Otelco (OTEL) 10-Q 2006 Q2 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 June 30, 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 xNo o

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 o Accelerated filer o Non-accelerated filer o

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

Yes oNo x

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 August 9, 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 June 30, 2006

TABLE OF CONTENTS

PART I FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets as of December 31, 2005 and June 30, 2006
	Consolidated Statements of Income for the three months and six months ended
	June 30, 2005 and 2006
	Consolidated Statements of Cash Flows for the six months ended June 30, 2005 and 2006
	Notes to Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures about Market Risk
Item 4.	Controls and Procedures
PART II OTHER INFORMATION
Item 4.	Submission of Matters to a vote of Security Holders
Item 6.	Exhibits

i

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.

OTELCO INC.

CONSOLIDATED BALANCE SHEETS

	December 31,			June 30,
	2005			2006
Assets				(unaudited)
Current assets
Cash and cash equivalents	$	5,569,233		$	9,025,517
Accounts receivable:
Due from subscribers, net of allowance for doubtful
accounts of $163,028 and $158,496 respectively		1,212,909			1,204,558
Unbilled receivables		1,828,104			1,853,499
Other		1,482,171			1,763,082
Materials and supplies		932,861			975,074
Prepaid expenses		504,256			437,326
Income tax receivables		749,591			749,591
Deferred income taxes		872,675			872,675
Total current assets		13,151,800			16,881,322
Property and equipment, net		44,555,611			42,661,952
Goodwill		119,431,993			119,431,993
Intangible assets, net		1,588,079			1,485,226
Investments		1,108,249			555,588
Deferred financing costs		6,971,610			6,284,735
Interest rate cap		5,318,728			6,460,374
Deferred costs - acquisition		-			85,940
Total assets	$	192,126,070		$	193,847,130
Liabilities and Stockholders' Equity
Current liabilities
Accounts payable	$	1,106,114		$	961,175
Accrued expenses		1,692,841			3,299,229
Advance billings and payments		1,204,680			1,184,739
Customer deposits		213,524			224,827
Total Current Liabilities		4,217,159			5,669,970
Deferred income taxes		15,345,890			15,345,890
Other liabilities		192,769			176,308
Total deferred tax and other liabilities		15,538,659			15,522,198
Long-term notes payable		161,075,498			161,075,498
Derivative liability		1,830,095			1,519,632
Class B common convertible to senior subordinated notes		3,655,454			3,876,917
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			3,695,090
Retained earnings (deficit)		(805,731	)		-
Accumulated other comprehensive income		899,019			2,385,611
Total stockholders' equity		5,809,205			6,182,915
Total liabilities and stockholders' equity	$	192,126,070		$	193,847,130

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

1

OTELCO INC.
CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

	Three months ended June 30,						Six months ended June 30,
	2005			2006			2005			2006
Revenues
Local services	$	4,341,025		$	4,325,046		$	8,769,650		$	8,655,800
Network access		5,235,327			5,170,581			10,964,633			10,315,636
Cable television		516,060			538,565			1,012,178			1,081,071
Internet		1,350,112			1,523,621			2,723,158			3,018,704
Total revenues		11,442,524			11,557,813			23,469,619			23,071,211
Operating expenses
Cost of services and products		3,020,050			3,185,359			6,073,594			6,361,801
Selling, general and administrative expenses		1,512,050			1,483,078			3,326,999			3,152,664
Depreciation and amortization		2,370,986			2,352,595			4,736,193			4,664,374
Total operating expenses		6,903,086			7,021,032			14,136,786			14,178,839
Income from operations		4,539,438			4,536,781			9,332,833			8,892,372
Other income (expense)
Interest expense		(4,057,957	)		(4,241,068	)		(8,035,748	)		(8,447,105	)
Change in fair value of derivative		337,696			130,721			615,479			310,462
Other income		47,215			2,809,270			320,691			2,996,509
Total other expense		(3,673,046	)		(1,301,077	)		(7,099,578	)		(5,140,134	)
Income before income tax and accretion expense		866,392			3,235,704			2,233,255			3,752,238
Income tax expense		(139,301	)		(1,071,400	)		(566,221	)		(1,232,610	)
Income before accretion expense		727,091			2,164,304			1,667,034			2,519,628
Accretion of Class B common convertible to senior
subordinated notes		(110,732	)		(110,731	)		(221,463	)		(221,463	)
Net income available to common stockholders	$	616,359		$	2,053,573		$	1,445,571		$	2,298,165
Weighted average shares outstanding:
Basic		9,676,733			9,676,733			9,676,733			9,676,733
Diluted		10,221,404			10,221,404			10,221,404			10,221,404
Net income per share
Basic	$	0.06		$	0.21		$	0.15		$	0.24
Diluted	$	0.04		$	0.20		$	0.10		$	0.22
Dividends declared per share	$	0.18		$	0.18		$	0.35		$	0.35

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

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OTELCO INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

	Six months ended June 30,
	2005			2006
Cash flows from operating activities:
Net income	$	1,445,571		$	2,298,165
Adjustments to reconcile net income to cash flows from operating activities:
Depreciation		3,844,022			3,874,647
Amortization		892,171			789,728
Interest rate caplet		50,716			344,946
Accretion expense		221,463			221,463
Change in fair value of derivative liability		(615,479	)		(310,462	)
Provision for uncollectible revenue		42,249			60,903
Gain on disposition of other assets		-			(2,686,745	)
Changes in assets and liabilities; net of assets and liabilities acquired:
Accounts receivables		142,418			(358,856	)
Material and supplies		33,296			(42,213	)
Prepaid expenses and other assets		68,151			66,930
Accounts payable and accrued liabilities		(566,838	)		1,461,447
Advance billings and payments		18,080			(19,941	)
Other liabilities		2,295			(5,158	)
Net cash from operating activities		5,578,115			5,694,854
Cash flows from investing activities:
Acquisition and construction of property and equipment		(2,359,481	)		(1,968,233	)
Proceeds from retirement of investment		80,846			3,226,651
Deferred charges - acquisition		-			(85,940	)
Net cash from investing activities		(2,278,635	)		1,172,478
Cash flows from financing activities:
Cash dividends paid		(3,411,048	)		(3,411,048	)
Loan origination costs and transaction cost		(63,262	)		-
Net cash from financing activities		(3,474,310	)		(3,411,048	)
Net increase (decrease) in cash and cash equivalents		(174,830	)		3,456,284
Cash and cash equivalents, beginning of period		5,406,545			5,569,233
Cash and cash equivalents, end of period	$	5,231,715		$	9,025,517
Supplemental disclosures of cash flow information:
Interest paid	$	8,287,120		$	8,085,647
Income taxes paid (received)	$	(350,000	)	$	40,000

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 the aforesaid subsidiaries after elimination of all material intercompany balances and transactions. On July 3, 2006, we completed the acquisition of Mid-Maine Communications, Inc. (see note 7, “Subsequent Events”). The Mid-Maine assets and liabilities acquired, as well as the results of Mid-Maine’s operations, are not reflected in the accompanying consolidated financial statements.

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 ended June 30, 2005 and 2006 the change in the fair value of the interest rate cap was $(1,554,453) and $610,139, respectively. For the six months ended June 30, 2005 and 2006 the change in the fair value of the interest rate cap was $(751,321) and $1,486,592, 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 June 30, 2005 and 2006 the cost of the interest rate cap was $29,619 and $181,984, respectively. For the six months ended June 30, 2005 and 2006 the cost of the interest rate cap was $50,716 and $344,946, respectively.

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.

4

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						For the six months
	ended June 30,						ended June 30,
	2005			2006			2005			2006
Weighted average common shares-basic		9,676,733			9,676,733			9,676,733			9,676,733
Effect of dilutive securities		544,671			544,671			544,671			544,671
Weighted-average common shares and potential
common shares-diluted		10,221,404			10,221,404			10,221,404			10,221,404
Net income available to common stockholders	$	616,359		$	2,053,574		$	1,445,571		$	2,298,165
Net income per basic share	$	0.06		$	0.21		$	0.15		$	0.24
Net income available to common stockholders	$	616,359		$	2,053,574		$	1,445,571		$	2,298,165
Plus: Accretion expense of Class B common
convertible to senior subordinated notes		110,732			110,732			221,463			221,463
Less: Change in fair value of derivative		(337,696	)		(130,721	)		(615,479	)		(310,462	)
Net income available for diluted shares	$	389,395		$	2,033,585		$	1,051,555		$	2,209,166
Net income per diluted share	$	0.04		$	0.20		$	0.10		$	0.22

5.  Other Comprehensive Income

The components of other comprehensive income consist of:

	For the three months					For the six months
	ended June 30,					ended June 30,
	2005			2006		2005			2006
Net income	$	616,359		$	2,053,574	$	1,445,571		$	2,298,165
Hedge accounting		(1,554,453	)		610,139		(751,321	)		1,486,592
Total comprehensive income	$	(938,094	)	$	2,663,713	$	694,250		$	3,784,757

6.  Other Income

Other income included the gain of $2,662,235 from the liquidation of the Rural Telephone Bank (RTB) stock. The RTB stock liquidation resulted from the United States Department of Agriculture closing the Rural Telephone Bank. 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 had a cost of $435,858.

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7.  Subsequent Events

On July 3, 2006, the Company acquired all of 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. Concurrent with the closing of the acquisition, we entered into an amended and restated credit agreement dated as of July 3, 2006, to amend and restate the Credit Agreement, dated as of December 21, 2004, by and among Otelco and the other credit parties signatories thereto and General Electric Capital Corporation , as a lender and an agent for the lenders. Details of the financing were filed with the Securities and Exchange Commission on a Current Report on Form 8-K on July 5, 2006 and are incorporated herein by reference.

8. Recent Accounting Pronouncements

On July 13, 2006, the Financial Accounting Standards Board issues Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, FIN 48. It interprets and clarifies the way companies account for uncertainty in income taxes. This pronouncement is effective for years beginning after December 15, 2006. We are evaluating the impact of this pronouncement but do not anticipate that it will have a material impact on the Company.

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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 June 30, 2006, we operated approximately 39,500 total access line equivalents.

Our core businesses are local telephone services and the provision of network access to other wireline, long distance and wireless carriers for calls originated or terminated on our network. With the industry direction of including unlimited calling as part of local services and our significant customer acceptance of our bundled offers, local services now includes what was formerly called long distance and other telephone services. Our core businesses generated approximately 82% of our total revenues in both the second quarter and first half of 2006. We also provide 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 four 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. We also receive revenues for providing long distance services to our customers. With the high level of acceptance of local service bundles including unlimited calling, these telephone services are viewed by our customers as part of their local telephone service. We also provide billing and collections services for other carriers under contract and receive revenues from directory advertising in our local communities.

·   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.

·   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.

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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. The introduction of unlimited calling bundles may positively impact customer churn. The growth of our digital high-speed Internet access services will continue to reduce demand for second access lines for residential and small business customers. 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 and bundling services to meet customer communications needs, increasing revenue per access line.  

	Year Ended December 31,						March 31,		June 30,
	2003		2004		2005		2006		2006
Access line equivalents (1):
Residential access lines		22,100		25,237		24,541		24,491		24,273
Business access lines		7,355		8,414		8,036		7,877		7,961
Access lines		29,455		33,651		32,577		32,368		32,234
Digital high-speed lines		2,185		3,488		5,962		6,800		7,323
Total access line equivalents		31,640		37,139		38,539		39,168		39,557
Long distance customers		11,374		13,641		14,438		15,618		16,566
Cable television customers		3,628		3,959		4,220		4,236		4,196
Dial-up Internet customers		2,331		15,348		12,149		11,659		10,614

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

In March, 2006, we introduced three bundled service packages including unlimited domestic calling to our Alabama residential customers. As of June 30, 2006, 24.3% of the Alabama residential customers signed up for one of the three packages. Our digital high-speed Internet customers continue to grow from 6,800 customers at March 31, 2006, to 7,323 at June 30, 2006. We expect continued revenue growth in this area of our business. This growth in our digital high-speed Internet customers has a negative effect on our dial-up Internet customers as some customers migrate to digital high-speed Internet access, and on our access lines as some customers will no longer have a need for second lines for purposes of dial-up Internet access. During second quarter 2006, residential and business access lines and business data circuits declined 0.4% while digital high-speed Internet customers grew 7.7% during the same period. On an annualized basis, access lines decreased 2.1% in 2006 while access line equivalents increased 5.3% on an annualized basis in 2006.

With the acceptance of our unlimited calling service bundles, our long distance customers increased 6.1% to 16,566 on June 30, 2006 and now represent 51.4% of our access lines. Our cable television customers declined slightly to 4,196 as of June 30, 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 9.0% to 10,614 on June 30, 2006 from 11,659 on March 30, 2006, including the subscribers we service outside of our telephone service area, reflecting the expected impact of the shift to digital high-speed Internet services.

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 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.

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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.

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 June 30,						Six Months Ended June 30,
	2005			2006			2005			2006
Revenues
Local services		37.9	%		37.4	%		37.4	%		37.5	%
Network access		45.8			44.7			46.7			44.7
Cable television		4.5			4.7			4.3			4.7
Internet		11.8			13.2			11.6			13.1
Total revenues		100.0	%		100.0	%		100.0	%		100.0	%
Operating expenses
Cost of services and products		26.4	%		27.5	%		25.9	%		27.6	%
Selling, general and administrative expenses		13.2			12.8			14.1			13.7
Depreciation and amortization		20.7			20.4			20.2			20.2
Total operating expenses		60.3			60.7			60.2			61.5
Income from operations		39.7			39.3			39.8			38.5
Other income (expense)
Interest expense		(35.5	)		(36.7	)		(34.2	)		(36.6	)
Change in fair value of derivative		3.0			1.1			2.6			1.3
Other income		0.4			24.3			1.3			13.0
Total other expense		(32.1	)		(11.3	)		(30.3	)		(22.3	)
Income before income taxes		7.6			28.0			9.5			16.2
Income tax expense		(1.2	)		(9.3	)		(2.4	)		(5.3	)
Income before accretion expense		6.4			18.7			7.1			10.9
Accretion of Class B common convertible to senior
subordinated notes		(1.0	)		(0.9	)		(0.9	)		(0.9	)
Net income available to common stockholders		5.4	%		17.8	%		6.2	%		10.0	%

Three months and six months ended June 30, 2006 compared to three months and six months ended June 30, 2005

Total Revenues. Total revenues increased 1.0% in the three months ended June 30, 2006 to $11.5 million from $11.4 million in the three months ended June 30, 2005. Total revenues decreased 1.7% in the six months ended June 30, 2006 to $23.1 million from $23.5 million in the six months ended June 30, 2005. The tables below provide the components of our revenues for the three months and six months ended June 30, 2006 compared to the same periods of 2005.

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For the three months ended June 30, 2006 and 2005 

	Three Months Ended June 30,				Change
	2005		2006		Amount			Percent
			(dollars in thousands)
Local services	$	4,341	$	4,325	$	(16	)		(0.4	)%
Network access		5,235		5,171		(64	)		(1.2	)
Cable television		516		538		22			4.3
Internet		1,350		1,524		174			12.9
Total	$	11,442	$	11,558	$	116			1.0

Local services. Local services (including long distance and other telephone services) revenue in the three months ended June 30, 2006 was basically unchanged at $4.3 million when compared to the three months ended June 30, 2005. Access lines decreased 785 during the period, while long distance customers increased 2,505. The introduction of unlimited residential calling bundles in Alabama moved nearly 25% of the relevant customer base into one of these plans, helping to slow the decline in access lines. The increased bundled revenue offset the lost revenue due to access line decline.

Network access. Network access revenue in the three months ended June 30, 2006 decreased 1.2% to $5.2 million, slightly lower than the three months ended June 30, 2005. A decline of $0.2 million in switched access, customer-based universal service charges and universal service fund payments was partially offset by an increase of $0.1 million in special access.

Cable television. Cable television revenue in the three months ended June 30, 2006 at $0.5 million was slightly higher than in the three months ended June 30, 2005. The increase was due to the impact of higher local advertising revenue, an increase in basic cable prices and growth of 33 customers.

Internet. Internet revenue in the three months ended June 30, 2006 increased 12.9% to $1.5 million from $1.4 million in the three months ended June 30, 2005. The addition of more than 2,900 new digital high-speed Internet customers generated just over $0.3 million, partially offset by more than $0.1 million associated with the decline in dial-up Internet customers associated with the conversion to digital high-speed Internet.

For the six months ended June 30, 2006 and 2005 

	Six Months Ended June 30,				Change
	2005		2006		Amount			Percent
			(dollars in thousands)
Local services	$	8,769	$	8,655	$	(114	)		(1.3	)%
Network access		10,965		10,316		(649	)		(5.9	)
Cable television		1,012		1,081		69			6.8
Internet		2,723		3,019		296			10.9
Total	$	23,469	$	23,071	$	(398	)		(1.7	)

Local services. Local services (including long distance and other telephone services) revenue in the six months ended June 30, 2006 declined 1.3% to $8.7 million from $8.8 million for the six months ended June 30, 2005. Access lines decreased 785 during the period, while long distance customers increased 2,505. The introduction of unlimited residential calling bundles in Alabama moved nearly 25% of the relevant customer base into one of these plans beginning in March 2006. The impact of basic service revenue loss prior to bundle introduction was the primary reason for the decline.

Network access. Network access revenue in the six months ended June 30, 2006 decreased 5.9% to $10.3 million from $11.0 million in the six months ended June 30, 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 first quarter 2005, $0.1 million from lower customer-based universal service charges, $0.1 million from a combination of lower access minutes and lower revenue per access minute as minutes shift to wireless, and $0.2 million in reduced Universal Service Fund payments.

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Cable television. Cable television revenue in the six months ended June 30, 2006 increased 6.8% to $1.1 million from $1.0 million in the six months ended June 30, 2005. The increase was due to the impact of higher local advertising revenue, an increase in basic cable prices and growth of 33 customers, partially offset by lower one-time installation revenue.

Internet. Internet revenue in the six months ended June 30, 2006 increased 10.9% to $3.0 million from $2.7 million in the six months ended June 30, 2005. The addition of more than 2,900 new digital high-speed Internet customers generated $0.6 million, partially offset by $0.3 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 June 30, 2006 increased 1.7% to $7.0 million from $6.9 million the three months ended June 30, 2005. Operating expenses in the six months ended June 30, 2006 increased 0.3% to $14.2 million from $14.1 million in the six months ended June 30, 2005.

For the three months ended June 30, 2006 and 2005

	Three Months Ended June 30,				Change
	2005		2006		Amount			Percent
			(dollars in thousands)
Cost of services and products	$	3,020	$	3,185	$	165			5.5	%
Selling, general and administrative expenses		1,512		1,483		(29	)		(1.9	)
Depreciation and amortization		2,371		2,353		(18	)		(0.8	)
Total	$	6,903	$	7,021	$	118			1.7

Cost of services and products. Cost of service and products increased 5.5% to $3.2 million in the three months ended June 30, 2006 from $3.0 million in the three months ended June 30, 2005. The increase was attributable to increased Internet, long distance and cable customers, as well as long distance usage associated with bundled services plans, partially offset by network and organizational efficiencies.

Selling, general and administrative expenses. Selling, general and administrative expenses in the three months ended June 30, 2006 at $1.5 million were slightly below the three months ended June 30, 2005. Savings from organizational changes made in the second half of 2005 and lower legal fees and insurance expenses offset higher sales commissions associated with bundled offers, and normal employee salary increases.

Depreciation and amortization. Depreciation and amortization decreased 0.8%, remaining at $2.4 million in the three months ended June 30, 2006 and 2005.

For the six months ended June 30, 2006 and 2005

	Six Months Ended June 30,				Change
	2005		2006		Amount			Percent
			(dollars in thousands)
Cost of services and products	$	6,074	$	6,362	$	288			4.7	%
Selling, general and administrative expenses		3,327		3,153		(174	)		(5.2	)
Depreciation and amortization		4,736		4,664		(72	)		(1.5	)
Total	$	14,137	$	14,179	$	42			0.3

Cost of services and products. Cost of services and products increased 4.7% to $6.4 million in the six months ended June 30, 2006 from $6.1 million in the six months ended June 30, 2005. The increase was attributable to costs associated with increased Internet, long distance and cable customers, as well as long distance usage associated with bundled services plans, partially offset by network and organizational efficiencies.

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Selling, general and administrative expenses. Selling, general and administrative expenses decreased 5.2% to $3.2 million in the six months ended June 30, 2006 from $3.3 million in the six months ended June 30, 2005. Savings from organizational changes made in the second half of 2005 and lower legal fees and insurance expenses more than offset higher sales commissions associated with increased bundle customers and normal employee salary increases.

Depreciation and amortization. Depreciation and amortization decreased 1.5% to just under $4.7 million in the six months ended June 30, 2006 from just over $4.7 million in the six months ended June 30, 2005. This is reflective of a small decrease in capital expenditures.

For the three months and six months ended June 30, 2006 and 2005

Interest expense. Interest expense increased 4.5% to $4.2 million in the three months ended June 30, 2006 from $4.0 million in the three months ended June 30, 2005. Interest expense increased 5.1% to $8.4 million in the six months ended June 30, 2006 from $8.0 million in the six months ended June 30, 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 early 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 $0.1 million in the three months ended June 30, 2006 compared to $0.3 million for the three months ended June 30, 2005 and by $0.3 million in the six months ended June 30, 2006 compared to $0.6 million for the six months ended June 30, 2005.

Other income. Other income was $2.8 million in the three months ended June 30, 2006, up from less than $0.1 million in the three months ended June 30, 2005. The change was attributable to the gain of $2.7 million associated with the redemption of Rural Telephone Bank (RTB) stock owned by three of our companies. The United States Department of Agriculture closed RTB and redeemed all outstanding stock. Other income was $3.0 million for the six months ended June 30, 2006, up from $0.3 million in the six months ended June 30, 2005. The RTB gain was the primary factor in the increase.

Income taxes. Provision for income taxes in the three months ended June 30, 2006 increased to $1.1 million from $0.1 million in the three months ended June 30, 2005. Provision for income taxes in the six months ended June 30, 2006 increased to $1.2 million from $0.6 million in the six months ended June 30, 2005. The Company estimates its effective tax rate for all of 2006 will approximate 32.85%. The effective tax rate for 2005 was 31.1%. The increase in income tax expense is driven by the increase in net income.

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 June 30, 2006 and 2005, this accretion expense was $0.1 million. For the six months ended June 30, 2006 and 2005, this accretion expense was $0.2 million.

Net income. As a result of the foregoing, net income available to common stockholders in the three months ended June 30, 2006 increased to $2.1 million from $0.6 million in the three months ended June 30, 2005 and in the six months ended June 30, 2006 increased to $2.3 million from $1.4 million in the six months ended June 30, 2005.

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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.

Cash flows from operating activities for the first six months of 2006 amounted to $5.7 million compared to $5.6 million for the first six months of 2005.

For the first six months of 2006, the Company received $1.2 million in cash flows related to investing activities compared to utilizing $2.3 million for the first six months of 2005. The acquisition and construction of property and equipment utilized $0.4 million less in the first six months of 2006 than in the same period of 2005 while the sale of RTB stock generated $3.1 million in 2006.

Cash flows from financing activities for the first six months of 2006 amounted to $3.4 million and for the first six months of 2005 amounted to $3.5 million, primarily reflecting cash dividends distributed to stockholders in both years. In addition, $0.1 million in transaction costs were reflected in the first six months of 2005.

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.

Recent Accounting Pronouncements

On July 13, 2006, the Financial Accounting Standards Board issues Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, FIN 48. It interprets and clarifies the way companies account for uncertainty in income taxes. This pronouncement is effective for years beginning after December 15, 2006. We are evaluating the impact of this pronouncement but do not anticipate that it will have a material impact on the Company.

Subsequent Events

On July 3, 2006, the Company acquired all of 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 19,900 access lines that is headquartered in Bangor, Maine. Concurrent with the closing of the acquisition, we entered into an amended and restated credit agreement dated as of July 3, 2006, to amend and restate the Credit Agreement, dated as of December 21, 2004, by and among Otelco and the other credit parties signatories thereto and General Electric Capital Corporation, as a lender and an agent for the lenders. Details of the financing were filed with the Securities and Exchange Commission on a Current Report on Form 8-K on July 5, 2006 and are incorporated herein by reference.

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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 June 30, 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 three months ended June 30, 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 4. Submission of Matters to a Vote of Security Holders

Otelco Inc. held its Annual Meeting of Stockholders on May 11, 2006. At that meeting, stockholders elected John P. Kunz and Andrew Meyers as Directors of the Company for a term to expire at the 2009 Annual Meeting of Stockholders. The results of the voting are as follows:

	Votes For		Votes Withheld
John P. Kunz		8,780,933		115,995
Andrew Meyers		8,812,300		84,628

The following directors also have terms in office that continue after the Annual Meeting of Stockholders: William Bak, Howard Haug, Stephen P. McCall, William F. Reddersen and Michael D. Weaver.

In addition, stockholders ratified the appointment of BDO Seidman, LLP as our Independent Registered Public Accounting Firm for the fiscal year ending December 31, 2006. The result of the voting is as follows:

	Votes For		Votes Against		Abstain		Broker Non-Vote
Ratification of appointment of independent
registered public accounting firm		8,831,735		23,991		41,202		0

Item. 6. Exhibits

Exhibits

See Exhibit Index.

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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.

Date: August 9, 2006	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) 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