**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10Q/A**

 
| **(Mark One)**                     |                                                                                                                                                                                                                                                                                              |
|------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **ý**                         | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                      |
|                               |                                                                                                                                                                                                                                                                                              |
|                               | **For the Quarterly Period Ended June 30,  2003**                                                                                                                                                                                                                                                 |
|                               |                                                                                                                                                                                                                                                                                              |
| **or**                             |
|                               |                                                                                                                                                                                                                                                                                              |
| **o**                              | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                     |
|                               |                                                                                                                                                                                                                                                                                              |
|                               | **For the transition period                         to                       ** |
|                               |                                                                                                                                                                                                                                                                                              |
| **Commission file number 0-20763** |

 

**McLEODUSA INCORPORATED**

(Exactname of registrant as specified in its charter)

 

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

 

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

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act). Yes oNo ý

 

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

 

The number of shares outstanding of eachclass of the issuer’s common stock as of August 1, 2003:

 

| Common Stock  Class A:  ($0.01 par value) |   | **166,021,505 shares** |
|------------------------------------------------|--------|------------------------|
| Common Stock  Class B:  ($0.01 par value) |   | **78,203,135 shares**  |
| Common Stock  Class C:  ($0.01 par value) |   | **35,546,879 shares**  |

 

 

----

 

**EXPLANATORY NOTE**

 

Based on discussions with SECstaff, the Company is reissuing as Exhibits 31.1 and 31.2 hereto thecertifications made pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(the “Certifications”) included in the Company’s Quarterly Report on Form 10-Qfor the fiscal quarter ended June 30, 2003 as filed with the Securities andExchange Commission on August 14, 2003 (the “Quarterly Report”) to removeexplanatory information provided in numbered paragraph 6.  This explanatory information was alsoprovided in the text of the Quarterly Report and remains therein.  The Company’s Chief Executive Officer andChief Financial Officer have also reconfirmed their certifications required bySection 906 of the Sarbanes-Oxley Act of 2002 in connection with thisamendment.  Except as provided herein,all other information contained in the Quarterly Report remains unchanged.

 

----

 

**McLEODUSA INCORPORATEDAND SUBSIDIARIES**

**INDEX**

 
| **PART I.  Financial Information** |
|-----------------------------------------|
|                                    |   |   |
| Item 1.                                 | Condensed Consolidated Financial Statements |
|                                    |   | Condensed Consolidated Balance Sheets, June  30, 2003 (unaudited) and December 31, 2002 |
|                                    | Unaudited Condensed Consolidated Statements  of Operations |
|                                    |   | Reorganized  McLeodUSA – for the three months ended June 30, 2003 |
|                                    |   | Reorganized  McLeodUSA – for the period April 17, 2002 to June 30, 2002 |
|                                    |   | Predecessor  McLeodUSA – for the period April 1, 2002 to April 16, 2002 |
|                                    | Unaudited Condensed Consolidated Statements of Operations and  Comprehensive (Loss) Income |
|                                    |   | Reorganized  McLeodUSA – for the six months ended June 30, 2003 |
|                                    |   | Reorganized  McLeodUSA – for the period April 17, 2002 to June 30, 2002 |
|                                    |   | Predecessor  McLeodUSA – for the period January 1, 2002 to April 16, 2002 |
|                                    | Unaudited Condensed Consolidated Statements  of Cash Flows |
|                                    |   | Reorganized  McLeodUSA – for the six months ended June 30, 2003 |
|                                    |   | Reorganized  McLeodUSA – for the period April 17, 2002 to June 30, 2002 |
|                                    |   | Predecessor  McLeodUSA – for the period January 1, 2002 to April 16, 2002 |
|                                    | Notes to the  Condensed Consolidated Financial Statements |
|                                    |   |   |
| Item 2.                                 | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
|                                    |   |   |
| Item 3.                                 | Quantitative and Qualitative Disclosures  About Market Risk |
|                                    |   |   |
| Item 4.                                 | Controls and Procedures |
|                                    |   |   |
| **PART II.  Other Information**    |
|                                    |
| Item 1.                                 | Legal Proceedings |
|                                    |   |
| Item 4.                                 | Submission of Matters to a Vote of Security Holders |
|                                    |   |
| Item 6.                                 | Exhibits and Reports on Form 8-K |
|                                    |   |
| Signatures                              |   |

 

2

----

 

**Item 1. Financial Statements**

 

**PARTI – FINANCIAL INFORMATION**

**McLEODUSA INCORPORATED AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCESHEETS**

**(Inmillions, except share data)**

 
|                                                                                                                                                                                                 |   | **June 30,  2003** |       | **December  31,  2002** |       |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|------------|-------------------------|------------|
|                                                                                                                                                                                                 |   | **(unaudited)**    |       |                    |       |
| **ASSETS**                                                                                                                                                                                           |   |               | ** ** |                    | ** ** |
| Current assets                                                                                                                                                                                       |   |               |       |                    |       |
| Cash and cash equivalents                                                                                                                                                                            |   | $                  | 83.0       |                    | $          | 170.6 |   |
| Trade receivables, net                                                                                                                                                                               |   | 82.2               |       | 93.1                    |       |
| Prepaid expenses and other                                                                                                                                                                           |   | 24.0               |       | 26.2                    |       |
| Assets held for sale                                                                                                                                                                                 |   | 10.4               |       | 11.1                    |       |
| Total current assets                                                                                                                                                                                 |   | 199.6              |       | 301.0                   |       |
|                                                                                                                                                                                                 |   |               |       |                    |       |
| Property and equipment                                                                                                                                                                               |   |               |       |                    |       |
| Land and buildings                                                                                                                                                                                   |   | 73.2               |       | 72.9                    |       |
| Communications networks                                                                                                                                                                              |   | 876.2              |       | 816.0                   |       |
| Furniture, fixtures and equipment                                                                                                                                                                    |   | 188.1              |       | 181.3                   |       |
| Networks in progress                                                                                                                                                                                 |   | 271.3              |       | 303.5                   |       |
|                                                                                                                                                                                                 |   | 1,408.8            |       | 1,373.7                 |       |
| Less accumulated depreciation                                                                                                                                                                        |   | 301.8              |       | 170.6                   |       |
|                                                                                                                                                                                                 |   | 1,107.0            |       | 1,203.1                 |       |
| Intangibles and other assets                                                                                                                                                                         |   |               |       |                    |       |
| Goodwill                                                                                                                                                                                             |   | 245.1              |       | 237.8                   |       |
| Other intangibles, net                                                                                                                                                                               |   | 217.7              |       | 234.5                   |       |
| Other                                                                                                                                                                                                |   | 20.5               |       | 23.9                    |       |
|                                                                                                                                                                                                 |   | 483.3              |       | 496.2                   |       |
| **TOTAL ASSETS**                                                                                                                                                                                     |   | $                  | 1,789.9    |                    | $          | 2,000.3 |   |
|                                                                                                                                                                                                 |   |               |       |                    |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                        |   |               |       |                    |       |
| Current liabilities                                                                                                                                                                                  |   |               |       |                    |       |
| Current maturities of long-term debt                                                                                                                                                                 |   | $                  | 24.4       |                    | $          | 15.0 |   |
| Accounts payable                                                                                                                                                                                     |   | 61.1               |       | 71.1                    |       |
| Accrued payroll and payroll related  expenses                                                                                                                                                        |   | 17.9               |       | 23.6                    |       |
| Other accrued liabilities                                                                                                                                                                            |   | 122.5              |       | 152.8                   |       |
| Deferred revenue, current portion                                                                                                                                                                    |   | 9.2                |       | 9.8                     |       |
| Liabilities related to discontinued  operations                                                                                                                                                      |   | 1.0                |       | 6.3                     |       |
| Total current liabilities                                                                                                                                                                            |   | 236.1              |       | 278.6                   |       |
| Long-term debt, less current maturities                                                                                                                                                              |   | 693.1              |       | 704.9                   |       |
| Deferred revenue, less current portion                                                                                                                                                               |   | 12.4               |       | 13.5                    |       |
| Other long-term liabilities                                                                                                                                                                          |   | 56.7               |       | 54.9                    |       |
|                                                                                                                                                                                                 |   | 998.3              |       | 1,051.9                 |       |
| Redeemable convertible preferred stock                                                                                                                                                               |   |               |       |                    |       |
| McLeodUSA Preferred Series A, redeemable,  convertible, $0.01 par value; 10,000,000 authorized and issued; 9,514,500 and  9,999,900 outstanding at June 30, 2003 and December 31, 2002, respectively |   | 166.6              |       | 172.6                   |       |
|                                                                                                                                                                                                 |   |               |       |                    |       |
| Stockholders’ equity                                                                                                                                                                            |   |               |       |                    |       |
| McLeodUSA Common, Class A $0.01 par value;  1,886,249,986 authorized, 164,756,231 and 162,500,481 issued and outstanding  at June 30, 2003 and December 31, 2002, respectively                       |   | 1.6                |       | 1.6                     |       |
| McLeodUSA Common, Class B $0.01 par value;  78,203,135 authorized, issued and outstanding at June 30, 2003 and December  31, 2002                                                                    |   | 0.8                |       | 0.8                     |       |
| McLeodUSA Common, Class C $0.01 par value;  35,546,879 authorized, issued and outstanding at June 30, 2003 and December  31, 2002                                                                    |   | 0.3                |       | 0.3                     |       |
| McLeodUSA Preferred Series B, $0.01 par  value; 10 authorized, issued and outstanding at June 30, 2003 and December  31, 2002                                                                        |   | —             |       | —                  |       |
| McLeodUSA Warrants                                                                                                                                                                                   |   | 22.6               |       | 22.6                    |       |
| Additional paid-in capital                                                                                                                                                                           |   | 958.0              |       | 951.9                   |       |
| Accumulated deficit                                                                                                                                                                                  |   | (358.3             | )          | (201.4                  | )          |
|                                                                                                                                                                                                 |   | 625.0              |       | 775.8                   |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                  |   | $                  | 1,789.9    |                    | $          | 2,000.3 |   |

 

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

 

3

----

 

**McLEODUSAINCORPORATED AND SUBSIDIARIESUNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS**

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

 
|                                                                                                                                                                                    |   | **Reorganized****McLeodUSA**           |   | **Reorganized****McLeodUSA**                         |   | **Predecessor****McLeodUSA**                         |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|------------------------------------------------------|--------|------------------------------------------------------|--------|
|                                                                                                                                                                                    |   | **Three  months ended  June 30, 2003** |   | **For the period  April 17, 2002 to  June 30, 2002** |   | **For the period  April 1, 2002 to  April 16, 2002** |   |
|                                                                                                                                                                                    |   |                                   |   |                                                 |   |                                                 |   |
| Revenues                                                                                                                                                                                |   | $                                      | 222.6  |                                                 | $      | 207.2                                                |   | $ | 47.3 |   |
|                                                                                                                                                                                    |   |                                   |   |                                                 |   |                                                 |   |
| Operating expenses:                                                                                                                                                                     |   |                                   |   |                                                 |   |                                                 |   |
| Cost of service (exclusive of  depreciation shown separately below)                                                                                                                     |   | 128.1                                  |   | 119.4                                                |   | 32.1                                                 |   |
| Selling, general and  administrative                                                                                                                                                    |   | 73.5                                   |   | 79.5                                                 |   | 17.5                                                 |   |
| Depreciation and amortization                                                                                                                                                           |   | 85.1                                   |   | 59.5                                                 |   | 17.4                                                 |   |
| Reorganization charges, net                                                                                                                                                             |   | —                                 |   | —                                               |   | 1,539.6                                              |   |
| Restructuring charge  (adjustment)                                                                                                                                                      |   | —                                 |   | —                                               |   | (6.8                                                 | )      |
| **Total operating expenses**                                                                                                                                                            |   | 286.7                                  |   | 258.4                                                |   | 1,599.8                                              |   |
| **Operating loss**                                                                                                                                                                      |   | (64.1                                  | )      | (51.2                                                | )      | (1,552.5                                             | )      |
|                                                                                                                                                                                    |   |                                   |   |                                                 |   |                                                 |   |
| Nonoperating (expense) income:                                                                                                                                                          |   |                                   |   |                                                 |   |                                                 |   |
| Interest expense, net of  amounts capitalized (contractual interest was $13.1 million for the period  April 1 to April 16, 2002)                                                        |   | (8.3                                   | )      | (8.2                                                 | )      | (1.8                                                 | )      |
| Other (expense) income                                                                                                                                                                  |   | (0.4                                   | )      | 1.1                                                  |   | (1.0                                                 | )      |
| Gain on cancellation of debt                                                                                                                                                            |   | —                                 |   | —                                               |   | 2,372.8                                              |   |
| **Total nonoperating (expense) income**                                                                                                                                                 |   | (8.7                                   | )      | (7.1                                                 | )      | 2,370.0                                              |   |
| **(Loss) income from continuing operations**                                                                                                                                            |   | (72.8                                  | )      | (58.3                                                | )      | 817.5                                                |   |
|                                                                                                                                                                                    |   |                                   |   |                                                 |   |                                                 |   |
| Discontinued operations:                                                                                                                                                                |   |                                   |   |                                                 |   |                                                 |   |
| Income from discontinued  operations (including net (losses) gains on disposals of ($2.9) and $151.2  for the periods April 17 to June 30 and April 1 to April 16, 2002,  respectively) |   | —                                 |   | 13.0                                                 |   | 152.6                                                |   |
| **Net (loss)****income**                                                                                                                                                                |   | (72.8                                  | )      | (45.3                                                | )      | 970.1                                                |   |
| Preferred stock dividend  (contractual dividends were $0.9 million for the period April 1 to April 16,  2002)                                                                           |   | (1.2                                   | )      | (1.1                                                 | )      | —                                               |   |
| **Net (loss) income applicable to common  shares**                                                                                                                                      |   | $                                      | (74.0  | )                                                    | $      | (46.4                                                | )      | $ | 970.1 |   |
|                                                                                                                                                                                    |   |                                   |   |                                                 |   |                                                 |   |
| Basic and diluted (loss) income  per common share:                                                                                                                                      |   |                                   |   |                                                 |   |                                                 |   |
| (Loss) income from continuing  operations                                                                                                                                               |   | $                                      | (0.27  | )                                                    | $      | (0.22                                                | )      | $ | 1.30 |   |
| Discontinued operations                                                                                                                                                                 |   | —                                 |   | 0.05                                                 |   | 0.25                                                 |   |
| (Loss) income per common share                                                                                                                                                          |   | $                                      | (0.27  | )                                                    | $      | (0.17                                                | )      | $ | 1.55 |   |
| Weighted average common shares  outstanding                                                                                                                                             |   | 276.9                                  |   | 276.3                                                |   | 627.7                                                |   |
|                                                                                                                                                                                         |        |                                        |        |                                                      |        |                                                      |        |  |  |  |  |  |

 

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

 

4

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**McLEODUSAINCORPORATED AND SUBSIDIARIESUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

**ANDCOMPREHENSIVE (LOSS) INCOME**

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

 
|                                                                                                                               |   | **Reorganized****McLeodUSA**         |   | **Reorganized****McLeodUSA**                         |   | **Predecessor  McLeodUSA**                             |   |
|------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------|--------|------------------------------------------------------|--------|--------------------------------------------------------|--------|
|                                                                                                                               |   | **Six  months ended  June 30, 2003** |   | **For the period  April 17, 2002 to  June 30, 2002** |   | **For the period  January 1, 2002 to  April 16, 2002** |   |
|                                                                                                                               |   |                                 |   |                                                 |   |                                                   |   |
| Revenues                                                                                                                           |   | $                                    | 448.5  |                                                 | $      | 207.2                                                  |   | $ | 311.4 |   |
|                                                                                                                               |   |                                 |   |                                                 |   |                                                   |   |
| Operating expenses:                                                                                                                |   |                                 |   |                                                 |   |                                                   |   |
| Cost of service (exclusive of  depreciation shown separately below)                                                                |   | 265.5                                |   | 119.4                                                |   | 211.2                                                  |   |
| Selling, general and  administrative                                                                                               |   | 155.2                                |   | 79.5                                                 |   | 108.9                                                  |   |
| Depreciation and amortization                                                                                                      |   | 167.3                                |   | 59.5                                                 |   | 126.3                                                  |   |
| Reorganization charges, net                                                                                                        |   | —                               |   | —                                               |   | 1,596.8                                                |   |
| Restructuring charge  (adjustment)                                                                                                 |   | —                               |   | —                                               |   | (6.8                                                   | )      |
| **Total  operating expenses**                                                                                                      |   | 588.0                                |   | 258.4                                                |   | 2,036.4                                                |   |
| **Operating loss**                                                                                                                 |   | (139.5                               | )      | (51.2                                                | )      | (1,725.0                                               | )      |
|                                                                                                                               |   |                                 |   |                                                 |   |                                                   |   |
| Nonoperating (expense) income:                                                                                                     |   |                                 |   |                                                 |   |                                                   |   |
| Interest expense, net of  amounts capitalized (contractual interest was $93.6 million for the period  January 1 to April 16, 2002) |   | (17.0                                | )      | (8.2                                                 | )      | (33.2                                                  | )      |
| Other (expense) income                                                                                                             |   | (0.4                                 | )      | 1.1                                                  |   | 2.0                                                    |   |
| Gain on cancellation of debt                                                                                                       |   | —                               |   | —                                               |   | 2,372.8                                                |   |
| **Total  nonoperating (expense) income**                                                                                           |   | (17.4                                | )      | (7.1                                                 | )      | 2,341.6                                                |   |
| **(Loss) income  from continuing operations**                                                                                      |   | (156.9                               | )      | (58.3                                                | )      | 616.6                                                  |   |
| Discontinued operations:                                                                                                           |   |                                 |   |                                                 |   |                                                   |   |
| Income from discontinued  operations (including net gain on disposals of $148.3 for the period January  1 to April 16, 2002)       |   | —                               |   | 13.0                                                 |   | 167.1                                                  |   |
| **Net (loss)  income**                                                                                                             |   | (156.9                               | )      | (45.3                                                | )      | 783.7                                                  |   |
| Preferred stock dividend  (contractual dividends were $8.9 million for the period January 1 to April  16, 2002)                    |   | (2.4                                 | )      | (1.1                                                 | )      | (4.8                                                   | )      |
| **Net (loss)  income applicable to common shares**                                                                                 |   | $                                    | (159.3 | )                                                    | $      | (46.4                                                  | )      | $ | 778.9 |   |
|                                                                                                                               |   |                                 |   |                                                 |   |                                                   |   |
| Basic and diluted (loss) income  per common share:                                                                                 |   |                                 |   |                                                 |   |                                                   |   |
| (Loss) income from continuing  operations                                                                                          |   | $                                    | (0.58  | )                                                    | $      | (0.22                                                  | )      | $ | 0.97 |   |
| Discontinued operations                                                                                                            |   | —                               |   | 0.05                                                 |   | 0.27                                                   |   |
| (Loss) income per common share                                                                                                     |   | $                                    | (0.58  | )                                                    | $      | (0.17                                                  | )      | $ | 1.24 |   |
| Weighted average common shares  outstanding                                                                                        |   | 276.6                                |   | 276.3                                                |   | 627.7                                                  |   |
|                                                                                                                               |   |                                 |   |                                                 |   |                                                   |   |
| Other comprehensive income, net  of tax:                                                                                           |   |                                 |   |                                                 |   |                                                   |   |
| Unrealized holding losses  arising during the period                                                                               |   | $                                    | — |                                                 | $      | —                                                 |   | $ | (2.1 | ) |
| Less:  reclassification adjustment for gains included in net income                                                           |   | —                               |   | —                                               |   | 3.2                                                    |   |
| **Total other  comprehensive income**                                                                                              |   | —                               |   | —                                               |   | 1.1                                                    |   |
| **Comprehensive  (loss) income**                                                                                                   |   | $                                    | (156.9 | )                                                    | $      | (45.3                                                  | )      | $ | 784.8 |   |

 

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

 

5

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**McLEODUSAINCORPORATED AND SUBSIDIARIESUNAUDITED CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(In millions)**

 
|                                                                                  |   | **Reorganized  McLeodUSA**           |       | **Reorganized  McLeodUSA**                           |       | **Predecessor  McLeodUSA**                             |       |
|---------------------------------------------------------------------------------------|--------|--------------------------------------|------------|------------------------------------------------------|------------|--------------------------------------------------------|------------|
|                                                                                  |   | **Six  months ended  June 30, 2003** |       | **For the period  April 17, 2002 to  June 30, 2002** |       | **For the period  January 1, 2002  to April 16, 2002** |       |
|                                                                                  |   |                                 | ** ** |                                                 | ** ** |                                                   | ** ** |
| **Cash Flows from Operating Activities**                                              |   |                                 |       |                                                 |       |                                                   |       |
| Net (loss) income from  continuing operations                                         |   | $                                    | (156.9     | )                                                    | $          | (58.3                                                  | )          | $ | 616.6 |   |
| Adjustments to reconcile net  (loss) income to net cash used in operating activities: |   |                                 |       |                                                 |       |                                                   |       |
| Depreciation                                                                          |   | 134.2                                |       | 47.5                                                 |       | 108.6                                                  |       |
| Amortization                                                                          |   | 33.1                                 |       | 12.0                                                 |       | 17.7                                                   |       |
| Accretion of interest                                                                 |   | 1.8                                  |       | 0.7                                                  |       | 4.1                                                    |       |
| Loss (gain) on sale of assets                                                         |   | —                               |       | 1.2                                                  |       | (6.4                                                   | )          |
| Non cash reorganization items                                                         |   | —                               |       | —                                               |       | 1,538.4                                                |       |
| Gain on cancellation of debt                                                          |   | —                               |       | —                                               |       | (2,372.8                                               | )          |
| Restructuring charge  (adjustment)                                                    |   | —                               |       | —                                               |       | (6.8                                                   | )          |
| Changes in assets and  liabilities, net of dispositions:                              |   |                                 |       |                                                 |       |                                                   |       |
| Trade receivables                                                                     |   | 1.6                                  |       | 10.3                                                 |       | 14.3                                                   |       |
| Prepaid expenses and other                                                            |   | 7.7                                  |       | (12.9                                                | )          | 10.2                                                   |       |
| Accounts payable and accrued  expenses                                                |   | (48.8                                | )          | (26.9                                                | )          | (43.3                                                  | )          |
| Deferred revenue                                                                      |   | (1.6                                 | )          | (4.8                                                 | )          | 1.1                                                    |       |
| **Net cash used in operating activities**                                             |   | (28.9                                | )          | (31.2                                                | )          | (118.3                                                 | )          |
|                                                                                  |   |                                 |       |                                                 |       |                                                   |       |
| **Cash Flows from Investing Activities**                                              |   |                                 |       |                                                 |       |                                                   |       |
| Purchases of property and  equipment                                                  |   | (36.9                                | )          | (19.8                                                | )          | (37.2                                                  | )          |
| Other assets                                                                          |   | (21.3                                | )          | (12.8                                                | )          | (16.5                                                  | )          |
| Sale of available for sale  securities                                                |   | —                               |       | —                                               |       | 2.0                                                    |       |
| Proceeds from the sale of  assets                                                     |   | 1.6                                  |       | 4.7                                                  |       | 19.1                                                   |       |
| Proceeds from the sale of  businesses                                                 |   | —                               |       | —                                               |       | 679.7                                                  |       |
| Other                                                                                 |   | —                               |       | (0.4                                                 | )          | —                                                 |       |
| **Net cash (used in) provided by investing  activities**                              |   | (56.6                                | )          | (28.3                                                | )          | 647.1                                                  |       |
|                                                                                  |   |                                 |       |                                                 |       |                                                   |       |
| **Cash Flows from Financing Activities**                                              |   |                                 |       |                                                 |       |                                                   |       |
| Payments on long-term debt                                                            |   | (2.1                                 | )          | (2.1                                                 | )          | (734.3                                                 | )          |
| Investment by Forstmann Little                                                        |   | —                               |       | —                                               |       | 175.0                                                  |       |
| **Net cash used in financing activities**                                             |   | (2.1                                 | )          | (2.1                                                 | )          | (559.3                                                 | )          |
|                                                                                  |   |                                 |       |                                                 |       |                                                   |       |
| **Net decrease in cash and cash equivalents  from continuing operations**             |   | (87.6                                | )          | (61.6                                                | )          | (30.5                                                  | )          |
|                                                                                  |   |                                 |       |                                                 |       |                                                   |       |
| **Net cash provided by discontinued  operations**                                     |   | —                               |       | 1.6                                                  |       | 31.6                                                   |       |
|                                                                                  |   |                                 |       |                                                 |       |                                                   |       |
| **Cash and cash equivalents**                                                         |   |                                 |       |                                                 |       |                                                   |       |
| Beginning                                                                             |   | 170.6                                |       | 138.2                                                |       | 137.1                                                  |       |
| Ending                                                                                |   | $                                    | 83.0       |                                                 | $          | 78.2                                                   |       | $ | 138.2 |   |
|                                                                                  |   |                                 |       |                                                 |       |                                                   |       |
| **Supplemental Disclosure of Cash Flow  Information**                                 |   |                                 |       |                                                 |       |                                                   |       |
| Cash payments for interest                                                            |   | $                                    | 20.3       |                                                 | $          | 12.8                                                   |       | $ | 16.2 |   |
|                                                                                  |   |                                 |       |                                                 |       |                                                   |       |
| **Supplemental Schedule of Noncash Investing  and Financing Activities**              |   |                                 |       |                                                 |       |                                                   |       |
| Preferred stock dividends                                                             |   | $                                    | 2.4        |                                                 | $          | 1.1                                                    |       | $ | 4.8 |   |
|                                                                                       |        |                                      |            |                                                      |            |                                                        |            |  |  |  |  |

 

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

 

6

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

 

McLeodUSA Incorporated(“McLeodUSA”), a Delaware corporation, through its subsidiaries, providesintegrated communications services, including local services, primarily in 25Midwest, Southwest, Northwest and Rocky Mountain states.  McLeodUSA’s business is highly competitiveand is subject to various federal, state and local regulations.

 

On January 31, 2002, McLeodUSAIncorporated, the parent company, filed a voluntary petition for relief underChapter 11 of the United States Bankruptcy Code in the United States BankruptcyCourt for the District of Delaware (the “Bankruptcy Court”).  On April 16, 2002, McLeodUSA Incorporatedemerged from the Bankruptcy Court proceedings pursuant to the terms of itsamended plan of reorganization (the “Plan”). The Plan was filed with the Bankruptcy Court on February 28, 2002 andwas confirmed on April 5, 2002.

 

During the period from January31, 2002 to April 16, 2002, McLeodUSA operated as a debtor-in-possession.   The unaudited condensed consolidatedfinancial statements during the period from January 31, 2002 to April 16, 2002,have been prepared in accordance with the provisions of Statement of Position90-7, *FinancialReporting by Entities in Reorganization Under the Bankruptcy Code*(“SOP 90-7”).  McLeodUSA adopted the provisions of SOP 90-7 upon commencement of theBankruptcy Court proceedings. The unaudited condensed consolidated statementsof operations for the periods January 1, 2002 to April 16, 2002 and April 1,2002 to April 16, 2002 separately disclose expenses related to the Chapter 11proceedings as reorganization charges. Interest expense on all of theoutstanding senior notes and the preferred stock dividends on the Series APreferred Stock ceased to accrue after filing by McLeodUSA on January 31, 2002.Interest and dividends ceased by operation of law.  See Note 3 for further discussion of the emergence frombankruptcy.

 

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

 

For the periods January 1, 2002to April 16, 2002, April 1, 2002 to April 16, 2002 and April 17, 2002 to June30, 2002, the operating results of businesses held for sale have been reportedas discontinued operations in the McLeodUSA Unaudited Condensed ConsolidatedStatements of Operations in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 144 *Accounting for the Impairment or Disposal ofLong-Lived Assets* (“SFAS 144”). Assets held for sale and liabilities related to discontinued operationshave been presented separately in the asset and liabilities sections of thecondensed consolidated balance sheets. See Note 2 for further discussion of discontinued operations.

 

**Interim Financial Information (unaudited)**

In the opinion of management,the accompanying unaudited condensed consolidated financial statements includeall adjustments, consisting of normal recurring adjustments, necessary for afair presentation of the financial position and results of operations ofMcLeodUSA.  The operating results forthe interim periods are not necessarily indicative of the operating results tobe expected for a full year or for other interim periods.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America(“GAAP”) have been condensed or omitted pursuant to instructions, rules andregulations prescribed by the Securities and Exchange Commission (“SEC”).  Although management believes that the disclosuresprovided are adequate to make the information presented not misleading,management recommends that you read these unaudited condensed consolidatedfinancial statements in conjunction with the audited consolidated financialstatements and the related footnotes included in the McLeodUSA Annual Report onForm 10-K/A for the fiscal year ended December 31, 2002, filed with theSEC on April 10, 2003.

 

**Accountingfor Stock-based Compensation**

Aspermitted by SFAS No. 123, *Accounting for Stock-Based Compensation*(‘‘SFAS123’’), McLeodUSA measures compensation using the intrinsic value based methodas prescribed by Accounting Principles Board Opinion No. 25, *Accountingfor Stock Issued to Employees,*but is required to make proformadisclosures in the footnotes to the financial statements as if the measurementprovisions of SFAS 123 and SFAS No. 148 *Accounting for Stock-Based Compensation-Transitionand Disclosure — an Amendment of SFAS 123*had been adopted. Underthe intrinsic value method,

 

7

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compensationis measured as the difference between the market value of the stock on thegrant date, less the amount required to be paid for the stock. The difference,if any, is charged to expense over the vesting period of the options. Nostock-based employee compensation cost is reflected in net loss, as all optionsgranted under the plan had an exercise price greater than or equal to themarket value of the underlying common stock on the date of grant. The followingtable illustrates the effect on net loss and net loss per share for the threeand six months ended June 30, 2003, and for the period April 17, 2002 to June30, 2002 as if McLeodUSA had applied the fair value recognition provisions ofSFAS 123 to stock-based employee compensation. During the period January 1, 2002 to April 16, 2002, there were optionsoutstanding under Predecessor McLeodUSA option plans.  No pro forma information has been presented below for 2002 underPredecessor McLeodUSA option plans because those option plans were terminatedupon the confirmation of the Plan on April 5, 2002.

 

 
|                                                                                                    |   | **Reorganized  McLeodUSA**              |   | **Reorganized  McLeodUSA**           |   | **Reorganized  McLeodUSA**             |   |
|---------------------------------------------------------------------------------------------------------|--------|-----------------------------------------|--------|--------------------------------------|--------|----------------------------------------|--------|
|                                                                                                    |   | **Three  months  ended  June 30, 2003** |   | **Six months  ended  June 30, 2003** |   | **April 17,  2002  to  June 30, 2002** |   |
| Net loss applicable to common shares, as  reported                                                      |   | $                                       | (74.0  | )                                    | $      | (159.3                                 | )      | $ | (46.4 | ) |
| Less:   total stock-based employee compensation expense determined under fair  value based methods |   | (2.1                                    | )      | (4.4                                 | )      | (8.8                                   | )      |
| Pro forma net loss applicable to common  shares                                                         |   | $                                       | (76.1  | )                                    | $      | (163.7                                 | )      | $ | (55.2 | ) |
|                                                                                                    |   |                                    |   |                                 |   |                                   |   |
| **Loss per share:**                                                                                     |   |                                    |   |                                 |   |                                   |   |
| Basic and diluted, as reported                                                                          |   | $                                       | (0.27  | )                                    | $      | (0.58                                  | )      | $ | (0.17 | ) |
| Basic and diluted, pro forma                                                                            |   | $                                       | (0.27  | )                                    | $      | (0.59                                  | )      | $ | (0.20 | ) |

** **

**Basic and diluted loss per common share**

Loss percommon share has been computed using the weighted average number of shares ofcommon stock outstanding.  All stockoptions granted, and the convertible preferred stock and warrants outstandingare anti-dilutive, and are therefore excluded from the computation of earningsper share. In the future, the stock options, convertible preferred stock andwarrants may become dilutive.  Assumingexercise or conversion of stock options and convertible securities, dilutedshares would have been approximately 422****million at June 30, 2003.

 

**Guarantees**

In November 2002, the FinancialAccounting Standards Board (“FASB”) issued FASB Interpretation No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*.  This interpretation clarifies disclosures that are required to bemade by a guarantor in its interim and annual financial statements aboutobligations under certain of its issued guarantees. In addition, theinterpretation clarifies that a guarantor is required to recognize, at theinception of certain types of guarantees, a liability for the fair value of theobligation undertaken in issuing these guarantees. The recognition andmeasurement provisions of this interpretation are applicable to guaranteesissued or modified after December 31, 2002, and the disclosure requirementsbecame effective as of December 31, 2002. At June 30, 2003, McLeodUSA, theparent company, has various guarantees related to subsidiary commitments underoperating leases.  As of June 30, 2003the guarantees total $29.2 million and expire over various periods throughSeptember 2016, corresponding with the termination of the lease agreements.

 

**Note 2:  Assets Held For Sale**

 

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

 

Also in 2001, McLeodUSAinitiated a financial restructuring to substantially reduce its outstandingdebt.  As part of the financialrestructuring, McLeodUSA and its senior secured lenders agreed to amendMcLeodUSA’s Credit Agreement dated May 31, 2002 (the “Credit Agreement”) topermit the financial restructuring.  Thekey elements of the financial

 

8

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restructuring included, amongother things (1) the sale of McLeodUSA Media Group Inc. and its subsidiaries(“Pubco”) and the use of the proceeds therefrom to make a payment to holders ofall of its outstanding notes (including its10 1/2 % Senior Discount Notes, 9 1/4 % Senior Notes, 8 3/8 %Senior Notes, 9 1/2 % Senior Notes, 8 1/8% Senior Notes, 12% SeniorNotes, 11 1/2 % Senior Notes and 11 3/8 % Senior Notes (collectively,the “Notes”)), and (2) the sale of McLeodUSA’s Illinois independentlocal exchange carrier (“ICTC”) upon completion of the restructuring and use ofthe first $225 million of net proceeds to prepay the term loans under theCredit Agreement.

 

For the periods April 17, 2002to June 30, 2002, April 1, 2002 to April 16, 2002 and January 1, 2002 to April16, 2002, the operating results of the businesses listed below have beenreported as discontinued operations in the McLeodUSA Unaudited CondensedConsolidated Financial Statements in accordance with SFAS 144.  At December 31, 2002, all of the businesseshad been sold.  The remaining assetsheld for sale totaling $10.4 million are comprised of real estate and an equityinterest in a partnership.  Theliabilities related to discontinued operations represent unpaid selling costs.

 

For the periods January 1, 2002to April 16, 2002, April 1, 2002 to April 16, 2002 and April 17, 2002 to June30, 2002, the amount of revenue and net income (including gains or losses onthe sales) attributable to discontinued operations and the assets held for salewere as follows (in millions):

 
|             |   | **Reorganized****McLeodUSA**         |   | **Predecessor****McLeodUSA**         |   | **Predecessor****McLeodUSA**           |   |
|------------------|--------|--------------------------------------|--------|--------------------------------------|--------|----------------------------------------|--------|
|             |   | **April 17, 2002 to  June 30, 2002** |   | **April 1, 2002 to  April 16, 2002** |   | **January 1, 2002 to  April 16, 2002** |   |
| **Revenues:**    |   |                                 |   |                                 |   |                                   |   |
| IBS              |   | $                                    | — |                                 | $      | —                                 |   | $ | 1.2 |   |
| CapRock Services |   | —                               |   | 0.6                                  |   | 8.8                                    |   |
| Pubco            |   | —                               |   | 18.0                                 |   | 94.3                                   |   |
| DTG              |   | 8.7                                  |   | 1.6                                  |   | 12.0                                   |   |
| Greene County    |   | 1.5                                  |   | 0.3                                  |   | 2.3                                    |   |
| ICTC             |   | 22.8                                 |   | 4.9                                  |   | 31.7                                   |   |
|             |   | $                                    | 33.0   |                                 | $      | 25.4                                   |   | $ | 150.3 |   |

 

 
|                   |   | **Reorganized****McLeodUSA**         |   | **Predecessor****McLeodUSA**         |   | **Predecessor****McLeodUSA**           |   |
|------------------------|--------|--------------------------------------|--------|--------------------------------------|--------|----------------------------------------|--------|
|                   |   | **April 17, 2002 to  June 30, 2002** |   | **April 1, 2002 to  April 16, 2002** |   | **January 1, 2002 to  April 16, 2002** |   |
| **Net income (loss):** |   |                                 |   |                                 |   |                                   |   |
| IBS                    |   | $                                    | (0.5   | )                                    | $      | 1.1                                    |   | $ | 1.0 |   |
| CapRock Services       |   | (0.1                                 | )      | 7.6                                  |   | 8.3                                    |   |
| Pubco                  |   | —                               |   | 143.4                                |   | 150.0                                  |   |
| DTG                    |   | 4.0                                  |   | (0.4                                 | )      | (0.4                                   | )      |
| Greene County          |   | 0.3                                  |   | —                               |   | 0.2                                    |   |
| ICTC                   |   | 9.3                                  |   | 0.9                                  |   | 8.0                                    |   |
|                   |   | $                                    | 13.0   |                                 | $      | 152.6                                  |   | $ | 167.1 |   |

 

9

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**Note3:   Emergence from Chapter 11 Proceedings**

 

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

 

•                  The eliminationof approximately $3 billion of indebtedness, including accrued interest,represented by the Notes;

 

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

 

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

 

•                  The investmentby two funds affiliated with Forstmann Little & Co. of $175 million inexchange for (1) 74,027,764 shares of Reorganized McLeodUSA Class A CommonStock, (2) 5-year warrants to purchase 22,159,091 shares of ReorganizedMcLeodUSA Class A Common Stock for $30 million and (3) 10 shares of ReorganizedMcLeodUSA Series B Preferred Stock;

 

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

 

•                  The conversionof the Predecessor McLeodUSA Series A Preferred Stock into 33,696,559 shares ofReorganized McLeodUSA Class A Common Stock.

 

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

 

10

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The condensedfinancial information for the predecessor parent company, McLeodUSAIncorporated, for the periods April 1, 2002 to April 16, 2002 and January 1,2002 to April 16, 2002 is as follows (in millions):

 
|                                          |   | **Predecessor****McLeodUSA**         |   |
|-----------------------------------------------|--------|--------------------------------------|--------|
|                                          |   | **April 1, 2002 to  April 16, 2002** |   | **January 1, 2002  to April 16, 2002** |   |
| Operating expenses:                           |   |                                 |   |   |   |
| Selling, general and  administrative          |   | $                                    | 2.9    |   | $ | 8.7 |   |
| Depreciation and amortization                 |   | 0.4                                  |   | 5.1 |   |
| Reorganization charges, net                   |   | 1,539.6                              |   | 1,596.8 |   |
| Restructuring charge  (adjustment)            |   | (6.8                                 | )      | (6.8 | ) |
| Total operating expenses                      |   | 1,536.1                              |   | 1,603.8 |   |
|                                          |   |                                 |   |   |   |
| Nonoperating income:                          |   |                                 |   |   |   |
| Interest expense, net of  amounts capitalized |   | (1.7                                 | )      | (33.0 | ) |
| Gain on cancellation of debt                  |   | 2,372.8                              |   | 2,372.8 |   |
| Other income                                  |   | 0.4                                  |   | 0.4 |   |
| Equity in net losses of  subsidiaries         |   | (17.9                                | )      | (119.8 | ) |
| Total nonoperating income                     |   | 2,353.6                              |   | 2,220.4 |   |
| Income from continuing  operations            |   | 817.5                                |   | 616.6 |   |
| Income from discontinued operations           |   | 152.6                                |   | 167.1 |   |
| Net income                                    |   | 970.1                                |   | 783.7 |   |
| Preferred stock dividend                      |   | —                               |   | (4.8 | ) |
| Net income applicable to common  shares       |   | $                                    | 970.1  |   | $ | 778.9 |   |

 

Contractualinterest was $13.1 million and $93.6 million for the periods April 1, 2002 toApril 16, 2002 and January 1, 2002 to April 16, 2002, respectively.  Contractual dividends were $0.9 million and$8.9 million for the periods April 1, 2002 to April 16, 2002 and January 1,2002 to April 16, 2002, respectively.

 

11

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|                                                                           |   | **Predecessor****McLeodUSA**         |       |
|--------------------------------------------------------------------------------|--------|--------------------------------------|------------|
|                                                                           |   | **April 1, 2002 to  April 16, 2002** |       | **January 1, 2002  to April 16, 2002** |   |
|                                                                           |   |                                 | ** ** |   | ** ** |
| **Cash Flows from Operating Activities**                                       |   |                                 |       |   |   |
| Net income from continuing operations                                          |   | $                                    | 817.5      |   | $ | 616.6 |   |
| Adjustments to reconcile net  income to net cash used in operating activities: |   |                                 |       |   |   |
| Depreciation and amortization                                                  |   | 0.4                                  |       | 5.1 |   |
| Accretion of interest                                                          |   | —                               |       | 4.1 |   |
| Noncash reorganization items                                                   |   | 1,485.1                              |       | 1,538.4 |   |
| Gain on cancellation of debt                                                   |   | (2,372.8                             | )          | (2,372.8 | ) |
| Restructuring charge (adjustment)                                              |   | (6.8                                 | )          | (6.8 | ) |
| Gain on sale of assets                                                         |   | (0.4                                 | )          | (0.4 | ) |
| Equity in losses of  subsidiaries                                              |   | 17.9                                 |       | 119.8 |   |
| Changes in assets and  liabilities, net of dispositions:                       |   |                                 |       |   |   |
| Prepaid and other assets                                                       |   | 0.7                                  |       | 6.5 |   |
| Accounts payable and accrued  expenses                                         |   | (0.4                                 | )          | 8.3 |   |
| Intercompany receivables                                                       |   | 22.1                                 |       | (73.5 | ) |
| **Net cash used in operating activities**                                      |   | (36.7                                | )          | (154.7 | ) |
|                                                                           |   |                                 |       |   |   |
| **Cash Flows from Investing Activities**                                       |   |                                 |       |   |   |
| Purchases of property and  equipment                                           |   | (0.6                                 | )          | (0.6 | ) |
| Proceeds from the sale of  businesses and assets                               |   | 622.1                                |       | 679.7 |   |
| **Net cash provided by investing activities**                                  |   | 621.5                                |       | 679.1 |   |
|                                                                           |   |                                 |       |   |   |
| **Cash Flows from Financing Activities**                                       |   |                                 |       |   |   |
| Proceeds from Forstmann Little  investment                                     |   | 175.0                                |       | 175.0 |   |
| Payments on long-term debt                                                     |   | (730.0                               | )          | (730.0 | ) |
| **Net cash used in financing activities**                                      |   | (555.0                               | )          | (555.0 | ) |
|                                                                           |   |                                 |       |   |   |
| **Net increase in cash and cash equivalents  from continuing operations**      |   | 29.8                                 |       | (30.6 | ) |
|                                                                           |   |                                 |       |   |   |
| **Net cash provided by (used in) discontinued  operations**                    |   | (6.1                                 | )          | 31.6 |   |
|                                                                           |   |                                 |       |   |   |
| **Cash and cash equivalents**                                                  |   |                                 |       |   |   |
| Beginning                                                                      |   | 97.5                                 |       | 120.2 |   |
| Ending                                                                         |   | $                                    | 121.2      |   | $ | 121.2 |   |

 

*Reorganization charges, net:*  Reorganization charges, net, are comprisedof items incurred by McLeodUSA as a result of reorganization under Chapter 11of the Bankruptcy Code.  Charges for theperiods April 1, 2002 to April 16, 2002 and January 1, 2002 to April 16, 2002consist of the following (in millions):

 
|                                             |   | **Predecessor  McLeodUSA**            |    |
|--------------------------------------------------|--------|---------------------------------------|---------|
|                                             |   | **April 1,  2002 to  April 16, 2002** |    | **January 1,  2002  to April 16, 2002** |   |
| Professional fees                                |   | $                                     | 53.6    |   | $ | 57.5 |   |
| Severance                                        |   | 0.9                                   |    | 0.9 |   |
| Write-off deferred financing fees and  discounts |   | —                                |    | 53.3 |   |
| Fresh-start adjustments to fair value            |   | 1,485.1                               |    | 1,485.1 |   |
|                                             |   | $                                     | 1,539.6 |   | $ | 1,596.8 |   |

 

12

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**Note 4: Trade Receivables**

 

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

 
|                                           |   | **June 30,  2003** |   | **December  31,  2002** |   |
|------------------------------------------------|--------|--------------------|--------|-------------------------|--------|
| Trade Receivables:                             |   |               |   |                    |   |
| Billed                                         |   | $                  | 114.8  |                    | $      | 137.6 |   |
| Unbilled                                       |   | 7.8                |   | 11.2                    |   |
|                                           |   | 122.6              |   | 148.8                   |   |
| Allowance for doubtful accounts and  discounts |   | (40.4              | )      | (55.7                   | )      |
|                                           |   | $                  | 82.2   |                    | $      | 93.1 |   |

 

**Note 5:  Other Accrued Liabilities**

 

Other accrued liabilitiesconsisted of the following (in millions):

 
|                           |   | **June 30,  2003** |   | **December  31,  2002** |   |
|--------------------------------|--------|--------------------|--------|-------------------------|--------|
| Restructuring                  |   | $                  | 44.1   |                    | $      | 61.2 |   |
| Accrued Sales/Use/Excise Taxes |   | 12.0               |   | 18.3                    |   |
| Accrued Property Taxes         |   | 15.6               |   | 15.8                    |   |
| Other                          |   | 50.8               |   | 57.5                    |   |
|                           |   | $                  | 122.5  |                    | $      | 152.8 |   |

 

**Note 6:  Restructuring Charges**

 

Changes in the carrying amountof the restructuring liability for the six months ended June 30, 2003 issummarized as follows (in millions):

 
|                          |   | **Liability at  December 31,  2002** |   | **Cash Payments  Through  June 30,  2003** |   | **Adjustments  Through  June 30,  2003** |   | **Remaining  Liability  June 30,  2003** |   |
|-------------------------------|--------|--------------------------------------|--------|--------------------------------------------|--------|------------------------------------------|--------|------------------------------------------|--------|
| Employee separations          |   | $                                    | 0.6    |                                       | $      | 0.7                                      |   | $                                        | 0.3    |   | $ | 0.2 |   |
| Facility closure costs        |   | 58.8                                 |   | 15.9                                       |   | (0.1                                     | )      | 42.8                                     |   |
| Other contractual commitments |   | 1.8                                  |   | 0.5                                        |   | (0.2                                     | )      | 1.1                                      |   |
|                          |   | $                                    | 61.2   |                                       | $      | 17.1                                     |   | $                                        | — |   | $ | 44.1 |   |

 

**Note 7: Goodwill and Other Intangible Assets**

 

On January 1, 2002, McLeodUSAadopted SFAS 142, *Accounting for Goodwill and Other Intangible Assets* (“SFAS142”).  SFAS 142 requires the use of anon-amortization approach to account for purchased goodwill and for separatelyrecognized (non-goodwill) intangible assets that have an indefinite usefullife.  Under this approach, goodwill andintangibles with indefinite lives are not amortized but are reviewed at leastannually for impairment.  Intangibleassets that do have finite lives will continue to be amortized over theirestimated useful lives.  As permitted bySFAS 142, McLeodUSA performed the transitional impairment tests on goodwill bycomparing the fair values of its reportable units containing goodwill balancesto their carrying values in the second quarter of 2002.  McLeodUSA will perform its 2003 annualimpairment tests during the third quarter.

 

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Changes in the carrying amountof goodwill for the six months ended June 30, 2003 are summarized as follows(in millions):

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

 

 

Intangible assets with finitelives at June 30, 2003 are summarized as follows (in millions):

 
|                              |   | **Gross** |   | **Accumulated  Amortization** |   | **Net** |   |
|-----------------------------------|--------|-----------|--------|-------------------------------|--------|---------|--------|
|                              |   |      |   |                          |   |    |   |
| Deferred line installation  costs |   | $         | 178.9  |                          | $      | 66.5    |   | $ | 112.4 |   |
| Customer base                     |   | 29.8      |   | 8.3                           |   | 21.5    |   |
|                              |   | $         | 208.7  |                          | $      | 74.8    |   | $ | 133.9 |   |

 

In connection with our adoptionof fresh-start reporting, independent appraisers valued the intangibleassets.  McLeodUSA’s customer base wasvalued at $24.0 million with a remaining life of five years.  Also included in the customer base is acustomer contract, valued at $5.8 million, and assigned a remaining life of 33months.  The trademarks McLeodUSA andPrimeLine were assigned a value collectively of $83.8 million.  The trademarks were determined to haveindefinite lives and are not being amortized.

 

**Note 8: Accounting for Asset Retirement Obligations**

 

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

 

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

 

•                  Central OfficeColocation Equipment:  McLeodUSAutilizes space within regional bell operating companies’ (“RBOCs”) centraloffices in which it has deployed a substantial number of assets.  Termination of business in those marketswould require removal of the equipment and restoration of the central office toits original state.

 

•                  TechnicalSites:  McLeodUSA leases space innumerous technical sites throughout its market area in which it deployssignificant assets. Termination of the lease or business in those markets wouldrequire the removal of those assets and restoration of the leased space to itsoriginal state.

 

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

 

Changes in the carrying amountof the asset retirement obligation for the six months ended June 30, 2003 issummarized as follows (in millions):

 
| Balance, December 31, 2002 |   | $   | 54.9   |   |
|----------------------------|--------|-----|--------|--------|
| Interest accretion         |   | 1.8 |   |
| Balance, June 30, 2003     |   | $   | 56.7   |   |

 

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**Note 9:  Litigation**

 

On December7, 2000, McLeodUSA acquired CapRock Communications Corp. (‘‘CapRock’’) pursuantto an Agreement and Plan of Merger, dated October 2, 2000, in exchange forapproximately 15.0 million shares of Class A Common Stock.  Several class action complaints have beenfiled in the United States District Court for the Northern District of Texas onbehalf of all purchasers of CapRock common stock during the period April 28,2000 through July 6, 2000.  The lawsuitsprincipally allege that, prior to its merger with McLeodUSA, CapRock madematerial misstatements or omissions of fact in violation of Section 10(b) ofthe Securities Exchange Act. Consolidated with these claims are allegations that CapRock’s June 2000registration statement for a public offering of common stock containedmaterially false and misleading statements and omitted certain materialinformation about CapRock in violation of Section 11 of the SecuritiesAct.  The named defendants in theselawsuits include CapRock and certain of its officers and directors. On July 7,2003, the parties executed a Memorandum of Understanding (“MOU”) by which theparties agreed to settle the action for a cash payment of $11 million whichwould be covered by a combination of insurance and a rebate of previously paidinsurance premiums.  The settlementcontemplated by the MOU is conditioned upon satisfactory confirmatory discoveryregarding the fairness of the settlement, execution of a definitive settlementagreement, and final court approval.

 

FormerChairman Clark E. McLeod, President Stephen C. Gray (then also Chief ExecutiveOfficer), Chairman and Chief Executive Officer Chris A. Davis (then ChiefOperating and Financial Officer) and former Chief Financial and AccountingOfficer J. Lyle Patrick (the ‘‘Individual Defendants’’) are defendants in anumber of putative class action complaints that have been consolidated into asingle complaint entitled In Re McLeodUSA Incorporated Securities Litigation,Civil Action No. C02-0001 (E.D. Iowa) (the ‘‘Iowa Class Action’’).  The Individual Defendants have filed amotion to dismiss the amended consolidated complaint in the Iowa ClassAction.  McLeodUSA has indemnificationobligations running to the Individual Defendants.  One of the putative class plaintiffs, New Millenium Growth FundLLC, also filed proofs of claim against McLeodUSA in McLeodUSA’s Chapter 11Case for at least $104,650 on its own behalf and for no less than approximately$300 million (plus interest, costs and attorney’s fees as allowed) on behalf ofall class claimants in the Iowa Class Action (the ‘‘Bankruptcy Claims’’ and,together with the Iowa Class Action, the ‘‘Securities Claims’’).  As the Securities Claims are in earlystages, it is impossible to evaluate the likelihood of unfavorable outcomes or,with respect to the Iowa Class Action, to estimate the amount or range ofpotential loss, if any, to McLeodUSA. With respect to the Bankruptcy Claims, onMay 2, 2002 the Bankruptcy Court issued an order establishing a disputed claimsreserve of 18,000,000 shares of Reorganized McLeodUSA Class A CommonStock.  Any recovery from the BankruptcyClaims would be limited to those shares of stock. McLeodUSA believes that theSecurities Claims are without merit and intends to defend them vigorously.

 

McLeodUSAis also involved in numerous regulatory proceedings before various publicutility commissions and the FCC, particularly in connection with actions by theRBOCs.  McLeodUSA anticipates the RBOCswill continue to pursue litigation, regulations and legislation in states withinMcLeodUSA’s 25-state footprint and before the FCC to reduce regulatoryoversight and regulation over their rates and operations.  The RBOCs are also actively pursuing majorchanges in the Telecommunications Act of 1996, by regulatory litigation and legislation,which McLeodUSA believes would adversely affect competitive telecommunicationsservice providers including McLeodUSA. If adopted, these initiatives could make it more difficult for McLeodUSAto challenge the RBOCs’ actions, or to compete with the RBOCs, in thefuture.  There are no assurances thatMcLeodUSA will prevail in its disputes with the RBOCs.  On May 9, 2003, legislation was enacted inIllinois that changes the methodology to be applied by the Illinois CommerceCommission in setting rates to be charged by incumbent local exchange carriersfor unbundled local loops.  On July 2,2003, the United States District Court for the Northern District of Illinoisentered a permanent injunction against enforcement of this legislation.  That decision is currently on appeal to the7th Circuit Court of Appeals.  McLeodUSAcan make no assurances as to the final outcome of this litigation or ultimatestatus of the legislation.

 

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

 

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**Note10:  Effects of New Accounting Standards**

 

In May 2003, the FASB issuedSFAS No. 150, *Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity (“SFAS 150”)*.  SFAS 150 establishes standards for how companies classify andmeasure certain financial instruments with characteristics of both liabilitiesand equity. The statement requires companies to classify a financial instrumentthat is within its scope as a liability (or an asset in some circumstances).SFAS 150 is effective for McLeodUSA beginning with the third quarter of 2003.  McLeodUSA does not believe the adoption ofSFAS 150 will have an impact on its consolidated financial statements.

 

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**Item 2****.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

The following discussion andanalysis provides information concerning the results of operations and ourfinancial condition and should be read in conjunction with the accompanyingunaudited condensed consolidated financial statements and notes thereto.  Additionally, the following discussion andanalysis should be read in conjunction with our audited consolidated financialstatements included in our Annual Report on Form 10-K/A for the year endedDecember 31, 2002.

 

Some of the statements in thisdiscussion include statements about our future expectations.  Statements that are not historical facts are“forward-looking statements” for the purpose of the safe harbor provided bySection 21E of the Exchange Act and Section 27A of the Securities Act.  Such statements may include projections offinancial and operational results and goals, revenue, profitability, savingsand cash.  These forward-lookingstatements are subject to known as well as unknown risks and uncertainties thatmay cause actual results to differ materially from our expectations.  Our expectations are based on variousfactors and assumptions and reflect only our predictions.  Factors that could cause actual results todiffer materially from the forward-looking statements 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 mostrecent Annual Report on Form 10-K and Form 10-K/A both filed with the SEC.  The Company undertakes no obligation toupdate publicly any forward-looking statements, whether as a result of futureevents, new information or otherwise.

 

**Overview**

 

McLeodUSA provides integratedcommunications services, including local services, in 25 Midwest, Southwest,Northwest and Rocky Mountain states. The Company is a facilities-based telecommunications provider with, asof June 30, 2003, 38 ATM switches, 45 voice switches, 584 collocations, 435DSLAMs and 3,710 employees.  As of April16, 2002, Forstmann Little & Co. became a 58% shareholder in the Company.

 

We deriveour revenue from our core competitive telecommunications and relatedcommunications services.  These servicesinclude local and long-distance services; dial-up Internet access services;high-speed/broadband Internet access services such as services using DSL, cablemodems and dedicated T1 access; bandwidth and network facilities leasing, salesand services, including access services; facilities and services dedicated fora particular customer’s use; advanced communication services for largerbusinesses such as frame relay, private line, and ISDN; and value-addedservices such as virtual private networks and web hosting.

 

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

 

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

 

We areinvolved in numerous regulatory proceedings before various public utilitycommissions and the FCC, particularly in connection with actions by theRBOCs.  We anticipate the RBOCs willcontinue to

 

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pursuelitigation, regulations and legislation in states within our 25-state footprintand before the FCC to reduce regulatory oversight and regulation over theirrates and operations.  The RBOCs arealso actively pursuing major changes in the Telecommunications Act of 1996, byregulatory litigation and legislation, which we believe would adversely affectcompetitive telecommunications service providers.  If adopted, these initiatives could make it more difficult for usto challenge the RBOCs’ actions, or to compete with the RBOCs, inthe future.  There are no assurancesthat we will prevail in our disputes with the RBOCs.  On May 9, 2003, legislation was enacted in Illinois that changesthe methodology to be applied by the Illinois Commerce Commission in settingrates to be charged by incumbent local exchange carriers for unbundled localloops.   On July 2, 2003, the UnitedStates District Court for the Northern District of Illinois entered a permanentinjunction against enforcement of this legislation.  That decision is currently on appeal to the 7th Circuit Court ofAppeals.  We can make no assurances asto the final outcome of this litigation or ultimate status of the legislation.

 

We have experienced operatinglosses since our inception as a result of efforts to build our customer base,develop and construct our communications network infrastructure, develop oursystems and expand into new markets.  Wewill continue to focus on increasing our customer base and migrating our customerbase onto our network, along with improving our operating margins by groomingour network to deliver service in the most effective and efficient manner, aswell as scaling back certain general and administrative functions.  We believe these actions will betterleverage our existing assets to produce more profitable revenues.  While we have undertaken certain strategicinitiatives to improve our business that are designed to result in eventuallygenerating positive cash flow, we may continue to generate negative cash fromoperations as a result of capital expenditures and projected interest on ourremaining outstanding debt.  We may beforced to change our strategy to respond to a changing competitive regulatoryenvironment and we cannot assure you that we will be able to maintain ouroperating margin.  We cannot assure youthat through our revised strategy we will be able to achieve or sustainprofitability or positive cash flows.

 

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

 

**SFAS 144 Re-AuditRequirement**

 

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

 

In lightof McLeodUSA’s reorganization, sale of businesses, and implementation offresh-start accounting on April 16,

2002,McLeodUSA has determined that the expense and effort associated with a re-auditis not in the best interest of

McLeodUSAor its stockholders.  As an alternativeto a re-audit McLeodUSA included in its most recent Annual Report on Form10-K/A unaudited consolidated financial statements, prepared in accordance withGAAP, reflecting the impact of the discontinued operations for the years endedDecember 31, 2001 and 2000.

 

In orderfor McLeodUSA to sell securities with a registration statement declared effectiveby the SEC, such registration

 

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

 

**Critical AccountingPolicies and Estimates**

 

Preparation of the financialstatements requires management to make estimates and assumptions that affectthe reported amounts of assets, liabilities, revenues and expenses. Managementbelieves the most complex and sensitive judgments, because of theirsignificance to the consolidated financial statements, result primarily fromthe need to make estimates about the effects of matters that are inherentlyuncertain. Management’s Discussion and Analysis and Note 1 to the Consolidated FinancialStatements in the McLeodUSA Annual Report on Form 10-K/A for the year endedDecember 31, 2002, describe the significant accounting estimates and policiesused in preparation of the Condensed Consolidated Financial Statements. Actualresults in these areas could differ from management’s estimates. There havebeen no significant changes in our critical accounting estimates during thesecond quarter of 2003.

 

**Three Months Ended June30, 2003 Compared with Three Months Ended June 30, 2002**

 

Revenue was $222.6 million forthe quarter ended June 30, 2003, a decrease of $31.9 million or 13% from thequarter ended June 30, 2002.  Thedecrease in revenue was primarily due to a decline in customers as well aslower average long distance revenue per customer partially offset by anincrease in local service, private line and data revenue per customer.    Long distance volume was downapproximately 17% compared to the same period last year reflecting the generaleconomic slowdown and increased competition. The second quarter also reflects the impact of the most recent reductionin access rates that are being phased in under a June 2001 FederalCommunications Commission order.  Thefull impact of this access rate reduction is expected to result in a reductionof revenue by approximately $10 million per quarter.

 

Cost of service was $128.1million for the quarter ended June 30, 2003, a decrease of $23.4 million or 15%from the quarter ended June 30, 2002. Approximately $19 million of this decrease is attributable to thereduction in revenues.  The balance ofthe decrease reflects the margin improvement initiatives that we began in 2002,including network cost reductions, migration of customers to the McLeodUSAnetwork and the elimination of non-profitable customers.  As a result of these cost savingsinitiatives, gross margin as a percent of revenue improved to 42% for thesecond quarter of 2003 from 41% for the same period a year ago.  As of June 30, 2003, 58% of our customer lineswere serviced over our own network compared to 42% as of June 30, 2002.  Utilization of our own networkinfrastructure allows us to better manageour customer base and provides for improved profitability.

 

SG&A expenses were $73.5million for the quarter ended June 30, 2003, a decrease of $23.5 million or 24%from the quarter ended June 30, 2002. The second quarter of 2003 includes a $7.9 million recovery related toMCI pre-petition accounts receivable. During the second quarter of 2003, anagreement was reached with MCI to offset pre-petition accounts receivableagainst amounts McLeodUSA owed MCI for pre-petition services.  We had recorded an $8.3 million chargeduring the second quarter of 2002 to fully reserve for the MCI pre-petitionaccounts receivable after their filing for Chapter 11 protection.  Excluding the effects of the MCI accountsreceivable, SG&A expenses decreased from $88.7 million in the secondquarter of 2002 to $81.4 million in the second quarter of 2003, resultingprimarily from a reduced workforce and improved business processes.

 

Depreciation and amortizationexpenses were $85.1 million for the quarter ended June 30, 2003, an increase of$8.2 million from the quarter ended June 30, 2002.  This increase was primarily due to a higher depreciable assetbase as a result of additional assets being placed in service.

 

In accordance with SOP 90-7,expenses resulting from the reorganization of the business in a bankruptcyproceeding are reported separately as reorganization charges.  Reorganization charges, net of $1,539.6million during the second quarter 2002 were comprised of professional fees of$53.6 million, severance of $0.9 million and fresh-start fair value adjustmentsof $1,485.1 million.

 

In the third quarter of 2001,we recorded a charge in connection with our strategic and operationalrestructuring to provide for involuntary employee separations, facilitiesconsolidations and other contractual commitments.  During the second quarter of 2002, we recorded a reduction ofthose reserves of $18.8 million due to lower than anticipated costs related toemployee separations and facility closure costs as well as the negotiation oflower payments on contractual commitments.

 

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This reduction was partiallyoffset by additional charges of $12.0 million, primarily for leased facilitiesidentified for termination and changes in assumptions based on current marketinformation.

 

Gross interest expense was$11.1 million for the quarter ended June 30, 2003, a decrease of $4.6 millionfrom the quarter ended June 30, 2002. The reduction was principally caused by lower debt amounts outstandingduring the second quarter of 2003 resulting from the $225 million pay down ofthe Credit Facility after the sale of ICTC on December 31, 2002.  The remaining portion of the decrease isattributed to lower interest rates on the amounts outstanding during 2003.  Interest expense of approximately $2.8million and $5.3 million was capitalized as part of our construction of ourfiber optic network during the second quarter of 2003 and 2002, respectively.

 

In accordance with SFAS 144,the operating results of businesses held for sale, and the gain or lossresulting from the sale thereof, have been reported as discontinued operationsin the unaudited condensed consolidated statements of operations ofMcLeodUSA.  All businesses held for salewere sold during 2002, and, as such, there is no income or loss fromdiscontinued operations included in the 2003 results.

 

**Six Months Ended June 30, 2003 Compared withSix Months Ended June 30, 2002**

 

Revenue was $448.5 million forthe six months ended June 30, 2003, a decrease of $70.1 million or 14% from thesix months ended June 30, 2002.  Thedecrease in revenue was primarily due to a reduction in customers, includingour efforts to eliminate non-profitable customers, as well as lower averagelong distance per customer.  Longdistance volume was down approximately 19% compared to the same period lastyear reflecting the general economic slowdown. In addition, we sold the assets of Splitrock Services, Inc. in 2002,which generated approximately $4.7 million of revenues during the first quarterof 2002.  The six months ended June 30,2003 also reflects the impact of the most recent reduction in access rates thatare being phased in under a June 2001 Federal Communications Commissionorder.  The full impact of this accessrate reduction is expected to result in a reduction of revenue by approximately$10 million per quarter.

 

Cost of service was $265.5million for the six months ended June 30, 2003, a decrease of $65.1 million or20% from the six months ended June 30, 2002. Approximately $45 million of the decrease is attributable to thereduction in revenues.  The balance ofthe decrease reflects the margin improvement initiatives that we began in 2002,including network cost reductions, migration of customers to the McLeodUSAnetwork and the elimination of non-profitable customers.  As a result of these cost savingsinitiatives, gross margin as a percent of revenue improved to 41% for the sixmonths ended June 30, 2003 from 36% for the same period a year ago.

 

SG&A expenses were $155.2million for the six months ended June 30, 2003, a decrease of $33.2 million or18% from the six months ended June 30, 2002. The first six months of 2003includes a $7.9 million recovery related to MCI pre-petition accountsreceivable.  During the second quarterof 2003, an agreement was reached with MCI to offset pre-petition accountsreceivable against amounts McLeodUSA owed MCI for pre-petition services.  We had recorded an $8.3 million chargeduring the second quarter of 2002 to fully reserve for the MCI pre-petitionaccounts receivable after their filing for Chapter 11 protection.  Excluding the effects of the MCI accountsreceivable in both periods, SG&A expenses decreased from $180.1 million inthe first six months of 2002 to $163.1 million in the six months ended June 30,2003, resulting primarily from a reduced workforce, facilities consolidationand improved business processes.

 

Depreciation and amortizationexpenses were $167.3 million for the six months ended June 30, 2003, a decreaseof $18.5 million from the six months ended June 30, 2002.  The decrease was primarily due to thereduction of our depreciable asset base as a result of fresh-start fair marketvalue adjustments of approximately $1.2 billion upon our emergence frombankruptcy in April 2002.

 

In accordance with SOP 90-7,expenses resulting from the reorganization of the business in a bankruptcyproceeding are reported separately as reorganization charges. Reorganizationcharges, net of $1,596.8 million during the six months ended June 30, 2002 werecomprised of professional fees of $57.5 million, severance of $0.9 million, thewrite-off of deferred financing fees and discounts on the Notes of $53.3million and fresh-start fair value adjustments of $1,485.1 million.

 

In the third quarter of 2001,we recorded a charge in connection with our strategic and operationalrestructuring to provide for involuntary employee separations, facilitiesconsolidations and other contractual commitments.  During the second quarter of 2002, we recorded a reduction ofthose reserves of $18.8 million due to lower than anticipated costs related toemployee separations and facility closure costs as well as the negotiation oflower payments on contractual commitments.

 

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This reduction was partiallyoffset by additional charges of $12.0 million, primarily for leased facilitiesidentified for termination and changes in assumptions based on current marketinformation.

 

Gross interest expense was$23.1 million for the six months ended June 30, 2003, a decrease of $32.1million from the six months ended June 30, 2002.  The significant reduction was principally caused by thecancellation of our Notes on the effective date of our Plan of Reorganizationand lower debt amounts outstanding during 2003 resulting from the $225 millionpay down of the Credit Facility after the sale of ICTC on December 31, 2002.  Interest expense of approximately $5.9million and $12.5 million was capitalized as part of our construction of ourfiber optic network during the six months ended June 30,  2003 and 2002, respectively.

 

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

 

In accordance with SFAS 144,the operating results of businesses held for sale, and the gain or lossresulting from the sale thereof, have been reported as discontinued operationsin the unaudited condensed consolidated statements of operations ofMcLeodUSA.  All businesses held for salewere sold during 2002, and, as such, there is no income or loss fromdiscontinued operations included in the 2003 results.

 

**Liquidity and Capital Resources**

 

We had $83.0 million of cashand cash equivalents at June 30, 2003. During the first six months of 2003 cash used in operating activitieswas $28.9 million and was primarily related to decreases in current liabilityaccounts, resulting from payments for payroll related expenses, restructuringliabilities and selling costs associated with discontinued operations.

 

Our capital expenditures were$36.9 million during the six months ended June 30, 2003, a decrease of $20.1million from the same period in 2002. Within our core footprint, our network infrastructure is largely inplace. We have managed our capital expenditures to coincide with the timing ofrevenue growth and continue to focus our expenditures on the migration ofcustomers from resale platforms to the McLeodUSA network in order to reducecosts and improve quality.  Networkquality, process improvement and cost reduction capital expenditures remainedessentially on plan.  We intend tocontinue to manage our capital expenditures consistent with business conditionsto support our on-switch, facilities-based strategy and augment for profitablerevenue growth as necessary.  We arecurrently re-evaluating the timing and amount of our previously announced $350million 2003-2004 capital expenditure plan. We expect capital expenditures to be approximately $80 to $90 millionfor 2003.

 

As ofJune 30, 2003, there remained $715 million outstanding under the CreditAgreement dated May 31, 2000 (the “Credit Agreement”) with principal repaymentsof $22.1 million due within the next twelve months.  The first scheduled principal payment of $5.5 million is dueSeptember 30, 2003.  As provided for inthe Third Amendment to the Credit Agreement dated November 29, 2001, we enteredinto an Exit Financing Facility with a consortium of banks upon consummation ofthe Plan on April 16, 2002 (the “Exit Facility”). The Exit Facility consistsinitially of a revolving credit facility of $110 million. In addition, we havethe right to obtain additional commitments to increase the size of the ExitFacility up to $160 million. The Exit Facility matures on May 31, 2007, withany outstanding amounts due on that date; no principal payments are due untilthis maturity date. The Exit Facility is secured by first priority liens on theassets of McLeodUSA and its domestic subsidiaries and ranks superior to theCredit Agreement.  As of June 30, 2003no amounts had been drawn on the Exit Facility. However, we have standbyletters of credit outstanding of $7.5 million that reduce our borrowingavailability under the Exit Facility.

 

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

 

The ExitFacility and the Credit Agreement include restrictions as to, among otherthings, additional indebtedness, liens, sale and lease-back transactions,investments, asset sales, certain payments by restricted subsidiaries, anddesignation of unrestricted subsidiaries. Both restrict our ability to make capital expenditures in excess of $300million annually in each of the years ending 2003 through 2005 and $350 millionannually in each of the years 2006 and 2007. The Exit Facility and the Credit Agreement also limit our leverage ratioand require minimum levels of access lines in service, interest coverage andconsolidated revenue**. **Ourability to borrow under the Exit Facility is subject to compliance with all ofthe covenants contained in the agreement. As of June 30, 2003, we were in compliance with all financial andoperating covenants under

 

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the ExitFacility and Credit Agreement.  On March14, 2003, we obtained a waiver from a majority of the participants in theCredit Agreement and Exit Facility of the provisions in the Credit Agreementand Exit Facility that required McLeodUSA to submit audited comparativefinancial statements as of and for the year ended December 31, 2002.

 

We expect to have fundsavailable to meet our operating and capital requirements from various sources,including existing cash balances, the Exit Facility, and cash flow from futureoperations.  We may meet any additionalfinancial needs by borrowing funds under the Exit Facility or by issuingadditional debt or equity securities. Althoughwe  presently meet all of the conditionsto make draws under the Exit Facility, an inability to achieve sufficientrevenue growth and cost savings could negatively impact our future financialperformance and cause us to fail to meet these conditions in the future.  Additionally, factors beyond our control,including a continued poor economic climate or a significant reduction indemand for our services, could cause us to fail to be in compliance withcertain covenants under the Exit Facility and Credit Agreement.  We cannot assure you that additionalfinancing will be available or available on terms that are acceptable tous.  Our ability to issue debtsecurities, borrow funds from additional lenders and participate in vendorfinancing programs is restricted by the terms of the Third Amendment and ExitFacility.

 

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

 

•                  changes indemand for our services;

•                  regulatory,technological or competitive developments;

•                  general economicconditions;

•                  networkdevelopment and maintenance schedules and the associated costs;

•                  a change in ourplans or projections; and

•                  newopportunities.

 

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

 

**Effects of NewAccounting Standards**

 

In May 2003, the FASB issuedSFAS No. 150, *Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity (“SFAS 150”)*.  SFAS 150 establishes standards for how companies classify andmeasure certain financial instruments with characteristics of both liabilitiesand equity. The statement requires companies to classify a financial instrumentthat is within its scope as a liability (or an asset in some circumstances).SFAS 150 is effective for McLeodUSA beginning with the third quarter of2003.  McLeodUSA does not believe theadoption of SFAS 150 will have a material impact, if any, on its consolidatedfinancial statements.

 

**Inflation**

 

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

 

**Item3**.  Quantitative andQualitative Disclosures About Market Risk

 

Upon the consummation of ourrestructuring on April 16, 2002, substantially all of our fixed rate debt waseliminated. We have variable rate debt of $715 million under the CreditAgreement outstanding at June 30, 2003. If market interest rates average 1% more in subsequent quarters than therates during the quarter ended June 30, 2003, quarterly interest expense wouldincrease by $1.8 million.  This amountwas determined by calculating the effect of the hypothetical interest rateincrease on our variable rate debt for the quarter and does not assume changesin our financial structure.

 

**Item4**.    Controls andProcedures

 

(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

 

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amended (the “Exchange Act”))as of the end of the period covered by this report.  Based on such evaluation, the Company’s Chief Executive Officeand Chief Financial Officer have concluded that, as of the end of such period,the Company’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**

 

**Item1****. Legal Proceedings**

 

OnDecember 7, 2000, McLeodUSA acquired CapRock Communications Corp. (‘‘CapRock’’)pursuant to an Agreement and Plan of Merger, dated October 2, 2000, in exchangefor approximately 15.0 million shares of Class A Common Stock.  Several class action complaints have beenfiled in the United States District Court for the Northern District of Texas onbehalf of all purchasers of CapRock common stock during the period April 28,2000 through July 6, 2000.  The lawsuitsprincipally allege that, prior to its merger with McLeodUSA, CapRock madematerial misstatements or omissions of fact in violation of Section 10(b) ofthe Securities Exchange Act. Consolidated with these claims are allegations that CapRock’s June 2000registration statement for a public offering of common stock containedmaterially false and misleading statements and omitted certain materialinformation about CapRock in violation of Section 11 of the Securities Act.  The named defendants in these lawsuitsinclude CapRock and certain of its officers and directors. On July 7, 2003, theparties executed a Memorandum of Understanding (“MOU”) by which the partiesagreed to settle the action for a cash payment of $11 million which would becovered by a combination of insurance and a rebate of previously paid insurancepremiums.  The settlement contemplatedby the MOU is conditioned upon satisfactory confirmatory discovery regardingthe fairness of the settlement, execution of a definitive settlement agreement,and final court approval.

 

FormerChairman Clark E. McLeod, President Stephen C. Gray (then also Chief ExecutiveOfficer), Chairman and Chief Executive Officer Chris A. Davis (then ChiefOperating and Financial Officer) and former Chief Financial and AccountingOfficer J. Lyle Patrick (the ‘‘Individual Defendants’’) are defendants in anumber of putative class action complaints that have been consolidated into asingle complaint entitled In Re McLeodUSA Incorporated Securities Litigation,Civil Action No. C02-0001 (E.D. Iowa) (the ‘‘Iowa Class Action’’).  The Individual Defendants have filed amotion to dismiss the amended consolidated complaint in the Iowa Class Action.  McLeodUSA has indemnification obligationsrunning to the Individual Defendants. One of the putative class plaintiffs, New Millenium Growth Fund LLC,also filed proofs of claim against McLeodUSA in McLeodUSA’s Chapter 11 Case forat least $104,650 on its own behalf and for no less than approximately $300million (plus interest, costs and attorney’s fees as allowed) on behalf of allclass claimants in the Iowa Class Action (the ‘‘Bankruptcy Claims’’ and,together with the Iowa Class Action, the ‘‘Securities Claims’’).  As the Securities Claims are in earlystages, it is impossible to evaluate the likelihood of unfavorable outcomes or,with respect to the Iowa Class Action, to estimate the amount or range ofpotential loss, if any, to McLeodUSA. With respect to the Bankruptcy Claims, onMay 2, 2002 the Bankruptcy Court issued an order establishing a disputed claimsreserve of 18,000,000 shares of Reorganized McLeodUSA Class A CommonStock.  Any recovery from the BankruptcyClaims would be limited to those shares of stock. McLeodUSA believes that theSecurities Claims are without merit and intends to defend them vigorously.

 

McLeodUSAis also involved in numerous regulatory proceedings before various publicutility commissions and the FCC, particularly in connection with actions by theRBOCs.  McLeodUSA anticipates the RBOCswill continue to pursue litigation, regulations and legislation in stateswithin McLeodUSA’s 25-state footprint and before the FCC to reduce regulatoryoversight and regulation over their rates and operations.  The RBOCs are also actively pursuing major changesin the Telecommunications Act of 1996, by regulatory litigation andlegislation, which McLeodUSA believes would adversely affect competitivetelecommunications service providers including McLeodUSA.  If adopted, these initiatives could make itmore difficult for McLeodUSA to challenge the RBOCs’ actions, or to competewith the RBOCs, in the future.  Thereare no assurances that McLeodUSA will prevail in its disputes with the RBOCs.  On May 9, 2003, legislation was enacted inIllinois that changes the methodology to be applied by the Illinois CommerceCommission in setting rates to be charged by incumbent local exchange carriersfor unbundled local loops.   On July 2,2003, the United States District Court for the Northern District of Illinoisentered a permanent injunction against enforcement of this legislation.  That decision is currently on appeal to the7th Circuit Court of Appeals.  McLeodUSAcan make no assurances as to the final outcome of this litigation or ultimatestatus of the legislation.

 

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

 

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**Item4.  Submission****of Mattersto a Vote of Security Holders**

 

The Annual Meeting of Stockholders of the Company was held on May 30,2003.  All of the proposals presentedfor stockholder consideration at the Annual Meeting were approved.  The following is a tabulation of the votingon each proposal presented at the Annual Meeting.

 

Proposal1-Election of Directors

 
|                  |   | **Term  Expires** |   | **Votes For** |   | **Votes Withheld** |   |
|-----------------------|--------|-------------------|--------|---------------|--------|--------------------|--------|
| G. Kenneth Burckhardt |   | 2006              |   | 270,669,272   |   | 4,862,995          |   |
| James E. Hoffman      |   | 2006              |   | 267,553,235   |   | 7,979,032          |   |
| Farid Suleman         |   | 2006              |   | 275,029,757   |   | 502,510            |   |
| Peter V. Ueberroth    |   | 2006              |   | 270,611,022   |   | 4,921,245          |   |
| Juan Villalonga       |   | 2006              |   | 270,543,576   |   | 4,988,691          |   |

 

Proposal2-Ratification of the appointment of Deloitte & Touche LLP as McLeodUSA’sindependent public accountants for the fiscal year ended December 31, 2003.

 
| Votes For        |   | 267,262,093 |   |
|------------------|--------|-------------|--------|
| Votes Against    |   | 8,230,386   |   |
| Absentions       |   | 39,788      |   |
| Broker Non-Votes |   | —      |   |

 

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**Item6****.  Exhibits andReports on Form 8-K**

 

(a)           Exhibits

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

 

(b)           Reports on Form 8-K

 

On April 24, 2003, we announced our financial results for the fiscalquarter ended March 31, 2003, and certain other information, in a pressrelease.

 

On June 13, 2003, we filed a Current Report on Form 8-K announcing thereceipt of formal notice from Nasdaq that McLeodUSA has regained compliancewith the minimum bid price requirement under the Nasdaq Marketplace Rules.

 

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**SIGNATURES**

 

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

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

 

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**INDEXTO EXHIBITS**

 

 
| **Exhibit  Number** |   | **Exhibit Description**                                                                                                          |
|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------|
| 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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