Otelco (OTEL) 10-Q 2006 Q1 Quarterly report

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 March 31, 2006 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 ýNo ¨

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

Large accelerated filer ¨    Accelerated filer ý    Non-accelerated filer ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes ¨No ý

APPLICABLE ONLY TO CORPORATE USERS:

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 May 10, 2006
Class A Common Stock ($0.01 par value per share)	9,676,733
Class B Common Stock ($0.01 par value per share)	544,671

OTELCO INC.

FORM 10-Q

For the three month period ended March 31, 2006

TABLE OF CONTENTS

Item 1. Financial Statements

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

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Item 4. Controls and Procedures

Item 6. Exhibits

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Unless the context otherwise requires, the words “we”, “us”, “our”, “the company” and “Otelco” refer to Otelco Inc., a Delaware corporation.

FORWARD-LOOKING STATEMENTS

The 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.

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PART 1.

FINANCIAL INFORMATION

Item 1. Financial Statements

OTELCO INC.

CONSOLIDATED BALANCE SHEETS

	December 31,			March 31,
	2005			2006
Assets				(unaudited)
Current assets
Cash and cash equivalents	$	5,569,233		$	5,586,214
Accounts receivable:
Due from subscribers, net of allowance for doubtful
accounts of $163,028 and $162,350 respectively		1,212,909			1,144,124
Unbilled receivables		1,828,104			1,799,377
Other		1,482,171			1,572,714
Materials and supplies		932,861			929,556
Prepaid expenses		504,256			513,345
Income tax receivables		749,591			749,591
Deferred income taxes		872,675			872,675
Total current assets		13,151,800			13,167,596
Property and equipment, net		44,555,611			43,803,951
Goodwill		119,431,993			119,431,993
Intangible assets, net		1,588,079			1,536,655
Investments		1,108,249			973,313
Deferred financing costs		6,971,610			6,628,173
Interest rate cap		5,318,728			6,032,219
Deferred charge - acquisition		—			14,890
Total assets	$	192,126,070		$	191,588,790
Liabilities and Stockholders' Equity
Current liabilities
Accounts payable	$	1,106,114		$	826,515
Accrued expenses		1,692,841			2,038,733
Advance billings and payments		1,204,680			1,253,810
Customer deposits		213,524			222,539
Total Current Liabilities		4,217,159			4,341,597
Deferred income taxes		15,345,890			15,345,890
Other liabilities		192,769			184,538
Total deferred tax and other liabilities		15,538,659			15,530,428
Long-term notes payable		161,075,498			161,075,498
Derivative liability		1,830,095			1,650,353
Class B common convertible to senior subordinated notes		3,655,454			3,766,186
Stockholders' Equity
Class A Common Stock, $.01 par value-authorized 20,000,000 shares;
issued and outstanding 9,676,733 shares		96,767			96,767
Class B Common Stock, $.01 par value-authorized 800,000 shares; issued
and outstanding 544,671 shares		5,447			5,447
Additional paid in capital		5,613,703			3,908,179
Retained deficit		(805,731	)		(561,137	)
Accumulated other comprehensive income		899,019			1,775,472
Total stockholders' equity		5,809,205			5,224,728
Total liabilities and stockholders' equity	$	192,126,070		$	191,588,790
The accompanying notes are an integral part of these consolidated financial statements.

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OTELCO INC.

CONSOLIDATED STATEMENTS OF INCOME

 (unaudited)

	Three months ended March 31,
	2005			2006
Revenues
Local service	$	3,643,645		$	3,501,885
Network access		5,729,307			5,145,055
Long distance and other telephone services		784,980			828,868
Cable television		496,118			542,506
Internet		1,373,045			1,495,083
Total revenues		12,027,095			11,513,397
Operating expenses
Cost of services and products		3,055,324			3,176,442
Selling, general and administrative expenses		1,813,170			1,669,586
Depreciation and amortization		2,365,206			2,311,779
Total operating expenses		7,233,700			7,157,807
Income from operations		4,793,395			4,355,590
Other income (expense)
Interest expense		(3,977,791	)		(4,206,037	)
Change in fair value of derivative		277,783			179,741
Other income		273,477			187,239
Total other expense		(3,426,531	)		(3,839,057	)
Income before income tax and accretion expense		1,366,864			516,533
Income tax expense		(426,920	)		(161,210	)
Income before accretion expense		939,944			355,323
Accretion of Class B common convertible to senior
subordinated notes		(110,732	)		(110,732	)
Net income available to common stockholders	$	829,212		$	244,591
Weighted average shares outstanding:
Basic		9,676,733			9,676,733
Diluted		10,221,404			10,221,404
Net income per share
Basic	$	0.09		$	0.03
Diluted	$	0.06		$	0.02
Dividends declared per share	$	0.18		$	0.18
The accompanying notes are an integral part of these consolidated financial statements.

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OTELCO INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

	Three months ended March 31,
	2005			2006
Cash flows from operating activities:
Net income	$	829,212		$	244,591
Adjustments to reconcile net income to cash flows from operating activities:
Depreciation		1,920,757			1,916,918
Amortization		444,449			394,861
Interest rate caplet		21,097			162,962
Accretion expense		110,732			110,732
Change in fair value of derivative liability		(277,783	)		(179,741	)
Provision for uncollectible revenue		28,902			38,947
Changes in assets and liabilities; net of assets and liabilities acquired:
Accounts receivables		274,720			(31,976	)
Material and supplies		(82,322	)		3,305
Prepaid expenses and other assets		32,058			(9,089	)
Accounts payable and accrued liabilities		(1,161,947	)		66,293
Advance billings and payments		46,570			49,130
Other liabilities		11,040			784
Net cash from operating activities		2,197,485			2,767,717
Cash flows from investing activities:
Acquisition and construction of property and equipment		(1,133,676	)		(1,158,880	)
Proceeds from retirement of investment		38,778			128,558
Deferred charges - acquisition		—			(14,890	)
Net cash from investing activities		(1,094,898	)		(1,045,212	)
Cash flows from financing activities:
Cash dividends paid		(1,705,524	)		(1,705,524	)
Loan origination costs and transacation cost		(30,533	)		—
Net cash from financing activities		(1,736,057	)		(1,705,524	)
Net increase (decrease) in cash and cash equivalents		(633,470	)		16,981
Cash and cash equivalents, beginning of period		5,406,545			5,569,233
Cash and cash equivalents, end of period	$	4,773,075		$	5,586,214
Supplemental disclosures of cash flow information:
Interest paid	$	4,279,963		$	4,046,312
Income taxes paid (received)	$	—		$	—
The accompanying notes are an integral part of these consolidated financial statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(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”), its wholly owned subsidiaries Otelco Telecommunications LLC (“OTC”), Otelco Telephone LLC (“OTP”), Hopper Holding Company, Inc. (“HHC”), Brindlee Holdings LLC (“BH”), Page & Kiser Communications, Inc. (“PKC”), and Mid-Missouri Holding Corporation (“MMH”). HHC’s wholly owned subsidiary is Hopper Telecommunications Company, Inc. (“HTC”). BH’s owned subsidiary is Brindlee Mountain Telephone Company, Inc. (“BMTC”). PKC’s wholly owned subsidiary is Blountsville Telephone Company, Inc. (“BTC”). MMH’s wholly owned subsidiary is Mid-Missouri Telephone Company (“MMT”). MMT is the sole stockholder of Imagination, Inc. The accompanying consolidated financial statements include the accounts of the Company and all of its subsidiaries after elimination of all material intercompany balances and transactions.

The consolidated financial statements and footnotes 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, 2005. 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.

2. Commitment 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 and Missouri Public Service Commission related primarily to rate making. Currently, none of the legal proceedings are expected to have a material adverse effect on our business.

3. Derivative and Hedge Activities

The interest rate cap was purchased on December 21, 2004, coincident with the closing of our initial public offering and the recapitalization of our senior notes payable. The interest rate cap was purchased to mitigate the risk of rising interest rates to limit or cap the rate at 7%. It is considered an effective hedge as all critical terms of the interest rate cap are identical to the underlying debt it hedges. Changes in the fair value of the interest rate cap are not included in earnings but are reported as a component of accumulated other comprehensive income. For the three months March 31, 2005 and 2006, the change in the fair value of the interest rate cap was $803,132 and $876,453, respectively. The cost of the interest rate cap is expensed as interest over the effective life of the hedge in accordance with the quarterly value of the caplets as determined at the date of inception. For the three months ended March 31, 2005 and 2006, the cost of the interest rate cap was $21,097 and $162,962, respectively.

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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 could occur if the Class B common stock were exercised into IDSs. Class B common stock is convertible on a one-for-one basis into IDSs, each of which includes a Class A common share. For periods prior to our conversion, membership units were treated on an as if converted basis into Class A and Class B common shares.

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

	For the three months
	ended March 31,
	2005			2006
Weighted average common shares-basic		9,676,733			9,676,733
Effect of dilutive securities		544,671			544,671
Weighted-average common shares and potential
common shares-diluted		10,221,404			10,221,404
Net income available to common stockholders	$	829,212		$	244,591
Net income per basic share	$	0.09		$	0.03
Net income available to common stockholders	$	829,212		$	244,591
Plus: Accretion expense of Class B common
convertible to senior subordinated notes		110,732			110,732
Less: Change in fair value of derivative		(277,783	)		(179,741	)
Net income available for diluted shares	$	662,161		$	175,582
Net income per diluted share	$	0.06		$	0.02

5. Other Comprehensive Income

The components of other comprehensive income consist of:

	For the three months
	ended March 31,
	2005		2006
Net income	$	829,212	$	244,591
Hedge accounting		803,132		876,453
Total comprehensive income	$	1,632,344	$	1,121,044

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6. Subsequent Events

On April 10, 2006, the company signed a definitive agreement to acquire Mid-Maine Communications, Inc. for approximately $37.8 million. Mid-Maine is a telecommunications company serving approximately 18,500 access lines that is headquartered in Bangor, Maine. The acquisition is expected to close in the third quarter of 2006, but is subject to financing, due diligence and regulatory approval. The company anticipates financing this acquisition with an expansion of its existing senior credit facility.

The United State Department of Agriculture is closing the Rural Telephone Bank (RTB). As part of the liquidation process, the company received on April 11, 2006, $3,098,093 for the redemption of all outstanding RTB stock owned by three of its subsidiaries. The investment has a cost of $435,858.

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

Overview

General

Since 1999, we have acquired and operate five rural local exchange carriers serving twenty exchanges through four central offices and thirteen remote switches in approximately 1,540 square miles of north central Alabama and central Missouri. We are the sole wireline telephone services provider in the rural communities we serve. Our services include local telephone, network access, long distance and other telephone related services, cable television and Internet access. We view, manage and evaluate the results of operations from the various telephony products and services as one company and therefore have identified one reporting segment as it relates to providing segment information. As of March 31, 2006, we operated approximately 39,100 total access line equivalents.

Our core businesses are local telephone service 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 75.1% of our total revenues in the first quarter of 2006. We also provide long distance and other telephone related services, cable television and dial-up and digital high-speed Internet access.

The following discussion and analysis should be read in conjunction with our financial statements and the related notes included in Item 1of Part 1 and 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 derive our revenues from five sources:

§ Local services. We receive revenues from providing local exchange telephone services. These revenues include monthly subscription charges for basic service, calling to adjacent communities on a per minute basis, local private line services and enhanced calling features, such as voicemail, caller identification, call waiting and call forwarding.

§ Network access services. 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 and Missouri are based on rates approved by the Alabama Public Service Commission and Missouri Public Service Commission respectively. Switched and special access charges for interstate and international services are based on rates approved by the Federal Communications Commission.

§ Long distance and other telephone services. We receive revenues for providing long distance services to our customers. We also provide billing and collections services for other carriers under contract and receive revenues from directory advertising.

§ Cable television services. We offer basic, digital and pay per view cable television services to a portion of our telephone service territory in both Alabama and Missouri.

§ Internet services. We receive revenues from monthly recurring charges for dial-up and digital high-speed Internet access.

Access Line and Customer Trends

The number of traditional access lines served is a fundamental factor in determining revenue stability for a telecommunications provider. Reflecting a general trend in the rural local exchange carrier industry, the number of access lines we serve has been decreasing gradually when normalized for territory acquisitions. We expect this trend to continue for the industry and our territory. In addition to the impact of the economy on our customers, the growth of our digital high-speed Internet access services will continue to have an impact on residential and small business customers’ requirements for second access lines. Our response to this trend will have an important impact on our future revenues. Our primary strategy consists of leveraging our strong incumbent market position to increase revenue per access line by selling additional services to our customer base.

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	Year Ended December 31,						March 31,
	2003		2004		2005		2006
Access line equivalents (1):
Residential access lines		22,100		25,237		24,541		24,491
Business access lines		7,355		8,414		8,036		7,877
Access lines		29,455		33,651		32,577		32,368
Digital high-speed lines		2,185		3,488		5,962		6,800
Total access line equivalents		31,640		37,139		38,539		39,168
Long distance customers		11,374		13,641		14,438		15,618
Cable television customers		3,628		3,959		4,220		4,236
Dial-up Internet customers		2,331		15,348		12,149		11,659

(1) We define total access line equivalents as access lines, cable modems and digital subscriber lines.

We will continue our strategy of increasing revenues by cross-selling to our existing customer base, in the form of bundled service packages and individual additional services as they become available. In March, 2006, we introduced three bundled service packages including unlimited domestic calling to our Alabama residential customers. In the first month, 13% of the Alabama residential customers signed up for one of the three packages. Our digital high-speed Internet customers continue to grow from 5,962 customers at December 31, 2005, to 6,800 at March 31, 2006. We expect continued revenue growth in this area of our business. This growth in our digital high-speed Internet customers is expected to have a negative effect on our dial-up Internet customers as some customers migrate to digital high-speed Internet access. In addition, we expect the growth in our digital high-speed Internet access customers will have a negative effect on our access lines as some customers will no longer have a need for second lines for purposes of dial-up Internet access. During first quarter 2006, residential and business access lines and business data circuits declined 0.6% while digital high-speed Internet customers grew 14.1% during the same period.

Our long distance customers increased to 8.2% to 15,618 on March 31, 2006 and now represent 48.3% of our access lines. Our cable television customers grew to 4,236 as of March 31, 2006. While we have experienced periodic increases in our cable television programming costs, and expect this trend to continue in the future, we expect these increases will be offset by a corresponding increase in the price that we charge our cable television customers for cable television service offerings. Dial-up internet customers declined 4.0% to 11,659 on March 31, 2006 from 12,149 on December 31, 2005, including the subscribers we service outside of our telephone service area, reflecting the shift to digital high-speed Internet services.

Categories of Operating Expenses

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

Cost of services. This includes expenses for salaries, wages and benefits relating to plant operation, maintenance and customer service; other plant operations, maintenance and administrative costs; network access costs; and costs of sales 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 (e.g., legal fees) relating to engineering, financial, human resources and corporate operations; public company expenses; information management expenses, including billing; allowance for uncollectibles; expenses for travel, lodging and meals; internal and external communications costs; insurance premiums; stock exchange and banking fees; and postage.

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Depreciation and amortization. This includes depreciation of our telecommunications, cable and Internet networks and equipment, and amortization of intangible assets.

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, operating margins decrease reflecting the lower margins associated with these more competitive 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 March 31,
	2005			2006
Revenues
Local service		30.3	%		30.4	%
Network access		47.6			44.7
Long distance and other telephone services		6.5			7.2
Cable television		4.2			4.7
Internet		11.4			13.0
Total revenues		100.0	%		100.0	%
Operating expenses
Cost of services and products		25.4	%		27.6	%
Selling, general and administrative expenses		15.1			14.5
Depreciation and amortization		19.7			20.1
Total operating expenses		60.2			62.2
Income from operations		39.8			37.8
Other income (expense)
Interest expense		(33.1	)		(36.5	)
Change in fair value of derivative		2.3			1.6
Other income		2.3			1.6
Total other expense		(28.5	)		(33.3	)
Income before income taxes and accretion expense		11.3			4.5
Income tax expense		(3.5	)		(1.4	)
Income before accretion expense		7.8			3.1
Accretion of Class B common convertible to senior
subordinated notes		(0.9	)		(1.0	)
Net income available to common stockholders		6.9	%		2.1	%

Three months ended March 31, 2006 compared to three months ended March 31, 2005

Total Revenues. Total revenues declined 4.3% in the three months ended March 31, 2006 to $11.5 million from $12.0 million in the three months ended March 31, 2005. The table below provides the components of our revenues for the three months of 2006 compared to 2005.

	Three Months Ended March 31,				Change
	2005		2006		Amount			Percent
			(dollars in thousands)
Local service	$	3,644	$	3,502	$	(142	)		(3.9	)%
Network access		5,729		5,145		(584	)		(10.2	)
Long distance and other telephone services		785		829		44			5.6
Cable television		496		543		47			9.5
Internet		1,373		1,495		122			8.9
Total	$	12,027	$	11,514	$	(513	)		(4.3	)

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Local service. Local service revenue in the three months ended March 31, 2006 decreased 3.9% to $3.5 million from $3.6 million in the three months ended March 31, 2005. Access lines decreased 1,256 during the period, accompanied by a small decrease in minutes of use on our various local calling arrangements. Growth of the Company’s digital high-speed Internet service results in the loss of some second access lines used by customers for dial-up Internet access.

Network access. Network access revenue in the three months ended March 31, 2006 decreased 10.2% to $5.1 million, $0.6 million lower than the three months ended March 31, 2005. The decline is primarily associated with $0.3 million in nonrecurring one time settlement revenue received by our three cost companies as part of the interstate settlement process in 2005, $0.1 million from the lower per minute access payments associated with a shift from traditional long distance minutes to wireless minutes completed within our territory and $0.1 million in reduced Universal Service Fund payments.

Long distance and other telephone services. Long distance and other telephone services revenue in the three months ended March 31, 2006 increased 5.6% to slightly more than $0.8 million from slightly less than $0.8 million in the three months ended March 31, 2005. This increase reflects the increase in long distance customers gained with the new service bundles including unlimited domestic calling introduced to Alabama residential customers in March 2006. Over 13% of the Alabama residential customer base adopted one of three bundled plans in March.

Cable television. Cable television revenue in the three months ended March 31, 2006 increased 9.5% to more than $0.5 million from slightly less than $0.5 million in the three months ended March 31, 2005. The increase was due to the impact of an increase in basic cable prices and growth of 213 customers.

Internet. Internet revenue in the three months ended March 31, 2006 increased 8.9% to $1.5 million from $1.4 million in the three months ended March 31, 2005. The addition of nearly 2,700 new digital high-speed Internet customers generated $0.2 million, partially offset by $0.1 million associated with the decline in dial-up Internet customers associated with the conversion to digital high-speed Internet.

Operating expenses. Operating expenses in the three months ended March 31, 2006 decreased 1.0% to slightly less than $7.2 million from slightly more that $7.2 million the three months ended March 31, 2005.

	Three Months Ended March 31,				Change
	2005		2006		Amount			Percent
			(dollars in thousands)
Cost of services	$	3,056	$	3,176	$	120			4.0	%
Selling, general and administrative expenses		1,813		1,670		(143	)		(7.9	)
Depreciation and amortization		2,365		2,312		(53	)		(2.2	)
Total	$	7,234	$	7,158	$	(76	)		(1.1	)

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Cost of services. Cost of services increased 4.0% to $3.2 million in the three months ended March 31, 2006 from $3.1 million in the three months ended March 31, 2005. The increase was attributable to increased Internet, long distance and cable customers partially offset by efficiency improvements and cost reductions.

Selling, general and administrative expenses. Selling, general and administrative expenses decreased from $1.8 million in the three months ended March 31, 2005 to $1.7 million in the three months ended March 31, 2006. Savings from organizational changes made in the second half of 2005 more than offset higher Sarbanes-Oxley expenses, increased fuel charges, and normal employee salary increases.

Depreciation and amortization. Depreciation and amortization decreased 2.2% to $2.3 million in the three months ended March 31, 2006 from $2.4 million in three months ended March 31, 2005. This small change reflects slightly reduced capital expenditures over the last three years.

Interest expense. Interest expense increased 5.7% to $4.2 million in the three months ended March 31, 2006 from $4.0 million in the three months ended March 31, 2005. Interest on the senior credit facility is capped at 7% for the five year term ending December 20, 2009 but was below the 7% rate in 2005. In addition, increased amortization of costs associated with the interest rate cap accounted for the increase.

Change in fair value of derivative associated with Class B common convertible to Class A common. The derivative value associated with the conversion option for our Class B common stock must be fair valued each quarter until conversion occurs, not later than December 21, 2009. The reduction in maximum time to conversion, the change in price of IDSs and the underlying Class A common stock and the expected time for conversion impact the fair value of the derivative. The combination of these factors changed the value of the derivative by $0.2 million in the three months ended March 31, 2006 compared to $0.3 million for the three months ended March 31, 2005.

Other income. Other income was $0.2 million in the three months ended March 31, 2006, down from $0.3 million in the three months ended March 31, 2005. The change was attributable to the lower annual patronage dividend income from CoBank received in first quarter 2006.

Income taxes. Provision for income taxes in the three months ended March 31, 2006 declined 62.2% to $0.2 million from $0.4 million in the three months ended March 31, 2005. The Company estimates its effective tax rate for all of 2006 will approximate 31%. The effective tax rate for 2005 was 31.1%.

Accretion of Class B common convertible to senior subordinated notes. Our Class B common stock was issued to the existing equity holders coincident with our initial public offering on December 21, 2004. These shares represent their retained interest in the company. They do not receive any dividends and will convert into IDSs not later than December 21, 2009. For the first two years after their issuance, the present value discount on the portion of the shares related to the conversion to senior subordinated notes is being accreted as a non-cash expense to the Company. For the three months ended March 31, 2006 and 2005, this accretion expense was $0.1 million.

Net income. As a result of the foregoing, net income available to common stockholders in the three months ended March 31, 2006 decreased 70.5% to $0.2 million from $0.8 million in the three months ended March 31, 2005.

Liquidity and Capital Resources

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

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Cash flows from operating activities for the first three months of 2006 amounted to $2.8 million compared to $2.2 million for the first three months of 2005. The difference is primarily the result of the payment of accrued expenses associated with the initial public offering during first quarter of 2005.

Cash flows from investing activities for the first three months of 2006 amounted to $1.0 million compared to $1.1 million for the first three months of 2005. The acquisition and construction of property and equipment utilized in our business accounted for virtually all of these amounts in both periods.

Cash flows from financing activities for the first three months of 2006 and 2005 amounted to $1.7 million, reflecting cash dividends distributed to stockholders in both years.

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

Subsequent events

On April 10, 2006, the company signed a definitive agreement to acquire the stock of Mid-Maine Communications, Inc. for approximately $37.8 million in cash, subject to post-closing adjustments. Mid-Maine is a telecommunications company serving approximately 18,500 access lines that is headquartered in Bangor, Maine. The acquisition is expected to close in the third quarter of 2006, but is subject to financing, due diligence and regulatory approval. The company anticipates financing this acquisition with an expansion of its existing senior credit facility.

The United States Department of Agriculture is closing the Rural Telephone Bank (RTB). As part of the liquidation process, the company received on April 11, 2006, $3.1 million for the redemption of all outstanding RTB stock owned by three of its subsidiaries. The investment has a cost of $0.4 million.

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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 speculative derivative or commodity type instruments. 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 are exposed to interest rate risk, primarily from the change in LIBOR or a base rate. 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 Chief Financial Officer concluded that our disclosure controls and procedures were effective as of March 31, 2006.

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 first three months of fiscal 2006 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II.

OTHER INFORMATION

Item 6. Exhibits

Exhibits

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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.

	OTELCO INC.
Date:  May 10, 2006	By:	/s/ CURTIS L. GARNER, JR.
		Name:   Curtis L. Garner, Jr. Title:     Chief Financial Officer

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EXHIBIT INDEX

Exhibit No.	Description
31.1	Certificate pursuant to Rule 13A-14(a) or Rule 15d-14(a) of 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) of 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

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