                  network development and maintenanceschedules and the associated costs;

•                  a change in our plans or projections;and

•                  new opportunities.

 

We also require substantialfunds for general corporate and other expenses and may require additional fundsfor working capital fluctuations.

 

**Effects of NewAccounting Standards**

 

In May 2003, the FASBissued SFAS No. 150, *Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity (“SFAS 150”)*.  SFAS 150 establishes standards for howcompanies classify and measure certain financial instruments withcharacteristics of both liabilities and equity. The statement requirescompanies to classify a financial instrument that is within its scope as aliability (or an asset in some circumstances). SFAS 150 is effective forMcLeodUSA beginning with the third quarter of 2003.  The adoption of SFAS 150 did not have an impact on theconsolidated financial statements of McLeodUSA.

** **

**Inflation**

 

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

 

**Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

Upon the consummation ofour restructuring on April 16, 2002, substantially all of our fixed rate debtwas eliminated. We have variable rate debt of approximately $709 million underthe Credit Agreement outstanding at September 30, 2003.  If market interest rates average 1% more insubsequent quarters than the rates during the quarter ended September 30, 2003,quarterly interest expense would increase by $1.8 million.  This amount was determined by calculatingthe effect of the hypothetical interest rate increase on our variable rate debtfor the quarter and does not assume changes in our financial structure.

 

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**Item 4.    Controlsand Procedures**

 

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

 

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

 

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**PART IIOTHER INFORMATION**

 

**Item1. Legal Proceedings**

 

OnDecember 7, 2000, McLeodUSA acquired CapRock Communications Corp. (“CapRock”)pursuant to an Agreement and Plan of Merger, dated October 2, 2000, in exchangefor approximately 15.0 million shares of Class A Common Stock.  Several class action complaints have been filedin the United States District Court for the Northern District of Texas onbehalf of all purchasers of CapRock common stock during the period April 28,2000 through July 6, 2000.  The lawsuitsprincipally allege that, prior to its merger with McLeodUSA, CapRock madematerial misstatements or omissions of fact in violation of Section 10(b) ofthe Securities Exchange Act. Consolidated with these claims are allegations that CapRock’s June 2000registration statement for a public offering of common stock containedmaterially false and misleading statements and omitted certain materialinformation about CapRock in violation of Section 11 of the SecuritiesAct.  The named defendants in theselawsuits include CapRock and certain of its officers and directors. OnSeptember 22, 2003, the parties executed a Stipulation of Settlement(“Settlement”) by which the parties agreed to settle the action for a cashpayment of $11 million which would be covered by a combination of insurance anda rebate of previously paid insurance premiums.  The court granted preliminary approval of the Settlement onOctober 14, 2003.  The Settlement isconditioned upon final court approval. No member of the plaintiff class objected to the Settlement by thedeadline, which was November 11, 2003. Final court approval is expected by the end of the year.

 

FormerChairman Clark E. McLeod, President Stephen C. Gray (then also Chief ExecutiveOfficer), Chairman and Chief Executive Officer Chris A. Davis (then ChiefOperating and Financial Officer) and former Chief Financial and AccountingOfficer J. Lyle Patrick (the “Individual Defendants”) are defendants in anumber of putative class action complaints that have been consolidated into asingle complaint entitled In Re McLeodUSA Incorporated Securities Litigation,Civil Action No. C02-0001 (E.D. Iowa) (the “Iowa Class Action”).  The Individual Defendants have filed amotion to dismiss the amended consolidated complaint in the Iowa ClassAction.  A magistrate judge has issued arecommended ruling denying the motion to dismiss, which now awaits finaldisposition by the district judge. McLeodUSA has indemnification obligationsrunning to the Individual Defendants. One of the putative class plaintiffs, New Millenium Growth Fund LLC,also filed proofs of claim against McLeodUSA in McLeodUSA’s Chapter 11 Case forat least $104,650 on its own behalf and for no less than approximately $300million (plus interest, costs and attorney’s fees as allowed) on behalf of allclass claimants in the Iowa Class Action (the “Bankruptcy Claims” and, togetherwith the Iowa Class Action, the “Securities Claims”).  As the Securities Claims are in early stages, it is impossible toevaluate the likelihood of unfavorable outcomes or, with respect to the IowaClass Action, to estimate the amount or range of potential loss, if any, toMcLeodUSA. With respect to the Bankruptcy Claims, on May 2, 2002 the BankruptcyCourt issued an order establishing a disputed claims reserve of 18,000,000shares of Reorganized McLeodUSA Class A Common Stock.  Any recovery from the Bankruptcy Claims would be limited to thoseshares of stock. McLeodUSA believes that the Securities Claims are withoutmerit and intends to defend them vigorously.

 

McLeodUSAis also involved in numerous regulatory proceedings before various publicutility commissions and the FCC, particularly in connection with actions by theRBOCs.  McLeodUSA anticipates the RBOCswill continue to pursue litigation, regulations and legislation in stateswithin McLeodUSA’s 25-state footprint and before the FCC to reduce regulatoryoversight and regulation over their rates and operations.  The RBOCs are also actively pursuing majorchanges in the Telecommunications Act of 1996, by regulatory litigation andlegislation, which McLeodUSA believes would adversely affect competitive telecommunicationsservice providers including McLeodUSA. If adopted, these initiatives could make it more difficult for McLeodUSAto challenge the RBOCs’ actions, or to compete with the RBOCs, in the future.  There are no assurances that McLeodUSA willprevail in its disputes with the RBOCs. On May 9, 2003, legislation was enacted in Illinois that changes themethodology to be applied by the Illinois Commerce Commission in setting ratesto be charged by incumbent local exchange carriers for unbundled localloops.  On July 2, 2003, theUnited States District Court for the Northern District of Illinois entered apermanent injunction against enforcement of this legislation.  The 7thCircuit Court of Appeals affirmed the District Court ruling on November 10, 2003.  McLeodUSA can make no assurances as to thefinal outcome of this litigation or ultimate status of the legislation.

 

The FCC released itsTriennial Review Order in August 2003 modifying its rules governingavailability of RBOC unbundled network elements to competitive carriers. TheTriennial Review Order established new rules governing the availability andpricing for the network elements the RBOCs must provide to competitivecarriers, and delegated authority to the states to apply certain of the new rulesin individual markets. The outcome of these individual state proceedings, ortheir ultimate impact on McLeodUSA and its access to particular networkelements, cannot be predicted.

 

On September 10,2003 the FCC issued a Notice of Proposed Rulemaking on TELRIC.  This is a proceeding to review the TotalElement Long Run Incremental Cost (“TELRIC”) methodology used to determine theprices charged to competitive carriers for unbundled network elements. A changein pricing methodology that materially increased unbundled network elementprices would increase our costs and could adversely affect our ability tocompete. A decision is anticipated during 2004.

 

McLeodUSAis not aware 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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**Item6.  Exhibits and Reports on Form 8-K**

 

(a)           Exhibits

 
| **Exhibit Number** |   | **Exhibit  Description**                                                                                                         |
|--------------------|--------|----------------------------------------------------------------------------------------------------------------------------------|
|               |   |                                                                                                                             |
| 4.1                |   | First Amendment dated  as of October 3, 2003 to the Credit Agreement dated as of April 16,  2002.                      |
| 4.2                |   | Fourth Amendment  dated as of October 3, 2003 to the  Credit Agreement dated as of May 31, 2000.                  |
| 31.1               |   | Certification of CEO  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
| 31.2               |   | Certification of CFO  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
| 32.1               |   | Certification of CEO  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2               |   | Certification of CFO  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

(b)           Reports on Form 8-K

 

OnJuly 23, 2003, we announced our financial results for the fiscal quarter endedJune 30, 2003, and certain other information, in a press release.

 

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**SIGNATURES**

 

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

 
|                            | **McLEODUSA INCORPORATED** |
|---------------------------------|----------------------------|
|                            | (registrant)               |
|                            |                       |   |
|                            |                       |   |
| Date:  April 30, 2004 | By:                        | /s/ Chris A.  Davis |   |
|                            |                       | Chris A. Davis |   |
|                            |                       | *Chairman and Chief Executive  Officer* |   |
|                            |                       |   |   |
|                            |                       |   |   |
| Date:  April 30, 2004 | By:                        | /s/ G. Kenneth  Burckhardt |   |
|                            |                       | G. Kenneth  Burckhardt |   |
|                            |                       | *Chief Financial Officer* |   |

 

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**INDEXTO EXHIBITS**

** **
| **Exhibit Number** |   | **Exhibit  Description**                                                                                                         |
|--------------------|--------|----------------------------------------------------------------------------------------------------------------------------------|
|               |   |                                                                                                                             |
| 4.1                |   | First Amendment dated  as of October 3, 2003 to the Credit Agreement dated as of April 16,  2002.                      |
| 4.2                |   | Fourth Amendment  dated as of October 3, 2003 to the  Credit Agreement dated as of May 31, 2000.                  |
| 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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