**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM10-Q**

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

** **

**McLEODUSA INCORPORATED**

(Exact name of registrant as specified in its charter)

** **
| **Delaware**                                                                        | ** ** | **42-1407240**                     |
|-------------------------------------------------------------------------------------|------------|------------------------------------|
| (State of  Incorporation)                                                           | ** ** | (IRS Employer  Identification No.) |
| ** **                                                                          | ** ** | ** **                         |
| **McLeodUSA  Technology Park  6400 C Street SW  P.O. Box 3177  Cedar Rapids, Iowa** | ** ** | **52406-3177**                     |
| (Address of principal  executive office)                                            | ** ** | (Zip Code)                         |

 

**319-364-0000**(Registrant’s telephone number,including area code)

 

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

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act). Yes ýNo o

 

Indicate by check mark whether the registrant has filed all documentsand reports required to be filed by Section 12, 13 or 15(d) of the SecuritiesExchange Act of 1934 subsequent to the distribution of securities under a planconfirmed by a court.  Yes  ý      No o

 

The number ofshares outstanding of each class of the issuer’s common stock as of October 29,2004:
| Common Stock Class A: ($0.01 par value) | 190,703,965 shares |   |
|-----------------------------------------|--------------------|--------|
| Common Stock Class B: ($0.01 par value) | 78,203,135 shares  |   |
| Common Stock Class C: ($0.01 par value) | 35,546,879 shares  |   |

 

 

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**McLEODUSA INCORPORATED ANDSUBSIDIARIES**

**INDEX**

 
| **PART  I.**  | **Financial  Information**                                                                                                | ** ** |
|---------------|---------------------------------------------------------------------------------------------------------------------------|------------|
| ** **    | ** **                                                                                                                |
| Item  1.      | Financial  Statements                                                                                                     |       |
|          | Condensed  Consolidated Balance Sheets  September 30, 2004 (unaudited) and December 31, 2003                              |       |
|          |                                                                                                                      |       |
|          | Unaudited  Condensed Consolidated Statements of Operations – for the three months ended  September 30, 2004 and 2003 |       |
|          |                                                                                                                      |       |
|          | Unaudited  Condensed Consolidated Statements of Operations – for the nine months ended  September 30, 2004 and 2003  |       |
|          |                                                                                                                      |       |
|          | Unaudited  Condensed Consolidated Statements of Cash Flows – for the nine months ended  September 30, 2004 and 2003  |       |
|          |                                                                                                                      |       |
|          | Notes  to the Condensed Consolidated Financial Statements                                                                 |       |
|          |                                                                                                                      |       |
| Item  2.      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                               |       |
|          |                                                                                                                      |       |
| Item  3.      | Quantitative  and Qualitative Disclosures About Market Risk                                                               |       |
|          |                                                                                                                      |       |
| Item  4.      | Controls  and Procedures                                                                                                  |       |
|          |                                                                                                                      |
| **PART  II.** | **Other  Information**                                                                                                    |       |
| ** **    |                                                                                                                      |
| Item 1.       | Legal  Proceedings                                                                                                        |       |
|          |                                                                                                                      |       |
| Item  6.      | Exhibits                                                                                                                  |       |
|          |                                                                                                                      |       |
| Signatures    |                                                                                                                      |
|               |                                                                                                                           |            |  |

 

2

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**PART I****– FINANCIAL INFORMATION**

**Item 1****. FinancialStatements**

**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCESHEETS**

**(Inmillions, except share data)**

** **
| ** **                                                                                                                                                                                                 | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                 | ** ** | **(unaudited)**         | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                                                                                 | ** ** | ** **              | ** ** | ** **             | ** ** |
| Current assets                                                                                                                                                                                             |       |                    |       |                   |       |
| Cash and cash  equivalents                                                                                                                                                                                 |       | $                       | 26.1       |                   | $          | 56.5 |   |
| Trade  receivables, net                                                                                                                                                                                    |       | 60.3                    |       | 65.6                   |       |
| Prepaid expenses  and other                                                                                                                                                                                |       | 25.2                    |       | 22.4                   |       |
| Assets held for  sale                                                                                                                                                                                      |       | 2.0                     |       | 2.0                    |       |
| Total current  assets                                                                                                                                                                                      |       | 113.6                   |       | 146.5                  |       |
| Property and  equipment                                                                                                                                                                                    |       |                    |       |                   |       |
| Land and  buildings                                                                                                                                                                                        |       | 78.0                    |       | 78.6                   |       |
| Communications  networks                                                                                                                                                                                   |       | 1,102.1                 |       | 996.3                  |       |
| Furniture,  fixtures and equipment                                                                                                                                                                         |       | 202.9                   |       | 196.8                  |       |
| Networks in  progress                                                                                                                                                                                      |       | 84.5                    |       | 171.6                  |       |
| Total property and  equipment                                                                                                                                                                              |       | 1,467.5                 |       | 1,443.3                |       |
| Less accumulated  depreciation                                                                                                                                                                             |       | 649.4                   |       | 435.6                  |       |
| Net property and  equipment                                                                                                                                                                                |       | 818.1                   |       | 1,007.7                |       |
| Intangibles and  other assets                                                                                                                                                                              |       |                    |       |                   |       |
| Goodwill                                                                                                                                                                                                   |       | —                  |       | 245.1                  |       |
| Other  intangibles, net                                                                                                                                                                                    |       | 156.0                   |       | 201.8                  |       |
| Other                                                                                                                                                                                                      |       | 24.1                    |       | 29.5                   |       |
| Total  intangibles and other assets                                                                                                                                                                        |       | 180.1                   |       | 476.4                  |       |
| **TOTAL  ASSETS**                                                                                                                                                                                          |       | $                       | 1,111.8    |                   | $          | 1,630.6 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                              |       |                    |       |                   |       |
| Current  liabilities                                                                                                                                                                                       |       |                    |       |                   |       |
| Current  maturities of long-term debt                                                                                                                                                                      |       | $                       | 40.4       |                   | $          | 27.1 |   |
| Accounts payable                                                                                                                                                                                           |       | 35.1                    |       | 30.5                   |       |
| Accrued payroll  and payroll related expenses                                                                                                                                                              |       | 20.4                    |       | 20.6                   |       |
| Other accrued  liabilities                                                                                                                                                                                 |       | 79.8                    |       | 100.9                  |       |
| Deferred  revenue, current portion                                                                                                                                                                         |       | 6.7                     |       | 6.9                    |       |
| Liabilities  related to discontinued operations                                                                                                                                                            |       | 0.3                     |       | 1.1                    |       |
| Total current  liabilities                                                                                                                                                                                 |       | 182.7                   |       | 187.1                  |       |
| Long-term debt,  less current maturities                                                                                                                                                                   |       | 724.7                   |       | 717.3                  |       |
| Deferred  revenue, less current portion                                                                                                                                                                    |       | 17.2                    |       | 15.1                   |       |
| Other long-term  liabilities                                                                                                                                                                               |       | 60.8                    |       | 58.3                   |       |
| Total  liabilities                                                                                                                                                                                         |       | 985.4                   |       | 977.8                  |       |
| Redeemable  convertible preferred stock                                                                                                                                                                    |       |                    |       |                   |       |
| McLeodUSA  Preferred Series A, redeemable, convertible, $0.01 par value; 10,000,000  authorized and issued; 4,432,741 and 7,377,149 outstanding at September 30,  2004 and December 31, 2003, respectively |       | 80.4                    |       | 131.1                  |       |
| Stockholders’  equity                                                                                                                                                                                 |       |                    |       |                   |       |
| McLeodUSA  Common, Class A $0.01 par value; 1,886,249,986 authorized, 190,664,756 and  175,527,257 issued and outstanding at September 30, 2004 and December 31,  2003, respectively                       |       | 1.9                     |       | 1.8                    |       |
| McLeodUSA  Common, Class B $0.01 par value; 78,203,135 authorized, issued and  outstanding at September 30, 2004 and December 31, 2003                                                                     |       | 0.8                     |       | 0.8                    |       |
| McLeodUSA  Common, Class C $0.01 par value; 35,546,879 authorized, issued and  outstanding at September 30, 2004 and December 31, 2003                                                                     |       | 0.3                     |       | 0.3                    |       |
| McLeodUSA  Preferred Series B, $0.01 par value; 10 authorized, issued and outstanding at  September 30, 2004 and December 31, 2003                                                                         |       | —                  |       | —                 |       |
| McLeodUSA  Warrants                                                                                                                                                                                        |       | 22.6                    |       | 22.6                   |       |
| Additional  paid-in capital                                                                                                                                                                                |       | 1,043.9                 |       | 993.3                  |       |
| Accumulated  deficit                                                                                                                                                                                       |       | (1,023.5                | )          | (497.1                 | )          |
| Total  stockholders’ equity                                                                                                                                                                           |       | 46.0                    |       | 521.7                  |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                       |       | $                       | 1,111.8    |                   | $          | 1,630.6 |   |

 

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

 

3

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**McLEODUSA INCORPORATED ANDSUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In millions, except per sharedata)**

 
| ** **                                                                           | ** ** | **Three months ended September  30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                           | ** ** | **2004**                              | ** ** | **2003** | ** ** |
|                                                                                 |       |                                  |       |   |   |
| Revenues                                                                             |       | $                                     | 168.1      |   | $ | 211.0 |   |
|                                                                                 |       |                                  |       |   |   |
| Operating expenses:                                                                  |       |                                  |       |   |   |
| Cost of service (exclusive of depreciation and amortization shown  separately below) |       | 94.1                                  |       | 117.4 |   |
| Selling, general and administrative                                                  |       | 62.5                                  |       | 80.0 |   |
| Depreciation and amortization                                                        |       | 88.8                                  |       | 86.6 |   |
| Impairment charge                                                                    |       | 263.1                                 |       | — |   |
| **Total operating expenses**                                                         |       | 508.5                                 |       | 284.0 |   |
| **Operating loss**                                                                   |       | (340.4                                | )          | (73.0 | ) |
| Nonoperating expense:                                                                |       |                                  |       |   |   |
| Interest expense, net of amounts capitalized                                         |       | (11.9                                 | )          | (8.9 | ) |
| Other expense                                                                        |       | (0.5                                  | )          | (0.3 | ) |
| **Total nonoperating expense**                                                       |       | (12.4                                 | )          | (9.2 | ) |
| **Net loss**                                                                         |       | (352.8                                | )          | (82.2 | ) |
| Preferred stock dividend                                                             |       | (0.8                                  | )          | (1.2 | ) |
| **Net loss applicable to common shares**                                             |       | $                                     | (353.6     | ) | $ | (83.4 | ) |
|                                                                                 |       |                                  |       |   |   |
| **Basic and diluted loss per common share**                                          |       | $                                     | (1.19      | ) | $ | (0.30 | ) |
| **Weighted average common shares outstanding**                                       |       | 296.7                                 |       | 278.9 |   |

 

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

 

4

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** **

**McLEODUSA INCORPORATED ANDSUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In millions, except per sharedata)**

 
| ** **                                                                           | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                           | ** ** | **2004**                            | ** ** | **2003** | ** ** |
|                                                                                 |       |                                |       |   |   |
| Revenues                                                                             |       | $                                   | 553.5      |   | $ | 659.5 |   |
| Operating expenses:                                                                  |       |                                |       |   |   |
| Cost of service (exclusive of depreciation and amortization shown  separately below) |       | 306.9                               |       | 382.9 |   |
| Selling, general and administrative                                                  |       | 206.7                               |       | 235.2 |   |
| Depreciation and amortization                                                        |       | 267.3                               |       | 253.9 |   |
| Impairment charge                                                                    |       | 263.1                               |       | — |   |
| Restructuring adjustment                                                             |       | (0.2                                | )          | — |   |
| **Total operating expenses**                                                         |       | 1,043.8                             |       | 872.0 |   |
| **Operating loss**                                                                   |       | (490.3                              | )          | (212.5 | ) |
| Nonoperating expense:                                                                |       |                                |       |   |   |
| Interest expense, net of amounts capitalized                                         |       | (34.6                               | )          | (25.9 | ) |
| Other expense                                                                        |       | (1.5                                | )          | (0.7 | ) |
| **Total nonoperating expense**                                                       |       | (36.1                               | )          | (26.6 | ) |
| **Net loss**                                                                         |       | (526.4                              | )          | (239.1 | ) |
| Preferred stock dividend                                                             |       | (2.4                                | )          | (3.6 | ) |
| **Net loss applicable to common shares**                                             |       | $                                   | (528.8     | ) | $ | (242.7 | ) |
|                                                                                 |       |                                |       |   |   |
| **Basic and diluted loss per common share**                                          |       | $                                   | (1.80      | ) | $ | (0.87 | ) |
| **Weighted average common shares outstanding**                                       |       | 293.3                               |       | 277.9 |   |

 

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

 

5

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**McLEODUSAINCORPORATED AND SUBSIDIARIESUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(In millions)**

 
| ** **                                                                                 | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                 | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| **Cash Flows from Operating Activities**                                                   |       |                                |       |   |   |
| Net loss                                                                                   |       | $                                   | (526.4     | ) | $ | (239.1 | ) |
| Adjustments to reconcile net loss to net cash provided by (used in)  operating activities: |       |                                |       |   |   |
| Depreciation                                                                               |       | 224.0                               |       | 203.7 |   |
| Amortization                                                                               |       | 43.3                                |       | 50.2 |   |
| Accretion of interest                                                                      |       | 2.7                                 |       | 2.6 |   |
| Loss (gain) on sale of assets                                                              |       | 1.5                                 |       | (0.1 | ) |
| Impairment charge                                                                          |       | 263.1                               |       | — |   |
| Changes in assets and liabilities:                                                         |       |                                |       |   |   |
| Trade receivables                                                                          |       | 5.9                                 |       | 8.2 |   |
| Prepaid expenses and other                                                                 |       | 3.2                                 |       | 11.4 |   |
| Accounts payable and accrued expenses                                                      |       | (17.5                               | )          | (52.9 | ) |
| Deferred revenue                                                                           |       | 1.9                                 |       | (0.8 | ) |
| Increase in restricted cash                                                                |       | ––                        |       | (9.0 | ) |
| **Net cash provided by (used in) operating activities**                                    |       | 1.7                                 |       | (25.8 | ) |
| **Cash Flows from Investing Activities**                                                   |       |                                |       |   |   |
| Purchases of property and equipment                                                        |       | (36.3                               | )          | (58.8 | ) |
| Other assets                                                                               |       | (22.8                               | )          | (32.2 | ) |
| Proceeds from the sale of assets                                                           |       | 8.1                                 |       | 3.1 |   |
| **Net cash used in investing activities**                                                  |       | (51.0                               | )          | (87.9 | ) |
| **Cash Flows from Financing Activities**                                                   |       |                                |       |   |   |
| Net proceeds from long-term debt                                                           |       | 40.0                                |       | –– |   |
| Payments on long-term debt                                                                 |       | (19.2                               | )          | (8.6 | ) |
| Deferred financing fees                                                                    |       | (1.9                                | )          | –– |   |
| **Net cash used in financing activities**                                                  |       | 18.9                                |       | (8.6 | ) |
| ** **                                                                                 |       |                                |       |   |   |
| **Net decrease in cash and cash equivalents**                                              |       | (30.4                               | )          | (122.3 | ) |
| **Cash and cash equivalents**                                                              |       |                                |       |   |   |
| Beginning                                                                                  |       | 56.5                                |       | 170.6 |   |
| Ending                                                                                     |       | $                                   | 26.1       |   | $ | 48.3 |   |
| **Supplemental Disclosure of Cash Flow Information**                                       |       |                                |       |   |   |
| Cash payments for interest                                                                 |       | $                                   | 30.9       |   | $ | 30.0 |   |
|                                                                                       |       |                                |       |   |   |
| **Supplemental Schedule of Noncash Investing and Financing Activities**                    |       |                                |       |   |   |
| Principal amount converted of Redeemable Preferred Series A to Class A  common stock       |       | $                                   | 53.2       |   | $ | 35.4 |   |
| Preferred stock dividends                                                                  |       | $                                   | 2.4        |   | $ | 3.6 |   |

 

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

 

6

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**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**NOTES****TO THECONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

McLeodUSA Incorporated (“McLeodUSA” or the “Company”), a Delawarecorporation, through its subsidiaries, provides integrated communicationsservices in 25 Midwest, Southwest, Northwest and Rocky Mountain states.  McLeodUSA’s business is highly competitiveand is subject to various federal, state and local regulations.

 

*Overview*

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

 

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

 

However, the Company’srevenues have not increased as forecasted and have been declining since2002.  The decline in revenue was drivenby the Company’s program to eliminate non-profitable customers, turnover ofcustomers to competitors in excess of new customers acquired, reduction of longdistance minutes used by its customer base, reduction in access rates asmandated by the FCC, and lower prices for some of its products.  The Company has taken significant actions toincrease revenue, including introduction of new competitively priced products,reorganization of the sales operation into three distinct channels, hiring ofexperienced executive sales leadership, expanding the involvement of the boardof directors and executive staff in the sales process and reducing customerchurn.  While the Company believes thatthese actions will over time result in profitable new revenue growth, thetiming and amount of that growth is yet to be determined.

 

The strategic plan andrecapitalization anticipated that the Company would require additional fundingto ultimately reach positive earnings and cash flow and established an exitfinancing facility (“Exit Facility”) of $160 million and obtained funding for$110 million of that facility as a revolver. In order to access the Exit Facility, the Company must be in compliancewith certain restrictive covenants.  Inthe first quarter of 2004 the Company recognized that as a result of thecontinued decline in revenues, it would be necessary to obtain an amendment tothose covenants from its lender group. The Company sought and obtained approval of amendments from its lendergroup on April 30, 2004.  Had the Companynot obtained these amendments it would have been in default of the priorminimum trailing four-quarter revenue covenant but would have been incompliance with all other covenants.  TheCompany was in full compliance with the amended covenants as of September 30,2004.  Going forward the Company willneed to increase its revenue and profitability in order to continue to meet therestrictive covenants.  If profitabilitydoes not increase as anticipated, the Company may be required to obtain waiversor further modifications of certain covenants in order to be in compliance withthe credit agreements.  Based on theexpected timing of the realization of certain retail and wholesale revenueinitiatives, it is more likely than not that the Company will not meet theminimum revenue covenant as of December 31, 2004.  The Company has initiated discussions withits lender group regarding obtaining a waiver for this covenant.  Minimum revenue is no longer a restrictivecovenant after December 31, 2004.  Whilethe Company believes it has strong relationships with its lender group, therecan be no assurance that the Company will be able to obtain a waiver and if notthe lender group will have all of the rights and remedies afforded them underthe Credit Agreement and Exit Facility, including the ability to accelerate therepayment of all amounts outstanding under the Credit Agreement and ExitFacility.

 

The Company hasundertaken numerous actions to conserve cash over the past 18 to 24 months,including the reduction of capital expenditures and selling, general andadministrative expenses (“SG&A”), as well as the execution of extensivecost reduction efforts initiated in late 2001 and continuing through 2004.  In the second quarter of 2004 the Companyimplemented a revised business plan which incorporated additional actionsfocused on reducing SG&A expenses and conserving cash. These additionalactions have all been completed and have resulted in a 22% reduction inSG&A expenses from the same quarter of last year.  Going forward the Company will continue toexecute similar actions to conserve cash until its revenue growth initiativestake hold.  The Company has beenselective in managing capital expenditures and does not believe that any of thereductions in capital spending will have a material impact on its ability togrow short-term revenues.

 

The Company endedSeptember 30, 2004 with $26.1 million of cash on hand.  Per the most recent amendments to the creditagreement, the Company made a $15 million withdrawal from the Exit Facility inthe beginning of the third quarter and a $20 million withdrawal in October 2004.Going forward the combination of these funds, cash from operations, and theproceeds from the sale of fiber assets will be used to meet the ongoing cashrequirements while the Company continues to execute the revenue growth plan andreduce quarterly cash usage. In addition, the Exit Facility allows for anadditional $50 million of outstanding debt, which could be funded from ourexisting lender group or other parties. Currently, the Company has used a total of $108 million, includingoutstanding letters of credit, against the Exit Facility.

 

7

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Ultimately, the Companybelieves that it will be successful in executing its strategy to profitablygrow revenue.  However, if the timing ofsuch growth limits or restricts its access to the unused portion of the ExitFacility, then it would be required to initiate more aggressive expensereductions and potentially seek alternative sources of funding.  In the event the Company seeks alternativesources of funding, there can be no assurances such funding sources would beavailable.

 

**Interim Financial Information (unaudited)**

In the opinion of management, the accompanying unaudited condensedconsolidated financial statements include adjustments, consisting of normalrecurring adjustments, necessary for a fair presentation of the financialposition and results of operations of McLeodUSA.  The operating results for the interim periodsare not necessarily indicative of the operating results to be expected for afull year or for other interim periods. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America (“GAAP”) have been condensedor omitted pursuant to instructions, rules and regulations prescribed by 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 for thefiscal year ended December 31, 2003, filed with the SEC on March 15, 2004.

 

**Accounting for Stock-basedCompensation**

As permitted by Statement of Financial AccountingStandards (“SFAS”) No. 123, *Accounting for Stock-BasedCompensation*(‘‘SFAS 123’’), McLeodUSA measures compensation usingthe intrinsic value based method as prescribed by Accounting Principles BoardOpinion No. 25, *Accounting for Stock Issued to Employees,*butis required to make proforma disclosures in the footnotes to the financialstatements as if the measurement provisions of SFAS 123 and SFAS No. 148 *Accounting for Stock-Based Compensation-Transition and Disclosure — anAmendment of SFAS 123*had been adopted. Under the intrinsic valuemethod, compensation is measured as the difference between the market value ofthe stock on the grant date, less the amount required to be paid for the stock.The difference, if any, is charged to expense over the vesting period of theoptions. No stock-based employee compensation cost is reflected in net loss, asall options granted under the plan had an exercise price greater than or equalto the market value of the underlying common stock on the date of grant.  The following table illustrates the effect onnet loss and net loss per share for the three and nine months ended September30, 2004 and 2003 as if McLeodUSA had applied the fair value recognitionprovisions of SFAS 123 to stock-based employee compensation.

 
| ** **                                                                                        | ** ** | **Three months ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                        | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Net loss  applicable to common shares, as reported                                                |       | $                                    | (353.6     | ) | $ | (83.4 | ) |
| Less: Total  stock-based employee compensation expense determined under fair value based  methods |       | (3.1                                 | )          | (2.6 | ) |
| Pro forma net  loss applicable to common shares                                                   |       | $                                    | (356.7     | ) | $ | (86.0 | ) |
| **Loss  per share:**                                                                              |       |                                 |       |   |   |
| Basic and  diluted, as reported                                                                   |       | $                                    | (1.19      | ) | $ | (0.30 | ) |
| Basic and  diluted, pro forma                                                                     |       | $                                    | (1.20      | ) | $ | (0.31 | ) |

 

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| ** **                                                                                        | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                        | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| Net loss  applicable to common shares, as reported                                                |       | $                                   | (528.8     | ) | $ | (242.7 | ) |
| Less: Total  stock-based employee compensation expense determined under fair value based  methods |       | (9.5                                | )          | (7.0 | ) |
| Pro forma net  loss applicable to common shares                                                   |       | $                                   | (538.3     | ) | $ | (249.7 | ) |
| **Loss  per share:**                                                                              |       |                                |       |   |   |
| Basic and  diluted, as reported                                                                   |       | $                                   | (1.80      | ) | $ | (0.87 | ) |
| Basic and  diluted, pro forma                                                                     |       | $                                   | (1.84      | ) | $ | (0.90 | ) |

 

**Basic and diluted loss per common share**

Loss per common share has been computed using theweighted average number of shares of common stock outstanding.  All stock options granted, and the convertiblepreferred stock and warrants outstanding are anti-dilutive, and are thereforeexcluded from the computation of earnings per share. In the future, the stockoptions, convertible preferred stock and warrants totaling approximately 125million shares and 137 million shares at September 30, 2004 and 2003,respectively, may become dilutive. Assuming exercise or conversion of stock options and convertiblesecurities, diluted shares would have been approximately 429 million and 423million at September 30, 2004 and 2003, respectively.

** **

**Guarantees**

In November 2002, the Financial Accounting Standards Board (“FASB”)issued FASB Interpretation No. 45, *Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others*.  Thisinterpretation clarifies disclosures that are required to be made by aguarantor in its interim and annual financial statements about obligationsunder certain of its issued guarantees. In addition, the interpretationclarifies that a guarantor is required to recognize, at the inception ofcertain types of guarantees, a liability for the fair value of the obligationundertaken in issuing these guarantees. At September 30, 2004 and 2003, McLeodUSA,the parent company, has various guarantees related to subsidiary commitmentsunder operating leases.  As of September30, 2004 and 2003 the guarantees total $24.2 million and $28.4 million,respectively, and expire over various periods through September 2016, correspondingwith the termination of the lease agreements.

 

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

 

McLeodUSA entered into an executive employmentagreement with its Chief Executive Officer, Chris A. Davis, as of October 14,2004.  Under the agreement, McLeodUSA hasagreed to make equalization payments, as necessary, to offset any reduction incertain annual cash compensation currently received by Ms. Davis from ForstmannLittle.  The amount of such equalizationpayments is not to exceed $500,000 annually.

 

**Note 2: Trade Receivables**

 

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

 
| ** **                                     | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| Trade  Receivables:                            |       |                    |       |                   |       |
| Billed                                         |       | $                       | 67.2       |                   | $          | 73.7 |   |
| Unbilled                                       |       | 5.2                     |       | 5.6                    |       |
|                                           |       | 72.4                    |       | 79.3                   |       |
| Allowance for  doubtful accounts and discounts |       | (12.1                   | )          | (13.7                  | )          |
|                                           |       | $                       | 60.3       |                   | $          | 65.6 |   |

 

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**Note 3:  OtherAccrued Liabilities**

 

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

 
| ** **                      | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------|------------|-------------------------|------------|------------------------|------------|
| Restructuring                   |       | $                       | 18.2       |                   | $          | 32.5 |   |
| Accrued  sales/use/excise taxes |       | 17.5                    |       | 18.6                   |       |
| Accrued property  taxes         |       | 12.3                    |       | 10.9                   |       |
| Other                           |       | 31.8                    |       | 38.9                   |       |
|                            |       | $                       | 79.8       |                   | $          | 100.9 |   |

 

**Note 4:  RestructuringCharges**

 

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

 
| ** **                    | ** ** | **Liability at  December 31,  2003** | ** ** | **Cash Payments  Through  September 30,  2004** | ** ** | **Adjustments  Through  September 30,  2004** | ** ** | **Remaining  Liability  September 30,  2004** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| Facility closure costs        |       | $                                    | 32.2       |                                            | $          | (14.1                                         | )          | $                                             | —     |   | $ | 18.1 |   |
| Other contractual commitments |       | 0.3                                  |       | —                                          |       | (0.2                                          | )          | 0.1                                           |       |
|                          |       | $                                    | 32.5       |                                            | $          | (14.1                                         | )          | $                                             | (0.2       | ) | $ | 18.2 |   |

 

**Note 5: Goodwill and Other Intangible Assets**

 

In accordance with SFAS142, *Accounting for Goodwill and Other Intangibles (“SFAS142”)*, goodwill and other indefinite lived intangible assets are notamortized but reviewed annually for impairment or more frequently if an eventoccurs or circumstances change that would more likely than not reduce the fairvalue below its carrying amount.  SFAS142 requires the identification of reporting units and the application of atwo-step approach to assess goodwill impairment.  In order to identify potential impairment,McLeodUSA performs annual impairment tests of goodwill by comparing the fairvalue of its reporting unit with its carrying amount, including goodwill.  If the carrying amount of its reporting unitexceeds its fair value, the impairment loss is measured in the second step bycomparing the implied fair value of goodwill, determined in the same manner asin a business combination, with its carrying amount.  McLeodUSA defined reporting units during itstransitional and annual goodwill impairment test as an operating segmentcomprised of McLeodUSA’s consolidated operations.

 

For other indefinitelived intangible assets SFAS 142 requires that the impairment test consist of acomparison of the fair value of the intangible asset with its carrying amount.  If the carrying amount of the intangibleasset exceeds its fair value, an impairment loss shall be recognized in anamount equal to that excess.  McLeodUSAhas established July 1 as the date for its annual impairment test for bothgoodwill and its other indefinite lived intangible asset.  During the quarter ended June 30, 2004, theCompany reviewed the specific requirements of SFAS 142 regarding the need forimpairment testing between annual tests and concluded that there were no eventsor changes in circumstances that would more likely than not reduce the fairvalue of its reporting unit below its carrying amount.

 

McLeodUSA performed itsannual goodwill impairment and other indefinite lived intangible assetsevaluations using the July 1 test date in connection with the preparation ofits financial statements for the quarterly period ending September 30,2004.  These evaluations (for whichmanagement has engaged a third party appraisal firm) have indicated full impairmentin the carrying amount of the Company’s goodwill and partial impairment in the McLeodUSAtrade name.

 

In order to assess thefair value of goodwill the Company utilized both a market approach as well asan income approach utilizing a discounted cash flow model. The impairment isprimarily based on the Company’s most recent projection of future operations,including the revised expected timing of retail and wholesale revenue growthmade in connection with the third party discounted cash flow model used indetermining the fair value of its reporting unit.  Consequently, McLeodUSA has recorded anon-cash impairment charge in its statement of operations for the three andnine months ended September 30, 2004 of $245.1 million, which represented thefull carrying value of goodwill.

 

10

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In order to assess the fair value of the McLeodUSA trade name, theCompany applied an income approach utilizing a “relief from royalty” method ofvaluation.  Utilizing this approach, theCompany determined that the trade name had a fair value of $64.9 million, ascompared to its carrying value of $82.9 million, indicating partial impairmentof $18.0 million.  The trade nameimpairment is primarily related to the reduced revenue forecast.  Consequently, McLeodUSA has recorded anon-cash impairment charge in its statement of operations for the three andnine months ended September 30, 2004 of $18.0 million.

 

Intangible assets with finite lives at September 30, 2004 and December31, 2003 are summarized as follows (in millions):

 
| ** **                       | ** ** | **Gross** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|----------------------------------|------------|-----------|------------|-------------------------------|------------|---------|------------|
| **September 30, 2004:**          |       |      |       |                          |       |    |       |
| Deferred line installation costs |       | $         | 142.1      |                          | $          | 64.2    |       | $ | 77.9 |   |
| Customer base                    |       | 29.8      |       | 17.0                          |       | 12.8    |       |
| PrimeLine Trademark              |       | 0.9       |       | 0.5                           |       | 0.4     |       |
|                             |       | $         | 172.8      |                          | $          | 81.7    |       | $ | 91.1 |   |

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

 

Annual estimated amortization expense for intangible assets above for2005 is $49 million, $26 million for 2006, and $2 million for 2007.

 

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

 

In July 2001, theFASB issued SFAS 143, *Accounting for AssetRetirement Obligations* (“SFAS 143”). SFAS 143 requires entities to record the fair value of a liability foran asset retirement obligation in the period in which the legal or contractualremoval obligation is incurred. McLeodUSA’s asset retirement obligations relate to three categories ofassets: fiber, central office colocation equipment and technical sites.

 

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

 

Changes in the carrying amount of the asset retirement obligation forthe nine months ended September 30, 2004 is summarized as follows (inmillions):

 
| Balance, December 31, 2003  |   | $    | 58.3   |   |
|-----------------------------|--------|------|--------|--------|
| Interest accretion          |   | 2.7  |   |
| Payments                    |   | (0.2 | )      |
| Balance, September 30, 2004 |   | $    | 60.8   |   |

 

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**Note 7:  LongTerm Debt**

 

OnApril 30, 2004 McLeodUSA entered into the Fifth Amendment to the Credit Agreementand the Second Amendment to the Exit Facility. The approved amendments include changes to the minimum revenue,leverage ratio and interest coverage ratio covenants.  The trailing four quarter minimum revenuecovenant was amended to $825 million, $780 million, $760 million, and $770million in the first quarter through fourth quarter of 2004, respectively.  There is no minimum revenue covenant in2005.  The leverage ratio was replacedwith a minimum cumulative EBITDA covenant (as defined in the Credit Agreementand Exit Facility, as amended) of $8 million, $16 million, $24 million and $34million for the first through fourth quarters of 2004, respectively, and atrailing four quarter minimum EBITDA of $49 million, $69 million, $89 million and $114 million for the firstthrough fourth quarters of 2005, respectively.** **The interest coverage****ratio was amended to 1.0x for each of the four quarters of2004 and 1.0x, 1.5x, 2.0x and 2.0x for the first through fourth quarters of2005, respectively.  The Company offeredand included in the amendment a downward revision to the capital expenditurelimits for 2004 and 2005 to $75 million and $100 million, respectively.  There were no changes to the capitalexpenditure limit of $200 million for the years 2006 and beyond.

 

McLeodUSApaid approximately $1.9 million in fees in April 2004 to the lender group inconnection with the approval of these amendments.  The Company is currently in compliance withthe amended financial covenants under the Credit Agreement and ExitFacility.  As of September 30, 2004,McLeodUSA had drawn $80 million on the Exit Facility and made its planned $20million withdrawal on October 20, 2004. Currently, the Company has used a total of $108 million, includingoutstanding letters of credit, against the Exit Facility.

 

The Company was in fullcompliance with the amended covenants as of September 30, 2004.  Going forward the Company will need toincrease its revenue and profitability in order to continue to meet therestrictive covenants.  If profitabilitydoes not increase as anticipated, the Company may be required to obtain waiversor further modifications of certain covenants in order to be in compliance withthe credit agreements.  Based on theexpected timing of the realization of certain retail and wholesale revenueinitiatives, it is more likely than not that the Company will not meet theminimum revenue covenant as of December 31, 2004.  The Company has initiated discussions withits lender group regarding obtaining a waiver for this covenant.  Minimum revenue is no longer a restrictivecovenant after December 31, 2004.  Whilethe Company believes it has strong relationships with its lender group, therecan be no assurance that the Company will be able to obtain a waiver and if notthe lender group will have all of the rights and remedies afforded them underthe Credit Agreement and Exit Facility, including the ability to accelerate therepayment of all amounts outstanding under the Credit Agreement and ExitFacility.

 

Interest expense of $1.4million and $8.3 million was capitalized as part of the construction of theCompany’s fiber optic network during the nine-month periods ended September 30,2004 and 2003, respectively.

 

**Note 8: Litigation**

 

Former Chairman Clark E. McLeod, PresidentStephen C. Gray (then also Chief Executive Officer), Chairman and ChiefExecutive Officer Chris A. Davis (then Chief Operating and Financial Officer)and former Chief Financial and Accounting Officer J. Lyle Patrick (the ‘‘IndividualDefendants’’) are defendants in a number of putative class action complaintsthat have been consolidated into a single complaint entitled In Re McLeodUSAIncorporated Securities Litigation, Civil Action No. C02-0001 (N.D. Iowa) (the ‘‘IowaClass Action’’). The Individual Defendants have filed a motion to dismiss theamended consolidated complaint in the Iowa Class Action, which was denied bythe district judge. One of the putative class plaintiffs, New Millennium GrowthFund LLC, also filed proofs of claim against McLeodUSA in McLeodUSA’s Chapter11 Case for at least $104,650 on its own behalf and for no less thanapproximately $300 million (plus interest, costs and attorneys’ fees asallowed) on behalf of all class claimants in the Iowa Class Action (the ‘‘BankruptcyClaims’’ and, together with the Iowa Class Action, the ‘‘SecuritiesClaims’’). 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 theBankruptcy Claims would be limited to those shares of stock. McLeodUSA believesthat the Securities Claims are without merit and intends to defend themvigorously.

 

McLeodUSA has indemnification obligations runningto the Individual Defendants, the terms of which provide for no limitation tothe maximum potential future payments under such indemnifications.  McLeodUSA is unable to develop an estimate ofthe maximum potential amount of future payments under the indemnifications dueto the inherent uncertainties involved in such litigation. McLeodUSA maintainsinsurance, subject to limitations set forth in the policies, which is intendedto cover the costs of claims made against its current and former Directors andOfficers.

 

McLeodUSA is also involved in numerous regulatoryproceedings before various public utility commissions and the FCC, particularlyin connection with actions by the Regional Bell Operating Companies (“RBOCs”).McLeodUSA anticipates the RBOCs will continue to pursue litigation, regulationsand legislation in states within McLeodUSA’s 25-state footprint and with theFCC to reduce regulatory oversight and regulation over rates, network accessand operations. The RBOCs are also actively pursuing major changes in theTelecommunications Act of 1996, by regulatory litigation and legislation, whichMcLeodUSA believes would adversely affect competitive telecommunicationsservice providers including McLeodUSA. If adopted, these initiatives could makeit more difficult for McLeodUSA to challenge the RBOCs’ actions, or to competewith the RBOCs, in the future. There are no assurances that McLeodUSA willprevail in its disputes with the RBOCs.

 

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The FCC released its Triennial Review Order (“TRO”)in August 2003 modifying its rules governing availability of RBOC unbundlednetwork elements to competitive carriers. The Triennial Review Orderestablished new rules governing the availability and pricing for the networkelements the RBOCs must provide to competitive carriers, and delegatedauthority to the states to apply certain of the new rules in individualmarkets. Several appeals of the TRO were consolidated in the Court of Appealsfor the District of Columbia (the “Court of Appeals”). On March 2, 2004, theCourt of Appeals issued a decision overturning many key elements of the TRO,remanding most of the order to the FCC for further action (*USTA II*).The Court of Appeals ruled that the FCC’s delegation of final impairmentdecisions to state agencies was unlawful. The Court also reversed the FCC’s nationwide finding regarding massmarket switching, dedicated transport and its delegation of decision-makingauthority to the states. The Court directed the FCC to give strongerconsideration to intermodal competition when revising its rules on remand. TheCourt upheld the FCC determination that RBOCs do not have to provide unbundledaccess at current prices to newly deployed technologies based on fiber andpacket-switching capabilities. The Court also upheld the FCC’s findings thatRBOCs are not required to provide unbundled switching to CLECs for businesscustomers served by high-capacity loops, such as DS-1 or packet switching.State proceedings that had been started to implement the TRO were suspended insome states and continued in other states. The Court originally stayedthe effective date of its order for 60 days in order to provide the FCC with anopportunity to implement new unbundling rules. Subsequently, on March 31, 2004, the FCC issued a press release andletters to a number of industry participants and trade associations encouragingindustry members to engage in commercial negotiations to address issues raisedin the TRO.  To facilitate thesecommercial negotiations, the FCC sought and obtained an additional 45-day stayfrom the Court of Appeals.   McLeodUSAhas executed Confidentiality Agreements with Qwest and SBC, our primarysuppliers of network facilities, and opened discussions with each of them. Onor about June 11, 2004, the Chief Executive Officers of each RBOC sent a letterto the FCC in which each promised to maintain the status quo for unbundledswitching until the end of the year.  OnJune 15, 2004, the stay of the Court of Appeals’ decision expired. The FCC andU. S. Department of Justice declined to appeal *USTA II*.  Competitive and interexchange carriers and anorganization representing state regulatory agencies filed appeals to the U.S.Supreme Court and requested a stay.  TheU.S. Supreme Court declined to issue a stay. Various representatives of the FCC stated during July 2004 that the FCCdesires to adopt interim unbundling rules in August 2004 and will concurrentlyissue a Notice of Proposed Rulemaking (‘NPRM”) intended to lead to final rulesthat the FCC will attempt to adopt before year-end.  On July 22, the FCC adopted and on August 22,2004, the FCC released an Interim UNE Order (the “Interim Order”) establishingrequirements that govern the availability of UNEs until the FCC adopts new,permanent unbundling rules.  The Interim Ordermaintained the RBOC obligations to provide UNEs at current prices until March2005.  Verizon, Qwest and the UnitedStates Telephone Association (“USTA”) appealed the Interim Order to the Courtof Appeals.  On October 4, all partiesfiled written comments with the FCC addressing permanent unbundling rules.  The Court of Appeals on October 6, 2004,issued a decision that puts on hold until January 4, 2005, the petition filedby Verizon, Qwest and USTA to immediately overturn the FCC’s InterimOrder.  This decision by the Court ofAppeals allows the FCC to complete new permanent UNE rules by year-end.  On October 12, 2004, the U.S. Supreme Courtrejected the appeal asking the Court to hear an appeal of the Court of Appeals *USTA II* decision.  OnOctober 19, all parties filed written reply comments with the FCC addressingthe permanent unbundling rules. Regardless of the success, or lack of success, of these commercialnegotiations and adoption of interim and final unbundling rules on remand, itis likely that unbundling rules will be the subject of continuedlitigation.  There can be no assurance that our businesses will not be materiallyadversely affected by continued legal challenges to unbundling rules, newlegislation passed in response to unbundling rules or any court decisions thatresult from continued legal challenge to unbundling rules or current law andregulations.

 

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

 

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

 

On October 18, 2004, the FCC released an Orderthat extends unbundling relief to the RBOCs for mass market fiber-to-the-curbloops with fiber that is within 500 feet of the premises.  The FCC also clarified that incumbent LECsare not required to add TDM capabilities into new packetized transmissionfacilities.  It is likely that thisadditional unbundling relief and

 

13

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new network modification rule will be the subjectof litigation.  Such changes could limitour access to mass market customers and adversely affect our ability tocompete.

 

On October 22, 2004, the FCC voted to eliminateany independent unbundling obligation under Section 271 of theTelecommunications Act of 1996 (“the ‘96 Act”) for any network element that hasbeen removed from Section 251 of the ‘96 Act. Such relief could limit our access to customers and adversely affect ourability to compete.

 

The FCC issued on March 10, 2004 its NPRM on ‘‘IP-enabledcommunications,’’ which includes VoIP. The NPRM asks broad questions regardingthe regulatory classifications of various ‘‘IP-enabled’’ services, includingdifferent VoIP services; the access charge and other intercarrier compensationimplications; the universal service implications; and the other social policyimplications such as law enforcement, disability and emergency 911 serviceissues and suggests, as a general proposition, the economic regulation ofvarious IP-enabled services should be kept to a minimum.

 

In May of 2004, the FCC announced a new rule governing CLEC accesscharges that imposed a limit on CLEC originating access rates to be no morethan the rate charged by the ILEC for the same functionality. The FCC orderstated its new rule limiting CLEC access charges was to be applied on aprospective basis. McLeodUSA filed tariff changes to implement the FCC’s newrule. The FCC’s Order also provided that under its prior rules, it would nothave been unreasonable for a CLEC to charge an Interexchange Carrier (“IXC”)for those services at the higher benchmark rate. Certain IXCs challengedapproximately $21 million of McLeodUSA’s access charges after the FCC issuedits orders related to certain types of toll free traffic for prior periodsbased on sufficiency of tariff grounds. McLeodUSA has written contracts withtwo of the IXCs that identify the rates or source of rates that McLeodUSA isentitled to charge for interstate access services.  McLeodUSA continued to bill for its servicesat the benchmark rate until the FCC’s new rule went into effect in June of 2004at which time it billed the revised rates required by the FCC’s new rule. As aconsequence of the withholding of payments by these carriers, McLeodUSA filed suitagainst Sprint Communications Corporation (“Sprint”) in the United StatesDistrict Court for the Northern District of Iowa claiming that, by Sprint’sfailure to pay the interstate access charges that the Company billed, Sprintwas in breach of its contract with the Company. In addition to its breach ofexpress contract claim against Sprint, the Company is pursuing recovery of itsinterstate access charges for toll free traffic under implied contract andunjust enrichment theories. The Company is also considering recovery optionsagainst other IXCs that are challenging these charges. The Company believesthat recovery of withheld amounts is probable; accordingly, no amounts havebeen reserved by the Company at September 30, 2004.

 

Generally, state utility commissions or thirdparties could raise issues with regard to our compliance with applicable lawsor regulations that could have a material adverse effect on our business,results of operations and financial condition. On September 8, 2004, the Washington state commission settled all issueswith McLeodUSA for $25,000 plus other non-financial issues.  Several other state utility commissions havereviewed or are actively reviewing the propriety of certain agreements weentered into with Qwest, including Arizona, Colorado and Oregon, and theseproceedings may result in fines or other sanctions against us or the impositionof other conditions detrimental to us, including the establishment of discountsavailable to other competitive telephone companies but not to us. Other statesmay initiate similar proceedings.

 

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

 

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

** **

In connection with its reorganization, McLeodUSAcompleted the sale of certain businesses, including McLeodUSA Media Group andits subsidiaries and Illinois Consolidated Telephone Company and associatedbusinesses.  In its most recent AnnualReport on Form 10-K, based on the requirements of SFAS 144, McLeodUSA reflectedthese businesses and other businesses that were sold as discontinued operationsfor the periods January 1, 2002 to April 16, 2002 and April 17, 2002 toDecember 31, 2002.  In accordance withGAAP, McLeodUSA is required to present its financial statements for the yearended December 31, 2001, reflecting these businesses as discontinued operations.  McLeodUSA’s former auditors, Arthur AndersenLLP (“Arthur Andersen”), audited McLeodUSA’s financial statements and issued anaudit opinion for the year ended December 31, 2001.  On April 24, 2002, McLeodUSA engaged Deloitte& Touche LLP (“Deloitte & Touche”) to serve as its independentaccountants for fiscal year 2002.  Inorder for McLeodUSA to comply with GAAP requirements related to the financialpresentation for discontinued operations in accordance with Regulation S-X,McLeodUSA would be required to obtain a new audit opinion with respect to theyear ended December 31, 2001.  SinceArthur Andersen is no longer able to perform audits of publicly tradecompanies, Deloitte & Touche has informed McLeodUSA, consistent with

 

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Interpretations of SAS No. 58 (AU Section 508),they would be required to re-audit McLeodUSA’s financial statements for theyear ended December 31, 2001 to provide McLeodUSA with an audit opinion on suchfinancial statements.

 

In light of McLeodUSA’sreorganization, sale of businesses, and implementation of fresh-startaccounting on April 16, 2002, McLeodUSA has determined that the expense andeffort associated with a re-audit is not in the best interest of McLeodUSA orits stockholders.  As an alternative to are-audit McLeodUSA has included in its most recent Annual Report on Form 10-Kunaudited consolidated financial statements, prepared in accordance with GAAP,reflecting the impact of the discontinued operations for the year ended December31, 2001.  In order for McLeodUSA to sellsecurities with a registration statement declared effective by the SEC, theregistration statement must contain three years of audited financials.

** **

**Note 10: Subsequent Event**

 

Effective November 1, 2004, McLeodUSA enteredinto a Partial Termination and Reconveyance Agreement (the “Agreement”) withLevel 3 Communications LLC (“Level 3”) which substantially terminates the CostSharing National IRU Agreement, dated April 26, 1999, and subsequent amendments(the “IRU Agreement”), between McLeodUSA and Level 3.  In connection the Agreement, McLeodUSA andLevel 3 also entered into agreements with three other parties pursuant to whichthe parties replaced McLeodUSA in certain remaining portions of the IRUAgreement.  The agreements substantiallyreturn the assets conveyed in the IRU Agreement back to Level 3 and/or theother parties, thereby eliminating McLeodUSA’s remaining obligations, includingoperating and maintenance services and related expenditures.  McLeodUSA will receive cash considerationfrom Level 3 and the other parties of approximately $14.1 million.  These actions are part of the Company’spreviously announced plan to dispose of non-core fiber assets.  McLeodUSA incurred no early terminationpenalties.

 

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**Information RegardingForward-Looking Statements**

 

Some of the statements in this discussion include statements about ourfuture expectations.  Statements that arenot historical facts are forward-looking statements for the purpose of the safeharbor provided by Section 21E of the Exchange Act and Section 27A of theSecurities Act.  Such statements mayinclude projections of financial and operational results and goals, includingrevenue, profitability, savings and cash. Insome cases, you can identify these so-called “forward looking statements” byour use of words such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,”“believe,” “estimate,” “predict”, “project”, “intend” or “potential” or the negativeof those words and other comparable words.****Theseforward-looking statements are subject to known as well as unknown risks anduncertainties that may cause actual results to differ materially from ourexpectations.  Our expectations are basedon various factors and assumptions and reflect only our predictions.  Factors that could cause actual results todiffer materially from the forward-looking statement include technological,regulatory, public policy or other developments in our industry, availabilityand adequacy of capital resources, current and future economic conditions, theexistence of strategic alliances, our ability to generate cash, our ability toimplement process and network improvements, our ability to attract and retaincustomers, our ability to migrate traffic to appropriate platforms and changesin the competitive climate in which we operate. These and other risks are described in more detail in our most recentAnnual Report on Form 10-K filed with the SEC. Except as required under the federal securities laws and rules andregulations of the SEC, the Company undertakes no obligation to update publiclyany forward-looking statements, whether as a result of future events, newinformation or otherwise.

 

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

 

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

 

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

 

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

 

However, the Company’srevenues have not increased as forecasted and have been declining since2002.  The decline in revenue has beendriven by our program to eliminate non-profitable customers, turnover ofcustomers to competitors in excess of new customers acquired, reduction of longdistance minutes used by our customer base, reduction in access rates asmandated by the FCC, and lower prices for some of our products.  We have taken significant actions to increaserevenue, including introduction of new competitively priced products, reorganizationof the sales operation into three distinct channels, hiring of experiencedexecutive sales leadership, expanding the involvement of the board of directorsand executive staff in the sales process and reducing customer churn.  While we believe that these actions will overtime result in profitable new revenue growth, the timing and amount of thatgrowth is yet to be determined.

 

The strategic plan andrecapitalization anticipated that we would require additional funding toultimately reach positive earnings and cash flow and established an exitfinancing facility (“Exit Facility”) of $160 million and obtained funding for$110 million of that facility as a revolver. In order to access the Exit Facility, the Company must be in compliancewith certain restrictive covenants.  Inthe first quarter of 2004 we recognized that as a result of the continueddecline in revenues, it would be necessary to obtain an amendment to thosecovenants from our lender group.  Wesought and obtained approval of amendments from our lender group on April 30,2004 and were in full compliance with the amended covenants as of September 30,2004.  Had the Company not obtained theseamendments it would have been in default of the prior minimum trailingfour-quarter revenue covenant but would have been in compliance with all othercovenants. Going forward we will need to increase revenue and profitability inorder to continue to meet the restrictive covenants.  If profitability does not increase asanticipated, the Company may be required to obtain waivers or furthermodifications of certain covenants in order to be in compliance with the creditagreements.  Based on the expected timingof the realization of certain retail and wholesale revenue initiatives, it ismore likely that not that the Company will not meet the minimum revenuecovenants as of December 31, 2004.  TheCompany has initiated discussions with its lender group regarding obtaining awaiver for this covenant.  Minimum revenueis no longer a restrictive covenant after December 31, 2004.  While the Company believes it has strongrelationships with its lender group, there can be no assurance that the Companywill be able to obtain a waiver and if not the lender group will have all of therights and remedies afforded them under the Credit Agreement and Exit Facility,including the ability to accelerate the repayment of all amounts outstandingunder the Credit Agreement and Exit Facility.

 

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We have undertakennumerous actions to conserve cash over the past 18 to 24 months, including thereduction of capital expenditures and selling, general and administrativeexpenses (“SG&A”), as well as the execution of our extensive cost reductionefforts initiated in late 2001 and continuing through 2004.  In the second quarter of 2004 the Companyimplemented a revised business plan which incorporated additional actionsfocused on reducing SG&A expenses and conserving cash (see *Management’s Discussion and Analysis — Liquidity and Capital Resources*foradditional details).  These actions havebeen completed and have resulted in a 22% reduction in SG&A expenses fromthe same quarter of last year.  Goingforward we will continue to execute similar actions to conserve cash until ourrevenue growth initiatives take hold.  Wehave been selective in managing capital expenditures and do not believe thatany of the reductions in capital spending will have a material impact on ourability to grow short-term revenues.  Ultimately,we believe the Company will be successful in executing its strategy toprofitably grow revenue.  However, if thetiming of such growth limits or restricts our access to the unused portion ofthe Exit Facility, then we would be required to initiate more aggressiveexpense reductions and potentially seek alternative sources of funding.  In the event the Company seeks alternativesources of funding, there can be no assurances such funding sources would beavailable.

 

**Overview of Our Business**

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

 

As of September 30, 2004, we operated a network with 696 access nodescollocated in RBOC central offices.  Weserve our customers by using various loop/access unbundled network elements (“UNEs”)provided by the RBOCs and aggregating them through our access nodes.  In turn, our access nodes are interconnectedthrough approximately 39 service node locations where our switching/routingsystems reside.  In a metropolitan area,access node to service node connectivity is based either on our own fiberfacilities or on UNE transport from the RBOCs. Our service nodes are located in most of the major metropolitan areasacross our footprint.  These servicenodes are in turn interconnected by our high capacity, inter-city corenetwork.  The underlying transport forour core network is based either on our own fiber or on leased capacity frominterexchange carriers.

 

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

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

 

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

 

Inconnection with our reorganization, McLeodUSA completed the sale of certainbusinesses.  In our most recent AnnualReport on Form 10-K, based on the requirements of SFAS 144, McLeodUSA reflectedthese businesses and other businesses that were sold as discontinued operationsfor the periods January 1, 2002 to April 16, 2002 and April 17, 2002 toDecember 31, 2002.  In accordance withaccounting principles generally accepted in the United States of America (“GAAP”),McLeodUSA is required to present its financial statements for the year endedDecember 31, 2001, reflecting these businesses as discontinued operations.  McLeodUSA’s former auditors, Arthur AndersenLLP (“Arthur Andersen”), audited McLeodUSA’s financial statements and issued anaudit opinion for the year ended December 31, 2001.  On April 24, 2002, McLeodUSA engaged Deloitte& Touche LLP (“Deloitte & Touche”) to serve as its independentaccountants for fiscal year 2002.  Inorder for McLeodUSA to comply with GAAP requirements related to the financialpresentation for discontinued operations in accordance with Regulation S-X,McLeodUSA would be required to obtain a new audit opinion with respect to theyear ended

 

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December31, 2001.  Since Arthur Andersen is nolonger able to perform audits of publicly traded companies, Deloitte &Touche has informed McLeodUSA, consistent with *Interpretationsof SAS No. 58 (AU Section 508),* that they would be required tore-audit McLeodUSA’s financial statements for the year ended December 31, 2001to provide McLeodUSA with an audit opinion on such financial statements.

 

**Critical Accounting Policies and Estimates**

 

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

 

**Liquidity and Capital Resources**

 

Prior to August 2001,McLeodUSA grew rapidly by focusing on top-line revenue growth, which requiredsignificant capital for the construction of local and long distance voicenetworks and a national data network and included the acquisition of numerousbusinesses.  By mid-2001, due to certainfactors, including but not limited to complications related to the Company’srapid growth and a general downturn in the economy and the telecommunicationssector in particular, the Company was not meeting internal expectations interms of profitability and cash flow.

 

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

 

We have generally completedthe construction and integration of our network assets and our future capitalexpenditures are focused on reducing cost of service, adding capacity to ournetwork to serve new customers, and developing new products to compete in themarketplace.  Our capital expenditureplan is closely managed.  The Companydoes not believe that it has significant capital requirements to complete itscurrent construction work in progress for its intended use.

 

In the near term, weexpect to incur net negative cash flows as the result of remaining leasepayments and lease buyouts associated with facility exits made in 2001 and 2002as part of our restructuring, and to fund continuing working capital needs andservice our debt.  We believe that theactions we have taken and the successful execution of our strategic plan willposition us to be successful over the long-term.

 

*Background of Capital Structure and Credit Facilities*

 

During2001, in connection with our revised business strategy, we began to explorerestructuring our capital structure.  Anyrestructuring involving a payment to bondholders, other than regularlyscheduled payments of principal and interest, required a majority consent underour Credit Agreement.  In order to effecta restructuring, we entered into the Third Amendment to the CreditAgreement.  Under the Third Amendment,the lenders under the Credit Agreement waived: (1) any bankruptcy and paymentcross-defaults with respect to the Notes arising from the restructuring; (2)covenants restricting the sales of assets in order to allow the sale of Pubcopursuant to the restructuring, and the use of the $600 million of proceedstherefrom to make a payment to the bondholders; and (3) certain other covenantsand other provisions of the Credit Agreement that would have restricted ourability to enter into various transactions necessary to consummate therestructuring.  The Third Amendmentcontained certain modifications that became effective upon our consummation ofthe Plan, including, among other things, the modification of various financialcovenants and the addition of a capital expenditure limitation, a 1% increasein the applicable rates of interest on the borrowings under the CreditAgreement and the establishment of certain prepayment premiums applicable tothe Credit Agreement term loan repayments made in the first three yearsfollowing the restructuring.

 

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Asprovided for in the Third Amendment to the Credit Agreement, we entered intothe Exit Facility with a consortium of banks upon consummation of the Plan onApril 16, 2002.  The Exit Facilityconsists initially of a revolving credit facility of $110 million.  In addition, we have the right to obtainadditional commitments to increase the size of the Exit Facility up to $160million.  The Exit Facility matures onMay 31, 2007, with any outstanding amounts due on that date; no principalpayments are due until this maturity date. The Exit Facility is secured by first priority liens on the assets ofMcLeodUSA and its domestic subsidiaries and ranks superior to the CreditAgreement.

 

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

 

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, capitalexpenditures and designation of unrestricted subsidiaries.  The Exit Facility and the Credit Agreementalso contain restrictive covenants that limit our leverage ratio and requireminimum levels of interest coverage and consolidated revenue.  On April 30, 2004 we entered into the FifthAmendment to the Credit Agreement and the Second Amendment to the ExitFacility.  The approved amendmentsinclude changes to the minimum revenue, leverage ratio and interest coverageratio covenants.  The minimum revenuecovenant was amended to $825 million, $780 million, $760 million, and $770million in the first quarter through fourth quarter of 2004, respectively.  There is no minimum revenue covenant in2005.  The leverage ratio was replacedwith a minimum cumulative EBITDA covenant (as defined in the Credit Agreementand Exit Facility, as amended) of $8 million, $16 million, $24 million and $34million for the first through fourth quarters of 2004, respectively, and atrailing four quarter minimum EBITDA of $49 million, $69 million, $89 million and $114 million for the firstthrough fourth quarters of 2005, respectively.** **The interest coverage****ratio was amended to 1.0x for each of the four quarters of2004 and 1.0x, 1.5x, 2.0x and 2.0x for the first through fourth quarters of2005, respectively.  The Company offeredand included in the amendment a downward revision to the capital expenditurelimits for 2004 and 2005 to $75 million and $100 million, respectively.  There were no changes to the capitalexpenditure limit of $200 million for the years 2006 and beyond.  AtSeptember 30, 2004 we were in compliance with all restrictive covenants.

 

Wepaid approximately $1.9 million in fees in April 2004 to the lender group inconnection with the approval of the Fifth Amendment to the Credit Agreement andthe Second Amendment to the Exit Facility. As of September 30, 2004 we were in compliance with the amendedfinancial covenants under the Credit Agreement and Exit Facility and continuedto have full access to the $110 million Exit Facility.  As of September 30, 2004, we had drawn $80million on the Exit Facility and on October 20, 2004, we made our planned $20million draw on the Exit Facility. Currently, the Company has used a total of $108 million, includingoutstanding letters of credit, against the Exit Facility.

 

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**2004Cash Flow**

 

Weended September 30, 2004 with $26.1 million of cash and cash equivalents versus$56.5 million at December 31, 2003.  Thisdecrease of $30.4 million resulted primarily from the following:

 
| Operating  Activities:                                                         |   |   |   |
|--------------------------------------------------------------------------------|--------|--------|--------|
| Increase in cash  from operations, excluding changes in assets and liabilities |   | $      | 8.2    |   |
| Payments for  restructuring liabilities                                        |   | (14.1  | )      |
| Source of cash  from changes in assets and liabilities                         |   | 7.6    |   |
| Net cash  provided by operating activities                                     |   | 1.7    |   |
|                                                                           |   |   |   |
| Investing  Activities:                                                         |   |   |   |
| Capital  expenditures                                                          |   | (36.3  | )      |
| Deferred line  installation costs                                              |   | (22.8  | )      |
| Sale of assets                                                                 |   | 8.1    |   |
| Net cash used by  investing activities                                         |   | (51.0  | )      |
|                                                                           |   |   |   |
| Financing  Activities:                                                         |   |   |   |
| Payments on  long-term debt                                                    |   | (19.2  | )      |
| Deferred  financing fees                                                       |   | (1.9   | )      |
| Proceeds from  long-term debt                                                  |   | 40.0   |   |
| Net cash  provided by financing activities                                     |   | 18.9   |   |
|                                                                           |   |   |   |
| Net decrease in  cash and cash equivalents                                     |   | $      | (30.4  | ) |
|                                                                                |        |        |        |  |  |

 

Thepayments for restructuring liabilities primarily related to remaininglease payments and lease buyouts associated with facility exits made in 2001and 2002 as part of our restructuring.  The source of cash related to changes inassets and liabilities primarily related to an increase in accounts payable anda decrease in our trade accounts receivable balances.  We expect our cash requirements to payrestructuring liabilities to be less than $3 million during the remainder of2004.

 

Asdiscussed above, we have reduced our growth-related capital expenditure planand expect to spend less than our prior forecast of $50 - $55 million during2004.  The capital expenditure plan forthe rest of 2004 remains dedicated to new product introduction, cost savingsprograms and strategic growth initiatives. Deferred line installation costs are the result of costs required to addcustomers onto our network.  Our deferredline installation expenditures throughout the rest of 2004 will be dependent onthe rate at which we add new customers.

 

During2003, our borrowings under the Credit Agreement began amortizing and principalpayments of $18.9 million were made in the first nine months of 2004.  During the fourth quarter of 2004, mandatorydebt repayments under the Credit Agreement will total $7.8 million.  In March, July, and October of 2004, weborrowed $25.0 million, $15 million and $20 million, respectively, under our$110 million Exit Facility.  Currently,the Company has used a total of $108 million, including outstanding letters ofcredit, against the Exit Facility.

** **

**Outlookfor 2004 and Future Funding Needs**

 

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

 

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

 

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non-core assets. We have completed approximately$5.5 million of fiber sales during the first nine months of 2004.  In addition, we completed an additional$14 million in fiber transactions early in the fourth quarter of 2004.  As a result of the actions described above theCompany significantly reduced its cash usage in the third quarter of 2004 andexpects to realize continuing benefits from these programs.

 

We ended September 30, 2004 with $26.1 million of cash on hand.  Per the most recent amendments to the creditagreement we made the planned $20 million withdrawal from the Exit Facility onOctober 20, 2004. Going forward the combination of these funds, cash fromoperations, and the proceeds from the sale of fiber assets will be used to meetthe ongoing cash requirements while the Company continues to execute the revenuegrowth plan and reduce quarterly cash usage. In addition, the Exit Facility allows for an additional $50 million ofoutstanding debt, which could be funded from our existing lender group or otherparties.

 

Our ability to access theremaining unused portion of the Exit Facility requires compliance with certainrestrictive covenants.  Those covenantsrequire increases in the Company’s revenue and profitability over time.  If profitability does not increase asanticipated, the Company may be required to obtain waivers or furthermodifications of certain covenants in order to be in compliance with the creditagreements.  Based on the expected timingof the realization of certain retail and wholesale revenue initiatives, it ismore likely than not that the Company will not meet the minimum revenuecovenant as of December 31, 2004.  TheCompany has initiated discussions with its lender group regarding obtaining awaiver for this covenant.  Minimumrevenue is no longer a restrictive covenant after December 31, 2004.  While the Company believes it has strongrelationships with its lender group, there can be no assurance that the Companywill be able to obtain a waiver and if not the lender group will have all ofthe rights and remedies afforded them under the Credit Agreement and ExitFacility, including the ability to accelerate the repayment of all amountsoutstanding under the Credit Agreement and Exit Facility.

 

**Three Months Ended September 30, 2004 Compared with Three Months EndedSeptember 30, 2003**

 

***Revenue.*** Total revenue for the quarter ended September 30, 2004 declined $42.9million, or 20%, to $168.1 million from $211.0 million for the quarter endedSeptember 30, 2003.  The following tablecompares our revenue for the three months ended September 30:

 
| ** **                                                                                    | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Local                                                                                         |       | $        | 90.1       |     | $          | 101.1        |       | $ | (11.0 | ) |
| Long distance                                                                                 |       | 31.7     |       | 42.8     |       | (11.1        | )          |
| Data services and other                                                                       |       | 31.9     |       | 37.6     |       | (5.7         | )          |
| Carrier access                                                                                |       | 11.0     |       | 26.1     |       | (15.1        | )          |
| Indefeasible rights of use agreements including those  that qualify as sales type leases |       | 3.4      |       | 3.4      |       | —       |       |
|                                                                                          |       | $        | 168.1      |     | $          | 211.0        |       | $ | (42.9 | ) |
|                                                                                               |            |          |            |          |            |              |            |  |  |  |  |  |  |

 

Total revenues declined by $42.9 million versus the third quarter of2003 due to a continued decline in total customers, FCC mandated reduction inaccess rates, and lower long distance volume and rates.  The decrease in long distance revenue isattributed to both a 10% drop in the volume of minutes, primarily driven bylower usage patterns across our customer base, as well as a 18% decline inaverage rates from the three months ended September 30, 2003.  Local and long distance average revenues percustomer have decreased year over year as the Company has reduced the cost ofservice and offered substantially more competitive pricing for theseproducts.  Access revenues have decreased$15.1 million from the third quarter of 2003 primarily due to the final phaseof the FCC mandated rate reduction which became effective July 1, 2004.  Included in revenues from indefeasible rightsof use in the above table is $1.4 million and $1.6 million for the quartersended September 30, 2004 and 2003, respectively, related to on-going revenuesfrom operating leases.

 

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

 

***Cost of Service***. Cost of service includes expenses directly associated with providingcommunication services to our customers. Costs classified as cost of service include, among other items, the costof connecting customers to our network via leased facilities, the costs paid tothird party providers for interconnect access and transport services, the costsof leasing components of our network facilities and the cost of fiber relatedto sales and leases of network facilities. Cost of service was $94.1 million for the quarter ended September 30,2004, a decrease of $23.3 million or 20% from the quarter ended September 30,2003.  Approximately $9 million of thedecrease reflects the results of our ongoing network cost reduction effortsthat began in 2002, including least cost routing, network optimizationincluding grooms, migration of customers to the McLeodUSA network andelimination of non-profitable customers. The balance of the decrease is attributed to the reduction in revenues.  The cost of fiber related to sales and leasesof network facilities was not significant for the quarters ended September 30,2004 and 2003.

 

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***Selling, general and administrative expenses.***  SG&A includes expenses related to salesand marketing, customer service, internal network operations and engineering,information systems and other administrative functions.  SG&A expenses were $62.5 million for thethird quarter of 2004, a decrease of $17.5 million or 22% from 2003.  The decrease in SG&A year over year isprimarily attributable to efficiencies realized as a result of our continuousprocess improvement program, which has been ongoing since early 2002 andadditional actions to reduce expenses and manage cash which were implemented inthe second quarter and will continue throughout 2004.  These combined actions have reducednon-essential expenses and reduced headcount from approximately 3,500 atSeptember 30, 2003 to 2,500 employees at September 30, 2004.

 

***Depreciation and amortization.***  Depreciation and amortization includes thedepreciation of our communications network and equipment, amortization of otherintangibles determined to have finite lives, and amortization over the life ofthe customer contract of one-time direct installation costs associated withtransferring customers’ local line service from the RBOCs to our localtelecommunications services. Depreciation and amortization expenses were $88.8 million for thequarter ended September 30, 2004, an increase of $2.2 million over the thirdquarter of 2003.  This increase was dueto a higher depreciable asset base as a result of additional assets beingplaced in service during 2003 and 2004.

 

***Impairment charge. ***Inaccordance with SFAS 142, we performed our annual impairment tests of goodwilland other indefinite-lived intangible assets in connection with our preparationof the financial statements for the quarter ended September 30, 2004.  The tests resulted in a $263.1 million non-cashimpairment charge to eliminate goodwill of $245.1 million and record impairmentof $18.0 million on the McLeodUSA tradename.

 

***Interest expense.*** Gross interest expense was $12.2 million for the quarter ended September30, 2004, an increase of $0.9 million over the third quarter of 2003 primarilyrelated to higher outstanding borrowings during the period.  Net interest expense increased by $3.0million in the quarter ended September 30, 2004 primarily due to lowercapitalized interest as a result of lower construction in progress balancesduring the quarter and increased outstanding borrowing.  Interest expense of approximately $0.3million and $2.4 million was capitalized as part of our construction of ourfiber optic network during the quarter ended September 30, 2004 and 2003,respectively.

 

**Nine Months Ended September 30, 2004 Compared with Nine Months EndedSeptember 30, 2003**

 

***Revenue.*** Total revenue for the nine months ended September 30, 2004 declined$106.0 million, or 16%, to $553.5 million from $659.5 million for the ninemonths ended September 30, 2003.  Thefollowing table compares our revenue for the nine months ended September 30:

 
| ** **                                                                                    | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Local                                                                                         |       | $        | 278.6      |     | $          | 313.9        |       | $ | (35.3 | ) |
| Long distance                                                                                 |       | 100.7    |       | 136.7    |       | (36.0        | )          |
| Data services and other                                                                       |       | 101.1    |       | 106.9    |       | (5.8         | )          |
| Carrier access                                                                                |       | 66.0     |       | 95.0     |       | (29.0        | )          |
| Indefeasible rights of use agreements including those  that qualify as sales type leases |       | 7.1      |       | 7.0      |       | 0.1          |       |
|                                                                                          |       | $        | 553.5      |     | $          | 659.5        |       | $ | (106.0 | ) |
|                                                                                               |            |          |            |          |            |              |            |  |  |  |  |  |  |

 

Total revenues declined by $106.0 million versus the first nine monthsof 2003 due to a continued decline in total customers, FCC mandated reductionin access rates, and lower long distance volume and rates.  The decrease in long distance revenue isattributed to both a 13% drop in the volume of minutes, primarily driven bylower usage patterns across our customer base, as well as a 16% decline inaverage rates from the nine-month period ended September 30, 2003.  Local and long distance average revenues percustomer have decreased year over year as the Company has reduced the cost ofservice and offered substantially more competitive pricing for theseproducts.  Access revenues have decreased$29.0 million from 2003 primarily due to the final FCC mandated ratereduction.  Included in revenues fromindefeasible rights of use in the above table is $4.3 million and $4.9 millionfor the nine month periods ended September 30, 2004 and 2003, respectively,related to on-going revenues from operating leases.

 

The Company has taken significant actions to increase revenue includingintroduction of new competitively priced products, reorganization of the salesoperation into three distinct channels, hiring of experienced executiveleadership and expanding

 

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the involvement of the board of directors and executive staff in thesales process.  While the Companybelieves that these actions will over time result in profitable new revenuegrowth, the timing and amount of that growth is yet to be determined.

 

***Cost of Service***. Cost of service includes expenses directly associated with providingcommunication services to our customers. Costs classified as cost of service include, among other items, the costof connecting customers to our network via leased facilities, the costs paid tothird party providers for interconnect access and transport services, the costsof leasing components of our network facilities and the cost of fiber relatedto sales and leases of network facilities. Cost of service was $306.9 million for the nine month period endedSeptember 30, 2004, a decrease of $76.0 million or 20% from the nine-monthperiod ended September 30, 2003. Approximately $36 million of the decrease reflects the results of ourongoing network cost reduction efforts that began in 2002, including least costrouting, network optimization including grooms, migration of customers to theMcLeodUSA network and elimination of non-profitable customers. The balance ofthe decrease is attributed to the reduction in revenues.  The cost of fiber related to sales and leasesof network facilities was $0.4 million for the nine months ended September 30,2004 and totaled $0.8 million for the nine months ended September 30, 2003.

 

***Selling, general and administrative expenses.***  SG&A includes expenses related to salesand marketing, customer service, internal network operations and engineering,information systems and other administrative functions.  SG&A expenses were $206.7 million for thenine months of 2004, a decrease of $28.5 million or 12% from 2003.  Our continuous process improvement program,which has been ongoing since early 2002, and specific additional actions takenin the second quarter and continuing throughout 2004 have yielded significantreductions in SG&A expense.  As aresult, headcount has been reduced from approximately 3,500 at September 30,2003 to 2,500 employees at September 30, 2004.

 

***Depreciation and amortization.***  Depreciation and amortization includes thedepreciation of our communications network and equipment, amortization of otherintangibles determined to have finite lives, and amortization over the life ofthe customer contract of one-time direct installation costs associated withtransferring customers’ local line service from the RBOCs to our localtelecommunications services. Depreciation and amortization expenses were $267.3 million for the ninemonths ended September 30, 2004, an increase of $13.4 million over the thirdquarter of 2003.  This increase was dueto a higher depreciable asset base as a result of additional assets beingplaced in service during 2003 and 2004.

 

***Impairment charge.***In accordance with SFAS 142,we performed our annual impairment tests of goodwill and other indefinite-livedintangible assets in connection with our preparation of the financialstatements for the quarter ended September 30, 2004.  The tests resulted in a $263.1 million non-cashimpairment charge to eliminate goodwill of $245.1 million and record impairmentof $18.0 million on the McLeodUSA tradename.

 

***Interest expense.*** Gross interest expense was $36.1 million for the nine months endedSeptember 30, 2004, an increase of $1.9 million over the third quarter of 2003primarily related to higher outstanding borrowings during the period.  Net interest expense increased by $8.7million in the nine months ended September 30, 2004 due to lower capitalizedinterest as a result of lower construction in progress balances during thequarter and increased borrowings outstanding. Interest expense of approximately $1.4 million and $8.3 million was capitalizedas part of our construction of our fiber optic network during the nine monthsended September 30, 2004 and 2003, respectively.

 

**Inflation**

 

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

 

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

 

Upon the consummation of our restructuring on April 16, 2002,substantially all of our fixed rate debt was eliminated. We have variable ratedebt of approximately $765 million under the Credit Agreement outstanding atSeptember 30, 2004.  If market interestrates average 1% more in subsequent quarters than the rates during the quarterended September 30, 2004, quarterly interest expense would increase by $1.9million.  This amount was determined bycalculating the effect of the hypothetical interest rate increase on ourvariable rate debt for the quarter and does not assume changes in our financialstructure.

 

**Item 4**.  Controls and Procedures

 

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

 

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

 

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

 

**Item 1. Legal Proceedings**

 

Former Chairman Clark E. McLeod, PresidentStephen C. Gray (then also Chief Executive Officer), Chairman and ChiefExecutive Officer Chris A. Davis (then Chief Operating and Financial Officer)and former Chief Financial and Accounting Officer J. Lyle Patrick (the ‘‘IndividualDefendants’’) are defendants in a number of putative class action complaintsthat have been consolidated into a single complaint entitled In Re McLeodUSAIncorporated Securities Litigation, Civil Action No. C02-0001 (N.D. Iowa) (the ‘‘IowaClass Action’’). The Individual Defendants have filed a motion to dismiss theamended consolidated complaint in the Iowa Class Action, which was denied bythe district judge. One of the putative class plaintiffs, New Millennium GrowthFund LLC, also filed proofs of claim against McLeodUSA in McLeodUSA’s Chapter11 Case for at least $104,650 on its own behalf and for no less thanapproximately $300 million (plus interest, costs and attorneys’ fees asallowed) on behalf of all class claimants in the Iowa Class Action (the ‘‘BankruptcyClaims’’ and, together with the Iowa Class Action, the ‘‘SecuritiesClaims’’). 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 theBankruptcy Claims would be limited to those shares of stock. McLeodUSA believesthat the Securities Claims are without merit and intends to defend themvigorously.

 

McLeodUSA has indemnification obligations runningto the Individual Defendants, the terms of which provide for no limitation tothe maximum potential future payments under such indemnifications.  McLeodUSA is unable to develop an estimate ofthe maximum potential amount of future payments under the indemnifications dueto the inherent uncertainties involved in such litigation. McLeodUSA maintainsinsurance, subject to limitations set forth in the policies, which is intendedto cover the costs of claims made against its current and former Directors andOfficers.

 

McLeodUSA is also involved in numerous regulatoryproceedings before various public utility commissions and the FCC, particularlyin connection with actions by the Regional Bell Operating Companies (“RBOCs”).McLeodUSA anticipates the RBOCs will continue to pursue litigation, regulationsand legislation in states within McLeodUSA’s 25-state footprint and with theFCC to reduce regulatory oversight and regulation over rates, network accessand operations. The RBOCs are also actively pursuing major changes in theTelecommunications Act of 1996, by regulatory litigation and legislation, whichMcLeodUSA believes would adversely affect competitive telecommunicationsservice providers including McLeodUSA. If adopted, these initiatives could makeit more difficult for McLeodUSA to challenge the RBOCs’ actions, or to competewith the RBOCs, in the future. There are no assurances that McLeodUSA willprevail in its disputes with the RBOCs.

 

The FCC released its Triennial Review Order (“TRO”)in August 2003 modifying its rules governing availability of RBOC unbundlednetwork elements to competitive carriers. The Triennial Review Orderestablished new rules governing the availability and pricing for the networkelements the RBOCs must provide to competitive carriers, and delegatedauthority to the states to apply certain of the new rules in individualmarkets. Several appeals of the TRO were consolidated in the Court of Appealsfor the District of Columbia (the “Court of Appeals”). On March 2, 2004, theCourt of Appeals issued a decision overturning many key elements of the TRO,remanding most of the order to the FCC for further action (*USTA II*).The Court of Appeals ruled that the FCC’s delegation of final impairmentdecisions to state agencies was unlawful. The Court also reversed the FCC’s nationwide finding regarding massmarket switching, dedicated transport and its delegation of decision-makingauthority to the states. The Court directed the FCC to give strongerconsideration to intermodal competition when revising its rules on remand. TheCourt upheld the FCC determination that RBOCs do not have to provide unbundledaccess at current prices to newly deployed technologies based on fiber andpacket-switching capabilities. The Court also upheld the FCC’s findings thatRBOCs are not required to provide unbundled switching to CLECs for businesscustomers served by high-capacity loops, such as DS-1 or packet switching.State proceedings that had been started to implement the TRO were suspended insome states and continued in other states. The Court originally stayedthe effective date of its order for 60 days in order to provide the FCC with anopportunity to implement new unbundling rules. Subsequently, on March 31, 2004, the FCC issued a press release andletters to a number of industry participants and trade associations encouragingindustry members to engage in commercial negotiations to address issues raisedin the TRO.  To facilitate thesecommercial negotiations, the FCC sought and obtained an additional 45-day stayfrom the Court of Appeals.   McLeodUSAhas executed Confidentiality Agreements with Qwest and SBC, our primarysuppliers of network facilities, and opened discussions with each of them. Onor about June 11, 2004, the Chief Executive Officers of each RBOC sent a

 

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letter to the FCC in which each promised to maintain the status quo forunbundled switching until the end of the year. On June 15, 2004, the stay of the Court of Appeals’ decision expired.The FCC and U. S. Department of Justice declined to appeal *USTA II*.  Competitive and interexchange carriers and anorganization representing state regulatory agencies filed appeals to the U.S.Supreme Court and requested a stay.  TheU.S. Supreme Court declined to issue a stay. Various representatives of the FCC stated during July 2004 that the FCCdesires to adopt interim unbundling rules in August 2004 and will concurrentlyissue a Notice of Proposed Rulemaking (‘NPRM”) intended to lead to final rulesthat the FCC will attempt to adopt before year-end.  On July 22, the FCC adopted and on August 22,2004, the FCC released an Interim UNE Order (the “Interim Order”) establishingrequirements that govern the availability of UNEs until the FCC adopts new,permanent unbundling rules.  The InterimOrder maintained the RBOC obligations to provide UNEs at current prices untilMarch 2005.  Verizon, Qwest and theUnited States Telephone Association (“USTA”) appealed the Interim Order to theCourt of Appeals.  On October 4, allparties filed written comments with the FCC addressing permanent unbundlingrules.  The Court of Appeals on October6, 2004, issued a decision that puts on hold until January 4, 2005, thepetition filed by Verizon, Qwest and USTA to immediately overturn the FCC’sInterim Order.  This decision by theCourt of Appeals allows the FCC to complete new permanent UNE rules byyear-end.  On October 12, 2004, the U.S.Supreme Court rejected the appeal asking the Court to hear an appeal of theCourt of Appeals *USTA II* decision.  On October 19, all parties filed writtenreply comments with the FCC addressing the permanent unbundling rules.  Regardless of the success, or lack ofsuccess, of these commercial negotiations and adoption of interim and finalunbundling rules on remand, it is likely that unbundling rules will be thesubject of continued litigation.  There can be no assurance that our businesseswill not be materially adversely affected by continued legal challenges tounbundling rules, new legislation passed in response to unbundling rules or anycourt decisions that result from continued legal challenge to unbundling rulesor current law and regulations.

 

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

 

On September 10, 2003, the FCC issued an NPRM onTELRIC. This is a proceeding to review the TELRIC methodology used to determinethe prices charged to competitive carriers for unbundled network elements. Achange in pricing methodology that materially increases unbundled networkelement prices would increase our costs and could adversely affect our abilityto compete. A decision is anticipated during 2005.

 

On October 18, 2004, the FCC released an Orderthat extends unbundling relief to the RBOCs for mass market fiber-to-the-curbloops with fiber that is within 500 feet of the premises.  The FCC also clarified that incumbent LECsare not required to add TDM capabilities into new packetized transmissionfacilities.  It is likely that thisadditional unbundling relief and new network modification rule will be thesubject of litigation.  Such changescould limit our access to mass market customers and adversely affect ourability to compete.

 

On October 22, 2004, the FCC voted to eliminateany independent unbundling obligation under Section 271 of theTelecommunications Act of 1996 (“the ‘96 Act”) for any network element that hasbeen removed from Section 251 of the ‘96 Act. Such relief could limit our access to customers and adversely affect ourability to compete.

The FCC issued on March 10, 2004 its NPRM on ‘‘IP-enabledcommunications,’’ which includes VoIP. The NPRM asks broad questions regardingthe regulatory classifications of various ‘‘IP-enabled’’ services, includingdifferent VoIP services; the access charge and other intercarrier compensationimplications; the universal service implications; and the other social policyimplications such as law enforcement, disability and emergency 911 serviceissues and suggests, as a general proposition, the economic regulation ofvarious IP-enabled services should be kept to a minimum.

 

In May of 2004, the FCC announced a new rule governing CLEC accesscharges that imposed a limit on CLEC originating access rates to be no morethan the rate charged by the ILEC for the same functionality. The FCC orderstated its new rule limiting CLEC access charges was to be applied on aprospective basis. McLeodUSA filed tariff changes to implement the FCC’s newrule. The FCC’s Order also provided that under its prior rules, it would nothave been unreasonable for a CLEC to charge an Interexchange Carrier (“IXC”)for those services at the higher benchmark rate. Certain IXCs challengedapproximately $21 million of McLeodUSA’s access charges after the FCC issuedits orders related to certain types of toll free traffic for prior periodsbased on sufficiency of tariff grounds. McLeodUSA has written contracts withtwo of the IXCs that identify the rates or source of rates that McLeodUSA isentitled to charge for interstate access services.  McLeodUSA continued to bill for its servicesat the benchmark rate until the FCC’s new rule went into effect in June of 2004at which time it billed the revised rates required by the FCC’s new rule. As aconsequence of the withholding of payments by these carriers, McLeodUSA filedsuit against Sprint Communications Corporation (“Sprint”) in the United StatesDistrict Court for the Northern District of Iowa claiming that, by Sprint’sfailure to pay the interstate access charges that the Company billed, Sprintwas in breach of its contract with the Company. In addition to its breach ofexpress contract claim against Sprint, the Company is pursuing recovery of itsinterstate access charges for toll free traffic under implied contract andunjust enrichment theories. The Company is also considering recovery optionsagainst other IXCs that are challenging these charges. The Company believesthat recovery of withheld amounts is probable; accordingly, no amounts havebeen reserved by the Company at September 30, 2004.

 

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Generally, state utility commissions or thirdparties could raise issues with regard to our compliance with applicable lawsor regulations that could have a material adverse effect on our business,results of operations and financial condition. On September 8, 2004, the Washington state commission settled all issueswith McLeodUSA for $25,000 plus other non-financial issues.  Several other state utility commissions havereviewed or are actively reviewing the propriety of certain agreements weentered into with Qwest, including Arizona, Colorado and Oregon, and theseproceedings may result in fines or other sanctions against us or the impositionof other conditions detrimental to us, including the establishment of discountsavailable to other competitive telephone companies but not to us. Other statesmay initiate similar proceedings.

 

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

 

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**Item 6****.  Exhibits**

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

 

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**SIGNATURES**

 

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

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

 

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**INDEX TO EXHIBITS**

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

 

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