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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

McLeodUSA Incorporated
(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code: (319) 364-0000

Securities registered pursuant to Section 12(g) of the Act:

Class A common stock, par value $0.01 per share
2.5% Series A convertible preferred stock, par value $0.01 per share
(Title of Classes)

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

        Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý

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

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

        The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 28, 2002, based upon the closing price of the registrant's common stock on June 28, 2002 is $68,184,455.^*/

        The number of shares outstanding of each of the registrant's classes of common stock, as of March 17, 2003, is:

•

Class A common stock, par value $0.01 per share: 162,500,978 shares



•

Class B common stock, par value $0.01 per share: 78,203,135 shares



•

Class C common stock, par value $0.01 per share: 35,546,879 shares

*/

Solely for the purposes of this calculation, all directors and executive officers of the registrant and all stockholders beneficially owning more than 5% of the registrant's common stock that have representation on the registrant's Board of Directors are considered to be affiliates.

DOCUMENTS INCORPORATED BY REFERENCE

        Portions of the definitive proxy statement for the Annual Meeting of Stockholders to be held on May 30, 2003 are incorporated by reference into Part III of this Form 10-K to the extent described therein.

TABLE OF CONTENTS

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Information Regarding Forward Looking Statements

        The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for certain forward looking statements. Some of the statements contained in this Form 10-K discuss future expectations, contain projections of results of operations or financial condition or state other forward-looking information. These statements are subject to known and unknown risks, uncertainties and other factors that could cause the actual events to differ materially from those contemplated by the statements. The forward-looking information is based on various factors and was derived using numerous assumptions. In some cases, you can identify these 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 words and other comparable words. You should be aware that those statements reflect only our current views with respect to such matters. Actual events or results may differ substantially. Important factors that could cause actual events or results to be materially different from the forward-looking statements include those discussed under the heading "Business—Risk Factors" and throughout this Form 10-K. We undertake no obligation to publicly update or revise any forward looking statements in connection with new or future events or otherwise.

PART I

ITEM 1.    BUSINESS.

Overview

        McLeodUSA Incorporated (together with its subsidiaries, referred to hereafter as "McLeodUSA," the "Company," "we," "us" or "our") is one of the nation's largest independent competitive telecommunications service providers, offering integrated local, long distance, Internet, and advanced communications services to homes and businesses in 25 Midwest, Southwest, Northwest, and Rocky Mountain states. Our principal executive offices are located at 6400 C Street SW, Cedar Rapids, Iowa 52406-3177, and our main phone number is (319) 364-0000.

        McLeodUSA was founded in 1992 and completed an initial public offering in June 1996. Our Class A Common Stock is currently traded on the NASDAQ SmallCap Market under the symbol "MCLD," and our Series A Preferred Stock is traded on the NASDAQ SmallCap Market under the symbol "MCLDO." In April 2002, we completed a Chapter 11 reorganization pursuant to a plan of reorganization, as more fully discussed below under "Business—Chapter 11 Reorganization."

        We are a facilities-based telecommunications provider with, as of December 31, 2002, 38 Asynchronous Transfer Mode switches, 50 voice switches, 562 collocations, 430 Digital Subscriber Line Access Multiplexers, over 31,000 route miles of fiber optic cable and approximately 3,700 employees. At December 31, 2002, we had approximately 432,000 customers.

        We derive our revenue from our core telecommunications and related communications services. These include local and long-distance services; dial-up Internet access services; high-speed/broadband Internet access services using DSL, cable modems, and dedicated T1 access; bandwidth and network facilities leasing, sales and services, including access services; facilities and services dedicated for a particular customer's use; advanced communications services for larger businesses such as frame relay, private line, and ISDN; and value-added services such as virtual private networks and web hosting. For the year ended December 31, 2002, we derived approximately 65% of our total revenues from local and long distance services; 13% from access services; 11% from private line and data services; and 11% from other sources. Approximately 84% of our competitive telecommunications services revenues were derived from retail sales and 16% from wholesale sales.

        We maintain a website with the address www.mcleodusa.com. We are not including the information contained on our website as a part of, or incorporating it by reference into, this Annual Report on Form 10-K. We make available free of charge (other than an investor's own Internet access charges)

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through our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to these reports, as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission.

Business Strategy—Vision Statement

        Our vision is to become a world-class, value-added telecommunications services provider with excellent customer relationships and strong, team-oriented business and operational performance, exhibiting the hallmarks of integrity, accountability, and commitment to excellence while providing a profitable return to our shareholders.

        We have strategically focused our business in the following 25-state footprint:

In 2002, we took significant steps to execute our business strategy, including the following:

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completed a financial restructuring, which reduced bank and bond indebtedness from nearly $4 billion to approximately $715 million, reducing annual interest expense from $365 million to approximately $50 million, see "Business—Chapter 11 Reorganization—Recapitalization";



•

completed divestiture of certain non-core businesses valued at approximately $1 billion, see "Business—Chapter 11 Reorganization—Divestitures";



•

completed a network optimization and standardization project, including the successful implementation of our regional transport and long distance network;



•

successfully migrated over 200,000 customer lines to on-net/on switch platforms, allowing us to better manage our customer base and provide for improved profitability;



•

launched new residential and business products and services under the Preferred Advantage^SM product line, featuring simplified product offerings, competitive pricing structures and enhanced billing formats, making it easier for our customers to buy bundled services and enabling a more efficient process for service installation and billing;



•

right-sized the organization and implemented workforce management programs;



•

initiated the StarQuality^SM training and certification quality program for all employees who touch our customers and/or our network; and



•

substantially improved business processes, infrastructure, productivity and quality, as evidenced by an approximately 65% reduction in service delivery intervals, a reduction in billing systems from 27 to 2, and the elimination of multiple network single points of failure to improve quality of service.

        As part of our business strategy, we also improved sales efficiencies by restructuring and refocusing our sales organization to align with the maximum market opportunity in profitable central offices. We also developed an integrated branding and marketing campaign utilizing advertising, direct marketing, and public relations, which was launched across our 25-state footprint in early 2003.

        As we enter 2003, we will continue to focus on increasing our market share, profitably growing our revenue and migrating our customer base onto our own network facilities to improve margins and facilitate improved customer service. We also plan to continue grooming our network to deliver service

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in the most effective and efficient manner, as well as continuing our focus on cost reductions and process improvement.

Network Facilities

        As of December 31, 2002, we operated a network with 562 access nodes collocated in Regional Bell Operating Company ("RBOC") central offices. We serve our customers by using various loop/access unbundled network elements ("UNEs") provided by the RBOCs and aggregating them through our access nodes. In turn, our access nodes are interconnected through approximately 50 service node locations where our switching/routing systems reside. In a metropolitan area, access node to service node connectivity is based either on our own fiber facilities or on UNE transport from the RBOCs. Our 50 service nodes are located in most of the major metropolitan areas across our footprint. These service nodes are in turn interconnected by our high capacity, inter-city core network. The underlying transport for our core network is based either on our own fiber or on leased capacity from interexchange carriers. We have also announced plans to spend up to $350 million over the next two years to further support our network and infrastructure growth requirements.

        We own and operate all the equipment in our access and service nodes. They provide the service logic and traffic management for all our services.

Products and Services

        We offer a complete portfolio of local, long distance, Internet, and advanced communications services principally via our Preferred Advantage product line, which can be sold separately or bundled. These include:

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local calling and features such as caller ID, call transfer, call forwarding, and 3-way calling;



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local data services such as dial-up and dedicated Internet access services, using DSL, cable modem and dedicated T1 technologies;



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long distance voice services such as outbound domestic and international long distance and toll free 800 services;



•

bandwidth and network facilities leasing, sales and services, including access services to carriers and wholesale purchasers;



•

calling card capabilities;



•

long distance/inter-LATA data services such as frame relay and private line for large businesses; and



•

advanced communications services such as virtual private networks and web hosting.

        Our service offerings can be categorized into Retail Services and Wholesale/Carrier Services, each of which is discussed in more detail below.

Retail Services—Preferred Advantage:

        As of December 31, 2002, we provided service, on a competitive retail basis, to about 432,000 customers, primarily small and medium-sized business customers in major metropolitan areas and in second- and third-tier markets in 25 states, and residential customers in second- and third-tier markets in 12 states. Since beginning sales activities in January 1994, we have increased our revenue from the sale of competitive telecommunications services from $4.6 million for the year ended December 31, 1994 to $992.1 million for the year ended December 31, 2002.

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        We have received state regulatory approval to offer local switched services using our own communications network facilities in each of the 25 states in our footprint. We intend to offer additional local switched services using our own network facilities, either alone or in combination with network elements purchased from existing telephone companies, in selected markets in our 25-state footprint.

        We have interconnection agreements with Qwest Communications International Inc. ("Qwest") in all states where Qwest is the incumbent local telephone company, with SBC Communications Inc. (through its subsidiaries) in all states where Ameritech Corporation or Southwestern Bell Telephone Company is the incumbent local telephone company, and with Verizon (through its GTE entities) and BellSouth in certain states. These agreements allow us to purchase unbundled network elements to connect our switching equipment and facilities to customers, and to resell services of these entities. One of our goals is to serve as many customers as possible using primarily our own network facilities because we believe this will allow us greater ability to control network costs, meet our customer service goals and prepare for possible changes in the regulatory environment.

        As of December 31, 2002, we served 52% of our local service customers using our own switching facilities connected to an unbundled local loop network element purchased from an incumbent local telephone company; we served 33% of our local service customers using both local loops and local switching purchased as unbundled network elements from incumbent local telephone companies; and we served 15% of our local service customers through resale of incumbent carrier retail services. This distribution compares to 36%, 40% and 24%, respectively, at the end of 2001.

        We provide long-distance service in some areas by purchasing communications network capacity, in bulk, from national long-distance carriers, and routing our customers' long-distance traffic over this capacity. In many of our local footprint states, we carry most of our long-distance traffic on our own network facilities. Our integrated communications services are further delineated below.

        In November 2002, we launched McLeodUSA Preferred Advantage products and services for both business and residential customers, which is our simplified product portfolio consisting of a variety of products and service choices ranging from simple local, long distance and Internet packages to tailored solutions of advanced communications for larger business customers.

        Residential Preferred Advantage Services.    We offer end-user residential customers integrated local, long distance, Internet and optional services such as calling card and residential 800 services directly in 12 states within our footprint and expect to expand these offerings to 8 more states in 2003. Product availability and pricing varies by market. Preferred Advantage products for residential customers include:

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a choice of three local service packages with a broad assortment of features;



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six long distance package plans using buckets of minutes based on anticipated calling patterns;



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dial-up Internet service; and



•

optional services such as voice mail, calling card, wire care, call restrictions, directory listing options, and toll-free numbers.

        Business Preferred Advantage Services.    In addition to residential services, we offer Preferred Advantage solutions for small to mid-size businesses, including the following:

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a choice of five local service packages with a wide variety of features;



•

seven long distance package plans using buckets of minutes based on anticipated calling patterns;



•

three Internet service options (dial-up, broadband and high speed);

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•

optional services including voice mail, calling card, wire care, call restrictions, directory listing options, hunting, conference calling, and other calling, features such as call forward busy/don't answer; and



•

flexible term and volume discount plans.

        Large Businesses/Major and Strategic Accounts Preferred Advantage Services.    McLeodUSA also serves large, major and strategic accounts that have more complex communications requirements via the Preferred Advantage "Toolkit" services which offer the ability to tailor customized solutions from a portfolio of services that include:

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a choice of five local service packages with a wide variety of features;



•

seven long distance package plans using buckets of minutes based on anticipated calling patterns;



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dedicated local Preferred Plan using T-1 and/or ISDN access connections;



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three Internet service options (dial-up, broadband, high speed);



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optional services including voice mail, calling card, wire care, call restrictions, directory listing options, hunting, conference calling, and other calling features such as call forward busy/don't answer;



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inter/intrastate rate per minute plans for long distance;



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enhanced 800 toll-free services;



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frame relay and private line services;



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web hosting and virtual private network services;



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flexible term and volume discount plans; and



•

FX 800 connection services.

Wholesale/Carrier Services:

        In addition to retail Preferred Advantage services, we provide a wide range of access, private line, network facilities and data services, as well as leased facilities to local and long-distance carriers, government agencies, wireless service providers, cable television companies and other carrier-class customers. These services generally include:

•

special access services between network facility centers, known as points-of-presence, or "POPs," that provide telecommunications lines that link the POPs of one long-distance carrier to POPs of other carriers in a market, allowing these POPs to exchange telecommunications traffic for transport to final destinations;



•

end-user special access services, that provide telecommunications lines that connect an end-user such as a large business to the local POP of its selected long-distance carrier;



•

long-distance carrier special access services that provide telecommunications lines that link a long-distance carrier POP to the incumbent local telephone company's local central office;



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private line services that provide telecommunications lines that connect various locations of a customer's operation and are used to transmit voice, video and/or data traffic;



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the sale and lease of network facilities; and



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other carrier access services.

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Sales, Marketing and Customer Service

        Direct sales personnel located in branch sales offices throughout our 25-state footprint conduct the majority of our sales of integrated communications services to business customers. We use telemarketers to sell these services to smaller business customers, including those located in areas that are geographically remote, and to residential customers. Sales activities in our branch sales offices are organized and managed by region.

        Our focus during 2002 was to realign our sales efforts to the most profitable, high potential markets based on the results of an extensive central office profitability analysis conducted in late 2001. We focused our sales and marketing efforts to target specific prospects and customers located in these markets, increasing our opportunity to grow profitable revenue for our business. In addition to physically locating our sales force in these locations, we have also matched our new advertising and direct marketing efforts to these targeted markets to enhance our opportunities for success. Detailed prospecting tools have been developed to identify high potential customer opportunities and increase sales force productivity. Finally, for 2003 we have added 250 central offices to the group of central offices where we are actively pursuing new sales. This has been done to expand our sales force's market opportunity, and is based on where our central office profitability studies have identified profitable revenue potential for our business.

        Our sales force is being trained to emphasize a customer-focused sales and service approach. For business field sales, we utilize a dedicated account representative who handles initial sales to new customers, and then assign an account team with responsibility to service and maintain the customer throughout their lifecycle with McLeodUSA. Our Customer Service Centers are available 24 hours a day, 7 days a week, and 365 days a year to handle issues and trouble resolution for all of our customers. We have streamlined this process, utilizing an Integrated Voice Response Unit, or "IVR," which allows customers to identify their needs with an automated menu, and transfer directly to a specialist trained to handle their specific needs. The IVR is designed to improve customer satisfaction on their first call by routing the customer to the person with the skills and tools needed to resolve a specific issue quickly and effectively. We believe this emphasis on a single point of contact for meeting customers' communications needs is very appealing to current and prospective customers. In 2003, we are embarking on an enhanced service model requiring employees who touch either our customers or our network to be StarQuality^SM certified. The goal of this extensive training and certification program is to ensure the highest levels of quality service for our customers.

        We have also developed and installed customer-focused software for providing integrated communications services. This software allows us to provide our customers one fully-integrated monthly billing statement for local, long distance, 800, international, voice mail, paging, Internet access and travel card services, and additional services when available. We believe that our customer-focused software platform is an important element in the marketing of our communications services and gives us a competitive advantage in the marketplace.

        Through an operating agreement with the Yell Group, as discussed under "Business—Chapter 11 Reorganization," we use telephone directories as advertising by including detailed product descriptions and information about our communications products in each directory. We believe these telephone directories provide us with a marketing presence in the millions of households and businesses that receive them. We also believe that the telephone directories provide a distinct competitive marketing advantage and strengthen our brand awareness.

        In January 2003, McLeodUSA launched a coordinated advertising campaign to ensure that McLeodUSA customers and prospects become fully aware of the advantages of doing business with us. We named the New York office of J. Walter Thompson to serve as agency of record for our advertising, and Protocol Marketing Group to manage all direct marketing programs related to our Preferred Advantage products. We also announced that we plan to spend approximately $18 million during 2003

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on a fully-integrated advertising and direct marketing campaign, targeted to reach the high potential markets and prospects identified by our intensive research efforts. This plan is intended to help drive profitable revenue growth for our business during 2003 and increase the presence and awareness of McLeodUSA as an attractive, integrated communications service provider.

Employees

        As of December 31, 2002, McLeodUSA and its subsidiaries had approximately 3,700 employees. We believe that our future success will depend on our continued ability to attract and retain highly skilled and qualified employees.

Executive Officers

        The following is a list of our executive officers as of March 17, 2003, together with biographical summaries of their experience. The ages of the persons set forth below are as of December 31, 2002.

Chris A. Davis.    Ms. Davis has served as Chairman and Chief Executive Officer since April 2002. She joined McLeodUSA as Chief Operating and Financial Officer and a Director in August 2001. Before joining McLeodUSA, Ms. Davis was Executive Vice-President, Chief Financial and Administrative Officer for ONI Systems Corp., a leading optical networking equipment company. Previously she spent seven years, from 1993 to 2000, as Executive Vice-President and Chief Financial and Administrative Officer and a director at Gulfstream Aerospace Corporation. Before joining Gulfstream, Ms. Davis spent 17 years in increasingly senior operating and financial management positions at General Electric Company. She is a director of Cytec Industries, Inc., Wolverine Tube, Inc. and Rockwell Collins, Inc.

Stephen C. Gray.    Mr. Gray serves as President of McLeodUSA and has been an officer and a director of McLeodUSA since 1993. Prior to joining McLeodUSA, Mr. Gray served from August 1990 to September 1992 as Vice President of Business Services at MCI, where he was responsible for MCI's local access strategy and for marketing and sales support of the Business Markets division. From February 1988 to August 1990, he served as Senior Vice President of National Accounts and Carrier Services for Telecom*USA, where his responsibilities included sales, marketing, key contract negotiations and strategic acquisitions and combinations. From September 1986 to February 1988 Mr. Gray held a variety of management positions with Williams Telecommunications Company.

G. Kenneth Burckhardt.    Mr. Burckhardt joined McLeodUSA as Executive Vice President and Chief Financial Officer in April 2002. He was also named to the McLeodUSA Board of Directors in April 2002. Prior to joining McLeodUSA, Mr. Burckhardt was interim CFO at ONI Systems, a leading optical networking company, from August 2001 through February 2002 and Vice President—Finance from May 2000 through August 2001. From 1994 to 2000, he worked at Gulfstream Aerospace Corporation, most recently as Senior Vice President, Finance. From 1977 to 1994, he held various financial management positions at General Electric Company.

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Shawn W. Vick.    Mr. Vick joined McLeodUSA as Executive Vice President, Sales in August 2002. He was previously Senior Vice President of International Sales at Bombardier Aerospace. Prior to Bombardier, Mr. Vick held increasingly senior sales executive positions at Gulfstream Aerospace from 1994 through 2000, most recently as Vice President—North American Sales.

Andreas Papanicolaou.    Mr. Papanicolaou joined McLeodUSA in August 2002. He was previously with Lucent Technologies where he was the general manager of optical network management beginning in October 2000. Prior to that, from 1997 to mid-2000, he was President of Lucent Digital Video, a Lucent venture that was later sold profitably by Lucent. Prior to Lucent Technologies, Mr. Papanicolaou spent more than 8 years at AT&T as product manager of services and in network planning. He started his career in 1976 at Bell Laboratories where he worked on several projects that helped the telecommunications industry transition from analog to digital technology. For that work he was recognized with the 81st Bell Labs Fellow Award in 1991.

James E. Thompson.    Mr. Thompson joined McLeodUSA in December 2002 after nearly eight years (1995 to 2002) with Alticor Inc., parent company of Amway Corporation, where he was Associate General Counsel, International Legal. He was also Chief Legal Officer for the Alticor business unit responsible for mergers and acquisitions, joint ventures and strategic alliances. Prior to Alticor, he was an attorney with Jones, Day, Reavis & Pogue from May 1987 to February 1995 in its Brussels, Belgium and Washington, D.C. offices.

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Chapter 11 Reorganization

        In connection with a change in our business strategy, during 2002 we down-sized our operations, streamlined and improved our business processes, and identified and divested non-core assets. We evaluated our capital structure and on January 31, 2002, McLeodUSA Incorporated, the parent company, filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware, or the "Bankruptcy Court." On April 16, 2002, McLeodUSA Incorporated emerged from the Bankruptcy Court proceedings pursuant to the terms of its amended plan of reorganization, or the "Plan," which became effective on that date. The general unsecured creditors of McLeodUSA, except for the holders of all of its outstanding notes, were unaffected by the Chapter 11 proceedings and the Plan. As used in this Form 10-K, the term "Predecessor McLeodUSA" refers to McLeodUSA and its operations prior to April 17, 2002.

        Recapitalization.    The Plan resulted in the following changes to our capital structure:

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The elimination of approximately $3 billion of indebtedness, including accrued interest, represented by the following notes: 10¹/2% Senior Discount Notes, 9¹/4% Senior Notes, 8³/8% Senior Notes, 9¹/2% Senior Notes, 8¹/8% Senior Notes, 12% Senior Notes, 11¹/2% Senior Notes and 11³/8% Senior Notes, or collectively, the "Notes";



•

In exchange for the cancellation of the Notes and the unpaid interest thereon, the bondholders received their pro rata share of (1) $670 million in cash, (2) 10,000,000 shares of Series A Preferred Stock, which is convertible into 15% of Class A Common Stock on a fully diluted basis as of the effective date of the Plan after giving effect to the Plan and conversion of the Class B Common Stock and Class C Common Stock (but prior to the exercise of the warrants) and (3) 5-year warrants to purchase 22,159,091 shares of Class A Common Stock for $30 million;



•

The investment by two funds affiliated with Forstmann Little & Co., or "Forstmann Little", of $175 million in exchange for (1) 74,027,764 shares of Class A Common Stock, (2) 5-year warrants to purchase 22,159,091 shares of Class A Common Stock for $30 million and (3) 10 shares of Series B Preferred Stock;



•

The conversion of Predecessor McLeodUSA Series D Preferred Stock and Predecessor McLeodUSA Series E Preferred Stock, held by Forstmann Little, into 78,203,135 shares of Class B Common Stock and 35,546,879 shares of Class C Common Stock, respectively; and



•

The conversion of Predecessor McLeodUSA Series A Preferred Stock into 33,696,559 shares of Class A Common Stock.

        The Plan also provided for the distribution of a portion of Class A Common Stock to holders of Predecessor McLeodUSA Class A Common Stock. These holders were entitled to share, together with holders of certain securities claims, in the distribution of 54,775,663 shares of Class A Common Stock. On May 2, 2002, the Bankruptcy Court entered an order establishing a disputed claims reserve of 18,000,000 shares of Class A Common Stock pending resolution of securities claims against McLeodUSA associated with putative securities class action lawsuits. McLeodUSA then commenced the distribution of 36,775,663 shares of McLeodUSA Class A Common Stock to record holders of Predecessor McLeodUSA Common Stock as of April 5, 2002, the distribution record date under the Plan. Upon the final determination of the amount, if any, of allowed securities claims under the Plan, such holders of Predecessor McLeodUSA Common Stock may be entitled to additional distributions of Class A Common Stock from the 18,000,000 shares held in the disputed claims reserve.

        Fresh-Start Accounting.    As of April 17, 2002, we implemented fresh-start accounting under the provisions of AICPA Statement of Position 90-7 ("SOP 90-7"), Financial Reporting by Entities in Reorganization Under the Bankruptcy Code. Under SOP 90-7, the reorganization equity value of McLeodUSA was allocated to our assets and liabilities, our accumulated deficit was eliminated, and our

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new equity was issued according to the Plan as if we were a new reporting entity. In conformity with fresh-start accounting principles, we recorded a $1.5 billion reorganization charge to adjust the historical carrying value of our assets and liabilities to fair market value reflecting the allocation of our $1.15 billion estimated reorganized equity value as of April 16, 2002. We also recorded a $2.4 billion gain on the cancellation of debt on April 16, 2002 pursuant to the Plan. For a more detailed discussion of SOP 90-7 and fresh-start accounting, see Item 8. "Financial Statements and Supplementary Data" in this Form 10-K.

        Divestitures.    Our refocused business strategy and the Plan resulted in divestitures of approximately $1 billion of non-core assets in 2002 as follows:

•

Illinois Consolidated Telephone Company: On December 31, 2002, we completed the sale of Illinois Consolidated Telephone Company and certain related telecommunication businesses to Homebase Acquisition Corp. for $271 million less the assumption of $20 million of debt resulting in gross proceeds of approximately $251 million. In connection with the transaction, McLeodUSA entered into a series of operating agreements with Homebase Acquisition Corp. and Illinois Consolidated Telephone Company pursuant to which the parties will continue to provide services, such as wholesale long-distance, telemarketing and fulfillment, and operator services.

Pursuant to the terms of the Plan, $225 million of the net proceeds from the sale of Illinois Consolidated Telephone Company were used to reduce the Term A and Term B loans under McLeodUSA's Credit Agreement, dated as of May 31, 2000, among McLeodUSA, various Lenders and The Chase Manhattan Bank, as Agent, as amended. We retained the balance of the proceeds, after fees and expenses.

•

Dakota Community Telephone, Inc.: On September 30, 2002, we completed the sale of our non-core operations in South Dakota and certain non-core overbuild competitive local exchange carrier and cable television operations in South Dakota, southwestern Minnesota and northwestern Iowa to PrairieWave Communications, Inc. for approximately $84 million.



•

Greene County Partners, Inc.: On August 20, 2002, we completed the sale of our interest in the cable television service provider for $16 million in cash and a note receivable of $3 million.



•

Pubco: On April 16, 2002, we completed the sale of McLeodUSA Media Group, Inc. and its subsidiaries, or collectively "Pubco", to Yell Group Limited for $600 million in cash. In connection with the transaction, we entered into a multi-year Publishing, Branding and Operating Agreement with Yellow Book, a subsidiary of Yell Group, which, among other things, provides for the continued publishing of telephone directories under the McLeodUSA brand. The proceeds received from the sale were used to pay the holders of the Notes.



•

CapRock Services Corp.: On April 8, 2002, we sold our subsidiary, IWL Communications, Incorporated d/b/a CapRock Services Corp., for $21 million in cash.



•

McLeodUSA Integrated Business Systems, Inc.: On January 24, 2002, McLeodUSA Integrated Business Systems, Inc., a subsidiary of McLeodUSA, sold certain of the assets used in its telecommunications customer premise equipment business in the metropolitan areas of Minneapolis, Minnesota; Cedar Rapids, Des Moines, Dubuque and Waterloo, Iowa; and Denver, Colorado, as well as the data provider business conducted by Integrated Business Systems under the name "DataNet," to Inter-Tel Technologies, Inc. for $8 million plus the assumption of certain liabilities. The sale excluded the telecommunications customer premise equipment business conducted in Illinois.

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        For a more detailed discussion of the financial impact to McLeodUSA of the above divestitures, see Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Form 10-K.

Telecommunications Industry

        The Federal Communications Commission, or the "FCC," estimates that the aggregate U.S. telecommunications revenues, including local, long-distance, private line, data telecommunications and wireless services, were approximately $303 billion in 2001. Of that total, local services generated over $132 billion (over 43%), toll services generated approximately $94 billion and wireless services accounted for over $76 billion of revenues in 2001. The communications industry is undergoing substantial changes due to macroeconomic, regulatory, and technological developments, changes in the competitive landscape, and restructuring in the industry.

        The market for local exchange services consists of a number of distinct service components, including: switched local calling services (including local usage and various features provided by the central office switch); local private line services (in which a transmission path between fixed points is dedicated to the use of a particular customer); and local network access services (in which various local network components are used to originate or terminate a long-distance call). Other related services include operator services, Internet access, calling cards, publication of "white page" and "yellow page" telephone directories and the sale of business telephone equipment.

        Historically, the market for local exchange service has been dominated by incumbent local telephone companies, each of which was the monopoly provider of these services for its service area. In addition to numerous independent and smaller incumbent local telephone companies, there are now four large local telephone companies—SBC, Qwest, BellSouth and Verizon. These large local telephone companies are referred to as "RBOCs" (Regional Bell Operating Companies). The RBOCs have the authority to provide local telephone service, local access service, toll service within LATAs, and other services, but are required by the Telecommunications Act of 1996 to demonstrate on a state-by-state basis that certain competitive conditions have been met before being allowed to provide long distance service between LATAs in each state in which the RBOC is the dominant incumbent local telephone company. The RBOCs have done so in 37 states and the District of Columbia, including 16 out of the 25 states in our local service footprint. In addition, rulings in five additional states, including four within our footprint, are expected by mid-April. We expect the RBOCs to be successful in obtaining authority to offer long distance service in the remaining states in the future. The RBOCs have generally gained long-distance market share after obtaining such authority.

        The Telecommunications Act of 1996 substantially expanded opportunities to compete with incumbent local telephone companies by eliminating state legal prohibitions on competition and requiring large incumbent local telephone companies to allow other providers (competitive local telephone companies) to purchase elements of the incumbent's network in order to offer service to end-users. The Telecommunications Act of 1996 also requires all telecommunications companies to allow other telecommunications providers to interconnect with their communications facilities and equipment on reasonable, non-discriminatory terms. In addition, incumbent local telephone companies are obligated to provide local number portability and dialing parity upon request and make their local services available for resale by competitors. Incumbent local telephone companies are also required to allow competitors nondiscriminatory access to poles, conduit space and other rights-of-way. A number of states have taken additional regulatory and legislative action to open local communications markets to competition.

        As a result of these and other developments, competitive local telephone companies have gained significant market share since the enactment of the Telecommunications Act of 1996. According to the FCC, as of June 2002, competitive local telephone companies provided 21.6 million, or 11.4% of the

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approximately 189 million in-service local telephone lines used by end-users, representing 10% growth in competitive local telephone company market size during the first six months of 2002. About 29% of these lines are served over local loop facilities owned by the competitive local telephone companies.

        As noted above, as a result of regulatory changes the RBOCs are now permitted to offer long distance services once it has been demonstrated that certain competitive conditions have been met. This is increasing customer expectations that their telecommunications providers will be able to offer them a complete package of services (local, long distance, voice and data). These regulatory changes are causing interexchange carriers to include local services in their product offering. There also continue to be emerging new technologies which introduce or enhance products or help the industry lower costs. Currently, these are not expected to fundamentally change the structure of the industry. Some emerging fixed wireless technologies may in the future reduce the industry's dependence on the RBOC copper loops for the last mile to the customer, but these developments are not expected to significantly impact the current competitive environment in the short term.

        The FCC estimates that high-speed (200 kbps or more in at least one direction) data lines connecting homes and businesses to the Internet increased by 27% during the first half of 2002, to a total of 16.2 million lines (or wireless channels) in service.

Competition

        The communications services industry is highly competitive. McLeodUSA faces intense competition in all of our markets. Our local exchange business competes with incumbent local telephone companies, which currently dominate their respective local telecommunications markets and in some cases have done so for more than a century. Our largest local service competitors, the RBOCs, have gained approval to offer long distance services in a majority of the states in our 25-state footprint and we expect that eventually they will no longer be prohibited from providing long distance services in any state. Our long-distance services also compete with the services of hundreds of other companies in the long-distance marketplace in most states. AT&T, WorldCom (including its MCI group) and Sprint currently dominate the long-distance market. The RBOCs have become important long-distance competitors in many states and we expect them to become major competitors in each state as they gain approval to enter the long-distance markets in remaining states in which they presently lack such authority. Our local and long-distance services also compete with the services of other competitive local telephone companies in many markets.

        Other competitors may include cable television providers, providers of communications network facilities dedicated to particular customers, microwave and satellite carriers, wireless telecommunications providers, private networks owned by large end-users, municipalities, electrical utilities and telecommunications management companies. Increasingly, McLeodUSA is subject to competition from Internet telephony and other Internet Protocol-based voice telecommunications service providers, which are currently subject to substantially less regulation than competitive and incumbent local telephone companies. Many of our existing and potential competitors have financial and other resources far greater than ours.

        Many of our competitors offer a greater range of communications services, or offer them in more geographic areas. For example, while our target market covers 25 states, many of our competitors are national or international in scope. Also, some of our competitors offer wireless services, Internet content services, and other services. Our inability to offer as wide a range of services as many of our competitors, or to offer them in as many locations, could result in our not being able to compete effectively against them.

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Regulation

        Our services are subject to federal, state and local regulation. In addition to industry specific regulation (such as FCC regulation of our telephone businesses), municipalities and other local government agencies regulate limited aspects of our business, such as use of government owned rights of way, construction permits and building codes. The following description covers some of the major regulations affecting us, but there are numerous other areas of regulation which influence our business.

        The FCC has jurisdiction over our telecommunications facilities and services to the extent they are used to provide, originate or terminate interstate or international telecommunications. State regulatory commissions retain jurisdiction over the same facilities and services to the extent they are used to originate or terminate intrastate telecommunications. Local governments may require McLeodUSA to obtain licenses, permits or franchises regulating use of public rights-of-way necessary to install and operate our networks. In addition, the licensing, construction, operation, sale and interconnection arrangements of wireless telecommunications systems are regulated to varying degrees by the FCC. Through our subsidiaries, we hold various federal and state regulatory authorizations. We often join other industry members in seeking regulatory reform at the federal and state levels to open additional telecommunications markets to competition, and to preserve existing pro-competitive conditions.

        The FCC classifies us as a non-dominant carrier, so our interstate and international rates are not subject to material federal regulation. We must offer interstate services at just and reasonable rates in a manner that is not unreasonably discriminatory, and must maintain geographically averaged interstate rates as required by federal law. The FCC limits the charges that McLeodUSA and other competitive local telephone companies can charge to long distance companies for access to their end-user customers. The FCC does impose prior approval requirements on transfers of control and assignments of radio licenses and operating authorizations and on discontinuation of services. The FCC has the authority to condition, modify, cancel, terminate or revoke such licenses and authorizations for failure to comply with federal laws or the rules, regulations and policies of the FCC. The FCC may also impose fines or other penalties for such violations.

        The FCC has established a "universal service" program that is supposed to ensure that affordable, quality telecommunications services are available to all Americans. The Telecommunications Act of 1996 sets forth policies and establishes certain standards in support of universal service, including that consumers in rural areas should have access to telecommunications and information services that are reasonably comparable in rates and other terms to those services provided in urban areas.

        McLeodUSA is required to make contributions to support federal and state universal service goals. Our contribution to federal universal service support programs is assessed against our interstate end-user telecommunications revenues. The contribution factor for the fourth quarter of 2002 is 7.2805%. McLeodUSA's contribution to state universal service programs is assessed against our intrastate revenues. Although many states are likely to adopt an assessment methodology similar to the federal methodology, states are free to calculate telecommunications service provider contributions in any manner they choose as long as the process is not inconsistent with the FCC's rules. In 2002, we paid approximately $17.7 million to the federal program and approximately $4.5 million to state programs.

        Telephone companies are subject to limitations on the use of customer information the carrier acquires by virtue of providing telecommunications services. Protected information includes information related to the quantity, technical configuration, type, destination and the amount of use of services. A carrier may not use such information acquired through one of its service offerings to market certain other service offerings without the approval of the affected customers. These restrictions may affect the ability of McLeodUSA to market a variety of packaged services to existing customers.

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        A customer may change its preferred long distance carrier at any time, but the FCC and some states regulate this process and require that specific procedures be followed. When these procedures are not followed, particularly if the change is unauthorized or fraudulent, the process is known as "slamming." The FCC has levied substantial fines for slamming and has increased the penalties for slamming, although no such fines have been assessed against us.

        The FCC is currently considering changes to its rules for telemarketing activities by telecommunications services providers. The FCC may propose rules requiring us to implement procedures to avoid calling individuals who have placed their names on a national do-not-call list, limiting our use of technologies that improve the efficiency of our telemarketing efforts or further limiting the hours in which we may place telemarketing calls. Though no specific rules have been proposed, the Federal Trade Commission ("FTC") has recently adopted consumer protection rules, including requirements prohibiting telemarketers from calling consumers listed on a newly established national do-not-call list and limiting the number of calls abandoned. While our common carrier activities are not subject to the FTC's jurisdiction in this regard, the FCC is required to adopt rules to coordinate its rules with those of the FTC. Rules such as these could reduce the effectiveness of our telemarketing efforts and result in additional customer acquisition costs.

        In addition to providing services as a regulated common carrier, through McLeodUSA Network Services, we provide certain competitive access services as a private carrier on a substantially non-regulated basis. In general, a private carrier is one that provides service to customers on an individually negotiated contractual basis, as opposed to a common carrier that provides service to the public on the basis of generally available rates, terms and conditions. Some of our operations are also subject to federal and state regulatory requirements, including, in some states, bonding requirements, due to our direct marketing, telemarketing and sale of prepaid calling cards.

        We provide intrastate common carrier services and are subject to various state laws and regulations. Most public utility commissions subject providers like us to some form of certification requirement, which requires providers to obtain authority from the state public utility commission before initiating service. In most states, we are also required to file tariffs setting forth the terms, conditions and prices for common carrier services that are classified as intrastate. We are often required to update or amend these tariffs when we adjust our rates or add new common carrier services, which may require prior regulatory approval, and are subject to various reporting and record-keeping requirements in these states. Some states impose service quality standards on our local service operations and require us to file reports showing our performance in meeting those standards.

        Many states also require prior approval for transfers of control of certified carriers, corporate reorganizations, acquisitions of telecommunications operations, assignment of carrier assets, carrier stock offerings and incurrence by carriers of significant debt obligations. Certificates of authority can generally be conditioned, modified, canceled, terminated or revoked by state regulatory authorities for failure to comply with state law or the rules, regulations and policies of state regulatory authorities. State utility commissions generally have authority to supervise telecommunications service providers in their states and to enforce state utility laws and regulations. Fines or other penalties also may be imposed for violations.

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

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        We are required to obtain construction permits and licenses or franchises to install and expand our fiber optic communications networks using rights-of-way. Some local governments, where we have installed or anticipate constructing networks, are proposing and enacting ordinances regulating use of rights-of-way and imposing various fees in connection with such use, including fees based on a percentage of certain revenues related to the use of the right-of-way. In some instances, we have negotiated interim agreements to authorize installation of facilities pending resolution of the fee issue. In some markets, we are objecting to or challenging various fees as improper under state or federal law. In many markets, the traditional local telephone companies do not pay rights-of-way fees or pay fees that are substantially less than ours. We must also negotiate and enter into franchise agreements with local governments in order to operate our video services networks.

        The Telecommunications Act of 1996 imposes a number of access and interconnection requirements on all local telephone companies, including competitive local telephone companies, with additional requirements imposed on incumbent local telephone companies. These requirements are intended to ensure access to certain networks under reasonable rates, terms and conditions. The FCC has adopted rules regulating the pricing of the leasing of each separate element of the incumbent local telephone company's network, known as unbundled network elements. The U.S. Supreme Court has upheld both the FCC's authority to adopt such pricing rules, and the specific pricing guidelines created by the FCC. In May 2002, however, a decision by the U.S. Court of Appeals for the District of Columbia overturned many of the FCC rules regarding which network elements must be separately made available, or unbundled, by the incumbent local telephone companies for lease by competitive local telephone companies.

        On February 20, 2003, the FCC announced a decision to revise its rules requiring the unbundling of network elements by the incumbent local telephone companies as part of its Triennial Review of the 1996 Telecom Act. Although a written order has not yet been issued, it appears that the new regulations limit the obligation of the incumbent local telephone companies to provide access to broadband network facilities. The new rules do not require incumbent local exchange carriers to make fiber-to-the-home loops or the increased transmission capacity that exists after the extension of fiber networks further into a neighborhood available as unbundled network elements to competitive service providers. Similarly, the FCC eliminated the requirement that line-sharing, where a competitive local telephone company offers high-speed Internet access over certain frequencies while the incumbent local telephone company provides voice telephone services over other frequencies using the same local loop, be available as an unbundled element.

        The FCC also eliminated its presumption that switching for business customers served by high-capacity loops, such as DS-1, must be unbundled to ensure competition. Instead, state utility commissions will have 90 days to determine based on market conditions that such switching must still be unbundled to preserve competition. The FCC also eliminated the current limited requirement for unbundling of packet switching. In addition, states will be required to consider within nine months of the order whether DS-switch ports should remain available as unbundled network elements.

        The new rules provide state utility commissions with an increased role in determining which individual elements must be unbundled in the markets they regulate. The state utility commissions are to make detailed assessments of the status of competition in the markets within their states to ensure that the unbundling requirements are applied in a manner consistent with the newly announced standard for determining which services are subject to mandatory unbundling. The FCC also apparently intends to open a Further Notice of Proposed Rulemaking seeking comment on whether the FCC should modify the pick-and-choose rule that permits requesting competitive local telephone companies to opt into individual portions of interconnection agreements without accepting all the terms and conditions of such agreements.

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        The new rules are expected to be subject to court review, and legislation on the same matters covered in the rules is possible. The Chairman of the FCC has indicated that he believes that these new regulations do not comply with the requirements of the U.S. Court of Appeals' May 2002 decision. There can be no assurance that our businesses will not be adversely affected by the implementation of these new regulations, state utility commission actions based upon the new regulations, new legislation passed in response to the new regulations or any court decisions that result from a legal challenge to these regulations. In particular, to the extent that the FCC's limitation on access to fiber deployed in local loop facilities limits our ability to obtain unbundled local loops for use in serving our customers, our business could be adversely affected.

        Regulations applicable to our business are subject to the political process and have changed repeatedly over the past decade. Further material changes in the law and regulatory requirements must be anticipated and there can be no assurance that our business will not be adversely affected by future legislation, new regulation or deregulation, or by court decisions.

Risk Factors

        In connection with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, set forth below are cautionary statements identifying important factors that could cause actual events or results to differ materially from any forward-looking statements made by us or on our behalf whether oral or written. We wish to ensure that any forward-looking statements are accompanied by meaningful cautionary statements in order to maximize to the fullest extent possible the protections of the safe harbor established in the Private Securities Litigation Reform Act of 1995. Accordingly, any such statements are qualified in their entirety by reference to, and are accompanied by, the following important factors that could cause actual events or results to differ materially from our forward-looking statements.

Financial Information Related to Our Post-Emergence Operations Is Limited

        Because we emerged from bankruptcy on April 16, 2002, and divested non-core assets in 2002, there is limited operating and financial data available from which to analyze our operating results and cash flows. As a result of fresh-start accounting, a comparison of information reflecting our results of operations and financial condition after our emergence from bankruptcy to prior periods may not be meaningful.

Executing Our Business Strategy Involves Substantial Risks

        There are substantial risks in implementing our business strategy, including:

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difficulties arising from a slower economy, which has adversely affected demand for competitive telecommunications services and may delay revenue growth and the length of time required to achieve profitability and positive cash flow;



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the chance for adverse regulatory, legislative and other governmental developments during the course of implementing our business strategy;



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reputation issues related to our bankruptcy and our restructuring that increase the risk that we may lose or fail to attract customers;



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potential difficulties in retaining quality management to execute our business strategy; and



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we may not have sufficient capital to continue to invest in improved business systems to support a larger enterprise.

        One or more of these factors, individually or combined, could affect adversely our ability to conduct our operations.

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Our Businesses Do Not Generate Positive Cash Flow

        Our operations consist primarily of our retail telecommunications business. To date, our retail telecommunication operations have not generated positive cash flow in any quarterly period. While the strategic initiatives we have undertaken to improve our business are designed to result in the telecommunication business eventually generating positive cash flow, there can be no assurance that these steps will be successful in the time and of the magnitude expected. Even if we achieve our targeted level of Earnings before Interest, Taxes, Depreciation and Amortization, or "EBITDA," we may continue generating negative cash from operations until fiscal 2005 as a result of capital expenditures and projected interest on the remaining amounts outstanding under the Credit Agreement dated as of May 31, 2000, among McLeodUSA Incorporated, the lenders party thereto, and JPMorgan Chase Bank, (the "Credit Agreement"). Retention of access to the amounts that remain available under the Credit Agreement, dated as of April 16, 2002, among McLeodUSA Incorporated, the lenders party thereto, and JPMorgan Chase Bank, as Agent, or the "Exit Facility," is critical in funding our future operations.

We Expect to Incur Significant Losses Over the Next Several Years

        If we do not become profitable in the future, we could have difficulty obtaining funds to continue our operations. We have incurred net losses every year since we began operations. McLeodUSA incurred a net loss applicable to its common shares of $204.9 million for the period April 17, 2002 to December 31, 2002. We expect to incur significant operating losses during the next several years. If we are unable to generate an operating profit in the future, there may be adverse consequences to our business.

We Have a Risk of Inadequate Liquidity

        Consummation of the Plan and the Third Amendment to the Credit Agreement impacted our post-restructuring liquidity position in the following manner:

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as of the date the Plan was confirmed, April 5, 2002, the Exit Facility commitments were $110 million;



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we are required to pay higher interest rates;



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we divested Pubco, which had generated positive cash flow, and used the proceeds from the sale to pay the holders of the Notes;



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we divested ICTC, which generated positive cash flow, and applied the first $225 million of the proceeds of that divestiture to the prepayment of term loans; and



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after consummation of the Plan, our operations consist primarily of our existing retail competitive telecommunications service operations, which have not generated positive cash flow in any quarterly period.

        One or more of these factors, individually or combined, could adversely affect our ability to conduct our operations.

        Although Forstmann Little invested $175 million in connection with our reorganization, after payments to holders of the Notes, prepayments on the Credit Agreement, and fees and expenses related to the restructuring, we did not retain any proceeds from such investment.

        Finally, we may need additional capital to expand our business and develop new products, which may be difficult to obtain. Failure to obtain additional capital may preclude us from developing or enhancing our products, taking advantage of future opportunities, growing our business or responding to competitive pressures.

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Failure to Raise Necessary Capital Could Restrict Our Ability to Develop Our Network and Services

        There can be no assurance that our capital resources will be sufficient to enable us to achieve operating profitability. Failure to generate or raise sufficient funds may require us to delay or abandon some of our plans or expenditures, which could harm our business and competitive position. We expect to meet our funding needs through various sources, including existing cash balances, our Exit Facility, vendor financing and cash flow from future operations. Our estimated aggregate capital expenditure requirements include the projected costs of:

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completing our in-region fiber optic communications network and deploying network assets currently not in service;



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activating and augmenting voice and data switches;



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constructing, purchasing, developing or improving telecommunications assets in our target markets; and



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improving the business infrastructure and systems to support a more efficient telecommunications company.

        We also require substantial funds for general corporate and other expenses and may require additional funds for working capital fluctuations.

        The Credit Agreement and the Exit Facility each place restrictions on our ability to make capital expenditures and engage in acquisitions.

        We may meet any additional financial needs by issuing additional debt or equity securities or by borrowing funds under the Exit Facility. We cannot assure that we will have timely access to additional financing sources on acceptable terms. Our ability to issue debt securities, borrow funds from additional lenders and participate in vendor financing programs are restricted under the terms of the Credit Agreement and the Exit Facility, and there can be no assurance that the lenders thereunder will waive these restrictions if we need additional financing beyond that permitted. If they do not, we may not be able to develop our markets, operations, facilities, network and services as we intend.

Risks Particular to Former Preferred Stockholders

        Holders of Predecessor McLeodUSA Preferred Stock who received shares of Class A, Class B and Class C Common Stock in our reorganization lost all rights associated with the Predecessor McLeodUSA Preferred Stock. The Predecessor McLeodUSA Preferred Stock obligated us to pay a certain amount of annual dividends. Current holders of our Class A, Class B and Class C Common Stock have no right to receive an annual payment of dividends. Moreover, cash dividend payments will continue to be prohibited under the terms of the Credit Agreement (other than in connection with certain employee benefit plans or to maintain certain licenses and franchises). Also, if we were to be liquidated, those who formerly held Predecessor McLeodUSA Preferred Stock would no longer be entitled to payment prior to holders of common stock.

Our Common Stock is Subject to Dilution

        The issuance of shares of Class A Common Stock, Class B Common Stock and Class C Common Stock to the holders of Predecessor McLeodUSA Preferred Stock resulted in dilution of the equity interests of the holders of Predecessor McLeodUSA Class A Common Stock. In addition, the issuance of shares of Class A Common Stock or options to management and employees would result in additional dilution of the prior equity interests of the holders of the Class A Common Stock which could adversely affect the market price and the value of Class A Common Stock. Moreover, the exercise of the warrants to purchase Class A Common Stock would result in a further dilution of the prior equity interests of the holders of the Class A Common Stock. There can be no assurance that we

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will not need to issue additional equity securities in the future in order to execute our business plan if we do not achieve our projected results or for other reasons, which could lead to further dilution to holders of the Class A Common Stock.

Our Class A Common Stock and Series A Preferred Stock Could Be Volatile, Increasing the Risk of Loss to Holders

        The market price of our Class A Common Stock and Series A Preferred Stock could be subject to significant fluctuations in response to various factors and events, including the depth and liquidity of the trading market for our Class A Common Stock and Series A Preferred Stock, changes in regulatory environment and variations in our operating results. In addition, in recent years the stock market in general, and the telecommunications sector in particular, have experienced broad price and volume fluctuations that have often been unrelated to the operating performance of the companies. Broad market fluctuations may also adversely affect the market price of our Class A Common Stock.

Risk of NASDAQ Delisting Our Common Stock

        McLeodUSA is required to meet certain requirements to ensure continued listing on the NASDAQ SmallCap Market. One of these requirements is that common stock listed on the SmallCap Market maintain a minimum bid price of $1 per share. Following the SEC's approval on March 11, 2003 of amendments to NASDAQ listing requirements, NASDAQ currently allows for an initial grace period of 180 calendar days for companies to comply with the minimum bid price requirement, with a second 180 calendar day grace period granted to companies that demonstrate compliance with any one of three NASDAQ SmallCap core listing standards during the initial grace period, and an additional 90 calendar day grace period granted to companies that meet any one of the core listing standards during the second grace period. McLeodUSA's second grace period to comply with the $1.00 minimum bid price per share requirement expires on June 1, 2003. Provided that McLeodUSA meets the applicable qualifying requirements, we would intend to continue our listing on the NASDAQ SmallCap Market under the additional 90 day grace period if required, and under any further extensions should they become available and be required. Failure to comply with other quantitative and qualitative listing criteria of the NASDAQ SmallCap Market could also result in the delisting of our common stock. In the event NASDAQ delists our common stock, we may seek an alternative exchange or market list for our common stock. A delisting from the NASDAQ SmallCap Market may adversely affect the liquidity and market price of our common stock.

The Warrants for McLeodUSA Class A Common Stock Will Not Be Listed and May Have Limited Liquidity

        We have not and do not intend to list the warrants to purchase shares of Class A Common Stock on the NASDAQ Stock Market or any national securities exchange. This may make the warrants illiquid and adversely affect the ability of holders thereof to sell warrants.

Adverse Treatment of Cancellation of Debt Income and Net Operating Losses May Adversely Impact Our Financial Position

        We realized substantial cancellation of debt, or "COD," income as a result of the implementation of the Plan. Because we were a debtor in a bankruptcy case at the time we realized the COD income, we are not required to include such COD income in our taxable income for federal income tax purposes. Instead, we will be required to reduce certain of our tax attributes by the amount of COD income so excluded. We believe that all of the parent company's net operating loss carryovers, or "NOLs," will be eliminated and certain of our other tax attributes (including alternative minimum tax credit carryovers and the tax basis of certain property we own) will be reduced or eliminated, as a result of COD income being excluded pursuant to the Plan. Some of the tax attributes of our

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subsidiaries would be reduced or eliminated if it is determined that such reductions must be applied on a consolidated group basis rather than on a separate company basis.

        An "ownership change" (as defined in Internal Revenue Code Section 382 ("Section 382")) occurred with respect to our stock in connection with the Plan. An ownership change generally occurs if certain persons or groups increase their aggregate ownership percentage in a corporation's stock by more than 50 percentage points in the shorter of any three-year period or the period beginning the day after the day of the last ownership change. Section 382 may apply to limit our future ability to utilize any remaining NOLs generated before the ownership change and certain subsequently recognized "built-in" losses and deductions, if any, existing as of the date of the ownership change. Our ability and that of our subsidiaries to utilize new NOLs arising after the ownership change will not be affected.

        A bankruptcy exception to the general Section 382 limitations may apply because our historic stockholders and creditors holding "qualified indebtedness" (as defined for purposes of Section 382) prior to the implementation of the Plan own at least 50% of our stock (by vote and value) after its implementation. Under this exception, our ability to utilize our pre-change NOLs would not be limited as described above, but the amount of our pre-change NOLs would be reduced by the amount of interest paid or accrued, during the current and immediately preceding three years, on the Notes in respect of which New Series A Preferred Stock was issued. The NOL adjustment for interest expense would be made prior to the tax attribute reductions described above. Under this exception, if we incur a second ownership change within two years of the change incurred as a result of the Plan, we would be unable to use any of our pre-change NOLs. We believe we qualify for the bankruptcy exception, and are analyzing whether it would be advantageous to have it apply or to elect for it not to apply.

Our Dependence on the RBOCs to Provide Many of Our Communications Services Could Make It Harder for Us to Offer Our Services at a Profit

        We depend on the RBOCs to provide many elements of our service. At the same time, the RBOCs are our largest local service competitors, and are rapidly becoming major competitors in long distance markets. Today, without using the unbundled network elements of these companies, we could not provide bundled local and long distance services to most of our customers. Because of this dependence, our communications services are highly susceptible to changes in the conditions for access to these facilities and to possible inadequate service quality provided by the RBOCs. Therefore, we may have difficulty offering our services on a profitable and competitive basis.

        Qwest Communications International Inc. (successor to U S WEST Communications, Inc.) and SBC Communications Inc. (including its wholly-owned subsidiaries Ameritech Corporation and Southwestern Bell Telephone Company) are our primary suppliers of network elements and communications services that allow us to transfer and connect calls. The communications facilities of our suppliers allow us to provide local service, long distance service and private lines dedicated to our customers' use. If these RBOCs or other companies are able to deny or limit our access to their communications network elements or wholesale services, we may not be able to offer our communications services at profitable rates.

        In order to interconnect our network equipment and other communications facilities to network elements controlled by the RBOCs, we must first negotiate and enter into interconnection agreements with them. Interconnection obligations imposed on the RBOCs by the Telecommunications Act of 1996 have been and continue to be subject to a variety of legal proceedings, including an upcoming FCC proceeding that proposes eliminating our ability to opt into portions of existing interconnection agreements, the outcome of which could affect our ability to obtain interconnection agreements on acceptable terms. There can be no assurance that we will succeed in obtaining interconnection agreements on terms that would permit us to offer local services using our own communications

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network facilities at profitable and competitive rates. See "Business—Regulation" and "Legal Proceedings."

Actions by the RBOCs May Make it More Difficult for Us to Offer Our Communications Services

        The RBOCs have pursued and continue to pursue measures before the Federal Communications Commission, the Congress, state public utility commissions, and state legislatures that may make it more difficult for us to offer our communications services. These efforts may result in regulatory changes that prevent or deter us from using their services or network elements. If the RBOCs withdraw or limit our access to services or charge us extraordinary fees or high prices relative to retail rates in any location, we may not be able to offer communications services in those locations, which would harm our business.

        We anticipate that the RBOCs will continue to pursue litigation, regulations and legislation in states within our target market area to reduce regulatory oversight over their rates and operations. If adopted, these initiatives could make it more difficult for us to challenge RBOC actions in the future, which could adversely affect our business.

        The RBOCs are also actively pursuing federal legislative and regulatory initiatives and litigation that could have the effect of decreasing the benefits to us of the provisions in the Telecommunications Act of 1996 intended to open local markets to competition, and that could increase the competition that we face from the RBOCs in data services, including by limiting the RBOCs' obligations to provide access to their facilities. If successful, these initiatives could make it more difficult for us to compete with the RBOCs and to offer services on a profitable and competitive basis.

        As discussed at its meeting on February 20, 2003 revising its rules requiring the unbundling of network elements by the incumbent local telephone companies, the FCC has apparently granted some of the relief requested by the RBOCs. The new regulations are expected to limit the obligation of the incumbent local telephone companies to provide access to broadband network facilities and to eliminate the requirement that line-sharing be available as an unbundled element. See "Business—Regulation" and "Legal Proceedings".

RBOCs' Being Allowed to Offer Bundled Local and Long Distance Services in Our Markets Could Cause Us to Lose Customers and Revenue and Could Make It More Difficult for Us to Enter New Markets

        Before being allowed to provide long distance services to customers in a state where it has been the dominant local telephone company, an RBOC is required to show compliance on a state-by-state basis that certain competitive conditions set forth in the Telecommunications Act of 1996 have been met. The RBOCs have successfully showed compliance in many states, and within our 25 state footprint the RBOC has been granted authority to provide long distance service in 16 states. We expect the RBOCs to be successful in obtaining authority to offer long distance service in the remaining states in the future. After obtaining authorization to provide interLATA services within a state, the RBOCs have generally been successful in gaining significant market share for such services. In addition, the ability of the RBOCs to expand their service offerings enhances their competitive position for local and other services.

        As a result of their obtaining long distance authority, the RBOCs could cause us to lose customers and revenues and make it more difficult for us to compete in those markets. We expect that the RBOCs will be permitted to offer interLATA services throughout the United States. As the RBOCs are allowed to offer in-region interLATA services in an increasing number of states, we will find it increasingly difficult to compete with them.

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Intense Competition in the Communications Services May Adversely Impact our Competitive and Financial Position

        We face intense competition in all of our markets. This competition could result in loss of customers and lower revenue for us. It could also make it more difficult for us to enter new markets. Entrenched, traditional local telephone companies, including Qwest Communications International Inc., SBC Communications Inc., BellSouth and Verizon, currently dominate their local communications markets and are gaining long distance market share in many states. We rely on them to provide our services and they are increasingly providing long-distance and other integrated communications services. Three major competitors, AT&T, WorldCom (including its MCI group) and Sprint, dominate the long distance market, in which the RBOCs are increasingly gaining market share. Hundreds of other companies also compete in the long distance marketplace. Many companies, including AT&T, WorldCom and Sprint, also compete in the local and long distance marketplace. While we own a substantial amount of switching and transmission facilities, and are expanding our local networks, we must rely on the purchase of facilities from AT&T, WorldCom, Sprint and others to provide long distance services. Thus, our ability to compete is partially dependent on the willingness of our larger competitors and others to make available to us on favorable terms switching and transmission facilities or capacity.

        Other competitors may include cable television providers, providers of communications network facilities dedicated to particular customers, microwave and satellite carriers, wireless telecommunications providers, private networks owned by large end-users, municipalities, electrical utilities and telecommunications management companies. Increasingly, we are subject to competition from Internet telephone and other IP-based telecommunications service providers, which are currently subject to substantially less regulation than competitive and traditional local telephone companies and are exempt from a number of taxes and regulatory charges that we are required to pay.

        Many of our competitors offer a greater range of communications services, or offer them in more geographic areas. For example, while our target market covers 25 states, many of our competitors are national or international in scope. Also, some of our competitors offer wireless services, Internet content services, and other services. Our inability to offer as wide a range of services as many of our competitors or to offer them in as many locations