** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

**(Mark One)**

**ý****                                ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIESEXCHANGE ACT OF 1934**

 

**Forthe Quarterly Period Ended March 31, 2004**

 

**or**

 

**TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**Forthe transition period                               to                                **

 

**Commissionfile number 0-20763**

 

**McLEODUSA INCORPORATED**

**(Exact name ofregistrant as specified in its charter)**

** **

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

 

**319-364-0000**

(Registrant’s 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 90 days.  Yes ý       Noo

 

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

 

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

 

The number ofshares outstanding of each class of the issuer’s common stock as of April 30,2004:

 
| Common Stock Class A:  ($0.01 par value) |   | 178,355,425 shares |   |
|-----------------------------------------------|--------|--------------------|--------|
| Common Stock Class B:  ($0.01 par value) |   | 78,203,135 shares  |   |
| Common Stock Class C:  ($0.01 par value) |   | 35,546,879 shares  |   |

 

 

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**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**INDEX**

 
| **PART I.  Financial Information** |                                                                                        |
|-----------------------------------------|---------------------------------------------------------------------------------------------|
|                                    |                                                                                        |   |
| Item 1.                                 | Financial Statements                                                                        |   |
|                                    |                                                                                        |   |
|                                    |                                                                                        | Condensed  Consolidated Balance Sheets, March 31, 2004 (unaudited) and December 31, 2003 |   |
|                                    |                                                                                        |   |   |
|                                    |                                                                                        | Unaudited  Condensed Consolidated Statements of Operations – for the three months ended  March 31, 2004 and 2003 |   |
|                                    |                                                                                        |   |   |
|                                    |                                                                                        | Unaudited  Condensed Consolidated Statements of Cash Flows  – for the three months ended March 31, 2004 and 2003 |   |
|                                    |                                                                                        |   |
|                                    | Notes to the Condensed Consolidated Financial Statements                                    |   |
|                                    |                                                                                        |   |
| Item 2.                                 | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   |
|                                    |                                                                                        |   |
| Item 3.                                 | Quantitative and Qualitative Disclosures  About Market Risk                                 |   |
|                                    |                                                                                        |   |
| Item 4.                                 | Controls and Procedures                                                                     |   |
|                                    |                                                                                        |   |
| **PART II.  Other Information**    |                                                                                        |
|                                    |                                                                                        |   |
| Item 1.                                 | Legal Proceedings                                                                           |   |
|                                    |                                                                                        |   |
| Item 6.                                 | Exhibits and Reports on Form 8-K                                                            |   |
|                                    |                                                                                        |   |
| Signatures                              |                                                                                        |

 

2

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**PARTI – FINANCIAL INFORMATION**

 

**Item1****. Financial Statements**

 

**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(In millions, exceptshare data)**

 
|                                                                                                                                                                                                  |   | **March 31,  2004** |    | **December  31,  2003** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|-------------------------|--------|
|                                                                                                                                                                                                  |   | **(unaudited)**     |    |                    |   |
| **ASSETS**                                                                                                                                                                                            |   |                |    |                    |   |
| Current assets                                                                                                                                                                                        |   |                |    |                    |   |
| Cash and cash equivalents                                                                                                                                                                             |   | $                   | 49.0    |                    | $      | 56.5 |   |
| Trade receivables, net                                                                                                                                                                                |   | 58.0                |    | 65.6                    |   |
| Prepaid expenses and other                                                                                                                                                                            |   | 22.0                |    | 22.4                    |   |
| Assets held for sale                                                                                                                                                                                  |   | 2.0                 |    | 2.0                     |   |
| Total current assets                                                                                                                                                                                  |   | 131.0               |    | 146.5                   |   |
| Property and equipment                                                                                                                                                                                |   |                |    |                    |   |
| Land and buildings                                                                                                                                                                                    |   | 78.4                |    | 78.6                    |   |
| Communications networks                                                                                                                                                                               |   | 1,073.6             |    | 996.3                   |   |
| Furniture, fixtures and equipment                                                                                                                                                                     |   | 199.4               |    | 196.8                   |   |
| Networks in progress                                                                                                                                                                                  |   | 102.4               |    | 171.6                   |   |
| Total property and equipment                                                                                                                                                                          |   | 1,453.8             |    | 1,443.3                 |   |
| Less accumulated depreciation                                                                                                                                                                         |   | 509.3               |    | 435.6                   |   |
| Net property and equipment                                                                                                                                                                            |   | 944.5               |    | 1,007.7                 |   |
| Intangibles and other assets                                                                                                                                                                          |   |                |    |                    |   |
| Goodwill                                                                                                                                                                                              |   | 245.1               |    | 245.1                   |   |
| Other intangibles, net                                                                                                                                                                                |   | 193.6               |    | 201.8                   |   |
| Other                                                                                                                                                                                                 |   | 25.0                |    | 29.5                    |   |
| Total intangibles and other assets                                                                                                                                                                    |   | 463.7               |    | 476.4                   |   |
| **TOTAL ASSETS**                                                                                                                                                                                      |   | $                   | 1,539.2 |                    | $      | 1,630.6 |   |
|                                                                                                                                                                                                  |   |                |    |                    |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         |   |                |    |                    |   |
| Current liabilities                                                                                                                                                                                   |   |                |    |                    |   |
| Current maturities of long-term debt                                                                                                                                                                  |   | $                   | 29.1    |                    | $      | 27.1 |   |
| Accounts payable                                                                                                                                                                                      |   | 27.9                |    | 30.5                    |   |
| Accrued payroll and payroll related  expenses                                                                                                                                                         |   | 18.4                |    | 20.6                    |   |
| Other accrued liabilities                                                                                                                                                                             |   | 85.3                |    | 100.9                   |   |
| Deferred revenue, current portion                                                                                                                                                                     |   | 6.2                 |    | 6.9                     |   |
| Liabilities related to discontinued  operations                                                                                                                                                       |   | 0.3                 |    | 1.1                     |   |
| Total current liabilities                                                                                                                                                                             |   | 167.2               |    | 187.1                   |   |
| Long-term debt, less current maturities                                                                                                                                                               |   | 734.5               |    | 717.3                   |   |
| Deferred revenue, less current portion                                                                                                                                                                |   | 16.8                |    | 15.1                    |   |
| Other long-term liabilities                                                                                                                                                                           |   | 59.2                |    | 58.3                    |   |
| Total liabilities                                                                                                                                                                                     |   | 977.7               |    | 977.8                   |   |
| Redeemable convertible preferred stock                                                                                                                                                                |   |                |    |                    |   |
| McLeodUSA Preferred Series A, redeemable,  convertible, $0.01 par value; 10,000,000 authorized and issued; 6,835,835 and  7,377,149 outstanding at March 31, 2004 and December 31, 2003, respectively |   | 122.3               |    | 131.1                   |   |
| Stockholders’ equity                                                                                                                                                                             |   |                |    |                    |   |
| McLeodUSA Common, Class A $0.01 par value;  1,886,249,986 authorized, 178,273,984 and 175,527,257 issued and outstanding  at March 31, 2004 and December 31, 2003, respectively                       |   | 1.8                 |    | 1.8                     |   |
| McLeodUSA Common, Class B $0.01 par value;  78,203,135 authorized, issued and outstanding at March 31, 2004 and December  31, 2003                                                                    |   | 0.8                 |    | 0.8                     |   |
| McLeodUSA Common, Class C $0.01 par value;  35,546,879 authorized, issued and outstanding at March 31, 2004 and December  31, 2003                                                                    |   | 0.3                 |    | 0.3                     |   |
| McLeodUSA Preferred Series B, $0.01 par  value; 10 authorized, issued and outstanding at March 31, 2004 and December  31, 2003                                                                        |   | —              |    | —                  |   |
| McLeodUSA Warrants                                                                                                                                                                                    |   | 22.6                |    | 22.6                    |   |
| Additional paid-in capital                                                                                                                                                                            |   | 1,002.2             |    | 993.3                   |   |
| Accumulated deficit                                                                                                                                                                                   |   | (588.5              | )       | (497.1                  | )      |
| Total stockholders’ equity                                                                                                                                                                       |   | 439.2               |    | 521.7                   |   |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                   |   | $                   | 1,539.2 |                    | $      | 1,630.6 |   |

 

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

 

3

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**McLEODUSAINCORPORATED AND SUBSIDIARIESUNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS**

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

 
|                                                                                 |   | **Three months ended March 31,** |   |
|--------------------------------------------------------------------------------------|--------|----------------------------------|--------|
|                                                                                 |   | **2004**                         |   | **2003** |   |
|                                                                                 |   |                             |   |   |   |
| Revenues                                                                             |   | $                                | 193.6  |   | $ | 225.9 |   |
|                                                                                 |   |                             |   |   |   |
| Operating expenses:                                                                  |   |                             |   |   |   |
| Cost of service (exclusive of  depreciation and amortization shown separately below) |   | 107.6                            |   | 137.4 |   |
| Selling, general and  administrative                                                 |   | 75.7                             |   | 81.7 |   |
| Depreciation and amortization                                                        |   | 90.2                             |   | 82.2 |   |
| **Total  operating expenses**                                                        |   | 273.5                            |   | 301.3 |   |
| **Operating loss**                                                                   |   | (79.9                            | )      | (75.4 | ) |
|                                                                                 |   |                             |   |   |   |
| Nonoperating expense:                                                                |   |                             |   |   |   |
| Interest expense, net of  amounts capitalized                                        |   | (11.1                            | )      | (8.7 | ) |
| Other expense                                                                        |   | (0.4                             | )      | — |   |
| **Total nonoperating  expense**                                                      |   | (11.5                            | )      | (8.7 | ) |
| **Net loss**                                                                         |   | (91.4                            | )      | (84.1 | ) |
|                                                                                 |   |                             |   |   |   |
| Preferred stock dividend                                                             |   | (0.8                             | )      | (1.2 | ) |
|                                                                                 |   |                             |   |   |   |
| **Net loss  applicable to common shares**                                            |   | $                                | (92.2  | ) | $ | (85.3 | ) |
|                                                                                 |   |                             |   |   |   |
| **Basic and  diluted loss per common share**                                         |   | $                                | (0.32  | ) | $ | (0.31 | ) |
| **Weighted average  common shares outstanding**                                      |   | 291.0                            |   | 276.3 |   |

 

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

 

4

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**McLEODUSAINCORPORATED AND SUBSIDIARIESUNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(In millions)**

** **
|                                                                                 |   | **Three months ended March 31,** |   |
|--------------------------------------------------------------------------------------|--------|----------------------------------|--------|
|                                                                                 |   | **2004**                         |   | **2003** |   |
| **Cash Flows  from Operating Activities**                                            |   |                             |   |   |   |
| Net loss                                                                             |   | $                                | (91.4  | ) | $ | (84.1 | ) |
| Adjustments to reconcile net  loss to net cash used in operating activities:         |   |                             |   |   |   |
| Depreciation                                                                         |   | 76.0                             |   | 65.9 |   |
| Amortization                                                                         |   | 14.2                             |   | 16.3 |   |
| Accretion of interest                                                                |   | 0.9                              |   | 0.9 |   |
| Loss (gain) on sale of assets                                                        |   | 0.4                              |   | (0.2 | ) |
| Changes in assets and  liabilities, net of dispositions:                             |   |                             |   |   |   |
| Trade receivables                                                                    |   | 7.9                              |   | 1.0 |   |
| Prepaid expenses and other                                                           |   | 1.1                              |   | 2.0 |   |
| Accounts payable and accrued  expenses                                               |   | (21.1                            | )      | (31.2 | ) |
| Deferred Revenue                                                                     |   | 1.0                              |   | (0.6 | ) |
| **Net cash used  in operating activities**                                           |   | (11.0                            | )      | (30.0 | ) |
|                                                                                 |   |                             |   |   |   |
| **Cash Flows  from Investing Activities**                                            |   |                             |   |   |   |
| Purchases of property and equipment                                                  |   | (13.3                            | )      | (13.8 | ) |
| Other assets                                                                         |   | (8.4                             | )      | (10.4 | ) |
| Proceeds from the sale of  assets                                                    |   | 6.0                              |   | 0.2 |   |
| **Net cash used  in investing activities**                                           |   | (15.7                            | )      | (24.0 | ) |
|                                                                                 |   |                             |   |   |   |
| **Cash Flows  from Financing Activities**                                            |   |                             |   |   |   |
| Net proceeds from long-term  debt                                                    |   | 25.0                             |   | — |   |
| Payments on long-term debt                                                           |   | (5.8                             | )      | (1.1 | ) |
| **Net cash  provided by (used in) financing activities**                             |   | 19.2                             |   | (1.1 | ) |
|                                                                                 |   |                             |   |   |   |
| **Net decrease  in cash and cash equivalents**                                       |   | (7.5                             | )      | (55.1 | ) |
|                                                                                 |   |                             |   |   |   |
| **Cash and cash  equivalents**                                                       |   |                             |   |   |   |
| Beginning                                                                            |   | 56.5                             |   | 170.6 |   |
| Ending                                                                               |   | $                                | 49.0   |   | $ | 115.5 |   |
|                                                                                 |   |                             |   |   |   |
| **Supplemental  Disclosure of Cash Flow Information**                                |   |                             |   |   |   |
| Cash payments for interest                                                           |   | $                                | 10.3   |   | $ | 10.6 |   |
|                                                                                 |   |                             |   |   |   |
| **Supplemental  Schedule of Noncash Investing and Financing Activities**             |   |                             |   |   |   |
| Principal amount converted of  Redeemable Preferred Series A to Class A common stock |   | $                                | 9.6    |   | $ | — |   |
| Preferred stock dividends                                                            |   | $                                | 0.8    |   | $ | 1.2 |   |

 

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

 

5

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**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**NOTES TO THE CONDENSED****CONSOLIDATEDFINANCIAL STATEMENTS**

 

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

 

McLeodUSA Incorporated(“McLeodUSA” or the “Company”), a Delaware corporation, through itssubsidiaries, provides integrated communications services in 25 Midwest,Southwest, Northwest and Rocky Mountain states.  McLeodUSA’s business is highly competitive and is subject tovarious federal, state and local regulations.

 

In the fourth quarter of 2001,the Company developed a revised strategic plan, which focused on profitablerevenue growth in our 25-state footprint. This plan served as the basis for its recapitalization with itsprincipal shareholder, Forstmann Little & Co., lender group, and PreferredShareholders, as well as the structuring of the Exit Facility (as definedbelow) and continues to serve as the basis of the Company’s yearly operatingplans.

 

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

 

However, the Company’s revenues have not increased as forecasted andhave been declining since 2002.  Thedecline in revenue was driven by the Company’s program to eliminatenon-profitable customers, turnover of customers to competitors in excess of newcustomers acquired, reduction of long distance minutes used by its customerbase, reduction in access rates as mandated by the FCC, and lower prices forsome of its products.  The Company hastaken significant actions to increase revenue, including introduction of newcompetitively priced products, reorganization of the sales operation into threedistinct channels, hiring of experienced executive sales leadership, expandingthe involvement of the board of directors and executive staff in the salesprocess and reducing customer churn. While the Company believes that these actions will over time result in profitablenew revenue growth, the timing and amount of that growth is yet to bedetermined.

 

The strategic plan and recapitalization anticipated that the Companywould require additional funding to ultimately reach positive earnings and cashflow and established an exit financing facility (“Exit Facility”) of $160million and obtained funding for $110 million of that facility as arevolver.  In order to access the ExitFacility, the Company must be in compliance with certain restrictivecovenants.  In the first quarter of 2004the Company recognized that as a result of the continued decline in revenues,it would be necessary to obtain an amendment to those covenants from its lendergroup.  The Company sought and obtainedapproval of amendments from its lender group on April 30, 2004, which wereeffective as of March 31, 2004, and was in full compliance with the amendedcovenants as of March 31, 2004.  Goingforward the Company will need to increase its revenue and profitability inorder to continue to meet the restrictive covenants.  If revenues and profitability do not increase as anticipated, theCompany may be required to obtain waivers or further modifications of certaincovenants in order to access any unused portion of the Exit Facility.  While the Company believes it has strongrelationships with its lender group, there can be no assurance that the Companycould obtain such waivers or the necessary covenant amendments.

 

The Company has undertaken numerous actions to conserve cash over thepast 18 to 24 months, including the reduction of capital expenditures andselling, general and administrative expenses (“SG&A”), as well as theexecution of extensive cost reduction efforts initiated in late 2001 andcontinuing through 2004.  In connectionwith the amendment to the covenants the Company developed a revised businessplan which incorporated additional actions focused on reducing SG&Aexpenses and conserving cash (see *Management’s Discussion and Analysis – Liquidity andCapital Resources*for additional details).  Going forward the Company will continue to execute on theseinitiatives and implement additional similar actions to conserve cash until itsrevenue growth initiatives take hold. The Company has been selective in managing capital expenditures and doesnot believe that any of the reductions in capital spending will have a materialimpact on its ability to grow short-term revenues.  Ultimately, the Company believes that it will be successful inexecuting its strategy to profitably grow revenue.  However, if the timing of such growth limits or restricts itsaccess to the unused portion of the Exit Facility, then it would be required toinitiate more aggressive expense reductions and potentially seek alternativesources of funding.  In the event theCompany seeks alternative sources of funding, there can be no assurances suchfunding sources would be available.

 

6

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**Interim Financial Information (unaudited)**

In the opinion ofmanagement, the accompanying unaudited condensed consolidated financialstatements include adjustments, consisting of normal recurring adjustments,necessary for a fair presentation of the financial position and results ofoperations of McLeodUSA.  The operatingresults for the interim periods are not necessarily indicative of the operatingresults to be 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 thedisclosures provided are adequate to make the information presented notmisleading, management recommends that you read these unaudited condensedconsolidated financial statements in conjunction with the audited consolidatedfinancial statements and the related footnotes included in the McLeodUSA AnnualReport on Form 10-K for the fiscal year ended December 31, 2003, filed with theSEC on March 15, 2004.

 

**Accounting for Stock-based Compensation**

Aspermitted by Statement of Financial Accounting Standards (“SFAS”) No. 123, *Accountingfor Stock-Based Compensation*(‘‘SFAS 123’’), McLeodUSA measurescompensation using the intrinsic value based method as prescribed by AccountingPrinciples Board Opinion No. 25, *Accounting for Stock Issued to Employees,*butis required to make proforma disclosures in the footnotes to the financialstatements as if the measurement provisions of SFAS 123 and SFAS No. 148 *Accountingfor Stock-Based Compensation-Transition and Disclosure — an Amendment of SFAS123*had been adopted. Under the intrinsic value method, 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 following table illustrates the effecton net loss and net loss per share for the three months ended March 31, 2004and 2003 as if McLeodUSA had applied the fair value recognition provisions ofSFAS 123 to stock-based employee compensation.

 
|                                                                                                   |   | **Three  months ended March 31,** |   |
|--------------------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                                   |   | **2004**                          |   | **2003** |   |
| Net loss applicable to common shares, as  reported                                                     |   | $                                 | (92.2  | ) | $ | (85.3 | ) |
| Less:  Total stock-based  employee compensation expense determined under fair value based methods |   | (3.2                              | )      | (2.3 | ) |
| Pro forma net loss applicable to common  shares                                                        |   | $                                 | (95.4  | ) | $ | (87.6 | ) |
| **Loss per share:**                                                                                    |   |                              |   |   |   |
| Basic and diluted, as reported                                                                         |   | $                                 | (0.32  | ) | $ | (0.31 | ) |
| Basic and diluted, pro forma                                                                           |   | $                                 | (0.33  | ) | $ | (0.32 | ) |

 

**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 totaling approximately 139 million and 140 million at March 31, 2004and 2003, respectively, may become dilutive. Assuming exercise or conversion of stock options and convertiblesecurities, diluted shares would have been approximately 430 million and 416million at March 31, 2004 and 2003, respectively.

 

7

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**Guarantees**

In November 2002, the FinancialAccounting Standards Board (“FASB”) issued FASB Interpretation No. 45, *Guarantor’s Accountingand Disclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others*.  Thisinterpretation clarifies disclosures that are required to be made by aguarantor in its interim and annual financial statements about obligationsunder certain of its issued guarantees. In addition, the interpretationclarifies that a guarantor is required to recognize, at the inception ofcertain types of guarantees, a liability for the fair value of the obligationundertaken in issuing these guarantees. At March 31, 2004 and 2003, McLeodUSA,the parent company, has various guarantees related to subsidiary commitmentsunder operating leases.  As of March 31,2004 and 2003 the guarantees total $26.8 million and $39.8 million,respectively, and expire over various periods through September 2016,corresponding with the termination of the lease agreements.

 

McLeodUSA has indemnificationobligations to its current and former Directors and Officers.  The terms of the indemnification obligationsprovide for no limitation to the maximum potential future payments under suchindemnifications.  McLeodUSA maintainsinsurance, subject to limitations set forth in the policies, which is intendedto cover the costs of claims made against its Directors and Officers.

 

**Note 2: Trade Receivables**

 

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

 

|                                           |   | **March 31,  2004** |   | **December  31,  2003** |   |
|------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
| Trade Receivables:                             |   |                |   |                    |   |
| Billed                                         |   | $                   | 66.1   |                    | $      | 73.7 |   |
| Unbilled                                       |   | 6.1                 |   | 5.6                     |   |
|                                           |   | 72.2                |   | 79.3                    |   |
| Allowance for doubtful accounts and  discounts |   | (14.2               | )      | (13.7                   | )      |
|                                           |   | $                   | 58.0   |                    | $      | 65.6 |   |

 

**Note3:  Other Accrued Liabilities**

 

Other accrued liabilitiesconsisted of the following (in millions):

 

|                           |   | **March 31,  2004** |   | **December  31,  2003** |   |
|--------------------------------|--------|---------------------|--------|-------------------------|--------|
| Restructuring                  |   | $                   | 24.6   |                    | $      | 32.5 |   |
| Accrued Sales/Use/Excise Taxes |   | 17.2                |   | 18.6                    |   |
| Accrued Property Taxes         |   | 10.0                |   | 10.9                    |   |
| Other                          |   | 33.5                |   | 38.9                    |   |
|                           |   | $                   | 85.3   |                    | $      | 100.9 |   |

 

**Note4:  Restructuring Charges**

 

Changes in the carrying amountof the restructuring liability for the three months ended March 31, 2004 issummarized as follows (in millions):

 
|                          |   | **Liability at  December 31,  2003** |   | **Cash Payments  Through  March 31,  2004** |   | **Remaining  Liability  March 31,  2004** |   |
|-------------------------------|--------|--------------------------------------|--------|---------------------------------------------|--------|-------------------------------------------|--------|
| Facility closure costs        |   | $                                    | 32.2   |                                        | $      | (7.9                                      | )      | $ | 24.3 |   |
| Other contractual commitments |   | 0.3                                  |   | —                                      |   | 0.3                                       |   |
|                          |   | $                                    | 32.5   |                                        | $      | (7.9                                      | )      | $ | 24.6 |   |

 

8

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

 

In accordance with SFAS142,  *Accounting for Goodwill and OtherIntangibles (“SFAS 142”),* goodwill is not amortized but reviewed annuallyfor impairment or more frequently if an event occurs or circumstances changethat would more likely than not reduce the fair value below its carryingamount.  SFAS 142 requires theidentification of reporting units and the application of a two-step approach toassess goodwill impairment.  In order toidentify potential impairment, impairment tests of goodwill are performed bycomparing the fair value of its reporting unit with its carrying amount,including goodwill.  If the carryingamount of its reporting unit exceeds its fair value, the impairment loss ismeasured in the second step by comparing the implied fair value of goodwill,determined in the same manner as in a business combination, with its carryingamount.  McLeodUSA defined reportingunits during its transitional and annual goodwill impairment tests as anoperating segment comprised of McLeodUSA’s consolidated operations.  McLeodUSA has established July 1 as the datefor its annual impairment test.  TheCompany’s last impairment test did not yield any impairment.

 

Intangible assets with finitelives at March 31, 2004 and December 31, 2003 are summarized as follows (inmillions):

 

|                              |   | **Gross** |   | **Accumulated  Amortization** |   | **Net** |   |
|-----------------------------------|--------|-----------|--------|-------------------------------|--------|---------|--------|
| **March 31,  2004:**              |   |      |   |                          |   |    |   |
| Deferred line installation  costs |   | $         | 133.3  |                          | $      | 39.4    |   | $ | 93.9 |   |
| Customer base                     |   | 29.8      |   | 13.5                          |   | 16.3    |   |
| PrimeLine Trademark               |   | 0.9       |   | 0.4                           |   | 0.5     |   |
|                              |   | $         | 164.0  |                          | $      | 53.3    |   | $ | 110.7 |   |

 

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

 

Upon its reorganization thetrademark McLeodUSA was assigned a value of $82.9 million by independentappraisers during the adoption of fresh-start accounting by McLeodUSA.  The trademark was determined to have anindefinite life and is not being amortized. Annual estimated amortization expense for intangible assets above for2005 is $46 million, $21 million for 2006, and $1 million for 2007.

 

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

 

In July 2001, the FASB issuedSFAS 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.

 

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.

 

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Changes in the carrying amountof the asset retirement obligation for the three months ended March 31, 2004 issummarized as follows (in millions):

 
| Balance, December 31, 2003 |   | $   | 58.3   |   |
|----------------------------|--------|-----|--------|--------|
| Interest accretion         |   | 0.9 |   |
| Balance, March 31, 2004    |   | $   | 59.2   |   |

 

**Note7:  Long Term Debt**

 

On April 30, 2004 McLeodUSA entered into the Fifth Amendment to theCredit Agreement and the Second Amendment to the Exit Facility.  The approved amendments include changes tothe minimum revenue, leverage ratio and interest coverage ratio covenants.  The trailing four quarter minimum revenuecovenant was amended to $825 million, $780 million, $760 million, and $770million in the first quarter through fourth quarter of 2004, respectively.  There is no minimum revenue covenant in2005.  The leverage ratio was replacedwith a minimum cumulative EBITDA covenant (as defined in the Credit Agreementand Exit Facility, as amended) of $8 million, $16 million, $24 million and $34million for the first through fourth quarters of 2004, respectively, and atrailing four quarter minimum EBITDA of $49 million, $69 million, $89 million and $114 million for the firstthrough fourth quarters of 2005, respectively.** **The interest coverage****ratio was amended to 1.0x for each of thefour quarters of 2004 and 1.0x, 1.5x, 2.0x and 2.0x for the first throughfourth quarters of 2005, respectively. The Company offered and included in the amendment a downward revision tothe capital expenditure limits for 2004 and 2005 to $75 million and $100 million,respectively.  There were no changes tothe capital expenditure limit of $200 million for the years 2006 andbeyond.  In addition, the secondamendment limits the outstanding amounts under the Exit Facility to $75.0million for the period from April 1, 2004 through June 30, 2004 and to $90.0million during the period July 1, 2004 through September 30, 2004.

 

McLeodUSA paid approximately $1.9 million in fees in April 2004 to thelender group in connection with the approval of these amendments.  The Company is currently in compliance withthe amended financial covenants under the Credit Agreement and ExitFacility.  As of March 31, 2003,McLeodUSA has drawn $65 million on the Exit Facility and has standby letters ofcredit outstanding of $9.0 million that further reduce its borrowing availabilityunder the Exit Facility.

 

Interest expense of $0.7 million and $3.1 million was capitalized aspart of the construction of the Company’s fiber optic network during thequarters ended March 31, 2004 and 2003, respectively.

 

** Note 8: Litigation**

** **

Former ChairmanClark E. McLeod, President Stephen C. Gray (then also Chief Executive Officer),Chairman and Chief Executive Officer Chris A. Davis (then Chief Operating andFinancial Officer) and former Chief Financial and Accounting Officer J. LylePatrick (the ‘‘Individual Defendants’’) are defendants in a number of putativeclass action complaints that have been consolidated into a single complaintentitled In Re McLeodUSA Incorporated Securities Litigation, Civil Action No.C02-0001 (N.D. Iowa) (the ‘‘Iowa Class Action’’). The Individual Defendantshave filed a motion to dismiss the amended consolidated complaint in the IowaClass Action, which was denied by the district judge. One of the putative classplaintiffs, New Millenium Growth Fund LLC, also filed proofs of claim againstMcLeodUSA in McLeodUSA’s Chapter 11 Case for at least $104,650 on its ownbehalf and for no less than approximately $300 million (plus interest, costsand attorneys’ fees as allowed) on behalf of all class claimants in the IowaClass Action (the ‘‘Bankruptcy Claims’’ and, together with theIowa Class Action, the ‘‘Securities Claims’’). As the Securities Claims are inearly stages, it is impossible to evaluate the likelihood of unfavorableoutcomes or, with respect to the Iowa Class Action, to estimate the amount orrange of potential loss, if any, to McLeodUSA. With respect to the BankruptcyClaims, on May 2, 2002 the Bankruptcy Court issued an order establishing adisputed claims reserve of 18,000,000 shares of Reorganized McLeodUSA Class ACommon Stock. Any recovery from the Bankruptcy Claims would be limited to thoseshares of stock. McLeodUSA believes that the Securities Claims are withoutmerit and intends to defend them vigorously.

 

McLeodUSAhas indemnification obligations running to the Individual Defendants, the termsof which provide for no limitation to the maximum potential future paymentsunder such indemnifications.  McLeodUSAis unable to develop an estimate of the maximum potential amount of futurepayments under the indemnifications due to the inherent uncertainties

 

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involvedin such litigation. McLeodUSA maintains insurance, subject to limitations setforth in the policies, which is intended to cover the costs of claims madeagainst its current and former Directors and Officers.

 

McLeodUSAis also involved in numerous regulatory proceedings before various publicutility commissions and the FCC, particularly in connection with actions by theRegional Bell Operating Companies (“RBOCs”). McLeodUSA anticipates the 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 rates, network access and operations. The RBOCsare also actively pursuing major changes in the Telecommunications Act of 1996,by regulatory litigation and legislation, which McLeodUSA believes wouldadversely affect competitive telecommunications service providers includingMcLeodUSA. If adopted, these initiatives could make it more difficult forMcLeodUSA to challenge the RBOCs’ actions, or to compete with the RBOCs, in thefuture. There are no assurances that McLeodUSA will prevail in its disputeswith the RBOCs.

 

The FCCreleased its Triennial Review Order (“TRO”) in August 2003 modifying its rulesgoverning availability of RBOC unbundled network elements to competitivecarriers. The Triennial Review Order established new rules governing theavailability and pricing for the network elements the RBOCs must provide tocompetitive carriers, and delegated authority to the states to apply certain ofthe new rules in individual markets. Several appeals of the TRO wereconsolidated in the Court of Appeals for the District of Columbia (the “Courtof Appeals”). On March 2, 2004, the Court of Appeals issued a decisionoverturning many key elements of the TRO, remanding most of the order to theFCC for further action. The Court of Appeals ruled that the FCC’s delegation offinal impairment decisions to state agencies was unlawful.  The Court also reversed the FCC’s nationwidefinding of presumptive impairment for mass market switches, and dedicatedtransport and loops. The Court directed the FCC to give stronger considerationto intermodal competition when revising its rules on remand. The Court upheldthe FCC determination that RBOCs do not have to unbundle loops made up of acombination of copper and fiber or to provide CLECs access to new loops. TheCourt also upheld the FCC’s findings that RBOCs are not required to provideunbundled switching to CLECs for business customers served by high-capacityloops, such as DS-1 or packet switching. State proceedings that had beenstarted to determine whether DS-0 switch ports should remain available as unbundlednetwork elements are being suspended in some states and continued in otherstates. The Court originally stayed the effective date of itsorder for 60 days in order to provide the FCC with an opportunity to implementnew unbundling rules.  Subsequently, onMarch 31, 2004, the FCC issued a press release and letters to a number ofindustry participants and trade associations encouraging industry members toengage in commercial negotiations to address issues raised in the TRO.  To facilitate these commercial negotiations,the FCC sought and obtained an additional 45-day stay from the Court ofAppeals.   McLeodUSA has executedConfidentiality Agreements with Qwest and SBC, our primary suppliers of networkfacilities, and opened discussions with each of them.  The stay of the Court of Appeals’ decision is now set to end onJune 15, 2004.  Regardless of thesuccess, or lack of success, of these commercial negotiations, it is likelythat the Court of Appeals’ decision and the TRO will be the subject of continuedlitigation.  There can be no assurance that our businesses will not be materiallyadversely affected by the TRO, continued legal challenges to the TRO, thedecision of the Court of Appeals, new legislation passed in response to the TROor any court decisions that result from continued legal challenge to the TRO orcurrent law and regulations.

 

The FCChas an open docket proposing to reform intercarrier compensation.  An industry group known as the “IntercarrierCompensation Forum” (ICF) is expected to provide a recommended framework forreforming intercarrier compensation related to switched access and reciprocalcompensation charges.  Once the ICFprovides its recommendation to the FCC, the FCC will solicit comments on theissue.  A final decision is expected noearlier than the first quarter of 2005, and the current framework ofintercarrier compensation rules could be materially affected.   Also, on May 13, 2004, it is anticipatedthat the FCC will issue a final decision on CLEC access charges that apply tothe routing of certain 800 traffic. There can be no assurance that our businesses will not be materiallyadversely affected by the decision.

 

 On September 10, 2003, the FCC issued aNotice of Proposed Rulemaking (‘‘NPRM’’) on TELRIC. This is a proceeding toreview the TELRIC methodology used to determine the prices charged tocompetitive carriers for unbundled network elements. A change in pricingmethodology that materially increases unbundled network element prices wouldincrease our costs and could adversely affect our ability to compete. Adecision is anticipated during 2004.

 

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

 

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Generally,state utility commissions or third parties could raise issues with regard toour compliance with applicable laws or regulations which could have a materialadverse effect on our business, results of operations and financial condition.Several state utility commissions have reviewed or are actively reviewing thepropriety of certain agreements we entered into with Qwest, includingWashington, Arizona, and Colorado, and these proceedings may result in fines orother sanctions against us or the imposition of other conditions detrimental tous, including the establishment of discounts available to other competitivetelephone companies but not to us. Other states may initiate similarproceedings.

 

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

 

**Note9:  SFAS 144, Unaudited 2001 FinancialStatements and Re-Audit Requirements**

 

Inconnection with its reorganization, McLeodUSA completed the sale of certainbusinesses, including McLeodUSA Media Group and its subsidiaries and IllinoisConsolidated Telephone Company and associated businesses.  In its most recent Annual Report on Form10-K, 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 year endedDecember 31, 2001, reflecting these businesses as discontinued operations.  McLeodUSA’s former auditors, Arthur AndersenLLP (“Arthur Andersen”), audited McLeodUSA’s financial statements and issued anaudit opinion for the year ended December 31, 2001.  On April 24, 2002, McLeodUSA engaged Deloitte & Touche LLP(“Deloitte & Touche”) to serve as its independent accountants for fiscalyear 2002.  In order for McLeodUSA tocomply with GAAP requirements related to the financial presentation fordiscontinued operations in accordance with Regulation S-X, McLeodUSA would berequired to obtain a new audit opinion with respect to the year ended December31, 2001.  Since Arthur Andersen is nolonger able to perform audits of publicly trade companies, Deloitte &Touche has informed McLeodUSA, consistent with Interpretations of SAS No. 58(AU Section 508), they would be required to re-audit McLeodUSA’s financialstatements for the year ended December 31, 2001 to provide McLeodUSA with anaudit opinion on such financial statements.

 

In light of McLeodUSA’s reorganization, sale of businesses, andimplementation of fresh-start accounting on April 16, 2002, McLeodUSA hasdetermined that the expense and effort associated with a re-audit is not in thebest interest of McLeodUSA or its stockholders.  As an alternative to a re-audit McLeodUSA has included in itsmost recent Annual Report on Form 10-K unaudited consolidated financial statements,prepared in accordance with GAAP, reflecting the impact of the discontinuedoperations for the year ended December 31, 2001.  In order for McLeodUSA to sell securities with a registrationstatement declared effective by the SEC, the registration statement mustcontain three years of audited financials.

 

Should McLeodUSA elect to conduct a re-audit of 2001 in order toutilize such effective registration statements, McLeodUSA does not know ifDeloitte & Touche would have any differences in opinion with the prioraudit conducted by Arthur Andersen.  Atthis time, McLeodUSA is aware of no material differences of opinion.  In regard to the 2001 unaudited financialstatements, the Company is in discussions with the SEC regarding the SEC’sinquiry into certain accounting matters, including disclosures related toseveral IRU contracts.

 

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**Information Regarding Forward-Looking Statements**

** **

Some of the statements in thisdiscussion include statements about our future expectations.  Statements that are not historical facts areforward-looking statements for the purpose of the safe harbor provided bySection 21E of the Exchange Act and Section 27A of the Securities Act.  Such statements may include projections of financialand operational results and goals, including revenue, profitability, savingsand cash. In some cases, you can identifythese so-called “forward looking statements” by our use of words such as “may,”“will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,”“predict”, “project”, “intend” or “potential” or the negative of those wordsand other comparable words.****These forward-looking statementsare subject to known as well as unknown risks and uncertainties that may causeactual 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 statement include technological,regulatory, public policy or other developments in our industry, availabilityand adequacy of capital resources, current and future economic conditions, theexistence of strategic alliances, our ability to generate cash, our ability toimplement process and network improvements, our ability to attract and retaincustomers, our ability to migrate traffic to appropriate platforms and changesin the competitive climate in which we operate.  These and other risks are described in more detail in our most recentAnnual Report on Form 10-K filed with the SEC. Except as required under the federal securities laws and rules andregulations of the SEC, the Company undertakes no obligation to update publiclyany forward-looking statements, whether as a result of future events, newinformation or otherwise.

 

**Item2**.    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 for the year endedDecember 31, 2003.

 

# *In the fourth quarter of 2001, theCompany developed a revised strategic plan, which focused on profitable revenuegrowth in our 25-state footprint.  Thisplan served as the basis for our re-capitalization with our principalshareholder, Forstmann Little & Co., our lender group, and our PreferredShareholders, as well as the structuring of the Exit Facility (as definedbelow) and continues to serve as the basis of our yearly operating plans*.

# * *

In order to execute our plan weinitiated a variety of programs across the business to significantly improvethe customer experience, eliminate unneeded infrastructure and cost, improvethe quality of the network and grow the top line revenues.  Over the past two years the Company hassuccessfully executed nearly all of these programs.  The operational and financial results of the Company, as reportedin our quarterly and annual financial releases, reflect the significant progressthat has been made in the operational areas.

 

However, the Company’s revenues have not increased as forecasted andhave been declining since 2002.  Thedecline in revenue was driven by the Company’s program to eliminatenon-profitable customers, turnover of customers to competitors in excess of newcustomers acquired, reduction of long distance minutes used by our customerbase, reduction in access rates as mandated by the FCC, and lower prices forsome of our products.  The Company hastaken significant actions to increase revenue, including introduction of newcompetitively priced products, reorganization of the sales operation into threedistinct channels, hiring of experienced executive sales leadership, expandingthe involvement of the board of directors and executive staff in the salesprocess and reducing customer churn. While the Company believes that these actions will over time result inprofitable new revenue growth, the timing and amount of that growth is yet tobe determined.

 

The strategic plan and recapitalization anticipated that the Companywould require additional funding to ultimately reach positive earnings and cashflow and established an exit financing facility (“Exit Facility”) of $160million and obtained funding for $110 million of that facility as arevolver.  In order to access the ExitFacility, the Company must be in compliance with certain restrictivecovenants.  In the first quarter of 2004the Company recognized that as a result of the continued decline in revenues,it would be necessary to obtain an amendment to those covenants from its lendergroup.  The Company sought and obtainedapproval of amendments from its lender group on April 30, 2004, which wereeffective as of March 31, 2004, and was in full compliance with the amendedcovenants as of March 31, 2004.  Goingforward the Company will need to increase its revenue and profitability inorder to continue to meet the restrictive covenants.  If revenues and profitability do not increase as anticipated, theCompany may be required to obtain waivers or further modifications of certaincovenants in order to access any unused portion of the Exit Facility.  While the Company believes it has strongrelationships with its lender group, there can be no assurance that the Companycould obtain such waivers or the necessary covenant amendments.

 

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The Company has undertaken numerous actions to conserve cash over thepast 18 to 24 months, including the reduction of capital expenditures andselling, general and administrative expenses (“SG&A”), as well as theexecution of its extensive cost reduction efforts initiated in late 2001 andcontinuing through 2004.  In connectionwith the amendment to the covenants the Company developed a revised businessplan which incorporated additional actions focused on reducing SG&Aexpenses and conserving cash (see *Management’s Discussion and Analysis – Liquidity andCapital Resources*for additional details).  Going forward we will continue to execute on these initiativesand implement additional similar actions to conserve cash until our revenuegrowth initiatives take hold.  We havebeen selective in managing capital expenditures and do not believe that any ofthe reductions in capital spending will have a material impact on our abilityto grow short-term revenues. Ultimately, we believe the Company will be successful in executing itsstrategy to profitably grow revenue. However, if the timing of such growth limits or restricts our access tothe unused portion of the Exit Facility, then we would be required to initiatemore aggressive expense reductions and potentially seek alternative sources offunding.  In the event the Company seeksalternative sources of funding, there can be no assurances such funding sourceswould be available.

 

**Overview of Our Business**

 

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

 

As of March 31, 2004, weoperated a network with 667 access nodes collocated in RBOC centraloffices.  We serve our customers byusing various loop/access unbundled network elements (“UNEs”) provided by theRBOCs and aggregating them through our access nodes.  In turn, our access nodes are interconnected throughapproximately 40 service node locations where our switching/routing systemsreside.  In a metropolitan area, accessnode to service node connectivity is based either on our own fiber facilitiesor on UNE transport from the RBOCs.  Ourservice nodes are located in most of the major metropolitan areas across ourfootprint.  These service nodes are inturn interconnected by our high capacity, inter-city core network.  The underlying transport for our corenetwork is based either on our own fiber or on leased capacity frominterexchange carriers

 

To develop these networks, wehave assembled a collection of metro and inter-city network assets in our25-state footprint, substantially all of which we own or control, making us afacilities-based carrier.  These networkassets incorporate state-of-the-art fiber optic cable, dedicated wavelengths oftransmission capacity on fiber optic networks and transmission equipmentcapable of carrying high volumes of data, voice, video and Internettraffic.  We operate in a 25-statefootprint, which consists of the following states:

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

 

**SFAS 144, Unaudited2001 Financial Statements and Re-Audit Requirements**

 

In connection with our reorganization, McLeodUSA completed the sale ofcertain businesses.  In our most recentAnnual Report on Form 10-K, based on the requirements of SFAS 144, McLeodUSAreflected these businesses and other businesses that were sold as discontinuedoperations for the periods January 1, 2002 to April 16, 2002 and April 17, 2002to December 31, 2002.  In accordancewith accounting principles generally accepted in the United States of America(“GAAP”), McLeodUSA is required to present its financial statements for theyear ended December 31, 2001, reflecting these businesses as discontinuedoperations.  McLeodUSA’s formerauditors, Arthur Andersen LLP (“Arthur Andersen”), audited McLeodUSA’sfinancial statements and issued an audit opinion for the year ended December31, 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

 

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accordance with Regulation S-X, McLeodUSA would be required to obtain anew audit opinion with respect to the year ended December 31, 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),*that they would be required to re-audit McLeodUSA’s financial statements forthe year ended December 31, 2001 to provide McLeodUSA with an audit opinion onsuch financial statements.

 

In light of McLeodUSA’s reorganization, sale of businesses, andimplementation of fresh-start accounting on April 16, 2002, we have determinedthat the expense and effort associated with a re-audit is not in the bestinterest of McLeodUSA or its stockholders. As an alternative to a re-audit, McLeodUSA has included in its most recentAnnual Report on Form 10-K unaudited consolidated financial statements,prepared in accordance with GAAP, reflecting the impact of the discontinuedoperations for the year ended December 31, 2001.  In order for McLeodUSA to sell securities with a registrationstatement declared effective by the SEC, such registration statement mustcontain three years of audited financials.

 

Should McLeodUSA elect to conduct a re-audit of 2001 in order toutilize such effective registration statements, McLeodUSA does not know ifDeloitte & Touche would have any differences in opinion with the prioraudit conducted by Arthur Andersen.  Atthis time, McLeodUSA is aware of no material differences of opinion.  In regard to the 2001 unaudited financialstatements, the Company is in discussions with the SEC regarding the SEC’sinquiry into certain accounting matters, including disclosures related toseveral IRU contracts.

 

**CriticalAccounting Policies 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 ConsolidatedFinancial Statements in the McLeodUSA Annual Report on Form 10-K for the yearended December 31, 2003, describe the significant accounting estimates andpolicies used in preparation of the Condensed Consolidated FinancialStatements. Actual results in these areas could differ from management’sestimates. There have been no significant changes in our critical accountingestimates during the first quarter of 2004.

 

**Liquidity and CapitalResources**

 

Prior to August 2001, McLeodUSA grew rapidly by focusing on top-linerevenue growth, which required significant capital for the construction oflocal and long distance voice networks and a national data network and includedthe acquisition of numerous businesses. By mid-2001, due to certain factors, including but not limited tocomplications related to the Company’s rapid growth and a general downturn inthe economy and the telecommunications sector in particular, the Company wasnot meeting internal expectations in terms of profitability and cash flow.

 

Beginning in August of 2001, we initiated a new strategic plan whichincluded a broad financial and operational restructuring.  Our new strategy was to refocus our businessto be a facilities-based communication services provider within our 25-statefootprint, improve business discipline and processes and reduce our coststructure, all with the goal of profitably growing revenues and generatingpositive cash flow from operations.  Keyelements of the restructuring included abandonment of the national networkplan, disposing of non-core businesses, reducing the employee base,consolidating facilities, reducing capital expenditures, and eliminatingunprofitable services and unprofitable customers.

 

We have generally completed the construction and integration of ournetwork assets and our future capital expenditures are focused on reducing costof service, adding capacity to our network to serve new customers, anddeveloping new products to compete in the marketplace.  Our capital expenditure plan is closelymanaged.  The Company does not believethat it has significant capital requirements to complete its currentconstruction work in progress for its intended use.

 

In the near term, we expect to incur net negative cash flows as theresult of remaining lease payments and lease buyouts associated with facilityexits made in 2001 and 2002 as part of our restructuring, and to fundcontinuing working capital needs and service our debt.  We believe that the actions we have takenand the successful execution of our strategic plan will position us to besuccessful over the long-term.

 

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*Background of CapitalStructure and Credit Facilities*

 

During 2001, in connection with our revised business strategy, we beganto explore restructuring our capital structure.  Any restructuring involving a payment to bondholders, other thanregularly scheduled payments of principal and interest, required a majorityconsent under our Credit Agreement.  Inorder to effect a restructuring, we entered into the Third Amendment to theCredit Agreement.  Under the ThirdAmendment, the lenders under the Credit Agreement waived: (1) any bankruptcyand payment cross-defaults with respect to the Notes arising from therestructuring; (2) covenants restricting the sales of assets in order to allowthe sale of Pubco pursuant to the restructuring, and the use of the $600million of proceeds therefrom to make a payment to the bondholders; and (3)certain other covenants and other provisions of the Credit Agreement that wouldhave restricted our ability to enter into various transactions necessary toconsummate the restructuring.  The ThirdAmendment contained certain modifications that became effective upon ourconsummation of the Plan, including, among other things, the modification ofvarious financial covenants and the addition of a capital expenditurelimitation, a 1% increase in the applicable rates of interest on the borrowingsunder the Credit Agreement and the establishment of certain prepayment premiumsapplicable to the Credit Agreement term loan repayments made in the first threeyears following the restructuring.

 

As provided for in the Third Amendment to the Credit Agreement, weentered into the Exit Facility with a consortium of banks upon consummation ofthe Plan on April 16, 2002.  The ExitFacility consists initially of a revolving credit facility of $110million.  In addition, we have the rightto obtain additional commitments to increase the size of the Exit Facility upto $160 million.  The Exit Facilitymatures on May 31, 2007, with any outstanding amounts due on that date; noprincipal payments are due until this 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.

 

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

 

The Exit Facility and the Credit Agreement include restrictions as to,among other things, additional indebtedness, liens, sale and lease-backtransactions, investments, asset sales, certain payments by restrictedsubsidiaries, capital expenditures and designation of unrestrictedsubsidiaries.  The Exit Facility and theCredit Agreement also contain restrictive covenants that limit our leverageratio and require minimum levels of interest coverage and consolidatedrevenue.  On April 30, 2004 we enteredinto the Fifth Amendment to the Credit Agreement and the Second Amendment tothe Exit Facility.  The approvedamendments include changes to the minimum revenue, leverage ratio and interestcoverage ratio covenants.  The minimumrevenue covenant was amended to $825 million, $780 million, $760 million, and$770 million in the first quarter through fourth quarter of 2004, respectively.  There is no minimum revenue covenant in2005.  The leverage ratio was replacedwith a minimum cumulative EBITDA covenant (as defined in the Credit Agreementand Exit Facility, as amended) of $8 million, $16 million, $24 million and $34million for the first through fourth quarters of 2004, respectively, and atrailing four quarter minimum EBITDA of $49 million, $69 million, $89 million and $114 million for the firstthrough fourth quarters of 2005, respectively.** **The interest coverage****ratio was amended to 1.0x for each of thefour quarters of 2004 and 1.0x, 1.5x, 2.0x and 2.0x for the first throughfourth quarters of 2005, respectively. The Company offered and included in the amendment a downward revision tothe capital expenditure limits for 2004 and 2005 to $75 million and $100million, respectively.  There were nochanges to the capital expenditure limit of $200 million for the years 2006 andbeyond.  In addition, the secondamendment limits the outstanding amounts under the Exit Facility to $75.0million for the period from April 1, 2004 through June 30, 2004 and to $90.0million during the period July 1, 2004 through September 30, 2004.

 

We have taken additional steps to conserve cash and improve liquiditywhile continuing to execute the revenue growth plan.  Actions that have been taken to generate further operationalefficiencies and focused expense management are expected to result inapproximately $8 million of quarterly SG&A run-rate savings by the fourthquarter of 2004.  We have reduced ourgrowth related capital expenditure plan and now expect to spend approximately$50 million to $55 million in 2004 versus our initial plan of $65 million.  The capital expenditure plan for 2004remains dedicated to new product introduction, cost savings programs and strategicgrowth initiatives.  In addition, we havere-initiated our plan to sell fiber assets. This plan was originally developed as part of our 2002recapitalization.  We did not implementthe plan at that time due to our success in selling other non-core assets.  We are targeting $50 million in fiber salesin 2004.

 

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We paid approximately $1.9 million in fees in April 2004 to the lendergroup in connection with the approval of these amendments.  We are currently in compliance with theamended financial covenants under the Credit Agreement and Exit Facility.  As of March 31, 2004, we have drawn $65million on the Exit Facility and we have standby letters of credit outstandingof $9.0 million that further reduce our borrowing availability under the ExitFacility.

 

**2004Cash Flow**

 

We ended the quarter with $49.0 million of cash and cash equivalentsversus $56.5 million at December 31, 2003. This decrease of $7.5 million resulted primarily from the following:

 

| Operating Activities:                                                          |   |   |   |
|--------------------------------------------------------------------------------|--------|--------|--------|
| Increase in cash from operations, excluding  changes in assets and liabilities |   | $      | 0.1    |   |
| Payments for restructuring liabilities                                         |   | (7.9   | )      |
| Use of cash for changes in assets and  liabilities                             |   | (3.2   | )      |
| Net cash used by operating activities                                          |   | (11.0  | )      |
|                                                                           |   |   |   |
| Investing Activities:                                                          |   |   |   |
| Capital expenditures                                                           |   | (13.3  | )      |
| Deferred line installation costs                                               |   | (8.4   | )      |
| Sale of assets                                                                 |   | 6.0    |   |
| Net cash used by investing activities                                          |   | (15.7  | )      |
|                                                                           |   |   |   |
| Financing Activities:                                                          |   |   |   |
| Payments on long-term debt                                                     |   | (5.8   | )      |
| Proceeds from long-term debt                                                   |   | 25.0   |   |
| Net cash provided by financing activities                                      |   | 19.2   |   |
|                                                                           |   |   |   |
| Net decrease in cash and cash equivalents                                      |   | $      | (7.5   | ) |

 

The payments for restructuring liabilities primarily related toremaining lease payments and lease buyouts associated with facility exits madein 2001 and 2002 as part of our restructuring. The use of cash related to changes in assets and liabilities primarilyrelated to a reduction of our other current liabilities, not including therestructuring liabilities, of $10.0 million during the first quarter of 2004,substantially offset by a reduction in our trade accounts receivable balancesof $7.9 million.  We expect ourquarterly cash requirements to pay restructuring liabilities to be less duringthe remainder of 2004.

 

As discussed above, we have reduced our growth-related capitalexpenditure plan and expect to spend approximately $50 million to $55 millionduring 2004.  The capital expenditureplan for 2004 remains dedicated to new product introduction, cost savingsprograms and strategic growth initiatives. Deferred line installation costs are the result of costs required to addcustomers onto our network in 2004.  Ourdeferred line installation expenditures throughout the rest of 2004 will bedependent on the rate at which we add new customers.

 

During 2003, our long-term debt began amortizing and principal paymentsof $5.5 million were made in the first quarter of 2004.  In March 2004, we borrowed $25.0 millionunder our $110 million Exit Facility. During the remainder of 2004, mandatory debt repayments under the CreditAgreement will total $21.2 million.

 

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**Outlookfor 2004 and Future Funding Needs**

 

We ended the first quarter of2004 with $49.0 million of cash on hand. In 2004, our cash requirements for new products, important capitalexpenditure projects, remaining lease payments and lease buyouts associatedwith facility exits made in 2001 and 2002 (as part of our restructuring) aswell as working capital will all be funded by cash generated from operatingactivities, sale of fiber assets and borrowings under the Exit Facility.  As contemplated in our strategic plan and aspart of our April 2004 discussions with our lender group, we plan to use theExit Facility to fund ongoing cash needs. We drew $25 million during March 2004 and at March 31, 2004 we hadapproximately $35 million of unused availability under the Exit Facility.  The most recent amendments include agreedupon withdrawals of $15 million in the third quarter and $20 million in the fourthquarter of 2004.  Our Exit Facilityallows for another $50 million of outstanding debt, which could be funded fromour existing lender group or other parties.

 

Our ability to access theremaining unused portion of the Exit Facility requires compliance with certainrestrictive covenants.  Those covenantsrequire increases in the Company’s revenue and profitability over time.  While the Company believes it will besuccessful in executing its strategy to profitably increase revenues, it may berequired to obtain waivers or amendments to those covenants from its lendergroup if revenues or profitability do not increase as anticipated.  The Company believes it has strongrelationships with its lender group, but there can be no assurances that theCompany could obtain any necessary waivers or amendments.  Under certain circumstances the Companywould be required to initiate more aggressive expense reductions or potentiallyseek alternative sources of funding, the availability of which cannot beassured.

 

**Three Months EndedMarch 31, 2004 Compared with Three Months Ended March 31, 2003**

 

***Revenue.***  Total revenue for the quarter ended March31, 2004 declined $32.3 million, or 14%, to $193.6 million from $225.9 millionfor the quarter ended March 31, 2003. The following table compares our revenue for the three months endedMarch 31:

 
|                                                                                     |   | **2004** |   | **2003** |   | **Variance** |   |
|------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|--------------|--------|
| Local                                                                                    |   | $        | 95.5   |     | $      | 106.8        |   | $ | (11.3 | ) |
| Long distance                                                                            |   | 35.9     |   | 48.2     |   | (12.3        | )      |
| Data services and other                                                                  |   | 35.5     |   | 34.8     |   | 0.7          |   |
| Carrier access                                                                           |   | 24.8     |   | 34.2     |   | (9.4         | )      |
| Indefeasible rights of use  agreements including those that qualify as sales type leases |   | 1.9      |   | 1.9      |   | —       |   |
|                                                                                     |   | $        | 193.6  |     | $      | 225.9        |   | $ | (32.3 | ) |

 

Total overall decline of $32.3million in total revenue versus the first quarter of 2003 is attributed tocontinued decline in total customers, FCC mandated reduction in access rates,and lower long distance volume and rates. The decrease in long distance revenue is attributed to both a 13% dropin the volume of minutes, primarily driven by lower usage patterns across ourcustomer base, as well as a 16% decline in average rates from the three monthsended March 31, 2003.  Local and longdistance average revenues per customer have decreased year over year as theCompany has reduced the cost of service and offered substantially morecompetitive pricing for these products. Access revenues have decreased $11.6 million from the first quarter of2003 due to the June 2003 FCC mandated rate reduction partially offset byincreased volume and increased revenues related to our FX 800 connectionservices.  Included in revenues fromindefeasible rights of use in the above table is $1.5 million and $1.7 millionfor the quarters ended March 31, 2004 and 2003, respectively, related toon-going revenues from operating leases.

 

The Company has takensignificant actions to increase revenue including introduction of newcompetitively priced products, reorganization of the sales operation into threedistinct channels, hiring of experienced executive leadership and expanding theinvolvement of the board of directors and executive staff in the salesprocess.  While the Company believesthat these actions will over time result in profitable new revenue growth, thetiming and amount of that growth is yet to be determined.

 

***Costof Service***. Cost of service includes expenses directly associated with providingcommunication services to our customers. Costs classified as cost of service include, among other items, the costof connecting customers to our network

 

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via leased facilities, thecosts paid to third party providers for interconnect access and transportservices, the costs of leasing components of our network facilities and thecost of fiber related to sales and leases of network facilities.  Cost of service was $107.6 million for thequarter ended March 31, 2004, a decrease of $29.8 million or 22% from thequarter ended March 31, 2003. Approximately $20 million of the decrease is attributed to the reductionin revenues.  The balance of the decreasereflects the results of our ongoing network cost reduction efforts that beganin 2002, including least cost routing, network optimization including grooms,migration of customers to the McLeodUSA network and elimination ofnon-profitable customers.

 

***Selling,general and administrative expenses.***  SG&A includes expenses related to salesand marketing, customer service, internal network operations and engineering,information systems and other administrative functions.  SG&A expenses were $75.7 million for thefirst quarter of 2004, a decrease of $6.0 million or 7% from 2003.  Our continuous process improvement program,which has been ongoing since early 2002, has yielded significant efficiencies.  As a result, headcount has been reduced fromapproximately 3,700 to 3,000 employees at March 31, 2003 and 2004,respectively.

 

***Depreciationand amortization.*** Depreciation and amortization includes the depreciation of ourcommunications network and equipment, amortization of other intangiblesdetermined to have finite lives, and amortization over the life of the customercontract of one-time direct installation costs associated with transferringcustomers’ local line service from the RBOCs to our local telecommunicationsservices.  Depreciation and amortizationexpenses were $90.2 million for the quarter ended March 31, 2004, an increaseof $8.0 million over the first quarter of 2003.  This increase was due to a higher depreciable asset base as aresult of additional assets being placed in service during 2003 and 2004.

 

***Interestexpense.*** Gross interest expense was $11.8 million for both of the quarters endedMarch 31, 2004 and 2003.  Net interestexpense increased by $2.4 million in the quarter ended March 31, 2004 due tolower capitalized interest as a result of lower construction in progressbalances during the quarter.  Interestexpense of approximately $0.7 million and $3.1 million was capitalized as partof our construction of our fiber optic network during the quarter ended March31, 2004 and 2003, respectively.

 

**Inflation**

** **

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

 

**Item3**.  Quantitativeand Qualitative 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 approximately $763 million under theCredit Agreement outstanding at March 31, 2004.  If market interest rates average 1% more in subsequent quartersthan the rates during the quarter ended March 31, 2004, quarterly interestexpense would increase by $1.9 million. This amount was determined by calculating the effect of the hypotheticalinterest rate increase on our variable rate debt for the quarter and does notassume changes in our financial structure.

 

**Item4**.            Controlsand Procedures

** **

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

 

(b) *Internal Controls over FinancialReporting*.  There have notbeen any changes in the Company’s internal control over financial reporting (assuch term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)during the fiscal quarter to which this report relates that have materiallyaffected, or are reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

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

 

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

 

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 (N.D. Iowa) (the ‘‘Iowa Class Action’’). TheIndividual Defendants have filed a motion to dismiss the amended consolidatedcomplaint in the Iowa Class Action, which was denied by the district judge. Oneof the putative class plaintiffs, New Millenium Growth Fund LLC, also filedproofs of claim against McLeodUSA in McLeodUSA’s Chapter 11 Case for at least$104,650 on its own behalf and for no less than approximately $300 million(plus interest, costs and attorneys’ fees as allowed) on behalf of all classclaimants in the Iowa Class Action (the ‘‘Bankruptcy Claims’’ and, togetherwith the Iowa Class Action, the ‘‘Securities Claims’’). As the Securities Claimsare in early stages, it is impossible to evaluate the likelihood of unfavorableoutcomes or, with respect to the Iowa Class Action, to estimate the amount orrange of potential loss, if any, to McLeodUSA. With respect to the BankruptcyClaims, on May 2, 2002 the Bankruptcy Court issued an order establishing adisputed claims reserve of 18,000,000 shares of Reorganized McLeodUSA Class ACommon Stock. Any recovery from the Bankruptcy Claims would be limited to thoseshares of stock. McLeodUSA believes that the Securities Claims are withoutmerit and intends to defend them vigorously.

 

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

 

McLeodUSAis also involved in numerous regulatory proceedings before various publicutility commissions and the FCC, particularly in connection with actions by theRBOCs. McLeodUSA anticipates the RBOCs will continue to pursue litigation,regulations and legislation in states within McLeodUSA’s 25-state footprint andbefore the FCC to reduce regulatory oversight and regulation over rates,network access and operations. The RBOCs are also actively pursuing majorchanges in the Telecommunications Act of 1996, by regulatory litigation andlegislation, which McLeodUSA believes would adversely affect competitivetelecommunications service providers including McLeodUSA. If adopted, theseinitiatives could make it more difficult for McLeodUSA to challenge the RBOCs’actions, or to compete with the RBOCs, in the future. There are no assurancesthat McLeodUSA will prevail in its disputes with the RBOCs.

 

The FCCreleased its Triennial Review Order in August 2003 modifying its rulesgoverning availability of RBOC unbundled network elements to competitivecarriers. The Triennial Review Order established new rules governing theavailability and pricing for the network elements the RBOCs must provide tocompetitive carriers, and delegated authority to the states to apply certain ofthe new rules in individual markets. Several appeals of the TRO wereconsolidated in the Court of Appeals for the District of Columbia (the “Courtof Appeals”). On March 2, 2004, the Court of Appeals issued a decisionoverturning many key elements of the TRO, remanding most of the order to theFCC for further action. The Court of Appeals ruled that the FCC’s delegation offinal impairment decisions to state agencies was unlawful.  The Court also reversed the FCC’s nationwidefinding of presumptive impairment for mass market switches, and dedicatedtransport and loops. The Court directed the FCC to give stronger considerationto intermodal competition when revising its rules on remand. The Court upheldthe FCC determination that RBOCs do not have to unbundle loops made up of acombination of copper and fiber or to provide CLECs access to new loops. TheCourt also upheld the FCC’s findings that RBOCs are not required to provideunbundled switching to CLECs for business customers served by high-capacityloops, such as DS-1 or packet switching. State proceedings that had beenstarted to determine whether DS-0 switch ports should remain available asunbundled network elements are being suspended in some states and continued inother states. The Court originally stayed the effective date ofits order for 60 days in order to provide the FCC with an opportunity toimplement new unbundling rules. Subsequently, on March 31, 2004, the FCC issued a press release andletters to a number of industry participants and trade associations encouragingindustry members to engage in commercial negotiations to address issues raisedin the TRO.  To facilitate thesecommercial negotiations, the FCC sought and obtained an additional 45-day stayfrom the Court of Appeals.   McLeodUSAhas executed Confidentiality Agreements with Qwest and SBC, our primarysuppliers of network facilities, and opened discussions with each of them.  The stay of the Court of Appeals’ decisionis now set to

 

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end on June 15, 2004.  Regardless of the success, or lack ofsuccess, of these commercial negotiations, it is likely that the Court ofAppeals’ decision and the TRO will be the subject of continued litigation.  Therecan be no assurance that our businesses will not be materially adverselyaffected by the TRO, continued legal challenges to the TRO, the decision of theCourt of Appeals, new legislation passed in response to the TRO or any courtdecisions that result from continued legal challenge to the TRO or current lawand regulations.

 

The FCChas an open docket proposing to reform intercarrier compensation.  An industry group known as the “IntercarrierCompensation Forum” (ICF) is expected to provide a recommended framework forreforming intercarrier compensation related to switched access and reciprocalcompensation charges.  Once the ICFprovides its recommendation to the FCC, the FCC will solicit comments on theissue.  A final decision is expected noearlier than the first quarter of 2005, and the current framework ofintercarrier compensation rules could be materially affected.   Also, on May 13, 2004, it is anticipatedthat the FCC will issue a final decision on CLEC access charges that apply tothe routing of certain 800 traffic. There can be no assurance that our businesses will not be materiallyadversely affected by the decision.

 

 On September 10, 2003, the FCC issued aNotice of Proposed Rulemaking (‘‘NPRM’’) on TELRIC. This is a proceeding toreview the TELRIC methodology used to determine the prices charged tocompetitive carriers for unbundled network elements. A change in pricingmethodology that materially increases unbundled network element prices wouldincrease our costs and could adversely affect our ability to compete. Adecision is anticipated during 2004.

 

The FCCissued on March 10, 2004 its NPRM on ‘‘IP-enabled communications,’’ which includesVoIP. The NPRM asks broad questions regarding the regulatory classifications ofvarious ‘‘IP-enabled’’ services, including different VoIP services; the accesscharge and other intercarrier compensation implications; the universal serviceimplications; and the other social policy implications such as law enforcement,disability and emergency 911 service issues and suggests, as a generalproposition, the economic regulation of various IP-enabled services should bekept to a minimum.

 

Generally,state utility commissions or third parties could raise issues with regard toour compliance with applicable laws or regulations which could have a materialadverse effect on our business, results of operations and financial condition.Several state utility commissions have reviewed or are actively reviewing thepropriety of certain agreements we entered into with Qwest, includingWashington, Arizona, and Colorado, and these proceedings may result in fines orother sanctions against us or the imposition of other conditions detrimental tous, including the establishment of discounts available to other competitivetelephone companies but not to us. Other states may initiate similarproceedings.

 

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

 

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

 

(a)           Exhibits

 
|   | **Exhibit  Number** |   | **Exhibit  Description**                                                                                                         |
|--------|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------|
|   |                |   |                                                                                                                             |
|   | 4.1                 |   | Second Amendment dated as of April 21, 2004 to the  Credit Agreement dated as of April 16, 2002.                                 |
|   | 4.2                 |   | Fifth  Amendment dated as of April 21, 2004 to the Senior Credit Agreement dated as  of May 31, 2000.                            |
|   | 31.1                |   | Certification  of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
|   | 31.2                |   | Certification  of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
|   | 32.1                |   | Certification  of CEO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. |
|   | 32.2                |   | Certification of CFO pursuant to 18 U.S.C. Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  |

 

(b)           Reports on Form 8-K

 

On February18, 2004 we filed a Current Report on Form 8-K announcing our financial resultsfor the fiscal quarter and total year ended December 31, 2003, and certainother information, in a press release.

 

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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:  May 10, 2004 | By:                        | /s/ Chris A. Davis |   |
|                     |                       | Chris A. Davis |   |
|                     |                       | *Chairman and Chief Executive Officer* |   |
|                     |                       |   |   |
|                     |                       |   |   |
| Date:  May 10, 2004 | By:                        | /s/ G. Kenneth Burckhardt |   |
|                     |                       | G. Kenneth Burckhardt |   |
|                     |                       | *Chief Financial Officer* |   |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** |   | **Exhibit Description**                                                                                                          |
|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------|
| 4.1                 |   | Second  Amendment dated as of April 21, 2004 to the Credit Agreement dated as of  April 16, 2002.                                |
| 4.2                 |   | Fifth  Amendment dated as of April 21, 2004 to the Senior Credit Agreement dated as  of May 31, 2000.                            |
| 31.1                |   | Certification  of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
| 31.2                |   | Certification  of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
| 32.1                |   | Certification  of CEO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. |
| 32.2                |   | Certification  of CFO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. |
|                |   |                                                                                                                             |

 

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