Otelco (OTEL) 10-Q 2007 Q3 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 September 30, 2007 Or
¨	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 ¨

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 x 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 ¨No 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 November 5, 2007
Class A Common Stock ($0.01 par value per share)	12,676,733
Class B Common Stock ($0.01 par value per share)	544,671

OTELCO INC.

FORM 10-Q

For the three month period ended September 30, 2007

TABLE OF CONTENTS

PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements	2
	Consolidated Balance Sheets as of December 31, 2006 and September 30, 2007	2
	Consolidated Statements of Income for the three months and nine months ended September 30, 2006 and 2007	3
	Consolidated Statements of Changes in Stockholders’ Equity (Deficit) as of September 30, 2007	4
	Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2007	5
	Notes to Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	22
Item 4.	Controls and Procedures	23
PART II	OTHER INFORMATION
Item 6.	Exhibits	23

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

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.

1

PART 1. FINANCIAL INFORMATION

Item 1. Financial Statements

OTELCO INC.

CONSOLIDATED BALANCE SHEETS

	December 31,			September 30,
	2006			2007
Assets				(unaudited)
Current assets
Cash and cash equivalents	$	14,401,849		$	17,565,053
Accounts receivable:
Due from subscribers, net of allowance for doubtful
accounts of $221,762 and $207,359 respectively		3,105,636			2,870,450
Unbilled receivables		2,324,213			2,521,484
Other		1,680,144			2,068,639
Materials and supplies		1,962,938			1,926,254
Prepaid expenses		1,062,947			566,420
Deferred income taxes		766,225			832,946
Total current assets		25,303,952			28,351,246
Property and equipment, net		60,493,789			55,415,315
Goodwill		134,182,309			134,570,435
Intangible assets, net		11,340,806			9,971,280
Investments		1,240,250			1,213,246
Deferred financing costs		6,652,393			6,246,801
Interest rate cap		4,542,160			2,833,166
Deferred charges		96,628			60,186
Total assets	$	243,852,287		$	238,661,675
Liabilities and Stockholders' Equity
Current liabilities
Accounts payable	$	1,658,911		$	1,253,551
Dividends payable		1,705,524			2,234,274
Accrued expenses		5,875,863			7,068,675
Advance billings and payments		2,119,701			2,085,730
Customer deposits		197,496			200,840
Total Current Liabilities		11,557,495			12,843,070
Deferred income taxes		24,712,213			24,778,934
Other liabilities		187,037			187,867
Total deferred tax and other liabilities		24,899,250			24,966,801
Long-term notes payable		201,075,498			170,036,724
Derivative liability		2,107,877			1,383,679
Class B common convertible to senior subordinated notes		4,085,033			4,085,033
Stockholders' Equity
Class A Common Stock, $.01 par value-authorized 20,000,000 shares;
issued and outstanding 12,676,733 shares		96,767			126,767
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		284,041			30,456,624
Retained deficit		(1,137,166	)		(5,154,673	)
Accumulated other comprehensive income		878,045			(87,797	)
Total stockholders' equity		127,134			25,346,368
Total liabilities and stockholders' equity	$	243,852,287		$	238,661,675
The accompanying notes are an integral part of these consolidated financial statements.

2

OTELCO INC.

CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

	Three months ended September 30,						Nine months ended September 30,
	2006			2007			2006			2007
Revenues
Local services	$	6,363,046		$	6,502,105		$	14,956,503		$	19,381,216
Network access		6,533,743			6,612,250			16,849,379			19,190,669
Cable television		550,914			547,044			1,631,985			1,642,985
Internet		2,765,643			2,867,381			5,846,691			8,547,085
Transport services		923,625			1,065,521			923,625			3,122,940
Total revenues		17,136,971			17,594,301			40,208,183			51,884,895
Operating expenses
Cost of services and products		6,139,234			6,326,014			12,501,035			19,131,470
Selling, general and administrative expenses		2,451,477			2,676,515			5,604,141			7,597,843
Depreciation and amortization		3,406,789			3,474,799			7,384,289			10,879,513
Total operating expenses		11,997,500			12,477,328			25,489,465			37,608,826
Income from operations		5,139,471			5,116,973			14,718,718			14,276,069
Other income (expense)
Interest expense		(5,623,615	)		(5,844,898	)		(14,757,595	)		(16,633,507	)
Change in fair value of derivative		27,234			186,055			337,696			654,472
Other income		201,506			268,356			3,198,013			715,389
Total other expense		(5,394,875	)		(5,390,487	)		(11,221,886	)		(15,263,646	)
Income (loss) before income tax and accretion expense		(255,404	)		(273,514	)		3,496,832			(987,577	)
Income tax (expense) benefit		1,375			(394,197	)		(1,231,235	)		97,079
Income (loss) before accretion expense		(254,029	)		(667,711	)		2,265,597			(890,498	)
Accretion of Class B common convertible to senior
subordinated notes		(110,732	)		-			(332,195	)		-
Net income (loss) available to common stockholders	$	(364,761	)	$	(667,711	)	$	1,933,402		$	(890,498	)
Weighted average shares outstanding:
Basic		9,676,733			12,546,298			9,676,733			10,643,766
Diluted		10,221,404			13,090,969			10,221,404			11,188,437
Net income (loss) per share
Basic	$	(0.04	)	$	(0.05	)	$	0.20		$	(0.08	)
Diluted	$	(0.04	)	$	(0.07	)	$	0.19		$	(0.14	)
Dividends declared per share	$	0.18		$	0.18		$	0.53		$	0.53

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

3

OTELCO INC.

Consolidated Statements of Changes in Stockholders' Equity (Deficit)

(unaudited)

															Accumulated
															Other
	Class A				Class B				Additional			Retained			Comprehensive			Total
	Common Stock				Common Stock				Paid In			Earnings			Income			Stockholders'
	Shares		Amount		Shares		Amount		Capital			(Deficit)			(loss)			Equity
Balance, December 31, 2005		9,676,733	$	96,767		544,671	$	5,447	$	5,613,703		$	(805,731	)	$	899,019		$	5,809,205
Comprehensive income:
Net income													244,594						244,594
Interest rate cap																876,453			876,453
Total comprehensive income																			1,121,047
Dividends declared										(1,705,524	)								(1,705,524	)
Balance, March 31, 2006		9,676,733	$	96,767		544,671	$	5,447	$	3,908,179		$	(561,137	)	$	1,775,472		$	5,224,728
Comprehensive income:
Net income													2,053,574						2,053,574
Interest rate cap																610,139			610,139
Total comprehensive income																			2,663,713
Dividends declared										(213,089	)		(1,492,437	)					(1,705,526	)
Balance, June 30, 2006		9,676,733	$	96,767		544,671	$	5,447	$	3,695,090		$	-		$	2,385,611		$	6,182,915
Comprehensive income:
Net income													(364,761	)					(364,761	)
Interest rate cap																(1,454,244	)		(1,454,244	)
Total comprehensive income																			(1,819,005	)
Dividends declared										(1,705,524	)		-						(1,705,524	)
Balance, September 30, 2006		9,676,733	$	96,767		544,671	$	5,447	$	1,989,566		$	(364,761	)	$	931,367		$	2,658,386
Comprehensive income:
Net income													(772,405	)					(772,405	)
Interest rate cap																(53,322	)		(53,322	)
Total comprehensive income																			(825,727	)
Dividends declared										(1,705,525	)		-						(1,705,525	)
Balance, December 31, 2006		9,676,733	$	96,767		544,671	$	5,447	$	284,041		$	(1,137,166	)	$	878,045		$	127,134
Comprehensive income:
Net income													(118,207	)					(118,207	)
Interest rate cap																(392,097	)		(392,097	)
Total comprehensive income																			(510,304	)
Dividends declared										(284,041	)		(1,421,484	)					(1,705,525	)
Balance, March 31, 2007		9,676,733	$	96,767		544,671	$	5,447	$	-		$	(2,676,857	)	$	485,948		$	(2,088,695	)
Comprehensive income:
Net income													(104,581	)					(104,581	)
Interest rate cap																623,503			623,503
Total comprehensive income																			518,922
Dividends declared										-			(1,705,524	)					(1,705,524	)
Balance, June 30, 2007		9,676,733	$	96,767		544,671	$	5,447	$	-		$	(4,486,962	)	$	1,109,451		$	(3,275,297	)
Comprehensive income:
Net income (loss)													(667,711	)					(667,711	)
Interest rate cap																(1,197,248	)		(1,197,248	)
Total comprehensive income																			(1,864,959	)
Dividends declared										(2,234,274	)		-						(2,234,274	)
Subsequent Public Offering
Issuance of IDSs		3,000,000		30,000		-		-		34,998,584			-			-			35,028,584
Capitalized transactions costs offset
against proceeds of offering										(2,307,686	)		-			-			(2,307,686	)
Balance, September 30, 2007		12,676,733	$	126,767		544,671	$	5,447	$	30,456,624		$	(5,154,673	)	$	(87,797	)		25,346,368

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

4

OTELCO INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

	Nine months ended September 30,
	2006			2007
Cash flows from operating activities:
Net income (loss)	$	1,933,402		$	(890,498	)
Adjustments to reconcile net income to cash flows from operating activities:
Depreciation		6,390,925			8,933,812
Amortization		578,904			1,945,696
Interest rate caplet		543,321			673,425
Amortization of debt premium		-			(16,533	)
Amortization of loan cost		1,311,927			2,233,495
Accretion expense		332,195			-
Change in fair value of derivative		(337,695	)		(654,472	)
Provision for uncollectible revenue		123,979			114,979
Gain on disposition of other assets		(2,686,745	)		-
Changes in assets and liabilities; net of assets and liabilities acquired:
Accounts receivables		(155,522	)		(642,120	)
Material and supplies		(20,652	)		(117,903	)
Income tax receivable		287,804			-
Prepaid expenses and other assets		101,675			496,527
Accounts payable and accrued liabilities		4,888,886			(1,002,997	)
Advance billings and payments		1,888			(33,971	)
Other liabilities		(3,860	)		4,174
Net cash from operating activities		13,290,432			11,043,614
Cash flows from investing activities:
Acquisition and construction of property and equipment		(3,662,910	)		(4,386,579	)
Proceeds from retirement of investment		3,226,651			7,871
Payment for the purchase of Mid-Maine Commuincations, Inc.,
net of cash acquired		(15,905,248	)		-
Deferred charges		(67,921	)		(2,033	)
Net cash from investing activities		(16,409,428	)		(4,380,741	)
Cash flows from financing activities:
Cash dividends paid		(3,411,048	)		(3,411,048	)
Direct cost of subsequent public offering		-			(2,307,686	)
Repayment of long-term debt		(24,347,299	)		(55,353,032	)
Loan origination costs		-			(1,827,903	)
Proceeds from long-term notes payable		40,000,000			-
Proceeds from issuance of IDS		-			59,400,000
Net cash from financing activities		12,241,653			(3,499,669	)
Net increase in cash and cash equivalents		9,122,657			3,163,204
Cash and cash equivalents, beginning of period		5,569,233			14,401,849
Cash and cash equivalents, end of period	$	14,691,890		$	17,565,053
Supplemental disclosures of cash flow information:
Interest paid	$	12,130,902		$	13,878,086
Income taxes paid (received)	$	(262,632	)	$	(153,468	)
Dividends declared but not paid	$	1,705,524		$	2,234,274
The accompanying notes are an integral part of these consolidated financial statements.

5

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, Otelco Telephone LLC, Hopper Holding Company, Inc. (“HHC”), Brindlee Holdings LLC (“BH”), Page & Kiser Communications, Inc. (“PKC”), Mid-Missouri Holding Corporation (“MMH”), and Mid-Maine Communications, Inc. (“Mid-Maine”). HHC’s wholly owned subsidiary is Hopper Telecommunications Company, Inc. BH’s owned subsidiary is Brindlee Mountain Telephone Company, Inc. PKC’s wholly owned subsidiary is Blountsville Telephone Company, Inc. MMH’s wholly owned subsidiary is Mid-Missouri Telephone Company (“MMT”). MMT is the sole stockholder of Imagination, Inc. Mid-Maine’s wholly owned subsidiaries are Mid-Maine Telecom, Inc. (“MMTI”) and Mid-Maine TelPlus (“MMTP”). 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 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, 2006. 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 presentation.

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

3.Income Deposit Securities Issued

On July 5, 2007, the Company completed its offering of 3,000,000 Income Deposit Securities (IDS) units through an underwritten public offering at $19.80 per unit. The price per unit is comprised of $11.68 allocated to each share of Class A common stock and $8.11 allocated to each senior subordinated note, plus $0.01 representing accrued interest from June 30, 2007. The Company used the net proceeds of approximately $55.4 million to repay senior secured indebtedness under its credit facility, reducing senior debt from $120.0 million to approximately $64.6 million. The $8.11 allocated to each senior subordinated note represents a premium of $0.61 over the $7.50 stated principal amount. The additional IDS units increase senior subordinated debt by $22.5 million, bringing senior subordinated debt to approximately $105.4 million. Therefore, total debt was reduced from approximately $201.1 to $170.0 million.

The following is a summary of the offering receipts and disbursements and related use of funds:

Receipts
Proceeds from issuance of IDS units	$	59,400,000
Disbursements
Direct cost of subsequent public offering		2,307,686
Principal repayment of long-term debt		55,353,032
Loan origination costs		1,827,903
Total		59,488,621
Net disbursements	$	(88,621	)

6

4.Derivative and Hedge Activities

An 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 3% plus the applicable margin on $80 million in senior debt for five years. On July 5, 2007, the Company repaid $55,353,032 in debt, reducing its senior debt below the level of the rate cap. The cap is considered an effective hedge for the remaining senior debt as all critical terms of the interest rate cap are identical to the underlying debt it hedges. The balance of the cap is no longer considered an effective hedge but is considered an investment. Adjustments have been made to Accumulated Other Comprehensive Income to reflect this change.

Changes in the fair value of the effective portion 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 September 30, 2006 and 2007 the change in the fair value of the effective portion of the interest rate cap was $(1,454,243) and $(1,197,248), respectively. For the nine months ended September 30, 2006 and 2007 the change in the fair value of the effective portion of the interest rate cap was $32,349 and $(965,841), respectively.

The cost of the effective portion 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. The expense related to the ineffective portion of the interest rate cap is reflected in the change in fair value of derivative. For the three months ended September 30, 2006 and 2007 the cost of the effective portion of the interest rate cap was $198,376 and $254,494, respectively. For the nine months ended September 30, 2006 and 2007 the cost of the effective portion of the interest rate cap was $543,322 and $722,288, respectively.

The corresponding other comprehensive income related to the ineffective portion of the hedge, which totaled $254,355, has been reclassified from other comprehensive income to other income to reflect this change.

5.Income (loss) per Common Share and Potential Common Share

Basic income (loss) per common share is computed by dividing net income (loss) by the weighted-average number of shares outstanding for the period. Diluted income (loss) per common share reflects the potential dilution that could occur if the Class B common stock were exercised into IDSs. Diluted loss per share for the three months ended September 30, 2006, does not include the potential common shares as their effect would be anti-dilutive and there have been no adjustments to the net loss for accretion expense or change in fair value of derivative. 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 (loss) for the Company’s basic and diluted income (loss) per common share calculation is as follows:

	For the three months						For the nine months
	ended September 30,						ended September 30,
	2006			2007			2006			2007
Weighted average common shares-basic		9,676,733			12,546,298			9,676,733			10,643,766
Effect of dilutive securities		544,671			544,671			544,671			544,671
Weighted-average common shares and potential
common shares-diluted		10,221,404			13,090,969			10,221,404			11,188,437
Net income (loss) available to common stockholders	$	(364,761	)	$	(667,711	)	$	1,933,402		$	(890,498	)
Net income (loss) per basic share	$	(0.04	)	$	(0.05	)	$	0.20		$	(0.08	)
Net income (loss) available to common stockholders	$	(364,761	)	$	(667,711	)	$	1,933,402		$	(890,498	)
Plus: Accretion expense of Class B common
convertible to senior subordinated notes		-			-			332,195			-
Less: Change in fair value of derivative		-			(186,055	)		(337,696	)		(654,472	)
Net income (loss) available for diluted shares	$	(364,761	)	$	(853,766	)	$	1,927,901		$	(1,544,970	)
Net income (loss) per diluted share	$	(0.04	)	$	(0.07	)	$	0.19		$	(0.14	)

7

6.Acquisition

On July 3, 2006, the Company acquired 100% of the outstanding common stock of Mid-Maine through a merger of Mid-Maine with MM Merger Corp, with Mid-Maine as the surviving wholly-owned subsidiary. Mid-Maine owns 100% of two subsidiaries, MMTI and MMTP. Mid-Maine provides telecommunications solutions, including voice, data and Internet services, to residential and business customers in portions of Maine and extends Otelco into the New England market.

The stated purchase price in the acquisition agreement was $37,750,000. The purchase price was $40,555,738, including transaction costs and the assumed notes payable of $24,347,299 which were paid off at closing. The excess of the purchase price over the market value of assets and liabilities is reflected as goodwill of $14,971,176. The goodwill related to the acquisition is not deductible for tax purposes. The aggregate consideration paid for the acquisition was as follows:

Cash paid	$	16,208,439
Notes payable assumed		24,347,299
Purchase price	$	40,555,738

The allocation of the net purchase price for the Mid-Maine acquisition is as follows:

	July 3, 2006
Cash	$	208,399
Other current assets		3,536,833
Property and equipment		20,167,479
Intangible assets		10,700,606
Goodwill		15,138,442
Other assets		2,367,842
Current liabilities		(3,074,876	)
Other liabilities		(8,488,987	)
Purchase price	$	40,555,738

8

The intangible assets at time of acquisition included regulated and unregulated customer based assets fair valued at $8.8 million which have remaining lives of 25 years. The customer base assets are being amortized over a 15 year life. Also, intangible assets included a non-competition agreement fair valued at $1.8 million which had a remaining life of 2 years.

Concurrent with the closing of the acquisition, the Company 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 to the agreement and General Electric Capital Corporation as a lender and agent for the lenders. The credit facilities under the amended and restated credit agreement are comprised of:

· Term loans of $120 million due July 3, 2011, consisting of an original term loan of $80 million, and an additional term loan of $40 million, used to finance the acquisition and related transaction costs and to provide working capital for the Company and its subsidiaries and for other corporate purposes; and

· A revolving loan commitment of up to $15 million.

The term loan facility was fully drawn concurrent with closing. Interest rates applicable to the term loan and any revolving loans are an index rate plus 2.25% or LIBOR plus 3.25%. In addition, there are fees associated with undrawn revolver balances and certain annual fees. The Company has an $80 million interest rate cap through December 16, 2009 which caps LIBOR plus 3.25% margin at 6.25%.

The acquisition was accounted for using the purchase method of accounting and accordingly, the accompanying financial statements include the financial position and results of operations from the date of acquisition.

The following unaudited pro forma information presents the combined results of operations of the Company as though the acquisition of Mid-Maine had occurred at the beginning of the preceding year. The results include certain adjustments, including increased interest expense on notes payable and increased amortization expense related to intangible assets. The pro forma financial information does not necessarily reflect the results of operations had the acquisition been completed at the beginning of the period or those which may be obtained in the future.

	Unaudited			Unaudited
	Three months ended			Nine months ended
	September 30, 2006			September 30, 2006
Revenues	$	17,309,107		$	51,737,343
Income from operations		5,123,399			14,006,173
Net income (loss)		(392,426	)		1,063,341
Basic net income (loss) per share	$	(0.04	)	$	0.11
Diluted net income (loss) per share	$	(0.04	)	$	0.10

7. Long-Term Debt

On July 3, 2006, the Company amended and restated its term credit facility with General Electric Capital Corporation dated as of December 21, 2004 on July 3, 2006, increasing the balance from $80 million to $120 million and extending its maturity from December 21, 2009 to July 3, 2011. On July 13, 2007, the Company amended that agreement to, among other things, reduce the margin it pays on the loan to vary with the Company’s total leverage ratio. In addition, the maximum term loan commitment under the amended and restated credit facility was reduced to $64,646,968.

9

Long-term notes payable consists of the following:

	December 31,		September 30,
	2006		2007
Term credit facility, General Electric Capital Corporation;
variable interest rate of 8.62% and 7.11% at December 31, 2006 and
September 30, 2007, respectively. There are no principal payments.
Interest payments are due on the last day of each LIBOR period or at
three month intervals, whichever date comes first. Interest rate is the
index rate plus the applicable term loan index margin or the
applicable LIBOR rate plus the applicable term loan LIBOR margin.
On July 3, 2007, the Company repaid $55,353,032 in senior debt
with the proceeds from its offering of 3,000,000 Income Deposit
Securities (IDS). The unpaid balance will be due on July 3, 2011	$	120,000,000	$	64,646,968
13% Senior subordinated notes, due 2019; interest payments
are due quarterly. On July 3, 2007, the Company sold
3,000,000 IDS units that included $22,500,000 in senior
subordinated debt and, $1,830,791 in premium paid for
debt. Premium amortization for the three months ended
September 30, 2007 was $16,533		72,575,498		96,889,756
13% Senior subordinated notes, held seperately, due 2019;
interest payments are due quarterly		8,500,000		8,500,000
Total long-term notes payable	$	201,075,498	$	170,036,724
Less: current portion		-		-
Long-term notes payable	$	201,075,498	$	170,036,724

Associated with these long-term notes payable, the Company wrote off $1.0 million in deferred financing costs associated with the payoff of the CoBank notes payable on December 21, 2004 and capitalized $8.1 million in deferred financing costs associated with the new credit facility and the 13% senior subordinated notes. On July 3, 2006, an additional $1,545,743 in deferred financing costs was capitalized. The credit facility is secured by the total assets of the Company.

The Company has a revolving credit facility of $15,000,000 available as of December 21, 2004. There was no balance as of December 31, 2006 and September 30, 2007. The interest rate is the index rate plus a 2.25% margin or LIBOR rate, plus a 3.25% margin, whichever is applicable. The Company pays a commitment fee of 0.50% per annum, payable quarterly in arrears, on the unused portion of the revolver loan. The commitment fee expense was $95,104 and $56,875 for the years ended December 31, 2006 and for the nine months ended September 30, 2007, respectively.

The deferred financing costs related to the issuance of debt is capitalized and amortized over the life of the debt obligation. Amortization of deferred financing costs is reflected in interest expense. The amortization of deferred financing costs also includes unamortized loan cost that was expensed due to the related debt being extinguished. The unamortized loan cost that was expensed and included in interest expense for both the three months and nine months ended September 30, 2006 and 2007 was $215,082 and $1,064,526, respectively.

Maturities of long-term debt for the next five years are as follows:

2007	$	-
2008		-
2009		-
2010		-
2011		64,646,968
Thereafter		105,389,756
Total	$	170,036,724

The above schedule of maturities of long-term debt excludes the $4.1 million liquidation value of Class B common shares convertible into senior subordinated notes in the mezzanine section of the consolidated balance sheet.

10

8.  Subsidiary Guarantees

The Company has no independent assets or operations separate from its operating subsidiaries. The guarantees of its senior subordinated notes by five of its seven 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 September 30, 2007 and December 31, 2006; condensed consolidating statements of income for the three months ended September 30, 2007 and September 30, 2006; condensed consolidating statements of income for the nine months ended September 30, 2006 and September 30, 2007; and condensed consolidating statements of cash flows for the nine months ended September 30, 2007 and September 30, 2006.

Otelco Inc.

Condensed Consolidating Balance Sheet

September 30, 2007

			Guarantor			Non-Guarantor
	Parent		Subsidiaries			Subsidiaries			Eliminations			Consolidated
ASSETS
Current assets
Cash and cash equivalents	$	-	$	17,519,402		$	45,651		$	-		$	17,565,053
Accounts receivable, net		60,801		6,147,411			1,252,361			-			7,460,573
Materials and supplies		-		917,626			1,008,628			-			1,926,254
Prepaid and other current assets		24,684		489,506			52,230			-			566,420
Deferred income taxes		832,946		-			-			-			832,946
Investment in subsidiaries		86,453,730		-			-			(86,453,730	)		-
Intercompany receivables		75,109,153		-			-			(75,109,153	)		-
Total current assets		162,481,314		25,073,945			2,358,870			(161,562,883	)		28,351,246
Property and equipment, net		-		39,792,759			15,622,556			-			55,415,315
Goodwill		-		136,507,075			(1,936,640	)		-			134,570,435
Intangibles assets, net		-		6,543,852			3,427,428			-			9,971,280
Investments		1,000		887,059			325,187			-			1,213,246
Other long-term assets		9,643,677		(503,524	)		-			-			9,140,153
Total assets	$	172,125,991	$	208,301,166		$	19,797,401		$	(161,562,883	)	$	238,661,675
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities
Accounts payables and accrued expenses	$	6,809,252	$	2,269,080		$	1,478,168		$	-		$	10,556,500
Intercompany payables		-	$	60,874,788			14,234,365			(75,109,153	)		-
Other current liabilities		-		2,189,472			97,098			-			2,286,570
Total current liabilities		6,809,252		65,333,340			15,809,631			(75,109,153	)		12,843,070
Deferred income taxes		4,728,411		17,544,383			2,506,140			-			24,778,934
Other liabilities		-		187,867			-			-			187,867
Long-term notes payables		129,773,248		40,263,476			-			-			170,036,724
Derivative liability		1,383,679		0			-			-			1,383,679
Class B common convertible to senior subordinated notes		4,085,033		0			-			-			4,085,033
Stockholders' equity (deficit)		25,346,368		84,972,100			1,481,630			(86,453,730	)		25,346,368
Total liabilities and stockholders' equity (deficit)	$	172,125,991	$	208,301,166		$	19,797,401		$	(161,562,883	)	$	238,661,675

11

Otelco Inc.

Condensed Consolidating Balance Sheet

December 31, 2006

			Guarantor		Non-Guarantor
	Parent		Subsidiaries		Subsidiaries			Eliminations			Consolidated
ASSETS
Current assets
Cash and cash equivalents	$	-	$	14,376,843	$	25,006		$	-		$	14,401,849
Accounts receivable, net		21,028		6,050,195		1,038,770			-			7,109,993
Materials and supplies		-		847,045		1,115,893			-			1,962,938
Prepaid and other current assets		3,487		1,006,316		53,144			-			1,062,947
Deferred income taxes		766,225		-		-			-			766,225
Investment in subsidiaries		75,751,926		-		-			(75,751,926	)		-
Intercompany receivables		34,232,103		-		-			(34,232,103	)		-
Total current assets		110,774,769		22,280,399		2,232,813			(109,984,029	)		25,303,952
Property and equipment, net		-		42,745,710		17,748,079			-			60,493,789
Goodwill		-		136,118,949		(1,936,640	)		-			134,182,309
Intangibles assets, net		0		7,689,851		3,650,955			-			11,340,806
Investments		1,000		914,063		325,187			-			1,240,250
Other long-term assets		10,589,917		701,264		-			-			11,291,181
Total assets	$	121,365,686	$	210,450,236	$	22,020,394		$	(109,984,029	)	$	243,852,287
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payables and accrued expenses	$	4,924,962	$	3,081,839	$	1,233,497		$	-		$	9,240,298
Intercompany payables		-		15,495,558		18,736,545			(34,232,103	)		-
Other current liabilities		-		2,238,188		79,009			-			2,317,197
Total current liabilities		4,924,962		20,815,585		20,049,051			(34,232,103	)		11,557,495
Deferred income taxes		4,661,690		17,544,383		2,506,140			-			24,712,213
Other liabilities		-		187,037		-			-			187,037
Long-term notes payables		105,458,990		95,616,508		-			-			201,075,498
Derivative liability		2,107,877		-		-			-			2,107,877
Class B common convertible to senior subordinated notes		4,085,033		-		-			-			4,085,033
Stockholders' equity (deficit)		127,134		76,286,723		(534,797	)		(75,751,926	)		127,134
Total liabilities and stockholders' equity (deficit)	$	121,365,686	$	210,450,236	$	22,020,394		$	(109,984,029	)	$	243,852,287

Otelco Inc.

Condensed Consolidated Statement of Income

For the Three Months Ended September 30, 2007

				Guarantor			Non-Guarantor
	Parent			Subsidiaries			Subsidiaries			Eliminations			Consolidated
Revenue	$	728,372		$	15,719,069		$	3,301,431		$	(2,154,570	)	$	17,594,302
Operating expenses		(728,372	)		(11,453,838	)		(2,449,688	)		2,154,570			(12,477,328	)
Income from operations		-			4,265,231			851,743			-			5,116,974
Other income (expense)		(4,178,399	)		(1,212,087	)		(1	)		-			(5,390,487	)
Earnings from subsidiaries		3,904,886			-			-			(3,904,886	)		-
Income before income tax and accretion expense		(273,513	)		3,053,144			851,742			(3,904,886	)		(273,513	)
Income tax expense		(394,197	)		-			-			-			(394,197	)
Accretion of class B common convertible
to senior subordinated notes		-			-			-			-			-
Net income (loss) to common stockholders	$	(667,710	)	$	3,053,144		$	851,742		$	(3,904,886	)	$	(667,710	)

12

Otelco Inc.

Condensed Consolidated Statement of Income

For the 3 Months Ended September 30, 2006

				Guarantor			Non-Guarantor
	Parent			Subsidiaries			Subsidiaries			Eliminations			Consolidated
Revenue	$	674,130		$	15,288,099		$	2,998,694		$	(1,823,950	)	$	17,136,973
Operating expenses		(584,787	)		(10,835,769	)		(2,400,894	)		1,823,950			(11,997,500	)
Income from operations		89,343			4,452,330			597,800			-			5,139,473
Other income (expense)		(3,187,114	)		(2,258,166	)		50,403			-			(5,394,877	)
Earnings from subsidiaries		3,286,918			-			-			(3,286,918	)		-
Income before income tax and accretion expense		189,147			2,194,164			648,203			(3,286,918	)		(255,404	)
Income tax expense		(443,176	)		444,551			-			-			1,375
Accretion of class B common convertible
to senior subordinated notes		(110,732	)		-			-			-			(110,732	)
Net income (loss) to common stockholders	$	(364,761	)	$	2,638,715		$	648,203		$	(3,286,918	)	$	(364,761	)

Otelco Inc.

Condensed Consolidated Statement of Income

For the Nine Months Ended September 30, 2007

				Guarantor			Non-Guarantor
	Parent			Subsidiaries			Subsidiaries			Eliminations			Consolidated
Revenue	$	2,216,258		$	46,588,191		$	9,465,209		$	(6,384,763	)	$	51,884,895
Operating expenses		(2,216,258	)		(34,328,561	)		(7,448,770	)		6,384,763			(37,608,826	)
Income from operations		-			12,259,630			2,016,439			-			14,276,069
Other income (expense)		(11,689,383	)		(3,574,251	)		(12	)		-			(15,263,646	)
Earnings from subsidiaries		10,701,806			-			-			(10,701,806	)		-
Income before income tax and accretion expense		(987,577	)		8,685,379			2,016,427			(10,701,806	)		(987,577	)
Income tax expense		97,079			-			-			-			97,079
Accretion of class B common convertible
to senior subordinated notes		-			-			-			-			-
Net income (loss) to common stockholders	$	(890,498	)	$	8,685,379		$	2,016,427		$	(10,701,806	)	$	(890,498	)

Otelco Inc.

Condensed Consolidated Statement of Income

For the Nine Months Ended September 30, 2006

				Guarantor			Non-Guarantor
	Parent			Subsidiaries			Subsidiaries			Eliminations			Consolidated
Revenue	$	1,931,388		$	36,936,655		$	6,166,168		$	(4,826,028	)	$	40,208,183
Operating expenses		(1,932,694	)		(24,007,582	)		(4,375,217	)		4,826,028			(25,489,465	)
Income from operations		(1,306	)		12,929,073			1,790,951			-			14,718,718
Other income (expense)		(9,435,791	)		(1,836,498	)		50,403.0000			-			(11,221,886	)
Earnings from subsidiaries		13,378,480			-			-			(13,378,480	)		-
Income before income tax and accretion expense		3,941,383			11,092,575			1,841,354			(13,378,480	)		3,496,832
Income tax expense		(1,675,786	)		444,551			-			-			(1,231,235	)
Accretion of class B common convertible
to senior subordinated notes		(332,195	)		-			-			-			(332,195	)
Net income (loss) to common stockholders	$	1,933,402		$	11,537,126		$	1,841,354		$	(13,378,480	)	$	1,933,402

13

Otelco Inc.

Condensed Consolidating Statement of Cash Flows

For the Nine Months Ended September 30, 2007

				Guarantor			Non-Guarantor
	Parent			Subsidiaries			Subsidiaries			Eliminations			Consolidated
Cash flows from operating activities:
Net income (loss)	$	(890,498	)	$	8,685,379		$	2,016,427		$	(10,701,806	)	$	(890,498	)
Adjustment to reconcile net income (loss)
to cash flows from operating activities		1,054,855			8,863,229			3,312,318			-			13,230,402
Changes in assets and liabilities, net of
assets and liabilities acquired		(41,288,005	)		44,410,203			(4,418,488	)		-			(1,296,290	)
Cash flows from investing activities		(121,090	)		(3,370,039	)		(889,612	)		-			(4,380,741	)
Cash flows from financing activities		41,244,738			(55,446,213	)		-			10,701,806			(3,499,669	)
Net increase (decrease) in cash and cash equivalents		-			3,142,559			20,645			-			3,163,204
Cash and cash equivalents, beginning of period		-			14,376,843			25,006			-			14,401,849
Cash and cash equivalents, end of period	$	-		$	17,519,402		$	45,651		$	-		$	17,565,053

Otelco Inc.

Condensed Consolidating Statement of Cash Flows

For the Nine Months Ended September 30, 2006

				Guarantor			Non-Guarantor
	Parent			Subsidiaries			Subsidiaries			Eliminations			Consolidated
Cash flows from operating activities:
Net income (loss)	$	1,933,402		$	11,537,126		$	1,841,354		$	(13,378,480	)	$	1,933,402
Adjustment to reconcile net income (loss)
to cash flows from operating activities		1,568,132			3,359,112			1,748,073			-			6,675,317
Changes in assets and liabilities, net of
assets and liabilities acquired		13,749,947			(14,537,997	)		5,884,224			-			5,096,174
Cash flows from investing activities		(461,953	)		(6,893,747	)		(9,468,189	)		-			(16,823,889	)
Cash flows from financing activities		(16,789,528	)		15,652,701			-			13,378,480			12,241,653
Net increase (decrease) in cash and cash equivalents		-			9,117,195			5,462			-			9,122,657
Cash and cash equivalents, beginning of period		-			5,511,939			57,294			-			5,569,233
Cash and cash equivalents, end of period	$	-		$	14,629,134		$	62,756		$	-		$	14,691,890

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

Overview

General

Since 1999, we have acquired and operate six rural local exchange carriers (RLEC) operating in eleven counties in approximately 2,390 square miles of north central Alabama, central Maine and central Missouri. We are the sole wireline telephone services provider in the rural communities we serve. We also provide competitive telecommunications services through several subsidiaries. Our services include local and long distance telephone, network access, transport, digital high-speed and dial-up Internet access, cable television and other telephone related services. 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 September 30, 2007, we operated approximately 67,263 access line equivalents.

Our core businesses are local and long distance telephone services and the provision of network access to other wireline and wireless carriers for calls originated or terminated on our network. Our core businesses generated approximately 74% of our total revenues in both the third quarter and first nine months of 2007. We also provide cable television service in some markets and dial-up and digital high-speed Internet access in all of our markets.

14

The following discussion and analysis should be read in conjunction with our financial statements and the related notes included in Item 1 of 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, long distance services, 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 in our local communities. A growing portion of our subscribers take bundled service plans which include multiple services including domestic long distance services.

· 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, Maine and Missouri are based on rates approved by the Alabama Public Service Commission (“APSC”), Maine Public Utilities 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 Alabama and Missouri. We will begin offering high definition and digital video recording services in Alabama in fourth quarter 2007.

· Internet services. We receive revenues from monthly recurring charges for dial-up and digital high-speed Internet access, including dial-up customers throughout the State of Maine and in areas surrounding our Missouri service area.

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

Access Line and Customer Trends

The number of traditional access lines served is one of the fundamental factors 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. Our competitive carrier access lines continue to grow as we further penetrate our chosen markets. The introduction of unlimited calling bundles may positively impact customer churn over time. 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.

15

Subscriber Metrics

					March 31,		June 30,		September 30,
	2005		2006		2007		2007		2007
Access line equivalents (1):
Residential access lines		24,541		29,832		29,789		29,483		29,156
Business access lines		8,036		22,171		22,577		23,537		24,122
Access lines		32,577		52,003		52,366		53,020		53,278
Digital high-speed lines		6,314		11,951		12,960		13,353		13,845
Total access line equivalents		38,891		63,954		65,326		66,373		67,123
Long distance customers		14,438		21,370		22,066		22,358		22,420
Cable television customers		4,220		4,188		4,211		4,187		4,170
Dial-up Internet customers		12,149		19,587		18,313		17,220		16,263

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

Access lines increased 0.5% during third quarter 2007 and 2.5% year-to-date 2007, with 53,278 access lines in service as of September 30, 2007. Our digital high-speed Internet customers continue to grow, increasing 3.7% for third quarter 2007 from 13,353 subscribers at June 30, 2007, to 13,845 at September 30, 2007. Nearly 32% of our RLEC access lines also have digital high-speed Internet service. Access line equivalents increased 1.1% during third quarter 2007 and 5.0% year-to-date 2007, with 67,123 access line equivalents in service as of September 30, 2007. The primary factors in the growth in access lines and access line equivalents is the increase in digital high-speed lines across all of our operating areas and the increase in business access lines in Maine.

In 2006, we introduced bundled service packages including unlimited domestic calling to our Alabama residential and all Missouri customers. As of September 30, 2007, over 8,500 customers benefit from one of these packages representing over 35% of the offered base. Our long distance customers increased to 22,420 during third quarter 2007 for year-to-date growth of 4.9%. Our cable television customers declined slightly to 4,170. High definition and digital video services are being introduced in Alabama during fourth quarter 2007. Dial-up Internet customers decreased 5.6% to 16,263 during third quarter 2007 and 17.0% year-to-date 2007. This change includes the subscribers we serve outside of our telephone service area in Missouri and throughout Maine and will continue to reflect the expected impact of the shift to digital high-speed Internet services.

Our Rate and Pricing Structure

Our Alabama companies are regulated under the Alabama Communications Reform Act of 2005 (“ACRA”). State regulation under the provisions of ACRA began October 31, 2006 for new services and on February 1, 2007 for existing services. Regulation under ACRA eliminates the APSC’s jurisdiction over retail telephone rates and service terms, with the exception of limited authority to enforce a statutory cap on certain non-bundled basic residential and business service and optional calling features. APSC retains jurisdiction over interconnection agreements, access charges and other wholesale arrangements. The APSC retains exclusive jurisdiction over residential service complaints but its authority is limited to enforcing the terms of service agreements and federal truth in billing requirements.

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.

16

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 uncollectible accounts; 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, such as non-compete agreements and customer lists.

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 September 30,						Nine Months Ended September 30,
	2006			2007			2006			2007
Revenues
Local services		37.1	%		37.0	%		37.2	%		37.3	%
Network access		38.1			37.6			41.9			37.0
Cable television		3.2			3.1			4.1			3.2
Internet		16.2			16.3			14.5			16.5
Transport services		5.4			6.0			2.3			6.0
Total revenues		100.0	%		100.0	%		100.0	%		100.0	%
Operating expenses
Cost of services and products		35.8	%		36.0	%		31.1			36.9
Selling, general and administrative expenses		14.3			15.2			13.9			14.6
Depreciation and amortization		19.9			19.7			18.4			21.0
Total operating expenses		70.0			70.9			63.4			72.5
Income from operations		30.0			29.1			36.6			27.5
Other income (expense)
Interest expense		(32.8	)		(33.2	)		(36.7	)		(32.1	)
Change in fair value of derivative		0.1			1.0			0.8			1.3
Other income		1.2			1.5			8.0			1.4
Total other expense		(31.5	)		(30.7	)		(27.9	)		(29.4	)
Income before income taxes		(1.5	)		(1.6	)		8.7			(1.9	)
Income tax expense		0.0			(2.2	)		(3.1	)		0.2
Income before accretion expense		(1.5	)		(3.8	)		5.6			(1.7	)
Accretion of Class B common convertible to senior subordinated notes		(0.6	)		0.0			(0.8	)		-
Net income available to common stockholders		(2.1	)%		(3.8	)%		4.8	%		(1.7	)%

Three months and nine months ended September 30, 2007 compared to three months and nine months ended September 30, 2006

Total Revenues. Total revenues increased 2.7% in the three months ended September 30, 2007 to $17.6 million from $17.1 million in the three months ended September 30, 2006. Total revenues increased 29.0% in the nine months ended September 30, 2007 to $51.9 million from $40.2 million in the nine months ended September 30, 2006. The primary reason for the nine month increase is the acquisition of Mid-Maine as of July 3, 2006. The tables below provide the components of our revenues for the three months and nine months ended September 30, 2007 compared to the same period of 2006.

17

For the three months ended September 30, 2007 and 2006 

	Three Months Ended September 30,				Change
	2006		2007		Amount			Percent
	(dollars in thousands)
Local service	$	6,363	$	6,502	$	139			2.2	%
Network access		6,534		6,612		78			1.2
Cable television		551		547		(4	)		(0.7	)
Internet		2,766		2,867		101			3.7
Transport Services		923		1,066		143			15.5
Total	$	17,137	$	17,594	$	457			2.7

Local services. Local services revenue increased 2.2% to $6.5 million in the three months ended September 30, 2007 from $6.4 million in the three months ended September 30, 2006. Mid-Maine CLEC revenue grew $0.2 million and long distance revenue grew in all companies, partially offset by lower RLEC basic service revenue, reflecting a decrease in access lines. Unlimited calling bundles in Alabama and Missouri represent 35% and 34% respectively of the relevant customer base.

Network access. Network access revenue increased 1.2% to $6.6 million in the three months ended September 30, 2007 from $6.5 million in the three months ended September 30, 2006. The increase is driven by an increase in switched access revenue in Missouri associated with the growth in unlimited long distance plans.

Cable television. Cable television revenue remained constant at just over $0.5 million in the three months ended September 30, 2007 and the three months ended September 30, 2006.

Internet. Internet revenue increased 3.7% to $2.9 million in the three months ended September 30, 2007 from $2.8 million in the three months ended September 30, 2006. The increase reflects growth of more than 2,500 new digital high-speed Internet customers and increased CLEC internet business bandwidth which more than offset the decline in dial-up Internet customers associated with the conversion to digital high-speed Internet.

Transport Services. Transport services revenue increased 15.5% to $1.1 million in the three months ended September 30, 2007 from $0.9 million in the three months ended September 30, 2006. The increase is attributable to growth in wide area network transport services in Maine.

For the nine months ended September 30, 2007 and 2006

	Nine Months Ended September 30,				Change
	2006		2007		Amount		Percent
	(dollars in thousands)
Local service	$	14,957	$	19,381	$	4,424		29.6	%
Network access		16,849		19,191		2,342		13.9
Cable television		1,632		1,643		11		0.7
Internet		5,847		8,547		2,700		46.2
Transport services		923		3,123		2,200		238.4
Total	$	40,208	$	51,885	$	11,677		29.0

Local services. Local services revenue in the nine months ended September 30, 2007 increased 29.6% to $19.4 million from $15.0 million for the nine months ended September 30, 2006. The addition of Mid-Maine and the continued growth in Maine CLEC business customers accounted for an increase of $4.9 million. Our Alabama and Missouri local services revenue decreased $0.4 million, reflecting a decrease in access lines, partially offset by the increased feature and long distance revenue associated with bundled service offerings.

18

Network access. Network access revenue in the nine months ended September 30, 2007 increased 13.9% to $19.2 million from $16.8 million in the nine months ended September 30, 2006. The addition of Mid-Maine accounted for an increase of $2.5 million. An increase in Missouri switched access, a decrease in Alabama switched access, and a decline in universal service fund payments in Missouri accounted for a decrease of $0.2 million.

Cable television. Cable television remained constant at just over $1.6 million in the nine months ended September 30, 2007 and the nine months ended September 30, 2006.

Internet. Internet revenue in the nine months ended September 30, 2007 increased 46.2% to $8.5 million from $5.8 million in the nine months ended September 30, 2006. The addition of Mid-Maine and the continued growth in CLEC internet business bandwidth accounted for an increase of $2.3 million. The addition of more than 1,900 new digital high-speed Internet customers in Alabama and Missouri generated $0.8 million, partially offset by $0.4 million associated with the decline in Alabama and Missouri dial-up Internet customers resulting from the conversion to digital high-speed Internet.

Transport services. Transport services revenue increased 238.4% to $3.1 million in the nine months ended September 30, 2007 from $0.9 million in the nine months ended September 30, 2006. The increase is attributable to the acquisition of Mid-Maine and the continued growth in wide area network transport services in Maine.

Operating expenses. Operating expenses in the three months ended September 30, 2007 increased 4.0% to $12.5 million from $12.0 million in the three months ended September 30, 2006. Operating expenses in the nine months ended September 30, 2007 increased 47.5% to $37.6 million from $25.5 million in the nine months ended September 30, 2006. The nine month increase is primarily attributable to the acquisition of Mid-Maine as of July 3, 2006.

For the three months ended September 30, 2007 and 2006

	Three Months Ended September 30,				Change
	2006		2007		Amount		Percent
	(dollars in thousands)
Cost of services	$	6,139	$	6,326	$	187		3.0	%
Selling, general and administrative expenses		2,451		2,676		225		9.2
Depreciation and amortization		3,407		3,475		68		2.0
Total	$	11,997	$	12,477	$	480		4.0

Cost of services and products. Cost of service and products increased 3.0% to $6.3 million in the three months ended September 30, 2007 from $6.1 million in the three months ended September 30, 2006. Costs associated with higher CLEC revenue in Maine and increased long distance customers in Missouri were partially offset by improved network efficiency and Internet help desk cost reductions.

Selling, general and administrative expenses. Selling, general and administrative expenses increased 9.2% to $2.7 million in the three months ended September 30, 2007 from $2.5 million in the three months ended September 30, 2006. Legal and due diligence costs and an increase in operating taxes were the cause of the increase.

Depreciation and amortization. Depreciation and amortization increased 2.0% to $3.5 million in the three months ended September 30, 2007 from $3.4 million in the three months ended September 30, 2006. The increase is associated with higher depreciation and amortization in Maine, partially offset by lower depreciation expense in Alabama.

19

For the nine months ended September 30, 2007 and 2006

	Nine Months Ended September 30,				Change
	2006		2007		Amount		Percent
			(dollars in thousands)
Cost of services	$	12,501	$	19,131	$	6,630		53.0	%
Selling, general and administrative expenses		5,604		7,598		1,994		35.6
Depreciation and amortization		7,384		10,880		3,496		47.3
Total	$	25,489	$	37,609	$	12,120		47.5

Cost of services and products. Cost of services and products increased 53.0% to $19.1 million in the nine months ended September 30, 2007 from $12.5 million in the nine months ended September 30, 2006. The addition of Mid-Maine accounted for $6.4 million of the increase. The balance of $0.2 million reflects the increased cost associated with additional digital high-speed Internet customers and bundled long distance services usage in Alabama and Missouri, partially offset by savings from handling our Internet help desk internally and by network and organizational efficiencies.

Selling, general and administrative expenses. Selling, general and administrative expenses increased 35.6% to $7.6 million in the nine months ended September 30, 2007 from $5.6 million in the nine months ended September 30, 2006. The acquisition of Mid-Maine accounted for $1.6 million of the increase. Corporate legal and external affairs costs and operating taxes accounted for the balance of the increase.

Depreciation and amortization. Depreciation and amortization increased 47.3% to $10.9 million in the nine months ended September 30, 2007 from $7.4 million in the nine months ended September 30, 2006. An increase of $3.3 million is associated with the acquisition of Mid-Maine, including the amortization of intangibles of $8.8 million for customer based assets with an effective life of 15 years and $1.8 million for a non-competition agreement with a remaining life of nine months; and a telephone plant adjustment associated with the purchase price allocation. The balance of $0.2 million is associated with higher depreciation in Alabama and Missouri.

Interest expense. Interest expense increased 3.9% to $5.8 million in the three months ended September 30, 2007 from $5.6 million in the three months ended September 30, 2006. Interest expense increased 12.7% to $16.6 million in the nine months ended September 30, 2007 from $14.8 million in the nine months ended September 30, 2006. On July 5, 2007, the Company completed its offering of 3,000,000 Income Deposit Securities (IDS) units, increasing the associated senior subordinated debt by $22.5 million to approximately $103.6 million. The Company used the net proceeds of approximately $55.4 million to repay senior secured indebtedness under its credit facility, reducing senior debt from $120.0 million to approximately $64.6 million. Total debt was reduced from approximately $201.1 million to $168.2 million. The unamortized balance of loan costs of $1.1 million associated with the repaid indebtedness is reflected as interest in the quarter ending September 30, 2007, compared to $0.2 million in the quarter ending September 30, 2006. Interest expense is reduced by the amortization of the associated bond premium.

On July 13, 2007, the Company entered into a first amendment to its amended and restated credit agreement dated July 3, 2006. Among other things, the amendment reduced the applicable margins on the interest rates under the credit agreement, initially reducing the applicable LIBOR margin from 3.25% to 1.75% on the $64.6 million of senior debt. After September 30, 2007, the margins adjust quarterly on a prospective basis based on the total leverage ratio of the Company but never exceed 2.5%.

Change in fair value of derivative. 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 our 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 reduced the fair value of the Class B derivative by $0.2 million and $0.4 million more in the three months and nine months ended September 30, 2007 than in the three months and nine months ended September 30, 2006. The repayment of senior indebtedness in July 2007 reduced senior debt below the $80 million level of our 3% three month LIBOR rate cap through 2009. The $15.4 million balance of the rate cap is no longer an effective hedge to interest costs and is considered an investment. The change in fair value of the ineffective portion of the rate cap increased in value $0.1 million during third quarter 2007.

20

Other income. Other income increased to $0.3 million in the three months ended September 30, 2007, up from $0.2 million in the three months ended September 30, 2006. Other income decreased to $0.7 million in the nine months ended September 30, 2007, down from $3.2 million in the nine months ended September 30, 2006. In 2006, we reflected a one time gain of $2.7 million associated with the redemption of Rural Telephone Bank (RTB) stock owned by three of our companies. The balance of the change is related to higher interest income on higher cash balances and the income from the ineffective portion of the $80 million, 3%, three month LIBOR rate cap which is considered an investment rather than a reduction to interest expense.

Income taxes. Provision for income taxes was an expense of $0.4 million and a benefit of $0.1 million, respectively, in the three months and nine months ended September 30, 2007 compared to an expense of $1.2 million and no expense/benefit, respectively, in the three months and nine months ended September 30, 2006 reflecting the net loss for both periods in 2007. The RTB gain in 2006 was the primary driver of net income before taxes which resulted in the tax expense for 2006.

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 was accreted as a non-cash expense to the Company. The process was completed in 2006, resulting in no charges in 2007.

Net income (loss). As a result of the foregoing, there was a net loss of $0.7 million and $0.9 million available to common stockholders, respectively, in the three months and nine months ended September 30, 2007 compared to a net loss of $0.4 million and net income of $1.9 million, respectively, in the three months and nine months ended September 30, 2006.

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 nine months of 2007 amounted to $11.0 million compared to $13.3 million for the first nine months of 2006. The decrease is primarily attributable to the interest expense associated with the acquisition of Mid-Maine in 2006.

Cash flows from investing activities in the first nine months of 2007 used $4.4 million compared to using $16.4 million in the first nine months of 2006. The acquisition and construction of property and equipment utilized $0.7 million more in the first nine months of 2007 than in the same period of 2006, reflecting higher expenditures associated with the Mid-Maine acquisition. The balance reflected the one-time gain on the liquidation of RTB stock and the acquisition of Mid-Maine in 2006.

Cash flows from financing activities for the first nine months of 2007 used $3.5 million compared to generating $12.2 million for the first nine months of 2006. In addition to reflecting payments of dividends to shareowners in both periods, the 2007 results reflect the completion of offering 3,000,000 shares and the resultant changes in senior and subordinated debt while the 2006 results reflect the acquisition of Mid-Maine and its financing. Dividends for third quarter 2007 and 2006 were paid in October as September 30 fell on a non-bank day.

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.

21

On July 5, 2007, the Company completed its offering of 3,000,000 Income Deposit Securities (IDS) units through an underwritten public offering at $19.80 per unit. The price per unit was comprised of $11.68 allocated to each share of Class A common stock and $8.11 allocated to each senior subordinated note, plus $0.01 representing accrued interest from June 30, 2007. The Company used the net proceeds of approximately $55.4 million to repay senior secured indebtedness under its credit facility, reducing senior debt from $120.0 million to approximately $64.6 million. The $8.11 allocated to each senior subordinated note represents a premium of $0.61 over the $7.50 stated principal amount. The additional IDS units increased senior subordinated debt by $22.5 million, bringing the total senior subordinated debt to approximately $103.6 million. Total debt was reduced from approximately $201.1 million to $170.0 million.

On July 13, 2007, the Company entered into a first amendment to its amended and restated credit agreement dated July 3, 2006. Among other things, the amendment reduced the applicable margins on the interest rates under the credit agreement, initially reducing the applicable LIBOR margin from 3.25% to 1.75% on the $64.6 million of senior debt. After September 30, 2007, the margins adjust quarterly on a prospective basis based on the total leverage ratio of the Company.

The following table discloses aggregate information about our contractual obligations as of September 30, 2007, including scheduled interest and principal for the periods in which payments are due (in millions):

	Total		Less than 1 Year		1-3 years		3-5 years		More than 5 years
Amended and restated credit facility Term	$	64,646,968	$	-	$	-	$	64,646,968	$	-
Revolver (1)		-		-		-		-		-
Senior subordinated notes(2)		107,660,530		-		-		-		107,660,530
Expected interest expense(3)		184,826,577		16,723,650		35,021,807		31,611,070		101,470,050
Total contractual cash obligations	$	357,134,075	$	16,723,650	$	35,021,807	$	96,258,038	$	209,130,580

(1) We have a $15.0 million revolving credit facility with a July 2011 maturity. No amounts were drawn on this facility on September 30, 2007 or during 2007. The company pays a commitment fee of 0.50% per annum, payable quarterly in arrears, on the unused portion of the revolver loan.

(2) Includes $4.1 million liquidation value of Class B common stock convertible into senior subordinated notes and interest on those notes beginning December 21, 2009, the date they can be exchanged for IDSs on a one-for-one basis without passing a financial test. If Class B common were to convert prior to this date, the annual interest on the senior subordinated debt would be $0.5 million.

(3) Expected interest payments to be made in future periods reflect anticipated interest payments related to our $64.6 million senior credit facility and our $107.7 million senior subordinated notes at 13.0%, including those associated with our IDSs and those sold separately. Interest on the senior credit facility reflects a LIBOR three month rate of 5.20% plus a margin of 1.75% through November 30, 2007 and 2.0% thereafter, partially offset by a 3% cap on three month LIBOR for $64.6 million under the credit facility through December 21, 2009. We have assumed in the presentation above that we will hold the senior credit facility until maturity in 2011 and the senior subordinated notes until maturity in 2019. No interest payment is included for the revolving credit facility because of the variability and timing of advances and repayments thereunder.

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. With the repayment of our senior debt as a result of the underwritten public offering, the portion of our $80 million 3% rate cap on three month LIBOR above our current $64.6 million senior credit facility is considered an investment rather than an effective hedge and is treated as such in our financial statements.

22

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 September 30, 2007.

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, 2007 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.

23

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 7, 2007	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