OTELCO INC. - FORM 10-Q - November 4, 2011

Attached files

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EX-32.1 - EXHIBIT 32.1 - OTELCO INC.	ex32-1.htm
EX-32.2 - EXHIBIT 32.2 - OTELCO INC.	ex32-2.htm
EX-31.2 - EXHIBIT 31.2 - OTELCO INC.	ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - OTELCO INC.	ex31-1.htm
EXCEL - IDEA: XBRL DOCUMENT - OTELCO INC.	Financial_Report.xls

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

	For the quarterly period ended September 30, 2011

	Or

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

	For the transition period from to

Commission File Number: 1-32362

OTELCO INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware		52-2126395
(State or Other Jurisdiction of Incorporation or		(I.R.S. Employer Identification No.)
Organization)

505 Third Avenue East, Oneonta, Alabama		35121
(Address of Principal Executive Offices)		(Zip Code)

(205) 625-3574

(Registrant’s Telephone Number, Including Area Code)

N/A

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x

No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x

No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o

Accelerated filer x

Non-accelerated filer o

Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o

No x

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class		Outstanding at November 4, 2011
Class A Common Stock ($0.01 par value per share)		13,221,404
Class B Common Stock ($0.01 par value per share)		0

OTELCO INC.

FORM 10-Q

For the three month period ended September 30, 2011

TABLE OF CONTENTS


		Page

PART I FINANCIAL INFORMATION		2
Item 1.	Financial Statements	2
	Consolidated Balance Sheets as of December 31, 2010 and September 30, 2011	2
	Consolidated Statements of Operations for the Three Months and Nine Months Ended September 30, 2010 and 2011	3
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2010 and 2011	4
	Notes to Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	22
Item 4.	Controls and Procedures	23

PART II OTHER INFORMATION		24
Item 6.	Exhibits	24

Unless the context otherwise requires, the words “we,” “us,” “our,” “the Company” and “Otelco” refer to Otelco Inc., a Delaware corporation, and its consolidated subsidiaries as of September 30, 2011.

FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements that are subject to risks and uncertainties. Forward-looking statements give our current expectations relating to our financial condition, results of operations, plans, objectives, future performance and business. These statements may include words such as “anticipate,” “estimate,” “expect,” “project,” “plan,” “intend,” “believe” and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events. These forward-looking statements are based on assumptions that we have made in light of our experience in the industry in which we operate, as well as our perceptions of historical trends, current conditions, expected future developments and other factors we believe are appropriate under the circumstances. Although we believe that these forward-looking statements are based on reasonable assumptions, you should be aware that many factors could affect our actual financial condition or results of operations and cause actual results to differ materially from those in the forward-looking statements.

PART I FINANCIAL INFORMATION

Item 1. Financial Statements

OTELCO INC.

CONSOLIDATED BALANCE SHEETS

	December 31, 2010			September 30, 2011
				(unaudited)
Assets
Current assets
Cash and cash equivalents	$	18,226,374		$	17,761,824
Accounts receivable:
Due from subscribers, net of allowance for doubtful accounts of $230,752 and $273,345, respectively		4,406,257			4,360,122
Unbilled receivables		2,161,277			2,197,367
Other		4,299,088			5,486,213
Materials and supplies		1,817,311			1,999,397
Prepaid expenses		1,305,028			1,180,987
Deferred income taxes		626,267			626,267
Total current assets		32,841,602			33,612,177

Property and equipment, net		63,887,213			62,616,216
Goodwill		188,190,078			188,190,078
Intangible assets, net		25,934,042			20,501,145
Investments		1,967,095			1,947,963
Deferred financing costs		5,757,825			4,731,752
Deferred income taxes		4,415,097			4,415,097
Other assets		183,946			122,940
Total assets	$	323,176,898		$	316,137,368

Liabilities and Stockholders’ Deficit
Current liabilities
Accounts payable	$	768,055		$	1,460,497
Accrued expenses		7,926,954			7,217,175
Advance billings and payments		1,595,133			1,485,017
Deferred income taxes		353,285			353,285
Customer deposits		172,479			179,524
Total current liabilities		10,815,906			10,695,498

Deferred income taxes		42,512,576			42,512,576
Interest rate swaps		2,471,331			830,299
Advance billings and payments		656,968			625,930
Other liabilities		368,349			401,144
Long-term notes payable		271,595,855			271,133,432
Total liabilities		328,420,985			326,198,879

Stockholders’ Deficit
Class A Common Stock, $.01 par value-authorized 20,000,000 shares; issued and outstanding 13,221,404 shares		132,214			132,214
Additional paid in capital		921,718			-
Retained deficit		(6,298,019	)		(10,193,725	)
Total stockholders’ deficit		(5,244,087	)		(10,061,511	)
Total liabilities and stockholders’ deficit	$	323,176,898		$	316,137,368

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

OTELCO INC.
CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2011			2010			2011

Revenues	$	26,145,227		$	25,302,747		$	78,450,381		$	76,195,806

Operating expenses
Cost of services and products		10,336,220			10,985,814			31,374,193			32,762,538
Selling, general and administrative expenses		3,307,743			3,248,746			9,775,255			9,485,763
Depreciation and amortization		5,773,298			4,944,033			17,692,899			15,176,030
Total operating expenses		19,417,261			19,178,593			58,842,347			57,424,331

Income from operations		6,727,966			6,124,154			19,608,034			18,771,475

Other income (expense)
Interest expense		(6,320,757	)		(6,222,487	)		(18,488,869	)		(18,591,790	)
Change in fair value of derivatives		(358,833	)		654,791			(1,421,282	)		1,641,032
Other income		150,790			6,189			533,649			388,686
Total other expense		(6,528,800	)		(5,561,507	)		(19,376,502	)		(16,562,072	)

Income before income tax		199,166			562,647			231,532			2,209,403
Income tax (expense) benefit		(136,091	)		322,815			(136,835	)		(36,013	)

Net income available to common stockholders	$	63,075		$	885,462		$	94,697		$	2,173,390

Weighted average common shares outstanding:
Basic		13,221,404			13,221,404			12,906,173			13,221,404
Diluted		13,221,404			13,221,404			13,221,404			13,221,404
Basic net income per share	$	0.00		$	0.07		$	0.01		$	0.16
Diluted net income per share	$	0.00		$	0.07		$	0.01		$	0.16

Dividends declared per share	$	0.18		$	0.18		$	0.53		$	0.53

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

OTELCO INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

	Nine Months Ended September 30,
	2010			2011
Cash flows from operating activities:
Net income	$	94,697		$	2,173,390
Adjustments to reconcile net income to cash flows from operating activities:
Depreciation		10,164,224			8,751,166
Amortization		7,528,676			6,424,864
Amortization of debt premium		(68,220	)		(76,595	)
Amortization of loan costs		1,019,326			1,026,072
Change in fair value of derivatives		1,421,282			(1,641,032	)
Provision for uncollectible revenue		179,634			545,338
Changes in operating assets and liabilities; net of operating assets and liabilities acquired:
Accounts receivables		(1,574,850	)		(1,654,102	)
Material and supplies		205,834			(182,086	)
Prepaid expenses and other assets		206,918			111,735
Income tax receivable		389,486			-
Accounts payable and accrued liabilities		(142,257	)		(17,338	)
Advance billings and payments		(59,859	)		(141,154	)
Other liabilities		69,397			39,841

Net cash from operating activities		19,434,288			15,360,099

Cash flows used in investing activities:
Acquisition and construction of property and equipment		(6,443,959	)		(8,448,004	)
Deferred charges		(1,041	)		-

Net cash used in investing activities		(6,445,000	)		(8,448,004	)

Cash flows used in financing activities:
Cash dividends paid		(6,894,819	)		(6,990,817	)
Direct cost of exchange of Class B shares for Class A common shares		(194,053	)		-
Principal repayment of long-term debt		-			(385,828	)
Loan origination costs		(155,160	)		-

Net cash used in financing activities		(7,244,032	)		(7,376,645	)

Net increase (decrease) in cash and cash equivalents		5,745,256			(464,550	)
Cash and cash equivalents, beginning of period		17,731,044			18,226,374

Cash and cash equivalents, end of period	$	23,476,300		$	17,761,824

Supplemental disclosures of cash flow information:
Interest paid	$	17,345,346		$	17,642,313

Income taxes paid (received)	$	(197,534	)	$	165,061

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

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2011

(unaudited)

1. Organization and Basis of Financial Reporting

Basis of Presentation and Principles of Consolidation

The consolidated financial statements include the accounts of Otelco Inc. (the “Company”) and its subsidiaries, all of which are either directly or indirectly wholly owned. These include: Otelco Telecommunications LLC (“OTC”); Otelco Telephone LLC (“OTP”); Hopper Telecommunications Company, Inc. (“HTC”); Brindlee Mountain Telephone Company, Inc. (“BMTC”); Blountsville Telephone Company, Inc. (“BTC”); Mid-Missouri Holding Corporation (“MMH”) and its wholly owned subsidiary Mid-Missouri Telephone Company (“MMT”) and its wholly owned subsidiary Imagination, Inc.; Mid-Maine Telecom, Inc. (“MMTI”); Mid-Maine TelPlus (“MMTP”); The Granby Telephone & Telegraph Co. of Massachusetts (“GTT”); War Acquisition Corporation (“WT”); The Pine Tree Telephone and Telegraph Company (“PTT”); Saco River Telegraph and Telephone Company (“SRT”); CRC Communications of Maine, Inc. (“PTN”); and Communications Design Acquisition Corporation (“CDAC”).

The accompanying consolidated financial statements include the accounts of the Company and all of the aforesaid subsidiaries after elimination of all material intercompany balances and transactions. The unaudited operating results for the three months and nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011 or any other period.

The consolidated financial statements and notes included in this Form 10-Q should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2010. The interim consolidated financial information herein is unaudited. The information reflects all adjustments (which include only normal recurring adjustments), which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the periods included in the report.

Certain prior year amounts have been reclassified to conform with the current year’s presentation.

Recent Accounting Pronouncements

During 2011, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) 2011-01 through 2011-09. Except for ASU 2011-04, ASU 2011-05, ASU 2011-08, and ASU 2011-09, which are discussed below, these ASUs provide technical corrections to existing guidance related to specialized industries or entities and therefore, have minimal, if any, impact on the Company.

In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”), an update to Accounting Standards Codification (“ASC”) 820, Fair Value Measurements and Disclosures (“ASC 820”). ASU 2011-04 provides guidance to change the wording used to describe many of the requirements in U.S. generally accepted accounting principles for measuring fair value and for disclosing information about fair value measurements. For public entities, ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011 and is to be applied prospectively. Early application by public entities is not permitted. As ASU 2011-04 impacts presentation only, the adoption of this update will not impact our consolidated financial statements.

In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income (“ASU 2011-05”), an update to ASC 220, Comprehensive Income. This ASU requires the components of net income and the components of other comprehensive income to be presented either in a single continuous statement of comprehensive income or in two separate but continuous statements. ASU 2011-05 eliminates the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. This guidance does not change the items that must be reported in other comprehensive income, when an item of other comprehensive income must be reclassified to net income or how earnings per share is calculated or presented. ASU 2011-05 is effective for public entities for interim and annual periods beginning after December 15, 2011. Early adoption is permitted. As ASU 2011-05 impacts presentation only, the adoption of this update will not impact our consolidated financial statements.

In September 2011, the FASB issued ASU 2011-08, Testing Goodwill for Impairment (“ASU 2011-08”), an update to ASC 350, Intangibles – Goodwill and Other (“ASC 350”). This ASU will provide an entity with the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if an entity concludes otherwise, then it is required to perform the first step of the two-step impairment test in accordance with ASC 350. ASU 2011-08 is effective for annual and interim goodwill impairment tests for fiscal years beginning after December 15, 2011. Early adoption is permitted. As ASU 2011-08 impacts testing procedures only, the adoption of this update will not impact our consolidated financial statements.

In September 2011, the FASB issued ASU 2011-09, Disclosures about an Employer’s Participation in a Multiemployer Plan (“ASU 2011-09”), an update to ASC 715, Compensation – Retirement Benefits, subtopic 80, Multiemployer Plans. ASU 2011-09 requires additional disclosures for multiemployer pension plans and multiemployer other postretirement benefit plans. ASU 2011-09 is intended to create greater transparency in financial reporting by disclosing the commitments an employer has made to a multiemployer pension plan and the potential future cash flow implications of an employer’s participation in the plan. ASU 2011-09 is effective for public entities for annual periods with fiscal years ending after December 15, 2011. Early adoption is permitted. As ASU 2011-09 impacts disclosure only, the adoption of this update will not impact our consolidated financial statements.

2. Commitments and Contingencies

From time to time, we may be involved in various claims, legal actions and regulatory proceedings incidental to and in the ordinary course of business, including administrative hearings of the Alabama, Maine, Massachusetts, Missouri, New Hampshire, and West Virginia Public Service Commissions relating primarily to rate making. Currently, none of the legal proceedings are expected to have a material adverse effect on our business.

3. Derivative Activities

The Company has two interest rate swaps with approved counterparties. The first swap has a notional amount of $90 million with the Company paying a fixed rate of 1.85% and the counterparty paying a variable rate based upon the three month LIBOR interest rate. It is effective from February 9, 2009 through February 8, 2012. The second swap has a notional amount of $60 million with the Company paying a fixed rate of 2.0475% and the counterparty paying a variable rate based upon the three month LIBOR interest rate. It is effective from February 9, 2010 through February 8, 2012. From an accounting perspective, the documentation for both swaps does not meet the technical requirements of ASC 815, Derivatives and Hedging, to allow the swaps to be considered highly effective hedging instruments and therefore the swaps do not qualify for hedge accounting. The change in fair value of the swaps is charged or credited to income as a change in fair value of derivatives. Over the life of the swaps, the cumulative change in value will be zero.

4. Income per Common Share and Potential Common Share

Basic income per common share is computed by dividing net income by the weighted-average number of shares outstanding for the period. Diluted income per common share reflects the potential dilution that would occur had all of the issued and outstanding shares of Class B common stock been exchanged for Income Deposit Securities (“IDSs”) at the beginning of the period. On June 8, 2010, all of the Company’s issued and outstanding shares of Class B common stock were exchanged for IDSs on a one-for-one basis. Each of the IDSs issued in the exchange includes a common share. Diluted amounts are not included in the computation of diluted loss per common share when the inclusion of such amounts would be anti-dilutive. The Company does not have any outstanding stock arrangements that might be potentially dilutive.

A reconciliation of the common shares for the Company’s basic and diluted income per common share calculation is as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2010		2011		2010		2011

Weighted average of common shares-basic		13,221,404		13,221,404		12,906,173		13,221,404

Effect of dilutive securities		-		-		315,231		-

Weighted-average common shares and potential common shares-diluted		13,221,404		13,221,404		13,221,404		13,221,404

Net income available to common stockholders	$	63,075	$	885,462	$	94,697	$	2,173,390

Net income per basic share	$	0.00	$	0.07	$	0.01	$	0.16

Net income available to common stockholders	$	63,075	$	885,462	$	94,697	$	2,173,390
Less: Change in fair value of Class B derivative		-		-		-		-

Net income available for diluted shares	$	63,075	$	885,462	$	94,697	$	2,173,390

Net income per diluted share	$	0.00	$	0.07	$	0.01	$	0.16

5. Acquisition

On October 14, 2011, Shoreham Telephone LLC (“Shoreham”), a direct wholly owned subsidiary of the Company, completed its acquisition of all of the issued and outstanding capital stock of Shoreham Telephone Company, Inc. (“STC”), a privately-held integrated telecommunications services provider serving customers in middle Vermont (the “Stock Purchase”). The aggregate consideration paid for the issued and outstanding capital stock of STC was approximately $4.5 million in cash, subject to adjustment as provided in the Stock Purchase Agreement, dated as of April 1, 2011, by and among Shoreham, Donald S. Arnold, III, James C. Arnold, Susan E. Arnold and STC, as amended on October 14, 2011. The Stock Purchase was financed from the Company’s cash on hand. Immediately following the closing of the Stock Purchase, STC merged with and into Shoreham, with Shoreham continuing as the surviving entity in the merger.

6. Fair Value Measurement

The Company adopted ASC 820, which defines fair value, establishes a framework for measuring fair value and requires additional disclosures about fair value measurements. The framework that is set forth in this standard is applicable to the fair value measurements where it is permitted or required under other accounting pronouncements.

ASC 820 defines fair value as the exit price, which is the price that would be received to sell an asset or paid to transfer a liability in a transaction between market participants at the measurement date. ASC 820 establishes a three-tier fair value hierarchy that prioritizes inputs to valuation techniques used for fair value measurement.

●

Level 1 consists of observable market data in an active market for identical assets or liabilities.

●

Level 2 consists of observable market data, other than that included in Level 1, that is either directly or indirectly observable.

●

Level 3 consists of unobservable market data. The input may reflect the assumptions of the Company, not a market participant, if there is little available market data and the Company’s own assumptions are considered by management to be the best available information.

In accordance with ASC 820, the following tables represent the Company’s fair value hierarchy for its financial assets and liabilities as of December 31, 2010 and September 30, 2011:

	December 31, 2010
	Fair Value		Level 1 (1)		Level 2 (2)		Level 3 (3)
Liabilities
Interest rate swaps	$	2,471,331	$	-	$	2,471,331	$	-
Total liabilities	$	2,471,331	$	-	$	2,471,331	$	-


	September 30, 2011
	Fair Value		Level 1 (1)		Level 2 (2)		Level 3 (3)

Liabilities
Interest rate swaps	$	830,299	$	-	$	830,299	$	-
Total liabilities	$	830,299	$	-	$	830,299	$	-

(1) Quoted prices in active markets for identical assets.

(2) Significant other observable inputs.

(3) Significant unobservable inputs.

The interest rate swaps are valued at the end of the quarter based on available market information.

7. Subsidiary Guarantees

The Company has no independent assets or operations separate from its operating subsidiaries. The guarantees of its senior subordinated notes by 12 of its 14 operating subsidiaries are full and unconditional, joint and several. The operating subsidiaries have no independent long-term notes payable. There are no significant restrictions on the ability of the Company to obtain funds from its operating subsidiaries by dividend or loan. The condensed consolidated financial information is provided for the guarantor entities.

The following tables present condensed consolidating balance sheets as of December 31, 2010 and September 30, 2011; condensed consolidating statements of operations for the three months ended September 30, 2010 and 2011; condensed consolidating statements of operations for the nine months ended September 30, 2010 and 2011; and condensed consolidating statements of cash flows for the nine months ended September 30, 2010 and 2011.

Otelco Inc.
Condensed Consolidating Balance Sheet
December 31, 2010

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated
ASSETS

Current assets
Cash and cash equivalents	$	-		$	18,064,970		$	161,404		$	-		$	18,226,374
Accounts receivable, net		-			9,741,477			1,125,145			-			10,866,622
Materials and supplies		-			893,186			924,125			-			1,817,311
Prepaid expenses		184,055			1,022,697			98,276			-			1,305,028
Deferred income taxes		626,267			-			-			-			626,267
Investment in subsidiaries		131,010,180			-			-			(131,010,180	)		-
Intercompany receivable		(129,599,481	)		-			-			129,599,481			-
Total current assets		2,221,021			29,722,330			2,308,950			(1,410,699	)		32,841,602

Property and equipment, net		218,301			54,043,819			9,625,093			-			63,887,213
Goodwill		239,970,317			(49,843,599	)		(1,936,640	)		-			188,190,078
Intangible assets, net		-			23,326,214			2,607,828			-			25,934,042
Investments		1,203,605			433,059			330,431			-			1,967,095
Deferred income taxes		4,415,097			-			-			-			4,415,097
Other long-term assets		5,757,825			183,946			-			-			5,941,771

Total assets	$	253,786,166		$	57,865,769		$	12,935,662		$	(1,410,699	)	$	323,176,898

LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)

Current liabilities
Accounts payable and accrued expenses	$	2,280,661		$	,659,879		$	1,754,469		$	-		$	8,695,009
Intercompany payables		-			(131,769,870	)		2,170,389			129,599,481			-
Other current liabilities		353,285			1,678,145			89,467			-			2,120,897
Total current liabilities		2,633,946			(125,431,846	)		4,014,325			129,599,481			10,815,906

Deferred income taxes		22,592,597			16,666,501			3,253,478			-			42,512,576
Other liabilities		2,471,331			1,025,317			-			-			3,496,648
Long-term notes payable		231,332,379			40,263,476			-			-			271,595,855
Stockholders’ equity (deficit)		(5,244,087	)		125,342,321			5,667,859			(131,010,180	)		(5,244,087	)

Total liabilities and stockholders’ equity (deficit)	$	253,786,166		$	57,865,769		$	2,935,662		$	(1,410,699	)	$	323,176,898

Otelco Inc.
Condensed Consolidating Balance Sheet

September 30, 2011

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated
ASSETS

Current assets
Cash and cash equivalents	$	-		$	17,752,032		$	9,792		$	-		$	17,761,824
Accounts receivable, net		-			10,879,007			1,164,695			-			12,043,702
Materials and supplies		-			849,575			1,149,822			-			1,999,397
Prepaid expenses		160,297			952,807			67,883			-			1,180,987
Deferred income taxes		626,267			-			-			-			626,267
Investment in subsidiaries		149,543,965			-			-			(149,543,965	)		-
Intercompany receivable		(154,353,456	)		(330,279	)		330,279			154,353,456			-
Total current assets		(4,022,927	)		30,103,142			2,722,471			4,809,491			33,612,177

Property and equipment, net					53,727,539			8,888,677			-			62,616,216
Goodwill		239,970,317			(49,843,599	)		(1,936,640	)		-			188,190,078
Intangible assets, net		-			18,079,590			2,421,555			-			20,501,145
Investments		1,203,605			413,927			330,431			-			1,947,963
Deferred income taxes		4,415,097			-			-			-			4,415,097
Other long-term assets		4,731,752			122,940			-			-			4,854,692

Total assets	$	246,297,844		$	52,603,539		$	12,426,494		$	4,809,491		$	316,137,368

LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)

Current liabilities
Accounts payable and accrued expenses	$	1,713,218		$	5,140,551		$	1,823,903		$	-		$	8,677,672
Intercompany payables		-			(154,353,456	)		-			154,353,456			-
Other current liabilities		353,285			1,544,978			119,563			-			2,017,826
Total current liabilities		2,066,503			(147,667,927	)		1,943,466			154,353,456			10,695,498

Deferred income taxes		22,592,597			16,666,501			3,253,478			-			42,512,576
Other liabilities		830,299			1,027,074			-			-			1,857,373
Long-term notes payable		230,869,956			40,263,476			-			-			271,133,432
Stockholders’ equity (deficit)		(10,061,511	)		142,314,415			7,229,550			(149,543,965	)		(10,061,511	)

Total liabilities and stockholders’ equity (deficit)	$	246,297,844		$	52,603,539		$	12,426,494		$	4,809,491		$	316,137,368

Otelco Inc.

Condensed Consolidating Statement of Operations

For the Three Months Ended September 30, 2010

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated

Revenue	$	922,701		$	25,557,714		$	2,569,589		$	(2,904,777	)	$	26,145,227
Operating expenses		(922,701	)		(19,202,600	)		(2,196,737	)		2,904,777			(19,417,261	)
Income from operations		-			6,355,114			372,852			-			6,727,966
Other income (expense)		(6,565,182	)		(62,197	)		98,579			-			(6,528,800	)
Earnings from subsidiaries		6,764,348			-			-			(6,764,348	)		-
Income before income tax		199,166			6,292,917			471,431			(6,764,348	)		199,166
Income tax expense		(136,091	)		-			-			-			(136,091	)

Net income to common stockholders	$	63,075		$	6,292,917		$	471,431		$	(6,764,348	)	$	63,075

Otelco Inc.

Condensed Consolidating Statement of Operations

For the Three Months Ended September 30, 2011

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated

Revenues	$	789,508		$	24,680,968		$	2,555,301		$	(2,723,030	)	$	25,302,747
Operating expenses		(789,507	)		(19,228,795	)		(1,883,323	)		2,723,032			(19,178,593	)
Income from operations		1			5,452,173			671,978			2			6,124,154
Other expense		(5,471,374	)		(90,130	)		(3	)		-			(5,561,507	)
Earnings from subsidiaries		6,034,020			-			-			(6,034,020	)		-
Income before income tax		562,647			5,362,043			671,975			(6,034,018	)		562,647
Income tax benefit		322,815			-			-			-			322,815

Net income to common stockholders	$	885,462		$	5,362,043		$	671,975		$	(6,034,018	)	$	885,462

Otelco Inc.

Condensed Consolidating Statement of Operations

For the Nine Months Ended September 30, 2010

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated

Revenue	$	2,543,780		$	76,324,827		$	8,121,091		$	(8,539,317	)	$	78,450,381
Operating expenses		(2,543,780	)		(58,125,997	)		(6,711,887	)		8,539,317			(58,842,347	)
Income from operations		-			18,198,830			1,409,204			-			19,608,034
Other income (expense)		(19,246,771	)		(228,260	)		98,529			-			(19,376,502	)
Earnings from subsidiaries		19,478,303			-			-			(19,478,303	)		-
Income before income tax		231,532			17,970,570			1,507,733			(19,478,303	)		231,532
Income tax expense		(136,835	)		-			-			-			(136,835	)

Net income to common stockholders	$	94,697		$	17,970,570		$	1,507,733		$	(19,478,303	)	$	94,697

Otelco Inc.

Condensed Consolidating Statement of Operations

For the Nine Months Ended September 30, 2011

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated

Revenues	$	2,356,860		$	74,334,212		$	7,679,207		$	(8,174,473	)	$	76,195,806
Operating expenses		(2,356,860	)		(57,121,439	)		(6,120,507	)		8,174,475			(57,424,331	)
Income from operations		-			17,212,773			1,558,700			2			18,771,475
Other income (expense)		(16,324,377	)		(240,685	)		2,990			-			(16,562,072	)
Earnings from subsidiaries		18,533,780			-			-			(18,533,780	)		-
Income before income tax		2,209,403			16,972,088			1,561,690			(18,533,778	)		2,209,403
Income tax expense		(36,013	)		-			-			-			(36,013	)

Net income to common stockholders	$	2,173,390		$	16,972,088		$	1,561,690		$	(18,533,778	)	$	2,173,390

Otelco Inc.
Condensed Consolidating Statement of Cash Flows
For the Nine Months Ended September 30, 2010

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated

Cash flows from operating activities:
Net income	$	94,697		$	17,970,570		$	1,507,733		$	(19,478,303	)	$	94,697
Adjustment to reconcile net income to cash flows from operating activities		2,372,388			15,397,870			2,474,664			-			20,244,922
Changes in assets and liabilities, net of assets and liabilities acquired		24,255,251			(21,849,526	)		(3,311,056	)		-			(905,331	)
Net cash provided by operating activities		26,722,336			11,518,914			671,341			(19,478,303	)		19,434,288
Cash flows used in investing activities		-			(5,792,495	)		(652,505	)		-			(6,445,000	)
Cash flows used in financing activities		(26,722,336	)		1			-			19,478,303			(7,244,032	)
Net increase in cash and cash equivalents		-			5,726,420			18,836			-			5,745,256

Cash and cash equivalents, beginning of period		-			17,617,266			113,778			-			17,731,044

Cash and cash equivalents, end of period	$	-		$	23,343,686		$	132,614		$	-		$	23,476,300

Otelco Inc.

Condensed Consolidating Statement of Cash Flows

For the Nine Months Ended September 30, 2011

	Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Eliminations			Consolidated

Cash flows from operating activities:
Net income	$	2,173,390		$	16,972,088		$	1,561,690		$	(18,533,778	)	$	2,173,390
Adjustment to reconcile net income to cash flows from operating activities		(691,555	)		13,777,274			1,944,094			-			15,029,813
Changes in assets and liabilities, net of assets and liabilities acquired		24,210,292			(23,327,940	)		(2,725,456	)		-			(1,843,104	)
Net cash provided by operating activities		25,692,127			7,421,422			780,328			(18,533,778	)		15,360,099
Cash flows provided by (used in) investing activities		218,301			(7,734,365	)		(931,940	)		-			(8,448,004	)
Cash flows provided by (used in) financing activities		(25,910,428	)		5			-			18,533,778			(7,376,645	)
Net decrease in cash and cash equivalents		-			(312,938	)		(151,612	)		-			(464,550	)

Cash and cash equivalents, beginning of period		-			18,064,970			161,404			-			18,226,374

Cash and cash equivalents, end of period	$	-		$	17,752,032		$	9,792		$	-		$	17,761,824

8. Revenue Concentrations

Revenues for interstate access services are based on reimbursement of costs and an allowed rate of return. Revenues of this nature are received from the National Exchange Carrier Association in the form of monthly settlements. Such revenues amounted to 9.8% and 9.9% of the Company’s total revenues for the nine months ended September 30, 2010 and 2011, respectively.

The Company has a contract through 2012 with Time Warner Cable (“TW”) for the provision of wholesale network connections to TW’s customers in Maine and New Hampshire. TW represented approximately 10.5% and 11.7% of the Company’s consolidated revenue for the nine months ended September 30, 2010 and 2011, respectively. Other unrelated telecommunications providers also pay the Company access revenue for terminating calls through us to TW’s customers.

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

Overview

General

We operate ten rural local exchange carriers (“RLECs”) serving subscribers in north central Alabama, central Maine, western Massachusetts, central Missouri and southern West Virginia. We are the sole wireline telephone services provider for many of the rural communities we serve. We also operate competitive local exchange carriers (“CLECs”) serving subscribers throughout the states of Maine and New Hampshire. Our services include local and long distance telephone services, network access, other telephone related services, cable television (in some markets) and internet access. We view, manage and evaluate the results of operations from the various telecommunications services as one company and therefore have identified one reporting segment as it relates to providing segment information. As of September 30, 2011, we operated approximately 97,958 access line equivalents and supplied an additional 155,691 wholesale network connections. Our acquisition of all of the issued and outstanding capital stock of Shoreham Telephone Company, Inc. (“STC”), a privately-held integrated telecommunications services provider serving customers in middle Vermont, on October 14, 2011 will add approximately 5,100 access line equivalents.

Our core businesses are local and long distance telecommunications services, wholesale access to the local and long distance network and the provision of network access to other wireline, long distance and wireless carriers for calls originated or terminated on our network. Our core businesses generated approximately 78.3% of our total revenues in the third quarter of 2011. We also provide cable and satellite television service in some markets and digital high-speed data lines and dial-up internet access in all of our markets.

The following discussion and analysis should be read in conjunction with our financial statements and the related notes included in Item 1 of Part I and the other financial information appearing elsewhere in this report. The following discussion and analysis addresses our financial condition and results of operations on a consolidated basis.

Revenue Sources

We offer a wide range of telecommunications and entertainment services to our subscribers. More than half of our residential customers receive packages of services that are delivered and billed together. Our CLEC subscribers contract with us for selected services that meet their specific telecommunications requirements. Our revenues come from five sources:

●

Local services. We receive revenues from providing local exchange telecommunications services in our ten rural territories, from the wholesale network services in New England and on a competitive basis throughout Maine and New Hampshire. These revenues include monthly subscription charges for basic service, calling beyond the local territory on a fixed price and on a per minute basis, local private line services and enhanced calling features, such as voicemail, caller identification, call waiting and call forwarding. We also provide billing and collections services for other carriers under contract and receive revenues from directory advertising. A growing portion of our rural subscribers take bundled service plans which include multiple services, including unlimited domestic calling, for a flat monthly fee.

●

Network access. We receive revenues from charges established to compensate us for the origination, transport and termination of calls of long distance and other interexchange carriers. These include subscriber line charges imposed on end users and switched and special access charges paid by carriers. Switched access charges for long distance services within Alabama, Maine, Massachusetts, Missouri, New Hampshire and West Virginia are based on rates approved by the Alabama Public Service Commission, the Maine Public Utilities Commission (the “MPUC”), the Massachusetts Department of Telecommunications and Cable, the Missouri Public Service Commission, the New Hampshire Public Utilities Commission (the “NHPUC”) and the West Virginia Public Service Commission, respectively, where appropriate. Switched and special access charges for interstate and international services are based on rates approved by the Federal Communications Commission.

●

Cable television. We offer basic, digital, high-definition, digital video recording and pay per view cable television services to the majority of our telephone service territory in Alabama, including Internet Protocol television (“IPTV”) and Video on Demand (“VOD”). We are a reseller of satellite services for DirecTV in Missouri.

●

Internet. We receive revenues from monthly recurring charges for digital high-speed data lines, dial-up internet access and ancillary services such as web hosting and computer virus protection.

●

Transport. We receive monthly recurring revenues for the rental of fiber to transport data and other telecommunications services in New England.

Voice and Data Access Line Trends

The number of access lines served is a fundamental factor in determining revenue stability for a telecommunications provider. Reflecting a general trend in the RLEC industry, the number of rural voice access lines we serve has been decreasing gradually when normalized for territory acquisitions. We expect that this trend will continue, and may be potentially impacted by the effect of the economy on our customers. These trends will be partially offset by the growth of data access lines, also called digital high-speed internet access service. Our competitive carrier voice and data access lines have grown as we continue to further penetrate our chosen markets. Our ability to continue this growth and our response to the rural trends will have an important impact on our future revenues. Our primary strategy consists of leveraging our strong incumbent market position, selling additional services to our rural customer base and providing better service and support levels than the incumbent carrier to our competitive customer base.

Key Operating Statistics

	December 31,				March 31,		June 31,		September 30,		Quarterly % Change from
	2009		2010		2011		2011		2011		June 30, 2011
Otelco access line equivalents(1)		100,356		99,639		99,271		98,304		97,958		(0.4	)%

RLEC and other services:
Voice access lines		48,215		45,461		44,770		44,113		43,444		(1.5	)%
Data access lines		20,066		20,852		21,158		21,137		21,162		0.1	%
Access line equivalents(1)		68,281		66,313		65,928		65,250		64,606		(1.0	)%
Cable television customers		4,195		4,227		4,029		4,054		4,156		2.5	%
Satellite television customers		100		125		217		222		224		0.9	%
Additional internet customers		9,116		6,975		6,435		6,046		5,654		(6.5	)%
RLEC dial-up		786		393		341		307		274		(10.7	)%
Other dial-up		6,439		4,300		3,786		3,403		3,085		(9.3	)%
Other data lines		1,891		2,282		2,308		2,336		2,295		(1.8	)%

CLEC:
Voice access lines		28,647		29,944		30,084		29,842		30,145		1.0	%
Data access lines		3,428		3,382		3,259		3,212		3,207		(0.2	)%
Access line equivalents(1)		32,075		33,326		33,343		33,054		33,352		0.9	%
Wholesale network connections		132,324		149,043		152,101		154,785		155,691		0.6	%

	For the Year Ended				For the Three Months Ended
	December 31,				March 31,		June 31,		September 30,
	2009		2010		2011		2011		2011
Total revenues (in millions):	$	103.8	$	104.4	$	25.4	$	25.5	$	25.3
RLEC	$	60.8	$	58.4	$	14.2	$	14.3	$	14.1
CLEC	$	43.0	$	46.0	$	11.2	$	11.2	$	11.2

(1) We define access line equivalents as voice access lines and data access lines (including cable modems, digital subscriber lines and dedicated data access trunks).

In our RLEC territories, access line equivalents decreased by 644 during third quarter 2011, or 1.0%, compared to June 30, 2011. Voice access lines declined 1.5% while data access lines increased by 0.1% during the period. For 2011, RLEC access line equivalents have declined 2.6%. We offer location specific bundled service packages, many including unlimited domestic calling, tailored to the telecommunications requirements of our customers and priced competitively. Our acquisition of all of the issued and outstanding capital stock of STC on October 14, 2011 will add approximately 5,100 access line equivalents.

In our Maine and New Hampshire CLEC operations, access line equivalents increased by 298 during third quarter 2011, or 0.9%, compared to June 30, 2011. Voice access lines increased 1.0% while data access lines decreased 0.2% during the period. This increase is primarily driven by installations of our new hosted private branch exchange (“PBX”) product. Virtually all of our competitive customers are businesses, with service bundles tailored to their specific business requirements.

Competitive pricing and bundling of services have led Otelco’s long distance service to be the choice of the majority of the customers in the rural markets we serve. In addition, almost all of our Maine and New Hampshire CLEC customers have selected us as their long distance carrier. Our cable television customers increased 2.5% from June 30, 2011 to 4,156 as of September 30, 2011. We upgraded 21 customers to our digital offerings and added 81 new IPTV customers during the same period. Our other internet customers decreased 6.5% to 5,654 as of September 30, 2011 compared to June 30, 2011. This also includes the subscribers we service outside of our telephone service area throughout Missouri and Maine, reflecting the shift to digital high-speed internet services. In Missouri, we are expanding our data access lines for digital high-speed internet in selected areas outside of our telephone service territory. Approximately 40% of the other internet customers are served by high-speed data capability from Otelco.

Our Rate and Pricing Structure

Our CLEC pricing is based on market requirements. We combine varying services to meet individual customer requirements, including technical support, and provide multi-year contracts which are both market sensitive for the customer and profitable for us. The MPUC and the NHPUC impose certain requirements on all CLECs operating in their markets for reporting and for interactions with the various incumbent local exchange and interexchange carriers. These requirements provide wide latitude in pricing services.

Our RLECs operate in five states and are regulated in varying degrees by the respective state regulatory authorities. The impact on pricing flexibility varies by state. In Maine, two of our wholly owned subsidiaries, Saco River Telegraph and Telephone Company and The Pine Tree Telephone and Telegraph Company, have obtained authority to implement pricing flexibility while remaining under rate-of-return regulation. Our rates for other services we provide, including cable, long distance, data lines and dial-up and high-speed internet access, are not price regulated. The market for competitive services, such as wireless, also impacts our ability to adjust prices. With the increase of bundled services offerings, including unlimited long distance, pricing for individual services takes on reduced importance to revenue stability. We expect this trend to continue into the immediate future.

Categories of Operating Expenses

Our operating expenses are categorized as cost of services and products; selling, general and administrative expenses; and depreciation and amortization.

Cost of services and products. This includes expenses for salaries, wages and benefits relating to plant operation, maintenance, sales and customer service; other plant operations, maintenance and administrative costs; network access costs; and costs of services for long distance, cable television, internet and directory services.

Selling, general and administrative expenses. This includes expenses for salaries, wages and benefits and contract service payments relating to engineering, financial, human resources and corporate operations; information management expenses, including billing; allowance for uncollectible revenue; expenses for travel, lodging and meals; internal and external communications costs; insurance premiums; stock exchange and banking fees; and postage.

Depreciation and amortization. This includes depreciation of our telecommunications, cable and internet networks and equipment, and amortization of intangible assets. Certain of these amortization expenses continue to be deductible for tax purposes.

Our Ability to Control Operating Expenses

We strive to control expenses in order to maintain our strong operating margins. As our revenue shifts to non-regulated services and CLEC customers, operating margins decrease reflecting the lower margins associated with these services. We expect to control expenses while we continue to grow our business.

Results of Operations

The following table sets forth our results of operations as a percentage of total revenues for the periods indicated:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2011			2010			2011
Revenues
Local services		47.5	%		46.3	%		47.1	%		46.8	%
Network access		30.9			31.8			31.4			31.5
Cable television		2.7			3.0			2.7			2.9
Internet		13.5			13.6			13.5			13.6
Transport services		5.4			5.3			5.3			5.2
Total revenues		100.0	%		100.0	%		100.0	%		100.0	%
Operating expenses
Cost of services and products		39.5	%		43.5	%		40.0	%		43.0	%
Selling, general and administrative expenses		12.7			12.8			12.5			12.5
Depreciation and amortization		22.1			19.5			22.5			19.9
Total operating expenses		74.3			75.8			75.0			75.4

Income from operations		25.7			24.2			25.0			24.6

Other income (expense)
Interest expense		(24.2	)		(24.6	)		(23.6	)		(24.4	)
Change in fair value of derivatives		(1.4	)		2.6			(1.8	)		2.2
Other income		0.6			0.0			0.7			0.5
Total other expenses		(25.0	)		(22.0	)		(24.7	)		(21.7	)

Income before income tax		0.7			2.2			0.3			2.9

Income tax (expense) benefit		(0.5	)		1.3			(0.2	)		(0.0	)

Net income available to common stockholders		0.2	%		3.5	%		0.1	%		2.9	%

Three Months and Nine Months Ended September 30, 2011 Compared to Three Months and Nine Months Ended September 30, 2010

Total revenues. Total revenues decreased 3.2% in the three months ended September 30, 2011 to $25.3 million from $26.1 million in the three months ended September 30, 2010. Total revenues decreased 2.9% in the nine months ended September 30, 2011 to $76.2 million from $78.5 million in the nine months ended September 30, 2010. The tables below provide the components of our revenues for the three months and nine months ended September 30, 2011 compared to the same periods of 2010.

For the three months ended September 30, 2011 and 2010

	Three Months Ended September 30,				Change
	2010		2011		Amount			Percent
	(dollars in thousands)
Local services	$	12,423	$	11,715	$	(708	)		(5.7	)%
Network access		8,077		8,048		(29	)		(0.4	)
Cable television		717		770		53			7.4
Internet		3,521		3,442		(79	)		(2.2	)
Transport services		1,407		1,328		(79	)		(5.6	)
Total	$	26,145	$	25,303	$	(842	)		(3.2	)

Local services. Local services revenue decreased 5.7% to $11.7 million in the three months ended September 30, 2011 from $12.4 million in the three months ended September 30, 2010. Declines in RLEC voice access lines related revenue in 2011 accounted for a decrease of $0.4 million. The balance of the decline is due to one-time CLEC revenues in the three months ended September 30, 2010, including a refund from a service provider tax audit.

Network access. Network access revenue decreased 0.4% to slightly more than $8.0 million in the three months ended September 30, 2011 from slightly less than $8.1 million in the three months ended September 30, 2010. A small decline in interstate and intrastate switched access revenue was offset by an increase in end user related fees.

Cable television. Cable television revenue increased 7.4% to $0.8 million in the three months ended September 30, 2011 from $0.7 million in the three months ended September 30, 2010. Growth in IPTV subscribers, VOD, and the shift to high-definition packages in Alabama was offset by the decline in basic cable revenue, including revenue associated with the conversion of our Missouri cable customers to satellite services during first quarter 2011.

Internet. Internet revenue decreased 2.2% to $3.4 million in the three months ended September 30, 2011 from $3.5 million in the three months ended September 30, 2010. Growth in broadband data lines partially offset the loss of dial-up internet subscribers, including those customers in Maine and Missouri that are outside of our local service areas.

Transport services. Transport services revenue decreased 5.6% to $1.3 million in the three months ended September 30, 2011 from $1.4 million in the three months ended September 30, 2010. Market price changes for new and existing customers caused the decline.

For the nine months ended September 30, 2011 and 2010

	Nine Months Ended September 30,				Change
	2010		2011		Amount			Percent
	(dollars in thousands)
Local services	$	36,948	$	35,661	$	(1,287	)		(3.5	)%
Network access		24,666		23,984		(682	)		(2.8	)
Cable television		2,082		2,229		147			7.1
Internet		10,559		10,356		(203	)		(1.9	)
Transport services		4,195		3,966		(229	)		(5.5	)
Total	$	78,450	$	76,196	$	(2,254	)		(2.9	)

Local services. Local services revenue decreased 3.5% to $35.7 million in the nine months ended September 30, 2011 from $36.9 million in the nine months ended September 30, 2010. RLEC revenue, including bundled services such as long distance, decreased $1.2 million reflecting the decline in RLEC access lines. A $0.1 million refund in 2010 from a service provider tax audit accounted for the remaining difference.

Network access. Network access revenue decreased 2.8% to $24.0 million in the nine months ended September 30, 2011 from $24.7 million in the nine months ended September 30, 2010. A decline of $0.2 million in RLEC end user revenue corresponded with the decline in RLEC access lines. The positive outcome in 2010 of $0.5 million in billing related disputes accounted for the balance of the difference.

Cable television. Cable television revenue increased 7.1% to $2.2 million in the nine months ended September 30, 2011 from $2.1 million in the nine months ended September 30, 2010. Growth in IPTV subscribers, pay per view revenue, satellite services revenue, and the shift to high-definition packages increased revenue $0.5 million, which was partially offset by a $0.4 million decline associated with the conversion of our Missouri cable customers to satellite services during first quarter 2011 and fewer basic cable customers.

Internet. Internet revenue decreased 1.9% to $10.4 million in the nine months ended September 30, 2011 from $10.6 million in the nine months ended September 30, 2010. The growth in new digital data access lines, including related equipment rental, and Missouri fiber leases accounted for an increase of $0.3 million. The decline of dial-up internet customers associated with the conversion to digital data access lines, including those customers in Maine and Missouri that are outside of our local service areas, accounted for a decrease of $0.5 million.

Transport services. Transport services revenue decreased 5.5% to $4.0 million in the nine months ended September 30, 2011 from $4.2 million in the nine months ended September 30, 2010. Market price changes for new and existing customers caused the decline.

Operating expenses. Operating expenses in the three months ended September 30, 2011 decreased 1.2% to $19.2 million from $19.4 million in the three months ended September 30, 2010. Operating expenses in the nine months ended September 30, 2011 decreased 2.4% to $57.4 million from $58.8 million in the nine months ended September 30, 2010. The tables below provide the components of our operating expenses for the three months and nine months ended September 30, 2011 compared to the same periods of 2010.

For the three months ended September 30, 2011 and 2010

	Three Months Ended September 30,				Change
	2010		2011		Amount			Percent
	(dollars in thousands)
Cost of services and products	$	10,336	$	10,986	$	650			6.3	%
Selling, general and administrative expenses		3,308		3,249		(59	)		(1.8	)
Depreciation and amortization		5,773		4,944		(829	)		(14.4	)
Total	$	19,417	$	19,179	$	(238	)		(1.2	)

Cost of services and products. Cost of services and products increased 6.3% to $11.0 million in the three months ended September 30, 2011 from $10.3 million in the three months ended September 30, 2010. RLEC costs decreased $0.1 with higher internet and pole rental costs more than offset by organizational efficiencies. CLEC costs increased $0.5 million from higher collocation, hosted PBX initial installation and sales costs.

Selling, general and administrative expenses. Selling, general and administrative expenses decreased 1.8% to $3.2 million in the three months ended September 30, 2011 from $3.3 million in the three months ended September 30, 2010. Lower employee costs of $0.3 million were partially offset by an increase of $0.3 million in uncollectible revenue reserves and due diligence expenses associated with the acquisition of STC.

Depreciation and amortization. Depreciation and amortization decreased 14.4% to $4.9 million in the three months ended September 30, 2011 from $5.8 million in the three months ended September 30, 2010. Amortization of intangible assets associated with the acquisition of three entities from Country Road Communications LLC (the “CR Companies”) decreased $0.3 million, including contract and customer base intangible assets. Amortization of the telephone plant adjustment associated with the Mid-Maine acquisition was completed at the end of second quarter 2011, accounting for a decrease of $0.2 million. The remaining decrease of $0.3 million reflects lower depreciation of plant assets in our regulated entities as assets become fully depreciated.

For the nine months ended September 30, 2011 and 2010

	Nine Months Ended September 30,				Change
	2010		2011		Amount			Percent
	(dollars in thousands)
Cost of services and products	$	31,374	$	32,762	$	1,388			4.4	%
Selling, general and administrative expenses		9,775		9,486		(289	)		(3.0	)
Depreciation and amortization		17,693		15,176		(2,517	)		(14.2	)
Total	$	58,842	$	57,424	$	(1,418	)		(2.4	)

Cost of services and products. Cost of services and products increased 4.4% to $32.8 million in the nine months ended September 30, 2011 from $31.4 million in the nine months ended September 30, 2010. RLEC increases included $0.1 million related to pole expense and $0.1 million in cable television programming costs in 2011. Associated with the Company’s continued CLEC expansion in the New England states, there was a $1.1 million increase in costs for hosted PBX projects, collocation sites, and an expanded sales team. The remaining difference of $0.1 million reflected a Universal Service Administrative Company audit accrual made in 2011.

Selling, general and administrative expenses. Selling, general and administrative expenses decreased 3.0% to $9.5 million in the nine months ended September 30, 2011 from $9.8 million in the nine months ended September 30, 2010. Operational synergies and decreases in insurance costs, franchise taxes, and employee costs of $0.6 million were partially offset by reserves for uncollectible amounts of $0.3 million.

Depreciation and amortization. Depreciation and amortization decreased 14.2% to $15.2 million in the nine months ended September 30, 2011 from $17.7 million in the nine months ended September 30, 2010. Amortization of intangible assets associated with the acquisition of the CR Companies decreased $0.9 million, including a covenant not to compete and contract customer base assets. A decrease of $1.4 million reflected lower depreciation of plant assets in our regulated entities as assets become fully depreciated, as well as the application of additional information to more accurately reflect the remaining useful lives of these regulated assets. The remaining decrease of $0.2 million resulted from the completion of amortization at the end of second quarter 2011 of the telephone plant adjustment associated with the Mid-Maine acquisition.

For the three months ended September 30, 2011 and 2010

	Three Months Ended September 30,						Change
	2010			2011			Amount			Percent
	(dollars in thousands)
Interest expense	$	(6,321	)	$	(6,222	)	$	(99	)		(1.6	)%
Change in fair value of derivatives		(359	)		655			1,014		NM
Other income		151			6			(145	)	NM
Income tax (expense) benefit		(136	)		323			459		NM

Interest expense. Interest expense decreased 1.6% to $6.2 million in the three months ended September 30, 2011 from $6.3 million in the three months ended September 30, 2010, due to lower interest expense on our long-term notes receivable reflecting voluntary prepayments of $6.5 million in 2010 and 2011.

Change in fair value of derivatives. We have two interest rate swap agreements to hedge our exposure to changes in interest rate costs associated with our senior credit facility. From an accounting perspective, the swaps do not meet the technical requirements to allow the swaps to be considered highly effective hedging instruments and therefore the swaps do not qualify for hedge accounting. These swap agreements must be considered investments and the change in value is reflected as a change in fair value of derivatives on our statement of operations. The liability associated with the swaps decreased $0.7 million in the three months ended September 30, 2011 reflecting the shorter time to maturity, compared to an increase in liability of $0.4 million in the three months ended September 30, 2010. Over the life of the swaps, the cumulative change in value will be zero. See —Liquidity and Capital Resources below for additional explanation.

Other income. Other income decreased to less than $0.1 million in the three months ended September 30, 2011 from $0.2 million in the three months ended September 30, 2010, reflecting a one-time benefit in 2010.

Income tax (expense) benefit. Provision for income taxes was a benefit of $0.3 million in the three months ended September 30, 2011 and an expense of $0.1 million in the three months ended September 30, 2010.

For the nine months ended September 30, 2011 and 2010

	Nine Months Ended September 30,						Change
	2010			2011			Amount			Percent
	(dollars in thousands)
Interest expense	$	(18,489	)	$	(18,592	)	$	103			0.6	%
Change in fair value of derivatives		(1,421	)		1,641			3,062		NM
Other income		534			389			(145	)		(27.2	)
Income tax expense		(137	)		(36	)		101		NM

Interest expense. Interest expense increased 0.6% to $18.6 million in the nine months ended September 30, 2011 from $18.5 million in the nine months ended September 30, 2010. Interest associated with the exchange of our Class B shares for IDSs in June 2010 accounted for an increase of $0.2 million partially offset by $0.1 million of lower interest expense on our long-term notes receivable reflecting voluntary prepayments of $6.5 million in 2010 and 2011.

Change in fair value of derivatives. We have two interest rate swap agreements to hedge our exposure to changes in interest rate costs associated with our senior credit facility. From an accounting perspective, the swaps do not meet the technical requirements to allow the swaps to be considered highly effective hedging instruments and therefore the swaps do not qualify for hedge accounting. These swap agreements must be considered investments and the change in value is reflected as a change in fair value of derivatives on our statement of operations. The liability associated with the swaps decreased $1.6 million in the nine months ended September 30, 2011 reflecting the shorter time to maturity, compared to an increase in liability of $1.4 million in the nine months ended September 30, 2010. Over the life of the swaps, the cumulative change in value will be zero. See — Liquidity and Capital Resources below for additional explanation.

Other income. Other income decreased 27.2% to $0.4 million in the nine months ended September 30, 2011 from $0.5 million in the nine months ended September 30, 2010, reflecting lower interest income on invested cash in 2011 and a one-time benefit in 2010.

Income tax expense. Provision for income taxes was an expense of less than $0.1 million in the nine months ended September 30, 2011 and an expense of $0.1 million in the nine months ended September 30, 2010.

Net income. As a result of the foregoing, there was net income of $0.9 million in the three months ended September 30, 2011 and less than $0.1 million in the three months ended September 30, 2010. There was net income of $2.2 million in the nine months ended September 30, 2011 and less than $0.1 million in the nine months ended September 30, 2010.

Liquidity and Capital Resources

Our liquidity needs arise primarily from: (i) interest payments related to our senior credit facility and our senior subordinated notes; (ii) capital expenditures; (iii) working capital requirements; (iv) dividend payments on our Class A common stock (“common stock”); and (v) potential acquisitions.

Historically, we satisfy our operating cash requirements from the cash generated by our business and utilize borrowings under our senior credit facility to facilitate acquisitions; however, we financed our acquisition of STC using cash on hand. For the nine months ended September 30, 2011, we generated cash from our business to invest in additional property and equipment, acquire STC, pay interest on our senior debt, pay interest associated with the senior subordinated debt inherent in our IDSs and fund dividends (as declared by our board of directors) on the shares of common stock that are inherent in our IDSs. After meeting all of these needs of our business and making a voluntary prepayment on our senior credit facility, cash decreased from $18.2 million at December 31, 2010 to $17.8 million at September 30, 2011. The Company has as its current policy to return a high percentage of its available cash to its IDS holders.

Cash flows from operating activities for the first nine months of 2011 amounted to $15.4 million compared to $19.4 million for the first nine months of 2010. Net income, when adjusted for its non-cash components, declined by $3.1 million reflecting lower revenues, including the positive outcome in 2010 of bill related disputes, and somewhat higher costs and expenses. The changes in operating assets and liabilities of $0.9 million reflect a $0.4 million income tax receivable only in 2010 and a change of $0.3 million in the level of materials and supplies and accrued liabilities.

Cash flows used in investing activities for the first nine months of 2011 were $8.4 million compared to $6.4 million in the first nine months of 2010. The higher rate of capital expenditures for property and equipment in the first nine months of 2011 accounted for the difference. In second quarter of 2011, we experienced storm damage in our Alabama territory. All but approximately $0.2 million of the damage was covered by insurance.

Cash flows used in financing activities for the first nine months of 2011 were $7.4 million compared to $7.2 million for the first nine months of 2010, reflecting payments of dividends to stockholders in both periods. The dividend was $0.17625 per share per quarter in both periods. We have paid twenty-seven consecutive quarterly dividends at this rate since the Company went public in December 2004. The number of shares of common stock outstanding increased in June 2010 in connection with the exchange of our Class B shares for IDSs increasing dividends in 2011 by $0.1 million. We incurred costs of $0.3 million in 2010 in connection with the exchange. We made a voluntary prepayment of $0.4 million in 2011 on our long-term notes payable.

We do not invest in financial instruments as part of our business strategy. The Company has a $90 million notional amount interest rate swap with the Company paying 1.85% and the counterparty paying a variable rate based upon the three month LIBOR for three years beginning February 9, 2009 and a $60 million notional amount interest rate swap with the Company paying 2.0475% and the counterparty paying a variable rate based upon the three month LIBOR for two years beginning February 9, 2010. From an accounting perspective, the documentation for both swaps does not meet the technical requirements of Accounting Standards Codification (“ASC”) 815, Derivatives and Hedging, to allow the swaps to be considered highly effective as hedging instruments and therefore the swaps do not qualify for hedge accounting.

We also have received patronage shares, primarily from one of our lenders, over a period of years for which there is a limited market to determine value until the shares are redeemed by the issuing institution. Historically, these shares have been redeemed at a value similar to their issued value. Due to the uncertainty of this future value, these shares are carried at approximately 55% of their issued value.

We anticipate that operating cash flow, together with borrowings under our senior credit facility, will be adequate to meet our currently anticipated operating and capital expenditure requirements for at least the next 12 months.

The following table provides a summary of the extent to which cash generated from operations is reinvested in our operations, used to pay interest on our senior debt and senior subordinated notes or distributed as dividends to our stockholders for the periods indicated. The table reflects the increased investment in our business during 2011, including the replacement of storm damaged poles, lines and equipment.

	Nine Months Ended September 30,
	2010			2011
	(Dollars in Thousands)
Cash generation
Revenues	$	78,450		$	76,196
Other income		534			389
Cash received from operations		78,984			76,585
Cost of services and products		31,374			32,763
Selling, general and administrative expenses		9,775			9,486
Cash consumed by operations		41,149			42,249
Cash generated from operations	$	37,835		$	34,336

Cash utilization
Capital investment in operations	$	6,444		$	8,448
Senior debt interest and fees		7,319			7,190
Interest on senior subordinated notes		10,264			10,497
Dividends		6,895			6,991
Cash utilized by the Company	$	30,922		$	33,126

Percentage of cash utilized of cash generated		81.7	%		96.5	%

We use adjusted earnings before interest, taxes, depreciation and amortization (“Adjusted EBITDA”) as an operational performance measurement. Adjusted EBITDA, as presented in this Form 10-Q, corresponds to the definition of Adjusted EBITDA in the indenture governing our senior subordinated notes and our senior credit facility. Adjusted EBITDA, as presented in this Form 10-Q, is a supplemental measure of our performance that is not required by, or presented in accordance with, accounting principles generally accepted in the United States (“U.S. GAAP”). Our senior credit facility requires that we report performance in this format each quarter and involved lending institutions utilize this measure to determine compliance with credit facility requirements. We report Adjusted EBITDA in our quarterly earnings press release to allow current and potential investors to understand this performance metric and because we believe that it provides current and potential investors with helpful information with respect to our operating performance and cash flows. However, Adjusted EBITDA should not be considered as an alternative to net income or any other performance measures derived in accordance with U.S. GAAP or as an alternative to net cash provided by operating activities as a measure of our liquidity. Our presentation of Adjusted EBITDA may not be comparable to similarly titled measures used by other companies. Adjusted EBITDA for the three months and nine months ended September 30, 2010 and 2011, and its reconciliation to net income, is reflected in the table below:

	Three Months Ended September 30,					Nine Months Ended September 30,
	2010		2011			2010		2011
	(dollars in thousands)
Net income	$	63	$	885		$	95	$	2,173
Add: Depreciation		3,264		2,922			10,164		8,751
Interest expense - net of premium		5,979		5,880			17,470		17,566
Interest expense - amortize loan cost		342		342			1,019		1,026
Income tax expense (benefit)		136		(323	)		137		36
Change in fair value of derivatives		359		(654	)		1,421		(1,641	)
Loan fees		19		19			57		57
Amortization - intangibles		2,509		2,023			7,528		6,425
Adjusted EBITDA	$	12,671	$	11,094		$	37,891	$	34,393

Recent Accounting Pronouncements

below, these ASUs provide technical corrections to existing guidance related to specialized industries or entities and therefore, have minimal, if any, impact on the Company.

In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”), an update to ASC 820, Fair Value Measurements and Disclosures. ASU 2011-04 provides guidance to change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. For public entities, ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011 and is to be applied prospectively. Early application by public entities is not permitted. As ASU 2011-04 impacts presentation only, the adoption of this update will not impact our consolidated financial statements.

Acquisition

On October 14, 2011, Shoreham Telephone LLC (“Shoreham”), a direct wholly owned subsidiary of the Company, completed its acquisition of all of the issued and outstanding capital stock of STC (the “Stock Purchase”). The aggregate consideration paid for the issued and outstanding capital stock of STC was approximately $4.5 million in cash, subject to adjustment as provided in the Stock Purchase Agreement, dated as of April 1, 2011, by and among Shoreham, Donald S. Arnold, III, James C. Arnold, Susan E. Arnold and STC, as amended on October 14, 2011. The Stock Purchase was financed from the Company’s cash on hand. Immediately following the closing of the Stock Purchase, STC merged with and into Shoreham, with Shoreham continuing as the surviving entity in the merger. The Company believes that this acquisition will provide strategic benefits in expanding its New England operations.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Our short-term excess cash balance is invested in short-term commercial paper. We do not invest in any derivative or commodity type instruments. Our two interest rate swap agreements are technically not effective hedges and therefore do not qualify for hedge accounting. The change in the fair value of the swaps is charged or credited to income as a change in fair value of derivatives on our statement of operations. Over the life of the swaps, the cumulative change in value will be zero. Accordingly, we are subject to minimal market risk on our investments.

We have the ability to borrow up to $15.0 million under a revolving loan facility. The interest rate is variable and, accordingly, we would be exposed to interest rate risk, primarily from a change in LIBOR or a base rate, should the facility be used. Currently, we have no loans drawn under this facility.

Item 4. Controls and Procedures

With the participation of the Chief Executive Officer and the Chief Financial Officer, management has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2011.

There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) during the three months ended September 30, 2011 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II OTHER INFORMATION

Item 6. Exhibits

Exhibits

See Exhibit Index.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: November 4, 2011	OTELCO INC.

	By:	/s/ Curtis L. Garner, Jr.
		Curtis L. Garner, Jr.
		Chief Financial Officer

EXHIBIT INDEX

Exhibit No.		Description

31.1		Certificate pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934 of the Chief Executive Officer

31.2		Certificate pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934 of the Chief Financial Officer

32.1		Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief Executive Officer

32.2		Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief Financial Officer

101		The following information from the Company’s quarterly report on Form 10-Q for the quarterly period ended September 30, 2011 formatted in Extensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets; (ii) Consolidated Statements of Operations; (iii) Consolidated Statements of Cash Flows; and (iv) Notes to Consolidated Financial Statements, tagged as blocks of text

OTELCO INC. - FORM 10-Q - November 4, 2011

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OTELCO INC. Reports