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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

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 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 30, 2004, based upon the closing price of the registrant's common stock on June 30, 2004 is $48,526,990.32.^*/

        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 number of shares outstanding of each of the registrant's classes of common stock, as of March 1, 2005, is:

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Class A common stock, par value $0.01 per share: 196,148,210 shares



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



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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.

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 in this Annual Report on Form 10-K include statements about our future expectations. Statements that are not historical facts are "forward-looking statements" for the purpose of the safe harbor provided by Section 21E of the Exchange Act and Section 27A of the Securities Act. Such statements may include projections of financial and operational results and goals, including revenue, profitability, savings and cash. 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. These forward-looking statements are subject to known as well as unknown risks and uncertainties that may cause actual results to differ materially from our expectations. Our expectations are based on various factors and assumptions and reflect only our predictions. Factors that could cause actual results to differ materially from the forward-looking statement include technological, regulatory, public policy or other developments in our industry, availability and adequacy of capital resources, our ability to continue as a going concern, our ability to implement a strategic transaction or a capital restructuring, current and future economic conditions, the existence of strategic alliances, our ability to generate cash, our ability to implement process and network improvements, our ability to attract and retain customers, our ability to migrate traffic to appropriate platforms and changes in the competitive climate in which we operate. These and other risks are described in more detail in the Form 10-K under the heading "Business—Risk Factors" and throughout the Form 10-K. The Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of future events, new information 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 services providers, offering integrated 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." On March 16, 2005, we announced, among other matters, that we would be pursuing strategic alternatives, including a capital restructuring, as more fully described below under "Business Strategy."

        We are a facilities-based telecommunications services provider with, as of December 31, 2004, 38 Asynchronous Transfer Mode switches, 39 voice switches, 699 collocations, 432 Digital Subscriber Line Access Multiplexers, four voice over internet protocol ("VoIP") network gateways, one call control element and approximately 2,400 employees. At December 31, 2004, we had approximately 348,000 customers.

        We derive our revenue from our core telecommunications and related communications services. These include local and long distance services; local data services such as dial-up and dedicated

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Internet access services, using DSL, cable modem and dedicated T1 access; integrated access services, which link voice and data lines together on one high-speed connection; conference calling services; wireless services; 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, hosted Exchange and shared web hosting. For the year ended December 31, 2004, we derived approximately 70% of our total revenues from local and long distance services; 11% from access services; 15% from private line and data services; and 4% from other sources. Approximately 83% of our competitive communications services revenues were derived from retail sales and 17% from wholesale sales.

        We operate our business as a single segment, engaging in the provision of communications services based upon a single, integrated, interconnected communications network in our 25-state footprint. We review operating results, assess performance and allocate resources on a company-wide, single segment basis.

        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) 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 be 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. In order to execute our vision, we employ a strategy which consists of:

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delivering simplified products packaged to provide value-added customer solutions;



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engaging in customer oriented thinking;



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providing a low cost, highly reliable, facilities-based network;



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streamlining our business processes and implementing the "right" systems infrastructure scalable for growth;



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employing a highly trained, committed workforce delivering high quality performance;



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promoting teamwork, integrity and accountability in all we do;



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focusing on profitable revenue growth and positive cash flow.

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

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        Over the past year we took significant steps to continue executing our business strategy, including the following:

Revenue Growth and New Products:

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entered into a multi-year agreement with MCI to enable MCI to provide local telephone services to its residential customers using McLeodUSA facilities; MCI and McLeodUSA anticipate migrating a minimum of 200,000 local lines onto the McLeodUSA network;



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launched Preferred Advantage^SM Dynamic Integrated Access, using the next generation of VoIP to offer integrated voice and data communications services over one single T-1 facility to customer locations, with planned expansion to a total of 35 markets within the Company's 25 state footprint by the end of the second quarter;



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launched Preferred Advantage® Conference Calling, providing a full range of enhanced audio and web-based conferencing options for business customers;



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launched Preferred Advantage® Hosted Exchange and Shared Web Hosting, including advanced email, company branding, meeting scheduler, shared calendar, shared contacts, collaborative task management, shared folders and contact management tools to increase efficiency and productivity with a user-friendly web portal, allowing business customers to manage all of their services;



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launched Preferred Advantage® Managed Services for Dedicated Internet Access to business customers providing a totally managed, outsourced Internet service that combines Dedicated Internet Access network services from McLeodUSA with industry-leading customer premise equipment and network management software;



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introduced new flexible Preferred Advantage® Local Voice packages providing customized local service with a choice of features and bundled services discounts;



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expanded our Preferred Advantage® DSL services to include home/office networking and wireless service;

Operational Improvements:

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completed the annual StarQuality® certification program, certifying 100% of the employees who interact with our customers or network;



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improved overall customer satisfaction to 93% from 92% at the end of 2003, and improved billing accuracy to 99.9%;



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continued to enhance our facilities-based platform, successfully improving our customer platform mix, with over 70% of our customers on our own switching platforms;



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continued overall network quality, consistently achieving 99.999% network reliability;



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continued to further reduce cost of service through our ongoing cost reduction program focusing on network optimization including least cost routing and data integrity programs; and



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streamlined processes and managed operations, expenses, cash flow and capital expenditures in line with revenues.

Pursuit of Strategic Alternatives:

        As an independent communications services provider, realizing the revenue growth benefits of operational excellence continues to be a challenge for the Company as we compete against large, financially strong competitors with well-known brands. Most recently, the Federal Communications

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Commission ("FCC") has finalized its unbundling rules and the communications industry consolidation has accelerated. With the recent merger announcements in the industry, we believe that the large telecommunications providers will likely become even more aggressive upon the closing of these transactions further challenging our ability to grow revenue.

        In light of the inability of the Company to achieve new revenue growth in excess of existing customer turnover and ultimately generate enough operating cash flow to service the existing level of debt, our Board of Directors has authorized the Company to pursue strategic alternatives. In support of these initiatives, we have hired Miller Buckfire Ying & Co., LLC and Gleacher Partners, LLC as the Company's financial advisors. We are now actively pursuing a strategic partner or a sale of the Company while also taking steps to maintain future liquidity, including evaluating a capital restructuring to reduce the current debt level enabling the Company to achieve positive cash flow going forward.

        We believe that the Company's operational excellence combined with a highly trained workforce, state of the art product offerings and expansive network could provide strategic benefits to existing multi-state and regional telecom services providers. In addition, through the extensive cost reduction programs, which have been implemented over the past several years, we believe the Company's wholesale product suite offers an attractive alternative to UNE-P providers for local access lines and competitive long distance services.

        In the interim, the Company has entered a forbearance agreement with the lenders under its Credit Agreement, dated May 31, 2000, as amended (the "Credit Agreement,") and its Exit Credit Agreement dated April 16, 2002, as amended, (the "Exit Facility" or collectively, the "Credit Facilities.") with respect to scheduled principal and interest payments on its loans under which its lenders have agreed not to take any action as a result of non-payment by the Company of approximately $18.1 million of scheduled principal amortization and interest payments due on or before March 31, 2005 and any related events of default through May 23, 2005.

Financial Restructuring:

        In light of the revenue outlook and the Company's on-going cash requirements, the Company has also begun discussions related to a capital restructuring with its agent bank and a group of lenders acting as a steering committee for the lenders under the Credit Facilities. The Company and this committee are in negotiations related to terms of a capital restructuring which includes the conversion of a significant portion of the Company's current outstanding debt into equity. Under such a restructuring, the holders of the Company's current debt would become equity shareholders of the Company with the current holders of the preferred and common stock unlikely to receive any recovery.

        There can be no assurance that the Company will be able to reach an agreement with its lenders regarding a capital restructuring or continued forbearance and covenant relief prior to the end of the initial forbearance period on May 23, 2005. There also can be no assurance that the Company will be able to identify a suitable strategic partner or buyer or reach agreement with any such strategic partner or buyer on terms and conditions acceptable to the Company prior to the end of the initial forbearance period. In the event these alternatives are not available to the Company, it is likely that the Company will elect to forgo making future principal and interest payments to its lenders while it continues to seek an extended forbearance period or permanent capital restructuring from its lenders, or alternatively, the Company could be forced to seek protection from its creditors.

        While the Company continues to explore a variety of options with a view toward maximizing value for all of its stakeholders, none of the options presented to date have suggested that there will be any meaningful recovery for the Company's current preferred stock or common stock holders. Accordingly, it is unlikely that holders of the Company's preferred stock or common stock will receive any recovery in a capital restructuring or other strategic transaction.

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        The Company believes that by not making principal and interest payments on the Credit Facilities, cash on hand together with cash flows from operations is sufficient to maintain operations in the ordinary course without disruption of services. The Company does not expect that the exploration of the alternatives described above will negatively impact its customers or vendors. The Company remains committed to continuing to provide the highest level of service to its customers and to maintaining its strong supplier relationships.

        We will continue to focus on providing world-class customer service, pursuing opportunities to profitably increase our revenue, reducing our cost of service and continuing our ongoing cash management programs as we pursue these strategic alternatives.

Network Facilities

        As of December 31, 2004, we operated a network with 699 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 39 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 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 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, including managed dedicated Internet 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;



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



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conference calling services, including a full range of audio and web-based conferencing options for business customers;



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wireless voice services for business utilizing the nationwide AT&T wireless network, now part of Cingular Wireless;



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calling card capabilities;



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



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advanced communications services such as virtual private networks, hosted Exchange and shared web hosting; and

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integrated access services, utilizing both standard T1 technologies and the next generation VoIP, which link voice and data lines together on one high-speed connection.

        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, 2004, we provided service to about 348,000 customers on a competitive retail basis. Our customers consist of large enterprise business customers and small to medium-sized business customers in major metropolitan areas and in second- and third-tier markets in 25 states. In addition, we provided services to residential customers in second- and third-tier markets in 20 states. Since beginning sales activities in January 1994, we have increased our revenue from the sale of competitive communications services from $4.6 million for the year ended December 31, 1994 to $716.2 million for the year ended December 31, 2004.

        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. In addition, we 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) ("SBC") in all states where SBC Midwest 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. McLeodUSA recently signed a commercial agreement with Qwest for a replacement of the unbundled network element platform. The Qwest Platform Plus service enables McLeodUSA to continue offering service to our end users in those markets where McLeodUSA has no alternative means to service our customers. One of our goals is to serve as many customers as economically advantageous 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, 2004, we served 71% 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 25% 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 4% of our local service customers through resale of incumbent carrier retail services. This distribution compares to 65%, 30% and 5%, respectively, at the end of 2003 and 52%, 33% and 15%, respectively, at December 31, 2002.

        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 described below.

        In November 2002, we launched McLeodUSA Preferred Advantage products and services for both business and residential customers. This is our simplified product portfolio consisting of a variety of product and service choices ranging from simple local, long distance and Internet packages to tailored solutions of advanced communications for larger business customers. We continued the introduction of additional Preferred Advantage products and services during 2004.

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        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 20 states within our footprint. Product availability and pricing vary by market. Preferred Advantage products for residential customers include:

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



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long distance package plans based on anticipated calling patterns, as well as flat rate per minute plans;



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dial-up Internet service and ADSL broadband service; and



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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 a variety of local service packages with a wide assortment of features;



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long distance package plans based on anticipated calling patterns, flat rate per minute plans and standard per minute plans offering specific interstate and intrastate rates;



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



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integrated access services, utilizing both standard T-1 technologies and the next generation of VoIP, which link voice and data lines on one high-speed connection;



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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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conference calling services, including a full range of audio and web-based conferencing options for business customers;



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wireless voice services for business utilizing the nationwide AT&T Wireless network, now part of Cingular Wireless; and



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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 with Preferred Advantage services which offer the ability to tailor customized solutions from a portfolio of services that include:

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



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long distance package plans based on anticipated calling patterns and flat rate per minute plans;



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interstate/intrastate rate per minute plans for long distance;



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standard and enhanced 800 toll-free services



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



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three Internet service options (dial-up, DSL, and dedicated 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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•

flexible term and volume discount plans;



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frame relay and private line services;



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wireless voice services for business utilizing the nationwide AT&T Wireless network, now part of Cingular Wireless;



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hosted exchange, shared web hosting and virtual private network services; and



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integrated access services, utilizing both standard T1 technologies and the next generation of VoIP, which link voice and data lines on one high-speed connection.

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:

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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;



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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;



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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;



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wholesale local services using the Company's UNE-L facilities for other carrier's local customers which would otherwise be offered across UNE-P by an RBOC; and



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other carrier access services.

        We entered into a multi-year agreement during 2004 with MCI whereby the Company will enable MCI to provide local telephone services to its residential customers using McLeodUSA facilities. The agreement provides for MCI and the Company to migrate a minimum of 200,000 local lines onto our UNE-L network by October 31, 2005.

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 field sales offices are organized and managed by region.

        We continue to focus our sales and marketing efforts to target specific prospects and customers located in high potential markets, thereby increasing our opportunity to grow profitable revenue for our business. In addition to physically locating our sales force in these locations, we also matched our advertising and direct marketing efforts to these targeted markets to enhance our opportunities for

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success. Detailed prospecting tools were developed to identify high potential customer opportunities and increase sales force productivity.

        Our sales force training emphasizes 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 require employees who either interact with our customers or touch our network to be StarQuality® certified. These employees are recertified annually. The goal of this extensive training and certification program is to ensure the highest levels of quality service for our customers.

        Our Customer Service Centers are organized into "Centers of Excellence," an innovative Customer Care program and service model designed to provide a more personalized and streamlined customer service experience. By promising end-to-end accountability to our customers, we believe our Center of Excellence concept allows for quick issue resolution, adds value to all interactions, and builds customer loyalty. Each of our Centers of Excellence are staffed with StarQuality certified cross-enterprise workgroups supporting customer communication, order fulfillment, billing accuracy and issue resolution, technical issue resolution, and customer retention. Customers are routed to the appropriate Center of Excellence representatives by way of Integrated Voice Response Unit technology. This technology allows the customer to identify their needs with an automated menu and transfers the call to a representative with skills and tools needed to resolve a specific issue quickly and effectively. This emphasis on a single point of contact for meeting customers' communications needs is very appealing to current and prospective customers, resulting in average customer satisfaction ratings exceeding 90% throughout 2004. All Call Centers are staffed with StarQuality certified representatives, ready and available 24 hours a day, 7 days a week, and 365 day a year.

        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 provides us a competitive advantage in the marketplace.

        Through an 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 competitive marketing advantage and strengthen our brand awareness.

        J. Walter Thompson serves as agency of record for our advertising, and Protocol Marketing Group manages direct marketing programs related to our Preferred Advantage products. In conjunction with J. Walter Thompson and Protocol, we launched an integrated marketing campaign to promote Preferred Advantage Wireless Service, designed specifically for businesses. The campaign included print advertising, radio spots, direct mail and bill inserts, supported with collateral and website content.

        In addition to the wireless campaign, we refreshed our other print advertising and radio spots to continue to focus on our key messages of superior customer service, network reliability and "no hidden charges or fine print." These ads were run in our key markets at various times throughout 2004. We also entered into an agreement with Vijay Singh, the top PGA Tour money winner in 2004, whereby he wore the McLeodUSA logo and participated in advertising, public relations and sales events during 2004.

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Employees

        As of December 31, 2004, McLeodUSA and its subsidiaries had approximately 2,400 employees. We believe that our future success will depend on our continued ability to attract and retain highly skilled and qualified employees.

Chapter 11 Reorganization

        During 2002 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 (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 (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";



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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;



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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;



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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



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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. Pursuant to the Plan, shares which were unclaimed by April 16, 2003 were cancelled. Upon the final determination of the amount, if any, of allowed securities claims under the Plan, such holders of Predecessor McLeodUSA Common Stock who received shares of McLeodUSA Class A Common Stock

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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 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 ("ICTC") 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 ICTC 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 ICTC were used to reduce the Term A and Term B loans under the Credit Agreement. 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.



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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.



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Pubco: On April 16, 2002, we completed the sale of McLeodUSA Media Group, Inc. and its subsidiaries (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. This Agreement has been amended and restated, but continues to provide among other things, 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.



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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.



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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

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liabilities. The sale excluded the telecommunications customer premise equipment business conducted in Illinois.

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Splitrock: On January 24, 2002, McLeodUSA completed the sale of certain of its internet/data assets (formerly part of Splitrock Services, Inc.) and wholesale dial-up Internet Service Provider ("ISP") customer base to Level 3 Communications, LLC ("Level 3") for approximately $50 million in cash and the assumption of certain operating liabilities. The transaction did not qualify as a discontinued operation under FAS 144 and the results of operations are included in continuing operations. Under the terms of the agreement, Level 3 purchased approximately 350 POPS (points of presence) across the United States, and the related facilities, equipment and underlying circuits, plus the wholesale ISP customer base. The transaction excluded fiber optic cable obtained under the existing IRU agreement with Level 3 and McLeodUSA in the acquisition of Splitrock. The parties also entered into operating agreements enabling McLeodUSA to continue providing service and support to customers in its 25-state footprint.

Telecommunications Industry

        The Annual Industry Telecom report disclosed that in 2003, total telecommunications industry revenue was $291 billion, local services revenue was $126 billion (over 43% of total), toll services revenue was $77 billion and wireless services revenue was $90 billion. 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 and dedicated 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); wireless services and local network access services (in which various local network components are used to originate or terminate local and long distance calls). 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 have been 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, and other services.

        The Telecommunications Act of 1996 (the "1996 Act") 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 certain elements of the incumbent's network in order to offer service to end users. The 1996 Act 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, all 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. All local telephone companies are also required to allow competitors nondiscriminatory access to poles, conduit space and other rights-of-way and to establish reciprocal arrangements for the transport and termination of traffic. A number of states have taken additional regulatory and legislative action to open local communications markets to competition.

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        As a result of these and other developments, competitive local telephone companies have gained market share since the enactment of the 1996 Act. According to the FCC, as of June 2004, competitive local telephone companies provided 32 million, or 17.8% of the approximately 180 million in-service local telephone lines used by end users, representing 7% growth in competitive local telephone company market size during the first six months of 2004. About 23.4% of these lines are served over local loop facilities owned by the competitive local telephone companies.

        As a result of regulatory changes, the RBOCs are now permitted to offer long distance services. This has increased customer expectations that their telecommunications providers will be able to offer them a complete package of services (local, long distance, voice and data). Also, new technologies continue to emerge and evolve, which introduce or enhance products and/or help the industry to lower costs. Currently, it is unclear when such technological advances will fundamentally change the structure of the industry. Some emerging fixed wireless and VoIP technologies have begun to reduce the industry's dependence on the RBOC loops for the last mile to the customer, although VoIP technology still needs competitive access to last mile cable or fiber broadband facilities.

        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 15% during the first half of 2004, to a total of 32.5 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 generally dominate their respective local telecommunications markets while also being our largest supplier, and wireless service providers, of which the two largest, Cingular and Verizon Wireless, are affiliated with RBOCs. Our largest local service competitors, the RBOCs, have gained approval to offer long distance services in all states. Our long distance services also compete with the services of a large number of other companies in the long distance marketplace in most states and with companies providing wireless services. Verizon, SBC, Qwest, AT&T, MCI and Sprint currently dominate the long distance market. The RBOCs have become important long distance competitors in each state in which we offer service. Our local and long distance services also compete with the services of other competitive local telephone companies in many markets. Most recently, the FCC has finalized its unbundling rules and the communications industry consolidation has accelerated. In addition, with the recent merger announcements in the industry, we believe that the large telecommunications providers will likely become even more aggressive upon the closing of these transactions further challenging our ability to grow revenue.

        Other competitors may include cable 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. 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 and state 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 that materially 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. The FCC also has declared jurisdiction over services classified as Information services such as DSL and VoIP. State regulatory commissions retain jurisdiction over the same facilities and services to the extent they are used to originate or terminate intrastate telecommunications services. 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 services, and has a proceeding pending in which it is reviewing all types of intercarrier compensation. The FCC imposes prior approval requirements on transfers of control and assignments of radio licenses and operating authorizations and on sale of assets, including customers and 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 and international end user telecommunications revenues. The contribution factor for the fourth quarter of 2004 is 8.9% of our interstate and international end user telecommunications revenue. 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 2004, we paid approximately $10.4 million to the federal program and approximately $3.1 million to state programs.

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        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.

        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 has implemented changes to its rules for telemarketing activities by telecommunications services providers. The FCC rules require us to implement procedures to avoid calling individuals who have placed their names on a national do-not-call list, limit our use of technologies that improve the efficiency of our telemarketing efforts, limit the hours in which we may place telemarketing calls, limit the number of calls abandoned and limit the time before which individuals are connected to a salesperson. Rules such as these reduce the effectiveness of our telemarketing efforts and result in additional customer acquisition costs. Several states have adopted similar measures with unique state requirements that require us to incur additional compliance 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 and telemarketing.

        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 that 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. Investigations remain pending in Arizona and Colorado. These proceedings may result in fines or other sanctions

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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.

        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 1996 Act 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 those elements of the incumbent local telephone company's network that must be made available to competitors 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 ("Court of Appeals") 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.

        In 2002, the FCC issued a Notice of Proposed Rulemaking ("NPRM") on Wireline Broadband/Cable Modem Classification Proceedings. The subject of these proceedings is whether cable modem service and telecommunications broadband access to the Internet services should be subject to Title II and Computer II/III safeguards. The RBOCs have advocated asking the FCC to determine that their broadband services are "private carriage" only subject to Title I, which would mean that McLeodUSA would not be entitled to use network elements of the broadband network. The RBOCs have also requested that the FCC forbear from enforcing Title II regulations on RBOC broadband services, which if granted would have the same effect on McLeodUSA.

        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. The FCC released its Triennial Review Order ("TRO") in August 2003 modifying its rules governing availability of RBOC unbundled network elements to competitive carriers. The TRO established new rules governing the availability and pricing for the network elements the RBOCs must provide to competitive carriers, and delegated authority to the states to apply certain of the new rules in individual markets. Several parties filed appeals in different federal appellate courts, which appeals were consolidated in the Court of Appeals.

        On March 2, 2004, the Court of Appeals issued a decision overturning many key elements of the TRO, remanding most of the order to the FCC for further action. The Court of Appeals ruled that the FCC's delegation of final impairment decisions to state agencies was unlawful. The Court also reversed the FCC's nationwide finding of presumptive impairment for mass-market switching, and dedicated transport and loops. The Court directed the FCC to give stronger consideration to intermodal competition when revising its rules on remand. The Court upheld the FCC determination that RBOCs do not have to unbundle loops made up of a combination of copper and fiber or to provide CLECs access to new fiber loops. The Court also upheld the FCC's findings that RBOCs are not required to

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provide unbundled switching to CLECs for business customers served by high-capacity loops, such as DS-1 or packet switching. On December 15, 2004, the FCC adopted new permanent rules that became effective on March 11, 2005. The new permanent rules eliminate access to unbundled local switching under Section 251(c)(3) of the 1996 Act and provide for a 12-month transition for elimination of UNE-P during which RBOCs may charge an extra $1 on each existing UNE-P line. Since March 11, 2005, McLeodUSA must have a commercial agreement with an RBOC for a UNE-P replacement product to offer service to new customers using unbundled local switching from the RBOC in almost all states. The FCC also eliminated unbundled access to high capacity loops in certain central offices depending on the amount of business access lines and fiber collocators in a wire center. Information provided by Qwest and SBC to the FCC indicates that seventeen wire centers in the 25 state local footprint of McLeodUSA are affected by this new rule. In addition, McLeodUSA may not obtain more than ten unbundled DS1s loops to one premise served by any wire center. McLeodUSA also does not have access to unbundled DS3 loops in certain RBOC wire centers. McLeodUSA is also limited to one unbundled DS3 loop to a particular premise in each RBOC wire center. The FCC also eliminated access to unbundled high capacity facilities that carry traffic between RBOC wire centers known as transport facilities. There is also a limit of ten or less DS1s transport circuits between two wire centers where access to DS3 transport has been eliminated. Unbundled DS3 transport is unavailable between two RBOC wire centers with 24,000 or more business lines or at least three unmatched fiber collocators in each wire center. McLeodUSA is required to replace unbundled high capacity loops and transport facilities in the affected markets with services provided by a third party supplier, or higher priced special access services or other commercially priced offerings from an RBOC. On February 14, 2005, the RBOCs asked the Court of Appeals to overturn the FCC's new unbundling rules. On February 24, 2005, Verizon asked the FCC not to enforce one portion of the Triennial Review Remand Order ("TRRO") that permits competitive carriers to convert special access circuits to unbundled high capacity circuits priced at Total Element Long Run Incremental Cost ("TELRIC"). Verizon claims it will suffer irreparable financial harm unless the FCC stays this provision. The FCC denied Verizon's request. Verizon subsequently petitioned the Court of Appeals to prevent competitive carriers from availing themselves of this TRRO provision.

        There can be no assurance that our businesses will not be adversely affected by the FCC's new permanent unbundling rules, continued legal challenges to the FCC's unbundling rules, new legislation passed in response to the new unbundling rules or any court decisions that result from continued legal challenges to the unbundling rules or current regulations.

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

        The FCC issued on March 10, 2004 its NPRM on "IP-enabled communications," which includes VoIP. The NPRM asks broad questions regarding the regulatory classifications of various "IP-enabled" services, including different VoIP services; the access charge and other intercarrier compensation implications; the universal service implications; and the other social policy implications such as law enforcement, disability and emergency 911 service issues and suggests, as a general proposition, that economic regulation of various IP-enabled services should be kept to a minimum. Certain RBOCs have advocated positions with respect to VoIP that, if adopted, could inhibit our ability to utilize VoIP and related technologies.

        Due to the growing deployment of VoIP services, the FCC and state commissions are conducting regulatory proceedings that could affect the regulatory duties and rights of entities such as McLeodUSA that plans to offer VoIP services. There is also regulatory uncertainty as to the imposition

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of access charges and other taxes, fees, and surcharges on VoIP services that in some manner transit over the Public Switched Telephone Network.

        In October 2002, AT&T Corporation filed a petition for declaratory ruling with the FCC with respect to phone-to-phone Internet Protocol telephony. The petition requested that the FCC declare that such services are exempt from the access charges applicable to circuit switched inter-exchange calls and that it is lawful to provide such service through local end user services. On April 21, 2004, the FCC denied AT&T's Petition, finding that AT&T's specific service offering is a telecommunications service; and (2) that access charges apply to the service. The FCC found that AT&T's offering involved an interexchange service that: (1) uses ordinary customer premises equipment with no enhanced functionality; (2) originates and terminates on the public switched telephone network; and (3) undergoes no net protocol conversion and provides no enhanced functionality to end users due to the provider's use of IP technology.

        Pulver.com filed a petition in February 2003 for declaratory ruling that asked the FCC to determine whether computer-to-computer calls over the Internet constituted a "telecommunications service" and, thus, were subject to access charges. On February 12, 2004, the FCC held that Pulver.com's service is neither telecommunications nor a telecommunications service. The FCC determined that because Pulver.com's peer-to-peer IP communications service does not offer or provide a transmission service, it is not offering "telecommunications" as defined under the 1996 Act. The FCC ruled that the service could not be classified as a "telecommunications service" under the 1996 Act because it is a free service not offered to the public for a fee. The FCC also decided to classify Pulver.com's service as an information service and intends to preempt state regulation of that service. These decisions, together with the results of other proceedings decided by, or pending before, the FCC could impact the terms and conditions under which the Company offers VoIP products and services.

        On September 22, 2003, Vonage Holdings Corporation ("Vonage"), filed a petition with the FCC requesting a declaration that its offerings, which originate on a broadband network in IP format and terminate on the PSTN, or vice versa, are interstate information services not subject to state regulation under the federal 1996 Act and existing FCC rules. On November 10, 2004, the FCC adopted an order ruling that Vonage's service was an interstate service not subject to state regulation. The FCC did not rule whether the service was a telecommunications service or an information service under the 1996 Act. This decision, together with the results of other proceedings decided by, or pending before, the FCC could impact the terms and conditions under which the Company offers VoIP products and services.

        On February 5, 2004, SBC Communications Inc. filed two petitions with the FCC relating to IP communications. The first requests a declaratory ruling that all services offered on an IP platform are interstate information services, not telecommunications services, and that they are immune from state regulation as a result. The second requests that the FCC forbear from applying certain common carrier regulation to services offered on IP platforms. The FCC has sought public comment with respect to SBC's forbearance petition, and, under the 1996 Act, the FCC must make a decision on the petition within one year of the petition's filing (with the possibility of a single 90-day extension available at the FCC's discretion). If the FCC does not act with respect to SBC's forbearance petition, the petition is deemed granted as a matter of law. On December 7, 2004, the FCC extended the time to respond to the forbearance petition to May 5, 2005. The FCC has requested comment with respect to SBC's petition for declaratory ruling. The Company cannot predict the outcome of this proceeding; however, a decision in this proceeding, together with the results of other proceedings decided by, or pending before, the FCC could impact the terms and conditions under which the Company offers VoIP products and services.

        The Company cannot predict the outcome of these proceedings or other FCC or state proceedings that may affect the Company's operations or impose additional requirements, regulations or charges

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upon the Company's provision of Internet access and related Internet Protocol-based telephony services.

        The FCC has enacted local number portability ("LNP") rules that allow consumers to switch providers and keep their existing phone number. In 1996, wireline carriers were required to permit wireline-to-wireline LNP in all U.S. markets. As of May 24, 2004, wireless carriers were required to implement wireless-to-wireless LNP in all U.S. markets.

        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, including with respect to McLeodUSA's continued access to RBOC network elements and facilities that are necessary for McLeodUSA to provide services to our customers and at what prices. There can be no assurance that our business will not be adversely affected by future legislation, new regulation or deregulation, or by court decisions.

        On June 21, 2004, Qwest asked the FCC to determine that it was no longer the dominant carrier as the incumbent LEC in the Omaha, Nebraska, market and therefore did not have to comply with the market-opening requirements in Section 251(c)(3) of the 1996 Act. On February 11, 2005, the FCC granted itself an additional 90 days until September 16, 2005 to rule on the Qwest petition. If Qwest's petition is granted, McLeodUSA will lose access to unbundled loops required to serve customers in this market.

        On January 31, 2005, the FCC issued an NPRM on special access pricing for services offered by ILECs. The NPRM will reexamine the FCC's pricing flexibility rules on special access and consider whether new categories of special services should be established. For those markets where access to unbundled high capacity circuits has been eliminated, the pricing structure of special access circuits will impact the feasibility of using special access services to serve customers.

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.

Executing Our Business Strategy Involves Substantial Risks

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

•

the Company is actively pursuing a strategic partner or a sale of the Company and there can be no assurances that it will be successful locating a strategic partner or purchaser;



•

we could be forced to seek protection from creditors in a Chapter 11 bankruptcy filing if our lenders do not continue to forbear from exercising their rights under the Credit Facilities or execute a capital restructuring to eliminate the ongoing level of principal and interest payments;



•

it is unlikely that holders of the Company's current preferred or common stock holders will receive any recovery in any capital restructuring or other strategic transaction;

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•

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



•

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



•

reputation issues related to our financial situation and liquidity needs that increase the risk that we may fail to attract and retain customers;



•

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



•

we may not have sufficient liquidity to continue to maintain our current operations; and



•

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

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

Increased Competition in the Telecommunications Industry Makes it Difficult for us to Attract Customers and Grow Revenues

        Despite our operational efficiencies, it has become increasingly difficult to compete against large, financially strong competitors with well-known brands. Most recently, the FCC finalized its unbundling rules and consolidation in the communications industry has accelerated. With the recent merger announcements in the telecommunications industry, we believe that the large telecommunications providers will likely become even stronger, making it more difficult for us to compete.

We May be Unsuccessful in Finding a Strategic Partner or Purchaser

        The Company is actively pursuing a strategic partner or a sale of the Company, while also taking steps to maintain future liquidity, including evaluating a capital restructuring to reduce current debt levels and to achieve future positive cash flow. There can be no assurances that the Company will be able to identify a suitable strategic partner or buyer or reach agreement with any strategic partner or buyer on terms and conditions acceptable to the Company. In any such transaction, the current holders of the Company's preferred and common stock are unlikely to receive any recovery.

Preferred and Common Stock Holders Are Not Likely to Receive Any Recovery in a Capital Restructuring or Other Strategic Transaction

        The Company has begun discussions related to a capital restructuring with its agent bank and a group of lenders acting as a steering committee for the lenders under its Credit Facilities. The Company and this committee are in negotiations related to terms of a capital restructuring which includes the conversion of a significant portion of the Company's current outstanding debt into equity. Under such a restructuring, the holders of the Company's current debt would become equity stockholders of the Company with the current holders of the preferred and common stock unlikely to receive any recovery.

We May be Forced to Seek Protection From Our Creditors

        The Company has entered into a forbearance agreement with its lenders with respect to scheduled principal and interest payments on its loans under which its lenders have agreed not to take any action as a result of non-payment by the Company of approximately $18.1 million of scheduled principal amortization and interest payments due on or before March 31, 2005, and certain related events of default through May 23, 2005. There can be no assurance that the Company will be able to reach an

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agreement with its lenders regarding a capital restructuring or continued forbearance and debt covenant relief prior to the end of the initial forbearance period. There can also be no assurance that the Company will be able to identify a suitable strategic partner or buyer or reach agreement with any such strategic partner or buyer on terms and conditions acceptable to the Company prior to the end of the initial forbearance period. In the event these alternatives are unavailable to the Company, it is likely that the Company will elect to forgo making future principal and interest payments to its lenders while it continues to seek an extended forbearance period from its lenders, and the Company could be forced to seek protection from its creditors.

Our Financial Statements Assume we can Continue as a "Going Concern"

        Our consolidated financial statements included elsewhere in this Annual Report on Form 10-K have been prepared assuming we can continue as a going concern. The report of our independent auditors accompanying our financial statements in this report on Form 10-K contains a comment stating that there is substantial doubt as to our ability to continue as a going concern.

        In the event our restructuring activities are not successful and we are required to seek protection from our creditors, additional significant adjustments may be necessary in the carrying value of assets and liabilities, the revenues and expenses reported and the balance sheet classifications used.

Our Business Does Not Generate Positive Cash Flow

        To date, our telecommunication operations have not generated positive cash flow in any quarterly period. There can be no assurance that any of the strategic initiatives we have undertaken to improve our business and eventually generate positive cash flow will be successful in the time and of the magnitude required for us to continue operations or avoid seeking protection from our creditors.

We Expect to Continue to Incur Significant Losses Over the Next Several Years

        We have incurred net losses every year since we began operations. McLeodUSA incurred a net loss applicable to its common shares of $627.4 million for the year ended December 31, 2004 (which included a writedown of goodwill and other intangible assets of $263.1 million), $300.3 million for 2003, and $204.9 million for the period April 17, 2002 to December 31, 2002. We expect to incur significant continued operating losses during the next several years. If we are unable to generate an operating profit in the future, there may be material adverse consequences to our business and our ability to continue operating, including the need to seek protection from our creditors.

We Have a Risk of Inadequate Liquidity

        Our financial position may adversely affect the willingness of potential customers to purchase their communications services from us. 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. Additionally, many of our critical suppliers of network services such as the RBOCs and IXCs are aware of our liquidity position and may seek to impose burdensome security deposits or require letters of credit that may negatively impact our liquidity position. There is no guarantee that these vendors will not be successful in imposing these requirements in light of our operating results and financial condition, or that the size of such deposit requirements would not have a material adverse affect on our liquidity and financial condition.

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

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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, cash flow from future operations, and proceeds from fiber sales. Our estimated aggregate capital expenditure requirements include the projected costs of: